The Federal Tax Lien
By Tony Mankus, Esq.
Ma and Pa taxpayers sign a contract with the local Realtor to sell their home. The Realtor finds someone who is willing to buy it. Everything is going along smoothly until the attorney discovers that the IRS has filed a tax lien against Ma and Pa. This causes confusion and puts the transaction into jeopardy. Ma and Pa are afraid that the sale will have to be canceled. If it's not canceled, they want to know whether they’ll be able to keep the proceeds of the sale. The lawyer checks the Internal Revenue Code and Treasury Regulations and wonders whether he will have to apply for a lien discharge or a lien subordination from the IRS in order to consummate the transaction. And, if so, he wonders how he will go about doing that.
What is an IRS lien, anyway, and why does it have such power to put fear and confusion in the hearts of buyers and sellers?
The short answer is that the federal tax lien ("FTL") is an encumbrance against all property and rights to property of the taxpayer, something akin to a bank's mortgage on a house or a lien on a car, except that it encumbers everything owned by the taxpayer, including the cash in his wallet, the clothing he wears or keeps in his closet, the furniture in his house, the chewing gum in his pocket, and even the false teeth in his mouth. And it is non-consensual. That is, while a person may grant a bank a mortgage on a house in order to get a loan to buy it, or a lien on a car, the federal tax lien arises without regard to the taxpayer's permission or consent.
Unlike a levy, however, the lien is - relatively speaking - passive. While a levy is an execution of the IRS' power to seize property, the lien remains a dormant right of the IRS until something happens to awaken it, i.e. the sale, or attempted sale, of property by the taxpayer, or IRS actively seeking to foreclose on the lien through a judicial proceeding. In the meantime, the taxpayer may enjoy a false sense of security by using the property, consuming it or even deriving income from it. In some cases, especially those involving non-commercial transactions and/or small personal property, such as cash or inventory, the taxpayer may even spend it or sell it to a bona fide purchaser who has no actual knowledge of the federal tax lien, without incurring any legal obligation to the IRS.
However, while the lien is not as dramatic as the levy, it is a form of stealth power that may spring up out of the legal shadows and surprise the taxpayer rudely at a time when he is not looking for any surprises. It is, in other words, another powerful weapon in IRS' large arsenal of administrative enforcement powers.
When and how does the lien arise?
The general federal tax lien is authorized by IRC §6321, which states the following:
If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto) shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.
This seems to say that the lien arises after demand for payment is made and after the taxpayer neglects or refuses to pay. The next logical question is, when does the IRS make a demand for payment? IRC §6303 requires the IRS to give notice to the taxpayer and demand payment from him within 60 days after the assessment of the tax. When does IRS assess the tax, and what is an "assessment," anyway? Pursuant to IRC §6203, the tax is assessed by recording the liability of the taxpayer's tax return in the office of the Secretary in accordance with established rules and regulations. IRS' rules and regulations allow it to "assess" the tax in its computers. This same computer then generates a letter to the taxpayer with the demand for payment.
Since IRC §6331 authorizes the IRS to levy on the taxpayer's property within 10 days after notice and demand has been made, it would seem that the lien arises within 10 days after the demand has been made. However, IRC §6322 states, in relevant part, that "the lien imposed by section 6321 shall arise at the time the assessment is made. ". These two sections of the IRC seem to contradict each other. (Another example of the confusion of the Code) One court has stated that, although the general tax lien arises at the time the assessment is made, it does not come into existence unless the taxpayer fails to comply with a demand for payment. [U.S. v. Baur, 442 F2d 1021, cert. den.(1971) 404 US 863] That makes one wonder how a lien can "arise" without coming into "existence." Another court has dealt with this contradiction a little more elegantly. It stated, in effect, that the lien arises 10 days after demand for payment. But, once it arises, it relates back to the date of assessment and that it is perfected and choate as of that date. See United States v. Fidelity Philadelphia Trust Co. 459 F.2d 771 (3rd Cir. 1972).
But, however it's phrased, the courts seem to agree that, in order for the lien to come into existence, three things are required: the assessment of the tax liability, the demand for its payment, and the refusal or neglect to pay it. Incidentally, being unable to pay after notice and demand is considered neglect or refusal to pay for purpose of the general tax lien. [In re: Baltimore Pearl Hominy Co. 5 F2d 553 (CA4 ,1925)] (Nice try Baltimore Pearl.)
