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Tax Liens

Federal Tax Liens

Under the Internal Revenue Code, if a person fails to pay taxes owed to the federal government, the government gains a lien on all of that person's property and interests in property. 26 USC &§ 6321. What constitutes a person's property creates a choice of law dilemma. First, a court will evaluate a person's rights under state law.United States v Drye, 528 US 49, 58 (1999). Then, based on that state law evaluation, the court will use federal law to determine if those rights constitute a property interest that can be reached by a federal tax lien.

This article first explains the rule illustrated inDryeand then applies it to several scenarios involving Illinois state law.

Disclaimer: United States v Drye

InDrye, Irma Drye died intestate; under Arkansas law, her entire $233,000 estate passed to her son, Rohn Drye. Because Rohn had $325,000 in unpaid tax assessments, he exercised his right under Arkansas law to disclaim his inheritance, creating the legal fiction that he had died before his mother. The estate passed to his daughter who created a trust that included the insolvent Rohn as a beneficiary. Under Arkansas law, disclaimed inheritance cannot be reached by creditors. Nevertheless, the Internal Revenue Service (IRS) sought to attach a tax lien to the trust.

Ultimately, the U.S. Supreme Court affirmed a favorable judgment for the IRS. To determine what property may be reached by a federal tax lien, a federal court first evaluates the debtor's rights using state law. In this case, state law gave Rohn the right to either accept or disclaim his inheritance. Then, that right was evaluated under federal law to determine if it was a property interest reachable by tax lien. The U.S. Supreme Court found that Rohn's right to disclaim was an exercise of dominion over the estate, which is the test for a reachable property interest. The state's legal fiction preventing creditors from reaching disclaimed inheritance was not operative where federal law determined that Rohn's right was a property interest.

Title insurance agents and practitioners should note that the Arkansas disclaimer law at issue inDryeis nearly identical to that in the Illinois Probate Act of 1975.

• For that reason, ATG takes the position that a disclaimer will not relieve title to the inherited property of the disclaimant's federal tax liens.

Can a Tax Lien Attach to Heirs' Property Interests in Property Sold by a Personal Representative?

When a debtor is given an interest in property through a decedent's estate, the debtor takes title at the moment of the decedent's death. A later probate determines the validity of any will and identifies heirs or devisees, but title passes at the moment of death. Therefore, if the debtor has any liens at the time of the decedent's death, the liens immediately attach to title to any land that the debtor obtains through the death.

Under the Probate Act of 1975, if a will grants an executor the power to sell an estate's assets, or if an independent administrator is appointed, the personal representative may sell the property without leave from either the descendants or the court. See 755 ILCS 5/20-15; see alsoStephen v Huckaba, 361 Ill App 3d 1047, 1049, 838 NE2d 347, 350, 297 Ill Dec 860 (4th D, 2005), but see 755 ILCS 5/28-8(i) and 20-4, which require consent of a specific devisee. The purchaser of that property "obtains the same title or interest as though the instrument were executed by the decedent immediately prior to his death." 755 ILCS 5/20-15. This legal fiction dates the sale back to immediately before the decedent's death, so an heir or devisee's liens will not attach to title to the property.

However, underDrye, federal tax liens attach when a party acquires an interest under state law that federal courts would construe as a "property interest." Since theDryecase, there is a significant likelihood that a federal court would find that the heir or devisee's right to property through the decedent's estate amounts to a property right because state legal fictions have not in other cases protected property from a federal tax lien. Ultimately, the attachment of the federal tax lien depends on the facts of a given probate administration and the control exercisable by the potential heirs.

• Therefore, it is ATG's underwriting position that federal tax liens belonging to an heir or devisee of a decedent's real property must always be raised on Schedule B of the commitment or policy for that property's title. This rule applies equally to property sold under Section 28-8 of the Probate Act of 1975 and to property sold under a power of sale in the will. This guideline requires that heirs and devisees' names must always be searched to find any open federal tax liens.

   

• Under Supervised Administration, Article 20 of the Probate Act of 1975, there is no similar relation-back theory for a sale of land by a personal representative, so all heirs' and devisees' names must be searched for all types of judgments and liens, which all must be raised as Schedule B exceptions. Federal tax liens cannot be removed from title because, under Section 20-6(f), the probate judge's authority to order a sale free and clear of liens extends only to "any lien or claim for lien of this State." Thus, a federal tax lien of an heir would have to be paid off or the subject of a settlement and release to insure clear title in a buyer.

Can a Tax Lien Attach to a Joint Tenant's Interest in Land?

