Earlier this year, the U.S. Supreme Court issued its long-awaited decision in the case of United States v. Craft, 122 S. Ct. 1414 (2002), holding that a federal tax lien may attach to the interest of an individual spouse in property held in a tenancy by the entirety (T by E). This decision has monumental importance in thirteen states that currently recognize the T by E as a means of protecting marital property, typically a home, from claims against one of the marriage partners. These states are Michigan, Delaware, Florida, Hawaii, Illinois, Indiana, Maryland, Missouri, North Carolina, Pennsylvania, Vermont, Virginia, and Wyoming.
Similar to a joint tenancy, entireties property provides a right of survivorship; upon the death of a spouse, the survivor is entitled to the whole of the property free of all claims of heirs or creditors of the deceased.
The defining characteristic of the T by E, however, is the notion that a husband and wife are one person, and property held in their “entirety” is not capable of being divided into parts nor of being sold or encumbered by one spouse without consent of the other. Likewise, before Craft, it was thought that an involuntary lien against one spouse could not attach to property held in a T by E.
Now, after Craft, federal tax law trumps the T by E, and one wonders whether the days may be numbered for this historic estate in land.
Picking Their Fight
The IRS is perpetually challenged by situations in which a delinquent taxpayer is a co-owner of assets, such as a home or business, with an innocent party. A particular thorn has been the scofflaw spouse who owns a home with an innocent partner, held in a T by E. In Craft, the IRS perceived it had a good case to try to “make some law.” Here’s what happened:
In 1972, Don and Sandra Craft purchased their home on Berwyck Road in Grand Rapids, Michigan, which they held in a T by E. The purchase price was $48,000, and the couple gave a purchase money mortgage for $37,000. Don (a lawyer) failed to file income tax returns for the years 1979 through 1986. As permitted by law, the IRS prepared “substitute” income tax returns for these years and assessed Don for unpaid tax liabilities of $482,446. In March 1989, after Don failed to pay, the IRS recorded a notice of federal tax lien against Don in the county land records. In August 1989, Don and Sandra executed a quitclaim deed conveying the Berwyck Road property to Sandra, individually. This deed recited a consideration of $1. The obvious purpose was to shield the property from Don’s tax lien. In January 1992, Don filed a Chapter 7 bankruptcy. His schedule of assets did not include the Berwyck Road property. Don obtained a discharge order and the case was closed in June 1992. Later, Sandra contracted to sell the property on terms yielding net sale proceeds of $119,888. A title search disclosed the tax lien, and the closing was put on hold because the title company would not insure over the tax lien, even though it appeared the lien did not attach to the property in T by E.
Don returned to bankruptcy court, where his case was reopened to deal with the tax lien. Ultimately, though, it was decided the court lacked jurisdiction because the property had not been part of Don’s bankruptcy estate. His case was closed a second time.
At loggerheads, Sandra and the IRS agreed that the sale would close, with one-half of the net proceeds ($59,944) being deposited in escrow pending outcome of litigation between them. In April 1993, Sandra filed suit in federal court seeking to quiet title to proceeds in the escrow account. In response, the government argued that its tax lien attached to Don’s interest in the property, even though the couple held title in T by E, and that it should recover half the sale proceeds. The government also claimed that the quitclaim deed to Sandra was a fraudulent conveyance.
On cross motions for summary judgment, the trial court ruled in favor of the government, reasoning that the T by E had ceased to exist for a “brief period” when the property was conveyed from Don and Sandra, as tenants by the entirety, to Sandra, individually, and the government’s lien attached to Don’s interest during this “brief period.” Sandra appealed.
The court of appeals reversed, rejecting the “brief period” analysis and finding that the ownership went from a T by E to Sandra individually, with no time during which Don had a separate interest to which the lien might attach. Craft v. United States, 140 F.3d 638 (6th Cir. 1998). The government petitioned the Supreme Court for review.
Meanwhile, in August 1998, Don died.
The Supreme Court Speaks
The Supreme Court reversed the court of appeals decision, holding (6–3) that even when property was held in T by E, each spouse had sufficient “individual rights” in the property for the lien to attach, as a matter of federal law.
The Court began its analysis by examining the federal statute authorizing the filing (or recording) of a lien to secure payment of unpaid federal tax liabilities. The statute provides that the lien shall attach to “all property and rights to property, whether real or personal, belonging to” the delinquent taxpayer. 26 U.S.C. § 6321. The Court explained that the “federal tax lien statute itself ‘creates no property rights but merely attaches consequences, federally defined, to rights created under state law.’” Id. at 1420 (citing United States v. Bess, 357 U.S. 51, 55 (1958)). Therefore, the Court looked to state law to determine the nature of entireties property rights, then to federal law to determine whether the “state-delineated” rights should be considered lienable “property” or “rights to property.”
To aid its discussion, the Court referred to a “common idiom” that describes “property” as a “‘bundle of sticks’—a collection of individual rights which, in certain combinations, constitute property.” Id. at 1420 (citing B. Cardozo, Paradoxes of Legal Science 129 (1928)). Remarking that “Michigan’s version of the estate is typical of the modern tenancy by the entirety,” the Court used the “bundle of sticks” metaphor to dissect the T by E, as follows:
According to Michigan law, [Don Craft] had, among other rights, the following rights with respect to the entireties property: the right to use the property, the right to exclude third parties from it, the right to a share of income produced from it, the right of survivorship, the right to become a tenant in common with equal shares upon divorce, the right to sell the property with the respondent’s [Sandra’s] consent and to receive half the proceeds from such a sale, the right to place an encumbrance on the property with the respondent’s consent, and the right to block respondent from selling or encumbering the property unilaterally. Id. at 1422.