While this discussion may seem somewhat like the middle ages' argument about how many angels can fit on the head of a pin, it is not purely academic. First, the lien is a prerequisite for any enforcement action to be taken by the IRS. IRS has no authority to enforce collection of the tax until the three requirements, stated in the paragraph above, have been complied with - except that the 10/30 day notice/demand requirements may be done away with in specific jeopardy situations, as discussed in Chapter 1. Second, courts have often had to deal with this issue, especially when there were other liens or encumbrances competing with the IRS for the taxpayer's assets. The issue of competing liens will be dealt with more fully later in this chapter.
How long does the lien last?
IRC §6322 provides that the lien will continue until the assessed tax is satisfied or becomes unenforceable by reason of lapse of time. Thus, once the tax is paid, or otherwise abated by the IRS, the lien is no longer enforceable. IRC §6325(a) states, in relevant part, that "the Secretary shall issue a certificate of release of any lien. on which (1) the Secretary finds that the liability for the amount assessed, together with all interest in respect thereof, has been fully satisfied or has become legally unenforceable;. "
If the tax is not paid, the lien remains in force until the statute of limitations for collection expires. IRC §6502 provides that the statute of limitation for the collection of tax is 10 years after the date of assessment. However, the collection statute may be extended by a waiver signed by the taxpayer (such as the one signed with the submission of an offer in compromise) or by the suspension of the statute by various reasons enumerated in IRC §6503, including bankruptcy proceedings and absence of the taxpayer from the United States. A bankruptcy proceeding extends the collection statute for the period that the taxpayer is in bankruptcy, plus an additional six months. [IRC §6503(h)]. If the taxpayer leaves the U.S. for a continuous period of at least six months, the collection statute is suspended for the time of his absence. [IRC §6503(c)]. By agreement (rather than by statute) the offer in compromise extends the collection statute for the length of time that it takes IRS to make a decision on the offer plus an additional one year.
It should be noted, however, that there are exceptions - or seeming exceptions - to the general lien duration rule. One of them is the bankruptcy exception. If, for example, the tax is discharged in bankruptcy, one would assume that the tax has become legally unenforceable and that the underlying tax lien is extinguished as well. Not so. In In re: Isom, [901 F2d 744 (1990, CA9)], the court stated that IRS wasn't required to release tax liens when the underlying debt was discharged. The court went on to state that while IRS could no longer collect the tax as a personal liability, the liens remained enforceable in rem. In U.S. v. Uria, 75 AFTR 2d 95-2258 (1995, DC FL), the court stated that the IRS' pre-petition liens survived the debtors' Chapter 7 bankruptcy and were enforceable, even though the underlying tax liabilities were discharged. The court went on to rule that IRC §6325(a)(1) did not require the IRS to release its liens upon discharge of the debtors, that the dischargeable debt wasn't necessarily unenforceable and that the discharge did not extinguish IRS's rights against the liened property. The court cited another case, In re Dillard, 118 B.R. (Bankr. N.D. Ill. 1990) which had also addressed the issue.
This is another one of those confusing/ambiguous issues. If the underlying tax has been discharged, what does IRS apply the money against that it collects in rem? (Just put it into an unallocated treasury account?) And what rem is the court talking about? Presumably there is no rem after the trustee sells the assets of the debtor, other than exempt property maybe. Also, if the underlying tax has been discharged, how long does the lien remain? In perpetuity? While some of these questions cannot be answered with complete clarity, the courts seemed to hold that the IRS' lien remains attached to any pre-petition property of the debtor/taxpayer, whether or not it was exempt, until it expires and becomes unenforceable by reason of lapse of time. (I.e. ten years from the date of assessment plus any extensions).
As a practical matter, however, the IRS routinely abates the discharged tax and releases any liens related to it in those States which have relatively modest exemption statutes. In those States with more generous exemption statutes, such as Texas and Florida, for example (they have an unlimited real estate exemption), the IRS may take a more aggressive posture in some cases, especially if the debtor's equity in any real estate is substantial. The IRS does not, however, assert that its lien attaches to any property acquired by the taxpayer after the bankruptcy petition date if the underlying tax has been discharged.
