The IRS’s reach in collecting unpaid and assessed taxes is broad, pervasive, and aimed “to reach every interest in property that a taxpayer may have” United States v. National Bank of Commerce, 472 U.S. 713, 719–720 (1985) (emphasis supplied). In exercising its expansive collection powers, the IRS often serves levies on banks, financial institutions, and other corporate entities acting as trustees concerning the administration of various trusts. What is a Corporate Trustee supposed to do when served with an IRS levy with respect to its beneficiary? What impact, if any, do spendthrift, forfeiture, and other discretionary provisions within the trust instrument have on the IRS levy? This article explains and analyzes the applicable federal tax law in the context of IRS levies served on trustees of various types of trusts, along with providing some recommended best practices.
Law and Analysis
Section 6321 of the Internal Revenue Code creates a lien on “all property and rights to property” belonging to any person who, being liable to pay any tax, neglects or refuses to pay the tax after notice and demand. The United States Supreme Court has described the statutory language as “broad” and reflective of a congressional intent “to reach every interest in property that a taxpayer may have.” United States v. National Bank of Commerce, 472 U.S. 713, 719–720 (1985) (emphasis supplied). Section 6321 is part of a “formidable arsenal of collection tools,” the common purpose of which “is to ensure the prompt and certain enforcement of the tax laws….” United States v. Rodgers, 461 U.S. 677, 683 (1983); see also Bank One Ohio Trust Co. v. United States, 80 F.3d 173, 175 (6th Cir. 1996). Section 6331, concerning the power to levy, is part of this same arsenal and includes the broad term “property.” When Congress used the term “property” as it does in IRC §§ 6321 and 6331, it aimed to reach every species of right or interest protected by law and having an exchangeable value. Drye v. United States, 528 U.S. 49, 56 (1999).
The creation of the lien under IRC § 6321 is characterized as a general lien because of its applicability to all taxes. Notice and demand for payment is generally made under IRC § 6303(a) within 60 days after making of the assessment of tax. Upon default by a taxpayer of the notice and demand for payment, a lien arises, commonly referred to as a “secret” lien because third parties are unaware of such lien. Moreover, IRC § 6331(a) provides that “if any person liable for any tax neglects or refuses to pay the same within 10 days after notice and demand,” the IRS can collect such tax by levy. Section 6323 requires that a Notice of Federal Tax Lien (“NFTL”) be filed, even though the lien arises on the date of assessment assuming nonpayment (lien relates back to the assessment date), before it is valid against purchasers, holders of security interests, mechanic’s lienors, and judgement lien creditors. Generally, the IRS will file a NFTL within six to nine months after the assessment date and after issuing several more notices for payment to the delinquent taxpayer. For the most part, a trustee and its “delinquent” beneficiary/taxpayer will be dealing with a filed Notice of Federal Tax Lien.
Neither IRC §§ 6321 nor 6331 create any property rights, but they do attach federally defined consequences to rights created under state law. United States v. Bess, 357 U.S. 51, 55 (1958). State law defines and controls that nature of the legal interest a taxpayer has in property, but the question of whether any tax consequences result thereafter is a matter of federal law. Aquilino v. United States, 363 U.S. 509, 513 (1960); Morgan v. Commissioner, 309 U.S. 78, 82 (1940); National Bank of Commerce, 472 U.S. at 727.
Thus, the threshold question in all tax lien and levy cases is whether and to what extent a taxpayer has an interest in “property” or a “right to property.” Id.
A levy only reaches obligations that exist when the levy is served. Obligations exist when the liability of the obligor is fixed and determinable, even though the right to receive payment is deferred to a later date. Treas. Reg. § 301.6331-1(a)(1). “Determinable” means that the amount of the liability is capable of being calculated or measured. See Reiling v. United States, 39 A.F.T.R.2d 77-1031, 1977 WL 1094 (N.D. Ind. 1997); CCA 200614006. The precise sum of the obligation need only be capable of measurement at some time in the future. See United States v. Hemmen, 51 F.3d 883, 890 (9th Cir. 1995) (construing Treas. Reg. § 301.6331-1(a)(1)); CCA 200614006.
This includes a right to receive future payments under a trust provided the right to receive such payments was not contingent upon the performance of future services. See Rev. Rul. 55-210, 1955-1 C.B. 544. In other words, the right to future income, if it is a fixed or present right to property, is subject to levy, even though the taxpayer cannot receive the property until some future date. In re Orr, 180 F. 3d 656, 664 (5th Cir. 1999). “Thus, if a taxpayer has a fixed right under a trust to receive periodic payments or a lump sum distribution from a trust, the levy seizes the rights to such payments or distributions.” CCA 200614006.
