United States v. MacKenzie (In re Leite)

112 F.4th 1246

IN RE: Michael A. LEITE; Andrea C. Carvalho, Debtors.

United States of America, Appellant, v. Robert A. MacKenzie, Trustee, Appellee.

No. 23-15825

United States Court of Appeals, Ninth Circuit

Argued and Submitted May 17, 2024 Phoenix, Arizona

Filed September 3, 2024

Appeal from the United States District Court for the District of Arizona, Dominic Lanza, District Judge, Presiding, D.C. No. 2:22-cv-00461-DWL

Matthew S. Johnshoy (argued) and Bruce R. Ellisen, Attorneys, Tax Division, Appellate Section; David A. Hubbert, Deputy Assistant Attorney General; United States Department of Justice, Washington, D.C.; for Appellant.

Terry A. Dake (argued), Terry A. Dake Ltd, Phoenix, Arizona, for Appellee.

Before: Susan P. Graber, Roopali H. Desai, and Ana de Alba, Circuit Judges.

OPINION

DE ALBA, Circuit Judge:

As Benjamin Franklin said, "nothing is certain except death and taxes." But how certain are taxes in a Chapter 7 bankruptcy? We address that question here, and we conclude that Mr. Franklin's maxim withstands both time and the Bankruptcy Code (Code).

I. Introduction

The Internal Revenue Service (IRS) appeals a judgment of the district court of Arizona that affirmed the bankruptcy court's allocation of proceeds of the sale of real property on a pro rata basis between the IRS and the Bankruptcy Estate (Estate) in a Chapter 7 bankruptcy. Specifically, the issue before us is the proper allocation method of sale proceeds where the IRS holds a valid tax lien that includes both unpaid taxes and related penalties, and where the Bankruptcy Trustee (Trustee) avoids the penalty portion under 11 U.S.C. § 724(a), but the sale proceeds are insufficient to pay both the tax and the penalty portions of the lien. There is no binding legal authority or Code provision that expressly provides an allocation method in these circumstances.

We have jurisdiction under 28 U.S.C. § 158(d)(1). After careful review and consideration of the record and the decisions below, the relevant Code provisions and existing case law, and the parties' briefing and oral argument, we hold that the pro rata method is inconsistent with the Bankruptcy Code. The district court thus erred in using that method. We therefore reverse and remand this case to the district court to require the bankruptcy court to determine the final allocation amounts under a tax-first method.

II. Factual and Procedural Background

In 2013, the IRS recorded a federal tax lien against Michael Leite and Andrea Carvalho's (Debtors) real property, located in Connecticut, for unpaid taxes from fiscal year 2009. Debtors filed for Chapter 7 bankruptcy in September 2019. The IRS filed a proof of claim for a total amount of $81,174.13, itemized as follows:

• $26,900.19 in taxes due, plus $19,038.80 in interest on the taxes, for a total of $45,938.99 (the "tax portion").

• $35,235.14 in penalties (the "penalty portion"), which was later reduced by an offset,¹ bringing the final amount of the penalty portion to $24,991.14.

In April 2020, the Trustee sold the property and netted $38,640.80 available to pay the tax lien. There were no junior lienholders with claims to the proceeds.

On May 8, 2020, the Trustee initiated adversary proceedings to avoid the penalty portion of the tax lien. On June 18, 2020, the Trustee moved for summary judgment on the issue of avoidance and argued that the proceeds from the sale should be allocated pro rata between the IRS and the Estate. The IRS did not dispute that the Trustee could avoid the penalty portion of the lien, but it argued that the proceeds should first pay the tax portion of the lien.

Ruling from the bench, the bankruptcy court noted that there was no case law supporting either approach. It concluded that the pro rata method "makes the most sense" because, in its view, the IRS and the Estate share the same lien priority position following avoidance under § 724 and the automatic preservation provision, § 551. On September 27, 2021, the district court affirmed, ruling the bankruptcy court had authority to apply the pro rata method under its equitable powers set forth in § 105(a). The court held that "[a]llocating proceeds in a manner other than pro rata" would disrupt the purpose of § 551 because it would "subrogate" the Estate's lien for the penalty portion to the IRS's lien for taxes. The district court determined that the "pro rata allocation is not inconsistent with § 551 and furthers the purposes of that provision." It also acknowledged that there was no statutory basis for the pro rata method, but nonetheless held that the pro rata method is proper because it is "not verboten" under the Code.²

III. Standard of Review

"We review de novo a district court's decision on appeal from a bankruptcy court." In re JTS Corp., 617 F.3d 1102, 1109 (9th Cir. 2010). "We apply the same standard of review applied by the district court" when reviewing the bankruptcy court decision, and thus we review "findings of fact ... for clear error, while... conclusions of law are reviewed de novo." Id. (citing In re Strand, 375 F.3d 854, 857 (9th Cir. 2004)). Statutory interpretation issues are legal conclusions that we review de novo. See In re Blixseth, 684 F.3d 865, 869 (9th Cir. 2012) (per curiam).

