Nothing in life is certain but death and taxes, and never more so than now. The reason is that two recent Supreme Court decisions expand the reach of the federal tax collector, and some assets which were previously safe are now in jeopardy. This article will discuss several situations in which the IRS now enjoys enhanced powers to proceed against the property of delinquent taxpayers. Specifically, in the paragraphs below we will consider the surprising and extremely important Supreme Court decisions in U.S. v Craft dealing with tenants by the entireties property, and in Drye v. U.S. which addresses the effect of qualified disclaimers.
Two previous articles in this ongoing series on dealing with the IRS Collection Division have explained the nature and scope of the federal tax lien.2 By way of a brief review, a “lien” is simply a legal encumbrance in favor of one party upon the property of another. In the case of federal income taxes, the lien is based on §6321 of the Internal Revenue Code.3 The lien arises immediately upon the assessment of any tax, and continues until the tax liability is paid in full or becomes unenforceable by operation of law,4 as for example upon the expiration of the ten-year statute of limitations on collections.
The filing of a Notice of Federal Tax Lien (Form 668) merely announces the existence of the lien, and is not required — the lien itself exists as a matter of law and can be perfected even without the filing of a notice. However, filing has significance in establishing the IRS’s priority against other claimants, such as purchasers, holders of security interests or mechanic’s liens, and judgment creditors.5 The federal tax lien attaches to “all property and rights to property” of the person liable for the tax.6 And it is the key phrase “property and rights to property” which has been at issue in the two Supreme Court cases that have recently reshaped the federal tax collection landscape.
Though the proposition seems to be under judicial attack, the question of the nature and extent of a taxpayer’s interest in property has long been thought to turn on the law of the state in which the property is located. Forty years ago, the Supreme Court explained this concept in Aquilino v. U.S., 363 U.S. 509 (1960):
The threshold question in this case, as in all cases where the Federal Government asserts its tax lien, is whether and to what extent the taxpayer had “property” or “rights to property” to which the tax lien could attach. In answering that question, both federal and state courts must look to state law, for it has long been the rule that “in the application of a federal revenue act, state law controls in determining the nature of the legal interest which the taxpayer had in the property sought to be reached by the statute.” (citations omitted)
While not explicitly overturning Aquilino, the Supreme Court’s recent decisions signal an ever-diminishing role for state law in determining whether or not a taxpayer has something amounting to “property or rights to property.”
U.S. v. Craft
On April 17th, while we were thanking the tax gods for letting us live through another filing season, the Supreme Court dropped a bomb on married taxpayers holding real estate as “tenants by the entireties.” In Maryland, two or more persons can own property as “joint tenants” or “tenants in common.” In addition, married persons can hold property in a special form of concurrent ownership called “tenants by the entireties.” The historical benefit of tenants by the entireties is that a spouse’s separate creditors are barred from encumbering or reaching the property in any way. This result is obtained because property held as tenants by the entireties is not viewed as being owned by either spouse, but by a legal construct called the “marital unity.” The Supreme Court has now decided that this long-established rule of law is fine for everyone but the Internal Revenue Service.
The vehicle which the Supreme Court used to overturn hundreds of years of statutory and common law was U.S. v. Craft. The case arose in Michigan, but the result is equally applicable in Maryland, Virginia, D.C., and any other state extending similar protection to tenants by the entireties property. Here’s the background: In 1972, Don and Sandra Craft purchased real estate in Michigan. They failed to file tax returns for 1979 through 1986, and in 1988 the IRS made an assessment against Don under its substitute for return (or “SFR”) procedures.7 Although the Crafts were married, joint filing status is an election which only taxpayers can make. Don was the one with the income, so the SFR assessment was solely against him. As a result, his wife Sandra was not liable for the tax. In March 1989, the IRS filed a notice of federal tax lien against Don, and five months later the Crafts transferred the real estate from joint ownership into Sandra’s separate name. Finally, although this isn’t even mentioned in the Supreme Court’s opinion, in 1992 Don Craft, an attorney, filed bankruptcy and received a discharge.8 The bankruptcy discharge meant that the IRS’s only way to collect the tax was to pursue its pre-petition lien.9
All of this percolated to the surface when Sandra entered into a contract to sell the property and the title company refused to insure the buyer’s title unless the IRS released its lien. The IRS agreed to do so, but only if the husband’s half of the proceeds was placed in escrow pending a determination as to the Service’s right to the money. Sandra sued to quiet title and recovered the escrowed funds, and the IRS raised two arguments, both of which were contrary to the law as we have long understood it here in Maryland. First, the IRS asserted that the transfer of title from tenants by the entireties to the wife alone was a fraudulent conveyance. Second, the IRS claimed that its lien attached to the husband’s interest in the tenants by the entireties property as of the date of assessment. The District Court, siding with the IRS but adopting a slightly different legal theory, found that the tax lien attached to the property when the transfer to Sandra destroyed the tenancy by the entireties. Having so ruled, the Court did not have to decide the fraudulent conveyance issue.
