The IRS often audits tax years where there is some change. This includes mergers, significant asset transfers, deaths or even divorces.
The reason why it does this is that these transitions create opportunities for savvy taxpayers or pitfalls for the unwary. These transitions also create motives and introduce new parties to income or assets that may have different needs for the income or assets. In short, it is where there is likely to be more noncompliance. It is where the IRS auditors are able to make the largest tax adjustments.
The same tax planning for divorce can also be done for IRS collection cases.
The court addresses a fact pattern like this in Estate of Washington v. Commissioner, T.C. Memo. 2022-4. In Washington, the court considered whether a divorcing couple enter into a divorce settlement agreement whereby one spouse is a judgment creditor, and then file that judgment in the local rules to trump the IRS’s general unfiled tax lien? This was addressed in the context of whether the taxpayer then settle their IRS back taxes by excluding the property from the spouse’s judgment in calculating the settlement amount.
Facts & Procedural History
This case involves a couple who were married for twenty five years. They divorced in 2006, but were living separately since 2002.
The divorce included a Marital Settlement Agreement. The settlement agreement included a several provisions that were part of the tax dispute. The issue this post focuses on is this provision regarding life insurance:
The parties’ son is currently named as the beneficiary of the Husband’s life insurance through his employment with a face amount of $100,000.4 The Husband agrees to irrevocably elect the Wife as the beneficiary of this coverage on his life for so long as he is employed, and further agrees not to borrow against or otherwise encumber such life insurance proceeds. The Husband agrees that his notarized signature on page 125 of this Agreement constitutes his irrevocable designation of the Wife as such beneficiary, and directs Radio One, upon receipt of a copy of this paragraph and the signature page, . . . to effectuate the intent of this paragraph by so listing the Wife as the irrevocable beneficiary.
The decedent-husband failed to file his tax returns for 2008-2010. He filed these returns in 2014 and negotiated an installment agreement with the IRS. He died one year later. The IRS filed a lien for these tax years two years after that.
The ex-spouse was named as personal representative in the estate. In that capacity, she caused the 2014 and 2015 tax returns to be filed.
The IRS started enforced collections against the estate and the estate made a proposal to settle the taxes. The IRS rejected the settlement proposal, which resulted in this court opinion.
One of the questions before the court was whether the settlement proposal had to factor in the life insurance policy as an asset.
The IRS’s Settlement Program
The IRS’s collection rules look to the taxpayer’s “reasonable collection potential.” The “reasonable collection potential” is basically monthly disposable income plus assets. The higher these amounts, the higher the settlement offer has to be. The IRS will usually not accept offers less than this amount.
The IRS can accept less than this for offers based on special circumstances and based on effective tax administration.
We won’t get into the nuances of those rules in this article (you can read more about the IRS’s settlement program here).
For this article, we are focusing on the whether the life insurance is an asset that is to be included in the computation of the offer amount.
Who is a Judgment Lien Creditor?
The estate argued that the ex-wife and personal representative was a judgement creditor of the decedent’s estate. It pointed to the language in the divorce settlement agreement regarding the life insurance.
Section 6323 provides a list and extensive rules for who is a judgment lien creditor.
The implementing regulations explain that the term “judgment lien creditor” means a person who has obtained a valid judgment, in a court of record and of competent jurisdiction, for the recovery of specifically designated property or for a certain sum of money.
The rules go on to say that the judgment has to be perfected under local law:
In the case of a judgment for the recovery of a certain sum of money, a judgment lien creditor is a person who has perfected a lien under the judgment on the property involved. A judgment lien is not perfected until the identity of the lienor, the property subject to the lien, and the amount of the lien are established. Accordingly, a judgment lien does not include an attachment or garnishment lien until the lien has ripened into judgment, even though under local law the lien of the judgment relates back to an earlier date. If recording or docketing is necessary under local law before a judgment becomes effective against third parties acquiring liens on real property, a judgment lien under such local law is not perfected with respect to real property until the time of such recordation or docketing. If under local law levy or seizure is necessary before a judgment lien becomes effective against third parties acquiring liens on personal property, then a judgment lien under such local law is not perfected until levy or seizure of the personal property involved. The term “judgment” does not include the determination of a quasi-judicial body or of an individual acting in a quasi-judicial capacity such as the action of State taxing authorities.
The court considered these rules in deciding whether the divorce settlement agreement caused the ex-wife to be a creditor of the estate.
The Divorce Settlement Agreement as a Judgement Lien
The court noted that the divorce order signed by the court did not include any reference to the divorce settlement agreement. It did not reference the settlement agreement. The court notes this defect in passing.
The court then turned to the other requirements, namely, that the judgment be for specific property or for a certain sum of money.
The court held that the divorce settlement language was too remote to be for a certain sum of money:
For Ms. Washington to be entitled to recover under the policy, Mr. Washington would have had to die while employed by Radio One, his employer when he executed the MSA, and Radio One would have had to retain in force the insurance coverage from the date of the Divorce Decree to the date of Mr. Washington’s death. But the Divorce Decree left Mr. Washington free to stop working for Radio One or to stop working altogether. And, of course, the Divorce Decree could not prevent Radio One from discontinuing the life insurance arrangement. So, as of the date of the Judgment, Ms. Washington did not have, and could not seek execution based on, a judgment for a certain sum of money.
The court also noted that the rules require the judgment to be perfected under local law. Local law in this case required the judgment to be recorded in the Recorder of Deeds Office, which it apparently was not.
The court did not address whether the life insurance was “specific property” as IRS Appeals did not include the proceeds as an asset. The court seems to reason that any claim would have been satisfied by the payment of the proceeds.
The Spouse as a Judgment Creditor
This case highlights how couples might structure their divorce settlement agreements when one spouse owes the IRS back taxes.
For example, the couple might enter into a divorce settlement agreement that is incorporated into the divorce court order, that identifies specific property that is to pass to the other spouse, and that is filed in the local records as a judgment. If this is done before the IRS files its lien notice or one of the exceptions in Section 6323 applies to the property, the judgment lien holder may take the property free of the IRS’s general unfiled tax lien.
This type of arrangement might help taxpayers who are divorcing and plan on transitioning assets to one spouse over time. Examples include a divorcing couple who own a small business or a portfolio of rental real estate. These assets may need to be transitioned over time as the business or real estate earn income. This can help the recipient spouse avoid existing tax balances or, as in this case, taxes that arise after the divorce when an IRS lien has not yet been filed.
This type of tax planning may be particularly useful for spouses who cannot qualify for innocent spouse relief, but who are truly an innocent spouse as to the taxes. Married by separated couples are an example. The same goes for individuals who are divorcing persons with known tax compliance problems. The perpetually non-compliant spouse is likely to continue to have tax compliance problems after the divorce. This type of judgment lien creditor planning may help the compliant spouse avoid being pulled into these disputes.
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