31 U.S.C. § 3713 is a fairly simple statute with less than simple implications. First enacted in 1797, the Federal Priority Statute has been on the books nearly as long as “the books” have existed. In a nutshell, § 3713 states that if a debtor or estate does not have sufficient assets to cover all debts, the federal government has priority over all other creditors. This means any federal tax liability and financial claims of the U.S. government that have priority must be paid before a fiduciary pays the remaining creditors. Under the Federal Priority Statute, the fiduciary can be personally liable for unpaid federal taxes and priority claims.
Application of the Federal Priority Statute
The Priority Statute states that “[a] claim of the United States Government shall be paid first when” the following exists:
- An estate’s assets are insufficient to pay all of the decedent’s debts, or
- The person indebted to the government is insolvent, meaning his liabilities exceed the value of his assets, and
- The insolvent debtor voluntarily assigns his property to a fiduciary, and either
- The property attaches as assigned or an act of bankruptcy occurs following insolvency
An act of bankruptcy includes:
- Making a payment to a creditor that is lower in priority than the federal government
- Committing a fraudulent conveyance
- Concealing assets to hinder, defraud, or delay creditors
- Permitting a lesser-priority creditor to obtain a judicial lien on any assets
- Assigning the assets for a lesser-priority creditor’s benefit
- Actually declaring bankruptcy
There is only one statutory exception to federal priority, although there are other judicial exemptions as well.
First, if a perfected lien has already attached to certain debtor assets before § 3713 is triggered, and the secured creditor actually takes title to the property, it is generally exempt from federal priority. Once the secured property passes to the creditor, it is no longer owned by the debtor and generally cannot be reclaimed by the government. Perfecting liens prior to insolvency is one of the few mechanisms for a non-government creditor to avoid federal priority of claims.
Second, § 3713 does not apply to disputes that fall under the Federal Tax Lien Act (FTLA). Instead, the priority rules set by the FTLA controls.
Third, § 3713 does not apply to bankruptcy proceedings, and all collection activity must cease once a petition for bankruptcy is filed under the bankruptcy law’s automatic stay. Bankruptcy trustees are exempt from personal liability under the Priority Statute, and the priority of claims drastically changes once a bankruptcy petition is filed.
Types of Claims Covered by the Federal Priority Statute
The Priority Statute covers all present and future federal claims, even if a lien has not attached. A federal claim includes any right of payment whether matured or unmatured, liquidated or unliquidated, disputed, contingent, legal, equitable, secured, or unsecured. Secured creditors must actually take title to the secured property in order to protect a secured asset from a federal claim even if that claim is unmatured or unsecured. This means that even secured creditors may not have priority over a federal debt without properly perfecting the lien.
Receivers and fiduciaries must be aware that tax liens are not the only debts that constitute federal claims under the statute. Federal priority claims include:
- Tax liability
- Criminal fines
- Housing debts
- Unemployment compensation taxes
- Expenses incurred and claimed
- Customs duties
- Surety on estreated bail bonds
- Emergency loans
- Misappropriated military funds
The majority of federal priority claims arise from federal tax liability, which means that the claims may be subject to Federal Tax Lien Act provisions. Claims that aren’t otherwise subject to the Federal Tax Lien Act are protected by the Priority Statue, which is often used as a fallback during IRS litigation. Unfortunately, fiduciaries may not be aware of the IRS silent lien that attaches to federal income tax liability before paying lesser priority claims. Creditors may have priority over an IRS “silent lien” in certain circumstances, and fiduciaries may be able to avoid personal liability for claims paid in good faith prior to discovering a potential federal claim.
Avoiding Fiduciary Liability & Enforcing Creditors Rights in Light of Federal Claims Priority
Under Section 3713(b), a personal representative or an estate that pays a creditor prior to satisfying all federal priority claims may be personally liable to the government in the amount of the payments made. Federal courts have helped to mitigate this liability to some degree by holding that the representative must have had actual or constructive knowledge (notice) of the federal claim prior to paying another creditor. However, a creditor paid out of priority and in good faith is generally not required to forfeit the assets received. All of the following parties are considered personal representatives subject to liability under the Priority Statute:
Bankruptcy trustees are excluded from liability, but receivers appointed by the court are not. One of the most effective mechanisms to avoid personal liability is to avoid § 3713 altogether. Working with an experienced tax attorney may help to ensure that appropriate measures are undertaken, such as seeking to avoid the appointment of an entity receiver or other personal representative and/or restructuring debts to avoid insolvency. Creditors should consider perfecting liens and taking title to any secured debts as soon as practicable if it appears that the debtor may have unpaid federal liabilities.
Consult a Qualified and Experienced Dallas-Fort Worth Tax Attorney Today
The experienced attorneys at Freeman Law PLLC, located in the Dallas-Fort Worth Metroplex, are available to help debtors and creditors alike navigate the intricacies of § 3713 (the Federal Priority Statute) and avoid exposure to personal liability. The Priority Statute is more complex than it appears. There are exceptions and exclusions to federal priority, and in some cases fiduciaries may be able to avoid liability for failure to pay federal priority claims. Contact our Dallas-based tax litigation lawyers online or by calling (214) 984-3000 for a consultation.