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This page contains a single entry by Associate Editor - 2 published on November 24, 2009 5:05 AM.

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Protecting Trust Assets from the Federal Tax Lien - Installment 2


SSRN link: Protecting Trust Assets from the Federal Tax Lien

By Bryan T. Camp


      This Article offers some ideas on how to keep the federal tax lien locked out from trust assets using property law concepts of springing and shifting executory interests.  It is being posted on Wealth Strategies Journal in three separate Installments.  Installment 1, already posted, illustrated the limited role that state law plays in controlling the scope of tax liens and in protecting non-delinquent third parties from the effect of the lien.  It explained the basics of the federal tax lien, focusing on the relationship between state and federal law and the two key methods by which the IRS enforces the lien: the administrative levy and the lien foreclosure suit.

      This is Installment 2 and it will introduce a basic hypothetical involving a fictitious elderly widower who wants to create a trust for his children and grandchildren. Installment 2 will then use the hypothetical to illustrate why spendthrift provisions offer no protection from federal tax liens and why it is likely that neither discretionary nor protective trusts do much better. Finally, Installment 3 will look at how Texas law regarding shifting executory interests might provide an opportunity for the well-advised settlor to craft trust provisions that can lock out the federal tax lien when a beneficiary encounters either expected or unexpected tax difficulties.

The Ineffectiveness of Spendthrift and Discretionary Trusts

A. Red Rader Hypothetical

      A hypothetical will help put the law in context and allow the reader to see how various trust provisions might or might not be effective against the federal tax collector.  Imagine an elderly, red-headed client, Eric "the Red" Rader, who has retired from a long and successful career as a salesman for Viking Range Corporation.  In addition to considerable assets in stocks and bonds, he owns two vacation homes, one in Vail and one in Key West.

      Red is a widower with one son, Darth, who is now forty years old.  Darth Rader is a study in contrasts.  His love for adventure has led to careers in emergency rescue operations and as an oil well control specialist.  He has travelled the world saving people and putting out fires.  While working in  Saudi Arabia, Darth met and married his wife Padma, and they have twin children, Leia and Luke, who are now ten years old.  But Darth's love of adventure has sometimes moved him to the darker side of life--gambling and associating with known drug runners.  Last Christmas Darth gave Red a book entitled "Hide Your Assets and Disappear: A Step-by-Step Guide to Vanishing Without a Trace" by Edmund Pankau.  Red thinks that Darth is getting mixed up in tax avoidance schemes involving Caribbean tax haven countries.  Red is worried about Darth and about what his possible delinquencies might mean for Padma and his two grandkids, all of whom he loves dearly.

      Red wants to create a trust in his Last Will and Testament for the benefit of Darth, Padma, Leia, and Luke.  On his death, Red wants most of his estate liquidated, except for the two vacation homes.  After making some charitable donations, he will put the residuary of the estate into a trust.  He wants Darth and Padma to be life beneficiaries with the trust paying each of them the trust's yearly income and with the trustee having the power to invade the trust corpus if needed for their health.  The grandchildren are to be the remaindermen, to take whatever is left in the trust upon the death of the survivor of Darth or Padma.  Red is not sure whether he wants to give Darth or Padma power of appointment.  As to the vacation homes, Red insists they be held in the trust and not sold.  The trustee will be directed to use the trust's income for the upkeep of both vacation homes so that Darth and his family can enjoy them.  Red wants the trustee to have broad discretion in renting out the vacation homes in order to help pay for their upkeep.  To protect Darth's family, Red does not want Darth to be able to pledge any of the trust's assets to creditors and does not want creditors to be able to break into the trust and seize Darth's share.  Red is particularly worried about the IRS.  He should be.

B. Problems with Spendthrift Trusts

      One option Red has is to insert a spendthrift provision into the trust.  Such provisions operate to restrain the voluntary or involuntary alienation of a beneficiary's interest in trust distributions or corpus, thus flummoxing creditor attempts to reach trust assets.[1] A typical provision that Red might use would read as follows:

No trust assets or income shall be liable for the debts of any beneficiary, nor subject to seizure under any judicial writ or proceeding.  No beneficiary shall have the power to give, grant, sell, assign, transfer, mortgage, pledge, encumber, or in any manner to anticipate or dispose of the interest in the   trust estate or its income or to dispose of the interest in the trust estate or its income or to dispose of any trust property until it has been actually delivered to him in accordance with the terms hereof . . . .[2]

      In Texas, spendthrift provisions are recognized by statute and enforced by courts.  Section 112.035 of the Texas Property Code provides that a settlor "may provide in the terms of the trust that the interest of a beneficiary in the income or in the principal or in both may not be voluntarily or involuntarily transferred before payment or delivery of the interest to the beneficiary by the trustee."  Case law also recognizes that spendthrift provisions will "protect the beneficiary's interest in the trust corpus and income from claims of a beneficiary's creditors while the corpus and income remain in the trust and are held by the trustee."[3]

      However, spendthrift provisions are totally ineffective against the federal tax lien.  Recall that the tax lien attaches to any property or rights to property, and the levy can either seize the taxpayer's property or rights to property or enforce a valid lien attached to any property.  Once state law recognizes a right, it is federal law that determines whether the tax lien attaches.  Texas has long recognized a beneficiary's "equitable, even though untouchable" interest in trust assets (for example, the right to receive income from the trust on a yearly or other routine basis).[4] Accordingly, the tax lien can attach to that interest, and settlors cannot immunize any interest in a trust from the federal tax lien once that interest is created.[5]

      It gets worse.  Even though a trust beneficiary may not receive any actual income from a trust, the tax lien attaches to the present right to receive future distributions.  Accordingly, once that lien attaches, the beneficiary cannot  shake it off even by diving into the refreshing waters of bankruptcy.  For example, in In re Orr, the taxpayer was the income beneficiary of a trust created by his grandfather's will.[6] The trust provided that Orr, after reaching a certain age, was to receive "all of the net income of the trust . . . distributed . . . annually or at more frequent intervals."[7] The trust also contained a standard spendthrift provision.

