Lien Priority Litigation

The case of Shirehampton Drive Trust v. JP Morgan Chase Bank et al.; No. 2:16-cv-02276 (D. Nev. 2019) presents a relatively straightforward lien priority fight.  The case shows the continued fallout from the great recession.  It also shows the perils of purchasing property at a foreclosure sale.  When a federal tax lien exists, such a purchase becomes especially perilous, as the purchaser discovers here.  I remember as a district counsel attorney having to deal with a few unsophisticated purchasers at foreclosure sales who discovered to their sorrow that the property which they thought they had purchased at such a bargain, would cost them much more than anticipated because of a federal tax lien that the sale did not defeat.  The Shirehampton case does not break new ground but merely serves as a cautionary tale.

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In 2008 Louisa Oakenell purchased property located at 705 Shirehampton Drive, Las Vegas, Nevada 89178 (“the property”). The property sits in a community governed by the Essex at Huntington Homeowners Association (“HOA”). The HOA requires its community members to pay dues.  At the time she purchased the property, she already owed the IRS significant income tax liabilities for 2005 and 2006.  The court described the relevant facts as follows:

This matter concerns a nonjudicial foreclosure on a property located at 705 Shirehampton Drive, Las Vegas, Nevada 89178 (“the property”). The property sits in a community governed by the Essex at Huntington Homeowners Association (“HOA”). The HOA requires its community members to pay dues.
 
Louisa Oakenell borrowed funds from MetLife Home Loans, a Division of MetLife Bank, N.A. (“MetLife”) to purchase the property in 2008. To obtain the loan, Oakenell executed a promissory note and a corresponding deed of trust to secure repayment of the note. The deed of trust, which lists Oakenell as the borrower, MetLife as the lender and Mortgage Electronic Registration Systems, Inc., (“MERS”) as the beneficiary, was recorded on December 24, 2008. MERS assigned the deed of trust to Chase in May 2013.
 
Oakenell fell behind on HOA payments. The HOA, through its agent Red Rock Financial Services, LLC (“Red Rock”) sent Oakenell a demand letter by certified mail for the collection of unpaid assessments on June 26, 2009. On July 21, 2009, the HOA, through its agent, recorded a notice of delinquent assessment lien. The HOA sent Oakenell a copy of the notice of delinquent assessment lien on July 24, 2009. The HOA subsequently recorded a notice of default and election to sell on October 21, 2009 and then a notice of foreclosure sale on September 18, 2012. Red Rock mailed copies of the notice of default and election to sell to Oakenell, the HOA, Republic Services, the IRS, and Metlife Home Loans. Red Rock did not mail a copy of the notice of default and election to sell to MERS. On January 28, 2013, the HOA held a foreclosure sale on the property under NRS Chapter 116. Shirehampton purchased the property at the foreclosure sale. A foreclosure deed in favor of Shirehampton was recorded on February 7, 2013.

In addition to falling behind on her HOA payments, however, Oakenell also stopped paying federal income taxes. The IRS subsequently filed notices of federal tax liens against Oakenell at the Clark County Recorder’s office on May 1, 2009 and June 24, 2009. As of October 1, 2018, Oakenell had accrued $250,953. 37 in income tax liability plus daily compounding interest.

For any reader not familiar with the federal tax lien, a quick detour into lien law may help.  For a more detailed discussion of this lien law, refer to Saltzman and Book, “IRS Practice and Procedure” at chapter 14.04, et seq.  When the IRS makes an assessment, it sends a notice and demand letter (required by IRC 6303) almost immediately thereafter.  If the taxpayer fails to pay the tax within the time prescribed in the notice and demand letter, the federal tax lien comes into existence relates back to the date of assessment and attaches to all of the taxpayer’s property and right to property.  The lien also attaches to all after-acquired property as long as the lien remains in existence.  In this case the federal tax lien would have attached to the property Ms. Oakenell purchased immediately upon closing; however, at that time the lien was known only to the IRS and Ms. Oakenell, since the IRS had not yet made the lien public by filing a notice of the lien.

In 1966 Congress passed the legislation establishing the lien priority rules that still apply today.  Congress gave the federal tax lien the broadest possible power; however, it limited that power by creating a first in time rule in IRC 6323(a).  That first in time rule allows a competing interest to defeat the federal tax lien if perfected prior to perfection of the federal tax lien.  Perfection of the federal tax lien occurs when the IRS files the notice in the appropriate place.  In this case the fight concerns the timing of the filing of the lien and not the location.

Because the notice of federal tax lien was filed here prior to the filing of the lien for the HOA, the federal tax lien defeats the lien of the association.  HOA fees seem a lot like local real estate taxes; however, if competing with the federal tax lien, the two types of ownership liens operate differently.  The real estate taxes, even though they arise after the existence of the filing of federal tax lien, come ahead of the filed federal tax lien because of IRC 6323(b)(6)(a).  Congress added this subparagraph in 1966 to avoid circular priority problems which arose when a real estate taxes went unpaid after the filing of a notice of federal tax lien.  Prior to 1966 courts had to struggle with the situation, because the purchase money mortgage defeated the IRS lien, the IRS lien defeated the later arising real estate taxes and the real estate taxes defeated the purchase money mortgage.  With the passage of this provision, Congress had the IRS step back in order to allow the real estate taxes to come before the IRS; however, it did not do the same for HOA fees.  As a consequence, the IRS defeats HOA fees that get recorded after the notice of federal tax lien.  Since that happened here, the purchaser bought the property subject to the substantial tax liabilities secured by the federal tax lien.  A very unfortunate result for the purchaser and one that should never occur but which does with surprising frequency.

In addition to the Shirehampton case, another lien priority case was recently decided, United States v. Patrice L. Harold et al.; No. 2:18-cv-10223.  I will discuss the Harold case in an upcoming post.

Will the IRS Take My Home?

LITC practitioners hear recurring worries from taxpayers with IRS problems: will I go to jail? will the IRS take my home? For the vast majority of people who owe taxes, the answer to both questions is no. Someone who simply owes a tax debt usually does not need to worry about going to jail or having their home taken by the IRS. However, this is not to say it never happens. There are perhaps one or two cases per month reported on daily tax news services, and the National Taxpayer Advocate’s 2017 Annual Report to Congress identified 60 opinions in that fiscal year involving section 7403Recent cases illustrate the steps the government must take and the factors courts consider when evaluating a request to foreclose. 

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The government has two separate legal mechanisms to seize a taxpayer’s home in order to collect a tax debt. The National Taxpayer Advocate explains in her 2017 ARC Purple Book: 

The IRS has two options, which cannot be used concurrently, to collect against the principal residence of a taxpayer or a residence that is owned by the taxpayer but occupied by the taxpayer’s spouse, former spouse, or minor child. One option is to obtain a court order allowing administrative seizure of a principal residence under IRC § 6334(e)(1). … The other option is a suit to foreclose the federal tax lien against a principal residence under IRC § 7403.

