6321 Bankruptcy page5

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In re Edgar Ballard, In re Beulah H. Ballard, Debtors. Jeffrey Fairfield, Trustee, Plaintiff-Appellant v. United States of America , Defendant-Appellee, Commonwealth of Virginia , Appellee

(CA-4), U.S. Court of Appeals, 4th Circuit, 94-2199, 9/20/95, 65 F3d 367, Affirming an unreported District Court decision

[Code Secs. 6321 and 6323 ]

Tax liens: Bankruptcy: Property held in tenancy by the entireties: Right of survivorship: Joint vs. individual creditors: Priority.--Proceeds from the sale of debtors' residence held in tenancy by the entireties became the sole property of the surviving debtor upon the death of his spouse, and, thus, the joint or individual character of creditors' claims did not affect their priority. Accordingly, the proceeds were required to be applied first to unsecured priority claims, including the IRS's claim for a trust fund recovery penalty, regardless of whether both or just the surviving debtor was liable for the penalty. The proceeds were not required to be applied exclusively to payment of the debtors' joint creditors, despite the trustee's contention that, under state ( Virginia ) law, entireties property is available in bankruptcy administration solely for the benefit of joint creditors. Upon the death of his spouse, the right of survivorship released the surviving debtor and his bankruptcy estate from all such conditions of the tenancy conceived to preserve unity of entireties property.

Jeffrey John Fairfield, Jeffrey J. Fairfield, P.C., 1175 Herndon Parkway , Herndon , Va. 22070 , for plaintiff-appellant. Helen F. Fahey, United States Attorney, Loretta C. Argrett, Assistant Attorney General, Patricia McDonald Bowman, Gary R. Allen, Gary D. Gray, Department of Justice, Washington, D.C. 20530, for defendant-appellee.

Before: HALL and WILLIAMS, Circuit Judges, and PHILLIPS, Senior Circuit Judge.

OPINION

WILLIAMS, Circuit Judge:

In this appeal, we confront an admittedly arcane but interesting question of first impression in this circuit concerning the interaction between federal bankruptcy law and Virginia property law. More specifically, we consider the effect of the termination of the marital estate and resulting devolution of tenancy by the entireties property upon the death of a spouse following the commencement of the couple's joint bankruptcy case. Ruling on the motion of the United States for summary judgment, the bankruptcy court concluded that the proceeds derived from the sale of debtors' property, held by tenancy in the entireties, became the sole property of Edgar Ballard upon the death of his wife, Beulah Ballard. The court held that the proceeds from the sale of the Ballards' entireties property must be applied to pay the unsecured priority claims before a distribution may be made to unsecured general creditors regardless of the joint or individual character of the claim. Trustee, Jeffrey Fairfield, appeals the entry of summary judgment by the United States Bankruptcy Court and affirmance by the United States District Court for the Eastern District of Virginia. For the reasons discussed below, we affirm.

I.

The parties do not dispute the underlying facts in this action. The debtors, Edgar and Beulah Ballard (the Ballards), filed a joint Chapter 11 petition on February 26, 1990. On the date of filing, the Ballards' principal asset consisted of residential real property located at 1841 Clachan Court , Vienna , Virginia . They owned this real property in fee simple as tenants by the entireties. On the List of Twenty Largest Creditors Holding Unsecured Claims, the Ballards included the following as undisputed, non-contingent debts: withholding taxes in the amount of $45,000 owed to the United States Internal Revenue Service and withholding taxes in the amount of $17,000 owed to the Commonwealth of Virginia , Department of Taxation.

On or about May 31, 1990, the IRS timely filed a proof of claim which was amended on February 13, 1992 when the IRS filed an amended proof of claim in the amount of $23,303.56, which consisted solely of a claim for a 100% penalty for the period ending December 31, 1989. ¹

Upon conclusion of the investigation into the employment tax liabilities of Ballene Services, Inc., ² the IRS determined that both Edgar and Beulah Ballard were responsible persons who failed to collect and pay over federal employment taxes withheld from the wages of the employees of Ballene Services, and that both should be held liable for the $23,303.56 penalty, pursuant to 26 U.S.C. §6672 .

On December 28, 1990, the bankruptcy court entered an order authorizing the debtors to sell their residential real property. Also on that date, the court entered a separate order requiring that the proceeds derived from the sale of the Ballards' residential real property "be paid by the settlement attorney in the form of a check payable to Edgar Ballard, Beulah H. Ballard and [their attorney] James G. Smalley; [and] that the check ... be deposited in an interest bearing account requiring the signatures of the Debtors and their counsel to release the funds." (J.A. 49.) The Ballards sold their property, realizing approximately $43,000 from the sale.

On March 18, 1991, Leanne Njus and Associates, Inc. (Njus), an unsecured joint creditor represented by the later-appointed and now-current Trustee, Jeffrey Fairfield, objected to the proofs of claim filed by other claimants and moved to determine the extent of consolidation of the debtors' estates for disallowance of certain claims and for related relief. Specifically, Njus objected to the IRS proof of claim on the basis that Beulah Ballard "was not a responsible person [as defined in IRC §6672(b) ] required to collect, truthfully account for, and pay over trust fund payroll taxes." (J.A. 50.) Njus further requested that the court enter an order allocating"one-half of the net sales proceeds resulting from the sale of the debtors' residence to each of the respective estates of the joint petitioners;" directing "that the respective estates of the debtors be held separate and apart;" and disallowing "the proofs of claim including the proof of claim filed by the United States." (J.A. 50-51.) Following a May 14, 1991, hearing, the bankruptcy court determined that Njus lacked standing to contest the tax claims of the United States and the Commonwealth of Virginia and dismissed Njus's motion with prejudice.

Beulah Ballard died after the May 14, 1991, hearing but before the bankruptcy case was converted to a Chapter 7 proceeding. Thereafter, by order entered April 6, 1993, Mr. Fairfield was confirmed as Chapter 7 trustee. On or about July 27, 1993, the Trustee, in his new capacity, renewed the motions and objections he had presented to the court on behalf of the Njus creditors in March of 1991. The United States , in turn, moved for summary judgment requesting dismissal of the Trustee's motion to segregate the debtors' estates and to overrule the Trustee's objection to the IRS's proof of claim. The United States argued that in light of Mrs. Ballard's death, whether she was personally liable for the §6672 penalty was a moot question.

