A Newsletter of the Real Estate Law Committees
of the Association of the Bar of the City Of New York

SUPREME COURT HOLDS THAT FEDERAL TAX LIEN
ATTACHES TO AN INTEREST BY THE ENTIRETIES

In a decision that many view as contrary to prevailing state law and long-established precepts of the common law surrounding real property, the Supreme Court of the United States recently held that a federal tax lien may attach to a taxpayer’s interest in real property held by the entireties. In United States v. Sandra L. Craft 1. , the Supreme Court, in viewing property as a “bundle of sticks”, reasoned that an interest by the entirety, although not forecloseable in any practical sense, had enough indicia of “property” to make it attachable by the Internal Revenue Service (“IRS”) under 26 U.S.C. §6321.

In 1988, the IRS assessed $482,446 in unpaid income tax liabilities against Don Craft, the husband of the respondent, for failing to file income taxes from 1979 to 1986. When Mr. Craft failed to pay, a federal tax lien attached to all his property. At the time, Mr. and Mrs. Craft owned a piece of real property in Grand Rapids, Michigan as tenants by the entirety. After the lien attached, Mr. Craft quitclaimed his interest to his wife for $1.00. Thereafter, when she attempted to sell the property, a title search revealed the lien. The IRS agreed to release the lien on the condition that half the proceeds from the sale be held in escrow pending determination of the validity of the lien and the Government’s entitlement to the proceeds.

Mrs. Craft then brought an action to quiet title to the escrowed proceeds. The Government asserted that its lien had attached to Mr. Craft’s interest in the tenancy by the entirety. It further claimed that the conveyance from Mrs. Craft to her husband once the lien attached was invalid as a fraud on creditors. The District Court granted the Government’s motion for summary judgment, holding that the tax lien attached when the interspousal transfer took place.

Both Mrs. Craft and the Government appealed. The Court of Appeals Sixth Circuit held that the tax lien did not attach to the property because, under Michigan law, the husband had no separate interest in property that was held by the entirety. It remanded to the District Court for a determination as to whether the interspousal transfer should be set aside as fraudulent.

On remand, the District Court concluded that the transfer was not fraudulent since Michigan law makes property held as tenancy by the entireties exempt from creditors. However, the Court did find that the husband’s use of nonexempt funds to pay the mortgage on the entireties property, which then placed such funds beyond the reach of creditors, constituted a fraudulent act under Michigan law and awarded the IRS a share of the proceeds of the sale to the extent of such payments.

But sides again appealed. The Court of Appeals held that the prior panel’s decision was law of the case and also affirmed the District Court’s determination that the husband’s mortgage payments were fraudulent as against creditors.

The Supreme Court granted certiorari to consider the Government’s claim that the husband had a separate interest in the entireties property that could be attached by the IRS under 26 U.S.C. §6321. In analyzing this question, the Supreme Court noted that the answer largely depends upon state law. The Supreme Court reasoned that it initially had to look to applicable state law to determine what rights the taxpayer had in the property sought to be attached. After determining such rights, the Supreme Court then would look to federal law to determine whether the taxpayer’s state-delineated rights qualify as “property” or “rights to property” within the reach of the federal tax lien legislation.

In determining whether the husband’s interest constituted property, the Supreme Court relied on a common idiom that describes property as a “bundle of sticks” -- a collection of individuals rights which, in certain combinations constitute property. The Supreme Court noted that state law determines only which sticks are in a person’s bundle. Whether those sticks qualify as “property” for the purposes of the federal tax lien statues, however, is a question of federal law.

In its decision, the Supreme Court discussed that, under the common law, real estate can be held in three forms of ownership – tenancy in common, joint tenancy and tenancy by the entirety. The Court noted that tenancy by the entirety is a unique form of concurrent ownership that can only exist between married persons. The Court also recognized that Blackstone did not characterize the tenancy by the entirety as a form of concurrent ownership at all. Instead, Blackstone reasoned that the entireties property was a form of single ownership by the marital unity rather then either of the spouses. The entireties property belonged to the married couple rather than either of them individually.

The Supreme Court noted that, under Michigan law, the respondent had, among other rights, the following rights with respect to the entireties property: the right to use the property, the right to exclude third parties from it, the right to a share of income produced from it, the right of survivorship, the right to become a tenant in common with equal shares upon divorce, the right to sell the property with his wife’s consent and to receive half the proceed from such sale, the right to place an encumbrance on the property with his wife’s consent, and the right to block his wife from selling or encumbering the property unilaterally.

After determining the husband’s rights under Michigan law, the Supreme Court turned to federal law to determine whether those rights qualify as “property” or “rights to rights” under the federal tax lien statute (26 U.S.C. §6321). The Supreme Court pointed out that Michigan law grants a tenant by the entirety some of the most essential property rights: the rights to use property, to receive income produced by it and to exclude others from it. The Supreme Court further noted that the right to exclude others is “one of the most essential sticks in the bundle of rights that are commonly characterized as property.” The Court reasoned that these rights alone may be sufficient to subject the husband’s interest in the entireties property to attachment. The Court went on to note that the husband’s rights extended beyond use, exclusion and income. He also possessed the right to alienate the property with the consent of his wife. While the wife argued that the husband lacked the unilateral right to alienate the property, the Government countered, and the Supreme Court agreed, that there is no reason to believe that this one stick – the right of unilateral alienation – is essential to the category of “property.” The Supreme Court pointed out that it had previously held that federal tax liens may attach to property that cannot be unilaterally alienated. The Court reasoned that excluding property that cannot be unilaterally alienated from attachment would exempt a rather large amount of what is commonly thought of as property, such as community property.

The Supreme Court further noted out that, if the position advanced by the taxpayer was sustained, the entireties property would belong to no one for the purposes of the federal tax lien statute since it encompasses all of a taxpayer‘s “property” and “rights to property”. The Court, therefore, concluded that the husband’s interest in the entirety constituted “property” or “rights to property” that could be attached by the IRS pursuant to 26 U.S.C. §6321. The Supreme Court reversed the judgement of the United States Court of Appeals for the Sixth Circuit.

Several Justices dissented.

Justice Scalia pointed out that this Supreme Court holding nullified a form of property ownership that protected the stay-at-home spouse or mother. This person is likely to be the survivor that obtains title to the property while unlikely to be the source of the indebtedness that gave rise to the lien.

In his dissent, Justice Thomas noted that the Supreme Court was allowing property to be attached which, under Michigan law, did not belong to either spouse individually. Justice Thomas noted that the majority was ignoring the primacy of state law in defining property interests and was in conflict with an unbroken line of authority from the Supreme Court, the lower courts and the IRS.