IRS Loses Out on Inheritance Bait and Switch

While the government has many powers, the Fifth Circuit recently decided that the IRS had no remedy when proceedings in a Louisiana state court deprived it of the benefits it was supposed to receive under a confirmed chapter 11 plan. The opinion can be found here. United States v. Lewis, No. 08-30964 (5th Cir. 10/1/09).

When Caroline and Nelson Hunt filed chapter 11 in the 1980s, they owed over $100 million in non-dischargeable taxes. As part of their plan, they agreed that any inheritance received by Caroline would go to the IRS. Caroline was the niece of Turner Hunt Lewis, who was in his 70s, childless and intestate at the time. This meant that if he died, his estate would be divided between his three nieces and nephews. His estate was ultimately worth $16.5 million.

However, when Mr. Lewis was on his deathbed some 13 years later in 2002, his nephews petitioned the state court in Louisiana for an inderdictment, which is like a guardianship. With the approval of the Louisiana court, they created a trust in which the share of the estate which would have gone to Caroline went to her children. The nephews acknowledged that they did this with Caroline's blessing for the purpose of keeping her share out of the hands of the IRS. The IRS was not given any notice of the proceedings.

Some years later, the IRS sued in federal court to set aside the trust. The District Court granted summary judgment against the IRS. In an unusually brief and blunt published opinion, the Fifth Circuit dispensed with the government's contentions.

The effect, and presumably the intent, of this course of action was to pass the estate to family who had no such tax obligation. Its legality is challenged here. The government has filed this federal suit claiming that the curators’ course of action was in fact contrary to Louisiana state law and that we should protect its rights by striking down the trust provision in favor of Caroline’s descendants and awarding Caroline the money she should have inherited, to be remitted to the I.R.S. according to the 1989 agreement.

We confess the considerable difficulty of understanding the basis under which this claim proceeds. In answering this question, we note what the United States has not alleged. The United States has not argued that any party committed tax fraud or violated any other specific internal revenue law with relation to the Turner Hunt Lewis Trust. The United States does not argue that Caroline or Nelson Hunt violated their agreement with the I.R.S. In essence, the government asks that we sit as a general court of review for a seven year old Louisiana district court trust law decision because it has the ultimate effect of redirecting the path of funds to a path beyond the reach of the federal government.

But the government has no claim to money that Caroline Hunt did not inherit, and the state court judgment decided no right of the government. Rather, it decided the authority of Lewis’s representatives to dispose of his property. Had Turner Hunt Lewis omitted Caroline Hunt from his will, the government would have had no recourse. His representatives did omit her. If their decision was effective, the matter ends. And a solemn judgment of a Louisiana state court with jurisdiction over the interdiction approved the omission of Caroline Hunt and is unchallenged. We see no reasoned basis for our authority to review that judgment and the I.R.S. offers none.

The government’s creditor relationship with the interdiction and state court judgment raises questions of standing and failure to state a claim. These issues are here not easily disentangled. Congress has given the I.R.S. access to federal courts to collect taxes, and – while this case pushes the outer limits of that license – we will reach the merits and affirm the district court’s rejection of the government’s claim. Ultimately, the government is unable to demonstrate any entitlement to the disputed moneys by virtue of its contract with Caroline Hunt.

Memorandum Opinion, pp. 3-4.

A concurring opinion noted that under Louisiana law, an affected party could have sought annulment of the judgment within one year of discovery if it was obtained through "ill practices." Having failed to utilize the remedy created by state law, the government was without a remedy in federal court.

The opinion is remarkable in that the Fifth Circuit panel chose to publish an opinion whose discussion did not cite any cases, statutes or rules (although the concurrence did reference the Louisiana annulment procedure). This could be seen as a public rebuke to the government both for pursuing a meritless claim and for failing to protect its interest.

While the precedential value of this opinion is minimal, it offers several practical lessons. The first is that state court judgments matter. Far too many debtors wait until after an adverse judgment has been rendered to seek bankruptcy relief. By that time, it may be too late. Once a judgment has been rendered in state court, it can only be challenged in state court no matter how badly it smells. The second lesson is to be careful in drafting plans and agreements. In this case, the expectation was that Caroline would receive an inheritance which would go to the government. However, there were many ways that expectation could have been thwarted. Caroline could have predeceased her rich uncle, he could have prepared a will excluding her or he could have lost the money in a casino. The fact that the nephews used a suspect, last minute move to divert the inheritance did not change the fact that the original promise was rather illusory to begin with.