On November 22, 2011, the US Court of Appeals for the Eleventh Circuit held in In re J.H. Investment Services, Inc. that the IRS waived its deficiency claim when it filed a proof of claim noting its secured claim but not any unsecured claims.

Creditors of J.H. Investment Services, Inc. (JHIS) initiated an involuntary Chapter 11 case, which resulted in the sale of JHIS property. The US Bankruptcy Court for the Middle District of Florida (Bankruptcy Court) held that $83,000 of the sale proceeds (Fund) be set aside for JHIS's unsecured creditors. The IRS had a claim against JHIS for unpaid taxes. The IRS filed several amendments to its proof of claim, with the final version stating that the IRS's entire $46 million claim was secured.

The Chapter 11 liquidating plan (Plan) proposed by the bankruptcy trustee excluded the Fund from the IRS' distribution. The disclosure statement filed by the trustee showed that the JHIS assets had a value of only $750,000. The IRS did not amend its proof of claim to include any unsecured claims or unsecured priority claims. But, the IRS objected to the Plan, arguing that as an undersecured creditor, it had an unsecured priority claim against the Fund. Both the Bankruptcy Court and then the US District Court for the Middle District of Florida held that, because the IRS did not indicate an intent to pursue an unsecured claim on its last proof of claim form, the other creditors did not have an opportunity to oppose the unsecured claim. Therefore the IRS was not entitled to any distribution from the Fund.

On appeal to the Eleventh Circuit, the IRS argued that section 506(a)(1) of the Bankruptcy Code automatically split its proof of claim into a secured and an unsecured claim and that the unsecured claim was allowed under section 502. Section 506(a)(1) states that "an allowed claim secured by a lien on property … is a secured claim to the extent of the value of such creditor's interest … and is an unsecured claim to the extent that the value of such creditor's interest … is less than the amount of such allowed claim." The unsecured portion of an undersecured claim is called a deficiency claim.

The Eleventh Circuit disagreed with the IRS's contention that section 506(a)(1) automatically asserts a deficiency claim and held that a creditor must take an affirmative step to pursue an unsecured claim. An undersecured creditor is not required to pursue a deficiency claim, but requiring it to signal its intent to pursue that claim serves an important notice function to other interested parties and gives them an opportunity to object to the claim. The Eleventh Circuit noted that Federal Rule of Bankruptcy Procedure 3001(a) and the related Official Bankruptcy Form 10 (proof of claim form) suggest that when an undersecured creditor does not note an unsecured claim on its proof of claim it has decided not to pursue that claim.

In addition, undersecured creditors are often granted permission to amend their proofs of claim to include deficiency claims. The IRS had no reason to believe that the value of the JHIS assets was $46 million. Even so, the IRS could have amended its last proof of claim to account for the deficiency when the trustee reported that the assets totalled no more than $750,000. Technically, the IRS later amended its proof of claim, but the trustee objected to it as untimely. The Eleventh Circuit did not address this issue because the IRS did not raise the disallowance of its amended proof of claim on appeal.

By not noting the unsecured claim on its proof of claim or amending its proof of claim when the deficiency became certain, the IRS did not provide notice to the trustee or other creditors that it intended to pursue an unsecured claim. In addition, the IRS's objection that the Plan did not address its unsecured priority claim also did not provide notice of its intent to pursue that claim because by failing to properly assert that claim on its proof of claim form, the IRS lacked standing to make the objection. As a result, the trustee and the other creditors did not have an opportunity to contest the claim. Therefore, the Eleventh Circuit held that distribution of the Fund to the IRS, without notice of the claim or an opportunity to object to it, would deprive the trustee and the other creditors of due process.

As a result of this ruling, secured creditors should endeavor to list all deficiency claims on their proofs of claim. If a secured creditor is uncertain whether there will be any deficiency, as soon as the deficiency is determined, the secured creditor should seek leave of the court to amend its proof of claim to include the unsecured claims.