Pavlovs Dog the Chicken and the Egg Decision in United States v. Craft Should Have Minimal Impact

Pavlovs Dog the Chicken and the Egg Decision in United States v. Craft Should Have Minimal Impact

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The "buzz" at a recent CLE conference was the potential impact that the recent Supreme Court case of United States v. Craft, 122 S.Ct. 1414 (2002), would have in the bankruptcy arena. Chapter 7 trustees salivated at the mere mention of the Craft opinion, postulating that Craft completely denuded the largely untapped golden vein of tenancy by the entireties property and that such previously untouchable property would soon become the principal ore in the liquidation smelter of many bankruptcy estates.

In Craft, the Supreme Court held that an IRS lien against one spouse attaches to the interest of that spouse in entireties property. The debtor in Craft was an individual who failed to pay federal income tax liabilities in the amount of $482,446. After a federal tax lien was filed against the debtor, the debtor and his wife executed a quitclaim deed purporting to convey his interest in certain Michigan real property held as tenants by the entireties to his wife. When the wife attempted to sell the property a few years later, a title search revealed the lien. The IRS agreed to release the lien and allow the sale with the stipulation that half of the net proceeds be held in escrow pending the determination of the government's lien in the property. The wife brought an action in federal district court to quiet title to the escrowed proceeds. The government's position in the case was that the tax lien attached to the husband's interest in the entireties property. The district court granted summary judgment in favor of the government, but the Sixth Circuit reversed. The Supreme Court granted certiorari to consider the government's claim that the husband had a separate property interest in the entireties property to which the federal tax lien attached.

The Supreme Court began its analysis with the axiom that the federal tax lien statute (26 U.S.C. §6321) itself creates no property rights but merely "attaches consequences, federally defined, to rights created under state law." Id. at 1420. As explained by the Court, "[w]e look initially to state law to determine what rights the taxpayer has in the property the government seeks to reach, then to federal law to determine whether the taxpayer's state-delineated rights qualify as 'property' or 'rights to property' within the compass of the federal tax lien legislation." Id.

Looking to Michigan law, the Court determined that the husband enjoyed the following rights with respect to the entireties property: the right to use the property, the right to exclude third parties from it, the right to a share of income produced from it, the right of survivorship, the right to become a tenant in common with equal shares upon divorce, the right to sell the property with his wife's consent and to receive half the proceeds from such sale, the right to place an encumbrance on the property given his wife's consent and the right to prevent his wife from selling or encumbering the property unilaterally. Id. at 1422. Writing that the statutory language authorizing federal tax liens is broad and "reveals on its face that Congress meant to reach every interest in property that a taxpayer might have," the Court concluded that, under Michigan law, the husband's individual interest in the entireties property constituted "property" or "rights to property" sufficient to fall within the broad language of the federal tax lien statute. Id. at 1425. Determining that the federal government is not bound by state-created exemptions, the Supreme Court reversed the decision of the Sixth Circuit and held that the IRS lien did attach to the husband's interest in the entireties property. Id.

Having pierced the seemingly impenetrable veil of entireties property, the question for bankruptcy practitioners is whether the Supreme Court's analysis in Craft can be extended in the bankruptcy context to allow the liquidation of entireties property even absent the attachment of a pre-petition federal tax lien. Fortunately for debtors, and unfortunately for bankruptcy trustees and creditors, the answer is, "probably not."

Under §541(a) of the Bankruptcy Code, the bankruptcy estate comprises "all legal or equitable interests of the debtor in property as of the commencement of the case." The cases are legion that hold that §541 includes in the bankruptcy estate a debtor's interest in entireties property. See, e.g., In re Cordova, 73 F.3d 38, 40 (4th Cir. 1996); In re Arrango, 992 F.2d 611, 614 (6th Cir. 1993); In re Hunter, 970 F.2d 299, 305 (7th Cir. 1992); In re Garner, 952 F.2d 232, 234 (8th Cir. 1991). However, once included as part of the bankruptcy estate, §522(b)(2)(B) of the Bankruptcy Code allows a debtor to exempt from the bankruptcy estate any interest the debtor holds as a tenant by the entirety to the extent that the interest is exempt under applicable non-bankruptcy law. Thus, although initially included in estate property, a debtor is entitled to immediately exempt entireties property from a bankruptcy estate to the extent that state law exempts such property from execution by creditors. The Supreme Court's decision in Craft should not alter this analysis. While the Supremacy Clause provides the underpinning for the government's right to sweep aside state-created exemptions via the federal tax lien statute when a federal statute, such as Bankruptcy Code 11 U.S.C. §522(b)(2)(B), specifically honors those state-created exemption rights, the protected status of entireties property in bankruptcy proceedings should not languish.

Not only does the Craft decision fail to provide bankruptcy trustees with ammunition sufficient to penetrate entireties property absent a pre-petition federal tax lien, it is conceivable that the Supreme Court's determination that a federal tax lien attaches to entireties property will not even apply in the bankruptcy context.

An interesting paradox arises when the circumstances of the Craft case—a federal tax lien filed against a single spouse who owns property as a tenant by the entirety—are presented in the context of a bankruptcy proceeding. Section 6321 of the Internal Revenue Code and §522(b)(2)(B) of the Bankruptcy Code combine to create the enigmatic chicken and egg scenario of which comes first. On the one hand, the Craft decision teaches that "exempt status under state law does not bind the federal collector." Craft, 122 S.Ct. at 1426. On the other hand, §522(b)(2)(B) directs that entireties exemptions under state law will be honored in bankruptcy. Whether §522(b) (2)(B) trumps the federal tax lien statute and undermines the Craft decision in the bankruptcy context is a question that will have to be decided by the courts. However, it would appear at first blush that if, under Craft, a federal tax lien attaches to entireties property prior to bankruptcy, then the mantra that "liens pass through bankruptcy unaffected" might very well prevent §522(b)(2)(B) from stripping off that pre-petition lien.

In conclusion, it is doubtful that Craft will arm bankruptcy trustees with the munitions necessary to pierce state-protected entireties property absent the existence of a pre-petition federal tax lien. Further, it is possible that Craft will have no application in bankruptcy cases whatsoever, and that §522(b)(2)(B) of the Bankruptcy Code may actually trump the Supreme Court's entire analysis in Craft, totally voiding, upon the filing of a bankruptcy petition, the federal tax lien in entireties property that the Craft decision validates.

Journal Date: 
Friday, November 1, 2002