In re Michael A. Leite (United States of America v. Mackenzie), No. 23-15825 (9th Cir. Sept. 3, 2024), the Ninth Circuit addressed the proper allocation of sale proceeds in a Chapter 7 bankruptcy when the IRS holds a tax lien that includes both unpaid taxes and related penalties. The court held that the pro rata method of allocation was inconsistent with the Bankruptcy Code, reversing the district court’s decision and instructing the bankruptcy court to apply a tax-first allocation method.
In the case, the IRS had recorded a tax lien against a debtor’s property in 2013 for unpaid taxes from 2009. The lien secured both the tax liability and associated penalties. In the debtor’s 2019 Chapter 7 bankruptcy case, the Chapter 7 trustee (“Trustee”) sold the property, yielding net proceeds of $38,640.80. However, the total tax lien, including penalties, exceeded this amount. The Trustee sought to allocate the proceeds on a pro rata basis between the IRS and the bankruptcy estate. The IRS objected, arguing that the tax portion of the lien should be paid first before any payment to the estate.
The key issue before the Ninth Circuit was whether the bankruptcy court was mistaken in allocating sale proceeds on a pro rata basis when the IRS’s tax lien included both an unavoidable tax portion and an avoidable penalty portion under 11 U.S.C. § 724(a). The Ninth Circuit ruled that the pro rata method was improper under the Bankruptcy Code. Section 724(a) allows a trustee to avoid the penalty portion of a tax lien, but not the tax portion, and the court held that the trustee’s power to avoid penalties does not extend to diminishing the value of the unavoidable tax portion. Additionally, Section 551 of the Bankruptcy Code states that while avoided liens are preserved for the estate’s benefit, this preservation does not entitle the estate to equal treatment with the IRS regarding tax liabilities. The Bankruptcy Code establishes clear priority rules under 11 U.S.C. § 507, which prioritize tax claims over penalties, and the court found that the pro rata method improperly disrupted this priority structure. The Ninth Circuit also cited In re Hutchinson, No. 17-12272-A-7, 2022 WL 1021873, at *4 (Bankr. E.D. Cal. April 1, 2022), which applied a tax-first method, ensuring that the unavoidable tax portion of the lien is satisfied before the bankruptcy estate recovers anything from the avoided penalty portion.
The Ninth Circuit reversed the district court’s decision and remanded the case, instructing the bankruptcy court to apply a tax-first method. This means that sale proceeds must first satisfy the tax liability before any portion of the avoided penalty is distributed to the bankruptcy estate. The Ninth Circuit also found that bankruptcy courts also cannot use equitable powers under 11 U.S.C. § 105(a) to override statutory priorities. This ruling clarifies the treatment of tax liens in Chapter 7 bankruptcies where lien proceeds are insufficient to cover both tax and penalty amounts. It reaffirms that the IRS’s tax claims take priority over the bankruptcy estate’s interest in avoided penalties. Chapter 7 trustees must apply a tax-first allocation method when distributing proceeds from the sale of property encumbered by a tax liability.