The IRS makes use of both options, by way of making a recommendation and referral to the Department of Justice Tax Division, which represents the IRS in Federal District Court. The IRM explains that  

[s]uits should still be brought to foreclose the federal tax lien and reduce the tax liability to judgment in lieu of bringing a section 6334(e)(1) proceeding whenever it is determined that such suits would be optimal. A lien foreclosure suit may be preferable to a section 6334(e)(1) proceeding when there are questions regarding title or lien priority that create an unfavorable market for administrative sale. See 35.6.3.2 for discussion of lien foreclosure suits. A lien foreclosure suit may also be a specific option when the collection statute of limitations is about to run.  

34.6.2.5.1 (06-12-2012), Procedures for Instituting a 6334(e)(1) Proceeding.  So, taxpayer representatives should be familiar with the requirements for both actions.

Administrative seizure with judicial approval 

In August of 2018, Keith blogged about an Eighth Circuit decision under section 6334United States v. Brabant-Scribner, No. 17-2825 (8th Cir. Aug. 17, 2018). Keith explains: 

The 1998 Restructuring and Reform Act added IRC 6334(e)(1)(A) to require that prior to seizing a taxpayer’s principal residence the IRS must obtain the approval of a federal district court judge or magistrate in writing. Before the passage of this provision, the IRS could seize a taxpayer’s home with the same amount of prior approval needed to seize any other asset owned by the taxpayer. No approval was necessary to seize any asset of the taxpayer.

The government has adopted Treasury Regulation 301.6334-1(d) incorporating additional procedures and standards. Keith summarizes: 

To convince the court to allow the sale of a personal residence, the IRS must show compliance with all legal and procedural requirements, show the debt remains unpaid and show that “no reasonable alternative” for collection of the debt exists. 

… the taxpayer has a right to object after the IRS makes its initial showing and “will be granted a hearing to rebut the Government’s prima facie case if the taxpayer … rais[es] a genuine issue of material fact demonstrating … other assets from which the liability can be satisfied.”  

Also, the regulation provides for written notice to family members and occupants of the property.  

Unfortunately for taxpayers, judicial approval may not be difficult for the IRS to obtain despite the above standards and procedures. In Brabant-Scribner, the court reasoned that an alternative “for collection” must provide for payment of the debt; therefore, it held that the IRS was not required to consider the taxpayer’s offer in compromise. Similar reasoning has been followed by other courts. E.g. United States v. Gower, No. 3:16-cv-01247 (M.D. FlaJul. 10, 2018). Nevertheless, the administrative collection statutes and regulations provide some procedural protections for the taxpayer and certain family members living in a home owned by the taxpayer. IRM procedures also provide significant safeguards, which the National Taxpayer Advocate has recommended that Congress codify in section 7403

Suit to foreclose judgment lien 

The government’s second option, if it seeks to seize a taxpayer’s home, is to foreclose the federal tax lien by filing suit pursuant to section 7403Les has discussed section 7403 previously, and I will borrow his summary:

Under Section 7403, a federal district court can “determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property,…, and a distribution of the proceeds of such sale according to the findings of the court. 

Yet that power to force a sale and distribution of the proceeds is limited. In the 1983 case US v Rodgers the Supreme Court said that while the government has broad discretion to force a sale, “Section 7403 does not require a district court to authorize a forced sale under absolutely all circumstances, and that some limited room is left in the statute for the exercise of reasoned discretion.” Keith has discussed the application of Rodgers in prior posts here and here. 

To assist courts in exercising that discretion, Rodgers identifies factors: 

1) “the extent to which the Government’s financial interests would be prejudiced if it were relegated to a forced sale of the partial interest actually liable for the delinquent taxes[;]” 

(2) “whether the third party with a nonliable separate interest in the property would, in the normal course of events (leaving aside § 7403 and eminent domain proceedings, of course), have a legally recognized expectation that that separate property would not be subject to forced sale by the delinquent taxpayer or his or her creditors[;]” 

(3) “the likely prejudice to the third party, both in personal dislocation costs and … practical undercompensation [;]” and 

(4) “the relative character and value of the nonliable and liable interests held in the property ….”

Once the government has decided to sue for foreclosure, the taxpayer and others hoping to prevent that outcome face an uphill battle. The government prevailed in 58 of the 60 cases identified by TAS in the 2017 Annual Report to Congress, and one case resulted in a split decision. The taxpayer prevailed in only one case. These lopsided statistics are consistent with prior years’ reports.  

At times courts’ analysis of the Rodgers factors is cursory or nonexistent, but sometimes the factors do make a difference and judicial discretion is exercised. In United States v. Kwitney, No. 6:18-cv-1366-Orl-37TBS (M.D. Fla. Feb. 8, 2019), the district court rejected a magistrate’s recommendation in favor of foreclosure, because the interests of a third party had not yet been adjudicated.  

A less happy outcome for the interested third party occurred on January 30 in United States v. Jackson, No. 3:16-cv-05096 (W.D. Mo. Jan. 30, 2019). Mr. Jackson’s wife jointly owned properties with him, but she was not liable for the tax debt. Unfortunately for her, Mrs. Jackson came to the court with unclean hands, having previously collaborated with Mr. Jackson in what the court found were fraudulent transfers of the property. The court nevertheless examined the Rodgers factors: 

With respect to the first factor, the Court finds Plaintiff’s financial interests would be prejudiced if it were relegated to the forced sale of only Phil Jackson’s interest in the Properties. As a practical matter, if Plaintiff foreclosed on Phil Jackson’s interests only, Sharon Jackson retains her interests in the Properties. Thus, the sale of Phil Jackson’s interests would not decrease the judgment amount Phil Jackson owes to Plaintiff. 

Translation: it will be hard, perhaps impossible, to find a buyer for Mr. Jackson’s half-interest in the property. The government is likely to collect nothing under this alternative.  

With respect to the second factor, Sharon Jackson lacks an expectation that the Properties would not be subject to sale. Sharon Jackson, as owner with Phil Jackson, participated in the fraudulent transfers (since disclaimed) of the Properties. In the Court’s view, this conduct “tilts the balance of legal expectation against” her under this factor. United States v. Bierbrauer, 936 F.2d 373, 376 (8th Cir. 1991). 