In its entry of oral findings from the bench, the bankruptcy court granted summary judgment to the United States , finding that upon Mrs. Ballard's death, Mr. Ballard's estate acquired the entire amount of the proceeds from the sale of their home, based on the Ballards' tenancy by the entireties interest in the proceeds. Thus, the court reasoned, whether Mrs. Ballard was also liable for the IRS tax claim was moot because, after her death, all the proceeds from the sale must be allocated to Mr. Ballard's estate. In its brief written order granting summary judgment to the United States , the bankruptcy court stated:

... the proceeds derived from the sale of the debtors' tenants by the entireties property was held by the debtors as tenants by the entireties, that such proceeds became the sole property of Edgar Ballard upon the death of Beulah Ballard, that such proceeds must first be applied to pay the unsecured priority claims before a distribution may be made to unsecured general creditors regardless of whether such creditors hold joint or non-joint claims and that the United States of America's motion for summary judgment should be granted.

(J.A. 15-16.) The Trustee appealed and the district court, in an oral ruling from the bench, affirmed the judgment of the bankruptcy court. The Trustee now appeals, articulating two arguments in support of reversal: (1) only joint creditors are entitled to distribution from the bankruptcy estates; and (2) that the sale of the Ballards' house under §363 of the Bankruptcy Code terminated their tenancy by the entireties and mandated an allocation of the sale proceeds between the two bankruptcy estates.

II.

We review de novo the bankruptcy court's grant of summary judgment and the district court's affirmance thereof. Savers Fed. Sav. & Loan Ass'n v. McCarthy Constr. Co. (In re Knightsbridge Dev. Co.), 884 F.2d 145, 147 n.3 (4th Cir. 1989).

A.

The Trustee's first contention need not detain us long. In support of his claim, the Trustee asserts that the sale of the Ballards' house under §363 of the Bankruptcy Code terminated their tenancy by the entireties and mandates an allocation of the sale proceeds between the two bankruptcy estates. ³ The record reflects that upon authorization of the bankruptcy court, the Ballards sold the property which they held as tenants by the entireties. The $43,000 proceeds from the sale were placed in an interest bearing account requiring the signatures of the Ballards and their counsel to release the funds.

Like the bankruptcy court, we discern no intent by Mr. and Mrs. Ballard to terminate their tenancy by the entireties upon the sale of their home. Again, looking to Virginia law, absent "an agreement or understanding to the contrary, the proceeds derived from a voluntary sale of real estate held by the entireties are likewise held by the entireties." Oliver v. Givens, 129 S.E.2d 661, 663 ( Va. 1963). The Trustee cannot point to any evidence in the record of this appeal which reflects an intent by the Ballards to sever their entireties interest in the proceeds from the sale of their home. Indeed, the manner in which the proceeds were paid and retained by order of the bankruptcy court preserved the tenancy by the entireties. Given the absence of any agreement or other indicia of the Ballards' intent to sever the entireties tenancy upon the sale of the real estate, we affirm the determination of the bankruptcy court that the entireties interest continued in the proceeds.

B.

The Trustee next contends that the bankruptcy court erred in concluding as a matter of law that the proceeds from the sale of the Ballards' residence, held as tenants by the entireties, became the sole property of Edgar Ballard's bankruptcy estate upon the death of Beulah Ballard, thus placing such proceeds within the reach of the IRS to satisfy a priority tax claim against Mr. Ballard. Specifically, the Trustee contends that because only joint creditors are entitled to distribution from the bankruptcy estates, the bankruptcy court's refusal to entertain his objection to the tax claim against Beulah Ballard must be reversed even if the tenancy by the entireties in the sale proceeds of the Ballards' residence endured until the death of Mrs. Ballard. The United States, however, contends that the bankruptcy court properly concluded that the Trustee's arguments are foreclosed by the death of Beulah Ballard and the resulting devolution by operation of Virginia property law of the entireties property in fee simple to her husband, Mr. Ballard, and consequently to his bankruptcy estate. Thus, whether the IRS is a joint creditor or merely a creditor of Mr. Ballard is irrelevant for the purpose of determining the priority of the various creditors. For the following reasons we agree with the conclusions of the bankruptcy court and, therefore, affirm.

The Bankruptcy Code broadly defines the property interests included in the bankruptcy estate to comprise "all legal or equitable interests of the debtor in property as of the commencement of the case," 11 U.S.C.A. §541(a)(1) (West Supp. 1995), and, in pertinent part, "[a]ny interest in property that the estate acquires after the commencement of the case." 11 U.S.C.A. §541(a)(7) (West Supp. 1995). This general rule of inclusion applies with equal force to the debtor's interest in entireties property, Chippenham Hosp., Inc. v. Bondurant (In re Bondurant), 716 F.2d 1057, 1058 (4th Cir. 1983); Napotnik v. Equibank and Parkvale Sav. Assoc., 679 F.2d 316, 318 (3d Cir. 1982) (construing §541 to include the debtor's interest in entireties property), although state law determines the particular features of this property interest. Butner v. United States , 440 U.S. 48, 55 (1979).

It is undisputed that at the time of the Ballards' joint filing for bankruptcy, they owned their home as tenants by the entireties, a form of concurrent ownership of property recognized by the Commonwealth of Virginia . Pitts v. United States , 408 S.E.2d 901, 903 ( Va. 1991); First Merchants Nat'l Bank v. Richmond Lumber & Bldg. Supply Co. (In re Norris), 5 B.R. 799, 802 (Bankr. E.D. Va. 1980); Vasilion v. Vasilion, 66 S.E.2d 599, 602 ( Va. 1951). Tenancy by the entireties comprises "four essential characteristics, that is, unity of time, unity of title, unity of interest, and unity of possession." Pitts, 408 S.E.2d at 903. In particular, neither spouse can effectuate a severance of the tenancy by his or her sole act either by conveying or disposing of any part of the property. Id. ; Vasilion, 66 S.E.2d at 602. This restriction on alienation stems from the common-law recognition of the husband and wife as a "juristic person separate and distinct from the spouses themselves." Pitts, 408 S.E.2d at 903 (citation and quotation marks omitted).

