State law disclaimers: always effective for federal tax purposes?

In recent years, beneficiaries have been filing disclaimers in efforts to avoid creditors, including IRS levies on estate proceeds. Under most state laws, disclaimers result in the bequest or inheritance passing to the person next in line to receive a share of the decedent's estate; creditors of the disclaiming heir may not reach the property.

Given this climate, beneficiaries owing back taxes have recently elected to disclaim bequests or inheritances with full knowledge that any assets received might be levied on and seized by the Service. By filing the election, these beneficiaries hoped that estate assets would pass free of IRS levies to another individual. Drye, S.Ct. (1999), addressed this issue. The taxpayer was insolvent at the time of his mother's death. Valid tax liens had been placed against all of his "property and rights to property" pursuant to the provisions of Sec. 6321. Initially appointed as administrator of his mother's estate, Drye resigned several months later. He was succeeded by his daughter, who served as administratrix of the estate and established a trust. The trust instrument provided that she and her parents would be the trust's beneficiaries. Further, the Dryes' legal counsel was named trustee and authorized to distribute trust funds for their health, maintenance and support. As a spendthrift trust, the entity was designed to shield corpus from creditors of the taxpayer. Immediately before resigning as administrator, Drye had filed a legal disclaimer in Probate Court, allowing the estate property to pass to his daughter (who then used the proceeds from the estate to fund the trust).

On learning of Drye's interest in the family trust, the IRS served a notice of levy on the trust. In response, the trust filed a wrongful levy action against the U.S. and the IRS counterclaimed. A district court ruled in favor of the Service. Upheld by the Eighth Circuit, the decision conflicted with Leggett, 120 F3d 592 (5th Cir. 1997) and Mapes, 15 F3d 138 (9th Cir. 1994).

The Supreme Court addressed the issue of whether any property rights had vested in the disclaiming beneficiary. The taxpayer did not dispute that, under Sec. 6321, the IRS can impose a lien on any "property" or "rights to property" belonging to a taxpayer who is delinquent in the payment of taxes. The issue before the Court was what constitutes rights to property under Sec. 6321.

Congressional intent has been interpreted to include any "right or interest protected by law and having an exchangeable value" (Jewett, 455 US 303 (1982)). Sec. 6334(a) provides an "exclusive" list of property or property rights that are exempt from Federal tax liens. Among the enumerated items are certain items necessary for the care and clothing of the family, as well as unemployment and workman's compensation benefits. The Court noted that inheritances or devises that have been disclaimed under state law are not included in this list or in any other Federal tax collection provision. Further, the Court distinguished this omission from contrasting language relating to Federal wealth transfer tax provisions. Instead, Sec. 2518 proclaims state law disclaimers to be "effective for Federal wealth transfer tax purposes and for those purposes only." Within this context and following prior case law, the Court interpreted Federal law to control what constitutes property for purposes of the Federal tax lien provisions.

Drye argued against this reasoning. Specifically, he claimed that state law was the proper guide in determining whether or not a disclaimed interest constituted a "right to property" subject to levy by the Federal government.

The Court disagreed. In response, a two-prong approach used in National Bank of Commerce, 472 US 713 (1985), was used. First, the Court looked to state law to determine what, if any, rights were held by the taxpayer in property subject to levy. Next, the Court relied on Federal law to see if those "properties" or "rights to property" were subject to tax. The Court concluded that the right to disavow a bequest did not eliminate the existence of a right in property in the first place. Any vesting of property rights in the taxpayer under state law created sufficient interest to satisfy the definition of property or rights to property for purposes of the Federal tax lien provisions.

Under state law, Drye had a vested interest in the property at issue at his mother's death; he alone could determine what would be done with it or who would receive the proceeds. Vested with a right of value, he could choose to accept the benefits of the estate (thereby allowing the property to be distributed to him) or disclaim the property (thereby channeling the property to a close relative).

Drye attempted to label this interest as a mere personal right to reject a gift. However, the Court distinguished a rejected gift from a disclaimed inheritance. In making this contrast, the Court pointed out that the donee's refusal of a gift merely restores the status quo. The donor then retains property ownership and ultimate distribution rights of the property in question. No status quo may be restored in a disclaimed inheritance. The decedent is dead. A disclaiming heir or devisee has ultimate control as to how the property is to be distributed. The Court felt that this power constituted a Sec. 6334(a) "right to property" and justified the government tax levy on the property.

In determining if a particular property or right to property under a bequest was subject to levy for Federal taxes due and owing by a recipient beneficiary, state law establishes the nature of the beneficiary's property rights. After an interest determination is made, Federal law determines if the interest is subject to levy. Proper structuring of the decedent's will may help to avoid an outcome similar to that in Drye. In such situations, care must be taken in drafting the instrument to prevent the beneficiary from exercising any control over estate property. Had Drye's mother established a testamentary, spendthrift trust (rather than the administratrix establishing an inter vivos trust) in her will and left her estate to the trust rather than to Drye, Drye could have avoided a "property" or "right to property" determination. More care in planning may have saved the corpus for the benefit of the intended beneficiaries.

FROM RAYMOND A. ZIMMERMAN, PH.D.,AND PAT EASON, PH.D, UNIVERSITY OF TEXAS AT EL PASO, EL PASO, TX (NEITHER ASSOCIATED WITH DFK INTERNATIONAL)

Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA