Lesson From The Tax Court: The Tax Liabilities You Leave Behind

We all know you can’t take it with you.  But what happens to the “it” after you die?  Ideally, you will have paid all your debts, and your Estate will distribute your “it” to the objects of your affection. The IRS will probably not be one of the objects of your affection.

However, few of us do everything ideally.  If you leave behind unpaid tax obligations, Congress has ensured that the federal government gets priority over the objects of your affection.  And tax claims also take priority over most other creditors.  But most is not all.  Some creditors get paid before the Tax Dude.  Thus, if your unpaid tax obligations exceed the assets in your Estate, then the objects of your affection will take bupkis ... unless they also happen to be one of the few types of creditors that get priority over the unpaid taxes.

That is what we learn from Estate of Anthony K. Washington v. Commissioner, T.C. Memo. 2022-4 (Feb. 2, 2022) (Judge Toro).  There, the decedent died with unpaid federal tax liabilities that exceeded the assets in his Estate.  The decedent’s ex-wife tried to convince the Tax Court that her claim against the Estate took priority over the tax claim.  Alternatively, she argued that the IRS erred when it did not account for her claim in evaluating the Estate’s Offer In Compromise (OIC), because ignoring her claim simply was not fair because paying the tax claim would leave the Estate with nothing.

Both arguments failed.  The case teaches us a lesson about the federal tax lien and about the difficulty Estates face in obtaining OICs.  Details in the usual space, below the fold.

Law:  Tax Liens and Priority
In general, a lien is just a formalized claim against something.  You can think of it as a charge or encumbrance that one person has on the property of another.  I like to think of it as a flock of virtual sticky notes that say “Pay Me” and as they fly around, they stick on various properties of the debtor.

One of the Service’s key collection tools is the federal tax lien.   Section 6321 provides:

“If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto) shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.”

Note this important point: the federal tax lien arises automatically by operation of law.  All the IRS has to do is (1) assess the tax and (2) send notice and demand for payment to the taxpayer’s last known address.  Then, once the taxpayer fails to pay, the federal tax lien arises and flies through the sky, landing on all the taxpayer’s property and rights to property.

But the tax lien is invisible.  No one knows it’s out there.  And it may not be the only lien against a taxpayer's property.  Other creditors may have claims.  The question then arises, who gets first dibs on the taxpayer’s property?  That is, what is the relative priority of the various claims, or liens?

The basic rule is “first in time, first in right.”  United States v. City of New Britain, 347 U.S. 81 (1954).  If that were the only rule, the federal tax lien would defeat all later arising claims on the taxpayer’s property, even while still in its secret state.

However, Congress allows certain competing creditor liens to take priority over the tax lien even when the tax lien arises first.  It has created an exception to the first in time rule in §6323.

Section 6323 provides that the federal tax lien “shall not be valid as against any purchaser, holder of a security interest, mechanic’s lienor, or judgment lien creditor until notice thereof which meets the requirements of subsection (f) has been filed by the Secretary.”  These four types of creditors (the “four horsemen”) are thus protected to the extent they perfect their liens before the NFTL is filed.  That is, while the general rule for lien priority is first-in-time-first-in-right, that rule is modified for these four horsemen, whose claims will beat the federal tax lien, when the lien is still in its secret state.

The common error I hear over and over is that people think their claims beat the IRS because there is no tax lien until the IRS has “filed its lien.”  Folks, the IRS does not “file its lien.”  The lien is out there, floating around, once the IRS simply assesses the tax, sends notice and demand, and the taxpayer fails to pay.  What the IRS must do, however, is make the lien public by filing a document giving public notice of the federal tax lien.  That document is called, logically enough, a Notice of Federal Tax Lien (NFTL).   The NFTL brings the lien to light, not to life.

That is a crucial point of law for today’s lesson.

