Introduction

      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.

By Bryan T. Camp

Introduction

      One common issue facing those who create trusts is how to protect beneficiaries from creditors.  One of the biggest, baddest creditors out there is the Internal Revenue Service (IRS or Service), wielding two weapons of mass collection:  the federal tax lien and the federal tax levy.  These weapons regularly pierce boilerplate spendthrift provisions.  Discretionary trusts do not fare much better.  Court decisions over the past ten years make it increasingly likely that even pure discretionary trusts contain clauses that traitorously turn over the treasure house keys to the federal tax lien.  Once the lien attaches, the IRS can enforce it through either administrative or judicial attachments, blowing through state law barriers that keep out other creditors.

      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.  This Article posits that a properly drafted tax lien lockout provision can deflect the federal tax lien.  Moreover, tax lien lockout provisions can do this in the context of a support trust, thus allowing settlors to give enforceable directions to their trustees and to avoid the potential downsides of pure discretionary trusts.  In short, tax lien lockout provisions can protect trust assets from the long and mighty arm of the IRS while preserving a client's wish to hold trustees to clear standards of behavior towards beneficiaries.

      This Article will be posted on Wealth Strategies Journal in three separate Installments. This Installment 1 illustrates 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 explains 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. Installment 2 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.

Basics of Federal Tax Liens and Levies

       Collecting tax is most usefully viewed as a process, not an event.  That is why § 6502 of the Internal Revenue Code (IRC) gives the IRS ten years from the date of the assessment to collect properly assessed but unpaid tax liabilities.[1] The IRS needs that time to resolve unpaid liabilities, either by chasing down assets to collect the full amount from those taxpayers who can pay or by developing collection alternatives for taxpayers unable to immediately pay in full.[2]

      During the entire multi-year collection process, one of the main collection tools the IRS uses to snag taxpayer assets is the mighty tax lien.  Although the IRS has other tools--notably the setoff power--it is the tax lien that tends to cause the most trouble for taxpayers.[3] Part III will explain (i) how the tax lien arises; (ii) the scope of its effect; and (iii) the two methods that the IRS uses to make it work.

A. How the Tax Lien Arises

     Section 6321 provides that:

If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in   addition thereto) shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.

      Section 6322 provides that the tax lien continues as a charge on all of a taxpayer's "property or rights to property" until the liability, including all accruing penalties and interest, is fully paid or until the lien becomes unenforceable "by reason of lapse of time."  The phrase "lapse of time" refers to the ten year period allowed for the collection of an assessed tax by § 6502, unless the government takes affirmative steps sooner to release or discharge the lien under § 6325.  Ten years, however,  is merely the shortest period in which the Service can collect an assessed tax.[4]

     Three aspects of the federal tax lien merit emphasizing: (1) it arises automatically; (2) there is only one tax lien securing a given tax liability; and (3) the tax lien is retroactive.[5] As to the first, the tax lien arises by operation of law once the three following events have occurred:  (i) the IRS must properly assess a liability; (ii) the IRS must send the taxpayer timely notice and demand for payment; and (iii) the taxpayer must fail to fully pay the liability.[6] While § 6321 does not itself require an assessment (only that the taxpayer be "liable to pay"), courts have inferred the assessment requirement from the language in § 6322.[7] Similarly, while § 6321 does not say when the "demand" must be made, courts have inferred the timeliness requirement from § 6303, which requires  the IRS to send a demand "within 60 days, after the making of an assessment    . . . ."[8] Finally, a failure to pay the entire amount of tax due after demand constitutes a neglect or refusal.[9]
     The second aspect of federal tax liens that many practitioners overlook is that there is only one tax lien per assessed tax, which exists in either a secret state or a public state.[10] When it first arises, the tax lien is "secret" in that there is no public record of its existence.  In order to protect certain creditors, Congress long ago decided that, although the tax lien may exist and be perfected on all property of the taxpayer as of the assessment date, it cannot be enforced against four types of competing creditors--known as the "four horsemen"--until such time as the IRS makes it visible by properly filing a Notice of Federal Tax Lien (NFTL).[11]

