SUBORDINATION OF CERTAIN TAX LIENS IN CHAPTER 7: SECTION 724(b)(2) OF THE BANKRUPTCY CODE (COMMISSION TRACK NUMBER 100)

Present Law

The general rule in a Chapter 7 liquidation is that, upon any sale of property, the claims of secured creditors must be satisfied in full before any payment is made to claimants with a statutory priority or to general unsecured creditors. Bankruptcy Code 724(b), which governs the order of distribution of property subject to valid, nonavoidable federal, state and local tax liens, deviates from the general rule that unsecured priority claims do not trump perfected secured claims. Under section 724(b), a trustee is required to subordinate valid tax liens to the costs of administration and other unsecured priority claims occupying the first through seventh rungs on the priority ladder. This allows unsecured priority claimants "to step into the shoes of the tax collector" (fn. 17) and receive distribution from property of the estate before valid tax claims despite the fact that the tax claim is properly allowed and secured. Moreover, section 724(b) enables a trustee to administer property that is otherwise without value to the estate due to the existence of liens in order to generate a pool of funds from which priority claims can be paid.

Proposals Before The Commission

Commission Track Number 100. The Government Working Group proposes that section 724(b)(2) be amended to limit the subordination of properly perfected nonavoidable tax liens on real and personal property to only section 507(a)(3) wage claims. See Government Working Group proposal number 2. The Department of Justice and Commissioner Shepard had proposed that Section 724(b) be repealed altogether. See Justice Proposal, p. 97; Santa Fe Discussion Issues, p. 2, Item IB1.

Task Force Position

The Task Force opposes all of these proposals.

Reasons for Position

Section 724(b)(2) was intended to free up assets to pay costs of administration and satisfy claims of employees having priority. As a result of subsequent amendments to Section 724(b), the favored claimants were expanded to include individual farmers and fishermen, individuals making deposits for personal, family or household use and alimony, maintenance and support claims. For nearly 60 years Congress has consistently postponed or subordinated government tax entities to payment of administrative expenses and wage claims, even if the claims of the government entity were secured by tax liens. (fn. 18)

Tax claims are generally given priority over most unsecured claims because (1) there is a public interest in insuring an uninterrupted flow of revenues for the purpose of supporting governmental operations and (2) the government, as an involuntary creditor, is not in a position to protect its interests by negotiating adequate security arrangements with a taxpayer when a tax debt is created. Notwithstanding these important public policy considerations underpinning priorities for most tax claims, bankruptcy laws have always subordinated tax claims to administrative expenses and some other claims. Section 724(b) is a recognition that statutory tax liens are no more than governmentally created superpriorities. Downgrading tax liens in bankruptcy merely validates the scheme of priorities created by the bankruptcy system. Bankruptcy Code priorities must supersede the states' interests in buttressing their collection capabilities. Therefore, we oppose any effort to change the basic structure of section 724(b).

Notwithstanding the foregoing, present law distorts the relative positions of local taxing authorities and commercial secured creditors. The expectation of such creditors is that their security interests will be primed by ad valorem real property tax liens. That bankruptcy should not give these creditors a windfall gave rise to the enactment of section 362(b)(18) in 1994. A similar "fix" is needed in section 724(b). If an estate is administratively insolvent, the secured creditor should not receive a windfall at the expense of the local taxing authority. The private secured creditor should bear the burden of ad valorem real property taxes.

Finally, it has been argued that section 724(b) is complex and it is often misapplied in practice. If the provision can be simplified, the Commission should address that problem, but it should not repeal a legislative policy of long standing.

Other Institutional Positions

The National Bankruptcy Conference and Association of the Bar of the City of New York oppose repeal of Section 724(b).

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fn. 17: H.R. Rep. No. 595, 9th Cong., 1st Sess. 382 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6338.

fn. 18: Bankruptcy Act Section 67c, as amended by the Chandler Act, P.L. No. 696, 52 Stat. 877 (June 22, 1938); P.L. No. 546, 66 Stat. 427 (July 7, 1952); P.L. No. 89-495, 80 Stat. 269 (July 5, 1966); and Bankruptcy Code Section 724(b).

Questions, comments or suggestions? kbercik@taxcounsellor.com

Last updated June 1, 1997