“The general rule is that, once the court finds that the taxpayer has property or a right to property in a trust under state law, any state law is inoperative to prevent attachment of a lien created by federal statutes.” LaSalle Nat’l Bank v. Unites States, 636 F.Supp. 874, 877 (N.D. Ill. 1986) citing Bess, 357 U.S. at 56-57 (emphasis added).
There are only two valid defenses to the failure to honor a levy: (1) the levied party was not in possession of property or rights to property of the taxpayer; and (2) at the time the levy was served, the property was subject to an attachment or execution under any judicial process. IRC § 6332(a); National Bank of Commerce, 472 U.S. at 721-22; see also Bank of Nevada v. United States, 251 F.2d 820, 824 (9th Cir. 1958), cert. denied, 356 U.S. 938 (1958).
In the context of trusts, the most common applicable defense is that the trustee was not in possession of property or rights to property of the taxpayer/beneficiary. To the extent a trustee claims that a taxpayer did not have the rights to the property as of the time of the levy, the trustee has the burden of proof to establish that lack of interest. See Flores v. United States, 551 F.2d 1169, 1174 (9th Cir. 1977) (“[I]t seems appropriate for such a person (one sued for failure to honor an IRS levy) to carry the burden of showing non-ownership by the taxpayer as a defense because the purpose of the statute is a coercive one which seeks to foster swift tender of property which has been levied upon.”).
If the trustee honors the levy, the trustee is “discharged from any obligation or liability to the delinquent taxpayer with respect to such property or rights to property arising from such surrender or payment.” IRC § 6332(e). If, on the other hand, the trustee refuses to honor a levy, the trustee may incur liability to the Government for the refusal. IRC § 6332(d); National Bank of Commerce, 472 U.S. at 721.
Consequences for the Failure to Honor a Valid IRS Levy
A trustee who fails to comply with a notice of levy faces personal liability for such failure under IRC § 6332(d)(1) to the extent of the taxpayer’s tax liability (including penalties and interest), as well as a penalty over and above the applicable amount in the amount of 50% unless reasonable cause for failure to honor the levy can be established. IRC § 6332(d)(2). Questions as to the validity of the levy and competing claims to the ownership of the funds are not deemed to be valid reasons for refusing to honor a levy. United States v. Daccarett, 6 F.3d 37, 59 (2d Cir. 1993).
To establish reasonable cause in order to avoid the 50% penalty, a trustee must show there was a “‘bona fide dispute … concerning the amount of the property to be surrendered pursuant to a levy or concerning the legal effectiveness of the levy.’” United States v. Donahue Industries, Inc. 905 F.2d 1325 F.2d 1325, 1331 (9th Cir. 1990) quoting Treas. Reg. § 301.6332-1(b)(2). “[S]erious deficiencies in the levy notices may call into question the legal effectiveness of the levy, and give reasonable cause for failing to honor the levy.” Donahue, 905 F.2d at 1332; see also United States v. 911 Management, LLC, 113A.F.T.R.2d 2014-368, 2014 WL 28996 (D. Ore. 2014)(holding that the custodian was not liable for the 50% penalty when there was a bona fide legal dispute over the effectiveness of the 2008 levies).
In other words, a failure to honor a levy without reasonable cause may result in a trustee having to the pay the IRS 150% of what the taxpayer/beneficiary owed the IRS. Further, at least one Circuit has held that there is no statute of limitations on suits to enforce a third party’s personal liability under IRC § 6332, and that the ten-year limitation period under IRC § 6502 applies only to actions against taxpayers and not against third parties in possession of the taxpayer’s property. United States v. Weintraub, 613 F.2d 612, 619-20 (6th Cir. 1979). As an alternative or supplement to a suit to enforce a levy, the federal government may sue the holder of the taxpayer’s property, like a trustee, for tortious conversion of the federal tax lien. United States v. Henshaw, 388 F.3d 738, 743 (10th Cir. 2004).
Application of Law to Trusts with Mandatory Distribution Provisions along with Spendthrift and/or Forfeiture Clauses
Generally, a trust instrument with mandatory distribution provisions that contains state-created spendthrift and forfeiture provisions, which are trigged upon an alienation event cannot defeat a federal tax lien or levy. See Northwestern Trust Company v. Internal Revenue Service, 622 F.2d 387, 390 (8th Cir. 1980). “[S]tate-law restraints on the alienation of property rights created under the state law do not affect the status of such rights as “property” or “rights to property” within the meaning of those terms as used in IRC § 6321. A restraint on alienation is ‘not an aspect of the substantive right,’ and thus ‘cannot serve to defeat the federal tax lien.’” Bank One, 80 F.3d at 176 quoting United States v. Rye, 550 F.2d 682, 685 (1st Cir. 1997). Once a federal tax lien attaches to an interest in an estate or trust, the lien or a subsequent levy cannot be defeated by a subsequent renunciation of the interest in question. See United States v. Comparato, 22 F.3d 455 (2d Cir.), cert. denied., 513 US 986 (1994); see also United States v. Mitchell, 403 U.S. 190, 204-05 (1971)(holding that the IRS levy attached to the trust, notwithstanding that under state law the renunciation would be effective retroactively).