The Trustee argues that the anti-alienation feature of entireties property requires that the proceeds from the sale of the Ballards' residence be applied exclusively to payment of joint creditors. He relies upon the general rule that entireties property under Virginia law is available for bankruptcy administration solely for the benefit of joint creditors. Sumy v. Schlossberg, 777 F.2d 921, 925 (4th Cir. 1985) (characterizing Maryland entireties property as an asset of debtors' joint bankruptcy estates and permitting liquidation only for the benefit of joint creditors); Ragsdale v. Genesco, Inc., 674 F.2d 277, 279 (4th Cir. 1982) (applying the same principle to Virginia entireties property); Virginia Nat'l Bank v. Martin (In re Martin), 20 B.R. 374, 376 (Bankr. E.D. Va. 1982) (same); Reid v. Richardson, 304 F.2d 351 (4th Cir. 1962) (same). In this appeal, however, we confront a distinguishing factual development--the death of Mrs. Ballard following the joint filing of bankruptcy--which implicates another equally important attribute of entireties property, the right of survivorship vested in the remaining spouse: ⁴

Upon the death of either spouse the whole of the estate by the entireties remains in the survivor. This is so not because he or she is vested with any new interest therein, but because in the first instance he or she took the entirety which, under the common law, was to remain to the survivor.

Vasilion, 66 S.E.2d at 602 (citing Lang v. Commissioner [3 USTC ¶1088 ], 289 U.S. 109, 111 (1933)). Of course, we recognize that the unique character of entireties property is such that the death of one spouse does not vest the other with interests he or she did not already hold. The termination of coverture does, however, extinguish the"separate and distinct" juristic personality that underlies those restrictions on alienation unique to entireties property. Thus, Mrs. Ballard's death released her surviving spouse, and thus, his bankruptcy estate, from all conditions of the tenancy conceived to preserve unity of entireties property. See Dollinger v. Bottom (In re Bottom), 176 B.R. 950, 953 (Bankr. N. D. Fla. 1994) ("[t]here is no question that the debtor's right of survivorship is part of the estate"); Waldschmidt v. Shaw (In re Shaw), 5 B.R. 107, 109-10 (Bankr. M.D. Tenn. 1980) (same). More simply put, when the dust settles, by operation of law, Mr. Ballard's bankruptcy estate holds a fee simple interest in the proceeds of the sale of their home.

Although no doubt disappointing to the Trustee and the joint creditors of the bankruptcy estate, it should come as no surprise that upon the destruction of the tenancy by the entireties, in this case by the death of Mrs. Ballard, their status as joint creditors would accord them no greater priority than that enjoyed by any non-joint creditor. Indeed, had Mrs. Ballard died prior to the bankruptcy filing, the joint creditors would fully expect to be in the same position they find themselves today. This result is not dictated by any provision of bankruptcy law but rather by the unique character of property held in tenancy by the entireties. We agree with the Trustee's contention that the commencement of a joint bankruptcy case does not disrupt a debtor's co-ownership of property as a tenant by the entireties. The Trustee, however, must accept all those features peculiar to this form of concurrent property ownership, those that inure to the benefit of joint creditors, such as preferred status during coverture, but also rights of survivorship that upon the death of a spouse collapse any meaningful distinction between joint and non-joint creditors. On this basis, therefore, we agree with the district court and affirm the decision of the bankruptcy court.

III.

In summary, we conclude that the bankruptcy court did not err in its determination that the proceeds derived from the sale of the Ballards' property held by tenancy in the entireties became the sole property of Edgar Ballard upon the death of his wife, Beulah Ballard. Thus, the funds must be applied first to pay the unsecured priority claims regardless of the joint or individual character of the claim.

AFFIRMED.

¹ The original proof of claim was in the amount of $29,975.65, listing two estimated claims in the amount of $2,236.00 for the debtors' federal income tax liability for the 1989 taxable year and in the amount of $27,739.65 for a 100% penalty for the period ending March 31, 1990. The sums claimed on the original and amended proofs of claim relate to unpaid federal withholding taxes withheld from the wages of the employees of Ballene Services, Inc. during the fourth quarter of 1988 and the second, third, and fourth quarters of 1989.

² The Ballards were the sole stockholders in Ballene Services, Inc.

³ Section 363 defines the rights and powers of the trustee with respect to the disposition of the property of the estate. It also articulates the rights of third parties asserting an interest in the subject property. 11 U.S.C.A. §363 (West Supp. 1995). See 2 Collier on Bankruptcy ¶363.01, at 363-6 (15th ed. 1995). The Ballards as Chapter 11 debtors-in-possession held the powers and duties of the Trustee. 11 U.S.C. §1107(a) (1988).

⁴ Until the moment of Mrs. Ballard's death, the Trustee would have been correct in his assertion. The Trustee, however, in his select focus on the anti-alienation provision, has ignored an equally important feature of tenancy by the entirety: the right of survivorship enjoyed by the spouse of the deceased.

[Dissenting Opinion]

HALL, Circuit Judge

I dissent because I believe that the sale of the property had the effect of severing the tenancy by the entireties, and, as a result, each bankruptcy estate should be deemed to contain half of the proceeds. It is therefore necessary to determine whether Mrs. Ballard was liable on the tax claims; if she was not, the tax creditors would be limited to the proceeds in her husband's estate.

At filing, all property of the debtors came into their respective estates. 11 U.S.C. §541(a)(1) . Filing alone did not sever the tenancy by the entireties. See In re DeMarco, 114 B.R. 121, 123 (Bankr. N.D.W.Va. 1990). However, the debtors-in-possession, who act as trustees, ¹ are charged with administering the estate, and the sale of the house severed the tenancy by the entireties. See id. at 124 ("The trustee has no title to property of the estate until he elects to take affirmative action and proceedings are had or orders made."). In the absence of an exemption that might dictate a different result, ² the money is simply allocable between the two estates.

I would agree that, had the sale occurred outside bankruptcy, there is support in Virginia law for finding a new tenancy by the entireties in the proceeds. See Oliver v. Givens, 129 S.E.2d 661, 663 ( Va. 1963) ("It is true ... that the sale of the real estate which the husband and wife owned as tenants by the entireties terminated such an estate in that property.... [I]n the absence of an agreement or understanding to the contrary, the proceeds derived from a voluntary sale of real estate held by the entireties are likewise held by the entireties."). However, the sale of the Ballards' residence was not a "voluntary sale" by a husband and wife. Instead, it was a liquidation of bankruptcy estate assets by debtors-in-possession, undertaken with the "agreement or understanding" that creditors would eventually consume the entire amount. By focusing on how state law would view the transaction, the majority loses sight of the bankruptcy context in which the sale took place.

