Everyone knows pensions are exempt assets that are safe from creditors, right? Nope. A recent U.S. Tax Court case (Wadleigh v. Commissioner) says that this is not always true.
Vance Wadleigh filed a 2001 federal income tax return on August 16, 2002, reporting a balance due but did not pay the tax. The IRS assessed a tax liability and issued a timely notice and demand for payment on September 16, 2002.
The assessment caused a section 6321 lien (the so-called “secret” lien) to attach to all of Wadleigh’s property, including an ERISA pension he had from his employer. Although the pension was fully vested, it would not be in payout status until November 2007. A Notice of Federal Tax Lien (NFTL) was filed in 2002, but was later withdrawn. As a result, the IRS had only a section 6321 lien with respect to the taxpayer’s 2001 tax liability.
In 2005, Wadleigh and his wife filed a voluntary Chapter 7 bankruptcy petition, listing the pension as an excluded asset. They were discharged in bankruptcy that included the 2001 federal income tax liability.
Despite the discharge, in 2006 the IRS issued a notice of intent to levy on the pension income.
After an appeal was denied, Wadleigh brought an action in the Tax Court, making three arguments:
1. His liability for the unpaid tax was discharged in bankruptcy,
2. The levy was invalid because it was made before he was in payout status, and
3. The proposed levy was invalid because a previous levy on his pension was released.
The Tax Court rejected all three arguments.
When a taxpayer fails to pay tax upon notice and demand, a section 6321 lien arises by operation of law and continues until the liability is satisfied or becomes unenforceable by lapse of time. The lien attaches to all property and rights to property belonging to the taxpayer from the moment the tax is assessed.
The IRS ordinarily follows up on the section 6321 lien by filing a Notice of Federal Tax Lien (NFTL) (1) to give it priority over judgment creditors, mechanic’s lienors and bona fide purchasers and (2) to prevent the lien from being discharged in bankruptcy.
If a taxpayer files for bankruptcy, the bankruptcy estate includes all legal or equitable interests of the debtor in property except assets excluded under section 541 of the bankruptcy code. As interpreted in Patterson v. Shumate, the section 541 exclusion includes interests in ERISA-qualified pension plans.
It is important to distinguish between excluded property and exempt property, however. Excluded property is never subject to the jurisdiction of the bankruptcy court at all, while exempt property is included in the bankruptcy estate but cannot be used to satisfy creditors’ claims.
When a debtor is discharged in bankruptcy, he is discharged from personal liability, but liens and other secured interests may survive. Exempt property can be subject to an IRS lien following discharge in bankruptcy if (1) the federal tax liability is not dischargeable or (2) the liability is dischargeable but the IRS filed a pre-petition NFTL.
Here, the IRS lien was not discharged in bankruptcy because the pension plan was an excluded asset under 26 U.S.C. 541(c)(2) and the trustee in bankruptcy had no power over it. Note, however, that only ERISA pensions are excluded under section 541(c)(2).
Thus, if Wadleigh had a non-ERISA pension like an IRA instead of the ERISA pension, it would have been an exempt asset rather than an excluded asset and could have been discharged in bankruptcy.
This suggests that a taxpayer with an ERISA pension subject to a secret section 6321 lien could convert the pension to an IRA before filing for bankruptcy and have the lien on the IRA discharged in bankruptcy. However, this planning strategy may have limited application though because it works only if the IRS fails to file a NFTL.