Federal Estate and Gift Tax Liens

FEDERAL ESTATE AND GIFT TAX LIENS

The United States imposes a federal estate tax on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States. Similarly, the United States imposes a gift tax on transfers which constitute a gift. For underwriting purposes, the mechanism for calculating such taxes is less important than the rights granted to the federal government for enforcing and collecting these taxes, both general and special. Of particular note is the federal estate tax lien, which operates as a silent lien against a decedent’s property and may be enforced without recorded notice appearing in the public records.

FEDERAL ESTATE TAX

A tax is imposed by statute on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States at the time of death. The federal estate tax provisions are found in 26 USC 2001, et seq. The taxable estate is derived from the gross estate, less applicable deductions. The federal estate tax is then applied to the taxable estate, and finally certain credits against the federal estate tax are allowed.

Gross Estate

The gross estate, defined at 26 USC 2031-2046, includes the value at the time of the decedent’s death of all of the decedent’s property, real or personal, tangible or intangible, wherever situated. The value of the gross estate includes both probate and non-probate property, to the extent of the interest of the decedent therein. This includes any interest in real property owned by the decedent at the time of his or her death: • in fee simple; • as tenant in common; • as joint tenant with right of survivorship; • as tenant by the entirety; • as dower or curtesy; • as life tenant; • in property transferred subject to revocation by the decedent; and • held pursuant to a power of appointment. The gross estate also includes insurance policies, annuities, and property transferred by the decedent within three years of his or her death, which is not a bona fide sale for full and adequate consideration.

Taxable Estate

The taxable estate, defined at 26 USC 2051-2058, is equal to the gross estate less certain allowable deductions, including those for funeral and estate administration expenses, debts of the decedent, charitable contributions, unpaid mortgages on, or any indebtedness in respect of, property where the value of the decedent’s interest therein, undiminished by such mortgage or indebtedness, is included in the value of the gross estate, and the marital deduction. The marital deduction can be one of the most significant deductions in reducing the decedent’s taxable estate. The marital deduction, found in 26 USC 2056, allows a reduction of the gross estate equal in value to any interest in property that has passed from the decedent to a surviving spouse.

The taxable estate is the basis upon which the federal estate tax is assessed. The federal estate tax rate, as set by Congress, is variable, and is applied to any estate value in excess of the then applicable exclusion amount (found in 26 USC 2010, and known as the “unified credit”), which varies annually. If the gross estate (not taxable estate) does not exceed the applicable exclusion amount in 26 USC 2010, then it is likely that no federal estate taxes are owed. However, if the gross estate does exceed the then applicable exclusion in 26 USC 2010, it is highly likely that estate tax is owed. After the tax itself has been computed, certain credits may be applied which reduce the tax liability dollar for dollar. Among the allowed credits are sums equal to the amounts of: • gift taxes paid where the value of the gift is included in the gross estate;

© 2010 Old Republic National Title Insurance Company All Rights Reserved 0110 • the unified credit; • state death taxes paid; • foreign death taxes paid; and • a portion of the estate taxes paid on property transferred to the decedent by a person who died within ten years prior to the decedent’s death.

Special and General Tax Liens

Federal tax liens fall into one of two categories: general or special. A general tax lien arises when the United States makes an assessment and demand for tax debts, and is codified in 26 USC 6321-6323. Liens for nonpayment of income and other taxes fall within the category of general tax liens. Special tax liens exist for limited purposes, and may be enforced without assessment and demand. Special tax liens are codified in 26 USC 6324(a) (estate taxes), 6324(b) (gift taxes), 6324A (deferred estate taxes), and 6324B (additional estate tax attributable to qualified real property).

Pursuant to 26 USC 6324(a)(1), the United States has the right, for a period of ten years after the date of death of a decedent, to impose a special tax lien upon the gross estate of a decedent. This lien has priority dating from the instance of the decedent’s death. Furthermore, pursuant to 26 USC 6324(a)(2), the estate tax is effective against any probate asset of the decedent. Finally, the federal government may record a separate notice of lien, which will effectively extend the duration of the estate tax lien beyond the initial ten-year period.

