No one wants their life savings seized by creditors, but can you leave an inheritance to a child or loved one who has spending and creditor problems or has a huge unpaid bill to the IRS? The answer is yes, but you must be very careful. Below is a case that recently presented itself to my office.
My client’s child has a large IRS lien for unpaid taxes. Dad wants to leave his estate to his only child but doesn’t want the IRS to seize it. The issue presented is/was:
Whether a completely discretionary trust with spendthrift provisions (I’ll explain what “spendthrift” means later in this article) will have its assets raided when a named beneficiary is subject to an IRS lien. NOTE: This memo does not address the issue of whether a lien will attach when the property is transferred into the trust or from the beneficiary to the trust; it only addresses if a lien will attach once the property is in the trust itself.
In my opinion, a properly drafted trust document can, in fact, protect against an IRS or other government lien; however, there are significant drawbacks and drafting complexities.
I came to my conclusion by way of the following analysis:
An IRS tax lien attaches to all “property and rights to property,” under Code section 26 US Code § 6321. Courts that have interpreted the phrase “rights to property” have concluded that this is controlled by “rights created under state law.” “[I]n the application of a federal revenue act, state law controls in determining the nature of the legal interest which the taxpayer has in the property . . . sought to be reached by the statute.”, said one court.
The precise use of certain legal terms and conditions within the trust will determine the outcome. For example, while spendthrift provisions (spendthrift means language in a trust that protects it from creditors) protecting a trust from normal creditors is valid in New Jersey but the IRS claims a right to “superlien” status that can reach beyond a spendthrift trust provision. This is because while state law controls whether a property right exists, federal law determines the rights of creditors like the IRS to seize property placed into a trust. Several courts have held that while may be no immediate rights in trust property, the mere existence of a spendthrift clause does not protect the trust against an IRS “superlien” because of the equitable interest in both the res (“res” means property, the “thing” of value held in the trust) and future distributions from the trust. Therefore, for the res to be safe from government collection, the individual subject to the lien must have absolutely no legal or equitable right to compel a distribution from the trust under New Jersey law.
The possibility that there is no equitable right to property by a beneficiary in a trust is recognized by the IRS itself in its own publications. In an Internal Legal Memorandum, the IRS has recognized that it can overcome the spendthrift provisions of a trust if a beneficiary is a trustee, if there is any ascertainable standard for distributions, or if there is a fixed income stream (either current or future payments). The memorandum does note that the IRS cannot accelerate future income sources and must wait for the distributions as they occur. Id. This repeats the IRS’s position that “[w]here a trust gives the trustee uncontrolled, absolute discretion with respect to distributions, if any, made to a beneficiary, the beneficiary has no basis to compel the trustee to make a distribution. Therefore, he does not have any interest which is subject to the federal tax lien.”)
The IRS did, however, at one time legally challenge a purely discretionary trust. In the case, the IRS challenged a discretionary trust with spendthrift provisions, stating that the federal tax lien should apply because, although there was complete discretion on behalf of the trustee, a beneficiary could sue to compel a distribution for abuse of that discretion—therein creating some type of equitable interest where the IRS lien could attach. A court said no to the IRS and held that the IRS could only compel a distribution if the trustee was violating the intent of the settlor. Because the trust at issue had a spendthrift clause and gave complete discretion to the trustee, the court held that it was not the settlor’s intent that the corpus be used to satisfy a beneficiary’s creditors. Further and of extreme importance to this decision, the trust had an alternate payee/beneficiary in the trust in case no distributions were ever made to the first beneficiary. Therefore, there was no equitable or legal interest in the property because the trustee could decide never to pay anything to the beneficiary. The court held that the IRS needed to wait until there was a distribution from the trust in order to have the lien attach. New Jersey law respects an absolutely discretionary trustee. Therefore, the IRS must also respect that there is no equitable or legal right for the superlien to attach. But before a trust is written, the drafter must be extremely careful not to have any contrary terms in the trust that will remove the sole and absolutely discretion of the trustee. Some of these contrary provisions to “complete trustee discretion” include ascertainable standards for distributions, language which limits trustee discretion, lack of contingent beneficiaries, the inclusion of real property (if the beneficiary has use of the property, that would create an equitable interest), power of appointment of any future trustees, or other inherent equitable rights that may cause problems converting what was expected to be a perfectly fine discretionary trust into a less-than-discretionary trust.
Overall, these trusts must be treated extremely carefully to ensure that the IRS or the NJ Division of Taxation doesn’t attempt to convert the trust into something the settlor had no intention for it to become.
If you have a question regarding asset protection or a family trust, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com. Please ask us about our video conferencing consultations if you are unable to come to our office.
By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ Estate Planning Attorney