It is the worst-case scenario for many individual taxpayers: a lien on their property. While a lien is not the same as seizure, as the property remains in the taxpayer’s possession, it does give the IRS first claim on the property above other creditors, and can have catastrophic effects on the individual’s ability to sell or refinance the property, as well as to obtain other credit. This article discusses the unique rules applicable to liens arising under estates and trusts.
Timing and Notice of Lien
Tax liens customarily arise after assessment of tax, either upon the filing of the initial tax return or as a result of a later deficiency [Internal Revenue Code (IRC) section 6203]. For example, a later deficiency may arise if the taxpayer was subject to an audit after the taxpayer had an opportunity to appeal or file a Tax Court petition (within 90 days of receipt of the statutory notice). If the taxpayer filed a Tax Court petition, the tax may be assessed within 60 days of the final judgment.
Tax liens generally require a mailed notice of assessment and demand for payment. A notice of tax lien must be filed in order to provide proper notice and priority. With respect to real property, the notice of lien is filed in the manner and location designated by state law in the state where the property is situated. With respect to personal property, the notice of lien is filed in the office designated by state law within the state where the property is situated [IRC section 6323(f)]. Note that, unlike general tax liens, the special estate tax lien arises automatically; no notice or filing is required (IRC section 6324).
Special Lien for Estate Tax
In order to collect an estate tax from a decedent’s estate, the IRS must first assess the tax, generally within three years of filing [IRC section 6501(a)]. Thereafter, collection can occur by levy or court proceedings initiated within 10 years after assessment, provided the time requirements are not suspended [IRC sections 6502(a), 6503(d)]. IRC section 6324 provides for a special lien applicable for estate and gift taxes. Unlike the income tax lien, the general estate tax lien does not need to be recorded, and thus been characterized as a silent lien [see CCA 201129037, citing Beaty v. U.S., 937 F.2d. 288 (1962)]. Section 6324(a)(1) provides that the estate tax “shall be a lien upon the gross estate of the decedent for ten (10) years from the date of death.” A limited exception is provided for payment of estate and administrative expenses that are allowed by a court having proper jurisdiction.
These rules result in surprising consequences for both estate and gift beneficiaries, as well as unsuspecting third parties.
Beneficiaries in receipt of nonprobate property face a similar challenge. IRC section 6324(a)(2) provides that if the estate tax is not paid, recipients of non-probate assets, such as IRAs and joint accounts, shall be personally liable for the unpaid taxes. All nonprobate property included in the gross estate under IRC sections 2034–2042 is included. Such liability is incurred “to the extent of the value, at the time of the decedent’s death, of such property.” The beneficiary remains liable if there is a sale or transfer of the property.
Donees are also subject to potential personal liability and may be held responsible for unpaid gift taxes; this liability is imposed to the extent of the value of such gift [IRC section 6324(b)]. As discussed below, personal liability may be imposed on the donee of both direct and indirect gifts. In the event of a sale or transfer of the gifted property, the donee remains liable for the unpaid taxes.
These rules result in surprising consequences for both estate and gift beneficiaries, as well as unsuspecting third parties. For example, in 2007, a father gifted a minority interest in a family limited partnership consisting of business interests, real estate, and securities to his children and grandchildren. Although a gift tax return was filed, the IRS asserted that it was insufficient for purposes of fixing the valuation due to deficiencies in the return preparation and valuation disclosure [LAFA 20152201, citing IRC section 6501(c)(9)]. The father died in 2008, survived by his children and grandchildren; his will appointed his son as executor. Assets reported on the estate tax return included real property, a savings account, an IRA, a revocable living trust (or pour-over trust), and life insurance proceeds. In addition, there was a brokerage account jointly held with the children. Seven months after the decedent’s death, the stock market and real estate markets suffered a major decline. This fact pattern raises many potential questions, which are addressed below.