Unlike general federal tax liens, imposition of the federal estate tax lien does not require any recordation of notice among the public records, and is effective even against subsequent bona fide purchasers of estate property. Detroit Bank v. U.S., 317 U.S. 329, 63 S.Ct. 297 (1943). In Detroit Bank, the U.S. Supreme Court specifically validated the legitimacy and enforceability of the federal estate tax over a vigorous argument by a property owner that the lack of any filing requirement for such lien violates the Due Process Clause of the 14th Amendment to the U.S. Constitution. The Court explained the reason for a lack of a filing requirement as follows: Congress, in providing for the estate tax lien, has proceeded on the assumption that in the case of the tax on property passing at death and which is distributed in consequence of the death, there is greater need of a lien in advance of assessment and demand for payment of the tax than in the case of other types of taxes; and that there is less need for protection of third persons by a recorded notice of the lien where the property passing at death is normally dealt with by probate and estate tax proceedings of public notoriety. Id. at 337, 63 S.Ct. at 301.

Another case, U.S. v. Vohland, 675 F.2d 1071 (9th Cir. 1981), further explored the issue of the applicability of an unrecorded federal estate tax lien against bona fide purchasers. The court came to the conclusion that “[u]nless a federal statute requires a government tax lien to be recorded, the unrecorded lien may be enforced against subsequent transferees.” Id. at 1075. Thus, there is no bona fide purchaser defense to the unrecorded federal estate tax lien.

Because the federal estate tax lien is a silent one, and because it follows property into the hands of heirs, distributees and transferees, particular caution must be exercised when underwriting because the federal estate tax can be significant, especially on large estates that exceed current exemptions. Although the tax rate varies on an annual basis, it is not unusual to see marginal estate tax rates in excess of 50%. Certain nonprobate assets that have been “transferred by a spouse, transferee, trustee, surviving tenant, person in possession, or beneficiary, to a purchaser or holder of a security interest shall be divested of the lien provided [in 26 USC 6324(a)(1)], and a like lien shall then attach to all property of such [transferor].” 26 USC 6324(a)(2). Therefore, the following nonprobate assets may be transferred to a third party by one of the identified beneficiaries of a decedent, and the transfer will effectively eliminate the federal estate tax lien: • Dower or curtesy or interest in lieu thereof (26 USC 2034);

© 2010 Old Republic National Title Insurance Company All Rights Reserved 0110 • Gifts made within three years of death (26 USC 2035); • Transfers with retained life estates for less than adequate and full consideration (26 USC 2036); • Revocable transfers (26 USC 2037); • Certain annuities (26 USC 2038); • Survivorship interests in joint tenancies and tenancies by the entirety (26 USC 2040); • Powers of appointment (26 USC 2041); and • Proceeds of life insurance (26 USC 2042)

Tax Deferral for Family Business

The federal statutes allow a deferral in certain cases of estate taxes when dealing with heirs of a family business under 26 USC 6324A. The deferral is codified at 26 USC 6166, and authorizes a tax deferral period of five years, and an installment payment period of up to ten years. The object of these sections is to provide tax relief to the heirs of a family business in order to pay estate taxes.

Where an election has been made by decedent’s executor pursuant to 26 USC 6324A to defer the estate tax, where 65% of the value of the decedent’s gross estate comprises the decedent’s interest in a closely held business, and an agreement has been filed to this effect, a lien is imposed which is in lieu of the special estate tax lien imposed by 26 USC 6324. In contrast to the special federal estate tax lien, the lien for deferred estate taxes will not be valid as against any purchaser, holder of security interest, mechanics’ lien, or judgment lien creditor until notice has been filed in accordance with 26 USC 6323(f). Such notice is not required to be re-filed.

The special lien for deferred estate taxes arises at the time the executor is discharged from liability or when notice of the lien is filed and continues until the liability for the deferred amount is satisfied or becomes unenforceable by lapse of time. The lien will be valid for the entire deferred period, and this extended time will not be included in calculating the general six year period for collectibility (see 26 USC 6503(d)).

The possibility of a special federal tax lien by reason of the deferred payment of estate tax may be ignored in issuing commitments or title policies unless a notice has been recorded among the public records. If a notice has been recorded, it is to be reported in all commitments or title policies as a lien on the property designated in the filed agreement.

Special Lien for Possible Additional Tax (Recapture)

A special lien for possible additional estate tax on qualified property where a qualified heir disposes of such qualified property or ceases to use it for a qualified purpose is established in 26 USC 6324B. A qualified heir to qualified property is entitled under 26 USC 2032A to elect an alternate value for qualified property according to specific rules, which results in a reduction of the estate tax payable. This reduction is only allowed, however, where the property is used as a farm or for farming purposes, or in a trade or business other than farming, and only where such property makes up a statutorily specified percentage of the gross estate of the decedent (see 26 USC 2032A(b)).

