Failure to pay federal income taxes could result in a tax lien against you and your property. In the case of an individual, such a lien is pretty straight forward. If the individual owns a house and the IRS records a lien at the registry of deeds, that lien prevents the owner from selling the house without first paying the IRS.
But what if the house is not owned by the taxpayer? What if, instead, the house is owned by a trust? Here things get a little less straightforward.
According to the IRS Revenue Manual, the question of whether a tax lien attaches to real estate owned by a trust is largely determined by the validity of the trust.
When the taxpayer himself creates the trust (i.e., when he is the grantor/settlor):
If the taxpayer is the grantor or settlor of a trust, the validity of the trust must be determined under applicable state law. If the grantor reserves a substantial interest or unrestricted control over the management of the operations that is not for the benefit of the purported beneficiary, the grantor remains the owner of the property and the trust will be ignored. For example, property in a family trust that is a sham – the grantors attempt to reduce their taxes by putting the property in trust, while retaining the use and benefits of the property – is subject to collection action to satisfy the grantors‘ liability. Whitesel Family Estate v. United States, 84-2 U.S. Tax Cas. (CCH) ¶ 9890 (S.D. Ohio 1984); Edwards Family Trust v. United States, 572 F. Supp. 22 (D. N.M. 1983).
When the taxpayer is the trust’s beneficiary (i.e., the person who receives the benefit of trust assets):
If the taxpayer is the beneficiary of a trust, a federal tax lien will attach to the taxpayer’s beneficial interest in the trust. This determination is made by reference to the trust instrument itself, with the appropriate state law governing construction of the terms of the instrument or the resolution of any ambiguities in the instrument. In some cases the lien will attach to the corpus of the trust [i.e., real estate] and the income payable to the beneficiary. In other cases the lien will attach only to the income as it becomes payable to the beneficiary, and in a few cases it may not attach to either the income or the corpus. The latter situation may arise where the trustee has the unrestricted power of disposition of the trust income; i.e., where he/she may legally refuse to make any further distribution to the taxpayer-beneficiary and instead make the distribution to other beneficiaries or simply accumulate the income.
The IRS advises taxpayers to seek help from attorneys in their states when forming trusts or dealing with property that may be encumbered by a federal tax lien.
The issue was considered by the Massachusetts Appeals Court in Zuroff v. First Wisconsin Trust Co., 41 Mass. App. Ct. 491. In Zuroff the court concluded that a federal tax lien against an individual did not constitute a lien on her residence because she held the real estate as a trustee. This was the case despite the fact that she transferred the property from herself individually to herself as trustee just prior to the recording of the tax lien.
The court noted,
The reach of a Federal tax lien is determined largely by State law, which defines what constitutes property or rights…to property…It is axiomatic, under Massachusetts law, that property that one holds as trustee is not subject to payment of the trustee’s personal debts: the plaintiffs do not argue otherwise. Rather, they argue, the special incidents of a nominee trust make a beneficiary’s interest in many cases subject to the payment of his or her debts…For purposes of decision we can assume that the IRS could have reached [the taxpayer’s] fifty-one percent equitable interest to apply to payment of her tax liabilities. It does not follow, however. that the Federal lien attached to [the taxpayer’s trust]so as to enable the IRS to reach it in the hands of a purchaser for value…Moreover, because [the taxpayer] individually transferred the trust property to Pamela, trustee, before the Federal tax lien was filed against her, nothing in the trust property’s record history would indicate that a lien filed against [her] individually would encumber the trust property.
It’s important to note that the court added,
The [taxpayer’s trust] is typical of nominee trusts, in that the names of the beneficiaries were filed with the trustee but not in the registry of deeds…Thus, the fact that [the taxpayer] was a beneficiary of the trust was not a matter of public record.
If her interest as a beneficiary were made public by recording the trust at the registry of deeds (which is done occasionally) would that have changed the court’s decision? That’s still unclear.
The bottom line is that you should be extremely cautious when buying a house from a trustee or trust beneficiary if there is a tax lien against them.
The decision as to whether the lien affects the property should be made by the title insurance underwriter who represents the title insurance company that will be covering you in case there is a problem after the purchase.
Law Office of Justin R. McCarthy 