The use of a spendthrift provision in a trust instrument is common. Generally, spendthrift provisions prohibit a third-party creditor from reaching a beneficiary’s interest in income and/or corpus of the trust until the trustee distributes such interest outright to the beneficiary. Because spendthrift provisions are creatures of state law, a common question is whether such protection extends to the IRS as a third-party creditor? This Insight discusses this topic more below.
The Federal Tax Lien
A federal tax lien arises when a taxpayer owes tax and fails to pay such tax. Under the Internal Revenue Code, it also arises on the date the tax was assessed and continues until the tax is either paid or becomes unenforceable due to lapse of time. See I.R.C. § 6322.
The scope of the tax lien is very broad: it generally attaches to all property and property rights of the taxpayer. I.R.C. § 6321. To determine the rights of a taxpayer in property, federal courts and the IRS look to state law. See Aquilino v. U.S., 363 U.S. 509 (1960). However, after this threshold inquiry, federal law controls whether the taxpayer’s property rights are subject to the tax lien. U.S. v. Nat’l Bank of Commerce, 472 U.S. 713 (1985); IRS v. Orr, 180 F.3d 656, 660 (5th Cir. 1999) (“It is well-settled that in federal taxation cases, the definition of underlying property interests is left to state law, but the consequences that attach to those interests are determined by reference to federal law.”).
Most states permit spendthrift provisions in trust instruments. For example, under Texas law, a settlor can create a spendthrift trust by memorializing in the trust agreement that the beneficiary’s interest in income and/or corpus is not subject to voluntary or involuntary transfer prior to payment or delivery of the interest to the beneficiary. Tex. Prop. Code § 112.035. With these “magic words,” many third-party creditors are unable to attach to the beneficiary’s interest in the spendthrift trust.
But although spendthrift provisions protect against most third-party creditor claims, federal courts have held that such provisions do not prohibit the federal tax lien from attaching to the taxpayer-beneficiary’s interest in the spendthrift trust. See, e.g., Bank One Ohio Trust Co. v. U.S., 80 F.3d 173 (6th Cir. 1996) (spendthrift trust does not defeat federal tax lien); U.S. v. Grimm, 865 F. Supp. 1303 (N.D. Ind. 1994) (concluding a valid spendthrift trust does not defeat attachment of the federal tax lien); U.S. v. Riggs Nat’l Bank, 636 F. Supp. 172 (D.D.C. 1986) (spendthrift trust does not prevent federal tax lien from attaching to a beneficiary’s interest in a trust); In re Orr, 180 F.3d 656 (5th Cir. 1999) (IRS liens survived bankruptcy and are valid against future income distributions to taxpayer-beneficiary of Texas spendthrift trust); Drye v. U.S., 528 U.S. 49 n.7 (“For example, although we do not here decide the matter, we note that an interest in a spendthrift trust has been held to constitute ‘property’ for purposes of § 6321 ‘even though the beneficiary may not transfer that interest to third parties.’”); In re Persky, No. 98-2729 (E.D. Pa. Oct. 5, 1998) (“Indeed, under the great weight of federal authority, the restraints on alienation in spendthrift trusts are not effective to prevent a federal tax lien from attaching under 26 U.S.C. § 6321.”); but see In re Wilson, 140 B.R. 400 (Bankr. N.D. Tex. 1992) (federal tax lien did not attach to discretionary trust, which is similar to spendthrift trust, because taxpayer-beneficiary did not have a property interest in the trust under Texas law).
The Federal Tax Levy
The Internal Revenue Code also permits the IRS to collect unpaid taxes through levy actions. See I.R.C. § 6331. Similar to the federal tax lien, the IRS may levy upon all property and property rights of the taxpayer at the time the levy is made. Id.
Generally, federal courts have held that the IRS may levy upon a taxpayer-beneficiary’s interest in a spendthrift trust. See, e.g., See Lasalle Nat’l Bank v. U.S., 636 F. Supp. 874 (D. Ct. Ill. 1986) (concluding that trustee of spendthrift trust was required to pay IRS in response to IRS levy); Cohen v. U.S., 82 AFTR 2d 98-6487 (D. Ct. C.D. Cal. 1998). However, at least one federal court has held that the IRS may not levy upon a taxpayer-beneficiary’s interest in a purely discretionary spendthrift trust. See Tex. Comm. Bank Nat’l Ass’n v. U.S., 76 AFTR 2d 75-7292 (S.D. Tex. 1995). In that case, the court held that the IRS’ levy was moot where the taxpayer-beneficiary was only entitled to receive discretionary payments with the potential—but not the guarantee—to receive additional payments from the trust in the future.
IRS Chief Counsel has also opined that the IRS may levy upon certain interests in a spendthrift trust. See CCA 200614006. In CCA 200614006, the taxpayer-beneficiary had a right to all current income of a spendthrift trust. Moreover, distribution of current income to the beneficiary was mandatory. On these facts, IRS Chief Counsel concluded that “such mandatory distribution of current income is a property right of the taxpayer that may be levied by the Service and collected as payable.” Moreover, IRS Chief Counsel concluded that “the levy will seize the entire stream of income payments, namely, the income payments currently due and all future income payments.”
But trust instruments are not uniform. For example, although beneficiaries may have some property right interest in a spendthrift trust, the trust instrument may limit any right to income or corpus until a contingent or later event occurs. Indeed, the IRS has recognized that its authority to levy funds from a spendthrift trust is not always a clear-cut issue. For example, in FSA 1999-1221, a father set up a spendthrift trust for his son, the taxpayer. The taxpayer had outstanding tax debts and submitted an offer in compromise based on doubt as to collectability. The offer submission indicated that the taxpayer had limited assets other than the taxpayer’s interest in a spendthrift trust.
During the scope of his representation of the taxpayer, the taxpayer’s representative argued to the IRS that the trustee had the sole discretion under the trust instrument as to whether the taxpayer would receive distributions. According to the representative, this made it different than a typical spendthrift trust.
Although the IRS disagreed and believed it had a “strong case” to continue with levy actions against the trust in the event the offer in compromise was rejected, it also conceded that it could not “be certain that [it] would prevail in an action to enforce . . . [the] levy based on the limited number of cases litigated on this issue.” Accordingly, the IRS recommended that it make a counteroffer to the taxpayer for a greater amount.
Spendthrift trusts protect against many third-party creditors. But such trusts do not generally protect against IRS collection actions. If a taxpayer-beneficiary of a spendthrift trust owes past due tax debts to the IRS, careful attention should be made to the specific language utilized in the trust to determine the scope of the taxpayer’s rights to the trust income and corpus. In the event the IRS attempts to collect the taxes from trust itself, taxpayers may be able to argue that the taxpayer-beneficiary’s rights to income and corpus would be limited if an eventual levy were made.
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