Filed Liens, Secret Liens, ERISA Pension Plans, and Bankruptcy

Most bankruptcy attorneys know that federal income taxes can be discharged in bankruptcy.  Simply stated, income taxes are dischargeable if (1) the original due date of the return plus extensions is more than three years before the bankruptcy filing date, (2) the return has been on file for at least 2 years on the day the bankruptcy petition is filed, and (3) the tax has been assessed for at least 240 days on the day the bankruptcy petition is filed.  Knowing the rules for discharging income taxes in bankruptcy is certainly important, but it’s not the whole story.  You also need to know what the discharge means for the bankruptcy debtor

I. What Is a Discharge?

Dischargeable debts are discharged as of the date the bankruptcy petition is filed.  To confirm the discharge, the Court enters an order of discharge about 120 days after the bankruptcy petition is filed.  As explained in 11 U.S.C. §524(a)(2), the discharge is a permanent court injunction which prevents all creditors (including the IRS) from taking any action to collect, recover or offset any discharged debt as a personal liability of the debtor.  In other words, the debtor is no longer personally liable for any discharged debt, including discharged taxes.

II.  In Personam vs. In Rem Liability

The debtor’s personal liability which is discharged in bankruptcy is often referred to by the legal name in personam.  If the debtor is personally liable for a debt that is legally enforceable in Oklahoma, the creditor can collect the debt even if the debtor moves to a different state.  The debtor’s move may make the creditor’s job harder, but it doesn’t affect whether the debt is enforceable.  When the debtor receives a discharge in bankruptcy, the debtor is no longer personally liable for most debts.  The discharge means that the creditor can no longer collect the debt from the debtor.  However, the in personam discharge does not necessarily mean that the debt is uncollectible.  The creditor may still be able to collect the debt from the assets of the debtor.  This is known as in rem liability.

In personam liability means that the debtor is personally liable for the debt.  The creditor can collect an in personam debt from any assets the debtor owns that are not exempt under state law. In contrast, in rem liability means that the creditor has a legal claim or lien against asset(s) owned by the debtor.  The lien may be limited to a specific asset owned by the debtor such as a car loan or a home mortgage, or it may apply to all assets owned by the debtor such as a federal tax lien or a federal restitution claim.  The distinction between in personam and in rem liability is important because in rem liability is not discharged in bankruptcy.  The United States Supreme Court explained this in Johnson v. Home State Bank, 501 U.S. 78 (1991): “Thus a bankruptcy discharge extinguishes only one mode of enforcing a claim–an in personam action–while leaving intact another–an in rem action.”  The reason only in personam liability is discharged in bankruptcy is obvious.  If a debtor could discharge both in personam and in rem liability in bankruptcy, a debtor could purchase a $1,000,000.00 home on day one, file bankruptcy on day two and live in the mansion for the rest of his life without paying for it.

III.  Federal Tax Liens and Bankruptcy

Section 6321 of the Internal Revenue Code (“IRC”) creates a lien in favor of the United States as follows:

If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto) shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.

The IRC §6321 lien (sometimes referred to as the “inchoate lien” or the “secret lien”) comes into existence as soon as the tax is assessed and notice and demand for payment has been mailed to the taxpayer.  The IRC §6321 lien is effective as against the taxpayer and his/her property even though it is not publicly recorded.  However, IRS is authorized under IRC §6323 to record its lien by filing a Notice of Federal Tax Lien (“NFTL”) in the local county land records office (sometimes call the “Recorder’s Office”) and/or the centralized UCC records.  IRS records its lien to obtain priority over potential creditors who have no knowledge that the debtor owes taxes.

  1. Assets Excluded from the Bankruptcy Estate. The day the debtor files bankruptcy, an estate is created which consists of all interests of any kind the debtor owns in real or personal property.  The bankruptcy estate includes virtually all the assets the debtor owns before filing, with one important exception.  Section 541(c)(2) of the bankruptcy code excludes ERISA qualified pension plans.  The debtor’s interest in an ERISA qualified pension account never becomes property of the estate.  See, Patterson v. Shumate, 504 U.S. 753 (1992).
  2. Exempt Assets. Exempt assets are included in the bankruptcy estate, but these assets are exempt from creditors in bankruptcy.  The exemptions differ from state to state, but exempt assets typically include some portion or all of the value of the debtor’s principal residence, household goods, furnishings and appliances and non-ERISA qualified retirement accounts such as IRAs, SEPP accounts and some 401(k) accounts.
  3. Effect of Tax Discharge When the NFTL is Recorded Before Filing Bankruptcy. If the debtor’s income taxes are dischargeable, the debtor is no longer personally liable for the tax debts.  Even if IRS recorded a NFTL before the bankruptcy was filed, IRS can no longer levy any property the debtor acquires after the bankruptcy is filed, such as wages and business income. However, when a NFTL is properly recorded before the bankruptcy is filed, the IRS lien survives the bankruptcy and continues as a lien against all assets the debtor owned prior to filing bankruptcy, regardless of whether those assets are exempt.  A properly recorded NFTL continues after bankruptcy as a lien on all exempt assets owned on the day the bankruptcy is filed, including pension plans, whether ERISA qualified or not.
  4. Effect of Tax Discharge When NFTL is Not Recorded. If IRS doesn’t record a NFTL before the debtor discharges the tax debt by filing bankruptcy, the IRS lien will be extinguished against all property of the bankruptcy estate, whether the property is exempt or not.  The unrecorded statutory lien under IRC §6321 is extinguished by Bankruptcy Code §522(c)(2)(B).  It is important to note, however, that bankruptcy only affects property of the bankruptcy estate.  Bankruptcy has no effect on excluded assets such as ERISA qualified pensions.
  5. What Happens If the Debtor Files Bankruptcy With an ERISA Qualified Plan?

Assume the debtor has $250,000.00 in an ERISA qualified pension plan and $100,000.00 in dischargeable federal income taxes on the day the debtor files bankruptcy.  Prior to filing bankruptcy, IRS has a statutory lien under IRC §6321.  Since ERISA qualified plans are not property of the debtor’s bankruptcy estate, and since IRS’s statutory lien survives the bankruptcy, IRS can (and probably will) assert its lien against the pension plan.  The key to this analysis is that the ERISA qualified plan is not property of the estate.  It’s not an exempt asset of the estate, because it never becomes property of the estate. Although IRS can no longer collect the debt personally from the debtor’s other assets, IRS can liquidate the debtor’s pension plan to get the money.  See, United States v. Snyder, 343 F. 3d 1171 (9th Cir. 2003); Chief Counsel Memo. No. 200634012 (08/25/06).

IV.  Conclusion

ERISA qualified pension plans are not property of the bankruptcy estate.  The IRS’s secret lien under IRC §6321 attaches to the pension account, and even though the income tax debt is discharged in bankruptcy, IRS can still levy on the excluded pension plan assets.