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Trusts and Estates

A Section of the Virginia State Bar.

Summer 1999 Newsletter

Newsletter - Trusts and Estates

Volume 16, No. 2

CAN A BENEFICIARY AVOID A FEDERAL TAX LIEN BY USING A DISCLAIMER?

By E. DIANE THOMPSON

In a development that many probate practitioners felt had been a long time coming, the United States Supreme Court has agreed to resolve a question that has divided the Circuits: Whether a disclaimer by an estate beneficiary can prevent a· federal tax lien from attaching to property which the beneficiary otherwise would inherit. The case that brings this issue before the Supreme Court is Drye Family 1995 Trust v. United States, 152 F.3d 892 (8th Cir. 1998). The Supreme Court granted certiorari on April 19, 1999 (67 U.S.L.W. 3633).

In Drye, an Arkansas resident died intestate on August 4, 1994, leaving an estate worth approximately $236,000. The intestate was survived by her son and sole heir-at-law and his daughter. On the date of his mother's death, the son was insolvent and owed the United States approximately $325,000 in assessed income taxes. On February 4, 1995, the son filed a disclaimer of all his interest in his mother's estate. On or about the same day, his daughter created the Drye Family 1995 Trust and funded it with the interest in the estate that passed to her by virtue of the son's disclaimer. The Trust permitted discretionary distributions to the son, his wife, and his daughter.

The Circuit Court noted that it was given considerable pause by the son's "retention of a life estate in the Trust, which was funded in large part if not entirely by the disclaimed property." Perhaps if the court had focused upon the question of acceptance, it would have decided the case by holding that no valid disclaimer occurred. Under the regulations of Internal Revenue Code section 2518, the acceptance of any consideration for making a disclaimer equates to acceptance of the property and thus prevents a valid disclaimer. An argument could. have been constructed based upon the appearance of a prearranged plan in which the son would receive his interest in the Trust in exchange for his disclaimer. This troublesome aspect of the factual situation hopefully will not affect the Supreme Court's opinion.

The Arkansas Probate Code, like the disclaimer statutes of many states, provides that a disclaimer effected under its provisions creates the legal fiction that the disclaimant predeceased the decedent and that the disclaimer relates back for all purposes to the date of death. Ark. Code Ann. § 28-2-108{a)(I) & (3). The appellants thus contended that the son never had a property interest in his mother's estate to which federal liens could attach. The government maintained that the federal tax liens attached to the son's interest in his mother's estate on the date of her death and that the subsequent disclaimer was ineffective to remove them.

The Eight Circuit agreed with the government's position that the property interest to which the lien attached was but "right to inherit" from the decedent rather than the actual assets formerly owned by the decedent. The court reasoned that, although a right or an interest - here, the right to inherit - is created by state law, federal law determines whether that interest is property. Code section 6321 creates a lien in favor of the United States upon all "property and rights to property" belonging to any person who has neglected or refused to pay any tax. The Code does not define "property" or "rights to property" for purposes of section 6321. Nevertheless, the court in Drye cited other appellate decisions that have interpreted "property" or "right to property" to mean state-law rights or interests that have pecuniary value and are tranSferable, even if the applicable state law does not determine such rights to be property. Here the right to inherit under state law was the property interest.

Further, the court reasoned, section 6334 specifically exempts certain property or rights to property from the ambit of section 6321 levy provisions, and section 6334(c) provides that the list of exempt property and rights in section 6334 is exhaustive. Because there is no specific exemption under section 6334 for property or rights to property disclaimed under state law, the court concluded that Congress's failure to exempt such property evidences· its intention to subject disclaimed property to federal levy.

Drye is not without precedent. Numerous decisions from the Eighth Circuit and elsewhere, faced with a variety of fact situations, have similarly concluded that a disclaimer does not avoid a federal tax lien. United States v. Comparato, 22 F.3d 455 (2d Cir. 1994) (purported disclaimer of a vested interest in wrongful death proceeds occurred approximately seven years after the disclaimer period); United States v. Solheim, 953 F.2d 379 (8th Cir. 1992) (disclaimer was untimely and state law had no relation-back language extending to an untimely disclaimer); Tinari v. United States, 78 A.F.T.R.2d (RIA) 96-6381, 96-2 U.S. Tax Cas. (CCH) ¶ 50460 (E.D. Pa. 1996); Estate of Adler, 869 F. Supp. 1021 (E.D.N.Y. 1994) (surviving spouse could not avoid an income tax lien when she attempted to renounce wrongful death proceeds). The Second Circuit Court of Appeals, in Comparato, applied the same reasoning followed by the Eighth Circuit Court of Appeals in Drye, holding that the lack of an exemption in section 6334 for the disclaimed interest was controlling, despite the relation-back theory of the applicable New York state law.