Therefore, if the IRS levies upon a trust with mandatory distribution provisions, the levy should be honored, even if the trust has spendthrift or forfeiture provisions that would be initiated upon receipt of the levy.
Application of Law to Various Discretionary Trusts
Determining whether a beneficiary has property or rights to property in the context of “support” trusts or “discretionary” trusts generally depends on the trustee’s duty to pay the funds, which itself depends on the terms of the trust. Aside from simple trusts with mandatory distribution provisions, this principle can be difficult to apply in practice. This is further complicated by various nuances between the laws of each state. For example, suppose a trust directs the trustee to pay the beneficiary “so much or all of the income and principal of the trust as may be required for support in the beneficiary’s accustomed manner of living.” Traditionally, this sort of trust was known as a “support trust.” See Restatement (Second) of Trusts § 154. Now, several states consider it to be a “discretionary trust” in which the trustee’s discretion is “limited by an ascertainable standard.” No matter the label, the trustee’s duty to pay is somewhat unclear because the trust does not specify payment amounts or schedules, but the duty is not empty, since the trustee must pay whatever amount is in fact required under the standard set forth in the trust. Thus, in many states the beneficiary’s right to the trust funds would be a right to payments in accordance with an ascertainable standard. See e.g., Duckett v. Enomoto, 117 A.F.T.R.2d 2016-1358, 2016 WL 1554979 (D. Ariz. 2016).
Continuing, suppose a trust permits the trustee to pay the beneficiary “any amount, including zero, of the income or principal of the trust as the trustee in his sole discretion shall determine.” Traditionally, this sort of trust was known as a “discretionary trust.” See Restatement (Second) of Trusts § 155. Some states now refer to it as a “purely discretionary” trust. Label aside, the trustee’s duty to pay is tenuous because “the trustee may in his absolute discretion refuse to make any payment to the beneficiary.” Restatement (Second) of Trusts § 155 cmt. c. But, the trustee is not absolved of all duty. Trustees must always act in good faith. No trust language, however strong, can entirely remove a power held in trust from judicial review; otherwise “the power would not be held in trust at all.” Stix v. Commissioner, 152 F.2d 562, 563 (2d Cir. 1945). Thus, no matter how broad a trustee’s discretion, he may not abuse it and most states recognize a beneficiary’s right to maintain a judicial proceeding against a trustee for an abuse of discretion. Generally, the beneficiary’s right to the trust funds would be a right to payments the withholding of which would constitute an abuse of discretion. See Duckett, 117 A.F.T.R.2d 2016-1358, 2016 WL 1554979.
Many discretionary trusts are likely to fall somewhere between the two scenarios noted above. Thus, the question will be whether a beneficiary has enough “control” over funds held in a discretionary trust to trigger a federal tax lien or levy attachment.
Recommended Best Practices for Trustees
Trusts with Mandatory Distribution Provisions
If a trustee is served with an IRS Notice of Levy concerning a taxpayer/beneficiary of a trust with mandatory distribution provisions of a fixed or determinable amount, the trustee should honor the levy as soon as possible. This obligation continues and applies to a right to receive future payments under a trust provided the right to receive such payments was not contingent upon the performance of future services. Further, the trustee should honor an IRS levy for this type of trust even if the trust contains spendthrift or forfeiture provisions.
However, the trust instrument should be examined to see if the taxpayer/beneficiary’s rights may differ when applied to the income of the trust versus the principal/corpus of the trust. For example, if the trust provides for mandatory distributions of a fixed or determinable amount of the income generated by the trust, but provides the trustee with sole discretion concerning the distribution of the principal of the trust, the trustee should honor the IRS levy as to the mandatory income distributions, but assert a defense under IRC § 6332(a) as to the principal. Namely, that the taxpayer/beneficiary does not have any property or rights to property as it pertains to the principal of the trust.
Discretionary Trusts Limited by an Ascertainable Standard
Here, the primary question will be whether a beneficiary has enough “control” over funds held in a discretionary trust to trigger federal tax lien or levy attachment. For discretionary trusts where the trustee’s discretion is limited by an ascertainable standard the trustee’s duty to pay is somewhat unclear because the trust does not specify payment amounts or schedules, but the duty is not empty, since the trustee must pay whatever amount is in fact required under the standard set forth in the trust instrument.
