The federal tax lien is at the heart of all enforced collection action taken by the IRS Collection Division. Accordingly, representing clients requires an understanding of how the lien arises, the kinds of property to which it attaches, the consequences of such attachment, the duration of the lien, the priority of the tax lien over the interests of other claimants to the taxpayer’s property, and the circumstances under which the IRS will removed or subordinate the lien. This is the first of a two-part article which will introduce these essential topics.
Nature of the lien
A lien is an encumbrance in favor of one party upon the property of another, in this case a “statutory” lien based on §6321 of the Internal Revenue Code.2 The lien arises when the taxpayer fails to pay any tax after notice and demand by the IRS for payment. The lien “relates back,” and is thus effective from the date of assessment, and it continues in force until the assessment is paid in full or becomes unenforceable,3 as for example, by the expiration of the statute of limitations on collections.4
Notice of federal tax lien
The filing of a notice5 publicly announcing the existence of the federal tax lien is not required; the lien itself, sometimes called the “secret lien,” 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 to the taxpayer’s property, such as purchasers, holders of security interests or mechanic’s liens, or judgment creditors.6
IRC 6323(f) provides rules for the place of filing for a notice of federal tax lien against both real and personal property. For real property, the notice is filed in the office designated by the state where the property is located. In Maryland, as in most states, this means that the notice is filed with the land records in the county in which the property is located. The residence of a corporation or partnership is the place where the principal office is located.7 A notice of federal tax lien for a taxpayer who resides abroad is filed with the Recorder of Deeds for the District of Columbia.
Under some circumstances a lien must be “refiled.” To remove any doubt about whether a lien is still enforceable when the notice shows the assessment is more than ten years old, the IRS must refile within a one year period ending ten years and 30 days after the date of assessment.8 Failure to refile at the appropriate time does not disturb the validity of the lien, but it does nullify the legal effect of the prior filing. In the case of a late refiling, any security interest arising after the prior filing but before the refiling obtains a priority to the same extent as if no notice of tax lien had been filed prior to the time of the late refiling.
Clients will sometimes point to minor errors in the information on tax lien notices, hoping that such errors invalidate the lien. With regard to the name, the relevant question is not whether it is the taxpayer’s exact legal name, but whether it is sufficient to put a third party on notice of the existence of a federal tax lien against the taxpayer. Thus, a notice filed in a nickname has been held to be sufficient to charge a prospective purchaser with constructive notice of the existence the lien.9Nevertheless, some courts have held that a minor misspelling of the taxpayer’s name renders the notice ineffective.10
Scope of the lien
The federal tax lien attaches to “all property and rights to property” of the person or entity liable for the tax.11 This broad statutory language has been interpreted to include real, personal and intangible property of greatly varying natures, as well as future interests, and even property acquired by the taxpayer after the lien has come into existence.12 Thus, the initial inquiry in determining whether something is encumbered by a tax lien is whether the taxpayer has a “interest” in the property sufficient to support the attachment of the lien. The question of the nature and extent of the taxpayer’s interest in property is one which turns on the law of the state in which the property is located. As explained by the Supreme Court in Aquilino v. U.S.:
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.”13
However, once the taxpayer’s property interest has been defined and deemed to exist under state law, it is federal law which then determines the consequences flowing from the federal tax lien as to that property right.14
Most encumbrances on or interests in a taxpayer’s property, if properly perfected prior to the date on which the federal tax lien arises, have priority over the lien.15 Notice of the lien must be filed before it has priority over most subsequently perfected interests in the taxpayer’s property. But once the notice is filed, the federal tax lien takes priority over all but a few subsequently arising interests in the taxpayer’s property. Remember, the lien itself does not transfer or convey the taxpayer’s property to the IRS. Such transfer of ownership is accomplished either through a judicial foreclosure of the lien, or through an administrative action such as a levy.
Liens on real property
Many questions about the impact of the federal tax lien involve real estate, and the reach of the Service’s lien often turns on the particular form in which ownership is held, especially where there is more than one owner. In Maryland (as in Virginia and D.C.), two or more persons can own real property as “joint tenants” or as “tenants in common.” In addition, married persons can hold property in a special form of joint tenancy called “tenants by the entireties.” Regardless of the nature of title, if a tax lien is outstanding against all those who share the ownership of the property, the tax lien will attach to and may be foreclosed against the entire property. But this is not the case for some forms of ownership when one co-owner is the subject of the lien and the others are not, as for example where one spouse owes taxes for which the other spouse is not liable. This situation can come about in many ways, including the following:
H owes income taxes arising prior to his marriage to W. (Marriage does not make W liable for H’s taxes, nor does it subject her property to H’s tax lien.)
H and W file their income tax returns “married filing separately,” with only one spouse owing tax.
