Court Finds IRS’ Attempt to Foreclose on Trust Property Plausible

Are assets transferred by your parents into a trust for your benefit subject to your tax liabilities? In general, no, provided the trust has the proper spendthrift language. Longstanding common law has recognized spendthrift clauses in trusts which restrain voluntary alienation of trust assets, thereby preventing a beneficiary’s creditors from reaching trust assets to satisfy debts of the beneficiary.1 Nonetheless, the U.S. District Court in New Jersey has just denied a taxpayer’s Motion to Dismiss the IRS’ Complaint seeking to foreclose tax liens against trusts funded by contributions by the taxpayer’s parents.  On March 18, 2019, the Court issued an Opinion in U.S. v. Hovnanian allowing the IRS to proceed in litigating its right to foreclose on property held in a spendthrift trust to satisfy tax liabilities of the father (who was not even the settlor of the trust) of the beneficiaries.2 This is an interesting contrast to Campbell v. Commissioner where the Tax Court respected a self-settled asset protection trust.3

Facts

Shant Hovnanian was assessed with approximately $5.5 million in income tax for the years 2002-2004 and 2007. The IRS filed a Notice of Federal Tax Lien on January 16, 2018. By September 30, 2018, the balance due with penalties and interest equaled $16.2 million. The IRS brought a Complaint seeking to foreclose on real property held in two trusts: (1) the VSHPHH Trust, and (2) the Pachava Trust.4 The IRS had listed each of these trusts as the taxpayer’s nominee on the filed Notice of Federal Tax Lien.

The VSHPHH Trust was formed on December 28, 2012 by Shant’s parents. Shant and his sister, Nina, were appointed as the initial trustees. At some time before litigation, Shant ceased serving as trustee. On January 1, 2015, Shant’s parents transferred property known as the Village Mall to the VSHPHH Trust. The trust beneficiaries were Shant’s and Nina’s children. This property was leased to tenants who, at least sometimes, were instructed to pay rent to an entity controlled by Shant. Property tax and insurance were paid by funds under Shant’s control rather than from the trust.

The Pachava Trust was formed on October 8, 2007 by Shant as settlor. On June 21, 2011, Shant’s mother transferred residential property at 520 Navesink River Rd., Red Bank, NJ to the trust. At the time of litigation, Nina Hovnanian was trustee of the Pachava Trust. Shant’s children are the trust’s beneficiaries. Shant resided in the 520 Navesink River Rd. property. He also directly paid property taxes and utilities.

Applicable State Law

A preliminary question the Court addressed was whether New Jersey or New York law applied. The trust documents contained provisions which stated that “all matters of interpretation, validity and administration of any trust held under this Trust Agreement shall be governed by the laws of the State of New York.”  The trusts argued that New York applied. The government argued that New Jersey law applied.

As a matter of common law, in determining the validity of a trust in land, the government argued that the laws of the state where real property is located control.5 As such, the IRS sought to have New Jersey law apply. The trusts cited to case law supporting a conclusion that the trusts’ choice of law provision should apply.6

The Court’s Opinion made quick work of this issue by stating “the Government was not a settlor, trustee, beneficiary, nor was it otherwise involved in [the trusts] formations.” The relevant property is located in New Jersey. As such, the Court held that New Jersey law should apply.

Alter Ego and Nominee Theories

In pursuing foreclosure on the properties held in the two trusts, the IRS advanced two theories: (1) alter ego; and (2) nominee. Although alter ego and nominee theories are sometimes conflated, they are two distinct legal theories. The Court described the difference in footnote 4 of its Opinion as follows:

Although the Government contends that the tests for nominee liability and alter ego liability “are often collapsed” (VSHPHH Opp’n at 4 n.1), “the concepts are distinct[.]”7

Under a nominee theory, the Government may levy upon only those assets to which a third party holds legal title, but from which the delinquent taxpayer enjoys the true beneficial ownership. Under an alter ego theory, however, the Government may seize all of the assets of an alter ego corporation if the separate entity is merely a sham.8.

In comparison with the six-factor test for the nominee theory as described above, the alter ego theory requires a finding that the trust was a “mere instrumentality” of the defendant, so that “liability generally is imposed only when the [defendant] has abused the privilege of incorporation by using the [trust] to perpetrate a fraud or injustice, or otherwise to circumvent the law.” 9

In summary, nominee theory applies when a third party holds bare legal title to an asset, but the taxpayer enjoys the benefits and burdens of ownership. An alter ego exists when an entity is a “mere instrumentality” of the taxpayer such that the relevant entity is merely a sham. Although the parties briefed alter ego, the Court’s opinion was limited to addressing nominee liability since it felt that theory sufficient to allow the case to proceed.

