Estate Plan Triggers Liability for Unpaid Taxes

Estate planning often involves transferring business interests from one generation to the next.  But what if the parent owes unpaid taxes? Can the children be held liable for the unpaid taxes? What about the surviving spouse? What if they were not aware of the steps taken to avoid paying taxes? The recent United States v Lax, No. 18-CV-4061 (E.D.N.Y. 2019) case provides an opportunity to consider these questions. 

Facts & Procedural History

This case involved a real estate owner who was diagnosed with stomach cancer.  According to the court, the decedent took steps before he died to avoid paying his taxes.    

The steps described by the court appear to be standard estate planning transfers.  He transferred his assets into business entities and a trust without adequate consideration.  The property interests were estimated to be more than $77 million. The decedent’s son and daughter were the executors of the estate and the trustees of his trust.  

The government brought suit against the surviving spouse to collect the unpaid taxes.  There was a question as to whether the surviving spouse knew of the decedent’s actions to avoid paying tax.  

The Fraudulent Transfer Laws

Federal law generally looks to state law to determine what property rights a taxpayer has.  Then, given these state-law property interests, Federal law dictates the tax implications. 

With respect to transfers, the state fraudulent transfer rules apply.  These laws are intended to prevent debtors from transferring assets to avoid paying their debts.  

This case involved the New York fraudulent transfer statute (Section 273 and 276 of the New York Debtor and Creditor Law).  If a court finds that this law applies, then the conveyance is set aside and disregarded.  

The New York statute reads as follows:

Where a conveyance or obligation is fraudulent as to a creditor, such creditor, when his claim has matured, may, as against any person except a purchaser for fair consideration without knowledge of the fraud at the time of the purchase, or one who has derived title immediately or mediately from such a purchaser,
a. Have the conveyance set aside or obligation annulled to the extent necessary to satisfy his claim, or
b. Disregard the conveyance and attach or levy execution upon the property conveyed.

This is similar to the statutes in other states.

Does the Defendant Have to be a Participant?

But does the law apply if the defendant was not a participant in the fraudulent transfer?  That was the issue in this ase. The surviving spouse in this case argued that she was not liable as she was not a “participant” in the fraudulent conveyances.  

The court summarized the law as follows:

There appears to be a split of authority regarding whether a `passive’ beneficiary or transferee who does not otherwise `participate’ in the fraudulent conveyances may be held liable. Compare Sullivan v. Kodsi, 373 F.Supp.2d 302, 309 (S.D.N.Y. 2005) (finding no authority for the proposition that “beneficiaries and transferees” who do not participate in the fraudulent transfers may be held liable), with Federal National Mortgage Association v. Olympia Mortgage Corp., 792 F.Supp.2d 645, 655 (E.D.N.Y. 2011) (“Courts applying Stochastic have repeatedly noted that one need only be a transferee or beneficiary to be a participant in a fraudulent transfer; not either a transferee or beneficiary of a fraudulent conveyance and a participant in the underlying fraud”) (emphasis in the original); Integrity Electronics, 2016 WL 3637004, at *10 n. 7 (concurring with Olympia Mortgage). 

If Sullivan applies, those who receive fraudulent transfers passively via a trusts are not liable.  If Stochastic applies, a transferee or beneficiary is automatically a participant in a fraudulent transfer.  The court did not address this split of authority in this case, as it noted that the surviving spouse signed some of the transfer documents.  Thus, it concluded that the surviving spouse participated in the transfers.  

This case suggests that, with some tax planning, it may be possible to shield the surviving spouse or other beneficiaries from the decedent’s unpaid taxes if they do not participate in the fraudulent transfers.