With respect to the third factor, Sharon Jackson will receive full compensation for her interests in the Properties. … 

Finally, with respect to the fourth factor, because Phil Jackson’s and Sharon Jackson’s interests in the Properties are equal, forced sale could net Plaintiff as much as half the value of each of the properties to apply to the tax judgment against Phil Jackson. Under these circumstances, the Plaintiff is likely to recover more than “a fraction of the value of the property.” Bierbrauer, 936 F.2d at 375. 

Mrs. Jackson also argued that if the properties were sold, she should receive half of the sale price before any of the sale expenses were deducted and before certain property tax liens were paid. The Court held against her on both counts. As co-owner Mrs. Jackson was equally liable for the property taxes, and the court reasoned that her legal interest in the property is subject to those liens. Regarding the administrative costs of sale,  

[The Jacksons] cite no legal authority for the premise that the sale costs for the Properties should be borne by Plaintiff. Thus, the Court relies on “the Government’s paramount interest in prompt and certain collection of delinquent taxes” to conclude that Plaintiff net proceeds from the sale of the Properties should be distributed to PALS first. Rodgers, 461 U.S. at 712. 

The government’s “paramount interest” certainly makes these cases very difficult for taxpayers and their family members to win.

The bottom line 

The case numbers are low: the government probably won’t try to seize your home for back taxes. However, it’s in taxpayers’ interests to resolve their collection disputes rather than ignore the IRS. And certainly, don’t try any funny business with fraudulent transfers.

Ponzi Scheme Victims Seek to Defeat the Federal Tax Lien with Constructive Trust Argument

All too often a person cheating others ends up pitting the defrauded individuals against the IRS in a battle over the remaining assets of the cheater. The most recent version of this longstanding problem exists now in the Ninth Circuit case of Wadsworth v. Talmage, 123 AFTR 2d 2019-305 (911 F.3d 994), (9th Cir. 2018) (order certifying question to the Supreme Court of Oregon). On December 27, 2018, the Ninth Circuit declined to sustain the dismissal of the action by the district court and certified the issue of the meaning of a constructive trust in Oregon to the Oregon Supreme Court. Presumably, the Oregon Supreme Court’s decision on the application of constructive trusts in that state will allow the Ninth Circuit to reach a decision on whether property existed to which the federal tax lien could attach.

These types of cases put the IRS in the awkward position of taking the assets of the thief to satisfy outstanding tax debts resulting from the theft. By taking those assets, the IRS prevents the actual victims of the theft from receiving restitution. I am always pulling for the victims in these cases because it does not seem right to me that the tax authority should take the money instead of the actual victims of the theft. I have written about these types of situations previously in the bankruptcy context, here and here, in circumstances in which the issue was whether the court could order a clawback of the money from the IRS.

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The Ninth Circuit describes the basic facts regarding the use of the money fraudulently obtained from investors:

John Wadsworth and other members of the RBT Victim Recovery Trust (collectively, “the Trust”) allege that Ronald Talmage, an investment manager, began fraudulently diverting his clients’ funds in the 1990s as part of a Ponzi scheme. Members of the Trust entrusted Talmage with “over $55 million” between 2002 and 2015.

In 1997, Talmage and his first wife purchased RiverCliff for almost $1 million. The property was purchased with the proceeds of Talmage’s Ponzi scheme. From 1998 to 2008, Talmage spent over $12.5 million of entirely stolen funds to improve the property. Talmage paid his first wife $1.5 million dollars in 2005 using money “stolen . . . from . . . Trust beneficiaries” to purchase her half-interest in RiverCliff after the couple divorced. Throughout this time, Talmage resided at RiverCliff.

Unlike the debtors in the bankruptcy cases linked above in which the issue was a clawback of money paid to the IRS, here the perpetrator of the scheme also failed to pay his taxes. Because he failed to pay his federal taxes, the IRS filed a notice of federal tax lien. The lien attached to RiverCliff and all of the property owned by Mr. Talmage. The IRS brought suit to foreclose its lien on the property. The Recovery Trust sought to intervene in that action and was denied. The Recovery Trust then brought this action seeking to quiet title to the property. At the district court level the IRS succeeded in having the suit dismissed. The referral to the Oregon Supreme Court comes because the Ninth Circuit sees the possibility that under Oregon law the Recovery Trust may have a superior property interest to the lien of the IRS.

Although the priority of the federal tax lien is determined under federal law, whether the taxpayer has a property interest to which the lien can attach is a question of state law. Looking at Oregon law, the Ninth Circuit found that opinions existed supporting both the majority and minority views of constructive trust:

The rights of the legal title-holder, and of lienors such as the Government, depend on when the constructive trust arises. Under the laws of the several states, a constructive trust can arise either at the moment a purchase is made with the fraudulently-obtained funds, or at the moment a court imposes the trust as an equitable remedy. Under the majority rule, a trust arises automatically at the moment of purchase. See In re Leitner, 236 B.R. 420, 424 (Bankr. D. Kan. 1999) (“[U]nder the majority state law rule, a constructive trust arises at the time of the occurrence of the events giving rise to the duty to reconvey the property, not at the date of final judgment declaring the trust . . .”); see also RESTATEMENT (THIRD) OF RESTITUTION AND UNJUST ENRICHMENT § 55 cmt. e (2011). In states following this rule, the legal title-holder is a constructive trustee who holds no rights beyond bare legal title. For purposes of the federal tax lien statute, 26 U.S.C. §6321, property held in a constructive trustee-taxpayer’s name therefore does not “belong” to the taxpayer, and tax liens cannot attach. See, e.g., FTC v. Crittenden, 823 F. Supp. 699, 704 (C.D. Cal. 1993) (finding that an “IRS lien does not attach” to business funds that are subject to a constructive trust under California law); Mervis Indus., Inc. v. Sams, 866 F. Supp. 1143, 1147 (S.D. Ind. 1994) (finding tax liens could not attach to property whose title is held by an embezzler because Indiana law “is clear” that “an embezzler, from the beginning, acquires no beneficial ownership in property purchased with stolen funds”).

Under the minority rule, a constructive trust arises only once it is imposed as a judicial remedy. In that case, the legal title-holder retains all the rights of a property owner until such a remedy is imposed by a court. Until that time, the property “belongs” to the title-holder for purposes of 26 U.S.C. § 6321 and federal tax liens against the title-holder can attach. If no court has imposed a trust when the tax liens attach, the beneficiaries of a potential constructive trust hold at most an inchoate claim to the property. For example, in Blachy v. Butcher, 221 F.3d 896, 905 (6th Cir. 2000) (quoting Soo Sand & Gravel Co. v. M. Sullivan Dredging Co., 244 N.W. 138, 140 (Mich. 1932)), the Sixth Circuit found that “[u]nder Michigan law, a ‘constructive trust is strictly not a trust at all, but merely a remedy administered in certain fraudulent breaches of trusts.’” Because “a constructive trust does not arise until a judicial decision imposes such a trust under Michigan law,” beneficiaries of the trust alleged in that case held only an inchoate state-created lien, over which an attached federal tax lien takes priority. Id.

