DEALING WITH THE IRS COLLECTION DIVISION

FEDERAL TAX LIENS -- Part I ^©

Burton J. Haynes, Attorney at Law¹

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.⁹ Nevertheless, 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.²⁴ Accordingly, 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.

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