How Can The Identical Proper Create 2 Separate Property Pursuits? – Tax

Highlights

  • In Goodrich v. USA, a 2020 case heard by the U.S.
    District Court for the Western District of Louisiana, a usufruct,
    which is akin to a life estate, was held to apply differently to
    distinct assets and thereby create separate and divergent property
    interests.
  • One type of property interest (nonconsumables) prevented the
    Internal Revenue Service (IRS) from retaining the proceeds from its
    levy, and the other type of property interest (consumables) allowed
    the IRS to keep the proceeds of its levy.
  • On appeal, the U.S. Court of Appeals for the Fifth Circuit on
    July 6, 2021, issued an opinion that certified questions to the
    Louisiana Supreme Court regarding a “naked” owner’s
    relationship to consumables.
  • This Holland & Knight alert explores the decisions,
    including the interaction of federal and state law principles that
    determine the nature and extent of a taxpayer’s interest in
    property.

The Internal Revenue Service (IRS) can file a lien and levy on
any and all of a taxpayer’s property (and rights to property)
regardless of how the property is held or titled. 26 U.S.C. §
6321. Whether the item is a taxpayer’s property is a subject of
continuous and contentious litigation between third parties and the
IRS.

Generally, a taxpayer’s property rights are a matter of
state law. Once it is found that a taxpayer has a state-created
interest in property, federal law takes over. However, sometimes
whether a state-created interest exists is blurred, which was the
precise situation in Goodrich v. USA, 125 A.F.T.R.2d
2020-1276 (W.D. La. 2020).

Background

Henry Goodrich (Henry) died owing a significant amount of
federal income taxes. Prior to his death, Henry held a usufruct,
which is akin to a life estate and was created by his deceased
wife’s will that included personal property, real property,
stocks and stock options (collectively, the “stock”),
cash and mineral interests. Unlike the personal property, real
property and mineral interests, Henry sold the stock during his
lifetime.

Henry’s three children (collectively, the
“children”) were the “naked” owners of the
property subject to Henry’s usufruct. Upon Henry’s passing,
the executor of the estate sold the real and personal property and
deposited most of the proceeds in a bank account (the
“estate’s checking account”) that was originally
funded by the closing of Henry’s bank account, which Henry
funded in part by the sale of the stock.

A few years after Henry died, the IRS issued levies against
funds in the estate’s checking account, including cash that
Henry received when he sold the stock. The IRS applied the seized
funds to Henry’s income tax liabilities, and the children filed
a wrongful levy claim under 26 U.S.C. § 7426 in the U.S.
District Court for the Western District of Louisiana.

The District Court held that the personal property, real
property and proceeds from the mineral interests were property of
the children pursuant to the usufruct; therefore, the IRS levy was
invalid. The District Court further held that the usufruct entitled
the IRS to possess the proceeds from the stock sale; thus, the IRS
levy was valid.

Wrongful Levy Claim Under Section 7426

To establish a wrongful levy claim, a third party must
demonstrate (1) that the IRS filed a levy with respect to a
taxpayer’s liability against property held by the non-taxpayer
third party, (2) the rights of the third party in the property are
superior to the rights of the IRS and (3) the levy was wrongful.
Oxford Capital Corp. v. United States, 211 F.3d 280, 283
(5th Cir. 2000).

To prove that a levy is wrongful, (1) the third party “must
first show some interest in the property to establish standing, (2)
the burden then shifts to the IRS to prove a nexus between the
property and the taxpayer, and (3) the burden then shifts back to
the plaintiff to prove the levy was wrongful, e.g., that the
property in fact did not belong to the taxpayer.”
Id.

