In Re John Darnell, Debtor.united States of America, Plaintiff-appellant, v. John Darnell and the Commonwealth of Kentucky, Defendants-appellees, 834 F.2d 1263 (6th Cir. 1987)

This appeal presents a question of first impression regarding the statutory construction of Sec. 724 of the Bankruptcy Code, 11 U.S.C. § 724, which controls the distribution of a debtor's property encumbered by tax liens. The United States District Court for the Western District of Kentucky, affirming the bankruptcy court, ordered the balance of debtor's property split pro rata between the competing tax liens of the Internal Revenue Service (IRS) and the Kentucky Department of Revenue, despite the fact that the IRS lien was perfected prior to the state lien. Because we disagree with the interpretation given to Sec. 724 by the courts below, we reverse.

On December 15, 1983, John Darnell, the debtor, filed a petition under Chapter 7 of the Bankruptcy Code, 11 U.S.C. § 701, et seq., seeking liquidation of his assets. Both the IRS and the Commonwealth of Kentucky filed proofs of claim for unpaid taxes that had arisen prior to the filing of the petition. The total amount of the claims of the United States was $145,997.14; the Commonwealth's claims totaled $129,812.71. It was undisputed that the federal tax liabilities had been assessed and notices of tax liens had been filed prior to the Commonwealth's tax claims.

The debtor's property was liquidated and, after satisfaction of certain expenses of administration, the amount of $21,773.02 remained available for distribution. By order of July 31, 1984, the bankruptcy court granted the trustee's request to distribute this amount pro rata between the United States and the Commonwealth.¹  On October 22, 1984, the United States filed a motion for reconsideration of that order, contending that, because its tax claims were "first in time" and thus senior to those of the Commonwealth, it was entitled to a distribution of all the available funds and was not required to share pro rata with the Commonwealth. In response, the Commonwealth did not contest the seniority of the federal tax liens but contended that, by virtue of the provisions of Sec. 724 of the Bankruptcy Code, the "first in time" rule was to be applied only to resolve disputes concerning the relative priority between a tax and nontax lien but did not apply to situations involving two (or more) competing tax liens.

Following a hearing and submission of supplemental briefs, the bankruptcy court issued its opinion, in which it essentially agreed with the Commonwealth's position and held that the United States's claim of priority for its secured lien was foreclosed by the "clear language" of the Bankruptcy Code. 58 B.R. 122 (Bankr.W.D. Ky. 1986). In so holding, the court looked first to Sec. 724(b) of the Code, which serves to subordinate secured tax claims to certain specified "priority" claims.²  Based on this provision, the court ruled that, because tax liens are subordinated to these priority claims, they also lose their secured status and are to be treated as simply another category of priority claim. Id. at 122-23. As a result, the court found that the status of the IRS and Kentucky liens was "identical" under Sec. 724(b) (3) and turned to Sec. 724(c) to resolve the question of appropriate distribution. Section 724(c) provides that whenever two or more competing liens of the same class are involved, distribution should take place "in the same order as distribution to such holders would have been other than under this section." Following this directive, the court found Sec. 726 of the Bankruptcy Code, which governs the manner of distribution of property of the estate with respect to priority claims and other unsecured claims, to be the appropriate law to apply.³  Id. at 123. Section 726 provides for pro rata distribution among two or more claims of the same priority class; therefore, the bankruptcy court sustained the pro rata distribution between the federal and state lienholders.

On appeal, the district court affirmed the judgment of the bankruptcy court, concluding that its judgment was supported by the legislative history of Sec. 724(b). This appeal followed.

We conclude that the courts below erred in holding that Sec. 724(b) of the Bankruptcy Code operates to divest tax liens of their status as secured claims. We reach this conclusion after thorough scrutiny of both the history of this section of the Code as well as its express language.

In bankruptcy, a debtor's assets in the hands of the trustee are subject to all liens and encumbrances existing at the date of the bankruptcy (and which are not otherwise invalidated by law). Such liens are recognized as a charge upon the bankrupt's assets. Included among those liens that remain as encumbrances are statutory liens, such as the tax liens at issue here.⁴  Accordingly, as a general rule, if a lien is perfected, it must be satisfied out of the asset(s) it encumbers before any proceeds of the asset(s) are available to unsecured claimants, including those having priority (such as holders of administrative claims).⁵  Collier on Bankruptcy p 507.02 (15th ed. 1985).

