U.S. v. Hutchinson/Salven (E.D. Cal.) and IRS v. Baldiga (D. Mass.)

The following is a case update written by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal. Ret.), analyzing a recent decision of interest:

Two recent district court cases, published within a couple months of each other but an entire continent apart, reached the same conclusion about a trustee’s distribution of proceeds recovered under Bankruptcy Code section 551 as a result of the penalty portions of IRS claims being avoided under section 724(a). Both courts concluded that the recovered money should not be used to pay the next in line junior secured creditor, but rather to pay general unsecured claims. United States of America v. Hutchinson/Salven (In re Hutchinson), 615 B.R. 596 (E.D. Cal. 5/4/20); Internal Revenue Service v. Baldiga (In re Baldiga), 2020 WL 4015775 (D. Mass. 7/16/20).

FACTS

In both Hutchinson and Baldiga the chapter 7 debtor owned a personal residence encumbered by a first priority mortgage and a series of secured tax liens filed by the IRS, covering between three and five years of unpaid tax liabilities. In both cases, part of each year’s IRS claim was penalties imposed for nonpayment of assessed taxes; the rest of each year’s claim was principal and interest. In both cases, when the combined tax liens were added to the mortgage the total far exceeded the value of the home; hence, the homes were over encumbered.

Both trustees recognized that the IRS penalties could be avoided under section 724(a), which states “[t]he trustee may avoid a lien that secures a claim of a kind specified in section 726(a)(4)”, which includes a claim based on a penalty. Equally noncontroversial was that the avoided liens were preserved for the benefit of the estate under section 551. The controversy arose over how the recovered funds should be distributed to the estate’s creditors, a question not answered by the statute nor by precedential case law in either Massachusetts or California.

The IRS asserted that once each penalty was avoided, the recovered funds should be paid out to the next in line secured creditor on the homes, in each instance the IRS, which had a principal and interest secured lien for the year following the year each avoided penalty had accrued. As an example (applicable in concept for each case), let’s say the property value is $500,000, with a first mortgage of $350,000, followed by a $100,000 tax lien for 2012 based on $80,000 of principal and interest and an avoidable penalty of $20,000. After the mortgage is paid, then the $80,000 2012 tax lien is paid and the $20,000 penalty recovered, with the trustee sitting in that priority position. Next in line is a 2013 tax lien for another $100,000 (followed by subsequent year tax liens with similar values), made up of $80,000 principal and interest and $20,000 avoidable/recoverable penalties.

The IRS asserted that the trustee must use the $20,000 in recovered penalties to pay the 2013 principal and interest, because it was next in line in the priority structure of the estate. It then followed that after the second tax lien was partially avoided – with all the proceeds eventually ending up in the IRS’s pockets based on this priority scheme – the avoidance and recovery was much to do about nothing: the money just ended up paying the IRS’s claim, with no benefit to the unsecureds. On these facts, in Hutchinson the IRS argued that the trustee had no reason to administer (by way of sale) the over encumbered property and should just abandon it to the debtor and the IRS to sort out their differences, if any. At issue in Baldiga was whether the trustee’s counsel should be compensated for the time spent avoiding and recovering the penalties if it resulted in no benefit to the unsecureds based on all the funds going to the secondary IRS claims anyway. The crux of both arguments was there was no resulting benefit to the estate.

Relying on policy arguments, scant case law, and secondary authorities, the trustees asserted that the junior secured creditors should not receive a windfall as a result of the bad behavior of the debtor which caused the recoverable penalty and that the preserved funds were for the benefit of the estate’s unsecured creditors. The property therefore had consequential value and should not be abandoned. In both instances, the bankruptcy courts agreed with the trustees, finding the property had consequential value for the estate’s unsecureds. The IRS appealed; both district courts affirmed.

REASONING

The district court in Hutchinson recited case law which established that the purpose of section 724(a) was to protect unsecured creditors from the debtor’s wrongdoing. If the result of the penalty avoidance was to put the funds back into the IRS’s hands based on its next in line lien, then the result would be the same as if the penalty was enforced, punishing the entirely innocent creditors for the wrongdoing of the debtor. In re Gill, 574 B.R. 709, 716 (9^th Cir. BAP 2017). The Massachusetts district court also cited Gill and found similar pronouncements in bankruptcy level cases strewn around the country. The Hutchinson decision made analogy to analysis in the renowned treatise Colliers, which asserted that when a lien was avoided under federal law (as was done here under section 724(a) and also could be done under sections 547 and 548), rather than state law, the purpose of the avoidance was for the benefit of the estate, not for the benefit of a junior lienholder who, but for the avoidance, was out of the money in the first place.

Following this sparse authority but firmly asserting that the policy was correct, each district court ruled that the avoidance did not move the IRS junior liens up in priority and the recovered money would go to the unsecureds. The result was the trustee could administer property, resulting in a substantial benefit to the unsecureds who could receive a dividend once the costs of administration were paid.

AUTHOR’S COMMENTS

Trustees’ use of section 724(a) to avoid IRS penalties on a debtor’s residence that otherwise appears over encumbered and therefore of no value to the estate has proven to be a tripping point for debtors and their counsel. The unwary often think that when what is owed on the mortgage and the IRS liens exceeds a home’s value, no chapter 7 trustee will touch the family residence, especially when a homestead exemption is also available. Two things cause this thinking to be flawed. The first is reflected in the outcome of these cases where the debtors could lose their homes since the recovered penalties will flow to the unsecureds, thereby benefitting the estates. (I say “could” because perhaps there is a settlement in the works). The second is borne out by section 522(c)(2)(B), which provides that an exemption is not effective as to a tax lien, such as those held here by the IRS.

Out of this dire outcome—a debtor losing her home—comes these policy-based rulings that the beneficiary of the recovered penalties is the general unsecured creditor body. This seems to me to be entirely the right result. When a debtor’s behavior increases a tax claim beyond just the unpaid tax and interest, the books should not be balanced on the backs of the innocent creditors. If the IRS gets the money anyway based on its subsequent liens, it is these creditors who will be penalized in the end. Moreover, if such penalties could not be recovered to benefit the estate, the trustees could not administer the homes at all, leaving the debtor the ability to negotiate some deal with the IRS by which the home is not lost. In that instance, the existence of the penalty favors, rather than punishes, the delinquent debtors.

These materials were authored by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal. Ret.), a member of the ad hoc group, with editorial contributions by Monique D. Jewett-Brewster, an attorney with Hopkins & Carley, ALC, a member of the ad hoc group and the 2018-19 Chair of the CLA Business Law Section. 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.