      For example, if a taxpayer borrows money under a home equity loan and the bank properly files its security interest, then the tax lien is not enforceable against the bank's lien because the bank is one of the four types of special creditors listed in § 6323(a), specifically a "holder of a security interest."  Only once the IRS files the public notice of the lien, the NFTL, may it enforce the tax lien against the four horsemen.  Once revealed by the NFTL, the tax lien is good against almost all comers within the jurisdiction in which it is filed.[12]

       Attorneys are often confused about the relation between the tax lien and the NFTL.  There is only one tax lien, although there may be multiple NFTLs, depending on how much property the taxpayer has and where the property is located.  However, it is the one and only tax lien that attaches automatically to the taxpayer's assets.[13]  The NFTL does not attach to anything.  The NFTL just makes the  lien visible and, hence, good against the four horsemen.  In short, the NFTL brings the tax lien to light, not to life.  This is especially important to keep in mind when it is just the taxpayer--perhaps one who is a trust beneficiary--who is trying to ward off the tax lien.

       The third notable aspect of the federal tax lien is its retroactive effect.  Once the tax lien arises, § 6322 provides that it relates back to the date of assessment.  The retroactive nature of the lien is critically important to understand because it means that, once a taxpayer has actually received the notice of assessed tax and the demand for payment, the taxpayer is just too darn late to avoid the tax lien by transferring assets.  All that happens is the transferred assets take the tax lien with them, for "it is of the very nature and essence of a lien, that no matter into whose hands the property goes, it passes cum onere . . . ."[14]   So, for example, in United States v. Kroblin where the IRS assessed taxes on February 19, 1990, and the taxpayer quickly transferred his interests in the marital home to his wife on February 27, 1990, the court held that the transfer was subject to the tax lien because the lien arose as of the assessment date, even though the three prerequisites may not have occurred until after the transfer date.[15]

B. The Scope of the Tax Lien

      Section 6321 says that the tax lien attaches to all "property and rights to property."  The trickiest part about understanding the scope of the tax lien is understanding how courts decide what constitutes "property and rights to property" to which the federal tax lien attaches.  The federal statute itself "[c]reates no property rights but merely attaches consequences, federally defined, to rights created under state law . . . ."[16]

       Courts use a two-step process to decide the scope of the federal tax lien.  The first step looks to state law to see what legal interests it creates for the taxpayer.[17]  The Supreme Court explained:

The threshold question . . . 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."[18]

The second step then looks to federal law to decide whether those interests constitute "property or rights to property" that the federal tax lien can latch onto.[19]

      It might seem, from this abstract formulation, that state property law has a great deal to say about the scope of the federal tax lien.  After all, if the tax lien can attach to only the legal interests of the taxpayer created by state law, then "the Government's lien under § 6321 cannot extend beyond the property interests held by the delinquent taxpayer."[20]  Courts routinely remind us that  the tax lien allows the IRS to only "step into the shoes" of the taxpayer and, equally routinely, quote Professor Bittker's apt adage that "the tax collector not only steps into the taxpayer's shoes but must go barefoot if the shoes wear out."[21]  However, it is sometimes difficult to discern the size of the taxpayer's shoes.

       The classic example is that of a life insurance policy that has a cash-surrender value.  In United States v. Bess, a delinquent taxpayer died owning a whole life policy in a state that did not give him any rights to the death benefits.[22]  The Supreme Court held that the tax lien did not attach to the death benefits paid to his widow.[23]  However, the taxpayer's ability under state law to demand payment of his cash surrender value was indeed property--a chose in action--to which the tax lien attached.[24]  Accordingly, the widow had to hand over to the IRS those proceeds paid to her that represented payment of the cash surrender value.  This was true even though state law generally prohibited creditors from reaching the cash surrender value.

       Although an evaluation of state law is the first step, state law is not the primary determinant of the federal tax lien's scope.  This is because federal courts do not simply accept state law's characterization of a right; instead, federal courts look to see whether any restrictions on a taxpayer's rights are an inherent part of what state law has created or whether those restrictions are simply disguised preferences, either preferring certain creditors over the property owner or preferring the property owner over certain creditors.[25]  "Were federal law not determinative of the classifier of the state-created interest, states could defeat the federal tax lien by declaring an interest not to be property, even though the beneficial incidents of property belie its classification."[26]  In other words, federal law looks past state law labels to determine whether that state law is truly defining the scope of property rights or instead creating a preference regime.