Insofar as the unencumbered assets of the bankruptcy estate are concerned, Congress has given a special status to certain creditors, commonly referred to as "priority" claimants. Section 507 of the Bankruptcy Code specifies the nature of the claims entitled to treatment as priority claims and the relative order in which they are to be paid.⁶  These priority claims insure payment, to the extent that available funds permit, of these enumerated types of claims before general unsecured claims are satisfied but, as a general rule, they are subordinate to claims that are secured by a perfected lien against the debtor's property.

Section 724 of the Bankruptcy Code, 11 U.S.C. § 724, however, sets forth an exception to the general rule that priority claims do not affect perfected secured claims.⁷  Section 724(b) was derived from Sec. 67(c) of the Chandler Act of 1938 (ch. 575, 52 Stat. 840 (1938)), which had substantially revised the Bankruptcy Act of 1898 (ch. 541, 30 Stat. 544 (1898)). Despite these revisions, the Chandler Act did not alter the established rule that, in determining priorities between competing liens, federal courts look to nonbankruptcy law. See Lerner Stores Corp. v. Electric Maid Bake Shops, 24 F.2d 780, 782 (5th Cir. 1928). What Sec. 67(c) did accomplish was the subordination of certain statutory liens to certain "priority" claims, i.e., claims for wages and administrative expenses. This subordination of certain liens to such legislatively-determined "priorities" was a new concept in bankruptcy law. Congress revised the Chandler Act in 1966 (Pub. L. No. 89-495, 80 Stat. 268 (1966)), leaving intact the prevailing rule that priority of statutory liens should be determined under the applicable nonbankruptcy law. See generally California State Dep't of Employment v. United States, 210 F.2d 242, 244 (9th Cir. 1954) (" [t]he sole concern of Congress in enacting Sec. 67, sub. c was to insure payment of administrative expenses and small wage claims [ahead of certain lien claims]"); S.Rep. No. 1159, 89th Cong., 2d Sess. reprinted in 1966 U.S.Code Cong. & Admin.News 2442, 2456, 2463 (citing Calif. State Dep't of Employment with approval); 4 Collier on Bankruptcy p 67.27, 382-83 (14th ed. 1978) (" [A]s to liens subordinated by Sec. 67(c), the bankruptcy court must depend on nonbankruptcy law for rules on marshalling such liens."). In the case at bar, applicable nonbankruptcy law mandates that, as between competing valid statutory liens, "the first in time is the first in right." United States v. New Britain, 347 U.S. 81, 85, 74 S. Ct. 367, 370, 98 L. Ed. 520 (1954).

In 1978, Congress again substantially revised the Bankruptcy Code. The prior Sec. 67(c) (3) was renumbered as Sec. 724(b) and, although altered in certain respects, was "derived from Sec. 67(c) (3) of the Bankruptcy Act ... without substantial modification in result." H.R.Rep. No. 595, 95th Cong., 1st Sess. 382; reprinted in 1978 U.S.Code Cong. & Admin.News 5787, 6338. Under Sec. 724(b), the first priority in distribution (subsection (1)) is for liens which are "senior" to the tax lien(s). The second priority (subsection (2)) is for those "priority" claims specified in Sec. 507(a) (1)-(6), e.g., administration expenses, wage claims, etc., but only up to the amount of the tax lien(s).⁸  The third priority (subsection (3)) is for the tax lien(s). The fourth priority (subsection (4)) is for those liens which are "junior" to the tax lien. The fifth priority (subsection (5)) provides for full payment, to the extent possible, of any amounts not paid to the tax lienholders under subsection (3). The final priority is for distribution to the estate.⁹  The legislative history clarifies that " [t]he result of these [subsections] are to leave senior and junior lienors and holders of unsecured claims undisturbed." H.R.Rep. No. 595, supra, at 382, reprinted in 1978 U.S.Code Cong. & Admin.News at 6338.

Section 724(b) does not address or define the relative priorities within a particular category of liens. However, Sec. 724(c) provides that " [i]f more than one holder of a claim is entitled to distribution under a particular paragraph of subsection (b) of this section, distribution to such holders under such paragraph shall be in the same order as distribution to such holders would have been other than under this section." In this appeal, the government contends that the directive of Sec. 724(c) mandates resort to nonbankruptcy law to determine the relative priorities between competing tax liens under Sec. 724(b) (3). Under this theory, and the nonbankruptcy "first in time, first in right" principle, the IRS would be entitled to receive the entire balance of the debtor's assets in payment of its superior secured claim. In contrast, the Commonwealth of Kentucky argues for an interpretation of this subsection which would preclude application of nonbankruptcy law since, in its view, the secured status of all tax claims has been abrogated by Sec. 724(b), rendering such liens merely "priority" claims occupying a position between Secs. 507(6) and 507(7). Therefore, it contends, resort to Sec. 726(b) of the Code, which governs payment of priority claims specified in Sec. 507 plus unsecured claims, is proper and under that subsection, payment of such claims "shall be made pro rata."