IV. Relevant Statutory and Legal Framework

A. Statutory Provisions

This case involves the interplay among, and the application of, several Code provisions in a Chapter 7 bankruptcy, so a brief review of the applicable law is appropriate.

To begin, as the courts below noted, no Code provision expressly delineates who and how much is paid following partial avoidance of a tax lien under § 724(a) when there are insufficient funds to pay the lien. Courts are reluctant to interpret the Code, "however vague the particular language under consideration might be, to effect a major change in pre-Code practice" that Congress did not at least discuss. Dewsnup v. Timm, 502 U.S. 410, 419, 112 S.Ct. 773, 116 L.Ed.2d 903 (1992). We also presume "that Congress did not intend to change preexisting bankruptcy law or practice" without a "clear indication[ ] to the contrary." Pac. Gas & Elec. Co. v. California ex rel. Cal. Dep't of Toxic Substances Control, 350 F.3d 932, 943 (9th Cir. 2003). Of course, if the statutory text is clear and unambiguous, we presume that Congress "says in a statute what it means and means in a statute what it says." Conn. Nat'l Bank v. Germain, 503 U.S. 249, 253-54, 112 S.Ct. 1146, 117 L.Ed.2d 391 (1992).

Section 724(a) is one express change from "pre-Code" practice. Before 1978, the Bankruptcy Act of 1898 barred all claims for penalties that were non-compensatory in nature. See Simonson v. Granquist, 369 U.S. 38, 40-41, 82 S.Ct. 537, 7 L.Ed.2d 557 (1962) (citing the prior statute that stated "[d]ebts owing to the United States ... as a penalty or forfeiture shall not be allowed" except as to any pecuniary losses arising from the penalty). But under § 724(a) of the current Code, penalties are avoidable rather than void per se. Section 724(a) provides that "[t]he trustee may avoid a lien that secures a claim of a kind specified in section 726(a)(4) of this title." Section 726(a)(4) lists the "kind" of claims, specifically "any fine, penalty, forfeiture, or for multiple, exemplary, or punitive damages ... to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim."

Congress explained that a lien for penalties is "voidable rather than void in Chapter 7, in order to permit the lien be revived if the case is converted to Chapter 11, under which penalty liens are not voidable." S. Rep. No. 95-989, at 96 (1978), as reprinted in 1978 U.S.C.C.A.N. 5787, 5882; H.R. Rep. 95-595, at 382 (1977), as reprinted in 1978 U.S.C.C.A.N. 5963, 6338. The purpose of § 724(a) is to "protect [ ] unsecured creditors from the debtor's wrongdoing," which is consistent with pre-Code policy. In re DeMarah, 62 F.3d 1248, 1252 (9th Cir. 1995) (quoting S. Rep. 95-989, at 96) (brackets in original); see also In re Gill, 574 B.R. 709, 716 (B.A.P. 9th Cir. 2017) (same); In re Bolden, 327 B.R. 657, 664 (Bankr. C.D. Cal. 2005); H.R. Rep. 95-595, at 382.

In addition to describing the "kind" of claim that is avoidable under § 724(a), § 726(a) also establishes the general order for distributing property of the Estate. Section 726(a)(4) places the "payment of any allowed claim, whether secured or unsecured," for fines, penalties, and the like as "fourth" in line behind payments for other claims and expenses. First in line under Section 726(a)(1) are payments for claims "of the kind specified in, and in the order specified in, section 507 of this title." Relevant here, § 507 places payments for "administrative expenses"—which includes taxes and related tax penalties allowed under § 503(b)—second in priority. 11 U.S.C. § 507(a)(2); see Czyzewski v. Jevic Holding Corp., 580 U.S. 451, 457, 137 S.Ct. 978, 197 L.Ed.2d 398 (2017) (explaining that "secured creditors" are the highest priority under § 507 and "[s]pecial classes of creditors, such as those who hold certain claims for taxes or wages, come next in a listed order"). Next come "low-priority creditors, including general unsecured creditors." Id. As the Supreme Court stated, the Code "makes clear that distributions of assets in a Chapter 7 liquidation must follow this prescribed order." Id. There must be "some affirmative indication" of congressional intent to depart from this priority system. Id. at 465, 137 S.Ct. 973.

Section 551 works in tandem with avoidance under § 724(a). Section 551 provides that a transfer avoided under seven specific statutes, including § 724(a), "is preserved for the benefit of the estate but only with respect to property of the estate." 11 U.S.C. § 551. In other words, penalties that a Trustee avoids under § 724(a) are automatically preserved for the Estate. This is another express change from pre-Code practice when a court had to...