Because state law controls a critical question concerning the competition between the parties due to the issue of what property interest in the taxpayer held, the Ninth Circuit correctly certified the question to the Oregon Supreme Court. The specifics of Oregon law may impact few readers but the issue of constructive trust and the ways that states have construed ownership in these situations has broad application. The lawyers for the trust have done a great job of keeping the case going in the face of significant adversity after being rebuffed in their effort to intervene and being dismissed in the quiet title action. They have one more hurdle to leap before the defrauded investors (and probably the lawyers themselves) have a chance at using the value of the property purchased by Talmage to satisfy their claims.

Ninth Circuit Affirms Earlier Decisions Denying Debtor Right to Alter IRS Lien after Bankruptcy

On November 7, 2017, I posted on the case of In re Nomillini in which the debtor sought to limit the secured claim of the IRS based on the confirmation of his chapter 13 plan. The Ninth Circuit, in an unpublished opinion dated December 18, 2018, denied the debtor’s motion to cut off the rights of the IRS lien in debtor’s property. Here, the debtor’s plan did not seek to limit the rights of the IRS as a secured creditor. The court relied on the normal rule that a lien against a debtor passes through the bankruptcy unaltered absent a specific attack on the lien as a part of the bankruptcy proceeding.

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The Ninth Circuit stated the general rule as follows:

For a debtor to avoid a creditor’s lien or otherwise modify the creditor’s in rem rights, the debtor’s confirmed plan must do so explicitly and provide the creditor with adequate notice that its interests may be impacted. Id. at 873. Any ambiguity in the plan will be interpreted against the debtor. Id. at 867.

Mr. Nomillini did not mention the IRS lien in his chapter 13 plan. He gave no notice to the IRS during his bankruptcy proceeding that he sought to reduce or eliminate its lien on his property. He sold his home. He entered into an agreement with the IRS that its lien would attach to the proceeds. The sale of the home brought a greater price than anticipated by the IRS when it filed its original lien. Based on the sale price, the IRS amended its claim to increase the amount of its lien claim to match the proceeds. Mr. Nomillini sought to limit the IRS lien claim to the amount of the original claim. He then brought an action seeking to avoid the IRS lien to the extent that it exceeded the original claim. The lower courts dismissed the case and the 9th Circuit affirmed.

Lien claims not only pass through bankruptcy unimpacted (absent a specific challenge) but the amount of a lien claim can change during or after a bankruptcy as the value of the property increases or decreases. When the IRS filed its original claim in this case, it had to value its lien claim and claim any portion not covered by equity in Mr. Nomillini’s property as an unsecured claim. Here, the value of the secured property turned out to be low either because the IRS made a wrong determination at the outset or because the property continued to increase in value. In either event the debtor does not receive a windfall because of the low value in the initial claim.

Once the property was sold, the value of the property was set and the IRS amended its claim up to the amount of the sales proceeds. The Ninth Circuit joins the lower courts in determining that the IRS has the right to do this. Had the property sold for less than the amount of the lien claim that the IRS made, the value of the lien claim would have decreased rather than increased. For this reason creditors often seek to protect themselves from a downward movement of value in secured property by seeking adequate protection. The IRS does not do this often because of the time involved to seek adequate protection and, in cases in which its lien is secured by real property, because of the difficulty in proving that the property will decrease in value.

The case resolves the issue in a manner consistent with existing law. The lesson here is that the value of a lien claim is not fixed at the time of filing bankruptcy.

The Federal Tax Lien and the Homestead Exemption

The case of In re Selander, No. 16-43505 (Bankr. W.D. Wash. Oct. 19, 2018) pits the bankruptcy trustee against the IRS. The trustee attempts to use a provision in Chapter 7 to take from property secured by the federal tax lien in order to pay his fees and other administrative costs. The IRS argues that when its lien attaches to property claimed by the debtor as a homestead, the provision allowing the trustee to use an asset secured by the federal tax lien does not apply. The case allows for an explanation of B.C. 724(b), in which Congress allows the use of money that would otherwise come to the government because of its secured position to pay unsecured priority creditors, and the interplay between the federal tax lien and the homestead exemption. The bankruptcy court here gets the law right and does a good job of explaining it.

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Mr. Selander filed a Chapter 7 petition on August 22, 2016. The Umpqua Bank filed a claim for over $5 million and the IRS filed one for over $700,000. The bank had liens against the debtor that predated the IRS’s federal tax lien. The debtor owned a ½ interest as a tenant in common of a home in the Seattle area. Other assets may have existed, but the house occupied the attention of the court.

The trustee of the bankruptcy estate found a buyer for the house for a gross sales price of $825,000. After paying off the mortgage, closing costs and the other owner, about $200,000 came to the bankruptcy estate. Washington is one of the states that allows debtors to choose between the federal bankruptcy exemptions in B.C. 522, or its own state-level exemptions, including a pretty generous homestead exemption of $125,000. The debtor elected to receive that amount as his homestead exemption.

The homestead exemption seeks to allow debtors something to get going after bankruptcy as part of their fresh start. While some states provide generous homestead exemptions and other states provide very little, the exemption in all states comes to the debtor subject to the federal tax lien. So, debtors owing federal taxes do not get the benefit of the homestead exemption that the state might intend since the state homestead law lacks the ability to pass property to the debtor in a way that overrides federal law. The operation of the federal tax lien vis-à-vis the homestead exemption has frustrated many debtors and provides one of many reasons to pay down federal tax debt prior to bankruptcy rather than to pay ordinary creditors.

The trustee ordinarily cannot use the homestead amount to pay his fees or to pay the claims of creditors of the estate. B.C. 522 carves the homestead amount out of the estate and gives it to the debtor as property exempt from the estate.

B.C. 724(b) allows the trustee to take an amount that would ordinarily go to the IRS because of the federal tax lien and use that amount to pay unsecured creditors of the bankruptcy estate entitled to priority status. The trustee is one of the creditors entitled to priority status. In the B.C. 724 analysis of Mr. Selander’s bankruptcy estate, nothing would go to the IRS because of the higher priority lien of Umpqua. That higher priority lien and the value of the assets in the estate prevents the IRS from having a secured claim against the estate. Without a secured claim held by the IRS, the trustee could not use B.C. 724(b) to carve out money to pay priority claimants.

Even though the IRS could not take from the estate, it stood to receive the homestead amount. The trustee argued that the payment of the homestead amount should allow the B.C. 724(b) carve out to occur even though the basis for the payment occurred from money not a part of the bankruptcy estate.

