It was pretty well accepted by family lawyers that a safe harbor for income taxes of a divorcing spouse was to elect the status of a married person filing separately. In that case it was thought the electing spouse was freed from tax liabilities arising from the improprieties of the other spouse without having to resort to the shaky, factual laden, desperation defenses of innocence found in IRC Section 6015. If in doubt file a separate return, went the advice. You’ll have no problems with the tax man. Well, as it turns out that is not quite as true because of United States v. Craft, 535 U.S. 274 (2002).
Don Craft didn’t file any income tax returns for the years 1979 through 1986. In 1988 the IRS assessed $482,486 in unpaid income taxes against Mr. Craft. When he failed to pay, pursuant to IRC Section 6321, the federal tax lien attached to “all property and rights to property, whether real or personal, belonging to him.” This lien attaches automatically and does not have to be filed in the public records although it can be filed to protect IRS from certain good faith purchasers or lenders.
At the time the lien attached the parties owned a piece of real property in Grand Rapids, Michigan as tenants by the entireties (TBE). After the IRS filed a Notice of its tax lien in the public records, Mr. Craft transferred his interest in the real property to his wife by quitclaim deed for one dollar.
Some years later the wife contracted to sell the property and the title search revealed the IRS lien. The IRS agreed to release the lien providing one-half of the proceeds were placed in escrow pending a determination of the government’s interest in the property.
Mrs. Craft filed an action in the U.S. District Court to quiet title to the escrowed proceeds. The Sixth Circuit reversed the summary judgment for the government and held that the husband had no separate interest in the TBE property and remanded on the question of whether the quitclaim deed conveyance was fraudulent.
The District Court, on remand, held, in part, that the transfer could not have been fraudulent because the property was exempted from the claims of creditors but that the payments on the mortgage from non-exempt funds were fraudulent transfers. Again, both parties appealed. The Sixth Circuit upheld the prior appellate ruling as the law of the case and the District Court’s finding that the husband’s mortgage payments were fraudulent.
The Supreme Court granted certiorari to consider whether the federal tax lien attached to escrowed proceeds representing the husband’s interest in TBE property.
The court recognized the uniqueness of TBE property ownership. Michigan law characterizes TBE as creating no individual rights whatsoever. One tenant in Michigan has no interest separable from that of the other. Each tenant is vested with an interest in the entire title. TBE enjoy the right of survivorship but unlike joint tenants cannot be severed without the consent of the co-tenant except in divorce or death.
Though Michigan law defines TBE property for purposes rights of the tenants inter-se and rights of creditors under Michigan law, local law does not so circumscribe the federal tax collector. Federal law must determine whether TBE rights are property under IRC Section 6321 to which the federal tax lien attaches. Thus, state laws prohibiting homestead alienation were held in United States. v. Rodgers, 461 U.S. 677 (1983) no bar to foreclosure of a federal tax lien.
That the husband could not alone alienate the TBE property does not mean that he completely lacked “property and rights to property” pursuant to IRC Section 6321. The court quoting from United States v. National Bank of Commerce, 472 U.S. 713 (1985)at 719-720 stated, “Congress intended to reach every interest in property that a taxpayer might have.” The court recited what it thought to be the property characteristics inherent in TBE ownership, namely: (a) the right to use the property, (b) the right to exclude third parties from it, (c) the right to a share of income produced from it, (d) the right of survivorship, (e) the right to become a tenant in common with equal shares upon divorce, (f) the right to sell the property with the co-tenant’s consent and receive half the proceeds from such sale, (g) the right to place an encumbrance on the property with the co-tenant’s consent, and, (h) the right to block the co-tenant from encumbering or selling the property.
Thus, where federal income taxes are owed by one or both divorcing spouses, a tax lawyer should be consulted about transferring property as part of a plan of marital dissolution.