IRS Tax Lien Did Not Attach to Trust Property

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Irs Tax Lien Did Not Attach To Trust Property
Irs Tax Lien Did Not Attach To Trust Property
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If someone sets up a trust for a third party and the third party owes the IRS back taxes, can the IRS reach the trust assets to satisfy the back taxes?

This is a common question that we get from those with trusts or those seeking to set up trusts. This is also a question for which the courts have reached different conclusions. Slight changes in the facts and even the applicable state law matters.

The Duckett v. Enomoto, No. CV-14-01771-PHX-NVW (D. Ariz. Nov. 13, 2015), case provides an opportunity to consider this topic. It is a case where the court sided with the taxpayer by concluding that the IRS lien did not attach to the trust assets.

Facts & Procedural History 

In this case, the taxpayer was the beneficiary of a trust established by his mother in her will. The will stipulated that the trustee would distribute funds to the taxpayer as needed for his support, medical expenses, and education, at the trustee’s sole discretion.

Specifically, the trust provided:

The Trustee shall pay to [the taxpayer] so much or all of the net income and principal of the trust as in the sole discretion of the Trustee may be required for support in the beneficiary’s accustomed manner of living, for medical, dental, hospital, and nursing expenses, or for reasonable expenses of education, including study at college and graduate levels. . . . In the Trustee’s sole discretion and to the extent the Trustee deems advisable, the Trustee may consider or disregard the funds available to the beneficiary from other sources or the duty of anyone to support the beneficiary.

This is often referred to as the HEMS standard, which is the abbreviation for health, education, support, and maintenance.

The IRS served a Notice of Levy on the trustee, demanding that any of the taxpayer’s “property and rights to property” held by the trustee be turned over to satisfy the taxpayer’s federal tax lien. Litigation ensued, with both the taxpayer and the IRS seeking a court ruling on whether the federal tax lien could attach to the trust funds.

Property to Which an IRS Lien Attaches

This case involves an interpretation of Section 6321. Section 6321 is the general provision that provides for the IRS tax lien.

Section 6321 says that if a person liable for taxes neglects or refuses to pay, the tax amount becomes a lien in favor of the United States on all property and rights to property belonging to the person.

Given this language, the court had to determine whether the taxpayer’s interest in the trust funds constituted “property” or “rights to property” under the statute. This, in turn, leads us to state law, as Federal law says that courts must first look to state law to identify the taxpayer’s rights in the property, and then to federal law to decide if those rights qualify as “property” or “rights to property” for tax liens.

Before considering state law in this case, it is helpful to consider the Drye v. United States, 528 U.S. 49 (1999) case. This is the leading case that addresses whether the IRS’s lien attaches to property.

The Drye case involved a disclaimer under state law. The term “disclaimer” refers to the right for a person to refuse to receive an inheritance. They can “disclaim” the inheritance. In Drye, the taxpayer’s mother passed away, leaving him a substantial inheritance. The taxpayer disclaimed the inheritance under Arkansas state law, which allowed the property to pass directly to his daughter.

The IRS asserted that the taxpayer’s disclaimer did not prevent the federal tax lien from attaching to the disclaimed property, arguing that the taxpayer had a sufficient interest in the property at the time of his mother’s death.

The Supreme Court agreed with the IRS, holding that the taxpayer’s right to the property before the disclaimer was sufficient to constitute “property” or “rights to property” under federal tax lien law, thus allowing the lien to attach despite the disclaimer. This ruling underscored the principle that federal tax liens can reach assets in which a taxpayer has significant control.

The Taxpayer’s Interest in the Trust

This brings us back to the Duckett case. The Duckett case involved Arizona law.

Under Arizona trust law as applied to the trust terms in this case, the taxpayer’s rights in the trust were conditional and dependent on the trustee’s discretion. The trust language gave the trustee the sole authority to decide the distributions for the taxpayer’s support and other needs. The taxpayer could only compel payments if the trustee’s withholding of funds constituted an abuse of discretion. The court also noted that the taxpayer’s right was not enforceable because it lacked a permanently fixed dollar value and was variable based on the taxpayer’s needs.

Based on this, the court concluded that while the taxpayer had a conditional right to compel payment from the trust under certain circumstances, this right did not equate to an outright ownership of the trust funds. It was not a current possessory right akin to the right in Drye. Therefore, the court held that the taxpayer’s interest in the trust funds was not “property” to which the IRS’s lien could attach.

This is similar to other cases, which also help highlight how trusts can be used to avoid the IRS levy. Here is another example involving a revocable trust.

The IRS’s Continuing Levy

This does not mean that the IRS is entirely out of luck. The IRS generally has ten years to collect unpaid taxes. This allows the IRS to sit back and wait for trust distributions. Once the distributions are made, the IRS can levy on the distributions.

The IRS can issue a continuing levy on the trustee. This puts the burden on the trustee to pay over any distributions that it decides to make. If the beneficiary cannot afford to wait out the IRS, this could mean that the taxpayer may end up paying the IRS even though the trust assets are beyond the IRS’s reach.

If the beneficiary cannot wait, then he or she may have to consider submitting an offer in compromise to settle the balance or entering into an installment agreement with the IRS. But even then, the IRS may try to factor the trust assets into its review of the taxpayer’s “reasonable collection potential.” The IRS may try to include the trust assets in computing the reasonable collection potential. This can result in the IRS not agreeing to accept an installment agreement or offer-in-compromise for the trust beneficiary.

The Takeaway

This case shows that the IRS lien does not always reach assets held in the trust to satisfy a beneficiary’s tax debt. The court concluded that the IRS lien did not attach to the trust assets due to the trustee’s discretionary authority and the conditional nature of the taxpayer’s rights. These types of terms of the trust and applicable state law are key. But even then, while the IRS may not directly attach a lien to discretionary trust assets, it can still issue a continuing levy on distributions. Taxpayers with similar trust arrangements should be aware of these nuances and consider options like offers in compromise or installment agreements to address their tax liabilities.

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