Dear constituency list members of the Insolvency Law Committee, the following is a case update written by Ethan B. Shakoori, Attorney at Franklin, Soto, Leeds, LLP analyzing a recent case of interest, In re Rios, 649 B.R. 30 (E.D. Wis. 2023).
In Rios, the Bankruptcy Court for the Eastern District of Wisconsin held that the Internal Revenue Service (“IRS”) had an “interest in property” through its federal tax liens on the Chapter 13 Debtors’ (“Debtors”) Social Security benefits. The Bankruptcy Court further held that the absence of any Notice of Federal Tax Lien (“NFTL”) did not affect the viability of the IRS’ federal tax liens against the Debtors, and that the IRS was entitled to relief from the automatic stay because the Debtors failed to adequately protect the IRS’s interest in the Debtors’ Social Security benefits.
To read the full published decision: click here.
According to the proof of claim filed by the IRS, the Debtors owed the IRS a total of $260,611.60 for past due taxes, including a secured claim in the amount of $220,204.28. No NFTL was filed in connection with this claim.
The Debtors reported that most of their combined monthly net income of $2,258 consisted of Social Security benefits. The Debtors proposed a Chapter 13 plan where all of their monthly net income would be used to pay the arrearage on their first mortgage, the arrearage on their second mortgage, a claim secured by the Debtors’ vehicle, a secured claim held by the Wisconsin Department of Revenue, the Chapter 13 Trustee’s fees, and the Debtors’ attorneys’ fees. The Debtors also proposed to pay a $612 priority claim held by the Wisconsin Department of Revenue and the unsecured priority portion of the past due federal taxes owed to the IRS, which the Debtors contended amounted only to $31,716.26. There were no proposed payments to any general unsecured claims or the IRS’s secured claim.
The Debtors objected to the IRS’s proof of claim. The IRS objected to confirmation of the Debtors’ Chapter 13 plan and filed a motion for relief from the automatic stay to implement its right of setoff and/or to enforce it statutory liens against the Debtors’ Social Security benefits. In its motion, the IRS asserted that neither its right of setoff nor its lien interest was adequately protected.
The Bankruptcy Court held that the IRS demonstrated a “colorable” interest in the Debtors’ Social Security benefits and was entitled to adequate protection. Pursuant to Internal Revenue Code § 6321, the IRS obtained a statutory tax lien on “all property and rights to property” of the Debtors at the time the IRS assessed the unpaid taxes. Relying on Supreme Court precedent, the Bankruptcy Court recognized that the Legislature’s use of the term “property” in IRC § 6321 aimed to reach “‘every species of right or interest protected by law and having an exchangeable value.’” Pursuant to IRC §§ 6321-6322, the IRS’s federal tax liens attached even to the Debtors’ rights to receive property in the future.
Although it was undisputed that the IRS did not file a NFTL related to the past due taxes claimed in the IRS’s proof of claim, the failure to file an NFTL did not affect the viability of the tax liens against the Debtors. The absence of a NFTL only affects the validity of the IRS’s tax liens against third parties. See 26 U.S.C. § 6323.
The Bankruptcy Court prophylactically addressed the argument that without a NFTL the exemptions section of the Bankruptcy Code would eliminate the IRS’s lien on the Debtors’ Social Security benefits. Section 522(c)(2) of the Bankruptcy Code states that exempt property is only liable for a debt secured by a tax lien where a notice of federal tax lien is properly filed. However, the Bankruptcy Court reasoned that Social Security benefits are excluded from the Debtors’ bankruptcy estate. See 42 U.S.C. § 407. “[N]o property can be exempted (and thereby immunized) … unless it first falls within the bankruptcy estate.” Owen v. Owen, 500 U.S. 305, 308 (1991). The Debtors’ Social Security benefits could not be exempted under Section 522(c)(2) because they were never a part of the bankruptcy estate. Accordingly, the Bankruptcy Court reasoned that nothing prevented the IRS from retaining its interest in the Debtors’ Social Security benefits.
The Debtors attempted to argue that they did not need to provide adequate protection to the IRS because the IRS is not a secured creditor under 11 U.S.C. § 506(a). The Bankruptcy Court rejected this argument noting that parties in interest are entitled to adequate protection under Section 362(d) and that the Court did not need to determine whether the IRS was a secured creditor to determine it had an interest in the Debtors’ property. The Bankruptcy Court granted the IRS’s motion for relief from stay, holding that the Debtors’ Chapter 13 plan did not adequately protect the IRS’s interest in the Social Security benefits or offer adequate protection to the IRS in exchange for spending its collateral to pay back other creditors.
The IRS’s motion for relief from stay also requested relief so that the IRS could implement its right of setoff as to the Debtors’ Social Security benefits. The Bankruptcy Court, however, declined to be the first court in the country to decide that Social Security benefits could be properly set off against pre-petition tax debt and reiterated that its sole determination was that cause existed to modify the stay to allow the IRS to enforce its statutory liens.
The Bankruptcy Court’s decision in Rios leaves open several questions, including whether social security benefits can be properly set off against pre-petition tax debt and what rights outside of bankruptcy do the Debtors’ other secured creditors have against the IRS given that the IRS failed to file a Notice of Federal Tax Lien. Nonetheless, counsel for debtors should be wary of set off rights when the government is providing income to the debtor and should be aware that they may need to account for secured IRS tax claims for pre-petition taxes, even where a Notice of Federal Tax Lien has not been filed, appreciating that a federal tax lien takes effect when the taxes are assessed. This case illustrates the pervasive effect that federal tax liens have on a debtor’s property. It should not be assumed that federal tax liens apply only to the debtor’s property at the time the bankruptcy petitions are filed. Counsel for debtors and creditors should refer to IRC §§ 6321-6322 to determine when a federal tax lien attaches, even to a debtor’s right to receive property in the future.
These materials were written by Ethan Shakoori, an Attorney at Franklin, Soto, Leeds, LP in San Diego, California (email@example.com). Editorial contributions were provided by Meredith King, an Attorney at Franklin, Soto, Leeds, LP in San Diego, California (firstname.lastname@example.org).