Another exception to the general lien duration rule is IRS' reduction of its tax claim to a judgment. If IRS sues the taxpayer in court under IRC §7401 and obtains a judgment, there is no statute of limitations. It remains a lien against any assets of the taxpayer in perpetuity. See Jones v. U.S. 699 F Supp 248 (DC KS, 1988). Half a century after his death, the tax assessment against Al Capone is still valid, even though IRS' recent efforts to find some of his "hidden" assets in an underground vault in Chicago - with television cameras and Geraldo Rivera in tow - was a public dud.
A third exception - sort of - is where the IRS agrees to discharge its lien as to a particular property or subordinate it to another creditor under authority of IRC §6325. While the underlying lien remains, it may be discharged or subordinated in order to allow a transaction, such as a sale of property or a loan, to go through. (That, incidentally, is what mom and pop may have to do in the example given at the beginning of this chapter.) The IRS may stand to gain some payment of money for the discharge or subordination, or it may do so for no consideration if there is no equity in the subject property to which the lien would attach. A fuller discussion on lien discharge and subordination (as well as a lien release and the issuing of a certificate of non-attachment) will be found in Chapter _, under the heading of "Other Administrative Remedies."
Finally, it should be noted that if IRS seizes assets of the taxpayer, or serves a notice of levy on a third party, before the collection period expires, the property seized can be sold or the levy enforced against the third party even though the collection statute (and therefore the lien) has expired. See U.S. v. Donahue Industries, Inc. 905 F2d 1325 (CA9, 1990); U.S. v. Stephens, 568 F Supp 1198 (DC CA, 1983); and U.S. v. Marine Midland Bank, N.A. 675 F Supp 775 (DC NY, 1987).
What property does the lien attach to?
The question of what property of the taxpayer the federal tax lien attaches to is not difficult to answer: it attaches to virtually all of it. The broad statutory language of IRC §6321 has been interpreted by the courts to include all real, personal and intangible property of the taxpayer, including future interests and property acquired by the taxpayer after the lien has come into existence. The only exception is that the lien does not attach to any interest of a non-competent American Indian in restricted land held by the United States. Treas. Reg. 301.6321-1. (This exception should be distinguished from the broader levy exemptions of IRC §6334, discussed in Chapters 1 and 3 above). In addition, the individual States cannot enact laws which will exempt the reach of the federal tax lien. See United States v. Bess, 357 U.S. 51 (1958) and United States v. Stern, 357 U.S. 39 (1958).
That's pretty broad. It would seem that there would be very few issues related to what the liens attach to. That's not true, however. The numerous court cases related to the issue lien attachment belie that assumption. The problems that arise in this connection usually involve the determination of whether the taxpayer has an interest in the property to begin with and, if so, the nature and extent of the interest. For example, if the taxpayer sets up a bank account in trust for a child, a legal question may arise as to whether the taxpayer has a property interest in the account. Can the IRS levy an account that was set up by the taxpayer but which is being held for the benefit of an innocent third party?
On the other hand, even if there is no doubt of the taxpayer's interest in the property, a question may arise as to the nature and extent of his interest in it. For example, when real property, otherwise subject to the tax lien, is held in some form of joint tenancy with one or more other parties but the tax lien asserted against the property is outstanding against only one of the parties in interest, a question may arise as to whether the IRS may enforce its lien by seizing the property and selling it to the detriment of an innocent third party or parties.
Finally, the question arises as to which laws govern the determination of those issues, state or federal. The laws governing the issues related to the federal tax lien are federal, while the laws governing property ownership are usually state laws. Do federal laws supersede state laws in cases of conflict? If they do not, which state law governs?
The discussion that follows below deals with many of the more common issues related to ownership interest that the courts have had to deal with throughout the years. To make them more manageable, the diverse cases on the subject have been assembled into a number of categories. It should not be assumed, however, that the discussion is by any means exhaustive. A more thorough discussion would be a book in itself.
Which laws govern, state or federal?
To answer the last series of questions first, the issue of whether the taxpayer has an interest in property, and the nature and extent of his interest in it, is determined by state law. In Aquilino v. United States, 363 U.S. 509 (1960), the United States Supreme Court stated, in relevant part, the following:
The threshold question in this case, as in all cases where the Federal Government asserts its tax lien, is whether and to what extent the taxpayer had "property" or "rights to property" to which the tax lien could attach. In answering that question, both federal and state courts must look to state law, for it has long been the rule that "in the application of a federal revenue act, state law controls in determining the nature of the legal interest which the taxpayer had in the property *** sought to be reached by the statute.