       State liquor license cases provide an excellent illustration of this tension and the problematic role of state law in determining the scope of the federal tax lien.  States issue liquor licenses and generally allow the holders some rights in them, such as the right to use them and the right to transfer them.[27]  Often, however, the very statutes that create the license property also build into the grant certain preferences for creditors, often in the form of restricting transfer of the license until the preferred creditors are paid off.  Sometimes federal courts have treated these built-in preferences as part and parcel of the state property interest.  More often, however, federal courts have treated these built-in preferences as creditor priority provisions that are ineffective against the supremacy of the federal statutes.

       In United States v. California, the court decided that state-created restrictions on transferability limited the scope of the federal tax lien because the restrictions were part of the granted property right.[28]  Specifically, California had reserved to itself payment of state taxes as a statutory condition for the transfer of a state-created liquor license.[29]  Even though the effect of the state scheme was to allow the state's claim for taxes to take priority over the federal government's claim for federal taxes, the court reason   ned that the issue was not the supremacy of the federal tax lien but was the nature of the property to which the lien attached:

[T]he license existed because the state had issued it.  If the licensee acquired something of value, it was because the state had bestowed it upon him.  Whatever value the license, as property, may have had to a purchaser depended upon its transferability.  If it was transferable, it was because the state had made it so.  If the state had seen fit to impose conditions upon issuance or upon transfer of property it has wholly created, that is the state's prerogative so long as its demands are not arbitrary or discriminatory.  The federal government has no power to command the state in this area.  It has   no power to direct that property be created by the state for purposes of  federal seizure.[30]

Accordingly, the scope of the federal tax lien was restricted to the value of the liquor license after state taxes were accounted for.

      In In re Kimura, however, the Ninth Circuit came to a different conclusion with respect to a similar statutory scheme.[31]  In that case, the relevant Alaska statutes provided that licenses could only be transferred after payment to certain third-party trade creditors.  The Ninth Circuit decided that, while California's reservation to itself of the right to be paid before a license could be transferred controlled the scope of property to which the tax lien could attach, a similar reservation in favor of third parties was merely a preference regime: "while a state, as the creator of a liquor license, may validly impose conditions on its transferability for the state's own benefit, it may not, consistently with paramount federal law, impose conditions which discriminate in favor of particular classes of creditors."[32]

       Finally, nothing better demonstrates the stark contrast between a state's ability to regulate non-federal creditors and its inability to regulate the scope of the federal tax lien than 21 West Lancaster Corp. v. Main Line Restaurant, Inc.[33]  There, the holder of a liquor license sold the license, along with the restaurant, to a buyer.  The IRS levied on the sale proceeds, and a lender also demanded payment.  The buyer filed an interpleader and asked the court to determine who was entitled to the money.  The IRS claimed that its lien attached to all the proceeds.  The lender claimed priority for two reasons.  First, the license was not property because the governing statute provided that "[t]he license shall continue as a personal privilege granted by the board and nothing herein shall constitute the license as property."[34]  Second, even if the license was property, its lien still took priority over the tax lien because the lender had filed its financing statements before the IRS had filed its NFTL.

      The Third Circuit rejected both propositions.  As to the first, the court looked beyond the label used by state law to see whether the taxpayer had a pecuniary interest in the license that could be sold:

[A] liquor license continues to have pecuniary value for its holder, in the  form of potentially increased business revenues.  Moreover, it may still be transferred and sold . . . .  Consequently, we conclude that a Pennsylvania liquor license constitutes property or rights to property within the meaning of § 6321, and is therefore subject to a federal tax lien.[35]

       Worse for the lender, however, was the circuit court's decision that, although the state statute was inoperative to restrict the scope of the federal tax lien, it was still controlling as to non-federal creditors.  Thus, those state law cases holding that a lender could not perfect a security interest in the liquor license were effective against the lender.[36]  Accordingly, the court reached  what it conceded was the "anomalous conclusion that although a liquor license is not property for purposes of a security interest under Pennsylvania state law, it is property for purposes of a federal tax lien."[37]