"[A] debtor in possession shall have all the rights, ... and shall perform all the functions and duties ... of a trustee serving in a case under [chapter 11]." 11 U.S.C. §1107(a). One of a trustee's duties is to "collect and reduce to money the property of the estate ...." 11 U.S.C. §704(1) . The bankruptcy court ruled that the sale of the Ballards' residence was authorized under 11 U.S.C.§363(b)(1), which provides that "[t]he trustee, after notice and hearing, may ... sell ... property of the estate ...." ³ The debtors-in-possession gave notice of the proposed sale pursuant to Bankr. R. 6004, which is required for the sale of estate property by a trustee or debtor-in-possession. The debtors' initial reorganization plan, filed after the sale, stated that the plan was one "of liquidation." The net proceeds, which were earmarked in the plan for payment to their creditors, constitute property of the estate that was being temporarily held by them in their role as debtors-in-possession.

The pivotal fact underlying the bankruptcy court's ruling that the tenancy by the entireties survived the sale of the residence was that "the proceeds were deposited into an interest-bearing account requiring the signature of both parties and their attorney." J.A. 25 (bench ruling on IRS's summary judgment motion). The majority likewise holds that "the manner in which the proceeds from the sale were paid and retained by order of the bankruptcy court preserved the tenancy by the entireties." Majority op. at 6. I believe this logic elevates form over substance.

A trustee "may make such deposit or investment of the money of the estate ... as will yield the maximum reasonable net return on such money ...." 11 U.S.C. §345. Debtors-in-possession, in the performance of their administrative duties, may do the same. Had the proceeds been placed in separate accounts, would the majority's analysis be different? Inasmuch as the debtors had not identified any individual debts of either of them, it simply made sense to require that the proceeds be kept in a single account. This mere administrative detail should not be permitted to eclipse the substance of the sale.

I would vacate the judgment below and remand with directions to determine whether Mrs. Ballard was liable on the tax claims.

¹ A trustee was not appointed until after the cases were converted to chapter 7.

² With regard to the residence, the only exemption claimed was the state homestead exemption; the debtors did not claim the exemption under 11 U.S.C. §522(b)(2)(B). The majority notes that had Mrs. Ballard not died, liquidation of the entireties estate would have been for the benefit of the joint creditors only. See majority op. at 8 & n.4. The majority seems to assume that this result would obtain even without a §522(b)(2)(B) exemption having been claimed. Only when the exemption option has been exercised, however, does the entireties property stand available for the satisfaction of only the joint debts. See Sumy v. Schlossberg, 777 F.2d 921, 927-29 (4th Cir. 1985); In re Ford, 3 B.R. 559, 570 (Bankr. D. Md. 1980) ("The trustee merely obtains and retains custody of the debtor's undivided interest consisting of the same unities, intact and unaltered, as they existed immediately prior to the filing of the petition, until such time as that interest, still intact and unaltered, is exempted from the estate under §522(b)(2)(B)."), aff'd Greenblatt v. Ford, 638 F.2d 14 (4th Cir. 1981). In each of the cases cited by the majority-- Sumy , Ragsdale, Martin and Reid (see majority op. at 8)--the debtor(s) had in fact claimed the exemption.

Even if only Mr. Ballard is liable for the tax claims, the IRS and other individual creditors would still be able to reach his portion of the sale proceeds. This result, however, is dictated by his failure to claim the §522(b)(2)(B) exemption and not, as the majority holds, by a dissolution of the tenancy by the entireties occasioned by Mrs. Ballard's death.

³ Whether the sale was conducted pursuant to §363(b)(1) or (h) is irrelevant. Inasmuch as both co-tenant spouses had filed for bankruptcy, there was no need to invoke §363(h) to consider the benefits of partition in kind or sale of one debtor's undivided interest. Subsection (h) was clearly written with non-debtor co-owners in mind.

 

 

 

In re Thomas Arthur Jones, Debtor. United States of America , Appellant v. Thomas Arthur Jones, Appellee

U.S. District Court, Dist. Kan., 93-4250-RDR, 4/27/95, 181 BR 538, Affirming in part, reversing in part and remanding an unreported Bankruptcy Court decision

[Code Sec. 6321 ]

Tax liens: Bankruptcy estate: Noncompetition payments.--Noncompetition payments made to a dentist in bankruptcy were subject to the IRS's tax liens. The noncompetition payments were for goodwill and a customer list in connection with the sale of his practice. The payments were not for post-petition services but were rooted in the period prior to bankruptcy. Therefore, the payments were includible in the bankruptcy estate, and the liens attached to the payments.

[Code Sec. 6672 ]

Application of payment: Voluntary payment.--The IRS was equitably estopped from applying a payment to a dentist's income tax liabilities rather than his payroll withholding tax liabilities. A pre-bankruptcy petition payment to the IRS made by the dentist was voluntary and should have been applied first to payroll withholding tax liabilities as agreed upon by the dentist and an IRS agent. The dentist was harmed by the IRS's application of his payment to his income tax liabilities because it resulted in a larger tax obligation than under the original agreement

Richard C. Wallace, Evans & Mullinix, P.A. 15301 W. 87th St., Pkwy., Lenexa, Kan. 66219-1428, for debtor. James J. Long, Department of Justice, Washington , D.C. 20530 , for appellant. Richard C. Wallace, Evans & Mullinix, P.A. 15301 W. 87th St., Pkwy., Lenexa, Kan. 66219-1428, for appellee. William H. Griffin, 433 Kansas Ave. , Topeka , Kan. 66601 -3527, for trustee.

MEMORANDUM AND ORDER

ROGERS, District Judge:

This is an appeal from the bankruptcy court. The United States contends that the bankruptcy court erred (1) in finding that payments under a covenant not to compete were not property of the debtor's estate and (2) in finding that a payment made by the debtor to the Internal Revenue Service was voluntary and that the IRS is equitably estopped from applying this payment to the debtor's income tax liability. Having carefully reviewed the arguments of the parties, the court is now prepared to rule.