      In 1992, the IRS assessed over $630,000 in income tax liabilities for multiple years against Orr and properly filed NFTLs for those liabilities in 1993. Orr filed his bankruptcy petition on November 1, 1995, and received a discharge of personal liability for the tax liabilities on May 21, 1996.  However, although discharged from personal liability, the federal tax lien remained attached to any property or rights to property that belonged to Orr as of the bankruptcy petition date and passed through bankruptcy.[8] Therefore, the question in Orr was "whether a federal tax lien in this situation attaches to a spendthrift trust beneficiary's equitable interest in the trust itself or to each individual distribution as it is paid to the beneficiary."[9]   If the property to which the lien attached was only each individual distribution, then the bankruptcy discharge would effectively cut off the IRS from taking part in any post-bankruptcy distributions from the trust.  However, if the property to which the lien attached was Mr. Orr's right to all future distributions, then the IRS could enforce the lien as to all future distributions.  That is, "the only way the IRS can collect from Orr's trust distributions is if the tax lien on future distributions attached before Orr's personal liability was discharged through bankruptcy."[10]

      The Fifth Circuit used the standard two-step analysis described above to decide the scope of the federal tax lien:  first, it determined what legal interest Texas law gave Orr in the trust; second, it determined the federal tax consequence of that legal interest.[11]  After explaining Texas law, the court concluded:

[A]t the time the liens were filed, Orr possessed equitable and legal rights to future income distributions from the Trust [notwithstanding the spendthrift clause].  With reference to federal law, we conclude that those rights constituted "property" or "rights to property" subject to attachment     pursuant to § 6321. Because the federal tax lien attached to Orr's rights to future payments at the time of the filing of the lien, Orr's subsequent bankruptcy does not affect the validity of the lien against Orr's equitable ownership of the Trust and legal right to receive income distributions from the Trust.  The tax lien is therefore valid against future income distributions.[12]

      The practical effect of Orr is that a beneficiary's interest in a spendthrift trust is vulnerable to the federal tax lien.  Worse, once the lien attaches, the IRS can either seize individual payments by repeated administrative levies, or it can foreclose on the entire interest by filing suit under § 7403.  If it chooses the latter course of action, then the IRS can obtain a court order that the trustee distribute all future payments to the IRS, up to the amount secured by the lien.[13]

C.  Problems with Discretionary Trusts

      The second approach Red could take toward protecting the trust's assets from Darth's potential tax troubles is to create some form of discretionary trust.  Discretionary trusts come in many flavors, but they all have the common feature of removing the obligation of the trustee to pay income or corpus to a beneficiary and replacing that obligation with discretion, such that no beneficiary has the right to demand a distribution from the trust.[14]  At the extreme, Red could give absolute discretion to the trustee, as follows:

The Trustee may distribute any amount, including zero, of the income or principal from the Trust to Darth and Padma during their lives, as the Trustee, in his uncontrolled discretion, sees fit to give them, and neither Darth nor Padma shall have any right to compel the Trustee to pay any amount from the Trust to or for their benefit.

      A more moderate discretionary trust would tie the discretion to some sort of ascertainable standard as in this example:

The Trustee shall pay to or for the benefit of Darth and Padma so much of the Trust income or principal as the Trustee, in his absolute and uncontrolled discretion, decides is necessary to maintain their health, education, or   current standard of living.

      Replacing a trustee's obligation to distribute trust assets with discretion has the same effect as a spendthrift provision because creditors cannot reach  the funds until the trustee's discretion has been exercised and a distribution has actually been made.[15]  However, provisions such as these differ from spendthrift trusts, at least in theory, in one crucial respect:  whereas spendthrift provisions simply seek to regulate a beneficiary's recognized legal or equitable interest in trust assets, discretionary provisions avoid giving a beneficiary a recognized legal or equitable interest in the first place.[16] In theory, by vesting discretion in the trustee, a discretionary trust divests the beneficiary of any interest to which the federal tax lien can attach.[17]

      Some states regulate the creation and operation of discretionary trusts by statute.  For example, North Carolina defines a "discretionary trust interest" by statute.[18]  Texas, however, recognizes discretionary trusts in case law, not by statute, and the extent of that recognition is unclear.  While numerous federal courts in Texas have declared that Texas recognizes discretionary trusts, they all appear to rely on dicta in Hughes v. Jackson, an opinion authored by an intermediate Texas appellate court that was then adopted by the Texas Supreme Court in 1935.[19]  The Texas Supreme Court  has never, so far, cited Hughes for the proposition that Texas recognizes absolute discretionary trusts.  In Hughes itself, the trust in question was for a limited purpose--the education of a beneficiary--with the trustee being given the discretion on when and how to accomplish that goal.  The Texas intermediate court adopted a rule excerpted from a contemporary treatise on trusts. [20]  A close reading of that excerpt and the surrounding passage indicates that it was discussing how beneficiaries of trusts that were created for a particular purpose could not alienate their interests because the settlor had limited their interests to the particular purpose stated.  Neither the treatise nor the courts in Hughes were discussing the validity of a trust that vested absolute discretion in a trustee--discretion both as to the operation of the trust and also as to its purposes.  Nonetheless, at least one intermediate Texas appellate court has recognized the validity of a discretionary trust.[21] Thus, while the issue is not settled, it would be reasonable to predict that the Texas Supreme Court would at least recognize the idea of a discretionary trust and possibly would recognize even the extreme form of a discretionary trust rather than the limited discretionary trust at issue in Hughes.