Once the property interest has been defined under the appropriate state law, however, federal law determines the consequences flowing from the existence of the federal tax lien with respect to the property right. Id.
Aquilino is fairly established case law and courts have followed it uniformly. The companion issue of which state law applies, however, has been a little thornier. The issue usually revolves around the situs of the property. Courts generally have held that all property, tangible or intangible, has a situs; a place where it is situated or located. Determining that situs is what has often been the bone of contention. In the case of real property, the answer is usually fairly obvious. The general rule is that the use, transfer, control and disposition of the realty and the rights of ownership therein are matters exclusively within the jurisdiction of the laws of the state where the property is located, whether or not the owner resides in the state. Sunderland v. United States, 266 U.S. 226 (1924).
The situs of personal property has often presented some difficulties. For purposes of the capacity to convey, the validity of a conveyance and the nature of interest conveyed, the courts have generally held that tangible personal property has a situs in, and is subject to the laws of, the state where the property is physically kept and used, or where the owner resides - depending on the nature and size of the property involved. Intangible personal property, on the other hand, such as copyrights, executory contracts or choses in action, generally have no physical qualities and, therefore, have no actual situs. In those cases, the courts have generally ruled that the situs of such intangible property should be considered the residence of the owner or the main office of the business.
Even those general rules do not always apply. For example, the situs of tangible personal property may be in one state for the purposes of taxation, but in another state for purposes of descent and distribution upon the death of the owner. Another example is that a debt generally has its legal situs in the state of the creditor, but the creditor's right to secured property may well be governed by the law of another state where the contract creating such indebtedness was entered into. In those cases the courts generally resort to the conflict of laws rules developed by the courts or by state statutes. However, federal laws may determine which state's conflict of laws rules may apply.
Jointly Held Real Property
Title to real property is often held jointly with others, such as with a spouse or with a partner or several partners. The forms of joint ownership include joint tenancy, tenancy
in common, tenancy by the entireties and community property. Each form of joint ownership has certain legal and technical attributes that are specified by the state which is the situs of the property. In order to hold title to the real property in the desired form of ownership the particular State's technical requirements of those attributes must be complied with. And while each State has its own requirements, there are sufficiently common threads among them in order to be able to generalize to a certain extent.
Joint Tenancy: In order to own real property in joint tenancy, most States require that the joint tenancy be created by an inter vivos devise or conveyance through a sale or by a gift. The conveyance must also observe the requirement of "unity"; that is, the interest of the tenants must be identical and it must be created by the same instrument, commence at the same time and be held by the same undivided possession. There is also a right of survivorship in joint tenancy; that is, upon the death of one tenant, title passes to the other tenant(s), and not to the heirs or beneficiaries of the decedent. Finally, the tenants may be composed of more than two and, unlike the requirement for tenancy by the entireties, they need not be husband and wife.
Tenancy in Common: This form of ownership is similar to that of joint tenancy in that it requires unity of ownership among the tenants. That is, each tenant must have the right to occupy the whole premises in common with his/her co-tenants. Where each tenant possesses a definite part of the real property to the exclusion of the other tenants, there is no unity of possession and thus, no tenancy in common. (Or any other form of joint tenancy, for that matter.) Where tenancy in common differs from the other forms of ownership is in the fact that the other "unities" (those of title, interest and time) need not be present at the time of creation. For example, the tenancy in common titles to the property may, but need not be, created at different times and by different instruments and may convey unequal percentages of ownership. The other main difference is in succession. Upon death of one of the tenants, the interest of the decedent does not pass to the surviving tenants; it passes to the heirs or legatees of the decedent.
Tenancy by the Entirety: That is also very similar to joint tenancy, except that this form of ownership can include only two people and they must be husband and wife. As in joint tenancy, the unities must be observed at the time of creation of the estate. In addition, the couple must be married at the time that the property is conveyed to them. If the couple divorce while they hold the property in tenancy by the entirety and still wish to keep joint title to the property, the form of ownership changes to either joint tenancy or tenancy in common, depending on state law. If one dies or the property is otherwise conveyed, the tenancy by the entirety is obviously destroyed, unless it is conveyed to another married couple who wish to take it in the same form of ownership.