The District of Columbia Circuit has dealt with a tangential issue involving priority between a Small Business Administration lien and a District lien for unpaid sales taxes. Pearlstein v. U.S. Small Business Admin., 719 F.2d 1169 (D.C. Cir. 1983). The court ruled that the later-perfected tax lien was "senior" to the SBA lien under applicable law, which it determined to be the non-bankruptcy law of the District of Columbia. Admittedly, this case did not involve competing liens of the same class but rather determination of whether a nontax lien would be considered "senior" to the tax lien under Sec. 724(b) (1). However, the court engaged in an exhaustive analysis of the history of bankruptcy law, particularly as it involved the evolution of Sec. 724 in general. The court noted that:

The statute does not define whether a lien "is senior to such tax lien" (subsection (1)) or "is junior to such tax lien" (subsection (4)), or state upon what basis the determination of those priorities shall be made. There is no indication that when Congress in section 724(b) restructured and restated the provisions covering the distribution of property in the estate that was subject to tax liens, it intended to change the prior settled law and practice that the relative priorities of liens in bankruptcy (including tax liens subordinated by section 67(c) (3) of the Chandler Act) were to be determined according to the non-bankruptcy lien law, or to create a new federal rule governing relative priority between tax and other liens. If Congress had intended to make such a drastic change in existing bankruptcy law, presumably it would clearly and explicity have so stated or indicated. It did neither.

Id. at 1175-76 (emphasis added).

Therefore, it is clear, and the Commonwealth does not dispute, that as between two or more competing nontax liens, non-bankruptcy law governs their priority. We can see no justifiable reason for treating competing tax liens differently. The Commonwealth points to legislative history stating that, " [i]n effect, a tax claim secured by a lien is treated as a claim between the fifth [now sixth] and sixth [now seventh] priority in a case under Chapter 7 rather than as a secured claim " as support for their position. 124 Cong.Rec. H11,098 (Sept. 28, 1978); S17,415 (Oct. 6, 1978). We cannot glean from this language a Congressional intent to extinguish a tax lien's secured status in favor of a simple "priority" claim, identical in status to those priorities set forth in Sec. 507. Such an intent is nowhere stated, and tax liens are repeatedly referred to as "liens," implying the continuation of their secured status. Moreover, the problem inherent in the Commonwealth's proffered explanation becomes apparent when considering a situation involving an intervening junior lien between two competing tax liens. In such a situation, treating both tax liens as "priorities" under Sec. 724(b) (2) and (3) would result in elevating the concededly "junior" tax lien above the lien occupying the superior position under Sec. 724(b) (4).¹⁰  This result cannot be squared with the stated Congressional intent that the status of senior and junior lienors remains intact under the current Code.

We also find support for our result in the fact that Sec. 724, titled "Treatment of certain liens," deals explicitly with priority and distribution problems involving property encumbered by liens. Section 726, titled "Distribution of property of the estate," by its terms mandates pro rata payment only of claims specified in Sec. 507 and subsections (2) through (5) of Sec. 726(a). Under Sec. 724, property is not distributed to the estate (Sec. 724(b) (6)) until all liens, both tax and nontax, are satisfied. Therefore, we construe Sec. 726 to govern only distributions from property which has become part of the debtor's "estate." Under this reading, the distribution scheme specified for multiple claims in a priority class which is set forth in Sec. 726 (pro rata) has no application to distribution under Sec. 724 since, by its terms, property distributed under that section does not become part of the estate unless or until all secured claims have been satisfied.¹¹ 

Admittedly, resort to nonbankruptcy law to determine the status of competing tax liens may, in certain instances, require a complex and sophisticated distribution analysis.¹²  However, this result is inescapable where the intent of Congress is manifested by both the express language of Sec. 724(b) of the Code as well as the stated purpose to continue prior practice without substantial modification.

Thus, as under prior law, we hold that the priority of all competing liens, both tax and nontax, is to be determined by reference to nonbankruptcy law. In the case at bar, since the competing liens involve a federal tax, federal law controls. Aquilino v. United States, 363 U.S. 509, 513-14, 80 S. Ct. 1277, 1280-81, 4 L. Ed. 2d 1365 (1960). Since the IRS lien was the first to be perfected, the entire balance of debtor's property is ordered distributed to the United States in satisfaction of its lien.