      That a discretionary trust can defeat the federal tax lien gains initial support from the fact that the IRS lost two of three recorded attempts in Texas to enforce its tax lien against discretionary trusts.  In 1987. Judge Fitzwater of the Northern District of Texas permitted the IRS to levy on assets in a trust that contained a moderate type of discretionary clause, one that tied the trustee's discretion to an ascertainable standard.[22]  In 1992, however, Judge Akard of the Bankruptcy Court in the Northern District of Texas rejected an IRS attempt to seize assets of a trust in In re Wilson.[23] He found that the trustee's discretionary powers were so absolute that the lien could not attach.[24]

      In 1995, the IRS also lost Texas Commerce Bank v. United States, where Judge Harmon for the Southern District of Texas rejected the IRS's attempt to hold a bank liable for failing to honor a levy that sought to reach assets held in a trust.[25]  The trust at issue provided that "the income of the trust was to be accumulated and retained by the trustee who was permitted to distribute . . . such amounts of the trust as, in the sole discretion of the trustee, may be in the best interests" of the taxpayer.[26]  The trust provided that the taxpayer would have rights to the income and principal in 2002.  Until then, however, it was  the trustee's "sole discretion" to make payments.[27]  The IRS tried to levy in 1993, but the bank ignored the levy and continued to make distributions to the taxpayer.  In its defense against the suit for failure to honor the levy, the bank argued that, because it had "sole discretion" over when and whether to make any distribution to the taxpayer, it had no "property or rights to property" belonging to the taxpayer at the time of the levy.[28]

      The court agreed with the bank that the taxpayer had no "property or rights to property" to which the levy could attach in 1995.[29]  The court first considered whether the taxpayer had sufficient rights to current distributions.  It concluded that the absolute nature of the trustee's discretion meant the taxpayer had no interest.[30]  Second, the court considered whether the taxpayer had a present right to future income in 2002 when she would become entitled to mandatory yearly distributions.  It concluded that there was no assurance that there would be any trust assets in 2002 because the trustee also had discretionary powers to distribute trust assets to other beneficiaries.[31]

      While these three cases some hope that discretionary trust language can fend off the federal tax lien, a careful practitioner would be foolish to rely on them, or to think that discretionary provisions will protect trust assets from the reach of the federal tax lien and levy powers, without further analysis.  This is particularly true because both of the favorable cases were written before the Supreme Court's game-changing decisions in Drye and Craft discussed in Part II.B. above.  Thus, the lower court case law may no longer provide much support, much less the proper analysis.

      Properly analyzed, discretionary trusts have four potential holes that the careful practitioner must try to close so that the federal tax lien cannot pierce the trust and attach to trust assets: (1) the tension between discretion and ascertainable standards contained in the trust instrument; (2) trust provisions that may be inconsistent with absolute discretion; (3) beneficiaries who have different types of interests in different types of trust property; and (4) the inherent equitable interests of all beneficiaries to certain standards of conduct by a trustee, no matter how much discretion the trust instrument purports to give.  As discussed below, it may not be possible to satisfactorily address all of these problems so as to block the IRS tax lien from attaching to trust assets.

1. Ascertainable Standards

      The hole is created by the inherent tension between language giving the trustee discretion and language giving the trustee guidance as to the purpose of the trust.  I submit that the more the settlor attempts to guide the trustee as to the administration of the trust--by using support trust terms such as "education," "needs," or "maintenance"--then the more likely the settlor will have given beneficiaries a legal interest in the trust assets to which a federal tax lien can attach.

      For example, the inclusion of support language was fatal in the Wright case in which the IRS was able to enforce the tax lien against a beneficiary.[32]  Likewise, in United States v. Taylor, the trust instrument contained the following language that was inconsistent with the notion of an absolute discretionary trust: "The [T]rustees shall pay to or apply for the benefit of my son, LEE JONES, JR., so much of the net income of said trust, up to the whole thereof, as the Trustees may from time to time deem necessary or advisable for his proper care, maintenance and support."[33]  The Taylor court held that the language establishing a standard for the trustee meant that the trust was a support trust, and the "taxpayer has a lifetime, enforceable, equitable right to support from the income of the trust."[34]  Accordingly, the tax liens attached, and the trustee was directed to pay over to the government all amounts that could be paid to the beneficiary.[35]

      Practitioners should not ignore Taylor just because it came out of California!  Courts in other jurisdictions have come to similar conclusions when discretionary trust language bumps up against language creating an ascertainable standard.  For example, in United States v. Delano, the federal district court in Colorado held that the following trust language did not prevent the tax lien from attaching:

During my son's lifetime, my trustee shall pay to or apply for the benefit of my son so much of the income or principal, or both, as my trustee in its sole and absolute discretion shall deem necessary or advisable for his maintenance, health, education, comfort and welfare.  My trustee may, but need not, consider all funds known to my trustee to be available to him.  Any undistributed income may be added to principal from time to time in the discretion of my trustee.[36]

     The court rejected the argument that the "sole and absolute discretion" language permitted the trustee to make no payments:

[T]he word 'shall' directly precedes the word 'pay' while the 'sole and absolute discretion' follows 'so much of the income or principal, or both.' Accordingly, the court concludes that the . . . trustees' discretion relate[s]  only to the amount of the payment and whether it came from trust income, principal, or both.[37]

      Practitioners should further be aware that, in non-tax contexts, the Texas Supreme Court has itself resolved conflicting language in favor of creating enforceable support trusts as opposed to unenforceable discretionary trusts.  Thus, in State v. Rubion, the state was seeking contribution from a testamentary trust for the costs of supporting the disabled beneficiary in a state institution.[38] The trustee claimed that provisions in the will giving the trustee broad discretion as to the operation of the testamentary trust allowed the trustee to refuse to pay for the costs that the state incurred in keeping the beneficiary.  The Texas Court of Appeals had agreed that the ambiguities in the will, coupled with extrinsic evidence, meant that the trustee had absolute discretion to refuse to make any payments for the beneficiary while she was in the state institution.