Law: The ETA OICs
An OIC is an alternative to full payment of tax.  I gave a brief overview of its history last week in Lesson From The Tax Court: The Proper Baseline For Offers In Compromise, TaxProf Blog (February 14, 2022).  While taxpayers are sometimes able to compromise their liability based on a doubt as to their actual liability, most OICs revolve around an analysis of the taxpayer’s “Reasonable Collection Potential” (RCP).  RCP consists of what the IRS believes the taxpayer can raise by (1) selling assets and (2) using the taxpayer’s disposable future income over some period of time.  Asset values are often discounted by some percentage to reflect the costs of quickly selling them.

From last week readers will recall that the RCP may either smaller or larger than the full amount of taxes owed.  If smaller, the IRS will generally require any OIC to match the RCP.   Sometimes, however, a taxpayer may be able to show special circumstances that justify acceptance of an offer amount even lower than the RCP.  Those are called DATC-SC offers.  See IRM 5.8.4.2 (05-10-2013).   If the RCP is larger than the full pay amount, then the IRS will generally require the taxapayer to fully pay.  Sometimes, however, a taxpayer may be able to show special circumstances that justify acceptance of offer for less than the full amount owed even when the taxpayer can, in theory, fully pay.  Those are called Effective Tax Administration (ETA) OICs.

As currently set out in Treas. Reg. 301.7122-1(b)(3), there are two types of ETA OICs: economic hardship and non-economic hardship.

First, Treas. Reg. 301.7122-1(b)(3)(i) permits the IRS to grant a taxpayer an ETA OIC based on economic hardship: “A compromise may be entered into to promote effective tax administration when the Secretary determines that, although collection in full could be achieved, collection of the full liability would cause the taxpayer economic hardship within the meaning of §301.6343-1.”  Treas. Reg. 301.6343-1, in turn, provides rules for deciding when a taxpayer’s economic hardship justifies the release of a levy.  It says that a levy should be released if enforcement of the levy would leave the taxpayer “unable to pay his or her reasonable basic living expenses.”

While this sounds a lot like the RCP standard, it is different in that here the IRS is allowing for adjustments based on factors that do not enter into the RCP calculation.  For example, while a taxpayer’s home might be an asset for RCP purposes, the forced sale of the home might displace the taxpayer’s elderly and frail parent and render the taxpayer unable to care for the parent.

The regulation (subsection (c)(3)(iii)) gives this example of economic hardship:

“The taxpayer is retired and his only income is from a pension. The taxpayer's only asset is a retirement account, and the funds in the account are sufficient to satisfy the liability. Liquidation of the retirement account would leave the taxpayer without an adequate means to provide for basic living expenses. The taxpayer's overall compliance history does not weigh against compromise.”

Second, Reg. 301.7122-1(b)(3)(ii) allows for a “non-economic hardship” ETA OIC.  That is, even if a taxpayer does not otherwise qualify for an OIC, “the IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability.”  Notably, the regulation puts it on the taxpayer to “demonstrate circumstances that justify compromise even though a similarly situated taxpayer may have paid his liability in full.”

The regulation (subsection (c)(3)(iv)) gives this example of this second type of ETA OIC: a taxpayer who has a “serious illness that resulted in almost continuous hospitalizations” for 12 years during which period the taxpayer failed to file returns but, after the 12 years “the taxpayer's health has now improved and he has promptly begun to attend to his tax affairs.”  Meanwhile, the IRS had assessed not only taxes but interest and penalties.  The example implies that the IRS would at least compromise out the interest and penalties.

Note that ETA OICs are thus only available for taxpayers whose RCP shows they can fully pay their liability.  See Murphy v. Commissioner, 125 T.C. 301, 320 (2005) (Treas. Reg. 301.7122-1(b)(3) requires ability to fully pay as a precondition to ETA OIC).  If taxpayer has an RCP lower than the full liability, however, the DATC-SC seems to serve the same purpose.