H has been hit with the IRC §6672 trust fund recovery penalty, but W had nothing to do with H’s business and is not liable.
H and W file a joint income tax return and the IRS assesses a deficiency, but W is later exonerated under the IRC §6015 innocent spouse rules.16
In all forms of joint tenancy, two or more persons become the owners of property in equal and undivided shares. Often, the deed establishing a joint tenancy will recite the interests as “joint tenancy with right of survivorship.” State laws differ as to whether joint tenancy alone implies a right of survivorship if not so stated.17 Where only one joint tenant owes taxes, the lien attaches to his or her interest, and this interest can be sold. The majority of courts have held that the entire property may be sold and the proceeds divided with the other joint owner, rather than selling only the taxpayer’s undivided interest.18 If the person against whom a federal tax lien is outstanding predeceases the other joint tenants, the tax lien will cease to attach to the property.19 However, if that individual happens to be the survivor, the lien will attach to the entire property in his hands.
A tenancy in common, in contrast to a joint tenancy with right of survivorship, results in undivided interests in property without the right to succeed to the ownership of the undivided interest held by a deceased co-tenant. Thus, once a federal tax lien has attached to one tenant’s interest, the lien will survive his or her death and will continue to encumber the decedent’s interest in the property as it passes into the hands of his or her heirs.
A tenancy by the entirety is similar to the joint tenancy with right of survivorship, except that it can exist only between a husband and wife. An important characteristic is that the property is deemed owned not by either spouse, but by a fictional entity referred to as the “marital unity.” Upon the death of either spouse, the whole of the estate vests in the survivor. This occurs not because the survivor receives any new property interest, but because in the first instance he or she took the entirety which, under the common law, was to remain in the survivor. In Maryland, Virginia and the District of Columbia, a lien for a debt owed by only one of the spouses will not attach to property held as tenants by the entireties,20 although joint creditors (such as the IRS if both spouses are liable for the tax in question) can still reach such property.21
Liens on personal property
In addition to real estate, tangible personal property can be subject to the federal tax lien. The notice of lien is recorded in the county where the taxpayer resides at the time it is filed. If the notice is properly filed, the lien follows the personalty wherever it is thereafter located.
The most common kind of personalty subjected to the federal tax lien is a bank account. Difficult issues arise when accounts are held jointly by the taxpayer and one or more other persons. With a typical joint account, all co-holders have an unrestricted right to make withdrawals in amounts up to and including the entire balance, regardless of who deposited the funds into the account. The Supreme Court has held that this unrestricted right of withdrawal is a property right to which the federal tax lien attaches.22 Thus, in response to an IRS levy, the bank must pay over the full balance. The “true owner,”however, can file a wrongful levy action to recover his or her part of the funds.
Liens on trusts and terminable interests
Other important and interesting problems are presented by the application of the federal tax lien to the taxpayer’s interest in a trust. In general, the IRS’s lien attaches to whatever interest the taxpayer has in the trust. It is therefore necessary to carefully examine the trust instrument itself, with the appropriate state law governing construction of the terms of the instrument and the resolution of any ambiguities. In some cases, the federal tax lien will attach to the corpus of the trust and to the income payable to the beneficiary. In other cases, the lien will attach only to the income as it becomes payable to the beneficiary. And in a few cases the federal tax lien may not attach to either the income or the corpus.
A so-called “spendthrift” trust may, by its terms, confer certain benefits upon a beneficiary, but then purport to restrict the rights of creditors to reach those benefits. Nevertheless, in construing the reach of the federal tax lien, a trust instrument can only determine the nature and extent of the beneficiary’s property right in the trust’s corpus and income; it cannot control the effect of the federal tax lien upon that right. Thus, if the trust gives the taxpayer-beneficiary an enforceable right to the trust’s income or corpus, any trust provision purporting to place that right beyond the reach of the taxpayer’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.23
Some spendthrift trusts may constitute “protective trusts,” in that under their terms any effort by a creditor to assert a lien on the trust corpus, or on distributions to the beneficiary, causes the forfeiture of the beneficiary’s rights, and the trustee is thereafter given complete discretion to accumulate income or to distribute the income among some group that may or may not include the prior beneficiary. Since the beneficiary then has no right to the income until the trustee decides when and how to distribute it, the beneficiary has no property right to which the lien may attach.24Accordingly, the safest arrangement, at least with regard to a potential tax lien against a beneficiary, is a fully discretionary trust under which the beneficiary has no right to compel the trustee to make distributions of income or corpus.25
Sometimes a taxpayer holds a “terminable interest,” such as a life estate in property which ends on the death of the person holding the right. In the case of a life estate, the lien attaches to the life tenant’s interest, and may be enforced against that interest as long as the life tenant is alive. But upon the death of the life tenant the lien ceases to attach to the property, and it passes free of the lien to the remaindermen.