      The Supreme Court of Texas reversed.  It first recognized that the question was "whether [the beneficiary] can enforce a demand for the delivery of all or a part of the trust property for her present support." [39] The court thought that question "must depend upon the intention of the testatrix, for the testatrix had a legal right to devise her property as she saw fit and to prescribe the terms upon which her bounty should be enjoyed."[40]  Construing the trust as a whole, it held that the support-type language in the will did not create an ambiguity but instead trumped the discretionary language:

It is undoubtedly true that the will gives the respondent broad powers of management of the trust estate to provide "a means for the support" of the beneficiary and invests him with wide discretion in the use of the income or corpus, or both, when "the exigencies of the situation" require.  On the other hand, the central and controlling language of the will is that the trust property shall be used for the "support and maintenance" of the beneficiary "both in sickness and health."  That language, it seems to us, expresses the true intention of the testatrix.[41]

      One commentator suggested in 1983 that courts are wrong in their attempt to read trusts as being either support trusts or discretionary trusts.[42]  She  argued that courts should recognize a hybrid type of trust which she calls the "discretionary support trust."[43]  Similarly, the Restatement (Third) of Trusts does not draw a bright line between discretionary and support trusts but basically views all trusts as having some combination of discretionary features and support standards.[44]  And a few jurisdictions have abandoned an either/or position between support trusts and discretionary trusts.[45]  However, most courts continue to "use the designation 'support trust' and 'discretionary trust' to label, respectively, those trusts from which distribution can be compelled as opposed to those in which the trustee's broad discretion is controlled only by the duty of loyalty and obligation of good faith."[46]  And Texas courts appear to favor finding that trusts with competing provisions are support trusts.[47]

      For tax lien purposes, the concept of a discretionary support trust is not analytically useful.  Nor does it matter how ascertainable standards are blended with discretion for the trustee.  The relevant analysis remains:  to what extent does a beneficiary have enforceable rights in trust assets?  To the extent that courts in Texas, and elsewhere, read support provisions as providing enforceable rights regardless of discretionary provisions, then that creates "property or rights to property" for federal tax lien purposes.

     To summarize this first potential hole, if the trust instrument contains any kind of objective standard for uses of the trust income or principal, then that expression of the settlor's intent will likely be read as trumping any discretionary language and will create a legal interest under Texas law that is then subject to the federal tax lien, even if it may not be subject to the claims of ordinary creditors.

2. Provisions Inconsistent with Discretion

      The second potential hole in discretionary trusts is trickier to find   Even if the careful practitioner plugs the first hole by convincing the client to rigorously eliminate any mention of purpose in the trust instrument and by carefully avoiding language that contradicts the trustee's absolute and unfettered discretion, other typical trust provisions can still make the trust assets vulnerable to the federal tax lien.  For example, in our hypothetical, Red may want to give Darth and/or Padma powers of appointment over the residuary of the trust so that they can deal with unforeseen events.  A power of appointment is exactly the kind of "rein of control" that the United States Supreme Court held could be subject to the federal tax lien, as discussed above regarding the Drye case.[48]  There the Supreme Court held that the right to disclaim under state law was property under federal law and concluded that "despite the State's characterization, the heir possessed a 'right to property' in the estate--the right to accept the inheritance or pass it along to another--to which the federal lien could attach."[49]  Remember, too, that once the federal tax lien attaches, the IRS has a variety of ways to enforce the lien, including the nuclear bomb of a lien foreclosure suit under § 7403.[50]

      Spendthrift clauses may also inadvertently create an interest in trust assets to which the tax lien can attach.  In the two Texas federal court cases discussed above--In re Wilson and Texas Bank of Commerce,---where the IRS was not allowed to enforce its tax lien against the assets of a discretionary trust, each trust contained a typical spendthrift clause.  Both federal courts apparently missed the true significance of that clause in their analyses.  However, Texas state courts have not overlooked the significance.  In Burns v. Miller, Hiersche, Martens & Hayward, P.C., a law firm attempted to collect a judgment from the assets of a trust by using the powerful Texas turnover statute.[51]  The turnover statute allows creditors to reach all assets of a judgment debtor except those specifically exempted from its reach.[52]  The law firm argued that the spendthrift trust assets could not be considered exempt because they were not the judgment debtor's property at all.  In other words, the law firm argued that the spendthrift provisions deprived the judgment debtor of any interest in the trust assets; therefore, the assets could not be exempt because the trustees of the trusts owned the assets.  This, of course, reads the effect of spendthrift provisions exactly backwards, as the Fifth District Court of Appeals noted:

While this is a novel argument, it has no merit.  The trustee of a trust holds bare legal title and the right to possession of trust assets, while the beneficiary is considered the real owner of the property, holding equitable or beneficial title.  Furthermore, unless trust beneficiaries had an ownership interest in trust assets, spendthrift provisions disabling them from alienating that interest would be superfluous.  We conclude that [the beneficiary] has an ownership interest in the spendthrift trust assets at issue and that those assets are exempt property in terms of the turnover statute.[53]

      Accordingly, if an otherwise discretionary trust also contains a spendthrift provision, then the IRS will argue--and most likely win--that the beneficiary must have some legal interest in the trust that the spendthrift provision operates on.

3. Different Types of Trust Property

      The third hole that could allow the tax lien to invade discretionary trusts has less to do with particular language in a trust instrument than it does the type of property held by the trust.  In our example, the trust will contain both personalty and realty--the two vacation homes.  Although the vacation homes will be titled in the name of the trustee, the beneficial use of the homes is meant for Darth and Padma.  Looking closely at the analysis from Drye and Craft, the federal tax lien can attach to any one of the sticks that make up the bundle of sticks in a property, so long as that stick is recognized and protected by state law. 