Returning to the “federal question,” the Court concluded that Don’s property rights were sufficient to subject his interest to the federal tax lien. In large part, this conclusion was supported by the Court’s prior decision in Drye v. United States, 528 U.S. 49 (1999), in which the Court held that a federal tax lien attached to property to which the delinquent taxpayer was entitled by inheritance, even though the taxpayer made a timely disclaimer of the inheritance as permitted by state law. In Drye, as in the Craft case, the Court mentioned the taxpayers’ control over property as evidence of a lienable “property right.”
With that, the Craft case was remanded for the court of appeals to consider the value of Don’s interest in the Berwyck Road property.
Reaction to Craft and Unanswered Questions
Anyone familiar with the Drye case should have seen Craft coming. Nevertheless, the Craft decision has caused something of an uproar—especially in the thirteen states most affected—because it threatens the states’ interest in protection of marital property rights. This state interest includes protection for a homestead during marriage, as well as the right of lien-free survivorship for an innocent spouse.
The decision has also been criticized as a departure from the traditional rule that federal courts will defer to state laws to determine the nature of property rights—especially real property rights—in the absence of some overriding federal interest as declared by Congress and authorized by the Constitution.
As Justice Thomas said, in a dissent joined by Justices Stevens and Scalia:
Just as I am unwilling to overturn this Court’s longstanding precedent that States define and create property rights and forms of ownership, . . . I am equally unwilling to redefine or dismiss as fictional forms of property ownership that the State has recognized in favor of an amorphous federal common-law definition of property.
Id. at 1432 (citation omitted).
The Craft decision also raises a host of questions.
• Given that a federal tax lien attaches to a debtor spouse’s interest in entireties property, does the IRS have the power to enforce its lien—by forced sale of the property—without the consent of the nondebtor spouse? By extension of the Court’s reasoning, the answer seems to be “yes.” Once the lien attaches, there is no impediment to regular enforcement procedures. Will the IRS enforce these rights? Stay tuned.
• If the IRS may force a sale of the property, what is the nature of the property interest up for bid? Are prospective buyers to be offered “sticks” of rights? Despite its use of metaphor to explain why the lien attaches, there is nothing in the Craft decision to suggest that once attached the lien covers anything less than all of the debtor spouse’s proportional interest in the entireties property, i.e., an undivided one-half interest.
• If the IRS does not (or may not) force a sale of property during the lifetime of the debtor spouse, upon the death of the debtor is the surviving nondebtor spouse entitled to the whole ownership free of the tax lien? Again, by extension of the Court’s reasoning, it appears the federal tax lien is perfected when duly recorded and would therefore continue as a lien against the property after the death of a debtor spouse. Caveat: Unless extended, a federal tax lien expires 10 years after the date of assessment. 26 U.S.C. § 6502. Therefore, if the IRS waits too long, and fails to extend the lien, the property is “off the hook.”
• Given that state law prevents attachment of ordinary judgment liens and state tax liens against entireties property, does Craft have the effect of giving a federal tax lien priority over other previously recorded liens against a debtor spouse? Again, by extension of the Court’s reasoning, this would appear to be the case.
• After a federal tax lien attaches, and in the absence of a sale, does the lien have the effect of terminating the T by E? This conclusion may seem naturally to follow because attachment of a lien might destroy an essential unity unique to the T by E: unity of person. The Court’s decision does not address this issue, and, presumably, the federal government does not care one way or the other. Nevertheless, this is an important question because the answer may determine whether spouses with a compromised T by E may still have protection against other creditors of a debtor spouse and/or the right of survivorship as against competing claims of potential heirs or devisees. This question should be addressed by state legislatures, and the sooner the better.
• Does the Court’s decision leave any loopholes for protection of marital property from a federal tax lien? Seemingly, no. Remember: State laws may create and define property rights, but applicability of federal tax laws will be governed by federal law. At one point in Craft, the Court tells us that Don’s fundamental rights to use the property, to receive income from it, and to exclude others from it “alone may be sufficient” to subject his interest to a federal tax lien. The Court also says these rights are indicative of control over property, and it points to Drye’s reasoning that “control” is an “important consideration” in determining whether property is lienable under Code § 6321.
In sum, the Court seems to be saying that almost any indicia of ownership giving a taxpayer control over use or disposition of property may be sufficient for purposes of enforcement of Code § 6321. This leaves taxpayers with little “wiggle room.”
Finally, on remand, how will the lower court value Don’s interest in the Berwyck Road property? Hard to say, due not only to questions mentioned above but also because the agreement establishing the escrow account, almost 10 years ago, was mainly verbal. And the government failed to preserve most issues involved with dismissal of its fraudulent conveyance claim because there was no timely appeal.
It may take years for the IRS, the courts, and state legislatures to resolve questions raised by Craft. If, however, the Craft decision is ultimately interpreted to allow federal tax liens to attach to a one-half interest in T by E properties, and if it also allows federal tax liens to attach while state tax liens and ordinary judgment liens may not, then it may result in the demise of this historic estate in land. This is because state legislatures may react to the federal override of state property laws, and unfairness to other potential lienholders, by effectively killing the entireties estate.
As for other state-created property interests, the Drye and Craft decisions send a clear message. This Supreme Court will inspect them carefully, and will not hesitate to override those that may interfere with enforcement of federal tax laws. As the Court says in Craft:
The interpretation of 26 U.S.C. § 6321 is a federal question, and in answering that question we are in no way bound by state courts’ answers to similar questions involving state law. As we elsewhere have held, “exempt status under state law does not bind the federal collector.”
Id. at 1425–26 (quoting Drye v. United States, 528 U.S. at 51).
Bert Rush is Senior Vice President/National Counsel with First American Title Insurance Company in Santa Ana, California.