Court: IL tax collectors can’t ‘jump the queue’ of creditors to collect unpaid taxes from bankrupt debtors

By DM Herra | Jul 12, 2018

By Ken Lund from Reno, Nevada, USA [CC BY-SA 2.0 (https://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia Commons

Illinois state tax collectors cannot jump ahead of other creditors when collecting unpaid taxes from bankrupt estates, a federal appeals panel has ruled, rejecting the Illinois Department of Revenue’s attempt to collect delinquent taxes from two bankrupt businesses whose debts far outweighed their assets.

In one case, the IDOR hoped to recover more than $1.5 million in unpaid taxes from a business that sold for just over $5 million, while owing more than $14 million to the bank that held the mortgages on its five gas station properties. In the other, the agency hoped to recover more than half a million unpaid tax dollars from a business that owed its bank nearly $4 million.

In both cases, the bankruptcy court allowed the debtors to sell their businesses free and clear of all liens, claims and interests held by anyone other than the estate. Since the final sale price in both cases was substantially less than the amount owed to the senior creditors – the banks – the court ordered that all sale proceeds should go to the bank, leaving the remaining creditors with nothing.

IDOR objected on the grounds that it is not just any creditor. Unlike other types of creditors, the Department of Revenue is granted successor liability – the ability to collect unpaid debts from the purchaser of a property if the original debtor is unable to pay. It argued that if the court was going to extinguish its interest in the properties, it should set aside a portion of the sale proceeds as “adequate protection” for its interests.

The bankruptcy court noted that the law establishing adequate protection defines it as a way to compensate for a decrease in value of a creditor’s interest in a property. It is calculated by comparing what the creditor will receive against what it is owed. 

On appeal, a three-judge panel of the U.S. Seventh Circuit Court of Appeals found the value of IDOR’s interest had not changed; if the sale had taken place with all of the existing liens and claims intact, the agency would still not have collected because its claims were junior to those of other creditors.

“Given the lack of proof that IDOR’s interest had any value, the inevitable conclusion was that there was no decrease in the worth of its interest and therefore IDOR had no entitlement to compensation,” the appeals court wrote.

Judge Timothy Barnes drew a distinction between the calculable and realizable value of the agency’s interest – its calculable value may have been $1.5 million, but the amount of money it could realistically have expected to recover was zero, as the debtor was bankrupt and the buyer had no assets other than the purchased property itself.

Nonetheless, the IDOR attempted through a series of appeals to argue that before the banks received their portion of the sale proceeds, the IDOR was entitled to a slice, in the amount of 100 percent what it was owed.

“As IDOR sees things, it does not matter whether the purchasers had other assets apart from the purchased properties from which IDOR might have sought to collect the delinquent taxes,” the appellate court wrote. “The purchasers have already paid something for (the removal of) IDOR’s interest, and IDOR is entitled to that portion of the sale proceeds.”

The court said that had IDOR’s interest not been extinguished and it was allowed to pursue the purchaser, it was doubtful it would have been able to recover 100 percent of what was owed. Allowing it a piece of the purchase price while senior creditors were “out of the money” would be essentially allowing it “to jump the queue … and grant IDOR monetary protection for its interest at the expense of other creditors.” But because it was unable to place a value on what the interest may have been worth, the court said it was forced to set that interest at zero, leaving IDOR equally “out of the money.”

The case was decided by Seventh Circuit judges William J. Bauer, Joel Flaum and Ilana Rovner. Rovner wrote the opinion, and Bauer and Flaum concurred.

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Illinois Department of Revenue U.S. Bankruptcy Court for the Northern District of Illinois U.S. Court of Appeals for the Seventh Circuit

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