      Any trust that contains realty and gives the beneficiaries some right regarding that realty, other than the right to the income that the realty might produce, is vulnerable to the federal tax lien.  Take, for example, the right to use the property.  The Supreme Court recognized a use interest as one of the more important "sticks" in the bundle that federal law recognizes as property rights.[54]  If the trust instrument gives Darth and Padma a right to use the vacation homes and if Texas law will allow them to enforce the right, then the federal tax lien will attach.[55]

      Once the tax lien attaches to any interest in realty, the lien can then be enforced through a § 7403 lien foreclosure suit, and the IRS can force the sale of the entire realty.  Remember "the government has the right in a section 7403 proceeding to seek a forced sale of the entire property in which a delinquent taxpayer has an interest even where innocent others also have an interest in the property.  This special privilege arises from the express terms of section 7403    . . . ."[56]

4. Inherent Beneficiary Rights

      It gets worse.  Even if the cautious practitioner does everything right and carefully drafts the trust instrument to close up the three holes described above --- that is, even if the client agrees to create a trust vesting absolute discretion to all future trustees, agrees to keep realty out of the trust, and agrees that beneficiaries shall not have power of appointment --- there still remains one last problem that could cause assets in the trust to become impressed with the federal tax lien if a beneficiary becomes a delinquent taxpayer.

      As I discussed above, until the Supreme Court declared otherwise in Drye, it was the general rule that the federal tax lien would attach only to a state property right that was transferable and that had pecuniary value.[57]   As long  as the key issue was the extent to which a state-granted interest in property was transferable, or alienable, then discretionary trusts were a reasonable method to insulate trust property from the federal tax lien because discretionary trusts avoided giving beneficiaries a transferable interest in trust income or corpus.  And, empirically, we can find two examples of where discretionary trusts appeared to have successfully deflected the federal tax lien in Texas.[58]

      That all changed in 1999, after the two supporting cases in Texas were decided.  It was that year that the Supreme Court in Drye, rejected transferability as the analytical touchstone.[59]  As it later elaborated in Craft, the true test was to search for any one of the bundle of sticks that commonly are thought of as comprising property:

A common idiom describes property as a "bundle of sticks"--a collection of individual rights which, in certain combinations, constitute property.  State law determines only which sticks are in a person's bundle.  Whether those sticks qualify as "property" for purposes of the federal tax lien statute is a question of federal law.[60]

      Under this new analytical paradigm (some might say it has always been the true analytical paradigm), if a court determines that state law gives a taxpayer rights that will be enforced by state law, then federal law swoops in to claim those rights as property.  The place to start, then, is Texas law.  Texas law takes a broad view of what constitutes property for purposes of the Trust Code:

"Property" means any type of property, whether real, tangible or intangible, legal, or equitable. The term also includes choses in action, claims, and contract rights, including a contractual right to receive death benefits as designated beneficiary under a policy of insurance, contract, employees' trust, retirement account, or other arrangement.[61]

But it bears emphasizing that the state definition of property is only a starting point.  Rather than accept a state law label, one must first look at the specific legal interests, then one must determine whether they are property within the meaning of § 6121--the federal tax lien statute.

      Even as to the purest of pure discretionary trusts, trustees have certain state law duties which give the beneficiaries corresponding rights.  Heck, it would not be a trust otherwise.  Even absolute discretion is not absolute, as the Restatement of Trusts explains:

[W]ords such as "absolute" or "sole and uncontrolled" or "unlimited" are not interpreted literally.  It is contrary to sound policy, and a contradiction in terms, to permit the settlor to relieve a trustee of all accountability.  Even under the broadest grant of fiduciary discretion, a trustee must act honestly and (as cases have sometimes quoted from prior Restatements) "in a state of mind contemplated by the settlor."  What this means is that courts will intervene to prevent trustees from acting in bad faith, or without regard to the terms and purposes of the trust or the interests of its beneficiaries, or for some purpose or motive other than the accomplishment of the purposes of the discretionary power.  Except to the extent the power is for the personal benefit of a beneficiary-trustee, the court may also be called upon to     prevent the trustee from failing to act, whether capriciously, arbitrarily, or from a misunderstanding of the trustee's powers or duties.[62]

      Specifically, Texas law imposes the following duties on trustees, duties that give beneficiaries corresponding rights to have judicially enforced: (1) the duty not to self-deal; (2) the duty of fidelity to the interest of the beneficiary;  (3) the duty to exercise reasonable care and skill in preserving and managing trust property; (4) the duty to enforce claims of the trust; (5) the duty to deal impartially with beneficiaries; (6) the duty to keep accounts and furnish information; and (7) the duty to keep trust property separate.[63]  The Texas Supreme Court summed it up this way:

The discretion with which a trustee of a support trust is clothed in determining how much of the trust property shall be made available for the support of the beneficiary and when it shall be used is not an unbridled discretion.  He may not act arbitrarily in the matter, however pure may be   his motives.  His discretion must be reasonably exercised to accomplish the purposes of the trust according to the settlor's intention and his exercise thereof is subject to judicial review and control.[64]

Beneficiaries who believe that a trustee has violated some or all of these can obtain and have obtained both judicial review and damages, both in Texas and elsewhere.[65]

      State law thus gives all beneficiaries of all types of trusts equitable rights, such as equitable rights in the proper maintenance and investment of the trust property, equitable rights to fair treatment as to even discretionary distributions, and equitable rights to fair dealing as between them. Now the inquiry becomes whether those interests amount to "property or rights to property" within the meaning of § 6121.  It is difficult to see why not.