On appeal, the Sixth Circuit reversed. Applying the law as it had been consistently interpreted in Michigan (and in Maryland, D.C. and Virginia), the Court held that under tenancy by the entireties the husband owned no separate interest in the property, and he therefore had nothing to which the federal tax lien could attach. As a result, the Sixth Circuit sent the case back to the District Court for consideration of the fraudulent conveyance issue.
On remand, the District Court held that since the Sixth Circuit had determined that Don did not own anything to which the lien could attach, there couldn’t have been a fraudulent conveyance. In other words, the transfer from joint name to the wife’s name did no violence to the IRS’s lien interest in the property because in fact the IRS had no lien interest in any event. However, the District Court held that the husband’s use of his own funds to make mortgage payments on property which was legally beyond the reach of his separate creditors violated the Michigan fraudulent conveyance statute. This did not cause the transfer to be set aside, but the Court awarded the IRS an amount equal to the mortgage payments the husband had made.
At this point, both sides again appealed to the Sixth Circuit, which this time affirmed the trial court’s new positions, including the conclusion that the husband’s mortgage payments constituted fraudulent conveyances recoverable by the IRS. Finally, on April 17, 2002, the Supreme Court reversed the Sixth Circuit and adopted the IRS’s original position that the lien had attached to the tenants by the entireties property. The Court also strongly hinted that in any future case it would hold that an insolvent husband’s transfer of his interest in tenants by the entireties property to his wife constitutes a fraudulent conveyance.
The Supreme Court reached these conclusions while purporting to honor the role of state law, by noting that as to tenants by the entireties property Michigan law gives each spouse important legal rights. These include the right to use the property, and to exclude others from doing so. The absence of the right to convey ownership, which clearly the spouses cannot accomplish except by acting together, was held not to be determinative. And, the Court reasoned, once state law gives a taxpayer right with respect to property, that fact is sufficient to permit the attachment of the federal tax lien to the property. Justice Thomas, joined by Justice Scalia, argued that this was a sea change in the relationship between federal and state law on this issue:
B)orrowing the metaphor of property as a bundle of sticks, a collection of individual rights which, in certain combinations constitute property . . . the Court proposes that so long as sufficient sticks in the bundle of property belong to a delinquent taxpayer, the lien can attach as if the property itself belonged to the taxpayer. This amorphous construct ignores the primacy of state law in defining property interests, eviscerates the statutory distinction between property and rights to property . . . and conflicts with an unbroken line of authority from this Court, the lower courts, and the IRS.
The situation in which one spouse owes tax but the other does not can come about in a variety of ways:
- H owes taxes prior to the marriage. (Marriage does not make W liable for H’s taxes, nor does it subject her separate property to H’s tax lien.)
- H and W file their tax returns “married filing separately,” with only one spouse owing tax.
- H is assessed the trust fund recovery penalty, but W had nothing to do with H’s business and is not liable.
- H and W file a joint return but W is later exonerated under the IRC §6015 innocent spouse rules.10
- H and W file a joint return but H later discharges his liability in bankruptcy.
In all these situations, real estate held by husband and wife as tenants by the entireties was heretofore safe from attachment by either spouse’s separate creditors.11 And after the Supreme Court’s decision in Craft that is still the case for all creditors except your friendly, neighborhood federal tax collector. The Sheriff of Nottingham would be jealous.
Drye v. U.S.
The second Supreme Court case worthy of discussion is Drye v. U.S., 528 U.S. 49 (1999). This case was decided December 7, 1999, and was relied upon by the Court in its analysis in Craft. Drye involved an effort to thwart the IRS through a “qualified disclaimer.” For those who don’t do probate work and are not familiar with the term, a disclaimer is an election by an heir to turn his back on property to which he would otherwise be entitled under a will or under the applicable laws of intestacy. Here are the facts: Mrs. Irma Drye died intestate (i.e. without a will) in 1994. She had one son, Rohn Drye, and he was appointed as administrator of her estate. Under the Arkansas intestacy statute, her property would have passed to him. Unfortunately, Mr. Drye had serious federal tax problems, and if he had distributed the money from his mother’s estate to himself, the IRS would have soon relieved him of it.
So what’s a creative guy to do? Mr. Drye (or more likely his lawyer) came up with the bright idea of disclaiming his interest in the estate. Like most states, Arkansas law provides that when an heir disclaims, his or her entitlement passes instead to whoever would have received it had the person disclaiming predeceased the decedent. In Mr. Drye’s case, this meant that his mother’s assets would pass to his daughter instead of to him. This was arranged, and upon receiving the distribution from her grandmother’s estate, Mr. Drye’s daughter promptly put the money into a trust under which she and her parents were the beneficiaries. Arkansas law provides that the creditors of a person disclaiming an interest in an estate cannot reach the assets thus disclaimed, which is consistent with the legal fiction that the disclaimant died prior to the decedent.
The similarity to Craft is that the federal courts looked to state law to determine whether the taxpayer had something amounting to “property or rights to property,” and then had to decide whether to honor state law purporting to put such property beyond the reach of the taxpayer’s creditors. Remember, the pattern here is that once a property right is deemed to exist, any provision of state law preventing creditors from attaching such property is ineffective against the IRS. The difference which was ignored by the majority opinion in Craft is that with tenants by the entireties property, state law specifies that neither spouse has a separately cognizable property interest, whereas in the case of a disclaimer the party disclaiming clearly has a property right which state law simply permits him to abandon and thereby direct to whoever would have inherited such property had he not survived the decedent.
