Does a chapter 7 bankruptcy trustee’s strong-arm powers extend to include the I.R.S.’s right to sell property owned by a husband and wife as tenants by the entirety when the non-filing spouse does not owe delinquent taxes?

Does a chapter 7 bankruptcy trustee’s strong-arm powers extend to include the I.R.S.’s right to sell property owned by a husband and wife as tenants by the entirety when the non-filing spouse does not owe delinquent taxes?

No, as the Fourth Circuit Court of Appeals ruled in Schlossberg v. Barney, 380 F.3d 174 (4th Cir., 2004), a chapter 7 bankruptcy trustee does not have the power to sell property owned by a husband and wife as tenants by the entirety when only one spouse has filed bankruptcy and there is no joint liability for unpaid taxes.  Although the husband and wife were not separated or divorced at the time of the bankruptcy filing, the case does concern rights in property when only one spouse files bankruptcy and the nondebtor spouse does not owe delinquent taxes.

A husband and wife can own real property in Virginia as tenants by the entirety with the common-law right of survivorship.  This tenancy is based on the old common law concept of a husband and wife as a single legal person (the husband).  Consequently the tenancy could not be severed by either spouse acting alone, and a creditor of just one of the spouses could not attach the real property to satisfy a judgment.  Upon divorce, the survivorship was eliminated and the tenancy automatically converts to a tenancy in common. (This is why it is very important for spouses facing divorce to consider the timing of the entry of the final decree of divorce as a judgment lien may then attach to that spouse’s interest in real estate.)

When someone files chapter 7 bankruptcy, the chapter 7 trustee not only steps into the shoes of the debtor in a sense to administer property of the bankruptcy estate, the chapter 7 trustee also has certain powers to set aside or avoid prepetition transfers of property.  The chapter 7 trustee’s avoidance powers include the so-called strong-arm powers contained in 11 U.S.C. §544, which give the trustee the same rights as a hypothetical creditor who extends credit to the debtor at the time the case is filed and has a judgment lien or an attachment, or a hypothetical bona fide purchaser of real property from the debtor with a perfected transfer at the time the case is filed.

The Internal Revenue Service (IRS) has rights greater than ordinary creditors, including ordinary judgment lien creditors, by virtue of its position as the agency of the U.S. Government charged with levying and collecting taxes.  The IRS can sever a tenancy by the entirety with the common-law right of survivorship so a federal tax lien can attach to the interest of a spouse who owes taxes, as established by the Supreme Court in United States v. Craft, 535 U.S. 274, 152 L.Ed.2d 437 (2002).

In Schlossberg, a husband and wife owned real property as tenants by the entirety, which had significant equity above the amount owed on the mortgage.  The husband alone filed chapter 7 bankruptcy and the husband alone owed unpaid taxes to the IRS.   The chapter 7 trustee wanted to sell the property and use the equity to pay the husband’s unsecured creditors.  The chapter 7 trustee contended in Schlossberg that his strong arm powers under 11 U.S.C. §544 as a hypothetical creditor to extend to include the rights of the IRS as a creditor, thus severing the tenancy by the entirety.  The U.S. Bankruptcy Court disagreed, overruling the trustee’s objection to the husband’s claimed exemption under 11 U.S.C. §522(b)(3)(B), which specifically protects a tenancy by the entirety if the tenancy is exempt from process under applicable nonbankruptcy law.   The U.S. District Court upheld the ruling of the bankruptcy court.  The Fourth Circuit Court of Appeals, which includes the federal district in Virginia, agreed with the bankruptcy court and the district court.

On appeal, the court ruled that the IRS is not a creditor who extends credit and thus does not fall within the ambit of 11 U.S.C. §544.  The court recognized the plain meaning of the bankruptcy code section at issue which concerns a voluntary creditor, not an involuntary creditor like the I.R.S., despite the IRS’s ability to enter into forbearance agreements for the repayment of a tax debt in installment payments under 26 U.S.C. §6159(c).  Further, the appeals court held that Congress did not intend that a chapter 7 trustee would wield the extraordinary powers of the federal government, which is based on the sovereign prerogative grounded in the mandate to lay and collect taxes.  If the court adopted the trustee’s reasoning, then the protection afforded entireties property under 11 U.S.C. §522(b)(2)(B) would be nullified, along with the protection to a nondebtor spouse under 11 U.S.C. §363(h), which allows administration of tenants by the entireties property if there are joint debts under certain circumstances.  Additionally, adopting the trustee’s position would mean no state law exemptions would exist, as the IRS’s power is limited only by the exemptions in 26 U.S.C. §6334(a).

You should consult with your bankruptcy and family law lawyer or Richmond divorce lawyer James H. Wilson, Jr.,  to discuss your property rights when your spouse files bankruptcy.

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