      The Supreme Court has repeatedly insisted that "Congress meant to reach every interest in property that a taxpayer might have."[66]  Equitable rights are unquestionably "rights to property" to which the tax lien can attach.[67]  There is still a question of how may the IRS enforce its lien against those rights.  Also, there is the question of what dollar amounts those rights have.  However, uncertainty as to value does not change the nature of the interests that can count as property or rights to property.  In enforcing the tax lien against a discretionary trust, one court noted that the "taxpayer's property right in the trust at bar differs from any other property right only in that it has no permanently fixed dollar value."[68]  In this situation, there is some utility to discretionary provisions.  They can prevent the IRS from vindicating the tax lien through administrative levy and, instead, force the IRS to unleash its mightiest weapon, which is the lien foreclosure suit under § 7403.[69]

      In sum, a discretionary trust will be vulnerable to the federal tax lien if the trust language inadvertently gives the beneficiary any type of property interest.  Even if the settlor intends to create an unfettered zone of trustee discretion, the inclusion of contrary language creating some ascertainable standard, the inclusion of inconsistent provisions such as spendthrift or power of appointment provisions, and the inclusion of different types of property in which the beneficiary might have different sticks of enforceable interests, all work to destroy the trust's ability to withstand the attachment of the federal tax lien.  It is even likely that under the analytical method adopted by the Supreme Court in Drye and Craft, the equitable interests created by state law for any beneficiary of any trust will be "property or rights to property" for purposes of the federal tax lien statute.  Moreover, once that federal tax lien attaches, it's all over except for the litigation on just how the IRS can vindicate the lien.[70]

This is the end of Installment 2, using a basic hypothetical to show why existing spendthrift and discretionary distribution provisions are probably ineffective to protect trust assets from the federal tax lien. The next and final installment of this article will examine how practitioners may want to consider using state law concepts of shifting executory interests to create a structure whereby the tax troubles of one trust beneficiary will not frustrate the donor's intent to benefit all beneficiaries.

       [1].   See generally 4 Kenneth McLaughlin, Jr., Texas Probate, Estate and Trust Administration, § 80.05[5] (Matthew Bender and Co., Inc. 2008) (collecting cases).

       [2].   See In re Orr, 180 F.3d 656, 658 (5th Cir. 1999) (example taken from the trust at issue).

       [3].   Burns v. Miller, Hiersche, Martens & Hayward, P.C., 948 S.W.2d 317, 321 (Tex. App.--Dallas 1997, pet. denied) (holding that the assets held in a valid spendthrift trust created for a judgment debtor by his deceased parents were exempt from the turnover provisions in section 31.002(a)(2) of the Texas Civil Practice and Remedies Code); see also First  Bank & Trust v. Goss, 533 S.W.2d 93, 94-96 (Tex. Civ. App.--Houston [1st Dist.] 1976, no writ) (holding that a spendthrift trust's assets were exempt from garnishment).

       [4].   United States v. Dallas Nat'l Bank, 152 F.2d 582, 586 (5th Cir. 1945) (holding that the tax lien attached to the beneficiary's interest in trust distributions despite the spendthrift clause).

       [5].   Spendthrift trusts have been found to be ineffective against the federal tax lien in all states where the issue has been litigated.  See, e.g., First Nw. Trust Co. v. Internal Revenue Serv., 622 F.2d 387, 390 (8th Cir. 1980); United States v. Rye, 550 F.2d 682, 685 (1st Cir. 1977); Leuschner v. First W. Bank & Trust, 261 F.2d 705, 708 (9th Cir. 1958).

       [6].   In re Orr, 180 F.3d at 656.

       [7].   Id. at 657.

       [8].   See In re Isom, 901 F.2d 744, 745-46 (9th Cir. 1990) (holding that the tax liens remained attached to the taxpayer's property despite the Chapter 7 discharge).  This is a specific application of the settled general principle that a discharge in bankruptcy does not remove liens that attached and were perfected as to property of the debtor before the petition date.  See id.  Rather, such liens remain on the property and the property remains liable "in rem" for the debts secured by the liens.  See id.; see, e.g., In re Thompson, 182 B.R. 140, 154 (Bankr. E.D. Va. 1995) (holding that after a bankruptcy discharge, a creditor can proceed in rem against property securing their claim).  As the Supreme Court puts it, "liens pass through bankruptcy."  Dewsnup v. Timm, 502 U.S. 410, 417(1992); Johnson v. Home State Bank, 501 U.S. 78, 84-86 (1991).

       [9].   In re Orr, 180 F.3d at 661.

      [10].   Id. at 662.

      [11].   Id. at 659-64.

      [12].   Id. at 664.

      [13].   United States v. Riggs Nat'l Bank, 636 F. Supp. 172, 177 (D.D.C. 1986) (holding that the protective trust with a forfeiture clause was inoperative against the federal tax lien, therefore ordering the trustee "to turn over to the United States at regular intervals, and no less than semi-annually, all income earned by said Trust from the date of this Order until the tax liabilities described above have been fully satisfied, or until the death of [the taxpayer], whichever first occurs.").

      [14].   See, e.g., Estate of Vak v. Comm'r, 973 F.2d 1409, 1410 (8th Cir. 1992) ("The trustees could elect to distribute or accumulate current income, in whole or in part, in their discretion.  The trustees also had an unrestricted sprinkling power among the holders of the beneficial certificates for both corpus and income.").  When a trustee is given discretion as between a group of beneficiaries, the discretion is sometimes called a sprinkling power.  See id.  A sub-type of discretionary trust is the protective trust, which grants beneficiaries defined rights until the happening of an event at which time it becomes a discretionary trust.  The trust at issue in Riggs Nat'l Bank, 636 F.Supp. at 175-76 is an example of a protective trust.