In contrast, the Fifth and Ninth Circuit Courts of Appeals have reached precisely the opposite conclusion. In these circuits, the decisions hold that a disclaimer operates retroactively, pursuant to state law, and thus the disclaimant never acquires a property interest to which a lien can attach. Leggett v. United States, 120 F.3d 592 (5th Cir. 1997) (reversing the Southem District of Texas); Mapes v. United States, 15 F.3d 138 (9th Cir. 1994); United States v. McCrackin, 189 F. Supp. 632 (S.D. Ohio 1960).

The court in Leggett considered two possible analyses of the operation of disclaimers under Texas law. Under one view, which the court named the "Transfer Theory," the intended beneficiary has a vested property right from the moment of death, and the effect of a valid disclaimer is to transfer the property to other beneficiaries. Under the second view, the "Acceptance-Rejection Theory," property passes at the moment of death into a kind of state of suspension in the decedent's estate, and thereafter the intended beneficiaries may accept or reject their inheritances. When a beneficiary accepts an inheritance, the law engages in the legal fiction that he owned the property from the moment of death; likewise, upon a proper rejection, the fiction is that the intended beneficiary never acquired the property interest from the decedent. The Fifth Circuit held that Texas courts had adopted the Acceptance-Rejection Theory, and thus Leggett's timely, valid disclaimer prevented her from ever acquiring a property right to which a federal tax lien could attach. Moreover, the court specifically held that the right of acceptance or rejection was not itself a property right under Texas law. The court reconciled its holding and the decisions of the Second Circuit (Comparato) and the Ninth Circuit (Mapes) by reference to the underlying state law: In New York (Comparato), the right to inherit was itself a property interest, while in Texas and Arizona (Mapes) it was not. Finally, the court refused to apply an expansive reading of section 6321, suggesting that such an approach was precluded by Congress's failure to define property more broadly than state law does or to prohibit taxpayers from making disclaimers.

If the Supreme Court holds, as did the court in Leggett, that the right to inherit is not a property interest under state. law, and that there is nothing to which a lien can attach if property is disclaimed, then the positions of taxpayers indebted to the United States will vary depending upon state law. In a number of states it has been established by statute or decisional law that a disclaimer prevents the disclaimant's creditors from reaching the disclaimed property. The cases tend to apply a relation-back doctrine that views the disclaimer as retroactively eliminating the disclaimant's interest in the property, leaving no interest which can be transferred by the disclaimant. Cal. Probe Code § 281 (West 1991); Md. Code Ann., [Estates & Trusts] § 9-204(f) (1973); Tompkins State Bank v. Niles, 537 N.E.2d 274 (III. 1989); Estate of Hansen, 248 N.E.2d 709 (III. App. Ct. 1969); National City Bank v. Oldham, 537 N.E.2d 1193 (Ind. Ct. App. 1989); Frances Slocum Bank & Trust Co. v. Estate of Martin, 666 N.E.2d 411 (Ind. Ct. App. 1996); Baltrusaitis v. Cook, 435 N.W.2d 417 (Mich. Ct. App. 1988); Succession of Neuhauser, 579 So. 2d 437 (La. 1991) (creditor failed to prove renouncing beneficiary either disclaimed with intent to defraud or that the disclaimer caused or increased insolvency); Trew v. Trew, 558 N.W.2d 314 (Neb. App. 1996); Estate of Opatz, 554 N.W.2d 813 (N.D. 1996) (neither judgment lien nor garnishment summons constitutes an "encumbrance" barring a disclaimer); Parks v. Parker, 957 S.W.2d 666 (Tex. App. 1997); Dyer v. Eckols, 808 S.W.2d 531 (Tex. App. 1991); Estate of Goldammer, 405 N.W.2d 693 (Wis. Ct. App. 1987); Abbott v. Willey, 253 Va. 88, 479 S.E.2d 528 (Va. 1997) (After Attorney Willey converted clients' funds to his personal use, the clients obtained a promissory note obligating both him and his wife Kathleen Willey to make repayment. Willey then committed suicide and, in a case of first impression, the Virginia Supreme Court permitted Mrs. Willey to disclaim insurance proceeds, which then passed for the benefit of her children). See also Estate of Heater v. Department of Public Aid, 640 N.E.2d 654 (III. App. Ct. 1994), in which the court acknowledged that a beneficiary could disclaim to prevent creditors from taking the inheritance, but that a personal representative of a deceased beneficiary could not do so because of the personal representative's fiduciary duty to all interested persons, including creditors of the deceased.