In order to maintain the full advantage of this tax reduction, the taxpayer must not dispose of the property or cease to use it for farming, or trade or business purposes, before the expiration of a term of 15 years commencing at the time of the decedent’s death. Otherwise, an additional estate tax results which in effect recaptures all or a part of the differential in taxes which resulted from the election of the alternate value for the property.

26 USC 6324B imposes a lien upon farm, trade or business property, for which an election of the alternate value has been made. The lien is for an amount equal to the adjusted tax difference attributable to said election, and arises at the time this election is made. Neither an apparent payment of the federal estate tax nor the expiration of the ten year statute of limitations will prevent the imposition of the recapture tax, and therefore, this lien will be in effect for fifteen years, or until any and all recaptured taxes

© 2010 Old Republic National Title Insurance Company All Rights Reserved 0110 are fully paid. This lien is not valid as against any purchaser, holder of security interest, mechanics’ lien or judgment lien creditor until notice has been filed in accordance with 26 USC 6323(f). There is no re-filing requirement.

FEDERAL GIFT TAX

Generally, there is a federal tax imposed on the transfer of property by gift by any individual, resident or nonresident. “Taxable gift” has been defined as the total amount of gifts made during the calendar quarter, less allowable deductions. There is a substantial lifetime unified credit allowable which may reduce the gift tax liability dollar for dollar (see 26 USC 2502). The effect of this credit, taking into account the applicable tax rates, is that only substantial gifts made during one’s lifetime are subject to federal gift taxes.

The primary liability for federal gift taxes is in the donor. However, if the donor fails to pay the tax, the burden shifts directly to the donee to the extent of his or her gift. The federal gift tax is another example of a special federal tax lien, and is found in 26 USC 6324(b), which provides that Unless the gift tax is sooner paid in full or becomes unenforceable by reason of lapse of time, such tax shall be a lien upon all gifts made during the calendar year, for ten years from the date the gifts are made.

The treatment of special gift tax liens is somewhat different than that for estate tax liens. If the tax is not paid when due, the donee is personally liable, but any part of the property comprised in the gift to the transferee, which is subsequently transferred by him or her to a purchaser or holder of a security interest shall be divested of the special gift tax lien as to said purchaser or holder of security interest (see 26 USC 6324(b)).

EXTINGUISHING FEDERAL ESTATE OR GIFT TAX LIENS

Due to the extraordinary reach of the special federal estate tax lien, is it critical that any such lien be investigated and fully extinguished whenever there is any indication that a property has been conveyed from an estate during the previous decade. Accordingly, title agents must be sensitive to any deed granted by an executor, administrator or person otherwise identified as an heir to an estate.

There are two choices for clearing title with respect to the special federal tax lien: (1) wait out the period of limitations (either 10 or 15 years), or (2) obtain the necessary discharge or releases from the Internal Revenue Service. 26 USC 6325(c) indicates that subject to such regulations as the Secretary of Revenue or his delegate may prescribe, the Secretary or his delegate may issue a certificate of discharge if the Secretary or his delegate finds that the liability secured by such lien has been satisfied or otherwise provided for. In cases where tax liability has been merely adequately provided for, the Secretary or his delegate may issue a certificate discharging particularly described real property from the lien, as would be required to transfer property free from the lien, or if it is necessary to clear title. In this instance, the Secretary or his delegate may require that proceeds of the sale of property be held in a fund subject to the tax lien.

It is not the responsibility of the underwriter to procure the appropriate lien release documents, and any such special tax liens must be shown in Schedule B of the title policy or commitment until an appropriate certificate of release or discharge is of record, or until an adequate certificate of subordination issued by the United States has been filed pursuant to 26 USC 6325(d). Alternately, a special federal estate tax lien may be eliminated in a foreclosure by judicial action.

Due to the often significant credits available, many estates will not meet the minimum tax threshold, and thus, no tax liability would arise. If a tax lien for estate or gift taxes has been filed, then one must be concerned with both the general federal tax lien as well as the special federal tax lien. If a customer desires a policy without exception to a special federal estate or gift tax lien, require recordation of a

© 2010 Old Republic National Title Insurance Company All Rights Reserved 0110 certificate of release, discharge, or proper subordination of the special tax lien, or otherwise obtain satisfactory evidence that no tax is assessable. The possibility of a special federal tax lien for deferred payment of estate tax, as well as the possibility of a special federal tax lien for additional (recaptured) estate taxes, may be ignored when issuing commitments or title policies, unless a notice has been recorded. If a notice has been recorded, it must be reported in all commitments and title policies as a lien on the property designated in the filed agreement.