27 Aug Protecting an inheritance from the IRS

Q. Is there any way to leave assets in a will to someone who owes the IRS money and has a tax lien against them. Is there any way to protect an inheritance?

A. A spendthrift trust may be your answer. Or maybe not — at least when it comes to the IRS.

To create a spendthrift trust, in your will, you need to clearly leave the debtor’s inheritance to a designated trustee with directions that the trustee fund a trust for the sole benefit of the debtor, said Nancy Heslin Reading, an estate planning attorney with Reading Law Firm in Newton.

You also must specify that the assets in the trust cannot be encumbered by creditors, and that the debtor can’t use the assets in the trust as a security to obtain credit, she said.

“The downside is that the debtor cannot demand money from the trust,” Reading said.

The testator can specify how the debtor/beneficiary does get money, for example, receiving all the income on a quarterly basis, receiving income and principal at a fixed monthly amount until the money is exhausted, or receiving funds at the complete discretion of the trustee.

“Needless to say, such solutions are not popular with most beneficiaries, but they are popular with parents worried about adult children with debtor-creditor problems,” Reading said.

While spendthrift provisions can protect individuals from ordinary creditors under state law, state law has become increasingly ineffectual at protecting its own state citizens against the IRS, said Joseph Matheson, a certified public accountant with Matheson & Assoc. in Whippany.

He said discretionary provisions that have had limited success in the past are less effective now because the law has adapted to these attempts to avoid IRS attachments, Matheson said.

”A prudent practitioner should not be telling his or her client to rely on discretionary or sprinkling provisions to protect beneficiaries from the IRS,” he said. “The degree of discretion necessary to fend off a federal tax lien may not be acceptable with the desires of many clients.”

Matheson said there’s been some success in certain states through the use of “a shifting of executory interests,” he said.

“The key to their success is the careful selection of events that trigger the shift and the equally careful selection of persons to receive the shifted interests,” he said. “A properly drafted tax lien lockout provision may be able to protect the assets from a federal tax lien.”

Matheson said it’s important to keep in mind the line between what’s practical and what’s legal.

“The IRS will be relentless if there are assets they think they can attach,” Matheson said. ”They have an unlimited war chest to litigate this with you.”

He said the agency has been very successful at attaching assets and it differs from state to state as each state has their own state laws which impact the outcome.

“It may cost you more than what you could negotiate in a settlement,” he said. ”I would make a good faith effort to negotiate a settlement. I believe you’ll be better off in the long run unless there are millions at stake.”

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This story was first posted in August 2015.