Property Rights

In United States v. Craft, 535 U.S. 274, 276
(2002),1 the U.S. Supreme Court considered
whether federal tax liens imposed pursuant to 26 U.S.C. § 6321
may attach to property owned by a delinquent taxpayer and his or
her spouse as tenants by the entireties. The Supreme Court began by
describing the different roles of state and federal law in
determining what constitutes property for tax lien purposes
(citations omitted):

Whether the interests of
respondent’s husband in the property he held as a tenant by the
entirety constitutes “property and rights to property”
for the purposes of the federal tax lien statute, 26 U.S.C. §
6321, is ultimately a question of federal law. The answer to this
federal question, however, largely depends upon state law. The
federal tax lien statute itself “creates no property rights
but merely attaches consequences, federally defined, to rights
created under state law.” Accordingly, “[w]e look
initially to state law to determine what rights the taxpayer has in
the property the Government seeks to reach, then to federal law to
determine whether the taxpayer’s state-delineated rights
qualify as ‘property’ or ‘rights to property’
within the compass of the federal tax lien legislation.”
Id. at 278

Accordingly, for attachment to occur, the target property must
be subject to the tax lien statute. United States v.
Rodgers, 461 U.S. 677, 680 (1983). However, “the federal
tax lien statute … creates no property rights but merely attaches
consequences, federally defined, to rights created under state
law.” Craft, 525 U.S. at 278. Once the tax lien has
attached to the taxpayer’s state-created interests, federal law
determines the outcome. Aquilino v. United States, 363
U.S. 509, 513-14 (1960). As to state-created interests, federal
courts shall be bound by the property law decisions of the highest
court of a state. Commissioner v. Estate of Bosch, 387
U.S. 456 (1967), citing to Erie R.R. Co. v. Tompkins, 304
U.S. 64 (1938).

Usufruct Under Louisiana Law

In Goodrich, Henry was the usufructuary. A
“usufruct” is a right in a property owned by another,
normally for a limited time or until death. Simply stated, it is
the right to use the property, to enjoy the fruits and income of
the property, to rent the property out and to collect the rents,
all to the exclusion of the underlying real or “naked”
owner. The rights of a usufructuary “vary with the nature of
the things subject to it as consumables or nonconsumables.”
La. Civ. Code Art. 535.

Pursuant to La. Civ. Code Art. 536. “[t]he usufructuary
becomes the owner of consumables, such as money, and may consume or
sell them as he sees fit. As to consumable things, La. Civ. Code
Art. 538, “[a]t the termination of the usufruct he is bound
either to pay to the naked owner the value that the things had at
the commencement of the usufruct or to deliver to him things of the
same quantity and quality.”

Nonconsumable things – such as lands, houses, shares of stock,
animals, furniture and vehicles – are those that may be enjoyed
without alteration of their substance, although their substance may
be diminished or deteriorated naturally by time or by the use to
which they are applied. La. Civ. Code Art. 537. However, “[h]e
is bound to use them as a prudent administrator and to deliver them
to the naked owner at the termination of the usufruct.” La.
Civ. Code Art. 539.

“The usufructuary may not dispose of nonconsumable things
unless the right to do so has been expressly granted to him.”
La. Civ. Code Art. 568. Henry’s wife expressly granted to
Henry, in her will, the right to dispose of nonconsumable things.
As to the stock, Henry exercised that right.

Property Other Than Stock Proceeds: Nonconsumables

The U.S. government generally agreed that the children were
entitled to their interests in nonconsumables (i.e., mineral rights
and certain personal property) under Louisiana law. However, the
government claimed that because funds were deposited into the
estate’s checking account and were thus commingled, the funds
could not be traced to the disputed funds. Thus, the government
submitted that the children could not identify the disputed funds
and therefore it was entitled to the funds.

The District Court quickly disposed of the U.S. government’s
argument, noting that it was based on another non-binding circuit
court’s opinion2 and that the children’s records
were sufficient. The District Court then applied the law of
usufructuary as to nonconsumables and found that the children were
entitled to the funds derived from the nonconsumables.

Stock Proceeds: Consumables

The children and the U.S. government relied on a treatise3 to
interpret Louisiana law as to the usufruct’s consumables. The
children argued that the termination of a usufruct resulted in the
“reintegration of ownership” and the
“restoration” of full ownership or perfect ownership.
That is, when Henry sold the stock, the usufruct terminated as to
the stock and attached to the proceeds received from the
sales.4

The government alleged that the children merely had an unsecured
claim against Henry’s estate as to the stock proceeds and were
not actual owners of any particular cash. The U.S. relied on the
same treatise albeit different sections.5 In addition, the
government cited to four cases in support of its position.6

The District Court found In Re Succession of Catching
to be persuasive.7 Accordingly, the District Court found
that the children had a claim against the estate with respect to
the cash Henry received for the stock but did not immediately
become the owners of any particular cash at the moment of
Henry’s death. The obligation to the children was a debt or
obligation of the estate that was subject to administration and
payment only upon completion of the succession with adequate funds
available to satisfy the obligation. The children’s claim was,
therefore, in the nature of unsecured creditors of the succession
with respect to this claim.