      [15].   See Restatement (Third) of Trusts § 60 cmt. e (2001) ("A transferee or creditor of a trust beneficiary cannot compel the trustee to make discretionary distributions if the beneficiary personally could not do so.").

      [16].   See In re Wilson, 140 B.R. 400, 404 (Bankr. N.D. Tex. 1992).

      [17].   See id.

      [18].   N.C. Gen. Stat. § 36C-5-504(a)(2) (2006) ("'Discretionary trust interest' means an interest in a trust that is subject to the trustee's discretion, whether or not the discretion is expressed in the form of a standard of distribution.").

      [19].   Hughes v. Jackson, 125 Tex. 130, 81 S.W.2d 656 (1935).  The federal courts relying on the Hughes case start with In re Wilson, 140 B.R. at 404, and include: Bass v. Denney (In re Bass), 171 F.3d 1016, 1029 (5th Cir. 1999); Tex. Commerce Bank Nat'l Ass'n v.  United States, 908 F. Supp. 453, 457 (S.D. Tex. 1995);  In re Young, 297 B.R. 492, 496 (Bankr. E.D. Tex. 2003).

      [20].   Hughes, 125 Tex at 136, 81 S.W. at 659. ("This [purpose of education] was clearly the intention of the parties to the creation of the trust fund as shown by the testimony of Hughes and Cain and the other facts and circumstances of the record. Perry on Trust, Vol. 1, sec. 386a; Talley v. Ferguson, 64 W. Va., 328, 63 S. E. 456, 17 L. R. A. (N. S.) 1215. The opinion in Talley v. Ferguson, supra, quotes from Perry on Trust, supra. We think the law as there announced rules this case. We, therefore, also quote from Perry on Trust....").

      [21].   Van Hoose v. Moore, 441 S.W.2d 597, 612 (Tex. Civ. App.--Amarillo 1969, writ ref'd n.r.e.) (construing a testamentary trust to be a discretionary trust).

      [22].   Wright v. United States, No. 88-2655, slip op. at 6 (N.D. Tex. Aug. 11, 1989).  The provision read that: "the Trustee may pay to [the taxpayer] or for his benefit so much or all of the income and principal of the trust . . . at such time or times as the Trustee, in the Trustee's sole discretion, believes desirable for the comfortable maintenance, health, education . . . best interest and welfare of [the taxpayer]."  Id.  The trust did not contain a spendthrift clause.  Id.

      [23].   In re Wilson, 140 B.R. 400 (Bankr. N.D. Tex. 1992)

      [24].   Id. at 404.("[n]o standard or guide is attached to the [t]rustee's power.")

      [25].   Texas Commerce Bank Nat'l Ass'n v. United States, 908 F. Supp. 453, 459 (S.D. Tex. 1995).

      [26].   Id. at 455 (summarizing the trust provisions at issue and finding that this trust also had a standard spendthrift clause).

      [27].   Id.

      [28].   Id. at 455-56.

      [29].   Id. at 456.

      [30].   Id. at 458-59 ("to the extent that [the taxpayer] was entitled to wholly discretionary distributions from the trust in June 1993, there was no interest to which the IRS's levy could attach.").

      [31].   Id. at 459 ("[s]ince [the taxpayer's] right to receive income payments after November 3, 2002 is clearly a contingent, non-vested, and non-determinable right, the IRS's levy in June 1993 could not  reach it.").

      [32].   See supra note 122.

      [33].   United States v. Taylor, 254 F. Supp. 752, 754 n.1 (N.D. Cal. 1966).

      [34].   Id. at 755.

      [35].   Id. at 756 ("The trust being one fundamentally for support, the taxpayer has a basic beneficial right to receive payments from income to the extent needed for his support.  It follows that the government liens have attached to and subsist against that right.").

      [36].   United States v. Delano, 182 F. Supp. 2d 1020, 1022 (D. Col. 2001).

      [37].   Id.; see also Magavern v. United States, 550 F.2d 797, 801 (2nd Cir. 1977) (stating that the  language "Trustee shall pay over or use, apply and expend whatever part or all of the net income or principal" created a property right to which the lien could attach, notwithstanding the discretionary language, because the trustee did not have the discretion to deny a particular beneficiary anything at all); La Salle Nat'l Bank v. United States, 636 F. Supp. 874, 876 (N.D. Ill. 1986) (finding that the word "shall" indicated the settlor's intent that the trustee was obligated to pay and that the discretionary language just went to amount); State ex rel. Sec'y of Soc. Rehab. & Servs. v. Jackson, 822 P.2d 1033, 1038-39 (Kan. 1991) (finding that the discretionary language did not create a discretionary trust because the trust also contained mandatory language that controlled the distribution and that the discretionary language controlled only the amount and timing of the payments).

      [38].   State v. Rubion, 308 S.W.2d 4, 5-6 (1957).

      [39].   Id. at 8.

      [40].   Id.

      [41].   Id.

      [42].   Evelyn Ginsberg Abravanel, Discretionary Support Trusts, 68 Iowa L. Rev. 273, 277 (1983).

      [43].   Id.

      [44].   The Reporter's Notes in the Third Restatement of Trusts states the following:

The fact of the matter is that there is a continuum of discretionary trusts, with the terms of distributive powers ranging from the most objective (or "ascertainable," IRC § 2041) of standards (pure "support") to the most open ended (e.g., "happiness") or vague ("benefit") of standards, or even with no standards manifested at all (for which a court will probably apply "a general standard of reasonableness."

Restatement (Third) of Trusts § 60, reporter's note to cmt. a (2003).

      [45].   See Strojek by Mills v. Hardin County Bd. of Supervisors, 602 N.W.2d 566, 571 (Iowa Ct. App. 1999); Smith v. Smith, 517 N.W.2d 394, 398 (Neb. 1994).