Facts:
Mr. Washington made a lot of money in the years before his death.  But he did not always file returns or pay his taxes.  In 2014, after being contacted by the IRS, he filed his returns for 2008, 2009, and 2010.  But he did not pay the taxes owed.  He started an installment agreement but then died, intestate, in November 2015.  The IRS filed a Notice of Federal Tax Lien for those years in 2017.

Upon his death, Mr. Washington’s ex-wife—they had formally divorced in 2006 after having separated in 2002—was appointed his Personal Representative and took charge of distributing his Estate and cleaning up the mess he had left behind.  Why her?  You will soon see.

Eventually, in 2017, the Estate filed Mr. Washington’s income tax returns for 2014 and 2015.  But it also did not pay the taxes owed.  Why not?  You will soon see.

In 2018 the IRS sent out a levy CDP notice, seeking to collect about $190,000 in tax liabilities, not including penalties and interest.  At the CDP hearing the Estate offered to compromise for $10,000.  It claimed that its RCP was far less than the tax owed.  The only asset it said counted for RCP was a checking account with $34,000.  The IRS disagreed because the Estate had reported to the state probate court that its assets also included Mr. Washington’s 401(k) account, with a balance of $148,000.  The Estate said that did not count because Ms. Washington had a claim against the Estate for $100,000 and her claim took priority over the federal tax lien.

The Settlement Officer rejected the $10,000 OIC because it was nowhere near the RCP.  The Estate petitioned the Tax Court and soon asked for a remand back to Appeals, saying it had new information that the IRS should consider.  The IRS agreed to the remand.

Rinse and repeat.  The Estate once again said only the checking account should count for calculating RCP.  That was now reduced to $25,000.  But at least the Estate raised its offer, to $24,000.  It also added a request for an ETA OIC.  The “special circumstances” the Estate thought justified the ETA OIC involved that same $100,000 claim by Ms. Washington against the Estate.

So let’s take a closer look at Ms. Washington’s $100k claim.

At the time of their divorce, Mr. Washington had a $100k life insurance policy through his employer.  The beneficiary was their son.  Mr. Washington also had a 401(k) account.  One section of their long and complex Marital Settlement Agreement (MSA) required Mr. W. to change his life insurance beneficiary from their son to Ms. W.  But he never did.  When he died the son got the $100,000.  That is the source of Ms. W.’s claim against the Estate.

Another part of the MSA provided that Ms. W. totally disclaimed all rights to Mr. W.’s 401(k) account.  But there was a possible escape hatch.  The MSA granted “sole discretion” to the personal representative of Mr. Washington’s estate to distribute the 401(k) proceeds if they ended up flowing through his Estate.  And yes, they indeed come to the Estate since he had no POD.

Perhaps we now see why Ms. Washington sought to become the personal representative some 10 years after her divorce?  She wanted the $100,000 she was supposed to have gotten from the insurance!  The only source of money for her claim was the 401(k) account and if she was the personal representative, why then perhaps she had “sole discretion” to direct that flow of money.  To her.

So the big fight was over whether the 401(k) money was free to be paid out of the Estate or had to be paid to the federal government.  The Estate offered two reasons why it did not have to use the money to pay Mr. Washington’s tax debts.  Both failed, giving us our lessons.

Lesson 1: A Judgment Does Not Make You a Judgement Lien Creditor
Ms. Washington first argued that her claim trumped the federal tax lien because she had become a judgment lien creditor before the IRS had filed the NFTL. Treas. Reg. 301.6323(h)-1(g) defines a judgment lien creditor as a person who (1) has a valid judgment, (2) from a court of record and of competent jurisdiction, (3) for specific property for a specific sum of money and (4) “has perfected a lien under the judgment on the property involved.”  Ms. Washington arguably met the first two requirements: she had a judgment for divorce from a court of record.  But it was debatable whether that judgment entitled her to either a specific sum of money or specified property.  Judge Urda concluded it did not.  More importantly, she had done nothing to perfect her lien against the 401(k) account.  Far from it.  She had expressly disclaimed any interest in the 401(k) in the Marital Settlement Agreement!   So she could not shoehorn her way into the status of a judgment lien creditor and get priority over the federal tax lien, made public in 2017 by the NFTL.

