Business Law

Matter of Freeman, No. 3:20-BK-10338-DPC, 2023 WL 2665735 (D. Ariz. Mar. 28, 2023)

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The following is a case update written by Reno Fernandez, a bankruptcy appellate specialist with the Complex Appellate Litigation Group LLP, analyzing a recent decision of interest:


On March 28, 2023, the U.S. District Court for the District of Arizona affirmed a bankruptcy court’s decision to allocate sale proceeds pro rata between the tax-and-interest component and the penalty component of a tax lien avoided under Bankruptcy Code § 724(a). Matter of Freeman, No. 3:20-BK-10338-DPC, 2023 WL 2665735 (D. Ariz. Mar. 28, 2023).

To view the opinion, click here.


In a Chapter 7 case, the Trustee sold certain real property for $302,000 free and clear of two tax liens, resulting in net proceeds of $218,917.19.  The senior tax lien was for tax and interest of $256,669.98 and penalties of $106,645.16.  The junior tax lien was irrelevant as all parties agreed it was wholly unsecured.

The parties further agreed that the lien for penalties of $106,645.16 was avoidable under Bankruptcy Code § 724(a), which provides that:  “The trustee may avoid a lien that secures a claim of a kind specified in section 726(a)(4) of this title.”  In turn, Bankruptcy Code § 726(a)(4) identifies claims for fines and penalties, among other similar claims.

Before the bankruptcy court, on cross motions for summary judgment, the Trustee argued that the first $106,645.16 in sale proceeds should go to the estate because a lien avoided under § 724(a) is automatically preserved for the benefit of the estate under Bankruptcy Code § 551.  The United States argued that all of the sale proceeds should go to satisfy the unavoided tax-and-interest portion of its lien.

Invoking Bankruptcy Code § 105(a), the bankruptcy court ordered the sale proceeds to be distributed pro rata between the tax-and-interest and penalty components of the tax lien.  Accordingly, the estate would receive 29.35% of the sale proceeds ($64,252.37), and the Internal Revenue Service would receive 70.65% ($154,664.82).

The United States took an appeal to the district court, which affirmed.  The United States has taken a further appeal to the Ninth Circuit, which is pending.


The district court affirmed.  Key to its reasoning is the scope of avoidance under § 724(a).  Specifically, the district court held that § 724(a) results in avoidance of the entire lien, not just the penalty portion.  The opinion speaks of avoidance of an “undivided lien” and not any particular component of a lien.

Nevertheless, the United States argued for either a priority approach—recognizing that a claim for penalties is subordinate to ordinary claims—or for application of the distribution scheme under § 724(b), which provides for a waterfall of priorities applicable to unavoided tax liens.  Each approach would result in application of all sale proceeds to the government’s claim for non-penalty tax and interest.

However, the district court rejected both approaches. Despite subordination of penalty claims under § 726(a)(4), the court found that the Bankruptcy Code does not provide for subordination of components of an avoided lien, which all have equal priority.  Accordingly, the court rejected the priority approach.  The court also declined to apply § 724(b), noting that it expressly applies only to unavoided tax liens.

Finally, the district court analyzed the bankruptcy court’s application of § 105(a).  The district court determined that an exercise of equitable powers under § 105(a) is proper so long as it is not inconsistent with the terms of the Bankruptcy Code.  Having concluded that no other terms apply, the district court found the bankruptcy court’s pro rata approach was not inconsistent with the Bankruptcy Code.  Accordingly, the district court affirmed.


 The district court’s foundational holding that § 724(a) avoids a tax lien in its entirety, including both tax-and-interest and penalty components alike, is problematic.  The problem is that § 551 preserves an avoided lien for the benefit of the estate.  Accordingly, the estate should step into the government’s shoes with respect to the entire avoided lien.  It is unclear how this can be squared with the pro rata approach of paying some sale proceeds to the government and some to the estate. 

This review was written by Reno Fernandez, a bankruptcy appellate specialist with the Complex Appellate Litigation Group LLP, a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.

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