      [46].   Lang v. Commonwealth, 528 A.2d 1335, 1344 (Pa. 1987) (collecting cases).

      [47].   See, e.g., Keisling v. Landrum, 218 S.W.3d 737, 744 (Tex. App.--Fort Worth 2007, pet. denied) (using   State v. Rubion, 308 S.W.2d 4 (1957), to analyze discretionary provisions with support provisions and concluding that "like the testatrix in Rubion, [the settlor] created a support trust").

      [48].   See supra note 46-49 and accompanying text.

      [49].   United States v. Craft, 535 U.S. 274, 278 (2002) (citing Drye v. United States, 528 U.S. 49, 59-61 (1999)).

      [50].   Before the Craft case, the IRS would likely have taken the position that it could not leverage the lien on the appointment power to seize all trust assets because he cannot use that specific power to gain unrestricted access to the entire trust principal.  This would be analogous to the life insurance issue in United States v. Bess, where the Supreme Court noted that the "right to change the beneficiary, even to designate his estate to receive the proceeds, gives him no right to receive the proceeds while he lives."  United States v. Bess, 357 U.S. 51, 55 (1958); see I.R.S. Chief Couns. Adv. 200036045 (May 16, 2000), available at  However, since Craft, the IRS might believe that the power to divert the entire trust corpus can be seized and used to divert the assets to the IRS.

      [51].   Burns v. Miller, Hiersche, Martens & Hayward, P.C., 948 S.W.2d 317,320 (Tex. App.--Dallas 1997, pet. denied).

      [52].   Tex. Civ. Prac. & Rem. Code Ann. § 31.002 (Vernon 2008).  The turnover statute allows creditors to overcome normal procedural barriers in reaching the assets of debtors.  Id.  For example, the turnover statute authorizes a court to compel a debtor to execute documents that will aid in collecting a judgment debt.  Burns, 948 S.W.2d at 328.

      [53].   Burns, 948 S.W.2d at 322 (citation omitted) (emphasis added).

      [54].   Craft, 535 U.S. at 283 (citing Loretto v. Teleprompter Manhattan CATV Corp., 458 U.S. 419, 435 (1982)).

      [55].   See United States v. Rodgers, 461 U.S. 677, 693 (1983).

      [56].   Markham v. Fay, 74 F.3d 1347, 1354, n.5 (1st Cir. 1996).

      [57].   See supra notes 37, 43-49; see, e.g., Drye Family 1995 Trust v. United States, 152 F.3d 892, 895 (8th Cir. 1998) ("In enforcing § 6321, appellate courts have interpreted 'property' or 'rights to property' to mean state-law rights or interests that have pecuniary value and are transferable.").

      [58].   Tex. Commerce Bank Nat'l Ass'n v. United States, 908 F. Supp. 453, 457 (S.D. Tex. 1995); In re Wilson, 140 B.R. 400, 404 (Bankr. N.D. Tex. 1992).

      [59].   Drye v. United States, 528 U.S. 49, 51 (1999).

      [60].   Id. at 277 (citation omitted).

      [61].   Tex. Prop. Code Ann. § 111.004(12) (Vernon 2007).

      [62].   Restatement (Third) Trusts § 87 (2005) (citation omitted).

      [63].   See generally Kenneth McLaughlin, Jr., Texas Probate, Estate and Trust Administration, § 81.21 ("Duties of Trustee") (collecting cases); see also Jochec v. Clayburne, 863 S.W.2d 516, 518-19 (Tex. App.--Austin 1993, writ denied).

      [64].   State v. Rubion, 308 S.W.2d 4, 9 (Tex. 1957) (citations omitted).

      [65].   See, e.g., Jochec, 863 S.W.2d at 516.  A jury awarded a substantial judgment because of a trustee's conflict of interest, but the case was reversed by the appellate court for failure of the trial court to instruct the jury on waiver.  Id. at 521-22; see also In re Scheidmantel Trust, 868 A.2d 464, 481 (Pa. Super. 2005) (punishing the trustee for an unreasonable exercise of the "absolute discretion" conferred by the trust instrument and finding that "even when there is no evidence of bad faith or improper motive, the exercise of discretion by trustees is subject to the limitation that they must not act outside 'the bounds of reasonable judgment.'"); Wiggins v. PNC Bank, 988 S.W.2d 498, 501-02 (Ky. App. 1998) (awarding the beneficiaries damages from a trustee's abuse of discretion and violation of its duty of impartiality by favoring one set of beneficiaries over another by invading trust principal); Jones v. Jones, 30 N.Y.S. 177, 183-84 (1894) (removing a trustee for abusing discretion by favoring one beneficiary over others).

      [66].   United States v. Nat'l Bank of Commerce, 472 U.S. 713, 719 (1985).

      [67].   IRS v. Orr, 180 F.3d 656, 664 (5th Cir. 1999) (holding that the tax lien attached not only to trust distributions already made but also to the beneficiary's equitable interest in future trust distributions).

      [68].   United States v. Taylor, 254 F. Supp. 752, 756 (N.D. Cal. 1966).

      [69].   Compare Magavern v. United States, 550 F.2d 797, 801 (2d Cir.1977) (interpreting a trust's discretionary language as giving the trustee the duty to not deny payment to each beneficiary and ordering the trustee to honor an administrative levy by making the same payments to the IRS where the trustee had made regular payments to the taxpayer prior to the administrative levy) with First of Am. Trust Co. v. United States, 93-2 USTC ¶ 50,507 (C.D. Ill. 1993) (interpreting a trust's discretionary language concerning the invasion of principal as controlling over mandatory language thus refusing to allow the IRS to enforce the administrative levy).

      [70].   See, e.g., Markham v. Fay, 74 F.3d 1347, 1347 (1st Cir. 1996) (discussing various ways that the IRS can enforce a lien on beneficiary rights in a trust).