For creditors in bankruptcy proceedings, as with many things in life, priority is everything. It is often the case that a person filing for bankruptcy has insufficient funds to pay in full all of his or her creditors. As a result, creditors try to establish their priority so they are more likely to get paid before the money runs out. Section 507 of the Bankruptcy Code provides rules explaining the order in which expenses and claims have priority in bankruptcy. Notably, Section 507(a)(8) provides the IRS with priority treatment in bankruptcy with respect to claims for certain payments of tax, including claims that are for "a tax on or measured by income or gross receipts for a taxable year" or for "an excise tax on [certain] transaction[s]." As the recent case of In re Bailey, Np. 18-03328-5DMW (Bankr. E.D.N.C. May 24, 2019) makes clear, the IRS's priority in bankruptcy is limited to claims for tax, and does not extend to claims relating to penalties.
In Bailey, the IRS brought a proof of claim against the taxpayers relating to their liability for the "shared responsibility payment" for their failure to maintain minimum essential coverage (commonly called "the individual mandate") as required under the Patient Protection and Affordable Care Act. The statute that creates the individual mandate imposes the "penalty" on taxpayers that fail to comply with such requirement. [Note: The Tax Cuts and Jobs Act of 2017 effectively eliminated the penalty for noncompliance with the minimum essential coverage requirement after December 31, 2018, but the issues in this case relate to tax years 2015, 2016 and 2017.] Although the statutory language refers to a "penalty" for taxpayer's failure to comply with the individual mandate, the IRS argued that its claim against the taxpayers is entitled to qualify for priority status as a claim for either income tax or as an excise tax.
The court acknowledged that the "way an exaction is labeled in legislation is not determinative of its true nature" and "the court must examine the function of the [statute] and its imposition of the shared responsibility payment to determine whether the [payment] is a tax or a penalty." The court cites to United States v. Reorganized CF&I Fabricators of Utah (518 U.S. 213 (1996)) for the idea that the hallmark of a penalty is "punishment for an unlawful act or omission." Looking at the characteristics of the shared responsibility payment, the court concluded that the payment is indeed a penalty rather than a tax. The court highlighted the fact that the shared responsibility payment is meant to deter individuals from foregoing health insurance, and is only "owed if an individual disobeys the mandate to maintain coverage…." Additionally, the court concluded that the shared responsibility payment does not meet the definition of an income tax or excise tax that is described in the statute. As a result, the IRS's claim was for a penalty and thus was not entitled to be given priority status over other claimants.