Community Property: The estate of community property is created by state law as an incident of marriage. It gives each spouse a one half interest in the other spouse’s property or income acquired during the marriage. It has been defined to include all property, real and personal, except that owned by either spouse at the time of marriage or acquired during marriage by gift, devise, bequest or descent. It is a relatively recent legal development that did not exist at common law. Eight states have community property laws, including Texas, California, Louisiana, Arizona, Washington, Idaho, Nevada and New Mexico, though they differ from each other in some significant respects.
When a federal tax lien is filed against one or more individuals or entities which own real property in some form of joint ownership, but not against all of them, the legal issue of whether the lien attaches to the property arises. If it does attach, the question becomes how the lien affects the rights of the parties who owe no taxes.
In the case of property held in joint tenancy, the federal tax lien attaches to the taxpayer’s proportionate interest. As long as neither the owners, nor security holders (including the IRS) take any action to dispose of the property, the lien will remain a dormant right against the property and will not impede its use by the owners. In the event that the taxpayer against whom the lien is outstanding predeceases any of the other joint tenants, the lien ceases to attach to the property and the IRS is left holding the bag, Fecarotta v. United States, 154 F. Supp. 592 (D. Ariz. 1956). If the opposite happens, ie: the other joint tenants die before the taxpayer, the lien will attach to the entire property and the IRS will make out like a bandit – provided there is any equity in the property. [The one exception to the above is if the decedent joint tenant leaves a taxable estate which is not paid. At that point, a special 10 year federal estate tax lien arises and attaches to any interest the decedent/taxpayer had in jointly held property before his death. IRC §6324, Detroit Bank v. United States, 317 U.S. 329 (1943)]
If the joint tenants attempt to sell the property voluntarily to any third party, the proceeds due the taxpayer from the sale, up to the amount of taxes due (including accrued interest and penalties), must be remitted to the IRS before it will agree to release or discharge its lien against the property. The unaffected joint tenant can receive his or her share of the proceeds without regard to the lien.
If another secured party, such as the mortgagee, forecloses on the property, the IRS will again have to be paid the funds that would be due the taxpayer if it were not for the lien – provided that the IRS appears in court and asserts its lien rights. (As a practical matter, the IRS does not always appear in judicial foreclosures to assert its lien rights even, if there is sufficient equity in the property to yield some proceeds to the IRS. In those cases IRS’ rights are foreclosed and it gets nothing.)
If the IRS takes an active role against the taxpayer and seeks to enforce its lien rights against the property through judicial foreclosure under IRC §7403(a), the courts have generally held that the entire property may be sold and the proceeds divided with the other joint owners, rather than selling only the taxpayer’s interest. United States v. Washington, 402 F. 2d 3 (4th Cir. 1968), cert. Denied, 402 U.S. 978 (1971); United States v. Overman, 424 F. 2d 1142 (9th Cir. 1970). This is not universally true, however. In United States v. Eaves, 499F. 2d 869 (10th Cir. 1974), the court interpreted IRC §7403(a) as conferring flexibility and broad discretion in allowing the sale of only the taxpayer’s one half interest. Also some state statutes prohibit anyone other than a joint tenant or tenant in common to seek a partition of the property. In those states the IRS has been denied the right to sell the entire interest, Folsom v. United States, 306 F. 2d 361 (5th Cir. 1952). Of course, if the IRS bids in at its own sale and buys the property, it will be allowed to partition the property. Folsom v. United States, supra.
If the IRS seizes and sells the property administratively (rather than judicially), it will sell only the taxpayer’s interest. If there are two tenants, the joint tenancy is destroyed by the act of sale and the purchaser becomes a tenant in common with the tenant whose interest was not sold by the IRS. If there are three or more joint tenants, the joint tenants become tenants in common with the purchaser, though they remain joint tenants between each other, with the right of survivorship.
The practical reality of an administrative sale (or a judicial sale, for that matter) of only a partial interest in real property is that the purchase price is invariably less than the proportionate share of the interest being sold. Any third party bidding in to buy only a partial interest will not pay the full proportionate price since the ownership he is purchasing is subject to the rights of the other tenant(s). In addition, he is buying it subject to a six month right of redemption by the taxpayer, thus depressing the price even further. The buyer cannot convey the property to someone else for at least six months. The buyer cannot evict the taxpayer for at least six months and he certainly cannot evict the other tenant whose interest has not been sold. Thus, in those situations, the taxpayer would be well advised to sell the property himself, possibly to the other joint tenants, since he is more likely to receive a fair market value for his interest than if the IRS sells it administratively. On the other hand, there is an opportunity for the other joint tenants to buy the taxpayer’s interest in the property at an IRS administrative sale for a bargain basement price. It depends on whose interest is being represented.