Liens on intangibles
Intangible property is also subject to the federal tax lien. Such property includes licenses, franchises, debts owed to the taxpayer, and any other such “chose in action.” A chose in action is a personal right not reduced to possession and recoverable by a suit at law. The tort claim which you have against someone who has wrongfully injured you is an example of a chose in action.
Life insurance proceeds are generally not subject to the federal tax lien because the proceeds are paid only on death, and therefore are not owned during the taxpayer’s lifetime.26 The cash surrender value of a life insurance policy, however, can be reached by the federal tax lien. Indeed, the cash surrender value remains encumbered even after the death of the insured, and the Service can recover from the policy proceeds to the extent of its pre-death lien on the cash surrender value.27
The taxpayer’s right to receive alimony payments is also a property right to which the federal tax lien may attach.28 In contrast, however, child support payments are not subject to the Service’s lien; they are deemed the property of the child, and not property of the taxpayer parent.
Exemptions
In general, no property or right to property is “exempt” from the reach of the federal tax lien. Although IRC §6334 provides certain limited exemptions from seizure pursuant to an IRS levy, that is an entirely different question than whether such property becomes encumbered by the Service’s lien. Furthermore, the only relevant exclusions are those provided for in the Internal Revenue Code; individual states cannot enact exemption laws which limit the reach of the federal tax lien.29 This is why state statutes, such as Maryland’s law protecting retirement accounts and IRAs from creditors, are not effective in protecting the same assets from the Internal Revenue Service.30
Conclusion
The federal tax lien is exceedingly broad in scope, and reaches property and rights to property which are often protected from the claims of other creditors. Understanding the impact of the lien on a client’s assets is essential to mapping an effective strategy for resolving the client’s tax problems.
In the second part of this article, to be published in the next issue of The Freestate Accountant, we will examine the priority of the federal tax lien against other claimants to interests in a taxpayer’s property. This will include the various “superpriority” provisions and the complex lien priority rules governing commercial financing arrangements. In addition, we will discuss the mechanics of seeking the release, discharge, subordination or withdrawal of the federal tax lien.
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.bjhaynes.com)
2 In addition to the general tax lien, there are special liens for estate and gift taxes, arising at the date of death or the date of the gift. See IRC §6324.
3 IRC §6322.
4 IRC §6502. The limitations period was increased from six years to ten years effective November 5, 1990, by the Revenue Reconciliation Act of 1990, and can be extended in various ways, such as by the execution of an extension agreement, or by the filing of an offer in compromise or a petition in bankruptcy.
5 The IRS uses Form 668.
6 IRC §6323(a).
7 D’Antoni, Inc. v. Great Atlantic & Pacific Tea Co., Inc., 496 F.2d 1378 (5th Cir. 1974); see also Rev. Rul. 74-571.
8 IRC §6323(g).
9 Hannus v. U.S., (W.D. Wash. 1958) 60-2 USTC 77,485.
10 In U.S. v. Friedlander, 235 F. 2d 753 (5th Cir. 1956), the lien was upheld although the name was spelled “Freidlander” instead of “Friedlander.” But liens were held invalid where filed against “Ruby Luggage” rather than “S. Ruby Luggage,” U.S. v. Ruby Luggage, 142 F. Supp. 701 (S.D.N.Y. 1954), and where the taxpayer’s name was spelled “Manual Castillo” instead of “Manuel Castillo,” Haye v. U.S., 416 F. Supp. 1168 (C.D., Cal. 1979). Also, a notice filed against “W.B. Clark, Sr.,” was defective when the taxpayer’s name was “W.R. Clarke, Sr.” Continental Investments v. U.S., 142 F. Supp. 542 (W.D. Tenn. 1953).
11 IRC §6321.
12 Regs. §301.6321-1. See also Glass City Bank v. U.S,, 326 U.S. 265 (1945).
13 Aquilino v. U.S., 363 U.S. 509 (1960).
14 Federal law also defines the priority of competing claims to property after it is determined under state law that a property right exists. Aquilino, supra.; see also U.S. v. Acri, 348 U.S. 211 (1955).
15 The priority of the federal tax lien versus other claimants will be discussed in more detail in Part II of this article.
16 See also the author’s previous articles in The Freestate Accountant describing the innocent spouse rules.
17 In Maryland, there is a statutory presumption against joint tenancy “unless the deed . . . expressly provides that the property granted is to be held in joint tenancy.” See §2-117of the Real Property Article. Failure to state that the tenancy is with the right of survivorship requires an inquiry into the intent of the parties, with the presumption in favor of finding a mere tenancy in common without such survivorship rights. Similarly, in Virginia the conveyance of property in joint tenancy without additional language of survivorship results in a mere tenancy in common.
