We welcome back guest blogger Matthew Hutchens of the University of Illinois Gies College of Business. With co-author Erin Stearns, Hutch recently updated the lien and levy chapters of Effectively Representing Your Client Before the IRS. In today’s post, he examines a recent Fifth Circuit opinion in which niche questions of Louisiana law will determine whether plaintiffs can sue to recover their levied inheritance. Christine
I.R.C. § 7426(a)(1) provides that if the IRS levies upon property claimed by a third party who has “an interest” in such property to collect the taxes of someone else, that third party can bring a suit in federal district court to recover the property. In Goodrich et al. v. United States, No. 20-30422 (5th Cir. 2021), the United States Court of Appeals for the Fifth Circuit tackled the question of what qualifies as “an interest” that would allow a third party to bring a wrongful levy suit to recover property levied to satisfy the debt of another taxpayer.
Ultimately, the court adopted the definition used by several other Circuits, including the Seventh, Ninth, and Eleventh, that “an interest” in the context of a wrongful levy suit requires the third party to hold “a fee simple or equivalent interest, a possessory interest, or a security interest in the property levied upon.”
The court also explained that whether an interest exists is a jurisdictional question, because without an interest in the levied property, I.R.C. § 7426(a)(1)’s waiver of sovereign immunity does not apply—depriving the court of subject matter jurisdiction to hear the claim.
The case also reminds us that while the determination of what ownership interest qualifies a third party to bring a wrongful levy suit is a question of federal law, whether an ownership interest actually exists (i.e., what does the third party own) is determined by state property laws. And, thanks to Louisiana’s French history and civil law influences, the Goodrich case involves some state law property issues and terminology that will look quite foreign to most federal tax practitioners.
Facts of the Case
The taxpayer, Mr. Goodrich, passed away with significant federal tax debts. At the time of his death, Mr. Goodrich had a lifetime usufruct over various properties he had previously inherited from his deceased spouse. A usufruct is the right to enjoy the use of property during the term of the usufruct (similar to the common law life estate, but the duration can be shorter than a lifetime). Mr. Goodrich’s three children were the naked owners of the property subject to his usufruct. A naked owner owns the property, but they do not have the full rights to use the property. At the end of the usufruct, all the rights to the property revert to the naked owner, similar to a remainder interest at common law.
The properties at issue where Mr. Goodrich held a lifetime usufruct with the children as naked owners were: 1) mineral rights, proceeds of which were deposited in the estate bank accounts after Mr. Goodrich’s death; 2) furniture that was sold as part of an estate sale (including a master bathroom towel rack that somehow fetched $1,200); and 3) shares of stock that Mr. Goodrich had sold years earlier.
Sometime after Mr. Goodrich passed away, the IRS issued a levy to Mr. Goodrich’s estate bank accounts. At this point, an attorney for the estate argued to the IRS revenue officer via a phone conservation and a letter that the children owned all of the cash in the accounts, with Mr. Goodrich’s ownership rights having ceased at death and all rights reverting to the children as naked owners. However, the IRS did not release the levy and collected approximately $250,000 from the accounts, prompting the children to file the wrongful levy suit.
With regard to the mineral rights income and furniture sold after Mr. Goodrich’s death, the district court agreed with the children that upon Mr. Goodrich’s death (and the termination of the usufruct), they became the full owners of the usufruct property. Thus, the proceeds of from the mineral rights and the proceeds from the sale of the furniture both occurring after Mr. Goodrich’s death belonged to the children—entitling the children to a return of those levied proceeds.
However, the mineral rights and the furniture existed at the time of Mr. Goodrich’s death. More complicated were the shares of stock that Mr. Goodrich had held as usufruct that were sold prior to Mr. Goodrich’s death. The appeal to the Fifth Circuit focused on those stock shares.
As previously mentioned, Mr. Goodrich had inherited these shares as a usufruct from his deceased spouse. And, by the terms of his spouse’s will, Mr. Goodrich was allowed to sell or otherwise dispose of the shares during his lifetime. However, the will also stated that in the event of a disposition, the usufruct would not terminate but would attach to the proceeds of the disposition, including their reinvestment.
Further, under Louisiana law dealing with usufructs where the property is consumed or disposed of, when the usufruct ended Mr. Goodrich was bound “either to pay to the naked owner the value that the things had at the commencement of the usufruct or to deliver to him things of the same quantity and quality.” So, at Mr. Goodrich’s death, the children were entitled to something to compensate them for being deprived of the stock shares. But, what was the exact ownership interest that they had? And, would it rise to the level of “an interest” for purposes of bringing a 7426(a)(1) action?
Legal Dispute & Open State Law Questions
The children argued unsuccessfully at the district court that they were entitled to an amount of cash equal to the sales proceeds from when Mr. Goodrich sold the shares of stock (i.e., the children argued that they owned the cash in the estate bank accounts up to the share sales price). The district court instead determined that the children were unsecured creditors of the estate in an amount equal to the stock sales proceeds, making the levy on the bank accounts proper (since the IRS enjoys statutory priority over unsecured creditors when a tax lien arises as a matter of law). And, because the estate had insufficient funds to pay the entire tax debt, the children, as unsecured creditors, would receive nothing from the shares Mr. Goodrich previously sold (one might say they lost their shirt as naked owners).
The children appealed, and the Fifth Circuit found that determining the relationship of the children as naked owners vis a vis the estate at the termination of the usufructuary to be unresolved by existing Louisiana law. The court also found it appropriate to certify to the Louisiana Supreme Court the question of what the children as naked owners owned upon the termination of the usufruct where the property was previously disposed. So, the Fifth Circuit certified the following questions to the Louisiana Supreme Court:
- Does a usufructuary’s testamentary usufruct of consumables render naked owners unsecured creditors of the usufructuary’s succession?
- If not, what is the naked owner’s relationship to those consumables?
The Louisiana Supreme Court’s resolution of these property law questions remains pending as of this writing. Ultimately, the resolution of these questions may not be very broadly applicable (only two states, Louisiana and Georgia, recognize usufructs). But, the case is an important reminder of what the Supreme Court said 36 years ago in United States v. National Bank of Commerce, 472 U.S. 713, 722 (1985) about federal tax levies: “[T]he federal statute ‘creates no property rights but merely attaches consequences, federally defined, to rights created under state law.”