The standards of review are well-settled. The bankruptcy court's findings of fact must be upheld unless they are clearly erroneous. Bankr.R. 8013; In re Mullet, 817 F.2d 677, 678 (10th Cir. 1987). The bankruptcy court's legal determinations are reviewed de novo. In re Yeates, 807 F.2d 874, 877 (10th Cir. 1986).

The factual background of this case is generally not in dispute. The debtor is a dentist who has practiced and is currently practicing in Kansas City , Kansas . Over the course of his practice, the debtor incurred significant tax liabilities, some for payroll withholding taxes (941 taxes) and some for income taxes (1040 taxes). Since 1984, the United States has assessed debtor for his failure to pay these taxes and filed a number of notices of federal tax liens. The debtor owed $29,078.97 in 941 taxes and $90,739.65 in 1040 taxes. In 1990, the debtor and IRS revenue officer Robert E. Moore entered into an oral agreement. The agreement provided that the debtor would make monthly payments of $1,000 to the IRS on his payroll tax liabilities and then make a lump sum payment in May 1991 for the remaining balance. Agent Moore had told debtor that he would have to pay all of his payroll taxes before the IRS would consider any offer to compromise or make monthly payments on his income taxes. Debtor made his monthly payments, but he was unable to make the necessary lump sum payment in May. Agent Moore informed the debtor that the IRS was "closing [him] out." In response, the debtor suggested selling his dental practice to satisfy the remaining balance owed on his payroll tax liabilities. The debtor made efforts to sell his business, but he was not successful until the summer of 1992. On June 8, 1992, the IRS mailed debtor its final notices of intention to levy. The notices gave him thirty days to pay the amounts owed or the IRS would seize his property, including his dental practice. The debtor made his efforts to sell his practice known to Agent Moore, and Agent Moore agreed to allow the debtor additional time to sell his practice before the IRS proceeded to levy on the property.

On July 3, 1992, debtor sold his dentistry practice and entered into an asset purchase agreement. Pursuant to the agreement, debtor received a cash payment of $75,000.00, an interest in gross collections generated from the dentistry practice valued at $100,000.00, a security agreement in the assets of the practice until the remainder of the purchase price was paid, and a right to use the facilities of the practice for an indefinite period. The debtor had told the sales agent and the buyer that the purchase amount, less the amount allocated to the debtor's agreement not to compete with the buyer in providing dental services, would have to be sufficient to pay the 941 taxes. The parties agreed to allocate $75,000.00 of the purchase price to the assets of the practice, which was enough to pay the costs and expenses of the sale, the liens prior to the IRS liens, and the 941 debt. They allocated the balance of the purchase price to the noncompetition agreement. This amounted to $50,000.00 and was to be paid over several years if certain conditions were met. The debtor has readily admitted that the price of the covenant not to compete represented business goodwill and customer base. After payment of the expenses of the sale, the debtor obtained a cashier's check in the amount of $29,078.97 payable to the IRS and himself. On October 16, 1992, debtor remitted the check to the IRS. The amount of the check was identical to the amount of 941 taxes shown on one of the final notices of intention to levy. The check and the attachments, however, contained no notation directing the IRS to apply it to debtor's 941 taxes. The IRS applied the amount contained on the check to debtor's 1983 and 1984 income taxes. On October 30, 1992, the debtor filed a voluntary petition in bankruptcy under Chapter 13 of the Bankruptcy Code. The debtor had informed the IRS in early October that he was contemplating filing bankruptcy.

The bankruptcy court decided that the postpetition payments made to the debtor pursuant to covenant not to compete were not subject to the tax liens of the IRS. In reaching this conclusion, the court relied upon In Re Wilson, No. 84-40588 (Bankr.D.Kan. 1986), aff'd, No. 86-4062-R (D.Kan. 1987). The bankruptcy court also determined that the IRS was equitably estopped from applying debtor's payment of $29,078.97 on October 16, 1992 to his income tax liability. The bankruptcy court held that the IRS was forced to credit the payment to debtor's 941 tax liability.

The court is faced with two issues: (1) Are the payments made pursuant to the covenant not to compete subject to the liens of the IRS? and (2) Should the IRS be equitably estopped from applying the $29,078.97 payment to debtor's 941 taxes?

I.

In general, a federal tax lien attaches to "all property and rights to property, whether real or personal, belonging to" the taxpayer. 26 U.S.C. §6321 . The lien imposed by §6321 arises when an assessment is made and continues until either the taxpayer's liability is satisfied or the statute of limitations on collection expires. 26 U.S.C. §6322 . Under the Bankruptcy Code, the claim of the IRS is a secured claim only if the claim is secured by a lien on "property in which the estate has an interest" and only "to the extent of the value of such creditor's interest in the estate's interest in such property." 11 U.S.C. §506(a). The secured status of the IRS is determined as of the petition date. 11 U.S.C. §506; In re Riley, 88 B.R. 906, 912 (Bankr.W.D.Wis. 1987). As a general rule, property acquired by the debtor's estate after the commencement of the bankruptcy is not subject to the liens of the IRS. 11 U.S.C. §552(a) ; In re Dente/Pender, 60 B.R. 164, 165 (Bankr.M.D. Fla. 1986).

The question here is whether the monies earned by the debtor from the noncompetition payments constitute earnings from personal services so that they were not part of the debtor's estate at the time of the filing of the bankruptcy petition or constitute proceeds from a contract right which existed and became property of the estate on the filing date. If the noncompetition payments constitute earnings from personal services, the liens of the IRS do not attach because such earnings were not part of the debtor's estate at the commencement of his bankruptcy. If, however, the payments were not considered earnings from personal services, but are deemed proceeds of a contract right which existed and became property of the estate on the filing date, the liens of the IRS would attach.