18 U.S. v. Kocher, 468 F. 2d 503 (2d Cir. 1972), cert. den. 411 U.S. 931 (1973); Washington v. U.S., 402 F. 2d 3 (4th Cir. 1968), cert. den., 402 U.S. 978 (1971); Contra, see Folsom v. U.S., 306 F. 2d 361 (5th Cir. 1962).
19 The reason is that the interest of a joint tenant with right of survivorship as a type of “terminable interest.” The survivorship feature extinguishes the taxpayer’s property right upon his death. In that event the property interest disappears, and there is nothing left to which the lien can attach. SeeParsons v. Anglim, 143 F.2d 534 (9th Cir. 1944).
20 State v. Friedman, 283 Md. 701, 705-06, 393 A.2d 1356 (1978); Annapolis Banking & Trust Co. v. Neilson, 164 Md. 8, 9-10, 164 A. 157 (1933); Ades v. Caplin, 132 Md. 66, 69, 103 A. 94 (1918); Jordan v. Reynolds, 105 Md. 288, 294, 66 A. 37 (1907).
21 This ability to protect real estate from separate creditors, including the IRS, is one of the crucial rights given up by the filing of joint income tax returns. This is why the author often cautions against the filing of joint tax returns except where the tax has or will be paid in full, and where there is little risk of subsequent audit adjustments. Especially when a group of tax returns is being filed for a delinquent taxpayer who is trying to get himself back into compliance, and the amount due exceeds his ability to pay, careful consideration must be given to filing “married filing separately” to protect joint property.
22 U.S. v. National Bank of Commerce, 472 U.S. 713 (1985); IRS v. Gaster, 94-2 USTC &50,622 (3d Cir. 1994) (holding that IRS cannot levy against a joint bank account where the delinquent taxpayer lacks the right to make a unilateral withdrawal of the funds).
23 Maryland accepts the use of spendthrift clauses subject to certain exceptions. See Watterson v. Edgerly, 388 A.2d 934, 935-36 (Md. Ct. Spec. App. 1978). If income is withheld under such a clause, the beneficiary may sue to get it; therefore there is a property right to which the federal tax lien can attach.
24 Nichols v. Eaton, 91 U.S. 716, 722-25 (1875) (protective trust, after forfeiture, confers no right which a court would enforce). But see McGavern v. U.S., 550 F.2d 797 (2d Cir.), cert. den., 434 U.S. 826 (1977) (lien effective against trust in which income payments were not completely discretionary with the trustee). Many courts have held that a simple spendthrift trust cannot defeat a tax lien. First Northwestern Trust Co. v. IRS, 622 F.2d 387 (8th Cir. 1980). One court has held that a spendthrift trust with a forfeiture clause is not effective to defeat a federal tax lien. U.S. v. Taylor, 254 F. Supp. 752 (N.D. Cal. 1966). It reached this result after balancing the state property law policies against the needs of federal tax collection, as called for in Aquilino v. U.S., 363 U.S. at 513-14 (1960). Some courts have found that it would be offensive and disruptive to federal tax law for a beneficiary to receive an income stream for years without paying taxes on it, only to have that income stream disappear once the IRS moves against it. U.S. v. Riggs National Bank, 636 F.Supp. 172 (D.D.C. 1986).
25 See First of America Trust Co. v. U.S., 93-2 USTC &50,507 (1993). If the instrument creates a discretionary trust, under Maryland law there is no interest in the trust corpus to which the lien can attach because even the beneficiary could not invade the corpus. The beneficiary of a discretionary trust cannot compel payments of the principal by the trustee absent a showing of dishonesty on the part of the trustee. First National Bank of Maryland v. Dept. of Health and Mental Hygiene, 399 A.2d 891, 894 (Md. 1979). It follows that a creditor cannot compel payment of the principal of a discretionary trust because the beneficiary could not compel such payment. The IRS, through its lien, has no greater right to the property than the taxpayer has at the time the tax lien arises. U.S. v. Durham Lumber Co., 363 U.S. 522, 525-26 (1958).
26 U.S. v. Bess, 357 U.S. 51 (1958).
27 Kovacs v. U.S. 355 F.2d 349 (9th Cir. 1966), cert. den., 384 U.S. 941 (1966).
28 U.S. v. Rye, 550 F.2d 682 (1st Cir. 1977); Rev. Rul. 53-89.
29 U.S. v. Bess, supra.; U.S. v. Stern, 357 U.S. 39 (1958); U.S. v. Heffron, 158 F.2d 657 (9th Cir.) cert. den., 331 U.S. 831 (1947).
30 IRAs are levied only if the taxpayer flagrantly disregards payment requests. IRM 536(14).1.