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The IRS secret 6321 Lien and ERISA Pensions

Something else to worry about: The IRS levying on a bankruptcy debtor's pension plan even though they never filed a "Notice of Federal Tax Lien" (NFTL). Wadleigh v. IRS; 134 T.C. 14; United States Tax Court decision June 15, 2010. My thanks to Rochester bankruptcy attorney William Neild for bringing this case to my attention and explaining its significance.

Here is what we already knew: when the IRS files a NFTL, it acts as a lien against all assets owned by the debtor, including assets, such as pension plans, that might be exempt as against regular creditors. So, a debtor files bankruptcy and lists an old, dischargeable, IRS tax debt: If the IRS had filed a NFTL prior to the bankruptcy filing, the lien against the debtor's assets survives bankruptcy even if the debtor's personal liability is discharged. If that debtor had, say, an exempt IRA account, the IRS could levy against that account after the bankruptcy, pursuant to the NFTA. Bankruptcy Code sect. 522(c)(2)(B) specifically states that exempt property is not exempt against properly filed tax liens.

But what about unfiled tax liens? When the IRS files a NFTL, it is usually filed in the taxpayer's county and/or with the Secretary of State where the taxpayer lives. This filing puts the world, including bankruptcy trustees, on notice of the lien. But the lien itself actually existed well before the NFTL is filed with the county clerk. Internal Revenue Code (IRC) Sect. 6321 states that, as between the IRS and the taxpayer, a tax lien exists the moment the tax is 'assessed'. At that point, the IRS is empowered to seize whatever property the taxman is allowed to take away by law, even though nobody (perhaps not even the taxpayer) knows about the existence of this 'secret' lien. Now the IRS usually follows up the 6321 lien by filing a NFTL, because that protects the IRS against third parties, such as judgment creditors or bonafide purchasers. But the lien itself exists when the tax is assessed, not when the NFTL is filed.

Now, as stated above, a filed NFTL survives as a lien against otherwise exempt bankruptcy property, under sect. 522(c)(2)(B). Correspondingly, if the IRS has assessed a secret 6321 lien, but has not filed a NFTL before the bankruptcy is filed, that secret does NOT survive the bankruptcy and the debtor retains exempt property free and clear of the IRS lien.

So when Mr. Wadleigh filed Chapter 7 in 2005 in California, he thought he was in fine shape. He listed an old 2001 IRS debt which was dischargeable, and the IRS had never filed a valid NFTL. But then the IRS went after his pension after the bankruptcy was over, and the Tax Court said the IRS was correct as a matter of bankruptcy law. Huh?

Unfortunately for the debtor, the tax court was probably right, because the debtor's pension was not an exempt asset of the bankruptcy case. More specifically, the pension was actually never an asset at all, exempt or otherwise, in the bankruptcy case. As the pension was never a bankruptcy asset, the secret lien was never avoided.

This actually makes sense when you carefully examine the status of ERISA pensions in bankruptcy cases. We (bankruptcy people) regularly refer to pensions as "exempt", and we are correct: there are multiple exemptions for retirement accounts under both state and federal bankruptcy law (11 USC §522(b)(3)(C) exempts tax-exempt pensions in all bankruptcy cases, no matter what state law says, and New York CPLR §5205(c)(2) and D&C §282(iii)(2)(e) exempts all retirement accounts when New York residents file bankruptcy.) But when it comes to ERISA pensions, the issue of exemptability doesn't actually come into play because the asset itself never enters the bankruptcy estate.

When Mr. Wadleigh filed bankruptcy, a separate legal entity called the "Bankruptcy estate of Wasleigh" was created as a matter of law, and all of Wadleigh's assets were transferred to this new estate. "All legal or equitable interests of the debtor in property as of the commencement of the case." are property of this estate, under 11 U.S.C. Sect. 541(a)(1). Or almost all; ERISA-qualified pensions do not transfer to the bankruptcy estate, under Sect. 541(c)(2). ERISA pensions are those pensions which cannot be transferred, voluntarily or otherwise, to third parties. The Supreme Court specifically stated that, under Sect. 541(C)(2), ERISA-qualified pensions are excluded for the bankruptcy estate. Patterson v. Shumate, 504 U.S. 753 (1992.)

This anti-alienability provision in ERISA is intended to protect the pensioner from being liened by judgment creditors, but it worked to the severe disadvantage to Mr. Wadleigh. When the IRS assessed a tax liability against him for his 2001 taxes, that assessment created a secret 6321 lien against all his assets, including his ERISA pension (the anti-alienability provisions of ERISA do not extend to the IRS.) When he filed bankruptcy, all of his assets -- except his ERISA pension -- became property of the bankruptcy estate, and the unfiled IRS lien was avoided against his exempt property. But since the ERISA pension didn't ever go into the bankruptcy estate, the secret lien was never avoided by bankruptcy, and the IRS was entitled to levy against the pension post-petition.

So what's a bankruptcy debtor to do? Remember, this situation only applies:
IF the wood-be bankruptcy debtor has dischargeable taxes and
IF the IRS has filed an assessment and
IF the IRS has not filed a valid Notice of Federal Tax Lien (NFTL) and
IF the debtor has an ERISA-qualified pension.

That's a lot of ifs. Add one more; what if the debtor had other unexempt property? Say the debtor has $30,000 in unexempt assets and an unfiled dischargeable $25,000 tax assessment. The debtor will have to pay the trustee $30,000 for the unexempt assets (or lose them) and another $25,000 to the IRS to avoid losing an ERISA pension. In that case, the debtor might want to induce the IRS to file a tax lien (and wait three months before filing, so the lien is not avoidable as a preference). Then the unsecured unexempt assets would be only $5,000, and the $25,000 paid to the IRS would replace money that would otherwise be paid to the trustee.

Another possible option: roll-over the ERISA pension to another non-ERISA pension, like an IRA. I am no tax expert, and that's who the debtor would need to consult, but a non-ERISA pension becomes exempt property of the bankruptcy estate and the unfiled secret 6321 IRS lien would be avoided as against the exempt non-ERISA pension.

Inevitable disclaimer: for more information, consult a tax professional.

Attachments:
Wadleightaxcourtdecision.pdf

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