      Since 1999, state law has become even less important in determining the scope of the federal tax lien.  Until 1999, the lower courts, as seen above in the liquor license cases, thought that a state-granted interest was property within the scope of the federal tax lien only when it had pecuniary value and was transferable.[38]  In 1999, however, the Supreme Court concluded, in Drye v. United States, that a federal tax lien attached to a taxpayer's right of inheritance, regardless of whether the state-granted right had pecuniary value or was transferable.[39]

      Drye was the last of several inheritance disclaimer cases that arose in the federal circuits within a short span of time.  The fact pattern common to all of these cases was the following: (1) a taxpayer had federal tax liabilities; (2) someone died leaving some mix of realty or personalty to the taxpayer by operation of the intestate statutes; (3) the taxpayer disclaimed the inheritance; and (4) upon execution of a timely disclaimer in the proper form, state law treated the taxpayer as never having owned the property.  The common question in all of these cases was whether the federal tax lien attached to the inheritance or whether the disclaimer was effective to prevent the lien from attaching.[40]

       In one thoughtful opinion, Leggett v. United States, the Fifth Circuit persuasively harmonized the seemingly disparate cases by relating them to how state law treated the right to disclaim.[41]  The court noted that some states used a "transfer theory" under which state law viewed the heir as owning the inheritance on the date the decedent passed, subject to a later right to disclaim the inheritance. Other states used an "acceptance/rejection" theory under which state law treated the heir as not owning the inheritance until such time as the heir either exercised control over the property in the inheritance or failed to disclaim within the statutory period, which is generally nine months.  The probate statute at issue in Leggett was typical of state disclaimer statutes:

Any person . . . who may be entitled to receive any property as a beneficiary and who intends to effect disclaimer irrevocably . . . shall evidence same as herein provided.  A disclaimer evidenced as provided herein shall be effective as of the death of decedent and shall relate back for all purposes to the death of the decedent and is not subject to the claims of any creditor of the disclaimant.  Unless the decedent's will provides otherwise, the property subject to the disclaimer shall pass as if the person disclaiming . . . had predeceased the decedent . . . [42]

       Looking to Texas court cases interpreting this and related statutes, the Fifth Circuit concluded that Texas law did not vest property rights in heirs as of the date of death. Instead, Texas law followed the "acceptance/rejection" theory and treated heirs as acquiring ownership  only once they "accepted" the inheritance by action or inaction:

       Under Texas law, [the taxpayer] had the right to accept [the decedent's] intended gift by taking possession of it, by exercising control and dominion over it, or by taking no action within the set time. She also had the right to reject [the] intended gift by filing a valid disclaimer within nine months.   This right of decision was not, itself, a property right under Texas law. Because [the taxpayer] rejected the intended gift, she never had a property right.  Therefore, the federal lien had nothing to which to attach.[43]

       Drye was a typical inheritance case.  Mr. Drye owed some $325,000 in federal income taxes.  When his mother died intestate, Mr. Drye was the only heir under the Arkansas probate statutes, and he stood to receive some $236,000 in mixed personalty and realty. His daughter stood next in line under the intestate laws, and, when Mr. Drye properly and timely disclaimed his inheritance, she became the heir and put the property into a trust.  The IRS seized the assets of the trust, and the trust filed a wrongful levy action as allowed under § 7426(a).

      When Drye came up to the Eighth Circuit, the court followed the traditional two-step process, and first looked to see whether the legal interest that the state law gave the taxpayer had pecuniary value and was transferable.[44] In holding for the Service, the Eighth Circuit held that--unlike Texas--the governing state law of Arkansas granted Mr. Drye property rights in the inheritance as of the date of death, and the retroactive effect of a disclaimer was a legal fiction that the federal law would ignore.[45]  Accordingly, the tax lien attached to the inherited personalty and realty at the date of the decedent's death.[46]

       Although the Supreme Court affirmed the Eighth Circuit's decision, it   did so using a very different analytical approach, one that significantly weakened the ability of state law to define the scope of the federal tax lien.[47]  The Supreme Court did not focus on whether state law gave Mr. Drye a transferable, pecuniary interest as of the day his mother died; instead, it focused on his right to disclaim. It was the legal right to disclaim that constituted the "property or rights to property" to which the lien attached, because that gave Mr. Drye control over the property that constituted the inheritance.  The Court used the following key analysis:

Arkansas law primarily gave Drye a right of considerable value--the right either to inherit or to channel the inheritance to a close family member (the next lineal descendant).  That right simply cannot be written off as a mere "personal right . . . to accept or reject [a] gift."  . . .  This power to channel the estate's assets warrants the conclusion that Drye held "property" or a "righ[t] to property" subject to the Government's liens.[48]

       What is manifestly unsatisfying about the Supreme Court's analysis is that it does not explain how the federal tax lien's attachment to the power to disclaim morphs into a lien on the underlying property affected by the power.  If state law extinguishes the right to disclaim after a certain time period, then it is not clear how the IRS can raise that power from the dead, as it were, years later to seize the assets.  The shoes have worn out.  The Supreme Court analogized the right to disclaim to a joint account holder's right to withdraw funds.[49] However, it is well settled that a bank need only pay over that which the taxpayer would have the power to withdraw at the time the levy is served.[50] Further, no one suggested that, once disclaimed, Mr. Drye had any power to reclaim the property.  Regardless of the criticism, the Supreme Court has spoken and we had best take heed.

      The most important aspect of Drye to understand is how the Court's new analysis reduced the ability of state law to circumscribe the scope of the federal tax lien.[51]  The Court made no attempt to analyze how state law viewed the relationship between the taxpayer and the property.  Unlike the Eighth Circuit, and the Fifth Circuit in Leggett, the Supreme Court made no attempt to decide what part of the relationship  between an heir and an inheritance was a legal fiction.  Instead, it sifted through state law simply to find some feature that could be, in some imaginable circumstance, part of that bundle of rights that make up property.  In other words, the teaching of Drye is that once state law gives a taxpayer any right, no matter how slim, that right becomes property to which the tax lien attaches.  Drye changes the task from understanding state property law in context to finding an excuse for the tax lien to attach.  In Drye itself, the excuse was the control Mr. Drye had over the property:

In sum, in determining whether a federal taxpayer's state-law rights  constitute "property" or "rights to property," "[t]he important consideration is the breadth of the control the [taxpayer] could exercise over the property . . . Drye had the unqualified right to receive the entire value of his mother's estate (less administrative expenses), . . . or to channel that value to his daughter.  The control rein he held under state law, we hold, rendered the inheritance "property" or "rights to property" belonging to him within the meaning of §  6321, and hence subject to the federal tax liens that sparked this controversy.[52] 

       After the Supreme Court issued its opinion in Drye, perceptive commentators noted that its approach increased the scope of the federal tax lien to include historically protected state property interests such as tenancies-by-the-entireties ("T by E") property.[53]  It had long been the rule that the federal tax lien would not attach to T by E property.[54]  This was because state laws provided that T by E property was held by "the marriage" with each marriage partner's interest merged.  It was that non-severable unity of ownership which led the Supreme Court to note in prior cases that "as a result of the peculiar legal fiction governing tenancies by the entirety in some States, no tax lien could attach in the first place because neither spouse possessed an independent interest in the property."[55]

      And, indeed, it took only three years after Drye before the Supreme Court decided, in United States v. Craft, that the federal tax lien attached to T by E property, and state law was ineffective to prevent the attachment.[56]   In Craft, Don Craft owed taxes.  His wife, Sandra Craft, did not.  Together they owned a house in Grand Rapids as T by E property.  After learning of the tax lien, they transferred the house to Sandra for one dollar so that she held sole title.  When she later went to sell the property, however, the buyer balked because of the NFTL. Sandra got the property discharged from the lien by agreeing to put half of the sale proceeds into escrow, and then filed a quiet title action.[57]

      The district court decided that the tax lien attached at the  moment the couple transferred the home to Mrs. Craft:

[E]ven though each spouse has an indivisible interest in the entireties   property and owns it as a whole, each also holds an individual interest.  . . .  This individual interest is not realized and remains inchoate until the entireties estate is terminated by the death of one spouse, divorce or joint conveyance.   . . .  As long as the entireties estate is intact, the property is not subject to levy and execution by the creditors of one spouse.  Yet, each spouse's survivorship interest is distinct, cognizable, and sufficient to  support attachment of a creditor's lien."[58]

      On appeal, the Sixth Circuit rejected that theory, holding that:

In Michigan, it is well established that one spouse does not possess a separate interest in an entireties property.  . . .  Although the entireties estate was terminated upon conveyance of the Berwyck Property to Sandra, Don's interest in the property terminated at the same time.  We are unaware of     any precedent indicating that an entireties estate is automatically transformed   into a tenancy in common as an intermediary step in the conveyance of the property.  To the contrary, it is clear that at the time the entireties estate terminated, Sandra was vested with "full and complete title."  Thus, Don never held an interest in the Berwyck Property to which the United States' lien could attach.[59]

      The Sixth Circuit also rejected the government's alternative argument   that the tax lien attached to some inchoate interest held by Mr. Craft.  The Sixth Circuit recognized that the federal tax lien could attach to a future or contingent interest in property, but it read Michigan state law, as construed by the Michigan Supreme Court, as denying that Mr. Craft held any severable future interest in the T by E property.[60]  Accordingly, "the federal tax lien could not attach to a future interest that did not exist under Michigan law."[61]

      As in Drye, the Supreme Court reversed the Circuit court without adopting the district court's theory.[62]  The Court instead used the analytical method it had used in Drye where it simply looked for any sliver of interest that state law gave Mr. Craft in the T by E property.  It found plenty:

[I]n Michigan, each tenant by the entirety possesses the right of   survivorship.  Each spouse--the wife as well as the husband--may also use the property, exclude third parties from it, and receive an equal share of the income produced by it.  Neither spouse may unilaterally alienate or encumber the property, although this may be accomplished with mutual consent.[63]

       These interests were more than enough to constitute property or rights to property "belonging to the taxpayer" to which the federal tax lien could attach.[64]  The Supreme Court thought that whether Mr. Craft's interests were severable or nonseverable future interests under state poperty law was irrelevant.  It was enough that "[t]hese rights . . . gave him a substantial degree of control over the entireties property, and, as we noted in Drye, 'in determining whether a federal taxpayer's state-law rights constitute "property" or "rights to property," [t]he important consideration is the breadth of the control the [taxpayer] could exercise over the property.'"[65]

      The role of state law is thus very slim in determining the scope of the federal tax lien.  Whenever state law gives a taxpayer any right, enforceable under state law, to control or affect the use or disposition of any one of those rights that are commonly thought of as comprising the "bundle of sticks" that make up property, the federal tax lien attaches, regardless of whether state law labels those enforceable rights as property interests or not.  Even contingent future interests are subject to the tax lien.[66]  As the liquor license cases show, it is irrelevant that the state legislature passes a statute that provides such rights are not property but are merely a privilege.  As Drye and Craft show, it is irrelevant that the highest court of a state holds that those enforceable rights are not property for state law purposes.  The federal tax lien will nonetheless stick to those legal interests, with consequences determined by federal law and with federal law controlling how the IRS may enforce the lien.

C. Enforcing the Federal Tax Lien

       Once the NFTL is filed, the IRS need do nothing more to enforce the federal tax lien.  As in Drye, the IRS can choose to wait passively for the taxpayer to sell property encumbered by the lien, at which time the lien will be paid off from the sale proceeds in priority with other creditors' claims on that property.  However, the IRS can also choose to actively seize and sell the property itself. It may seize property unilaterally through its administrative power of levy or judicially by seeking to foreclose the lien as to specified property.  This part will discuss each method in turn.

1. Administrative Levy

       Administrative levy is a "summary, non-judicial process, a method of self-help authorized by statute which provides the Commissioner with a prompt   and convenient method for satisfying delinquent tax claims."[67]  Specifically,     § 6331 gives the IRS the power to levy, which § 6331(b) defines as "the power of distraint and seizure by any means."[68]  Section 6332(a) requires that "any person in possession of (or obligated with respect to) property or rights to property subject to levy" must "surrender such property or rights" when properly served a notice of levy.  A person subject to a federal levy has two, and only two, defenses to the levy: (i) that the person does not have possession of (or obligation with respect to) property or rights to property subject to levy; or (ii) that another court has already placed the subject property under its control.[69]

       Three features of the administrative levy are important to understand for purposes of this article.  First, it has extraordinary reach.  Second, it is theoretically a provisional remedy.  Third, it only attaches to property existing at the time it is served.  Let's take a closer look at each feature.