The issue before the court has arisen in a number of bankruptcy cases, although none involving Chapter 13. One of the earliest cases deciding this issue, In re Hammond, 35 B.R. 219 (Bankr.W.D.Okla. 1983), held that postpetition noncompetition payments were not property of the estate because these payments were conditioned on the debtor's compliance with the covenant not to compete, and the debtor could not be compelled to perform services for the benefit of his creditors. The court reasoned as follows:

If an entity, be it Hammond or Hammond's estate, is to receive the payments in question, Hammond must abide by the agreement. We cannot force Hammond to comply. 'The bankrupt ... cannot be compelled to perform work or services for the benefit of his creditors or his trustee in bankruptcy.' 3 Remington on Bankruptcy 1228.25 (1941). It is a foil which thrusts both ways. Hammond is therefore performing a service which is not 'sufficiently rooted' in the bankruptcy past so as to render the payments property of the estate.

Id. at 223.

The support for Hammond in other courts has been limited. In In re Walden, 12 F.3d 445, 451-52 (5th Cir. 1994), the Fifth Circuit, relying upon Hammond, suggested in dicta that annuity payments made pursuant to a covenant not to compete were not part of the debtor's estate because such payments were for services performed by debtor after commencement of case. In In re Hofstee, 88 B.R. 308 (Bankr.E.D.Wash. 1988), aff'd without opinion, 116 B.R. 872 (B.A.P. 9th Cir. 1990), the bankruptcy court initially embraced Hammond ,, but later distinguished it in an addendum to the opinion.

Many cases, however, have criticized Hammond and held that such payments were not tantamount to earnings from services performed by the debtor. See, e.g., In re Johnson, 178 B.R. 216 (B.A.P. 9th Cir. 1995); In re Andrews, 153 B.R. 159 (Bankr.E.D.Va. 1993); In re McDaniel, 141 B.R. 438 (Bankr.N.D.Fla. 1992); In re Prince, 127 B.R. 187 (N.D.Ill. 1991); In re Bluman, 125 B.R. 359 (Bankr.E.D.N.Y. 1991). In Johnson, the bankruptcy appellate panel of the Ninth circuit explained the essence of these rulings with the following comment: "We conclude that compliance with a anti-competition agreement is not 'services performed' because refraining from the performance of services is not the performance of services." 178 B.R. at 220.

In Wilson , this court considered the issue. After a careful examination of the factual situation, the court affirmed the bankruptcy court's ruling that the postpetition payments under the noncompete agreement were compensation for the debtor's post-bankruptcy personal services and therefore excluded from the bankruptcy estate. In Wilson , the debtor sold an automobile dealership prior to filing for bankruptcy. The sales agreement contained a covenant not to compete clause. In reaching the conclusion that the payments under the noncompete agreement constituted earnings for personal services, the court stated:

The negotiations for Wilson 's dealership suggest, as noted by the bankruptcy court, that the non-competition payments were not part of the price for the sale of the business. The addition of the payments to the negotiated sale price would have put the final figure above Wilson 's initial asking price. This indeed would have been an odd result. Further, the facts fail to support any contention that these payments constituted value for goodwill. [The buyer] planned to move Wilson 's dealership and to operate it under another name. Finally, the facts suggest that the noncompetition agreement was entered into after the purchase agreement had been made. This fact again supports the contention that the payments were not part of the purchase price.

After carefully reviewing the recent law on this issue and considering the particular facts of this case, we are convinced that the bankruptcy court erred in concluding that the liens of the IRS did not attach to the noncompetition payments. The court is persuaded by recent opinions that have suggested that the decision in Hammond was incorrect and that payments made pursuant to a covenant not to compete are not services performed under the Bankruptcy Code. The court, however, need not decide that Wilson was erroneously decided because the particular facts of this case are readily distinguishable from Wilson . The undisputed facts in the record indicate that the noncompetition payments in this case were for goodwill and the customer list. The noncompetition payments were a method of paying for the value of the debtor's goodwill and customer list. The goodwill and the customer list were established prepetition. Under these circumstances, the noncompetition payments are not for postpetition services, but are "sufficiently rooted in the pre-bankruptcy past," such that any legal or equitable interest in property arising therefrom is includable in the bankruptcy estate.

This case is very similar to Prince. In Prince, an orthodontist filed a petition for bankruptcy. During the pendency of the proceeding, the debtor negotiated the sale of his orthodontist practice. As part of the agreement, the parties entered into a covenant not to compete which prohibited the debtor from engaging in any orthodontist practice in the immediate area. The debtor sought to exclude the noncompetition payments from his estate on the theory that he was earning the payments by not competing. The bankruptcy court held that the payments were for goodwill rather than services and, since the goodwill was inextricably tied to his prepetition activities, the payments were part of the estate. 127 B.R. at 191-92.

In his brief, the debtor has not disputed that the noncompetition payments are "rooted in [his] pre-bankruptcy past." Rather, the debtor argues only that these payments should not be regarded as property in the bankruptcy estate because such a finding would entangle his ability to make a "fresh start."

The court is not persuaded by the debtor's argument. As pointed out by the government, the fact that a covenant not to compete is determined to be property of the estate would not affect a debtor's ability to make a fresh start any more than any other type of property which is secured by lien. The concept of a fresh start would not be frustrated where a creditor has a secured claim in payments under a covenant not to compete. As explained by the court in McDaniel: "This section [11 U.S.C. §541 ] was intended to give debtor the ability to make a fresh start, not shield his pre-bankruptcy assets from his creditors." 141 B.R. at 440.

Moreover, the debtor's "fresh start" will not be inhibited by this ruling. The covenant not to compete only precludes him from working in an area within seven miles of the practice that he sold. With that exception, he can work anywhere as a dentist, and all of his earnings will be free from the claims of his prepetition creditors.

In sum, the court finds that the bankruptcy court erred in concluding that the liens of the IRS did not attach to the noncompetition payments. The decision of the bankruptcy court is reversed and remanded for proceedings consistent with this opinion.

II.

The United States next contends that the bankruptcy court erred as a matter of law in holding that the $29,078.97 payment made by the debtor was voluntary, and that the government was estopped from applying this payment to debtor's 1983 and 1984 federal income tax liability.