The Supreme Court, affirming the Eighth Circuit, found that Mr. Drye had a valuable and enforceable right to his mother’s estate, and that his effort to ignore this right by disclaiming it did not mean that it didn’t exist. Indeed, the fact that Mr. Drye could decide whether to accept the property or allow it to pass to another evidenced a dominion and control sufficient to support the attachment of the lien. In the Court’s words, “(j)ust as exempt status under state law does not bind the federal collector, so federal tax law is not struck blind by a disclaimer.”12
It should be noted that the Court’s analysis in Drye, especially given its reaffirmation in Craft, can be applied to situations beyond the disclaimer at issue in that case. So for example, the analysis confirms that property held in a so-called “spendthrift trust” is subject to attack by the IRS. Such a trust typically gives financial benefits to a beneficiary, but then seeks to restrict the rights of creditors to reach those benefits. However, a trust instrument can only determine the nature and extent of the beneficiary’s right to the trust’s corpus and income; it cannot control the effect of the federal tax lien on that right. Thus, if the trust gives the beneficiary enforceable rights to the trust’s income or corpus, any provision of state law or of the trust instrument itself purporting to place that right beyond the reach of the beneficiary’s creditors is generally not effective against the federal tax lien, regardless of whether the applicable state law recognizes spendthrift trusts as against other creditors.13 This proposition was confirmed by the Court’s opinion in Drye, which included the following explanatory footnote:
In recognizing that state-law rights that have pecuniary value and are transferable fall within §6321, we do not mean to suggest that transferability is essential to the existence of “property” or “rights to property” under that section. For example, although we do not here decide the matter, we note that an interest in a spendthrift trust has been held to constitute “property for purposes of §6321″ even though the beneficiary may not transfer that interest to third parties.
So in this context as well, state law protections effective against most other creditors are wholly ineffective against the IRS.14
While the Drye decision was not unexpected and was at least consistent with previous cases interpreting disclaimers and even spendthrift trusts, Craft was a real shock, upsetting hundreds of years of settled law. As Justice Thomas observed in his dissent,
. . . the Court nullifies (insofar as federal taxes are concerned, at least) a form of property ownership that was of particular benefit to the stay-at-home spouse or mother. She is overwhelmingly likely to be the survivor that obtains title to the encumbered property; and she (as opposed to her business-world husband) is overwhelmingly unlikely to be the source of the individual indebtedness against which a tenancy by the entirety protects. It is regrettable that the Court has eliminated a large part of this traditional protection retained by many States.
In effectively representing our clients, we must be aware of this major expansion of the IRS’s ability to reach previously protected assets. Once again, the Court has reminded us that state law is not federal law, and that we confuse the two at our peril.
1 Mr. Haynes is an attorney with offices in Burke, VA, and Burtonsville, MD, and is a member of the Maryland Society of Accountants’ Newsletter Committee. From 1973 to 1981 he was a Special Agent with the IRS Criminal Investigation Division in Baltimore, and in 1980 was named “Criminal Investigator of the Year” by the Association of Federal Investigators. He specializes in civil and criminal tax disputes and litigation, IRS collection problems, and the tax aspects of bankruptcy and divorce. (phone 703-913-7500; website www.haynestaxlaw.com )
2 The Freestate Accountant, Vol 37, No. 4 and No. 5.
3 In addition to the general tax lien, there are special liens for estate and gift taxes. See IRC §6324.
4 IRC §6322.
5 IRC §6323(a).
6 IRC §6321; Regs. §301.6321-1. See also Glass City Bank v. U.S., 326 U.S. 265 (1945).
7 IRC § 6020(b).
8 Craft v. U.S., 140 F.3d 638 (6th Cir. 1998).
9 A discharge does not disturb a secured creditor’s lien on property owned by the debtor at the time the petition is filed. See the author’s article on discharging tax debts in bankruptcy in The Freestate Accountant, Vol. 36, No. 1.
10 See The Freestate Accountant, Vol. 35, No. 4 and Vol. 37, No. 3, for the author’s articles on the innocent spouse rules.
11 State v. Friedman, 283 Md. 701, 393 A.2d 1356 (1978).
12 This was consistent with a previous disclaimer case, U.S. v. Irvine, 511 U.S. 224 (1994), cited in both Drye and Craft.
13 Maryland enforces spendthrift trusts with certain exceptions. See Watterson v. Edgerly, 388 A.2d 934, 935-36 (Md. Ct. Spec. App. 1978). In general, if income is withheld by the trustee, a beneficiary may sue to get it; accordingly, there is a cognizable property right, and the federal tax lien can attach.
14 The ability of the IRS to leap over state laws protecting assets from creditors can also be seen in the treatment of retirement savings held in IRAs, 401(k) accounts and pension plans. See the author’s article on this subject in The Freestate Accountant, Vol. 37, No. 6.