The court rejects the trustee’s argument, citing to relevant case law and finding:

There is no conflict between § 724(b) and § 522(k) because those two sections speak to different kinds of property. Section 724(b) involves property of the estate where the IRS holds a valid lien. In this scenario, Congress has made the decision that the bankruptcy trustee may subordinate the secured tax claim to pay administrative expenses. What § 724(b) does not address is the property a debtor removes from the estate by exemption, but still subject to a continuing lien of the IRS. This property is not covered by the plain language of § 724(b), which provides that it only applies to property ‘in which the estate has an interest….’ Exemptions remove property, or a certain value of that property, from the estate. Alsberg v. Robertson (In re Alsberg), 68 F.3d 312, 315 (9th Cir. 1995). Debtor’s Homestead Exemption removed the value of $125,000 from the estate but such exemption was powerless to eliminate the interest of the IRS in those funds claimed with the exemption.

The court noted that in the absence of the federal tax lien, the trustee’s attempt here would be a naked effort to take exempt funds to pay his fees, and that B.C. 522(k) prohibits that action. The bankruptcy court found that by claiming the homestead exemption, the debtor removed the property from both the estate and the application of B.C. 724(b).   It further found that the IRS need not bring a separate action to seize the money in the debtor’s bank account, but that the trustee should remit the $125,000 to the IRS. This victory by the IRS may benefit the debtor if the taxes were excepted from discharge. If the taxes would have been discharged by the bankruptcy, the debtor loses as well as the trustee since the debtor’s homestead exemption turns out to provide him with no benefit. Prior to filing bankruptcy, debtors should check the impact of a federal tax lien if they hope that bankruptcy will allow them to take certain assets with them. Mr. Selander’s case leaves him with a bankruptcy discharge but no major asset to take with him as he leaves bankruptcy.

 

Are Alleged Alter Egos, Successors in Interest and/or Transferees Entitled to Their Own Collection Due Process Rights Under Sections 6320 And 6330? Part 5

Lavar Taylor brings us the fifth installment of his series on Collection Due Process and third parties. Today he addresses strategies in litigating the issues. Lavar promises one more post on the topic after this one. When complete his work on this topic will be the equivalent of a law review article but with a very practical bent. For practitioners with clients who have derivative liabilities, Lavar provides significant insight into the law and the practice of representing parties operating in the dark shadows of the code and administrative practice. Although Lavar does not discuss the issue, it is interesting how the Taxpayer Bill of Rights promises of the right to challenge the IRS position and be heard and the right to appeal an IRS decision in an independent forum intersect with the way that these third parties are treated by the IRS. Keith

In Part 4 of this series, I discussed the questions of 1) how a putative alter ego/successor in interest/transferee of a taxpayer might pursue litigation in the Tax Court to raise the questions of whether they are entitled to Collection Due Process (“CDP”) rights under sections 6330 and 6320 of the Code, independent of the rights of the original taxpayer who incurred the liability, 2) whether the government can take administrative collection action against a putative alter ego/successor in interest/transferee without first obtaining a District Court judgment or making a separate assessment, and 3) whether the Tax Court has the ability to address issues 1 and 2 above, given that no notice of determination is ever issued by the IRS in these situations.

This post addresses the question of how a putative alter ego/successor in interest/transferee of a taxpayer might pursue litigation in the District Court to raise the questions of 1) whether they are entitled to Collection Due Process (“CDP”) rights under sections 6330 and 6320 of the Code, independent of the rights of the original taxpayer who incurred the liability, and 2) whether the government is prohibited from taking collection action against a putative alter ego/successor in interest/transferee of the taxpayer without first obtaining a District Court judgment against the putative alter ego/successor in interest/transferee, based on the arguments set forth in Part 3 of this series.

This post also discusses the factors affecting the decision of whether to litigate these issues in Tax Court or District Court. In addition, this post discusses why assertions of “nominee” status by the IRS are treated differently under the CDP rules.

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1. Litigating in District Court

An alleged alter ego/successor in interest/transferee has always had a remedy in District Court to challenge levy action against them in the form of a wrongful levy action brought under §7426. See, e.g., Towe Antique Ford Found. v. IRS, 999 F.2d 1387 (9th Cir. 1993). These lawsuits, however, have focused on whether the alleged alter ego/successor in interest/transferee was substantively liable for the tax liability under state law.

To the best of my knowledge, there are no reported decisions where the alleged alter ego/successor in interest/transferee has argued that the IRS levy action was improper because the IRS failed to send the alleged alter ego/successor in interest/transferee a separate §6330 Notice of Intent to Levy before taking levy action against them. Nor am I aware of any reported cases where the alleged alter ego/successor in interest/transferee brought a wrongful levy action claiming that the IRS cannot take any administrative collection action against a purported alter ego/successor in interest/transferee prior to the government obtaining a District Court judgment they are liable for the taxpayer’s taxes as an alter ego, successor in interest, or transferee of the taxpayer, based on the theory articulated in Part 3 of this series.

Frequently, the previously unannounced levy action against the alleged alter ego/successor in interest/transferee financially destroys them and deprives them of the resources needed to challenge the IRS’s assertion of liability. Under the law as interpreted by the IRS, the playing field is decidedly tilted in favor of the IRS. While there are undoubtedly many meritorious assertions of liability by the IRS, I am aware of a number cases in which the issue of liability as an alter ego/successor in interest/transferee was at best questionable or debatable. In our now-settled Tax Court case, for example, there was a state Supreme Court decision which made clear that, based on the undisputed facts in our case, it was not possible for our client to be an alter ego of the taxpayer. Yet the IRS, without properly investigating the facts, pursued levy action against our client, with the blessing of Area Counsel’s Office, based on the unsound premise that our client was an “alter ego” of the taxpayer.

Even where a third party is conceding that they are liable as an alter ego, successor in interest, or transferee of the taxpayer under state law, they can bring a wrongful levy action to challenge the procedural validity of the levy action, based on the failure of the IRS to issue a §6330 Notice of Intent to Levy to the third party prior to taking levy action against the third party.  The mere opportunity to seek administrative collection alternatives, such as an installment agreement, or even an offer in compromise based on doubt as to liability, without having to deal with unannounced levy action may often be the difference between financial life and death for an alleged alter ego/successor in interest/transferee.

For these reasons, any alleged alter ego/successor in interest/transferee, even if they agree that they are liable for the taxes assessed against the taxpayer can bring suit, either in District Court or in Tax Court to challenge the failure of the IRS to issue a separate §6330 Notice of Intent to Levy to them prior to taking levy action.   In such a suit they can also challenge the underlying ability of the government to ever take administrative collection action against an alleged alter ego/successor in interest/transferee prior to obtaining a District Court judgment in favor of the government (or prior to making a separate assessment), based on the theory articulated in Part 3 of this series.

