The IRS has broad powers when it comes to collecting unpaid tax debts, but its authority is not without limits.
For example, there are limits on what property the IRS can seize if the property is held by a third party. This can include property held in trust.
Consider the situation where a father creates a trust for the benefit of his grandchildren and he names his son as the trustee. If the son owes back taxes, can the IRS seize the trust assets to satisfy the son’s tax liability?
The court addresses this situation in Dalton v. Commissioner, T.C. Memo. 2008-165.
Facts & Procedural History
The taxpayers had unpaid taxes. The IRS filed a Levy Notice. The taxpayers responded by submitting a timely collection due process hearing request. During the CDP hearing with the IRS Office of Appeals, the taxpayers submitted an offer in compromise in an effort to settle the tax debt.
In evaluating the offer, the IRS asserted that the value of real property held in the trust had to be included in the amount of the taxpayer’s offer. The property was held in a trust. The taxpayers had purchased the property and then transferred the property to his father.
The trust was established by the taxpayer-husband’s father. The father then transferred the title to the real estate to the trust. The trust was to benefit the taxpayers’ children. The taxpayer-hsuband’s wife and father encumbered the property by taking out a mortgage on the property. After the taxpayer husband’s grandfather died, the taxpayer-husband took over as trustee. The taxpayer-husband then appointed his uncle to take over as trustee.
By the time the taxpayers had incurred the tax liability and submitted an offer in compromise, the taxpayers ended up residing on the property. The taxpayers 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 taxpayers’ offer in compromise.
About the IRS Lien
The IRS’s ability to take taxpayer property comes from its general lien, which arises by operation of law once a tax is assessed and remains unpaid.
This IRS lien attaches automatically to all of the taxpayer’s property and rights to property, including real estate, personal property, and financial assets. The lien does not have to be filed in the public records to be valid, and it continues until the tax liability is satisfied or becomes unenforceable due to the statute of limitations.
The authority for the IRS’s general lien is provided by Section 6321. Section 6321 states that “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 means that once a taxpayer has a tax liability, the IRS has a legal right to the taxpayer’s property and can seize or sell it to satisfy the debt. However, the IRS must follow specific procedures and provide the taxpayer with certain rights, such as notice and an opportunity to appeal, before taking any enforcement action.
Property & The Requirements
For the IRS lien to reach property, our federal tax law generally requires state or other law to 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 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 latter 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 lien is able to reach the property interest.
Property Held by a Third Party
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. This includes property held in trust with the taxpayer as the trustee.
Various theories have been used to support the existence of an interest under state law, such as resulting trust doctrines, constructive trust principles, fraudulent conveyance laws, and concepts drawn from state jurisprudence on piercing the corporate veil.
Beneficial, Not Legal Title
The court held that the IRS could not reach the property held by the trust. The court reasoned that the taxpayers only had the legal title and not the beneficial title. The beneficial title is what the IRS can levy.
The court reached this conclusion even though the:
- The taxpayer-husband was the trustee.
- The taxpayers’ children were named as beneficiaries of the trust.
- The taxpayers lived on the property and covered certain expenses.
The court remanded the case back to the IRS Office of Appeals for further consideration.
This case highlights the limitations on the IRS’s collection powers when it comes to taking property held by a third party to satisfy a tax debt. To reach property, federal tax law generally requires that the taxpayer have some property interest or right to the property. The court held that the IRS could not reach the property held by the trust in this case because the taxpayers only had legal title and not beneficial title, which is what the IRS can levy. This case underscores the importance of understanding the distinction between legal and beneficial title when it comes to property ownership and taxation.