       The scope of the administrative levy is as broad as that of the tax lien, and courts use the same analysis to determine what constitutes "property or rights  to property" of the taxpayer subject to levy.[70]  Like the tax lien, the levy can reach "every interest in property that a taxpayer might have."[71]  It allows the Service to step into the shoes of the taxpayer and exercise rights that state law would not allow any other creditor to exercise.[72]

       Most importantly for this Article's purpose, the Service can exercise access rights to property, even property that may not belong to the taxpayer.  The common example is a levy of a taxpayer's bank account held jointly with other depositors.  Taxpayers have no rights to any specific dollars in bank accounts or similar arrangements but, instead, they have a right to withdraw.[73]  It is this right to withdraw to which the tax lien attaches.

       The leading case regarding the ability of the IRS to exercise access rights to an account is United States v. National Bank of Commerce, where the Service levied on two bank accounts at the National Bank of Commerce.[74]  Each of the accounts had three account holders, only one of which was the delinquent taxpayer.  The IRS had no idea what monies in the accounts belonged to which account holder but, nonetheless, demanded that the bank pay over the monies.  Because Arkansas law gave the taxpayer an unqualified right to withdraw the proceeds of the joint account, the Supreme Court said that the right of withdrawal was the "property or rights to property" that both the federal tax lien attached to and the federal levy could seize.  The IRS levy could thus require the payment of all monies in the account, regardless to whom those monies belonged.[75]  Courts have used similar reasoning in authorizing the IRS to levy all manner of annuity and retirement funds when the beneficiary has the contractual right immediately to withdraw the money sought.[76]

       National Bank of Commerce also reveals a key limitation on the Service's administrative levy powers. Because the IRS steps into the shoes of the taxpayer, if state law places restrictions on the taxpayer's access rights to the funds, then those same restrictions bind the IRS.[77]  For example, the Service will not use an administrative levy to cash out a retirement plan when the relevant non-tax law requires that lump sum payments may be made only with a non-delinquent spouse's consent.[78]

       A key reason that the Supreme Court in National Bank of Commerce was so complacent about allowing the IRS to seize all the monies in the jointly held accounts was because of the second important feature of the administrative levy: it is a provisional remedy.  It allows the Service to seize first and ask questions later.  Third parties who have an interest in the property seized must come forward to assert their interest by filing suit in federal court under § 7426(a).[79]  For example, where the IRS levied on a bank account held solely in the taxpayer's name and the bank turned over the proceeds from the account, it was up to the taxpayer to prove, which he did, that the monies in the account belonged entirely to the estate of his late father, for which he was the executor.[80]  The fact that he was also the beneficiary of the estate did not give him a superior interest in the account over the estate, so the levy was wrongful.

       The third important feature to understand about administrative levy concerns timing.  Unlike the tax lien, the levy does not attach to after-acquired property but only to property rights and obligations that exist at the time of the levy.[81]  An obligation exists when the liability of the person levied to the taxpayer is fixed and determinable, even if the right to receive payments is deferred until a later date.[82]  So long as a present obligation exists, it does not matter that the precise sum of the obligation cannot be measured until some point in the future.  For example, a levy on a party-defendant being sued by the delinquent taxpayer captures any funds that party eventually becomes   obligated to pay the taxpayer as a result of the suit.[83]  In this way, an administrative levy can seize a present right to future payments.[84]

       This timing rule sometimes limits the usefulness of administrative levies.  For example, if the IRS serves an administrative levy on a bank at 1:00 p.m. in the afternoon, then the levy will seize only the monies on deposit with the bank at that moment.  If the taxpayer has previously closed out her accounts moments before, then the levy will fail to seize the monies.[85]  Likewise, additional funds put into the account after the levy hits are not captured by the levy.[86]

2. Lien Foreclosure Suit

       Section 7403 authorizes the government to institute a lien foreclosure suit and seek a judicial order authorizing the sale of property to which the federal tax lien is attached.  The statute provides for a plenary proceeding that adjudicates all interests with respect to the property, somewhat similar to a  quiet title action.  All persons who claim any interest in the property must be given notice of the suit and joined as parties.  Further, § 7403(c) provides that the court must "adjudicate all matters involved" and "finally determine the merits of all claims to and liens upon the property."  Most importantly, however, the court may decree the sale of the property and order the distribution of the sale proceeds "according to the findings of the court in respect to the interests of the parties and of the United States."[87]

       The chief advantage of this procedure over an administrative levy is that   it allows the IRS to seize and sell property in which a taxpayer holds joint ownership and with respect to which the taxpayer does not have an unqualified right to withdraw or use as against the co-owners.  Recall that the administrative levy allows the Service to seize a taxpayer's right of access to property.  While this is useful for bank accounts, it is less useful for joint interests in realty. For example, if a delinquent taxpayer owned a half-interest in an apartment building, then the IRS could use the administrative levy to seize and sell only that half-interest.  It would much rather seize and sell the entire building.  Using § 7403, it can.

