In re: US v. Warfield

Summary

In 2013, the IRS recorded a tax lien against Michael Leite and Andrea Carvalho's real property. In 2019, Leite and Carvalho filed Chapter 7 bankruptcy. The IRS filed a claim for $81,174.13, representing $45,938.99 in taxes and interest and $35,235.14 in penalties. The bankruptcy trustee sold the real property for $38,640.80 and then initiated an adversary proceeding to avoid the lien, arguing the proceeds should be split pro rata between the IRS and the bankruptcy estate. The IRS did not dispute avoidance of the penalty, but it argued the proceeds should pay the tax portion of the lien first. The bankruptcy court allocated the proceeds on a pro rata basis. The district court affirmed. This appeal followed.

Reversed and remanded with instructions. Under 11 U.S.C. Section 724(a), a bankruptcy trustee may avoid a lien that secures penalties to the extent the penalty is not compensation for actual pecuniary loss. After avoidance, Section 551 provides that an avoided lien is automatically preserved for the benefit of the bankruptcy estate. Preservation of priority, however, is limited in scope and only preserves what Section 724(a) avoids, which is limited to non-compensatory penalties. Accordingly, a trustee who avoids the penalty portion of a tax lien only preserves the original lien's priority and the value of the penalty portion. Section 726(a)(1) of the Bankruptcy Code prescribes the priority for payments of claims, and it places administrative expenses, which includes taxes and related penalties, second in priority, right after secured claims. Importantly, distribution of assets in a liquidation must follow this prescribed order, and there must be some affirmative indication of congressional intent to depart from the priority system. Here, although Section 724 protects unsecured creditors from the debtor's wrongdoing by allowing a trustee to avoid penalties, nothing in its text suggests Congress intended for that avoidance to diminish the value of unavoidable tax portions of a tax lien. A pro rata distribution method not only diminished the value of the tax portion of the lien, but in doing so, it also avoids and preserves part of the unavoidable portion of the tax lien for the estate.

— Joshua Ogle