Government Working Group
Proposal #2: Section 724(b)
Section 724(b) represents a fundamental collision at the intersection of bankruptcy and tax
policy. The statute governs the order of distribution of both real and personal property subject to
valid, nonavoidable federal, state and local tax liens in a chapter 7 case. Section 724(b)(2) departs
from the general rule that unsecured priority claims are junior in priority to perfected secured
claims. Under section 724(b)(2), the trustee is required to subordinate valid tax liens below the
costs of administration and a large number of other priority claims. The provision effectively
enables unsecured priority claimants occupying the first through seventh rungs on the section
507(a) priority ladder to step into the position of the taxing authority and receive distributions
from property of the estate despite the fact that the tax claim is properly allowed and secured. A
number of courts interpreting section 724(b) have held that a trustee is under no obligation to
marshal unencumbered assets of the estate as a prerequisite to subordinating prior and otherwise
valid tax liens. [ FN: See, e.g., Wurst v. City
of New York (In re Packard Properties, Ltd.), 112 B.R. 154, 158-59 (Bankr. N.D. Tex.
As originally enacted, section 724(b) was designed to reflect a policy choice that those who
toil on behalf of the chapter 7 estate should receive remuneration for the benefit conferred. Thus,
Congress sought to guarantee the payment of "only" the costs of administration in a
chapter 7 case and small wage claims by allowing a limited class of claimants to prime tax liens on
"personal" property. Indeed, the legislative history to the Code, as buttressed by the
Report of the Commission on the Bankruptcy Laws of the United States, reveals that the drafters
intended to limit the reach ofthe statute and exempt ad valorem taxes on real property from
subordination. [ FN: See H.R. Rep. No . 595,
95th Cong., 1st Sess. 382 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6338; S. Rep. No. 989,
95th Cong., 2d Sess. 96 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5882; H.R. Doc. No.
137, 93d Cong., 1st Sess. 212 (1973), reprinted in A & P Legislative History, at
476.] The statute has since been significantly expanded beyond its original
scope to allow a substantial number of unsecured priority claimants to invade valid and properly
perfected liens on both personal and real property. Additionally, some courts have
permitted administrative claimants in a superseded chapter 11 case to subordinate tax liens upon
an ensuing conversion to chapter 7. [ FN: See,
e.g., Morgan v. K.C. Machine & Tool Co. (In re K.C. Machine & Tool Co.),
816 F.2d 238 (6th Cir. 1987).]
Recently, Congress has recognized the importance of tax revenues to local governments and
the impact that bankruptcy has on their ability to protect their interests. In the wake of a number
of circuit court decisions which held that the automatic stay prevented statutory liens from
attaching to property for taxes accruing after the bankruptcy filing, Congress amended section
362 in 1994 in order to allow local governments to utilize their lien attachment authority to secure
the payment of property taxes. The protection afforded by Congress in the Bankruptcy Reform
Act of 1994 can, however, be rendered completely nugatory in many cases by section 724(b).
The Working Group on Government has had a number of meetings and discussions regarding
issues arising under section 724(b) and the appropriate scope of the statute. A number of
governmental units have appeared before the Commission and submitted comments regarding the
statute. The governments have argued that the statute, as presently constituted, undermines the
ability of governments to provide essential public services and should be amended.
The Working Group has developed alternative proposals aimed at remedying perceived
problems and inequities. Absent majority support for any one of the three alternatives, or for
another Proposal, no change to the current statute will be recommended.
Section 724(b) be amended as follows:
(1) Bankruptcy Code section 724(b) should be repealed;
(2) Bankruptcy Code section 724(b) should be amended to exempt from subordination
under the statute properly perfected, nonavoidable liens on real or personal property of
the estate arising in connection with an ad valorem tax. Section 724(b) should be further
amended to permit only (i) section 507(a)(1) administrative expense claims arising
in connection with the chapter 7 case; and (ii) section 507(a)(3) and (a)(4) priority wage
claims to prime any other properly perfected, nonavoidable tax lien on real or personal
property. Section 724(b) should also require the trustee to marshal unencumbered assets
of the bankruptcy estate and surcharge secured claims, if warranted by the circumstances,
under section 506(c) prior to subordinating any tax liens under thestatute; or
(3) Bankruptcy Code section 724(b) should be amended to permit only (i) section
507(a)(1) claims in connection with the administration of the chapter 7 case; and (ii)
section 507(a)(3) and (a)(4) priority wage claims, to prime any properly perfected,
nonavoidable tax lien on real and personal property. Section 724(b) should be further
amended to require the trustee to marshal unencumbered assets of the bankruptcy estate
and surcharge secured claims, if warranted by the circumstances, under section 506(c)
prior to subordinating any tax liens under the statute.
A comprehensive analysis of section 724(b) has been embodied in memoranda previously
circulated to the Commission. The memoranda set forth the policy justifications and rationale for
amendment and should be referred to in conjunction with this Proposal. The Proposal sets forth
"alternative" recommendations for reform.
Alternative (1) recommends a complete repeal of the statute. The subordination of
any valid and properly perfected tax liens on real or personal property to priority claims under
section 507(a)(1)-(7) would be precluded under Alternative (1). The Tax Advisory Committee of
the National Bankruptcy Review Commission has recommended that the Commission adopt this
alternative by a vote of five to four.