However, in other states the cases or statutes establish that a disclaimer cannot be used to prevent creditors from reaching the disclaimed property. Fla. Stat. § 689.21(6) (1943) (nontestamentary transfers); Fla. Stat. § 732.801(6) (testamentary transfers) (in either case, a disclaimer is barred if beneficiary is insolvent at time of event giving rise to the right to disclaim); La. Civ. Code art. 1021 (West 1973) (creditors of an heir who renounces an inheritance can be authorized by the judge to accept the property in the name of the debtor and in his stead); Mass. Gen. Laws ch. 191A, §8(2) (1958) (disclaimer barred if the beneficiary is insolvent at time of attempted disclaimer); Minn. Stat. § 525.532 Subd. 6 (1945) (testamentary); Minn. Stat. § 501B.86 Subd. 6 (1945) (nontestamentary) (in either case, disclaimer is barred if the beneficiary is insolvent); N.J. Rev. Stat. § 3B:9-9(d) (1937) (testamentary); N.J. Rev. Stat. § 46:2E-9(3) (1937) (nontestamentary) (in either case, disclaimer is barred if it is in fraud of creditors); N.C. Gen. Stat. § 31B-4(a)(4) (1943) (disclaimer is barred by sale of the property under judicial sale made before the renunciation is effected); N.D. Cent. Code § 30.1-10-01(5) (1943) (disclaimer is barred by sale of the property under judicial sale made before the disclaimer is made); 20 Pa. Cons. Stat. § 6202 (1930) (if a disclaimer is by a fiduciary or attorney-in-fact, a court may authorize the disclaimer only if no prejudice to rights of creditors).

In addition, some courts hold that creditors are not avoided by a disclaimer because such a renunciation is a fraudulent conveyance or a transfer. Stein v. Brown, 480 N.E.2d 1121 (Ohio 1985); Estate of Abesy, 470 N.W.2d 713 (Minn. Ct. App. 1991) (garnishee summons in place at time of attempted disclaimer was a transfer by judicial process, and under Minnesota law, a beneficiary could not disclaim if a transfer by judicial process occurred before the disclaimer). However, close attention is required to the specific language of the applicable statute to determine whether a disclaimer can avoid creditors under state law. For example, the Kansas statute prohibits a disclaimer' occurring after "any sale or other disposition ... pursuant to judicial process." Kan. Prob. Code Ann. § 59-2293(b) (1964). In Citizens State Bank v. Kaiser, 750 P.2d 422 (Kan.. Ct. App. 1988), it was held that an existing lien constituted a sale or other disposition. In contrast, the Mississippi statute uses the wording "sale of the property or interest under judicial sale made before the disclaimer is made." Miss. Code Ann. § 89-21-11(d) (1972). Presumably a creditor's claim could be defeated under this statute unless judicial sale had occurred. See also Pennington v. Bigham, 512 So. 2d 1344 (Ala. 1987) (pre-existing lien against beneficiary was an encumbrance which barred disclaimer.)

The answer to the question of whether a beneficiary can disclaim despite a pending federal tax obligation may also bear upon the feasibility of a disclaimer in the bankruptcy setting. The majority of bankruptcy cases hold that a beneficiary's disclaimer of a testamentary bequest within 180 days following the bankruptcy petition constitutes a transfer that a bankruptcy trustee can avoid. In In re Chenoweth, 132 B.R. 16] (Bankr. S.D. III. 1991), the court found an attempted disclaimer was an unauthorized post-petition transfer of property that now belonged to the bankruptcy estate and which could be avoided by the bankruptcy trustee under Bankruptcy Code section 549. The court focused on the language of section 541(a)(5)(A) of the Bankruptcy Code which included interests that the debtor "acquires or becomes entitled to acquire" within 180 days' after bankruptcy and determined that the debtor was entitled to acquire the interest in the estate. See also In re Lewis, 45 B.R. 27 (Bankr. W.D. Mo. 1984); In re Betz, 84 B.R. 470 (Bankr. N.D. Ohio 1987) (specifically not addressing "bankruptcy law considerations" because Ohio law would treat the disclaimer as a fraudulent conveyance). Arguably, however, a distinction could be made under a relation-back view of the disclaimer that might construe the disclaiming debtor as never having become "entitled to acquire" the disclaimed property within the meaning of section 541(a)(5)(A) of the Bankruptcy Code.

What about a pre-petition disclaimer? Again, there are differing views. The bankruptcy court in In re Brajkovic, 151 B.R. 402 (Bankr. W.D. Tex. 1993), viewed the execution of a disclaimer as the transfer of a property interest. The debtor was the devisee of an undivided one-half interest in certain Missouri real estate. Six weeks before filing bankruptcy, she disclaimed the property with the result that, under Missouri law, the property passed to her minor children. The court found that, despite the relation-back concept with regard to the legal title of the real estate after the disclaimer, immediately before the disclaimer the debtor had an interest in the property, albeit an equitable interest, and the court saw the execution of the disclaimer as a pre-petition transfer. See also In re Stevens, 112 B.R. 175 (Bankr. S.D. Tex. 1989), in which the court found that the right to control, deduct or receive a testamentary distribution constitutes an interest in property and that the date the renunciation was executed was the date of transfer. In re Perry, 40 B.R. 811 (Bankr. M.D. Tenn. 1984), involved a decedent's death on October 21, 1981, the beneficiary's renunciation of an interest in the decedent's real estate on July 15, 1982, and the beneficiary's filing of a Chapter 7 petition on April 20, 1983. The court held that the right to receive a testamentary distribution constituted an interest in property, that the disclaimer was a transfer, that the relation-back concept under Tennessee law did not change the time of the transfer, and that the transfer was fraudulent in that it was made when the debtor was under significant pressure from creditors. The court observed that the debtor had not disclaimed the personal property, which would be exempt in the bankruptcy proceeding.) Thus, it denied discharge because the debtor disclaimed within one year of filing bankruptcy.

