Business Law

In re Hutchinson

The following is a case update analyzing a case of recent interest.

Summary

The motion of the IRS to abandon property was denied because the property is not inconsequential to the bankruptcy estate. The Trustee’s statutory rights to avoid the penalty portion of a tax lien benefits the bankruptcy estate by providing a distribution to unsecured creditors from the avoided and preserved portion of the lien. United States v. Hutchinson, 615 B.R. 596 (E.D. Cal. 2020).

Facts

Leonard and Sonya Hutchinson filed a chapter 7 bankruptcy case. The debtors’ primary residence (the “Property”) is the subject of the dispute. The Property’s market value was estimated at $190,000. The Property was encumbered by a first deed of trust in the amount of approximately $84,000 and five tax liens totaling $412,067.47 which include taxes, interest on taxes, and penalties. The penalty portion of these tax liens totalled $162,690.85.

The Trustee asserted the estate’s interest in avoiding the penalty portion of the tax liens and sought to preserve them for the benefit of the bankruptcy estate pursuant to Sections 724(a) and 522(i), respectively. The government brought a motion to compel abandonment of the Property, arguing that the Property was of little or no value to the estate because no funds would remain to distribute to unsecured creditors if the Property were to be sold. The Trustee opposed the motion, and the bankruptcy judge denied the motion, finding that the Property was not inconsequential to the bankruptcy estate.

The court’s ruling to deny the motion to abandon was premised on the Trustee’s position that the penalty portions of each lien are avoided by operation of the Bankruptcy Code and are set aside for the benefit of unsecured creditors ‘lien-by-lien’ and do not simply pay out the non-avoided portion of the lien next-in-line. Instead, the non-avoidable portion would be treated as secured and the remainder as unsecured subject to “different and potentially disadvantageous treatment by the Trustee.” Because some money would be set aside to disburse to unsecured creditors, the Property was of value to the estate and should not be abandoned. The government appealed.

Reasoning

The Trustee’s duty is to maximize the assets of the estate to allow maximum recovery for creditors and to abandon interest in property of the estate that is burdensome or of inconsequential value. Trustees have power to avoid certain liens, including avoidance of liens to the extent they are a penalty. Penalty portions of avoided liens are preserved for the benefit of the bankruptcy estate for distribution to the unsecured creditors.

A critical point in the court’s analysis under Section 551 was that Congress intended to increase the assets of the bankruptcy estate and prevent junior lienors from improving in position at the expense of the estate when a senior lien is avoided. Without Section 551, the lien next-in-line would receive a windfall by improving the amount of their secured claim, all while the estate incurred the administrative expense to litigate the avoidance of a lien. Because the Trustee “steps into the shoes” of the avoided lienholder and enjoys the same rights as that lienholder enjoyed over competing interests, the lien’s priority remains intact. The amount the Trustee avoided would be set aside for disbursement to unsecured creditors.

The government argued that the total of its five liens including taxes and interest on taxes are priority as a whole before looking at the penalty portions as a whole, meaning the avoided penalty portions would receive distributions only if funds remained following satisfaction of the senior deed of trust and the tax and interest portions of all five secured liens. Under the government’s theory, the Property is of no value to the estate because reducing the property to money will not satisfy these liens.

The Trustee argued that the distribution order of the liens is based on each lien’s seniority according to its recordation dates. The first tax lien’s avoidable penalty portion is preserved for the benefit of the estate and deducted from any sale proceeds while the tax and interest portions of the lien receive a distribution. The process repeats for each additional tax lien until all sale property funds are exhausted. Under this theory, the Property is of value to the estate because its sale will result in some distribution to unsecured creditors.

Penalties accrued by the delinquent taxpayer are meant to punish them. Innocent creditors would be otherwise punished for debtor’s wrongdoings if penalty portions of a tax lien were not avoided and preserved for the benefit of creditors. Instead, the avoided and preserved penalty portions will go to creditors, the estate will be enriched, and the government still receives a distribution for the principal portion of its liens, with interest, in the order and priority of each respective lien.

The government asserts that lien avoidance as outlined above diverts property by paying general unsecured creditors before satisfying actual tax losses. However, the law disfavors penalties, and to the extent these penalties are not compensation for actual pecuniary loss the avoided portions would be a windfall to junior lienholders if not preserved for the benefit of the bankruptcy estate.

Author’s Commentary

The decision of this case seems to be the most equitable to all: the Trustee’s avoidance of the tax penalties protects the unsecured creditors from the debtors’ wrongdoings by allowing creditors to receive a distribution; the lien next-in-line is prevented from receiving a windfall from the avoidance action; the estate is enriched while the government still obtains the principal portion of its liens, with interest, in the order and priority of each respective lien; and the debtors get their discharge. It appears to be a win-win for all, however, an appeal was filed on July 9, 2020, so we shall see if the appellate court agrees.

These materials were written by Todd Turoci of the Turoci Bankruptcy Firm in Los Angeles (todd@theturocifirm.com).  Editorial contributions were provided by William E. Winfield of Nelson Comis Kettle & Kinney LLP, in Oxnard (wwinfield@calattys.com). 

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