5.7 The Craft Case
The Supreme Court in United States v. Craft, 122 S.Ct. 1415, 535 U.S. 274 (2002) held that property held as tenants by the entirety is subject to a federal tax lien against one (not both) spouse. The federal tax lien statue is, of course, a creature of federal law. It attaches to “property and rights to property” held by the taxpayer/debtor. According to Justice O’Connor’s opinion for the Court, whether the lien attaches to one spouse’s interest in tenants by the entirety property is ultimately a question of federal law. One looks first to state law to determine what rights a taxpayer has in the property the government seeks to reach. Then, one looks to see whether the rights that a taxpayer has in specific property qualify as “property or rights to property” under federal law. Justice O’Connor concluded that the debtor/taxpayer had sufficient rights in the “bundle of sticks” in tenants by the entirety property to rise to an attachable interest. These rights included the right of possession, of income, of sale proceeds (if the non-debtor spouse agreed to the sale), etc. The “legal fiction” that neither tenant has an interest separable from the other (per Blackstone) is not controlling as to the scope of the federal tax lien: “[I]f neither of them had a property interest in the entireties property, who did? This result not only seems absurd, but would also allow spouses to shield their property from federal taxation by classifying it as entireties property, facilitating abuse of the federal tax system.”
Justices Scalia and Thomas dissented. Justice Thomas objected to what he saw as a federalization of the law governing rights to property: “Before today, no one disputed that the IRS, by operation of § 6321, ‘steps into the taxpayer’s shoes,’ and has the same rights as the taxpayer in property or rights to property subject to the lien. I would not expand the ‘nature of the legal interest’ the taxpayer has in the property beyond those interests recognized under state law.” (Citations omitted.) Justice Scalia jointed in Thomas’ dissent: “[A] State’s decision to treat the marital partnership as a separate legal entity, whose property cannot be encumbered by the debts of its individual members, is no more novel and no more ‘artificial’ than a State’s decision to treat a commercial partnership as a separate legal entity, whose property cannot be encumbered by the debts of its individual members.”
The fact that the lien attaches to the debtor/taxpayer’s interest does not sever the tenancy. It gives the government the right to either (i) administratively seize and sell the taxpayer’s interest or (ii) foreclose the federal tax lien against the entireties property.
The administration option is problematic for the Internal Revenue Service: “Because of the nature of the entireties property, it would be difficult to gauge what market there would be for the taxpayer’s interest in the property. The amount of any bid would in all likelihood be depressed to the extent that the prospective purchaser, given the rights of survivorship, would take the risk that the taxpayer may not outlive his or her spouse. In addition, a prospective purchaser would not know with any certainty if, how, and to the extent to which the rights acquired in an administrative sale could be enforced … Levying on cash and cash equivalents held as entireties property does not present the same impediments as seizing and selling entireties property.” Notice 2003-60, 2003-39 IRB (9/11/03) (Q & A 7).
The most likely lien enforcement procedure will be foreclosure. Johnson, Why Craft Isn’t Scary, 37 Real Prop. Prob. & Tr. J., 439, 473-477 (Fall 2002). Foreclosure is supervised by a court under IRC § 7403 and anyone with an interest in the property is joined and heard. The court may order the sale of the whole property, then order “a distribution of the proceeds of such sale according to the findings of the court in respect to the interests of the parties and the United States.” IRC § 7403(c). The value of the respective spouses is an issue of fact:
Question (by the Court): “But in your review, you always value the taxpayer’s interest at 50 percent?”
Answer (by Mr. Jones): “No, I think in the Rodgers — well, if the property’s been sold, yes. If the property hasn’t been sold, and we’re talking about in a foreclosure context, I believe the Rodgers court goes through the example of the varying life expectancies of the two tenants, and which one — and I believe what the Court in Rodgers said was that each of them should be treated as if they have a life estate plus a right of survivorship, and the Court explains how that could well — I think in the facts of Rodgers resulted in only 10 percent of the proceeds being applied to the husband’s interest and 90 percent being retained on behalf of the spouse, but –”
Oral argument in Craft, page 15 of official transcript. “Rodgers” refers to United States v. Rogers (sic), 649 F.2d 1117 (5th Cir. 1981), rev’d, 461 U.S. 677 (1983) and Ingram v. Dallas Dep’t of Hous. & Urban Rehab., 649 F.2d 1128 (5th Cir. 1981), vacated 461 U.S. 677 (1983).
After Craft, the Bankruptcy Court in In re Basher, 291 B.R. 357 (Bankr. E. D. of Pa., 2003) ultimately concluded that the taxpayer failed to carry his burden of proof to rebut that the non-debtor spouse’s interest is greater than 50%. Nevertheless, the court refused to accept the IRS view of value because it failed to take into consideration the greater survivorship interest of the debtor’s younger spouse.
If the lien is not acted upon, and one spouse dies, the property goes to the survivor either free of the lien or not, depending on who is the survivor: “when a taxpayer dies, the surviving non-liable spouse takes the property unencumbered by the federal tax lien. When a non-liable spouse predeceases the taxpayer, the property ceases to be held in a tenancy by the entirety, the taxpayer takes the entire property in fee simple, and the federal tax lien attaches to the entire property.” Notice 2003-60 (Q & A 4.)
In Craft, the property was quit-claimed to the non-debtor spouse after the debtor spouse incurred the tax lien. Nevertheless, the lower courts held that no fraudulent conveyance was involved because no lien could attach. This point was not preserved on appeal. Justice O’Connor makes clear, however, that that issue will be present in future cases involving federal tax liens: “Since the District Court’s judgment was based on the notion that, because the federal tax lien could not attach to the property, transferring it could not constitute an attempt to evade the Government creditor, in future cases the fraudulent conveyance question will no doubt be answered differently.” (Citations omitted.) Thus, the technique involved in Watterson v. Edgerly, 40 Md. App. 230, 388 A.2d 934 (1978) will not be respected if a federal tax lien is involved.