After the IRS filed its Complaint seeking to foreclose on trust properties, the taxpayer and the trusts filed a motion to dismiss the IRS’ Complaint for failure to state a claim upon which relief can be granted. Specifically, as a matter of law, the taxpayer argued that the trusts could not be the nominee or alter ego of Shant since he did not contribute the properties to the trusts.10 The argument is that, in order for there to be a nominee situation, there must first be a transfer of assets from the taxpayer to the nominee (whether directly or indirectly). For an alter ego claim to proceed, the same rule applies.

With respect to the VSHPHH Trust: (a) Shant did not create the trust; (b) Shant did not contribute the relevant property to the trust; (c) Shat is not a beneficiary of the trust; and (d) Shant is no longer a trustee of the trust. With respect to the Pachava Trust: (a) Shant did not contribute property to trust; (b) the trust was formed before tax liabilities arose; and (c) Shant was never a trustee or beneficiary of the trust. Although Shant may have paid expenses and benefited from the trust, that does not change the fact that he did not transfer these properties to the trust, a requirement for the government to prevail to either of its theories.11

The Third Circuit has stated that “A third party is a taxpayer’s nominee where the taxpayer has engaged in a legal fiction by placing legal title to property in the hands of [that] third party while actually retaining some or all of the benefits of true ownership.”12 A six factor test applies to determine whether nominee liability applies:

  1. Whether the nominee paid adequate consideration for the property;
  2. Whether the property was placed in the nominee’s name in anticipation of a suit or other liabilities while the taxpayer continued to control . . . the property;
  3. The relationship between the taxpayer and the nominee;
  4. The failure to record the conveyance;
  5. Whether the property remained in the taxpayer’s possession; and
  6. The taxpayer’s continued enjoyment of the benefits of the property.13

The Court went on to review each of these factors with respect to both the VSHPHH Trust and the Pachava Trust as follows:

Factor VSPHH Trust Pachava Trust
1. Favors Government – nominal consideration Favors Government – nominal consideration
2. Favors Government – facts could indicate Shant’s parents contributed property to trust to avoid tax lien Favors Government – facts could indicate Shant’s parents contributed property to trust to avoid tax lien. Plus, trust was originally formed by Shant as settlor.
3. Slightly Favors Government – Shant’s proximity to every person involved Slightly Favors Government – Shant’s proximity to every person involved. Plus, trust was originally formed by Shant as settlor.
4. Favors the trust – conveyance recorded Favors the trust – conveyance recorded
5. Heavily Favors Government – Shant receives rental income and pays bills. Also, Shant attempted to hide true ownership from the IRS. Heavily Favors Government – Shant resides in property and pays bills. Also, Shant attempted to hide true ownership and the fact that he resided at the property from the IRS.
6. Heavily Favors Government – Same as Factor 5 Heavily Favors Government – Same as Factor 5

Based on this analysis of the relevant factors, and the requirement of the Government merely to show that the relief sought in the Complaint is “plausible on its face,”14 the Court’s Opinion allows the case to proceed on the merits.

Conclusion

As a preliminary matter, it is important to understand that this Opinion merely denied a motion to dismiss. The Court has yet to affirmatively rule that the IRS can foreclose on properties held in trust. The ultimate outcome may favor the taxpayer. Nonetheless, there is reason to be concerned with this Opinion which finds the IRS’ propositions “plausible.”

The law is clear that assets contributed into a spendthrift trust for someone other than the settlor (i.e. not a “self-settled” trust where the settlor also is the beneficiary) are protected from the beneficiary’s creditors.15 This is a long-established concept that is well recognized. The settlor’s motives should not be relevant. People often transfer assets into trusts for descendants to avoid creditors’ claims such as divorcing spouses, bankruptcies, lawsuits, etc. That is common, legitimate planning which does not make the trust a nominee or alter ego of a beneficiary. The assets funding the trust were never held by the debtor. Owners of property should be able to decide how they want to convey their property, and subject to what limitations. If the property owner is not making that conveyance as to impermissibly avoid their own creditors, then their choice should be respected.

