Protecting Trust Assets from the Federal Tax Lien

Abstract

One common issue facing those who create trusts is how to protect beneficiaries from creditors. One of the biggest, baddest creditors out there is the Internal Revenue Service (IRS or Service), wielding two weapons of mass collection: the federal tax lien and the federal tax levy. These weapons regularly pierce boilerplate spendthrift provisions. Discretionary trusts do not fare much better. Court decisions over the past ten years make it increasingly likely that even pure discretionary trusts contain clauses that traitorously turn over the treasure house keys to the federal tax lien. Once the lien attaches, the IRS can enforce it through either administrative or judicial attachments, blowing through state law barriers that keep out other creditors.

This Article offers some ideas on how to keep the federal tax lien locked out from trust assets using property law concepts of springing and shifting executory interests. This Article posits that a properly drafted tax lien lockout provision can deflect the federal tax lien. Moreover, tax lien lockout provisions can do this in the context of a support trust, thus allowing settlors to give enforceable directions to their trustees and to avoid the potential downsides of pure discretionary trusts. In short, tax lien lockout provisions can protect trust assets from the long and mighty arm of the IRS while preserving a client's wish to hold trustees to clear standards of behavior towards beneficiaries.

This Article proceeds in three parts. Part II illustrates the limited role that state law plays in controlling the scope of tax liens and in protecting non-delinquent third parties from the effect of the lien. It explains the basics of the federal tax lien, focusing on the relationship between state and federal law and the two key methods by which the IRS enforces the lien: the administrative levy and the lien foreclosure suit. Part III introduces a basic hypothetical involving a fictitious elderly widower who wants to create a trust for his kids and grandkids. Part III then uses this hypothetical to illustrate why spendthrift provisions offer no protection from federal tax liens and why it is likely that neither discretionary nor protective trusts do much better. Finally, Part IV looks at how Texas law regarding shifting executory interests might provide an opportunity for the well-advised settlor to craft trust provisions that can lock out the federal tax lien when a beneficiary encounters either expected or unexpected tax difficulties.

Keywords: NFTL, notice, tax, lien, levy, creditors, trusts, estates, spendthrift, sprinkling, discretionary, trustees, tax procedure, tax evasion, tax avoidance, assets, asset protection, IRS, tax administration

JEL Classification: H26, K19, K34, K39, K42, K49