As described above, IRC section 6324(a)(1) establishes an automatic 10-year lien with respect to the probate property of the estate. There is a limited exception for funds used to pay debts and administrative expenses that have been properly approved by a court. Recipients of any of the probate assets, including good-faith purchasers for value, will be surprised to find that the lien remains attached to the property. Probate property is not divested of a federal lien, and a purchaser takes such property subject to this hidden lien unless the estate fiduciary is discharged from personal liability pursuant to IRC section 2204. In First American Title Insurance Company v. U.S. [520 F.3d 1051 (9th Cir. 2008)], the plaintiff was held liable because the estate lien remained attached to probate property sold by the estate beneficiary. It was fortunate for the purchaser that title insurance was obtained, or the purchaser would have remained liable. Also note that, in the above example, the lien attached automatically to all of the probate property.
Under IRC section 6324(b), donees are liable for unpaid gift taxes in an amount equal to the fair market value at the date of gift. In U.S. v. Marshall [771 F.3d 854 (5th Cir. 2014)], J. Howard Marshall sold shares of Marshall Petroleum Inc. back to the corporation. The IRS determined that the sales price was inadequate and represented an indirect gift to the other shareholders, who were found liable for the gift tax plus interest. The unpaid gift tax and interest, however, exceeded the value of the initial gift, and the Fifth Circuit recently held that the total liability under IRC section 6324(b) could not exceed the fair market value of the gift [U.S. v. Marshall, 798 F.3d 296 (5th Cir. 2015)], substituting prior opinion, affirmed in part and reversed in part]. Due to the recent decline in the value of energy stocks, this result places an extremely heavy burden upon the beneficiaries of such gifts.
IRC section 6901 provides rules for assessment and collection against a transferee. The term “transferee” includes “donee, heir, legatee, devisee, and distributee,” and with respect to estate taxes also includes “any person who, under §6324(a)(2), is personally liable for any part of such tax” [IRC section 6901(h)]. This definition generally gives the IRS another avenue of collection from estate and gift beneficiaries and fiduciaries. In general, such amounts are required to be assessed and collected in the same manner as the underlying obligation. The statute of limitations for assessment against a transferee is the general three-year rule under IRC section 6501 plus an additional year [IRC section 6901(c)]; however, any factors that might have tolled the statute of limitations must be reviewed carefully. Section 6901 provides an alternative to section 6324, and is not a prerequisite with respect to collection against a transferee; the transferee liability is derivative of that of the transferor [Mangiardi v. U.S., 112 AFTR 2d 2013-5344 (S.D. Fla. 2013)]. The government may elect to utilize the collection procedures authorized in section 6901 as an alternative method of tax collection. This will provide an additional collection option from the trustee and beneficiaries of the IRA, brokerage account, or life insurance policy, as well as beneficiaries under the trust.
Imagine the surprise of a beneficiary who receives a share of a decedent’s IRA or joint bank account only to find the IRS has a hidden estate tax lien upon the assets. As stated above, IRC section 6324(a)(2) imposes such liability not only upon the beneficiaries, but also the trustee of any revocable living trust for any property included in the taxable estate under IRC sections 2034–2042. These sections include many assets within the taxable estate that pass automatically to the named beneficiary and will affect beneficiaries of revocable living trusts, named beneficiaries under insurance policies, joint owners, and beneficiaries of assets included within the estate by reason of the decedent’s retention of benefits or powers. The liability for the unpaid estate taxes is to the extent of the value of such property at the time of the decedent’s death; the beneficiary assumes the risk of any valuation decline. Unlike the lien for probate assets under IRC section 6324(a)(1), this lien is divested if the property is sold to a bona fide purchaser for fair value; however, a like lien shall then attach to all the property of such transferee [IRC section 6324(a)(2)].
Imagine the surprise of a beneficiary who receives a share of a decedent’s IRA or joint bank account only to find the IRS has a hidden estate tax lien upon the assets.
Under the facts of the above example, the recipients of the IRA, revocable living trust, life insurance beneficiary, and the brokerage accounts will all be subject to several liability for any unpaid estate taxes. This treatment could present a unique imbalance; for example, if two of the children are insolvent or have dissipated their inheritance, the other will incur tax liability for any unpaid estate tax. Lien recording is not necessary, and a tax lien will automatically apply to the nonprobate property (see CCA 201129037). The recipient of nonprobate property is also considered a transferee under section 6901(h), and the IRS is permitted to choose whether to collect the unpaid taxes under either section. Per CCA 201129037, an examination of state law is unnecessary.
