When a taxpayer fails to satisfy his financial obligations to the IRS a lien automatically arises and reaches all assets belonging to the taxpayer, wherever that property is located. The lien continues in force, against all the taxpayer’s property until the tax is paid in full. A properly recorded tax lien places all creditors and potential creditors on notice of the IRS’s claim to the taxpayer’s assets. This notice of the federal tax lien would make it extremely difficult, if not impossible, to sell the encumbered assets or secure a loan to pay off the tax debt. The IRS now has the right to foreclose on the lien and sell your assets at auction to pay the back taxes.
The tax lien is applicable against real, personal and intangible property of greatly varying natures, as well as future interests, and even property acquired by the taxpayer after the lien has come into existence. The law is clear that where an individual is liable for a federal tax debt and that individual later inherits property or is given property, the IRS may sell that property to satisfy the tax debt. The issue of how to place inherited assets beyond a creditor’s reach, especially when the creditor is the IRS, has long been the object of many tax and estate planners. The goal is to create an instrument that allows maximum use of the assets with little to no exposure to a creditor’s attacks. Enter the asset protection trust.
The asset protection trust is an advanced planning technique used in some states to prevent creditors, including the Internal Revenue Service, from reaching the taxpayers assets to satisfy a tax debt or lawsuit judgment. It does not eliminate the debt or remove liability for the judgment. The taxpayer remains liable, but if executed properly, the taxpayer’s assets can not be reached by the federal tax lien and therefore can not be levied or seized by the IRS. This protection against the tax lien and levy is accomplished by inserting a clause in the Asset Protection Trust instrument known as the Tax Lien Lock Out Provision (TLLP) and inserting shifting and springing executory interests into the trust document. Lets take a look at an example.
William is 75 years old and wants to leave his stock portfolio, worth $500,000, to his daughter and her husband Chris. William knows that Chris has a history of making very foolish financial decisions. He is also concerned that his son-in-law is involved in some questionable income tax transactions which could result in significant tax debt in the future. William directs his attorney to create an asset protection trust with a Trust Lien Lockout Provision.
The trust will provide that Chris shall be the beneficiary but in the event that one of certain “triggers” occur (such as receiving an audit notice) Chris will no longer be a beneficiary of the trust and all beneficial rights will “spring” up in another individual perhaps William’s grandson or another family member or guardian of the property. The language of the TLLP might provide that: “on the earliest day on which any triggering event occurs, Chris shall cease to be a beneficiary of this trust and his rights and interest in this trust shall shift to an alternate beneficiary. This shift in beneficiary is the key. Once Chris no longer owns any beneficial interest in the trust assets the threat of losing the property to the IRS is gone.
The trust will also provide a mechanism for Chris to regain his status as beneficiary. The language of the TLLP might provide: “After such time as all revesting conditions have occurred (such as release of the federal tax lien), the rights and interests he lost shall shift back and he will once again be the beneficiary of the trust.” At this point it is once again safe for Chris to own a beneficial interest in the trust since his IRS problems are now behind him.
It is important to distinguish the tax lien lockout provision from other types of trust provisions such as a spendthrift provision. A typical spendthrift provision prohibits a trust beneficiary from surrendering trust assets to a creditor and prohibits creditors from attacking trust assets to satisfy debts of the beneficiary. These provisions are completely ineffective against the IRS because the federal tax lien attaches to any property owned by the taxpayer, or property later acquired by the taxpayer. With a Spendthrift trust, the trust beneficiary has a property right in the trust. As long as the asset remains in trust, the IRS can’t take it. However, the tax lien still attaches to any future distributions. If trust assets are ever distributed, the IRS is waiting with open arms to seize or levy the property.
With the TLLP, Chris has no interest in the property for the IRS to seize. Since the IRS is required to serve notice on Chris that there may be a tax problem on the horizon, this notice serves as the triggering event which shifts Chris’ property interest away from him and causes that interest to spring up in alternate beneficiary. Since the triggering event automatically divests Chris of his beneficial interest and vests that property right in the alternate beneficiary, there is no property for the tax lien to attach to. Moreover, since the revesting conditions prohibit property from being revested in Chris until the tax problem is resolved, Chris will never have ownership of any of the trust assets during any period where he is in jeopardy of losing the property to the IRS. Put another way, before the tax lien ever arises, Chris ceases to be an owner of any trust property.
The Asset Protection Trust with a proper TLLP is definitely not a do it yourself project. Only an attorney experienced in both tax collection procedure and estate planning should attempt to create the instrument. An attorney who is not experienced in both disciplines is likely to create a trust that is adequate in protecting against most creditors but totally ineffective in keeping the IRS at bay. Other difficulties lie in determining whether the taxpayer’s state allows such a trust in the first place. In states that do not allow precisely the type of trust created above, alternatives offering similar, albeit less effective, protections can be readily created by an experienced professional. Another pitfall to overcome is determining an effective trigger to cause the beneficiary’s property interest to shift. The shift must occur early enough to avoid the tax lien or risk being ineffective but so early as to be premature and cause unnecessary headache or complication.