Estoppel is an equitable doctrine which may be invoked to avoid injustice. Heckler v. Community Health Services, Inc., 467 U.S. 51, 59 (1984). For estoppel to apply, a party claiming estoppel "must have relied on its adversary's conduct in such a manner as to change his position for the worse, and that reliance must have been reasonable in that the party claiming the estoppel did not know nor should it have known that its adversary's conduct was misleading." Id. The application of estoppel against the government is less than clear. See Penny v. Giuffrida, 897 F.2d 1543, 1546 (10th Cir. 1990). Although the Supreme Court has never applied estoppel against the government, the Court has left open the possibility that estoppel could be applied under the appropriate circumstances. Office of Personnel Management v. Richmond , 496 U.S. 414, 423 (1990). "[W]e are hesitant . . . to say that there are no cases in which the public interest in ensuring that the Government can enforce the law free from estoppel might be outweighed by the countervailing interest of citizens in some minimum standard of decency, honor, reliability in their dealings with their Government." Heckler, 467 U.S. at 60-61 (emphasis in original). "At a minimum, estoppel against the government is disfavored when its application 'thwarts enforcement of the public laws.' " Muck v. United States [93-2 USTC ¶50,592 ], 3 F.3d 1378, 1382 (10th Cir. 1993) (quoting Trapper Mining Inc. v. Lujan, 923 F.2d 774, 781 (10th Cir.), cert. denied, 112 S.Ct. 81 (1991)).

A party seeking to establish equitable estoppel against the government has the burden of demonstrating the following traditional elements of estoppel: (1) the party to be estopped must have known the facts; (2) the party to be estopped must intend that his conduct will be acted upon or must so act that the party asserting the estoppel has the right to believe that it was so intended; (3) the party asserting the estoppel must be ignorant of the true facts; and (4) the party asserting the estoppel must rely on the other party's conduct to his injury. Penny, 897 F.2d at 1545-46.

Having carefully reviewed the arguments of the parties, the court is persuaded that the bankruptcy court correctly decided that the government should be equitably estopped from applying the debtor's prepetition payment of $29,078.97 to his income tax liability. Pursuant to the agreement reached between the debtor and IRS, the payment made by the debtor to the IRS in October 1992 should have been credited to the debtor's 941 tax liability.

The United States has suggested that the payment made by the debtor was not voluntary and therefore debtor could not designate how the payment would be applied. Under the peculiar circumstances of this case, we believe that the payment was voluntary and that the IRS was aware or should have been aware of where the payment was to be applied. "The distinction between a voluntary and involuntary payment . . . is not made on the basis of the presence of administrative action alone, but rather the presence of court action or administrative action resulting in the actual seizure or property or money, as in a levy." Muntwyler v. United States [83-1 USTC ¶9275 ], 103 F.2d 1030, 1033 (7th Cir. 1983). The IRS had issued final notices of intention to levy in this case. However, following the issuance of these notices, the debtor contacted Agent Moore and informed him of his efforts to sell his dental practice in order to make the lump sum payment to the IRS. Agent Moore allowed the debtor additional time to pay voluntarily before the IRS proceeded to levy. These circumstances clearly indicate that the IRS viewed any forthcoming payment as voluntary. The mere presence of the administrative action alone does not convert the debtor's payment into an involuntary payment under these circumstances.

In considering the elements of estoppel, the court is in agreement with the assessment of those factors made by the bankruptcy court. The IRS was well apprised of the facts in this case. The debtor had a running dialogue with Agent Moore on the payment of these taxes. Agent Moore made it clear to the debtor that the IRS was interested in initially collecting the 941 taxes and provided him with an incentive in making these payments. The actions of the IRS, through Agent Moore, gave the debtor every reason to believe that his payment would be applied to his 941 taxes. The statements of Agent Moore after the debtor initially failed to make the lump sum payment led the debtor to believe that the intentions of the IRS had not changed. These statements by Agent Moore suggested that the agreement was still available and allowed the debtor additional time to comply with it. The debtor's actions in obtaining a check in the exact amount of the 941 taxes are an indication that he believed that the earlier agreement was still valid. The debtor was harmed because the application of his payment to his income taxes rather than his 941 taxes has left him with an obligation to pay a greater portion of his total tax debt than he would have paid if the IRS had abided by the original agreement. In sum, the court shall affirm this aspect of the bankruptcy court's ruling because we find that these circumstances compel the application of equitable estoppel. Equitable estoppel against the government under the circumstances of this case serves to promote fair play and does not thwart the enforcement of the public laws. As stated by Justice Jackson in his dissenting opinion in Federal Crop Insurance Corp. v. Merrill, 332 U.S. 380, 387-88 (1947): "It is very well to say that those who deal with the Government should turn square corners. But there is no reason why the square corners should constitute a one-way street." Or, as stated by Justice Black in a dissenting opinion in St. Regis Paper Co. v. United States, 368 U.S. 208, 229 (1961): "Our Government should not by picayunish haggling over the scope of its promise, permit one of its arms to do that which, by any fair construction, the Government has given its word that no arm will do. It is no less good morals and good law that the Government should turn square corners in dealing with the people than that the people should turn square corners in dealing with their government."

IT IS THEREFORE ORDERED that the decision of the bankruptcy court is affirmed in part and reversed in part. This case is remanded to the bankruptcy court for further proceedings consistent with this opinion.

IT IS SO ORDERED.

 

 

 

In re Elmer J. Schreiber and Linda Schreiber a/k/a Linda Spies, Debtors. Linda Schreiber a/k/a Linda Spies, Plaintiff v. The United States of America , Department of the Treasury, Internal Revenue Service, Defendant

U.S. Bankruptcy Court, No. Dist. Ill. , East. Div., 91 B 16970, 1/21/94, 163 BR 327, 163 BR 327

[Code Sec. 6321 ]

Bankruptcy and receivership: Lien for tax.--

In determining how much money was available to be applied against an IRS lien for taxes, the bankrupt owners' equity in their home was determined as of the date the home was sold, not the date the bankruptcy petition was filed. Due to a post-petition agreement by the second mortgage lender to settle its claim for less than the face amount, the owners' equity in the home went from a negative amount on the date the bankruptcy petition was filed to a positive balance. It had been argued that, at the time of filing, there was no equity for the IRS to attach. However, the confirmed plan of reorganization specifically mandated that any proceeds from the sale of the home should be distributed in accordance with local law to allowed secured claims. Thus, the proceeds remaining after payment of the mortgage lenders were properly allocable to the payment of the IRS's lien.