Similar options exist to challenge the validity of an alter ego/successor in interest/transferee notice of federal tax lien. A petition can be filed with the Tax Court, although care should be taken to file the petition promptly after the filing of the lien notice, to minimize the risk that such a petition might be deemed untimely by the Court. Such a petition will be subject to the same jurisdictional challenges as a levy petition.

Alleged alter egos/successors in interest/transferees likewise have always had the opportunity to file a quiet title action in District Court, pursuant to 28 U.S.C. §2410 in order to challenge the validity of the tax lien. See Spotts v. United States, 429 F.3d 248 (6th Cir. 2005). There is no reason why an alleged alter ego/successor in interest/transferee could not file a quiet title action in District Court based on the grounds that 1) the IRS failed to give them their own lien CDP rights as required by section 6320 after the filing of the notice of federal tax lien, and 2) the government is not permitted to take collection action against them in the absence of a separate assessment against them or a District Court judgment imposing liability as an alter ego, successor in interest, or transferee of the taxpayer, for reasons outlined in Part 3 of this series.

2. Tax Court or District Court: Making a Choice

If an alleged alter ego/successor in interest/transferee wishes to pursue litigation to challenge the ability of the IRS to levy without first issuing a separate §6330 Notice of Intent to Levy to challenge the ability of the IRS to take administrative collection action against a purported alter ego/successor in interest/transferee, choosing between Tax Court and District Court as a litigation forum can be difficult. District Court offers a forum where the court clearly has jurisdiction to rule on the issues at hand. District Court also is much quicker than Tax Court. Indeed, in our now-settled case, at the time of the settlement, the IRS’s motion to dismiss the petition for lack of jurisdiction had been pending with the Tax Court for over 12 months without any opinion being issued.

District Court Judges, however, often lack even basic familiarity with tax laws in general and with CDP laws in particular. Tax Court Judges have significant expertise in tax law and regularly deal with CDP procedures in their cases. They certainly have more expertise in determining the extent of their own jurisdiction than do District Court Judges. Page limitations on filings in District Court may hamper the ability of an alleged alter ego/successor in interest to fully brief all of the issues, which are complex and arcane, even to the most dedicated tax procedure junkies.

In addition, once the Department of Justice acquires jurisdiction over a case, settling that case can become much more difficult. There can be a dramatic difference in the levels of approval needed to settle a case with the Office of Chief Counsel and the levels of approval needed to settle a case with the Department of Justice.   See the Department of Justice Tax Division Settlement Reference Manual. Furthermore, the differences between the rules governing discovery in Tax Court and the rules governing discovery in the District Court generally make it far more expensive to litigate in District Court than in Tax Court.

An alleged alter ego/successor in interest/transferee who ventures into District Court in a wrongful levy action or a quiet title action also faces the possibility that the Department of Justice will seek an affirmative judgment against them, including a judgment for the foreclosure of real property owned by the alleged alter ego/successor in interest/transferee which the government contends can be reached in an effort to satisfy the taxes owed by the taxpayer. No such counterclaims can be filed by the government in Tax Court litigation; IRS must refer the matter to the Department of Justice for a separate lawsuit.

Yet, until the Tax Court has issued an opinion in this area, anyone who chooses Tax Court as their litigation forum currently faces the possibility that the Tax Court will eventually dismiss their petition for lack of jurisdiction in a way that fails to resolve the underlying question of whether alleged alter egos/successors in interest/transferees are entitled to their own independent CDP rights or whether the IRS may ever pursue administrative collection action against an alleged alter ego/successor in interest/transferee without first obtaining a District Court judgment. And however the Tax Court rules on this issue, the Tax Court’s ruling can be appealed to the relevant Court of Appeals.

The specific facts in each case will also be an important factor, as will the proclivities of the local District Court Judges. The rulings of the District Courts can also be appealed to the relevant Court of Appeals, but there will never be any appeal on the issue of whether the District Court lacks jurisdiction over such a suit, as long as the suit is brought within the applicable statute of limitations for wrongful levy actions and quiet title actions. (The statute of limitations for wrongful levy actions is now two years. 26 U.S.C. §6532(c). The statute of limitations on quiet title actions is six years. See Nesovic v. United States, 71 F.3d 776 (9th Cir. 1995). )

3. The Long, Hard Road Ahead

Given the circumstances described in this series of posts, it is likely to be quite some time before there is a definitive answer to the questions of whether alleged alter egos/successors in interest/transferees are entitled to their own independent CDP lien and levy rights and whether the IRS may ever take administrative collection action against a putative alter ego/successor in interest/transferee without first obtaining a District Court judgment or making a separate assessment. The speed at which the case law develops will depend in large part on how the Tax Court rules in its first published opinion on these issues. If the Tax Court rules that it has jurisdiction, that holding will drive litigation of these issues to the Tax Court. The IRS will then likely appeal the Tax Court’s holding(s) to multiple Courts of Appeal, possibly leading to a split in the Circuits and Supreme Court review of the issue(s) that split the Circuits.

If the Tax Court holds that it lacks jurisdiction but refuses to follow Adolphson and holds adversely to the government on the procedural issues in dismissing the petition for lack of jurisdiction, this holding will also drive litigation to the Tax Court. This will likely be followed by government appeals to multiple Courts of Appeal and possibly an eventual Supreme Court ruling in this area.

If the Tax Court holds that it lacks jurisdiction and follows Adolphson, a few brave hardy souls may continue to litigate in Tax Court, with the idea of taking their cases to the relevant Courts of Appeal But most litigation involving these issues will be driven to the District Courts, many of which may be reluctant to second guess the Tax Court’s holding on the jurisdictional issue. But the District Courts will still be able to rule on the substantive CDP issue, as well as on the issue of whether the government is required to obtain a District Court judgment (or make a separate assessment) against purported alter egos/successors in interest before the government can take collection action against them.

One or more of these issues are likely to end up being argued before the Supreme Court, absent any future legislative action by Congress. But it is likely to be a number of years before that happens.

4. “Nominee” Liens and Levies- Why The CDP Rules Are Different

In writing this series of posts, I have purposefully avoided including “nominee” liens and levies within the scope of my discussion of the extent to which the CDP provisions may be invoked by third party non-taxpayers against whom the IRS is pursuing collection action to collect taxes owed by the original taxpayer. Putative “nominees” are different from putative alter egos/successors in interest/transferees in that “nominees” are not themselves personally liable for the tax liability. Rather, a true nominee holds “property or rights to property” of a taxpayer as the agent of the taxpayer.   They are not personally liable for the tax. This distinction is critical for purposes of determining the rights of putative “nominees” under the CDP procedures.