A fiduciary of an estate or trust without sufficient property to pay all claims must first pay federal tax liabilities before other claims (31 USC section 3713). The law also imposes personal liability upon the fiduciary who pays other creditors prior to the government in instances where the fiduciary had either actual or inquiry notice of the tax lien. If no executor or administrator is appointed or qualified, “then any person in actual or constructive possession of any property of the decedent” incurs fiduciary liability for unpaid taxes (IRC section 2203). Therefore, under the facts of the above example, personal liability will ensue if the trustee of the revocable living trust distributes assets prior to paying the estate tax. This will also apply to trustees of pour-over trusts, which are commonly utilized in estate planning. The fiduciary liability extends beyond the unpaid estate taxes and will also apply to the decedent’s unpaid income taxes.
If one of the trust beneficiaries is subject to a tax lien, the trustee may be liable to the IRS if any distributions are made to the beneficiary. In U.S. v. Michel, [110 AFTR 2d 2012-53235 (E.D.N.Y. 2012)], the trustee was held liable for failing to comply with an income tax levy filed against the trust beneficiary with respect to unpaid income taxes. The trust was created under a mother’s will, and the trustee made discretionary distributions in the mistaken belief that the lien had been removed. Liability was imposed despite the trustee’s good faith; the court stated that a levy properly served within the 10-year collection period remains enforceable to the extent of the value of the property.
Trusts should be drafted as discretionary trusts not subject to any fiduciary standards other than the sole and absolute discretion of the trustee.
U.S. v. Michel presents some important lessons for asset protection trusts. First, trusts should be drafted as discretionary trusts not subject to any fiduciary standards other than the sole and absolute discretion of the trustee. In U.S. v. Butler [103 AFTR 2d 2009-1636 (W.D. Tex. 2009)], the trustee had sole and absolute discretion whether to make distributions, and therefore no enforceable property right existed under state law; the District Court held that the beneficiary had no enforceable payment rights until the trustee decided to make a distribution. Second, the settlor’s intent that no court have authority to declare distributions of income or principal in review of trustee discretion should be clearly stated. Third, any lien should be released or declared unenforceable before distributions are made.
Finally, trustee standards should not be avoided in asset protection trusts. Withholding distributions for tax purposes may not be a proper exercise of discretion, and a distribution, once declared or required, becomes a property right subject to the tax lien. In Duckett v. Enomoto, [117 AFTR 2d 2016-1999 (D. Az. 2016)], the trust included trustee distribution standards of health and support in the beneficiary’s accustomed manner of living. The court held that the trustee must apply these requirements in a fair and impartial manner. Had the trust described the distribution standard as solely at the trustee’s discretion, the trustee would have been better sheltered from potential liability, and the asset protection feature would have been stronger.
Discharge and Release
There are procedures to assist beneficiaries, executors, and trustees in avoiding personal liability and protecting purchasers of estate property. The executor cannot convey good title or avoid liability unless a discharge or release is obtained [see IRC sections 6905, 6325(b), and 6325(c)]. A request to discharge property is made using Form 4422, while fiduciary discharge from estate, gift, and income taxes is made under IRC section 2204 (estate taxes) or section 6905 (income and gift taxes) and by filing Form 5495. The IRS must respond within nine months. Finally, a request for prompt assessment of tax other than estate tax is made under IRC section 6501(d) by filing Form 4810, and the IRS must respond within 18 months.
In light of the above, advisors should adhere to the following rules in order to avoid any negative repercussions, financial and otherwise, arising from liens on gifted or bequeathed property:
- Do not distribute or sell property until a closing letter is received and the fiduciary is discharged.
- Request discharge under IRC sections 2204 and 6905 (Form 5495).
- File Form 4810 to obtain prompt assessment of the decedent’s income tax, employment tax, and gift tax liabilities. If property needs to be sold, obtain release of any liens (Form 4422).
- Obtain releases, indemnifications, and payback agreements for all distributions.
- Obtain title insurance for any real property, or otherwise confirm that all taxes are paid.
- Inquire as to outstanding estate tax obligations on nonprobate property.
These precautions will save a great deal of headache, allowing beneficiaries to avoid any unpleasant surprises.