Recently, I wrote about the nominee lien calling it the lis pendens of federal tax liens. A recent case gives me the chance to write about the competition between a third party who has filed an actual lis pendens and the federal tax lien. The case also provides an example of the type of lien I suggested that the IRS file when it has not yet filed the notice of federal tax lien at the time property transfers from the taxpayer to a third party through some mechanism other than purchase.
Dyane Smith v. United States involves a fight between the ex-wife of someone who, appears to be, both a bad husband and a bad taxpayer leaving two relatively innocent parties to fight over the mess created by him. The ex-wife has plenty of equity on her side but little law. The unfolding of the case shows again the power of the federal tax lien but also some compassionate actions that can save the ex-wife from complete defeat.
Mr. Smith moved out of the marital home to other property (referred to here as the Redding property) owned by the couple. While living separate from his wife but prior to the dissolution of the marriage, he failed to file returns for 2000 and 2001. Dyane Smith sued him for divorce on January 12, 2001. She recorded a lis pendens in early August, 2001. He filed his returns for 2000 and 2001 on February 2, 2003 by signing a Form 4340 – probably during a substitute for return examination. Assessments were made against him on March 3, 2003, and March 10, 2003. Apparently, the IRS timely and properly sent out notice and demand approximately at the same time as the assessments. The final decree of divorce was entered on July 15, 2003. The decree required him to make certain payments to her and to transfer the Redding property to her.
He transferred the property to Dyane Smith as a part of the property settlement in the divorce. Naturally, he did not warn her of his tax issues. The deed transferring the property was properly recorded. At the time of the transfer, she had no notice of the assessments against him for 2000 and 2001 and, consequently, no notice that a federal tax lien attached to the property at the time of transfer. On September 15, 2003, approximately one month after transfer of the property to Dyane Smith, the IRS recorded a notice of federal tax lien against Mr. Smith for the unpaid 2000 and 2001 federal income taxes in the jurisdiction of the Redding property.
She obtained a mortgage on the property in 2005 and a title company issued a letter evidencing clear title to the property. In 2009 she became aware of the notice of federal tax lien recorded against Mr. Smith and the potential complications that created with respect to her interest in the property. Meanwhile, an attorney in the IRS Counsel Office in Connecticut responded to questions from a revenue officer trying to collect the unpaid tax from Mr. Smith. The attorney discussed the problem someone like Dyane Smith or subsequent parties would have in identifying the existence of the federal tax lien on the property. He recommended the filing of a transferee lien (the very document I suggested the IRS should file in these situations.) He mistakenly, in my view, also recommended that the filed lien identify Dyane Smith as a nominee. The IRS did record the transferee/nominee lien in 2001.
Dyane Smith brought a quiet title action seeking a determination that her interest in the property defeated the federal tax lien. In her action she made several losing arguments. First, she made a due process argument which the court dismissed rather easily. I will not address the details of this argument as they provide little interest. Second, she argued that because she had recorded a lis pendens prior to the existence of the federal tax lien, her interest in the property came ahead of the federal tax lien. The court properly rejected this argument. The lis pendens argument runs into an issue of the application of federal or state law. The court determined that even if Connecticut law would give the party filing a lis pendens priority over a subsequent lien creditor, Connecticut law did not control the situation. State law creates property interests but does not control priority status. The lis pendens creates a property interest that remains inchoate until the final judgment establishing the interest of the party who filed the lis pendens. Here, the federal tax lien came into existence after the filing of the lis pendens but before the final judgment. In competition against the federal tax lien it must lose because it lace finality or choateness at the time the federal tax lien attached to the property. The issue has controlling, if old, Supreme Court precedence. United States v. Sec. Trust & Sav. Bank and United States v. Vermont.
Dyane Smith runs into this problem because she did not take the property in a way that defeats the unfiled federal tax lien. A purchaser or the holder of a security taking before the filing of the notice of federal tax lien could defeat the federal tax lien under IRC 6323(a). She did not qualify as a purchaser because she took the property through the divorce proceeding.
Even though her interest in the property does not defeat the federal tax lien, an issue still exists concerning what the court will do about it. The IRS sought to foreclose its lien interest in the property and have the property sold to satisfy the unpaid taxes of Mr. Smith. By the time of this action, Mr. Smith’s liability had dropped to about $37,000. The value of the property exceeded $700,000. The court looked at the appropriateness of allowing the IRS to foreclose its lien and sell the property. To make this determination the court looked to the decision of the Supreme Court in United States v. Rodgers.
The court looked first to the financial prejudice to the IRS. The court found that the sale of the property could satisfy the outstanding liability but that the IRS had been dilatory in collecting. On balance it found this factor neutral or only slightly in favor of allowing the sale. Next, it looked at Dyane Smith’s expectation of foreclosure. It determined that this factor weighed against forced sale of the property because she had no actual or constructive knowledge of the federal tax lien which gave her a reasonable expectation that the property would not be subject to foreclosure. Continuing to follow the Rodgers decision, the court next looked to the prejudice to Dyane Smith that would result from the foreclosure of the property by the IRS in terms of personal dislocation costs and under-compensation of interest. The relative value of the lien and the house coupled with the dilatory collection actions of the IRS led the court to conclude that this factor weighs against forced sale of the property. The final factor derived from Rodgers is the “relative character and value of the non-liable and liable interests held in the property….” Because Dyane Smith has a 100% ownership interest in the property at the time of the proposed foreclosure, this factor weighs heavily against foreclosure of the property.
So, the court refused to allow the IRS to foreclose its lien while simultaneously upholding the existence and priority of the lien. The court also encouraged the parties to come to a settlement that would allow the removal of the lien. This outcome seems most appropriate given the law and the circumstances of this case. Situations in which the federal tax lien attaches and property transfers prior to a recordation of the notice of federal tax lien will frequently create patterns of prejudice to both the IRS and the non-liable new owner of the property. Denying foreclosure and nudging the parties toward a settlement seems the best result. Dyane Smith still has the possibility that the title company that gave the erroneous clear title opinion could come into the picture to rescue her. In some ways this case reminded me of a penalty case in which the real thrust of the penalty litigation concerns the malpractice policy of the person who gave the advice that got the taxpayer into the penalty position. Here the title company did not give advice that got her into this position but it did give her a clear title report after she got there. It should bear some of the cost of fixing the problem caused by Mr. Smith.
In an early part of the opinion that I did not highlight, the IRS apparently failed to fix an order that would have allowed it to obtain a judgment against Mr. Smith. This could turn out to be an important misstep from a couple of angles although it is a correctable problem if timely addressed. The possibility still exists, at least until the statute expires, that Mr. Smith could pay his taxes which would remove the lien from Dyane Smith’s property. Getting the judgment gives the IRS much more time to seek to collect from Mr. Smith’s assets. The judgment also gives the IRS and Dyane Smith more time to work out a payment plan for the property assuming Mr. Smith cannot or will not pay off his debt. It also, however, makes it clear to her that she must deal with the debt underlying the lien since she will not have the ability to dispose of the property for a very long time without addressing the federal tax lien if the underlying tax assessment converts to a judgment.