Trustees May Be Liable in their Own Person and Estate for Failure to Comply with IRS Notices of Levy Issued against Trust Beneficiaries

In a recent case before the United States District Court for the Eastern District of New York, the United States government commenced an action against a trustee in order to collect unpaid federal taxes owed by the trust beneficiary. The District Court granted the government’s summary judgment motion and found the trustee liable for unpaid federal taxes plus interest.

In 1995, the beneficiary’s mother died.  Pursuant to her will, the majority of her estate was left to be held in trust, and administered, managed, invested and reinvested by the trustee as set forth in the will.  The relevant provision of the will directed the trustee to pay her son, the sole beneficiary of the trust, at least $1,000 per month, but not more than 60-percent of the net income of the trust.  The same provision also provided the trustee with sole discretion to pay trust principal to her son as necessary for the comfortable “maintenance, support, health, education and well being” of her son, and his two sons.  In February 1996, the trustee was issued letters of trusteeship for the trust created by the will.

In April 1996, the trustee was informed by his attorney by letter that the son owed the federal government for various taxes totaling $246,579.  The attorney additionally informed the trustee that whatever income was going to the son, regardless of the source, must go first to the creditor.  In June 1996, the trustee was served with an Internal Revenue Service (IRS) Notice of Levy and Notice of Federal Tax Lien. The Notice of Levy listed federal income tax liabilities and civil penalties that the son owed to the IRS for tax years 1979 through 1989.  The notice further stated that the levy required the trustee to turn over to the IRS “this person’s property and rights to property (such as money, credits and bank deposits) that you have or which you are already obligated to pay this person.”  In either 2000 or 2001, the trustee was directed by his new attorney to make distributions from the trust to the son because the IRS had been satisfied.  The trustee did not see the paperwork documenting satisfaction of the IRS levy and signed blank checks to permit the attorney to draw on the trust account for the son.  The government then commenced action against the trustee to collect the son’s delinquent tax liability through the judicial enforcement of the IRS levy.

The IRS has two principal tools to collect delinquent taxes.  The first is a lien foreclosure suit, brought pursuant to 26 U.S.C. § 7403(a).  The other is the issuance of a levy upon all property and rights to property belonging to the delinquent taxpayer, pursuant to 26 U.S.C. § 6331(a).  Where the taxpayer’s property is being held by another, the notice of levy is customarily served upon the custodian of the property pursuant to 26 U.S.C. § 6332(a).  Serving the notice on the custodian creates a custodial relationship between the person holding the property and the IRS so that the property comes into constructive possession of the government.  If the custodian fails or refuses to surrender the property or rights to property subject to the levy, the custodian becomes liable in his own person and estate to the government in the sum equal to the value of what he failed to surrender.  26 U.S.C. § 6332(d)(1).

Pursuant to New York law, the plain language of the trust instrument must be analyzed in order to determine a trust beneficiary’s property rights in trust income or principal.  The Second Circuit has held that a beneficiary has a property interest in trust income when the trust instrument sets out the trustee’s duty to pay income in mandatory terms.  Magavern v. United States, 550 F.2d 797, 801 (2d Cir.1977).  Therefore, when the trustee is required to make a payment of trust income to a beneficiary, even when the amount and timing of the mandatory income distribution are left to the trustee’s discretion, the trust beneficiary has a property right in trust income that is subject to a tax levy.

In the instant case, because the trustee’s duty pay out a certain amount of trust income was set forth in mandatory terms, the beneficiary had a right to property in the trust income, and the government tax levy could attach to this right.  However, the will did not require the trustee to pay trust principal to the beneficiary.  The terms of the trust left decisions with respect to the trust principal entirely to the trustee’s discretion.  Therefore, the beneficiary had no attachable right to property in the trust principal until the trustee decided to make a distribution of such principal to him.  The District Court concluded that the beneficiary had some property rights to both the trust income and that portion of the trust principal, if any, that was distributed to him.  These rights to property were in the possession of the trustee, and it was undisputed under the facts of the case that the trustee did not surrender any levied property to the IRS in compliance with 26 U.S.C. § 6332(a).  Therefore, the trustee could be liable in his own person and estate to the government under 26 U.S.C. § 6332(d)(1).

A custodian of property or rights to property that are subject to an IRS levy has only two defenses to avoid liability in his own person and estate.  The first available defense is that the trustee is neither in possession of nor obligated with respect to the property or rights to property belonging to the delinquent taxpayer.  26 U.S.C. § 6332(a).  The second available defense is that the taxpayer’s property or rights to property at issue are subject to attachment or execution under a judicial process.  Id. In the instant case, the first defense was not applicable because, pursuant to the terms of the will, the trustee was both obligated to pay the beneficiary certain amounts of trust income at given intervals and empowered to make discretionary distributions.  The trustee made no suggestion that the second defense was applicable. The absence of intentional or negligent conduct is not relevant as to whether an enforcement action may be maintained against the custodian; therefore, good faith could not absolve the trustee of liability for his failure to comply with his statutory obligations to surrender property pursuant to a valid IRS Notice of Levy.  Therefore, the District Court found that the trustee could not avoid liability for his actions under either of the two statutorily available defenses.

The District Court determined that the government established as a matter of law that the trustee failed to honor the Notice of Levy served on the trust beneficiary in June 1996 by improperly distributing estate assets to the trust beneficiary after the date of the levy.  However, the court also held that the trustee was liable for less than the judgment amount requested by the government, but the court permitted the government to submit a supplemental briefing as to its entitlement to additional estate money to which the trust beneficiary had a property right.

Should you have any questions relating to trusts or other personal asset protection issues, please do not hesitate to contact Attorney Susan Maya, at SMaya@Mayalaw.com or 203-221-3100, and Attorney Russell Sweeting, at RSweeting@Mayalaw.com or 203-221-3100, in the Maya Murphy office in Westport, Fairfield County, Connecticut.

United States v. Michel, 08 CV 1313 DRH WDW, 2012 WL 3011124 (E.D.N.Y. July 23, 2012)