In Part 1 of this series I noted that there are important differences between §§6320 and 6330, and their counterparts, §§ 6321 and 6331. Section 6321 imposes a lien against all “property and rights to property” of a person who is “liable for the tax.” Thus, there must be a personal liability for a tax obligation before a lien can arise against a person’s “property or rights to property” under §6321.

The language of §6320 makes clear that a lien CDP notice is only required to be sent to the “the person described in section 6321,” i.e., a person who is personally liable for the tax. Thus, a putative nominee of the taxpayer is not entitled to notice under §6320 and cannot invoke the lien CDP procedures if the IRS files a “nominee” notice of federal tax lien. Note, however, that a true “nominee” notice of federal tax lien should make clear that the IRS lien only attaches to the specific property, real or personal, which the putative nominee is supposedly holding as an agent of the taxpayer. As I will discuss in Part 6 of this series, virtually all “nominee” notices of federal tax lien flunk this test.

Section 6331, on the other hand, authorizes the IRS to levy on all “property and rights to property” of a person who is personally liable for a tax and to levy on all property on which there is a tax lien. Thus, it is possible that the IRS could levy on property that is possessed or owned by a third party which the IRS claims is encumbered by a tax lien, even though the person who possesses or owns that property is not personally liable for the tax.

Section 6330 provides that “[n]o levy may be made on any property or right to property of any person” unless notice is given to “such person” under §6330. Importantly, §6330 uses the phrase “any person,” not the phrase “person liable for the tax.” Section 6330 also does not refer specifically to the “person” described in §6331(a). I personally believe that this a distinction with a difference, and that Congress intended for any person who has a facially recognizable possessory or ownership interest in property under state law upon which the IRS intends to levy is entitled to notice under section 6330 and thus is entitled to invoke the collection due process procedures.

But the IRS thinks otherwise, and issued regulations which define the term “person” in §6330 as the “person liable for the tax.” Treasury Regulation §301.6330-1(a)(3), Question and Answer 1. If this regulation is valid, only persons who are personally liable for the tax are entitled to notice under §6330 and may invoke the CDP levy procedures. No true “nominees” can invoke CDP levy procedures under the IRS’s interpretation of the law.

If the cited Treasury Regulation is struck down as being inconsistent with the statute, however, true nominees would be entitled to notice under §6330 and would be entitled to avail themselves of the CDP levy appeal process. I believe this regulation is inconsistent with the statute. The phrase “any person” is about as broad as you can get, and the contrasting language of §6320 supports the conclusion that Congress’ use of the phrase “any person” in section 6330 was deliberate. Limiting the availability of the levy CDP appeal procedures to persons who are personally liable for the tax is contrary to the language of the statute.

I leave a more detailed analysis of why I believe that this regulation is not valid for another day. Suffice to say that anyone who is the subject of true nominee collection action, where the IRS merely claims that the property held by or ostensibly belonging to a third party on which the IRS has levied is being held by the third party putative nominee for the benefit of the taxpayer and is not asserting that the third party is personally liable for the taxes owed by the taxpayer, will have to convince the Court that this regulation is invalid should they bring an action in Tax Court or District Court to challenge the IRS “nominee” levy action on the grounds that the IRS failed to issue a §6330 Notice of Intent to Levy to the third party prior to levying on property owned or held by the third party.

Because alleged “nominees” are in a more perilous legal position than alleged alter egos/successors in interest/transferees when it comes to invoking the CDP procedures, It may be that the IRS will, in the future, show a greater interest in pursuing “nominee” collection activity as opposed to pursuing “alter ego/successor in interest/transferee” collection activity.   I have seen some evidence of this here in southern California, after the IRS read our pleadings in our now-settled case.

My experience is that many people in the IRS throw around the terms “alter ego,” “transferee,” and “nominee” like these terms are interchangeable body parts. Of course, nothing could be further from the truth. Alter egos and transferees are personally liable for the taxpayer’s taxes, based on applicable state law. Under California law, for example, the legal test for holding a third party liable as an alter ego is different from holding a third party liable as a transferee. The legal test for holding a third party liable as a successor in interest is likewise distinct from the tests for imposing liability as an alter ego or transferee. Nominees are not personally liable for the taxpayer’s tax liability.

Private practitioners should be prepared to call out the IRS if it attempts to sidestep efforts to hold the IRS accountable under the CDP provisions by improperly labeling all third party collection action as “nominee” collection action.

I have one more post to add to this series of posts. In Part 6, I will explain why virtually all IRS “nominee” notices of federal tax lien are improper in a way which can cause legal detriment to the alleged nominees. I have also seen a “transferee” notice of federal tax lien with this same impropriety. In addition to explaining the impropriety, I will offer a suggestion to the IRS on how it can cure this impropriety.

 

Revisiting Craft

It has been almost four years since I wrote a post on United States v. Craft, 535 U.S. 274 (2002). At the time I wrote the last post, a circuit split existed on how to value the interest of the spouses in a tenancy by the entirety. The IRS argues for a 50/50 valuation whereas some taxpayers argue for a valuation based on the actuarial interest of each of the spouses. The issue has been quiet recently, perhaps because of the lack of IRS activity in the area based on its diminished capacity or perhaps because the cases that have moved forward have all involved situations in which the 50/50 split favors the spouse who does not owe the tax. In United States v. Gerard, 121 AFTR 2d 2018-640 (N.D. Ind. April 9, 2018), another court voiced an opinion on how to split the proceeds.

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Robert and Cynthia Gerard bought a home in Indiana in 1990 as tenants by the entirety. Over 90% of the purchase of the property has been paid by Robert. From 2003 to 2008, Cynthia owned a business treated as a sole proprietorship and incurred employment taxes which remain unpaid. In 2012, following in the footsteps of the Crafts, Robert and Cynthia conveyed, by gift, the property to Robert individually. I am guessing they had not read the Supreme Court’s opinion at the time they decided to make this transfer and they may have thought that it would magically remove the federal tax lien from the property.

They argue that at the time of the transfer her interest was worth much less than his because he had contributed the lion’s share toward the purchase of the property and her business had been a net drain on the family finances. They further claim that the property was transferred due to her health and the need for Robert to manage her affairs.

The case involves a fight about the amount owed as well as the extent of the federal tax lien on the property. With respect to the amount owed, the Court found that Cynthia owed $60,969.04 plus statutory accruals, resolving that aspect of the case and then turned to the lien.