[Code Secs. 6321 and 6334 ]

Bankruptcy and receivership: Levy and distraint: Collection of tax: Seizure of property for unpaid taxes: Retirement accounts.--

A statutorily required clause in a pension plan that precluded ordinary creditors from attaching an employee's pension payments did not prevent a bankrupt couple's IRA from being subject to an IRS lien. Such anti-alienation clauses are not effective to block tax liens, tax judgments or tax levies.

[Code Sec. 6871 ]

Bankruptcy and receivership: Interest on tax: Post-petition interest.--

As an over-secured creditor, the IRS was entitled to post-petition interest from the date the bankruptcy petition was filed to the date the secured claim was fully paid. The value of the bankrupts' available assets following the sale of their residence was more than enough to satisfy the pre-petition IRS lien.

[Code Sec. 6321 ]

Bankruptcy and receivership: Lien for taxes: Property transferred during divorce.--

The liability of a former wife who divorced after a tax lien was filed and after she and her ex-husband filed a bankruptcy petition was not limited to the value of the property apportioned to her in the divorce. The IRS lien attached to the property, no matter who held it, and was unaffected by the divorce proceedings.

Arthur G. Jaros, Jr., Richter & Jaros, 1200 Harger Rd., Oak Brook, Ill. 60521, for plaintiff. Samuel D. Brooks, Department of Justice, Washington , D.C. 20530 , for defendant.

MEMORANDUM OPINION

SCHMETTERER, Bankruptcy Judge:

This adversary proceeding relates to the bankruptcy petition of Elmer and Linda Schreiber ("Schreibers" or "Debtors") filed under Chapter 11 of the Bankruptcy Code, Title 11 U.S.C. Their Plan was confirmed. Pursuant thereto, their house was later sold. The net proceeds of that sale are here in dispute. The United States asserts a tax lien against those proceeds.

Ms. Schreiber filed this action partly to determine the extent of the government's lien on Debtors' home. Mr. Schreiber is not a party to this adversary proceeding. Ms. Schreiber contends that, for purposes of the Internal Revenue Service's ("IRS") lien under 11 U.S.C. S 6321 , the amount of its allowed secured claim should be determined as of the petition date. She thereby seeks to take advantage of certain work by her attorney during the bankruptcy which resulted in a negotiated reduction of the second mortgage on the house. The home has since been sold and net proceeds resulted. The IRS claims that its lien applies to those proceeds. Pre-bankruptcy, the IRS held a tax lien on Debtors' property of $41,486.92. Ms. Schreiber says that the IRS had no equity to attach to when the bankruptcy was filed, and therefore cannot claim such equity now.

Ms. Schreiber further maintains that Mr. Schreiber's Qualified Individual Retirement Annuity ("IRA") should be excluded from the property subject to the IRS lien when determining extent of that lien. Plaintiff maintains that the IRA is exempt from the IRS lien pursuant to Treasury Regulation 401(a) -13(b)(2), and therefore should be excluded from Debtors' property subject to the lien. Finally, she contends that the government lien on other property, to the extent it applies to her, only applies to the value of "her" portion of those properties because the Schreibers are now divorced.

The IRS argues that the government is an oversecured creditor, as defined by §506(b), and thereby is entitled to post-petition interest. In addition, the government maintains that there is no legal basis for valuing the Schreiber's residence as of the petition date or for excluding the IRA from the reach of its lien.

The parties herein filed cross-motions for summary judgment. Both parties have made their respective filings required under Local District Rule 12(m) and (n).

For reasons discussed below, the government's allowed secured claim is valued as of the date of sale and at the actual sale price of the home, and Mr. Schreiber's IRA is found to be included in Debtors' property subject to the IRS lien. After those rulings, Debtors' home equity exceeds the amount of the IRS allowed secured claim, and so the IRS lien and claim accrued interest post-petition.

Ms. Schreiber's contentions as to the extent of the government's lien on other property are not supported by authority and are overruled.

Accordingly, by separate order the IRS motion for summary judgment is allowed and that of Ms. Schreiber is denied. Judgment will enter accordingly.

UNDISPUTED FACTS

From the respective filings these facts emerge as undisputed:

When the bankruptcy was filed, in addition to their home and Mr. Schreiber's IRA, Debtors had personal property subject to the IRS lien, and that other property is valued at $23,850.00. ¹ In addition, Mr. Schreiber owned an IRA valued at $15,856.87.

The Schreibers filed their petition for relief under Chapter 11 of the Bankruptcy Code on August 9, 1991. Their marriage has since been dissolved. Debtors scheduled an IRS secured claim of $40,000 pursuant to 26 U.S.C. §6321 , for income taxes, penalties, and interest for the tax periods ending December 1986 and 1987. In addition, an IRS unsecured priority claim for $84,000.00 was scheduled due to an asserted 100% tax liability of Mr. Schreiber as responsible officer of his corporate business under 26 U.S.C. §6672 . The latter claim arose because of withholding taxes owed by Princeton Products, Inc., for tax periods through August of 1991.

The IRS filed proofs of claims on October 11, 1991; December 16, 1991; and July 2, 1993. The amounts sought included $41,486.92 related to the secured claim under §6321 , and $35,016.35 for all IRS unsecured claims under §6672 for tax periods ending September of 1991. On September 18, 1990, the IRS had recorded a revenue lien against the Debtors in the Cook County, Illinois, Recorder of Deed's office for $33,772.28. Its $41,486.92 secured claim includes pre-petition interest and penalties on top of the recorded revenue lien.

When the bankruptcy petition was filed, the IRS lien against Debtors' residence was subordinate both to a first mortgage having a balance between $65,000.00 and $70,000.00 and a second mortgage of $195,000.00. Thus, on the filing date, the home was encumbered with a total of $265,000.00 in liens superior to that of the IRS. Since the home was appraised at $230,000.00 and ultimately sold for $231,000.00, a sum far less than this total of pre-bankruptcy liens, Plaintiff argues that the Debtors had no equity when the proceeding was filed. Subsequent to the bankruptcy filing, however, through settlement the second mortgage was allowed in the sharply reduced amount of $97,338.12, thereby lowering the total of the two superior liens to $167,661.88, at the time of sale, much less than the sale price.

On May 28, 1992, (nine and one-half months after the bankruptcy filing), Debtors' First Amended Plan of Reorganization as modified ("Plan") was confirmed herein. That Plan provided for sale of the Debtors' residence and for distribution following sale of all proceeds according to priorities of liens und