Federal Tax Liens / Tenancy by the Entireties
July 3, 2002
United States v. Craft
On April 17, 2002, the United States Supreme Court in United States v. Craft ruled that federal tax liens can attach to property held by a taxpayer as a tenant by the entirety. Tenancy by the entireties is a form of joint ownership recognized in North Carolina and fifteen other states whereby a husband and wife are considered a single, indivisible owner of the property. Neither spouse can unilaterally sell or encumber entireties property without the permission of the other In North Carolina, it is well established that an individual creditor of either a husband or a wife has no right to levy upon property held by the couple as tenants by the entirety. Levying against property includes seizing and selling it to pay off a debt.
In Craft, a wife brought suit against the IRS after it levied upon entireties property to recover some $482,446 in unpaid taxes owed by her husband. She argued that under Michigan state law creditors were precluded from levying against such property, and that the same limitations should apply to the IRS.
The Supreme Court disagreed, noting that a federal tax lien attaches to “all property and rights to property” of the delinquent taxpayer under 26 U.S.C. § 6321. Although state law determines what constitutes “property”, federal courts are not bound by state law when interpreting federal legislation. The Court noted that tenants by the entirety possess many property rights, i.e. the right of survivorship, the right to use the property, and the right to a share of income from the property. The Court held that these benefits constituted “rights to property” and fell within the broad scope of the federal tax lien statute.
Mrs. Craft argued that because either spouse could not unilaterally sell or encumber the property, it should not be subject to federal levy. The court rejected this argument and held that each spouse had enough individual rights in the property to allow the IRS to seize it.
Excluding property from a federal tax lien simply because the taxpayer does not have the power to unilaterally alienate it would exempt a rather large amount of what is commonly thought of as property. . . [In essence, the property would belong to nobody for purposes of the federal tax lien statute]. This result not only seems absurd, but would allow spouses to shield their property from federal taxation by classifying it as entireties property, facilitating abuse of the federal tax system.
The Court sent the case back to the lower court for a determination as to the value of the husband’s interest in the property.
Potential Bankruptcy Effects
By increasing the potential pool of assets recoverable by a federal tax lien, the Craft case has the potential to benefit unsecured creditors in any individual bankruptcy case involving such liens. In bankruptcy, the IRS is entitled to be paid before trade creditors and most other claims. Assume a bankruptcy estate with (a) assets of $150,000, composed of $100,000 in entirety property and $50,000 in non-entirety property; and (b) claims of $100,000, composed of $50,000 in tax liens, and $50,000 in unsecured claims. Before the Craft decision, the IRS would have been paid first and received all of the $50,000 in non-entirety property. This would have left only the $100,000 in entirety property (which unsecured creditors could not recover) and the unsecured creditors would have received nothing.
After the Craft decision, however, unsecured creditors have a much greater chance of recovery. IRS would still be paid first, but it could now enforce its claim against the value of the taxpayer’s interest in entireties property. Assuming that the court valued the taxpayer’s interest at one-half of the entireties property (1/2 of $100,000 = $50,000) and gave this amount to the IRS, the unsecured creditors could receive a full recovery of their claims in the $50,000 of non-entirety property.
The one drawback to this remedy is that it requires a bankruptcy court to order the IRS to take its recovery out of the entireties property before looking to other assets. However, regardless of the actions of the bankruptcy court, the fact that such property is now within the potential pool of debtor assets gives state law creditors additional leverage when negotiating with the IRS for final distribution of estate proceeds.
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