Lesson 2: Personal Representative’s Claim Does Not Entitle Estate to OIC
The Estate next tried for an ETA OIC, saying that Ms. Washington’s claim was the kind of “special circumstance” that made it an abuse of discretion for the IRS to have rejected its offer.  Basically, the argument was that it was not fair to Ms. Washington for her not to get the money.

Recall there are two types of ETA OICs: economic hardship and non-economic hardship.  Recall further that ETA OICs are, by definition, an escape valve for situations where the taxpayer can fully pay the liability but special circumstances would make that unfair.

Here, the Estate’s basic problem was that it could not fully pay the tax liability Mr. Washington had left behind.  Notice too that the Estate has no basis to argue for a DATC SC OIC.  That is because the special circumstances justifying DATC SC are the same that would figure into an economic hardship ETA.  See IRM 5.8.11.3 (10-04-2019)(“Factors establishing special circumstances under DATC are the same as those considered under ETA.”).

It is difficult for an Estate to establish “economic hardship” because that term refers to the ability of taxpayers to meet their basic living expenses.  See Treas. Reg. 301.6343-1(b)(4).  Ummm, Estates have no basic living expenses!  They don't live or breathe or need medical attention.  Sure, maybe the heirs or beneficiaries or Personal Representatives have basic living expenses, but they ain’t the taxpayer responsible for paying the tax: the Estate is.

Thus, the Estate’s last shot was to get a non-economic hardship ETA OIC.  It argued that Ms. Washington had spent a lot of time and effort as personal representative to settle her ex-husband’s affairs.  Op. at 28 note 26.  And, gosh, the sub-text here is that she got rooked by her ex-husband’s failure to live up to his promise to change the Life Insurance beneficiary.  Give the poor woman a break!

Judge Toro again says that the Estate cannot qualify for any type of ETA OIC because it could not fully pay the liabilities.  But he still then rejects the equitable argument with this explanation:

“When boiled down to their essence, the Estate’s arguments amount to a plea (1) that Mr. and Ms. Washington’s son be permitted to retain $100,000 in life insurance proceeds paid to him under the policy maintained by Mr. Washington’s employer, (2) that Ms. Washington (who under the MSA was supposed to have received the life insurance proceeds) be permitted to recover instead $100,000 from a retirement account to which she had disclaimed all rights, and (3) that the United States be required to compromise its claim for tax due on the substantial income that Mr. Washington earned [before his death]. We do not see how effective tax administration could possibly support such a result.”

Conclusion: Ms. Washington’s claim could not defeat the federal government’s tax claim, either directly by taking priority under §6323, or indirectly, by being incorporated into the RCP calculation for the Estate.  Her problems were simply not relevant to the Estate’s obligation to clean up the mess her ex-spouse left behind.  Further, we see again the lesson from last week: the Estate’s basic position that “hey, getting $24,000 is better than getting nothing” is the wrong analysis for OICs. The analysis is not against a comparison of no payment.  It’s against a default of the obligation to pay in full or pay the RCP which here included the 401(k) money.

Coda: But what about the Absolute Priority Statute?  Astute readers may well be asking why all the fuss and bother about lien priority when 31 U.S.C. 3713(a)(1) provides that “a claim of the United States Government shall be paid first when...(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.”  An executor who fails to do that becomes personally liable to the government up to the amount of erroneous distributions.  The quick answer is that the Supreme Court has interpreted that language narrowly so the statute should really be called the “Sort Of Absolute Priority Statute.”  Specifically, the Court ruled that the tax lien priority scheme in §6323 trumps the broad §3713 language.  See United States v. Estate of Romani, 523 U.S. 517 (1998).  As a result, Estates may first pay creditors who are entitled to priority over government claims without incurring liability.  Thus, in this situation the Absolute Priority Statute does not displace the lien analysis.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each week for a new Lesson From The Tax Court.