IRS Payment Agreement & Spendthrift Trust Distributions

Published Categorized as Installment Agreement, Tax Relief
IRS trust distribution, Austin Tax Attorney

The IRS generally cannot reach funds in a spendthrift trust to satisfy the trust beneficiary’s unpaid tax debts.  But can the IRS factor in trust distributions in calculating how much the taxpayer can pay under an installment agreement?  The recent Melasky v. Commissioner, 151 TC 9 (2018), suggests that the IRS can do this but also suggests how the trust language should be changed to avoid this result.

Facts & Procedural History

The taxpayers owed back taxes for several years.  They made several attempts to settle the balance by submitting four offers in compromise.  Once these were not successful, the taxpayers attempted to work out an installment agreement with the IRS.

In computing the reasonable collection potential and the monthly amount the taxpayers could be expected to pay, the IRS factored in distributions from a trust established in the taxpayer wife’s father’s will.  The trust named the taxpayer-wife as the trustee and gave her the power to make distributions to herself for her health, maintenance, support, and education:

Distributions During * * * [Mrs. Melasky’s] Life To * * * [Mrs. Melasky] And Descendants. During * * * [Mrs. Melasky’s] life, the Trustee may distribute to * * * [Mrs. Melasky], as primary beneficiary, and may distribute to her descendants (if any), as secondary beneficiaries, so much or all of the income and principal of * * * [Mrs. Melasky’s] trust (even though exhausting the trust) as the Trustee determines to be appropriate to provide for their continued health, maintenance, support, and education (including college or vocational, graduate or professional school education).

The IRS did not require the taxpayers to liquidate the trust to satisfy the liability, but it did factor the trust distributions into its installment agreement calculations.  This resulted in a higher monthly payment.

The IRS’s Installment Agreement Rules

The Code authorizes the IRS to accept installment agreements.  The IRS has promulgated rules that provide rules for computing the monthly payment amount the IRS will accept for installment agreements.

These rules generally subtract allowable monthly expenses from the taxpayer’s monthly income.  The IRS allows “necessary expenses.”  The IRS policy manual describes these expenses as those:

expenses that are necessary to provide for a taxpayer’s and his or her family’s health and welfare and/or production of income. The expenses must be reasonable. The total necessary expenses establish the minimum a taxpayer and family needs to live.

The question, in this case, was whether the trust distributions can be factored into the IRS’s calculations.

Distributions from Discretionary Spendthrift Trust

The taxpayers argued that the trust distributions were not to be considered in computing the amount of the monthly installment agreement, given that the trustee could not make the distributions given that the taxpayers had other income and assets available:

Petitioners object, suggesting that under Texas law the terms of the Farkas trust do not permit Mrs. Melasky to make distributions to herself—even to pay her share of expenses relating to her health, maintenance, support, and education—to the extent she had other income or assets available to pay those expenses. Consequently, they contend, the SO erred in concluding that petitioners would be able to rely on distributions from the trust to help defray their nontax living expenses.

The court did not agree. It noted that the taxpayers position was that they could not full pay the liability, as they requested a partial pay installment agreement.  Thus, the taxpayers had agreed that they did not have sufficient assets.  This led the court to conclude that the limitation on making the trust distributions was not applicable because the taxpayers did not have sufficient income and assets to pay their necessary expenses.

The court also noted that the trust allowed the taxpayer-wife, as trustee, to make distributions by considering “all circumstances and factors the [t]rustee deems pertinent.”  The court concluded that this language also caused the trust distributions to be included in the IRS’s calculations.

The Need to Modify Spendthrift Trust Language

It is common for trusts to allow the trustee to make distributions for “health, maintenance, support, and education.”  This language is typically included in trusts to help the settlor or person who set up the trust avoid estate taxes.  Now that the estate tax exemption was increased substantially, it is likely that the “health, maintenance, support, and education” standard is not needed.  Given this case, those whose estates are and will be below the exclusion amount may consider amending their trust documents to clarify that the distributions can only be made if no other source of income is available.