Following the District Court’s decision, the estate and the
children filed a timely appeal in the U.S. Court of Appeals for the
Fifth Circuit.

Fifth Circuit Opinion

In an opinion issued on July 6, 2021, the Fifth Circuit
disagreed with the District Court’s proposition that, as to a
usufruct, In Re Succession of Catching and the
Louisiana Civil Law Treatise were dispositive of the
property interest issue. See Goodrich v. USA, —- F.3d—- (5th
Cir. 2021)

However, in agreeing with the plaintiffs-appellants’
observation, the Fifth Circuit noted that Louisiana courts
(including the Louisiana Supreme Court) have not “decided the
precise issue of whether the naked owner of [money] occupies the
status of owner or creditor.” Accordingly, and to “avoid
making … a guess as to how the Louisiana Supreme Court would
address the issue,” the Fifth Circuit invoked a Louisiana
Supreme Court rule to certify the following questions to the
Louisiana Supreme Court:

  1. Does a usufructuary’s testamentary usufruct of consumables
    render naked owners unsecured creditors of the usufructuary’s
    succession?
  2. If not, what is the naked owner’s relationship to those
    consumables?

The decision means that the IRS’ ability to retain the
levied funds will depend on the Louisiana Supreme Court’s
interpretation of state law as to usufructs.

Conclusion

Thus, the Fifth Circuit held that treatises and lower state
court decisions are not dispositive of state property rights.
Rather, that is a decision reserved for the highest court in the
state. Commissioner v. Estate of Bosch, 387 U.S. 456
(1967).

Accordingly, Goodrich serves as a reminder that when
analyzing the legitimacy of an IRS lien on property (and rights to
property), it is wise to remember the basics: State law determines
the property interest, and the property right can be defined by the
state’s highest court. If the property right has been decided
by the state’s highest court, then federal law applies; if not,
then the individual’s property interest may need to be
determined before a wrongful levy action can be commenced.

Footnotes

1. In
Craft, the Supreme Court addressed the issue of whether
federal tax liens can attach to property owned in tenancy by the
entirety by the delinquent taxpayer and his unindebted spouse. The
Supreme Court ruled that the tax lien does attach to the
property.

2.
Bregman, Berbert & Schwartz, L.L.C. v. United States,
145 F.3d 664 (4th Cir. 1998)

3. 3 A.N.
Yiannopoulos, Louisiana Civil Law Treatise.

4. See 3
La. Civ. L. Treatise, Personal Servitudes §6:16-§6:18
(5th Ed.).

5. See 3
La. Civ. L. Treatise, Personal Servitudes [“A usufruct of
consumables differs from a usufruct of nonconsumables because the
usufructuary acquires ownership of the things and the naked owner
becomes a general creditor of the usufructuary.” § 1:3 at
9. “When the usufruct terminates by the death of the
usufructuary, the debts that the usufructuary owes the naked owner,
including restoration of the value of consumables that were subject
to the usufruct, are debts of the succession.” § 6:18 at
400 n. 2.].

6.
Succession of Majoue, 705 So.2d 225 (La.App. 5th Cir.
1997); Succession of Catching, 35 So.3d 449 (La.App. 2nd
Cir. 2010); Succession of Dittmar, 493 So. 2d 221 (La.App.
5th Cir. 1986); Succession of Feingerts, 162 So.3d 1215
(La.App. 4th Cir. 2015), writ. denied, 171 So.3d 936 (La.
2015).

7. In
Catching, the court “cited jurisprudence that stated
the obligation of the usufructuary in such cases “is in the
nature of a debt owed by the succession to the owners.” The
court held: “The usufruct terminated upon James’ death and
became a debt owed by the succession to the naked owner.” See
Catching, 35 So.3d at 451.

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