In the case of property held in tenancy in common, the dynamics are very similar to those of the jointly held property, except that the federal tax lien is not extinguished upon the death of the taxpayer. The heirs or legatees of the taxpayer take the property subject to the federal tax lien so that the executor or administrator of the estate is obligated to pay the IRS to the extent of the value of the lien in the property. In fact, the executor or administrator had better pay IRS the value of the lien since he may be help personally liable for non-payment of the tax under IRC §2204.
Real property held as tenancy by the entirety may or may not be sold by the IRS for the tax liability of just one of the tenants, depending on the laws of the state. In Missouri, for example, a court has held that the estate is immune from attachment, levy or the liens (including a federal tax lien) of a creditor of only one tenant, United States v. Hutcherson, 188 F 2d. 326 (8th Cir. 1951). Wyoming and Hawaii seem to have similarly strong statutes that prevent creditors’ liens against only one tenant from attaching to tenancy by the entireties property. In Talbot, Jim K. v. United States, 850 F. Supp. 969 (DC WY, 1994), the court held that the federal tax liens, recorded in the county clerk’s office at the time that the property was owned by the taxpayer and his wife as tenants by the entireties, never attached to the property. The court went on to say that, under Wyoming law defining tenancy by the entireties, neither spouse possessed independent interest in property to which the lien could attach. In Davies, Theo. E. & Co. Ltd. v. Long & Melone Escrow, Ltd. 876 F. Supp. 230 (DC HI, 1995), the court held that IRS’ lien was invalid. It went on to explain that, under Hawaii law, the husband didn’t hold a separate interest in the entirety property to which the lien could attach – until the wife’s death.
New York and Alaska, on the other hand, have ruled not only that the lien attaches to the tenant’s one half interest in the entireties, but also that state law permits a judgment creditor to execute upon an individual tenant – debtor’s interest in the entirety, Rothchild v. Lincoln Rochester Trust Co. 212 F. 2d. 584 (2nd Cir. 1959), Pilip v. United States, 191 F. Supp. 943 (DC AK, 1960).
Still other states, like Michigan, seem to take a middle ground. Michigan’s interpretation of its tenancy by the entireties statutes seem, in fact, to have evolved over the years. In Shaw v. United States, et. al. 94 F. Supp. 245 (DC MI, 1939), the court held that IRS’ lien did not attach to the husband’s interest in property held by the entireties. In Fischre III v. United States, 73 AFTR 2d. 94-2037 (DC MI, 1994), the court held that, even though IRS’ judgment lien against one taxpayer individually was a nullity as to entireties property, the lien nonetheless attached to the taxpayer’s individual survivorship interest and may be satisfied to the extent of that interest upon termination of the entireties estate by death of the non-debtor spouse, divorce or joint conveyance. The court further went on to rule that the lien filed and recorded against the property could remain for that limited purpose.
Some of these more aggressive statutes and court rulings seem to abut against the United States Supreme Court’s rulings in United States v. Bess, 357 U.S. 51 (1958) and United States v. Stern, 357 U.S. 39 (1958) prohibiting the individual states from enacting laws which exempt the reach of the federal tax lien.
A bona fide trust arises when an individual, usually called a settlor, transfers title and possession of property to another, called a trustee, to be held in benefit for one or more other persons, called beneficiaries. The trust may be established during the lifetime of the settlor, called an inter vivos trust, or by a will, in which case it is known as a testamentary trust. The property to which the trustee holds legal title is known as the "trust res", or the "corpus".
The IRS' lien may or may not attach to trust property depending on who the taxpayer is: the settlor, the beneficiary or the trustee. Since a trustee holds bare legal title for the benefit of others, the federal tax lien filed against the trustee does not attach to either the corpus of the trust or income generated by the corpus for any of the trustee's personal tax liabilities. The one exception to that would be if the trustee is also a beneficiary or one of the beneficiaries of the trust. In that case that IRS' lien should attach to the corpus and could be seized by service of a notice of levy.