On the other hand, in In re Atchison, 925 F.2d 209 (7th Cir. 1991) (Illinois law), cert. denied sub nom. Jones v. Atchison, 502 U.S. 860, 112 S.Ct. 178 (1991), the court held that a beneficiary's pre-petition disclaimer of a testamentary bequest governed by Illinois law did not constitute a "transfer" which could be avoided by the bankruptcy trustee under Bankruptcy Code section 548(a). Atchison filed for joint bankruptcy less than three months after she disclaimed an inheritance under her father's will, causing the property to pass to her children. The court found that the relation-back provision of the Illinois disclaimer statute eliminated any interest which Atchison held at the time of the disclaimer and that, absent a federal law to the contrary, a debtor's interest in property is determined by applicable state law. Similarly, in In re Simpson, 36 F.3d 450 (5th Cir. 1994) (Texas law), the bankruptcy trustee was not permitted to avoid a disclaimer filed one day before filing the bankruptcy petition. The court specifically rejected the reasoning of Brajkovic because it failed to give effect to the state law relation-back concept. Accord, Hoecker v. United Bank of Boulder, 476 F.2d 838 (10th Cir. 1973) (Colorado law).

In summary, the Supreme Court will have to decide whether the phrase "property or rights to property" in section 6321 of the Internal Revenue Code means the inherited property or the right to inherit. Further, if section 6321 refers to the inherited property itself, the Court must decide whether the relation-back concept, which is part of the statutory scheme of many states, works to erase any potential interest that the taxpayer ever had in the disclaimed property, preventing lien attachment. The effect of a ruling in favor of the taxpayer in Drye will be to produce differing results for taxpayers, depending upon the applicable .state law, with regard to creditor avoidance through the use of disclaimers. A ruling upholding the government's position in Drye will provide a predictable, albeit an unfavorable, outcome whenever a proposed beneficiary is subject to creditors' claims. Although this may seem to provide a uniform result for all taxpayers, in actuality, those taxpayers who can afford to plan in advance will be placed in a better position than those who cannot afford advance planning. In each situation when a taxpayer or debtor sought to avoid creditors through a disclaimer of an interest created by a grantor or testator, the creditors could have been avoided if the interest had never been created. The grantor or testator who is aware that a potential beneficiary is exposed to creditors' claims can simply omit that beneficiary from the estate plan.

E. Diane Thompson received her B.S. degree in mathematics from the College of William and Mary in 1977, her J.D. degree from the College of William and Mary in 1981 and an L.L.M. in Taxation from New York University in 1982. She is a principal in the law firm of Hojheimer Nusbaum, P. C. in Norfolk, Virginia where she practices almost exclusively in estate planning and administration, federal estate and gift taxation, fiduciary income taxation and does extensive work in the disclaimer area. Since 1986, Ms. Thompson has been instructing courses in her field for a number of state CPA societies, including Virginia, Alabama, Maryland, New Hampshire, New York, Ohio, Rhode Island, South Carolina, Vermont and Tennessee. The Virginia Society of CPAs has recognized her as an Outstanding Discussion Leader for each of 1990-1994. From 1988 until 1996, she taught courses in advanced estate planning and federal taxation of estates, gifts and trusts at Marshall Wythe School of Law, College of William & Mary, Williamsburg, Virginia. She also has been a conference lecturer for the Old Dominion University Annual Tax Conference, South Carolina Association of CPAs Tax Conference, Annual Virginia Accounting and Auditing Conference, VSCPAs Personal Financial Planning Conference, Duke Estate Planning Conference, and various conferences for the Virginia Law Foundation and the Washington, D.C. Bar. Ms. Thompson has written two articles on disclaimers for the Trust and Estates Newsletter of the Virginia State Bar Trusts and Estates Section. She is a member of the Virginia State Bar, Washington State Bar and Norfolk-Portsmouth, Virginia and American (member, Taxation Section; Real Property, Probate and Trust Law Section) Bar Associations as well as a Fellow: American College of Trusts and Estate Counsel. She has appeared in each edition of the Best Lawyers In America since the 1991-92 edition.