As argued by his counsel, Shant did not contribute these properties to the trusts. Further, he was not even a beneficiary of either trust. While he may have paid bills directly, that normally would be merely a gift to the trust. His use of trust assets may be more troubling, but this merely should give the trustee and/or beneficiaries claims against him. At the most, if Shant used the trust as his own back pocket, it may give rise to considering an alter ego theory of liability (which typically still would not apply to someone other than one who contributed the relevant property to the trust). However, the Court did not even address that theory, instead limiting its Opinion to nominee liability.

Regarding nominee liability, some of the Court’s findings are troubling. Factors 1-3 above would be similar in many, if not most, situations where someone makes a gift in trust – the gift (either lifetime or testamentary) is for little to no consideration, the settlor wants trust assets protected from creditors, and the relevant parties (settlor, trustee, beneficiaries, etc.) are related. Those factors should not cause a trust’s assets to be subject to a non-beneficiary or non-settlor creditor. Very troubling is that the Court found factors 5 and 6 to heavily favor the government. How can property “remain” in the taxpayer’s possession when the taxpayer never possessed the property in the first place? Rather, in this case, his parents were the original property owners. How can a taxpayer “continue” to enjoy benefits from the property which he did not own? Again, here, Shant’s parents enjoyed the property before it was gifted into trust. Shant could not “continue” to enjoy those benefits. Each of factors 5 and 6 seemingly would require the taxpayer to have had original ownership of the asset, yet the Court found that those factors strongly favored the government.

Time will tell what ultimately happens in this case. However, that the IRS would seek to foreclose on third-party spendthrift trust property and that a court would find that prospect “plausible” should be concerning. Should the government prevail, it may undermine well established trust law and affect legitimate planning engaged in by many people.

S. Gray Edmondson, J.D., LL.M.

Gray practices in the areas of tax, business, and estate planning. View Full Profile.

Footnotes

  1. See Restatement (Third) of Trusts §58.
  2. United States v. Hovnanian, 2019 WL 1233082 (D.N.J. March 18, 2019).
  3. We previously have written about a “self-settled” trust funded by the taxpayer’s own assets following Campbell v. Commissioner, T.C. Memo 2009-4.
  4. See Hovnanian Complaint
  5. See Restatement (Second) Conflicts of Law §278.
  6. In re Zukerkorn, 484 B.R. 182, 192 (9th Cir. BAP 2012) (in determining validity of trust, court applied the law of the state in the choice of law clause in the trust agreement); Hilliard v. Marshall, 91 F.Supp.2d 916, 919 (W.D.La. 1999) (same); see also In re Bernard L. Madoff Investment Securities LLC, 557 B.R. 89, 124 (Bkrtcy. S.D.N.Y. 2016)(in alter ego analysis, court applied Florida law because trusts were located in Florida). The only authorities cited by plaintiff for the proposition that New Jersey law applies because it is the situs of the trust property are from the 1970s — the Restatement (Second) Conflicts of Law § 278, which is in the process of being updated to reflect modern choice of law rules — and from the 1980s — F.P.P. Entrp. v. United States, 646 F. Supp. 713 (D. Neb. 1986).
  7. United States v. Bogart, 715 F. App’x 161, 166 n.4 (3d Cir. 2017).
  8. Id. (internal citations omitted)
  9. Shotmeyer v. N.J. Realty Title Ins. Co., 948 A.2d 600, 608 (N.J. 2008) (quoting Dep’t of Envtl. Prot. v. Ventron Corp., 468 A.2d 150 (N.J. 1983)).
  10. Lewis, 2014 WL 4638849, at *16 (W.D. La. 2014) (rejecting nominee liability where taxpayer did not transfer or otherwise pay for property at issue, notwithstanding that taxpayer lived at property); United States v. Towne, 406 F. Supp.2d 928, 937 (N.D.Ill. 2005)(same); Hill, 844 F.Supp. 263, 271 (same); see also De Beck, supra, 2012 WL 12860949, at *39 (for nominee liability government must show that taxpayer was “beneficial owner of the Property before and after the transfer”).
  11. At most, this was a breach of duty. It does not “convert the principal of the trust to the taxpayer’s personal property.” Citing to Cohen¸1998 WL 953979 *8 (C.D. Cal. 1998) and Greer, 383 F.Supp.2d 861, 868-69.
  12. United States v. Patras, 544 F. App’x 137, 140-141 (3rd Cir. 2013).
  13. Id. at 141-142.
  14. Schreane v. Seana, 506 F. App’x 120, 122 (3rd Cir. 2012).
  15. See supra Note 1.