Alternative (2) recommends an amendment to section 724(b) that would completely
exempt from subordination nonavoidable and properly perfected ad valorem property tax liens on
real and personal property. The exemption would recognize the impact that section 724(b) has on
governmental units and shelter nonavoidable and properly perfected ad valorem tax liens from
subordination. Alternative (2) would permit the expenses of administering the chapter 7 estate and
all wage claims entitled to priority under section 507(a)(3) and (a)(4) to prime all other tax liens.
Section 724(b) would not, however, be available as a mechanism to subordinate tax liens to any
other claim entitled to priority under section 507(a) or to administrative claimants in a superseded
chapter 11 case.
Alternative (2) would also impose a requirement that the trustee first marshal and exhaust
assets of the bankruptcy estate prior to resorting to subordination under section 724(b).
Section 724(b) does not impose a marshaling requirement and some courts have permitted the
invasion of the lien claim of taxing authorities without requiring the trustee to first administer
other estate assets. As a component of the marshaling requirement, Alternative (2) would also
direct the trustee to utilize section 506(c) in instances in which it is the secured creditor that is
driving an orderly liquidation under chapter 11 and deriving the benefit from the disposition of
assets prior to an ensuing conversion of the case.
Alternative (3) is similar to Alternative (2) with one important difference. Alternative
(3) would not completely exempt ad valorem property tax liens from subordination under
section 724(b). Rather, Alternative (3) would permit chapter 7 administrative expense claims
entitled to priority under section 507(a)(1) and all wage claims entitled to priority under section
507(a)(3) and (a)(4) to prime all tax liens. Alternative (3) would also impose the
marshaling requirement whichwould include a directive to resort to section 506(c) in appropriate
Alternative (3) would essentially reflect a policy choice that the payment of priority wage
claims and the costs of administering the chapter 7 estate should trump all tax liens,
including those which secure the payment of an ad valorem tax.
Summary of Positions
Section 724(b) has been discussed during the plenary and Working Group sessions of a
number of Commission meetings. The Commission has heard testimony and received a number of
submissions with respect to the Working Groups proposals. The views of particular
commentators and constituencies can be summarized as follows:
*Tax Advisory Committee of NBRC -- The Chair of the Tax Advisory
Committee to the National Bankruptcy Review Commission recently reported that while the
Committee believed that a proposal aimed addressing issues arising under section 724(b) is
"very important," the resolution of the issues is "highly controversial."
The Committee voted in favor of a complete repeal of the statute by a vote of five to four. The
Committee has also noted that section 724(b) represents fertile ground for challenge by states
under the Eleventh Amendment to the Constitution in the wake of the Supreme Courts
decision in Seminole Tribe.
*National Association of Attorneys General -- NAAG supports a repeal of section
724(b). If not repealed or otherwise restricted, NAAG contends that the statute should, at a
minimum, be amended to require administrative and other priority claims to be satisfied from
unencumbered funds prior to permitting the resort to subordination.
*American College of Bankruptcy -- The ACB submitted a questionnaire and
received responses from approximately one-third of the Fellows, which the ACB believes to be a
representative group of its membership. Forty-three respondents (70%) were against a complete
repeal of section 724(b), while eighteen (30%) respondents were in favor of its repeal.
*Commercial Law League of America -- The CLLA does not support a complete
repeal of section 724(b). However, in position papers presented to the Commission in connection
with the Commissions meetings in February and May, the CLLA appears to support
restricting the reach of section 724(b), especially with respect to ad valorem taxes. The CLLA
appears to favor a proposal that would allow the subordination of tax liens to only administrative
and wage claims as long as pre-conversion administrative and wage claims of the superseded
chapter 11 case would be protected as well. The CLLA would also favor amending section 506(c)
to lessen the impact of section 724(b).
*National Bankruptcy Conference -- The NBC does not support a repeal of section
724(b). The NBC has taken the position that a repeal of the statute would unfairly advance the
priority of government tax claims through liberal tax lien laws and would encourage the
proliferation of such laws.
*Department of Justice -- In a Report of the Bankruptcy Working Group, the DOJ
hasadvocated a complete repeal of the statute and contends that, especially with respect to liens
on real estate, no justification exists for discriminating against tax liens. The DOJ has further
opined that secured creditors should not be allowed to gain a windfall by having administrative
costs incurred in connection with the preservation and sale of collateral shifted to the taxing
authority by virtue of section 724(b).
*National Association of County Treasurers & Finance Officers -- The
NACTFO supports a complete repeal of section 724(b).
*ABA Tax Section Task Force -- In a report of the ABA Tax Section Task Force on
Tax Recommendations of the NBRC, the Task Force recommends an amendment, such as to
section 506(c), which would prevent the subordination of ad valorem real property tax liens to the
claims of secured creditors. The Task Force is of the view that such consensual lienholders expect
to have their liens primed by ad valorem property tax claims and the Code should not afford them
with a windfall at the expense of local governments.
Association of the Bar of the City of New York -- The Association does not support
a complete repeal of section 724(b).
*General Submissions as Reflected in Database -- The Commission has received a
substantial number of written, individual submissions commenting on the Working Groups
proposals with respect to section 724(b). An overwhelming majority of those commentators
support either a complete repeal of the statute or a substantial curtailment of its reach. It is,
however, significant to note that virtually all of those who have submitted written submissions in
favor of the Working Groups proposals represent the interests of governmental units.
Those in support of an amendment to section 724(b) are predominantly concerned with the
statutes impact on ad valorem tax liens.