The IRS has broad powers to collect unpaid tax debts. This power is not unlimited. In Dalton v. Commissioner, T.C. Memo. 2008-165, the U.S. Tax Court looks at one limitation on the IRS’s collection powers, namely, the IRS’s ability to take property that is held by a third party to satisfy the taxpayer’s tax debt.

Facts & Procedural History

This issue arose in Dalton because the taxpayer had submitted an offer-in-compromise in an effort to settle the taxpayer’s tax debt. The IRS asserted that the value of real property held in a trust had to be included in the amount of the taxpayer’s offer. The court was not able to agree with the IRS given the facts that were presented to the court. The court remanded the case back to the IRS appeals office, so that the appeals office could determine whether the property had to be included in the offer amount.

In Dalton, the property the IRS wanted the taxpayer to include in his offer in compromise was real estate held by a trust. The taxpayer had purchased the property and then transferred the property to his father. The trust was established by the taxpayer’s father. The father then transferred title to the real estate to the trust. The trust was to benefit the taxpayer’s children. The taxpayer’s wife and father encumbered the property by taking out a mortgage on the property. After the taxpayer’s grandfather died, the taxpayer took over as trustee. The taxpayer then appointed his uncle to take over as trustee. By the time the taxpayer had incurred the tax liability and submitted an offer in compromise, the taxpayer ended up residing on the property. The taxpayer did not execute a written lease agreement with the trust. The question is whether the unencumbered value of this real estate had to be included in the amount of the taxpayer’s offer in compromise.

Property & The Requirements  

For the IRS to reach property, federal tax law generally requires state or other law provide the taxpayer with some property interest or right to the property. These rights may come from direct ownership or some lesser interest in the property. For example, purchasing a piece of real property outright may give the taxpayer full ownership of the property. Leasing a piece of real property would not give the taxpayer an ownership interest in the property, but it would give the taxpayer the limited right to use or occupy the property. Transferring title to real property to a trust may or may not result in the taxpayer retaining an interest in the property. In the later case, the rights would be governed by the terms of the trust and by whether state law recognizes the property interest as belonging to the taxpayer.

Once it is determined that the taxpayer has an interest in property for purposes of state (or other law, such as federal law that grants rights to a patent holder), then federal tax law determines whether the IRS is entitled to reach the property interest.  The courts have established several factors that are to be considered in determining whether federal tax law allows the IRS to reach property held by a third party. These factors include:

  • whether no consideration or inadequate consideration was paid by the nominee for the property and/or whether the taxpayer expended personal funds for the nominee’s acquisition;
  • whether property was placed in the nominee’s name in anticipation of a suit or the occurrence of liabilities;
  • whether a close personal or family relationship existed between the taxpayer and the nominee;
  • whether the conveyance of the property was recorded;
  • whether the taxpayer retained possession of, continued to enjoy the benefits of, and/or otherwise treated as his or her own the transferred property;
  • whether the taxpayer after the transfer paid costs related to maintenance of the property (such as insurance, tax, or mortgage payments);
  • whether, in the case of a trust, there were sufficient internal controls in place with respect to the management of the trust; and
  • whether, in the case of a trust, trust assets were used to pay the taxpayer’s personal expenses.

The critical factor is whether the taxpayer retains control over the property that is held by the third party.

As applied, the IRS and taxpayer may find that state law does not provide the taxpayer with any interest in the property. They may also find that the IRS is not able to reach the property interest because the interest is not sufficient given the factors provided by our federal tax law. If the property is beyond the IRS’s reach, then the amount should not be included in determining the amount of the taxpayer’s offer in compromise (this ignores any fraudulent transfer, transferee liability, or proceeds tracing issues).

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