Ninth Circuit Nixes Use of Pro Rata Method to Allocate Sales Proceeds in Bankruptcy

(Parker Tax Publishing September 2024)

A panel of the Ninth Circuit reversed a district court order that affirmed a bankruptcy court's allocation of proceeds on the sale of real property in a Chapter 7 bankruptcy after concluding that the pro rata method the bankruptcy court used in allocating those proceeds was inconsistent with the Bankruptcy Code. According to the court, the district court's holding that the bankruptcy court had the authority to adopt and apply the pro rata method under its general powers of 11 U.S.C. Section 105(a) was erroneous because Section 105(a) does not allow a bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code or otherwise take action that the Code prohibits. In re Leite, 2024 PTC 310 (9th Cir. 2024).

Background

In 2013, the IRS recorded a federal tax lien against real property owned by Michael Leite and Andrea Carvalho's (the Debtors) for unpaid taxes. In 2019, the Debtors filed for Chapter 7 bankruptcy. The IRS filed a proof of claim for $81,174. This included $26,900 in taxes plus $19,039 in interest for a total of $45,939 (i.e., the tax portion). The claim also included $24,991 in penalties (i.e., the penalty portion), bringing the total amount owed to the IRS to $70,930.

In 2020, the bankruptcy trustee sold the property and netted $38,641. The trustee then initiated adversary proceedings to avoid the penalty portion of the tax lien and moved for summary judgment on the issue of avoidance. The trustee argued that the proceeds from the sale of the property should be allocated pro rata between the IRS and the bankruptcy 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.

The controversy went before a bankruptcy court which noted that there was no case law supporting either the trustee's or the IRS's approach to the allocation of the sales proceeds. The bankruptcy court concluded that the pro rata method made the most sense because, in its view, the IRS and the bankruptcy estate shared the same lien priority position following avoidance under 11 U.S.C. Section 724 and the automatic preservation provision in 11 U.S.C. Section 551.

Under Bankruptcy Code Section 724(a), penalties are avoidable rather than void per se. Section 724(a) provides that the trustee may avoid a lien that secures a claim of a kind specified in 11 U.S.C. Section 726(a)(4). Section 726(a)(4) applies to "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." Under Bankruptcy Code Section 551, any transfer avoided under Section 724(a) is preserved for the benefit of the estate, but only with respect to property of the estate.

Subsequently, a district court affirmed the bankruptcy court's decision and held that the bankruptcy court had authority to apply the pro rata method under its equitable powers as set forth in 11 U.S.C. Section 105(a). Under that provision, a bankruptcy court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of the Bankruptcy Code.

The district court held that allocating proceeds in a manner other than pro rata would disrupt the purpose of Section 551 because it would subrogate the bankruptcy estate's lien for the penalty portion to the IRS's lien for taxes. The district court also determined that the pro rata allocation was not inconsistent with Section 551 and furthered the purposes of that provision. The district court acknowledged that there was no statutory basis for the pro rata method, but nonetheless held that the pro rata method was proper because it is "not verboten" under the Code.

The IRS appealed to the Ninth Circuit. The specific issue before the court was 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 a bankruptcy trustee avoids the penalty portion under 11 U.S.C. Section 724(a) but the sale proceeds are insufficient to pay both the tax and the penalty portions of the lien.

Analysis

A panel of the Ninth Circuit reversed the judgment of the district court with respect to the use of the pro rata method employed by the bankruptcy court. The panel concluded that the district court erroneously held that the bankruptcy court had authority to adopt and apply the pro rata method under its general powers of 11 U.S.C. Section 105(a). Section 105(a), the Ninth Circuit panel said, does not allow a bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code or otherwise take action that the Code prohibits. According to the Ninth Circuit panel, the pro rata method (1) violates the express limitations of 11 U.S.C. Section 724(a) and the automatic preservation provision of 11 U.S.C. Section 551; (2) reduces the value of the unavoidable tax portion of the lien; and (3) disturbs the Bankruptcy Code's order of priorities without justification. No provision of the Bankruptcy Code, the panel observed, requires or guarantees that the Estate ultimately receives payment for the avoided penalty portion of a tax lien when the property at issue is over-encumbered.

The panel reasoned that the pro rata method and the trustee's argument shared the same flawed premise: that once a trustee avoids the penalty portion of a tax lien under Section 724(a), the trustee and the IRS become equal claimants with equal rights to the entire tax lien. This is not so, the panel said, because the Bankruptcy Code does in fact treat liens and claims for taxes differently than those for penalties and cited the fact that several courts have recognized that both the prior and current Bankruptcy Code disfavor recovery for penalties in bankruptcy. In short, the Ninth Circuit panel concluded that the pro rata method is inconsistent with existing case law and the present Bankruptcy Code's text and history.

The panel remanded the case to the district court to require the bankruptcy court to determine the final allocation under a tax-first method in which the sale proceeds pay the unavoidable tax portion of the lien first before paying the estate for the avoided penalty portion.

For a discussion of the discharge of taxes in bankruptcy, see Parker Tax ¶16,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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