If the discretionary trust in question contains “shall pay” clauses followed by clauses giving a trustee discretion as to the amount and timing of any distributions pursuant to an ascertainable support standard, then it is likely that an IRS lien attaches to the taxpayer/beneficiary’s right to any distributions. Given this, an IRS levy will also attach to these rights once it is served on the trustee. While an IRS lien or levy is likely to attach is this situation, the trustee may not have to immediately turn over any funds upon receipt of a Notice of Levy from the IRS, but a second level of review should be conducted, or outside counsel contacted, in which the following factors are considered before any funds are turned-over to the IRS:
- Is the taxpayer/beneficiary the sole beneficiary?
- Is the taxpayer/beneficiary also a co-trustee?
- Is there a history of regular distributions to the taxpayer/beneficiary at regular intervals?
- Do the limited discretionary provisions only apply to the income of the trust, i.e., is the distribution of the principal/corpus purely discretionary?
- What contingencies can terminate the taxpayer/beneficiary’s rights to distributions, if any?
To the extent that the taxpayer beneficiary is the sole beneficiary, a co-trustee, and has received regular distributions at regular intervals, the IRS’s position is even stronger. In this situation, the trustee should turn-over the “regular distribution” at the “regular interval” to the IRS after receiving a Notice of Levy, instead of the taxpayer/beneficiary. The trustee should not stop making payments altogether in this situation, as it is likely an abuse of the trustee’s discretion per the terms of the trust as the IRS steps into the shoes of the taxpayer/beneficiary. Further, the trustee will likely be subject to the 50% penalty of IRC § 6332(d)(2).
If the distribution patterns are irregular and rare, internal discussions should be held, along with consultation with outside counsel, before responding to the IRS. For example, the trustee may ultimately agree with the IRS the taxpayer/beneficiary has a right to a distribution, but that the timing and amount of that distribution is unclear based on the historic administration of the trust. That being said, it is generally safer for the trustee to honor the levy. If the limited discretionary provisions only apply to distributions of the income of the trust and the trustee has “pure” discretion as to the principal, the trustee should assert the applicable defenses under IRC § 6332(a) if the IRS tries to the levy on the principal/corpus of the trust.
Purely Discretionary Trusts
Here again, the primary question will be whether a beneficiary has enough “control” over funds held in a discretionary trust to trigger federal tax lien or levy attachment. For purely discretionary trusts, the trustee’s duty to pay is tenuous because the trustee generally may in his absolute discretion refuse to make any payment to the beneficiary. It is assumed that these purely discretionary trusts will contain “may pay” clauses subject to the trustee’s “sole/absolute discretion.”
Generally, an IRS lien or levy will likely not attach to a taxpayer/beneficiary’s right to any distributions, since such distributions are subject to the trustee’s sole discretion and the taxpayer/beneficiary does not have a present right to receive any distributions. However, this general rule may be overridden by state law rights provided to beneficiaries and/or the historic administration of the trust. Some states recognize a beneficiary’s right to maintain a judicial proceeding against a trustee for an abuse of discretion even if the trust is a purely discretionary trust. Further, if the trustee historically made regular distributions, at regular intervals, of similar amounts or amounts calculated by using the same formula, the IRS may have a stronger argument concerning attachment and current rights to property.
When faced with an IRS lien or levy on a purely discretion trust, the trustee’s general position should be that the taxpayer/beneficiary does not have any current rights to property and therefore, neither does the IRS per IRC § 6332(a). However, consideration should be given to the state law rights provided to beneficiaries concerning abuse of discretion. This is particularly true if the historic administration of the trust resulted in regular distributions, at regular intervals, of similar amounts or amounts calculated by using the same formula.
Ultimately, if there is a genuine question as to control and rights to property, up front discussions should be coordinated with outside counsel, the IRS, and the taxpayer/beneficiary, but, as trustee, the more conservative and safer approach would be to honor the IRS levy. Again, if the trustee honors the levy, he/she/it is “discharged from any obligation or liability to the delinquent taxpayer with respect to such property or rights to property arising from such surrender or payment.” IRC § 6332(e). If, on the other hand, the trustee refuses to honor a levy, the trustee may incur liability to the Government for refusal along with a potential 50% penalty. IRC § 6332(d); National Bank of Commerce, 472 U.S. at 721.
In any levy situation, the trustee should first contact the beneficiary/taxpayer and ascertain whether it is possible to satisfy the lien or levy attachment outside of the trust. If so, this would be the preferable method of resolving the levy on the Trustee as well as other implications arising from the controversy.