If the taxpayer is the beneficiary, rather than the trustee, the reachability of a trust by a federal tax lien depends on how the trust is set up and the state's trust laws. If the trust is set up so that the trustee (who may or may not be the settlor) controls the trust and the distribution from it to the taxpayer/beneficiary at his discretion, (such as in a spendthrift trust) chances are that the lien does not attach to the corpus of the trust. See Wilson v. U.S. (1992, Bktcy Ct TX) 71A AFTR 2d 93-4221 and Texas Commerce Bank National Assn v. U.S. et al, (1995, DC TX) 76 AFTR 2d95-7292. This is not universally true, however. In an Illinois spendthrift trust, the court held that the lien attaches, LaSalle National Bank v. U.S. (1986, DC IL) 58 AFTR 2d 86-5298, 636 F Supp 874, 86-2 USTC #9537. This is especially true if a trust is set up as a transparent sham to conceal assets from the reach of IRS or other creditors. See Don Gastineau Equity Tr. v. U.S. (1987, DC CA) 61 AFTR 2d 88-920, 687 F Supp 1422, 88-1 USTC #9314.
The lien does seem to attach, however, to any distributions from a trust, whether they are discretionary, periodic, or based on the occurrence of some specific event - as long as the trustee is put on notice of the lien. Where the distribution is based on the occurrence of a specific event, such as marriage, the reaching of a certain age, etc. or at the discretion of the trustee (ie: spendthrift trust), it is IRS’ position that a notice of levy must be served on the trustee at the time of the distribution. [See Sec. 35(20)(3) of the Legal Reference Guide.] It is not clear whether a notice of levy served on the trustee before distribution is legally sufficient to attach the lien to the funds. In a California case the trustee was held not liable for failure to surrender property where no income or trust corpus was due the taxpayer/beneficiary when notice of levy was served, and where income thereafter accumulated was held at the disposal of the court. Leuschner v. First Western Bank. & Tr. Co. (1957, DC CA) 52 AFTR 1549, 57-2 USTC #9734. It has been my experience, however, that trustees are generally reluctant to distribute funds to beneficiaries once they have some documentary notice of an IRS lien and a demand for turnover, i.e. notice of levy.
In those cases where periodic distribution to the taxpayer/beneficiary is provided for in the trust, the lien attaches to the distributions. A levy served on the trustee is effective to reach not only payments then due, but all subsequent payments that will become due, at such time as the payments become due. See IRC 6331(b) and Rev. Rul. 55-210, 1955-1, C.B. 544.
If the taxpayer is the settlor, the first question to be asked is whether the lien arose prior to the conveyance of the property into the trust. If it did, the lien attached to the property and followed it into the trust. Thus the IRS can seize and sell the corpus of the trust, or at least that portion which was conveyed into the trust after the lien attached to it. If the lien arose after the property was conveyed into the trust, the second question to be asked is whether the conveyance was revocable or irrevocable. If the conveyance is revocable, either at a specific time or on the occurrence of a specific event, it is reachable when the revocability condition is satisfied. If it is revocable at the will of the settlor, the corpus is arguably reachable by IRS' levy at any time. [See the discussion in U.S. v. Peelle, et al, 158 F Supp 45 (1958, DC NY)]
If the conveyance is irrevocable, the third question to be asked is whether the settlor is also a beneficiary. If he is a beneficiary, the taxpayer/beneficiary analysis would follow. If he is not a beneficiary, chances are good that IRS' lien would not attach to the corpus, unless there is fraud or some related criminal behavior.
Thus, while trusts can be constructed skillfully to avoid the reach of the IRS and/or any other creditors, a word of caution is in order. Case law is replete with sham trusts that were transparent efforts to avoid the payment of taxes, many of them set up after the tax lien arose.
A common form of a trust is the so-called "Totten Trust". It is created when a person deposits his own money in his own name as a trustee for another. Typically, a father might open a college education bank account for the benefit of his daughter, but retains the right to withdraw funds from it, either for his daughter's benefit, or his own. Unfortunately for the daughter, unless the father dies or completes the gift by some unequivocal act or declaration, such as the delivery of the passbook to the daughter, the funds on deposit are generally subject to IRS' lien if the taxpayer is the father. See U.S. v. The Emigrant Industrial Savings Bank, (1954, DC NY) 46 AFTR 269, 122 F Supp 547, 54-2 USTC #9447 and U.S. v. Williams, (1958, DC NJ) 1 AFTR 2d 1584, 160 S Supp 761, 58-1 USTC #9499.
(This Article is still in progress and has not been completed.)
© Tony Mankus, Mankus & Marchan, Ltd.
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