       The leading case on § 7403 foreclosure actions is United States v. Rodgers.[88]  There, the IRS had filed suit to foreclose the tax lien attached to a deceased taxpayer's home in Texas.  The deceased taxpayer's wife, Mrs. Rodgers, did not owe taxes but, under Texas law, she did have homestead rights in the property, where she still lived.  Article 16 of the Texas Constitution creates for spouses a species of property rights called homestead rights with respect to a declared homestead.[89]  Similar to T by E property, one spouse may not alienate homestead property without the consent of the other spouse, regardless of how it is titled.[90]  More importantly, even when one spouse dies, article 16, section 52 prohibits the partition, sale, or distribution of the property "during the lifetime of the surviving husband or wife, or so long as the survivor may elect to use or occupy the same as a homestead . . . ."

       In Rodgers, the Fifth Circuit refused to allow the IRS to foreclose its lien:

[W]hen a delinquent taxpayer shares his ownership interest in property  jointly with other persons rather than being the sole owner, his "property"  and "rights to property" to which the federal tax lien attaches under § 6321, and on which federal levy may be had under § 7403(a), involve only his interest in the property, and not the entire property.[91]

       This decision gave the IRS an unpleasant choice:  it could either wait until Mrs. Rodgers abandoned the property as homestead property or it could sell the deceased taxpayer's fractional interest in the property.  But the Fifth Circuit thought the very definition of homestead property under state law prevented the IRS from seizing and selling the home as a whole.[92]

      The Supreme Court reversed.[93]  It recognized that a "Texas homestead right is not a mere statutory entitlement, but a vested property right."[94]  State law, however, could not defeat federal law because "the power granted § 7403 is not the act of an ordinary creditor, but the exercise of a sovereign prerogative, incident to the power to enforce the obligations of the delinquent taxpayer himself, and ultimately grounded in the constitutional mandate to lay and collect taxes."[95]  The plain language in § 7403 allowed the IRS to "subject any property, of whatever nature, of the delinquent, or in which he has any right, title, or interest, to the payment of such tax or liability."[96]  Thus, "[t]his clause in and of itself defeats the reading proposed by the Court of Appeals."[97]  Accordingly, over the thoughtful dissent of four justices, the Court decided that § 7403 allowed the IRS to acquire rights greater than the delinquent taxpayer had under state law.  Instead of simply stepping into the shoes of the taxpayer, federal law gave the IRS "the power to sell jointly owned property [even] if an unindebted co-owner enjoys an indestructible right [under state law] to bar a sale and to continue in possession."[98]

     The Court was comfortable in reading the IRS statutory right so broadly, in contrast to the more limited power of administrative levy, because the IRS had to act through application to an Article III court and had to give notice to all others who also had rights to the subject property.  Analogizing to a quiet title action, the Court noted that the statute allowed a "district court hearing a   § 7403 proceeding to exercise a degree of equitable discretion and refuse to authorize a forced sale in a particular case."[99]

     The tax lien and the powers to levy or file a foreclosure suit are enormously powerful collection tools that the IRS can use at its discretion.  While state law has something to say about the scope of federal power, the undeniable trend in the case law has been to relegate state law from a leading role to a bit part and has resulted in the growth of a federal common law of property.  Even so, there remain property law concepts that may help taxpayers make trusts impervious to the federal tax collector if and when a beneficiary becomes a delinquent taxpayer.

This is the end of Installment 1, giving the basics on the law of tax liens. The next installment of this article will examine how, in light of this law, spendthrift trusts fail to protect trust assets  from the federal tax lien and, more importantly, how even discretionary trusts may no longer provide robust protections.