The Gerards argued that Robert was a purchaser when the property was transferred to him from joint ownership. That argument flies in the face of the statute. IRC 6323(h)(6) defines a purchaser as:

“a person who, for adequate and full consideration in money or monies worth, acquires an interest (other than a lien or security interest) in property which is a valid under local law against a subsequent purchaser without actual notice.”

Despite the deed of gift, the Gerards argue that Cynthia’s use of joint marital assets in connection with her business formed the basis for meeting the full and adequate consideration test. The IRS argued that the deed itself stated it was transferred “without any consideration other than love and affection.” It further argued that even if the language of the deed prepared by the Gerards does not control the transfer, the consideration they offer is past consideration which is insufficient to meet the test of adequate consideration. The Court agreed with the IRS on the issue of past consideration and determined that Robert was not a purchaser.

Having determined Robert did not purchase the property from the joint tenancy, the remaining dispute centered on the extent to which the liens attached to the property. The Gerards contend that Cynthia’s interest in the property was something less than half of the property and the federal tax lien only attached to her smaller interest. The arguments regarding who has what interest in the property usually stem from an application of the actuarial tables and usually occur when the husband owes the money and the actuarial tables show that the wife has the greater life expectancy. Here, the argument builds around the husband’s contribution toward the purchase of the property. The IRS argues that they each have a 50% interest and that’s what the court found that Indiana law supports. The court cites Indiana case law in support of the position that husband and wife each become owner of half of the property.

In addition to the several cases involving Indiana law, the court cited the earlier Craft decisions from the Third and Sixth Circuits, supporting a 50/50 split of the value of the property.  So, the court concludes that the lien against Cynthia attaches to her 50% interest in the property.  I was curious that I had not seen the Craft issue in some time and felt there must be cases decided since my last post.  My research assistant found the following cases which may benefit someone concerned with this issue: United States v. Tannenbaum, 2016 WL 4261755 (E.D.N.Y. 2016)United States v. Bogart, 715 Fed. Appx. 161 (3d Cir. 2017); United States v. Cardaci, 856 F.3d 267 (3d Cir. 2017); In re Conrad, 544 B.R. 568 (Bankr. D. Md. 2016); and United States v. Born, 2016 WL 1239219 (D. Alaska 2016).

The third issue in the case involves whether the court should allow the IRS to foreclose its lien and sell the property giving Robert a monetary amount equal to his interest in the property based on the sale. Although it initially sought summary judgment on this issue, the IRS backed away from that request and argued that the decision to foreclose required the gathering of facts. Such facts would be necessary in order to make a United States v. Rogers, 461 U.S. 677 (1983) determination that foreclosure properly serves the interests of all parties in this situation. So, the amount of the liability is now known, the extent of the lien in the property is known, and all that remains to learn is whether the court should order foreclosure or defer it based on the Rogers factors.

 

 

Innocent Spouse Status versus the Federal Tax Lien

The case of United States v. Kraus, No. 3:16-cv-5449 (W.D. Wash. April 3, 2018) demonstrates the problems that can occur when your spouse engages in tax protestor action even if you were “innocent.” The result here for the wife is the loss of her home, even though she has no personal liability for the unpaid tax. She argues that such a result renders her innocent spouse status somewhat meaningless; however, the court points out that innocent spouse status relieves the individual of personal liability but does not destroy the federal tax lien or the remedies available in connection with the lien.

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Ms. Lao married Mr. Kraus in 1988. At the time of the decision, they had three children ages 16, 24, and 27. During almost all of the marriage, Mr. Kraus earned the money used by the couple and she took care of the family. He handled all of the family finances, including tax filing, and gave her an allowance for household expenses. He stopped filing taxes in 1999, claiming that only federal employees need file tax returns. He ran a jewelry business with his brother. When the IRS audited the business and him individually, he did not engage in the audit, causing the agent to determine taxable income without the benefit of his assistance. As a result, the agent determined a huge liability because of the lack of expenses to offset the income. In addition to owing taxes for the years of non-filing, Mr. Kraus had numerous frivolous filing penalties for his tax protestor submissions to the IRS in response to its correspondence.

The couple sold their prior residence in 2003 and purchased a new home. At the time of the suit to foreclose, they had almost completely paid off the home. Mr. Kraus had also “transferred” the home to a trust though the couple and their children continued to live in the home, make all decisions related to the home, and pay all of the bills. Mr. Kraus told Ms. Lao that the transfer to the trust was for estate planning purposes and to protect the property from frivolous suits.

The couple was divorced in 2010 and she began working at a retail store. Mr. Kraus continued to live in the marital home and they split the bills. When the tax situation arose, she applied for and received innocent spouse status under IRC 66, since Washington is a community property state. Despite her innocent spouse status, the IRS sought to foreclose its lien on the property owned by the couple. The court quickly brushed aside the fraudulent transfer and determined that the lien attached to the property. Ms. Lao argued that allowing the IRS to foreclose on the house would render her IRC 66 relief “an empty shell of false security.” The court responded that IRC 66 relief does not entitle her to prevent foreclosure. “While innocent spouse relief prevents the assessment of a tax against Lao individually in any separate property she may possess, it does not affect the ability of the Government to pursue collection remedies against Lao’s interest in community property.” Under Washington law, “all debts of each spouse that are acquired during the marriage attach to the marital community as a whole and one spouse’s tax liabilities are presumed to be community debts if they are incurred during the marriage.”

Even if she obtained a separate property interest after the divorce, she took that interest subject to the preexisting liens or mortgages. “Any separate interest that Lao possesses in the subject property must lie in the equity that exceeds the preexisting mortgage and liens.”

The court finds an open question of whether the lien could continue to grow after her interest in the property separated from the marital community. The court said that interest accruing after the divorce may only attach to his separate property and requested additional briefing on this point. It appears that the IRS will obtain permission to foreclose on the entire property and sell it, leaving her with money from the sale but no home where she and the children, one of whom is a minor, have lived for 15 years. I was surprised that the court did not apply the equitable factors in United States v. Rogers, 461 U.S. 677 (1983) to decide whether selling the home under these circumstances was appropriate. Applying the factors in that case might cause the court to pause in making the decision to sell the property at this time – at least until the youngest child reaches the age of majority.

The case demonstrates the limits of innocent spouse status. Being an innocent spouse does not stop the IRS from taking collection action that can have a negative impact on the innocent spouse where property interests of the non-liable spouse remain intertwined with the liable spouse. While she will receive some equity from the sale of the home, this situation causes her to lose her home despite being innocent of the actions causing the liability.

For those interested in the power of the federal tax lien, the Pro Bono & Tax Clinics committee of the ABA Tax Section will host a panel discussing Kraus and other lien cases at the May Meeting in D.C. next week. Christine