A district court held that the IRS, and not a debtor of the estate, was entitled to the decedent's share of the sale proceeds from the sale of the assets of two limited partnerships that were sold to the debtor.
Background
When he died in 2006, Duane Bennett was the general partner in and owned a 40% interest in each of two limited partnerships, Black Star Land & Mining Ltd. and Manalapan Land Company.
After his death, the IRS assessed approximately $2.8 million in estate tax liabilities against his estate, and, on May 1, 2017, the estate's outstanding liability to the IRS was $2.1 million. The IRS recorded tax liens in Kentucky with Bell County in August 2010, and with Bell and Harlan counties in 2016.
The state court handling the estate appointed a receiver in June 2015 to wind up the estate's affairs. The receiver located a company, Kingdom Energy Resources LLC, which purchased the assets of the limited partnerships. The proceeds of this sale were distributed to Bennett's estate and the limited partner owners of the partnerships.
The limited partner owners, however, objected to the payment of Bennett's share of the proceeds to his estate. According to them, Bennett had taken substantial loans from the limited partnerships, and, at his death, he owed them a combined amount of over $2.3 million. Due to this dispute over the estate's share of the proceeds, the state court ordered the receiver to hold them in an escrow account.
In further proceedings, the limited partners argued that the partnerships were entitled to a setoff for the full amount of the estate's share of the sale proceeds. However, the limited partners soon realized they had a problem because Kingdom Energy had bought not only the assets of the limited partnerships, but also any loans made by or promissory notes made payable to them. Thus, after the sale, the limited partnerships did not own the loans and could not collect on them. Instead, Kingdom Energy owned them and was entitled to collect the $2.3 million.
Consequently, the limited partners dropped their argument that the amounts paid to Bennett were loans. Instead, they argued that under Kentucky law, the payments were excessive distributions to Bennett and that the partnerships were entitled to the estate's share of the proceeds to correct the overpayment to Bennett and equalize the payments among the limited partners.
Before the state court could resolve the issue of who should get the estate's share of the proceeds, the IRS got wind of the litigation and intervened, arguing that it should get the proceeds to satisfy the estate's outstanding tax liabilities. It removed the action to federal district court, where the limited partners and Kingdom Energy continued to argue that they were entitled to the proceeds.
The district court's decision
The district court held that the IRS was entitled to the estate's share of the proceeds from the sale of the limited partnerships' assets. The court found that the payments made to Bennett were not excessive distributions, so the limited partners' arguments failed. It further found that, while the IRS's claim to the proceeds might be defeated by a holder of a security interest in the estate's share of the proceeds that predated the IRS's liens, Kingdom Energy did not hold such a security interest.
The limited partners versus Kingdom Energy: Based on their argument that they were entitled to the estate's share of the proceeds because the payments the limited partnerships had made to Bennett were distributions, the limited partners were required to prove that the payments were distributions and not loans. The district court found that the limited partners had failed to do this. As the district court noted, in the state court the limited partners had presented affidavits from two individuals that the payments were loans and that the estate's executor had testified that they were. In the district court, the limited partners cited no evidence that the payments were distributions, only pointing to evidence that money was transferred from the limited partnerships to Bennett before his death. Thus, the district court found the payments were loans and that the only entity that could collect on them after the sale was Kingdom Energy.
Kingdom Energy versus the IRS: Kingdom Energy first argued that the estate's 40% ownership interest in the limited partnerships served as collateral on the loans to the decedent, which it purchased. It further argued that it had already foreclosed on the estate's 40% interest, which meant it had a right to 40% of the sale proceeds free and clear of the tax liens. Kingdom Energy asserted it accomplished this foreclosure by way of the "strict foreclosure" procedure outlined in Article 9 of Kentucky's version of the Uniform Commercial Code.
For Kingdom Energy to have foreclosed under the statute, the district court determined that it was necessary for the estate to have consented to Kingdom Energy's acceptance of the collateral (the estate's ownership interests in the partnerships) to satisfy the debt. After reviewing the evidence, the court found that the estate had not consented, so the company's attempt at strict foreclosure under the statute had failed.
The district court found, nonetheless, that Kingdom Energy still had a valid claim to the estate's proceeds from the asset sale because the estate owed Kingdom Energy for the loans to Bennett. Likewise, the court found that the IRS still had a valid claim to the estate's share of the proceeds because of the taxes owed by the estate.
The district court explained that because the escrowed proceeds belonged to the estate, the federal tax lien attached to them, but that federal tax liens do not automatically have priority over all other competing claims. Federal law governs the priority of claims, and the applicable law, Sec. 6223(a), states that tax liens are not valid against any "holder of a security interest" until the IRS files notice that meets the statute's requirements. The IRS filed its notice with respect to the sales proceeds from the sale of the limited partnership's assets on May 9, 2016. Therefore, the IRS's lien was not valid against any holder of a security interest in the proceeds that existed before that date.
Kingdom Energy did not argue it had a security interest in the sale proceeds. Instead, it argued it had a security interest in the estate's ownership interest in the limited partnerships, which made it a protected holder of a security interest for purposes of Sec. 6323.
The district court disagreed. Because the IRS had a tax lien against the sale proceeds themselves, the court found that in determining whether that tax lien was valid under Sec. 6323(a), the question was whether Kingdom Energy had a competing security interest in the proceeds themselves. Kingdom Energy by its own admission did not, so the tax lien was valid, and the IRS had a priority interest in the proceeds from the sale of the limited partnership interests.
Reflections
Although it is not clear from the court's opinion, presumably Kingdom Energy agreed to the sales price for the limited partnerships' assets under the assumption that it would not be receiving a payment from the estate for the loans owed by Bennett. If that was the case, and the company had been allowed (even if rightly so) to recover the estate's portion of the proceeds from the asset sale, it would have received an unjustified windfall.
Bennett v. Bascom, No. 5:17-113-KKC (E.D. Ky. 3/26/18)