The Seventh Circuit has held that, under Illinois law, a joint tenant has a "defined, separable interest in property to which [a] federal lien could attach."United States v Davenport, 106 F 3d 1333, 1335-36 (7th Cir., 1997). In Davenport, a married couple held property as joint tenants; subsequently, the IRS perfected a lien against the husband's interest in the property to satisfy a debt. The court found that the lien attached to the husband's undivided one-half interest.

The lien attaches only to the debtor's interest; for example, where the property undergoes forced sale to enforce the lien, the innocent tenants are compensated for their interests in the property.United States v Macchione, 309 F App'x 53, 56 (7th Cir., 2009) (citingDavenport, 106 F 3d at 1136-37 n. 5).

• For this reason, if you insure a fractional interest in land, ATG's underwriting guideline requires you to raise an exception for the possibility of a forced sale to enforce a co-tenant's lien.

Can a Tax Lien Attach to a Beneficiary's Interest in an Illinois Land Trust?

It is likely that a beneficiary's interest in a land trust can be reached by a federal tax lien. Under theDryeanalysis, a federal court would first look to a beneficiary's rights under state law. The Illinois Supreme Court has stated, "In examining a land trust it is apparent that true ownership lies with the beneficiaries.... Particularly in tax law, the realities of ownership are far more important than the technicalities of transfer."People v Chicago Title and Trust Co., 75 Ill 2d 479, 481, 389 NE2d 540, 545, 27 Ill Dec 476 (Ill, 1979). In that case, the Illinois Supreme Court found that the beneficiaries of a land trust could be liable personally to the State of Illinois for payment of forfeited real estate taxes because the beneficiaries' control of the land amounted to ownership under the real estate tax law.

A federal court would next decide whether the beneficiaries' "true ownership" constitutes a property interest. In a pre-Dryecase that essentially applied the same test, the Seventh Circuit stated, "Illinois law's characterization of the beneficiary's interest as personal property ... is not controlling for purposes of federal law.... [T]he beneficiary of a land trust is the 'equitable owner of real property.'"Matter of Gladstone Glen, 628 F 2d 1015, 1019 (7th Cir., 1980). Thus, the state's legal fiction was abrogated and the beneficiary of the trust has an interest in real property reachable by tax lien. See also,United States v Stamps, 1993 WL 389041, *3 (S D Ill, 1993).

Even if the property in the land trust was considered personal property, a tax lien may still attach. InUnited States v Stonehill, 83 F 3d 1156, 1159 (9th Cir, 1996), the court found that a "chose in action" constitutes a personal property interest under California law. Then, turning to federal law, since the interest was transferable and had pecuniary value, it was subject to attachment by a federal tax lien.Id.at 1160. The federal government may foreclose upon any real or personal property to satisfy a tax lien.Id.

• Therefore, it is ATG's underwriting guideline to raise as exceptions any federal tax liens against the beneficiary of a land trust that holds title.

United States v Craft: Tax Liens and Tenancy by the Entireties

A federal tax lien may attach to a person's undivided one-half interest in property owned as a tenancy by the entireties.United States v Craft, 535 U S 274, 276 (2002);United States v Jones, 877 F Supp 907, 917 (D NJ 1995). InCraft, a living couple held property in a tenancy by the entireties in Michigan, a state that recognizes "no individual rights whatsoever" of such tenants.Id.at 276, 281-82. Nevertheless, the rights to use the property and the right to survivorship create an individual property interest under federal law, so that even a person's tenancy by the entireties in such a state is reachable by a federal tax lien.Id.at 288-89.

Furthermore, the IRS's power to attach entireties property goes beyond that of a mere creditor; for example, statutes that may protect property from private creditors do not obstruct a tax lien from the IRS.Schlossberg v Barney, 380 F 3d 174, 180-81 (4th Cir., 2004). In Illinois, when the couple in Davenport transferred their ownership into a tenancy by the entireties, the lien remained enforceable by forced sale of the property.Davenport, 106 F 3d at 1336-37. Although state law at 735 ILCS 5/12-112 prohibits forced sale of entireties property against an innocent party, federal law takes precedence and makes no such prohibition.Id.

• ATG's underwriting position is that all judgments and liens belonging to tenants by the entirety must be raised as Schedule B exceptions on the commitment or policies for title insurance because those liens are attached, regardless of their enforceability.

Conclusion

In conclusion, federal tax liens must be raised as exceptions to title in many instances where it is not necessary to raise state law liens or judgments. Please use caution when you find a federal tax lien and contact the Underwriting Department if you have any questions or concerns.

© ATG|Casenotes/Bulletin 1005_v3n4

[Last update: 5-26-10]