Minimizing a Personal Representative’s (and Beneficiary’s) Personal Liability to Pay Taxes
A CPA recently told me that one of his clients, who was the personal representative of his dad’s estate, distributed all of the estate’s assets to the beneficiaries of the estate before all of the estate’s tax debts were paid. He then asked me if his client had any personal liability for such unpaid taxes. I told him yes, that the personal representative could be held personally liable for such unpaid taxes, but that the beneficiaries could also be held personally liable.
What follows is the content of a memorandum I gave the CPA explaining the risk to the personal representative (and the beneficiaries) when all of the assets of an estate are distributed before all of the estate’s tax debts are paid and how to minimize a personal representative’s (and, hence, the beneficiaries’) personal liability to pay such taxes….
I. Fiduciary Liability
Executors, administrators, personal representatives, and others that control and distribute the assets of a decedent’s estate are called fiduciaries. Such fiduciaries are required to respect the creditors’ priorities set forth in 31 U.S.C. §3713(b) when handling estate matters and if not, they may be held personally liable for the debts of the estate owed to the United States.
The imposition of personal liability is subject to the following three (3) conditions set forth in 31 U.S.C. §3713 and case law as made by courts: (1) The creditor priority set forth in 31 U.S.C. §3713(a) must apply; (2) The fiduciary’s liability cannot exceed the amount of debts paid before those owing to the United States are paid; and (3) The fiduciary must have notice of such debts.
Although the first two (2) conditions are somewhat straightforward, the third condition is more complicated because it does not exist in statutory form but has been consistently added by courts in such cases. “[I]t has long been held that a fiduciary is liable only if it had notice of the Claim of the United States before making the distribution.” Want v. Comm’r, 280 F.2d 777, 783 (2nd Cir. 1960).
What constitutes notice is usually dependent upon the facts and circumstances of a particular case but, in general, the requirement may be “satisfied by either actual knowledge of the liability or notice of such facts as would put a reasonably prudent person on inquiry as to the existence of the unpaid claim of the United States.” Leigh v. Comm’r, 72 T.C. 1105 (U.S.T.C. 1979). Inquiry is not required unless there are circumstances that would suggest to a reasonably prudent person that an inquiry be made. Rev. Rul. 66-43. Further, it is the burden of the IRS to prove that the fiduciary had notice of such debts.
When calculating and imposing personal liability for unfiled tax returns, IRS personnel are advised to take into account the notice that a particular fiduciary had regarding unfiled returns. Specifically, the IRS manual states that an IRS agent should “determine if and when the fiduciary had knowledge of the balance due or unfiled returns.” Internal Revenue Manual 220.127.116.11(3).
As a result of the three (3) aforementioned conditions, the basis and scope of personal liability as they pertain to fiduciaries is much more limited than such basis and scope as they pertain to transferees, discussed below.
II. Transferee Liability
Transferees of assets from a decedent’s estate owing estate, gift, or income taxes to the United States, whether they are heirs, devisees, or others, may be held personally liable for such debts through a summary procedure set forth in 26 U.S.C. § 6901 whereby the IRS can seek to impose personal liability upon transferees depending upon the type of tax obligation if a transfer, or series of transfers, rendered the decedent’s estate insolvent. However, § 6901 does not impose personal liability; rather, the legal authority to impose personal liability is different for each type of tax.
A. Federal Estate Tax
Section 6324(a)(2) provides that transferees of property included in the gross estate of a decedent are personally liable for unpaid estate taxes associated with such property. However, the courts are split as to whether the IRS must follow the procedures set forth in § 6901 to assess the tax against the transferee if the tax has been assessed against the estate.
In U.S. v. Russell, the Tenth Circuit Court of Appeals held that the collection procedures set forth in § 6901 are cumulative and alternative, and, therefore, the IRS was not required to follow the procedures set forth in § 6901. 461 F.2d 605 (10th Cir. 1972).
In U.S. v. Schneider, however, a district court held that assessment against the estate provided insufficient notice to the transferee. 92-2 USTC 60, 119 (N.D. 1992).
B. Federal Gift Tax
Unlike federal estate tax obligations, however, the courts agree that federal gift taxes need not be assessed against a transferee before the IRS can collect the tax.
Section 6324(b) imposes a lien “upon all gifts made during the period for which the return was filed, for 10 years from the date the gifts are made.” Section 6324(b) subsequently addresses the liability that will result from non-payment of taxes, in particular: “If the tax is not paid when due, the donee of any gift shall be personally liable for such tax to the extent of the value of such gift.”
C. Federal Income Tax
Determining the authority by which the IRS can impose personal liability for unsatisfied federal income tax obligations is much more complicated than for federal estate or gift tax obligations because there is no basis in the Internal Revenue Code (IRC) to do so; rather, the IRS must look to other legal authority, including: (1) state fraudulent transfer statutes, (2) federal fraudulent transfer statutes, or (3) equitable principles.
(1) State Fraudulent Transfer Statutes
Although a discussion of each state’s fraudulent transfer laws is not within the scope of this memo, each state has enacted statutes whereby transfers that are made for less than a fair valuation while a debtor is insolvent can be “avoided” by the courts. The basis for many of these fraudulent transfer statutes is the Uniform Fraudulent Transfer Act (UFTA). Although the specific provisions of each state’s particular codification of the UFTA may vary, the relevant provisions of the UFTA define “insolvent” as applicable to decedents’ estates as follows:
A debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets, at a fair valuation.
A debtor who is generally not paying his [or her] debts as they become due is presumed to be insolvent.
UFTA § 2; see also 24 O.S. § 114 (which uses the exact same definitions).
The U.S. Supreme Court has held that the IRS can leverage these state statutes to collect federal income tax obligations from transferees. Comr. v. Stern, 357 U.S. 39 (1958). The effect of these statutes is to return the transferred assets back to the transferor whereafter creditors of the transferor can attach those assets and use them to satisfy claims against the transferor.
Various federal tax courts have held that the IRS need not “assess” the tax in order for it to affect the insolvency of a debtor; rather the “the tax is ascertainable when the tax period ends” and must be factored into insolvency calculations from that point forward. 67 T.C.M. 1968, 1970 (U.S.T.C. 1994). In making such insolvency calculations, courts have further held “that the transferee is liable irrespective of the particular moment at which the transferor lapsed into insolvency, if such results no later than at the end of a series of transfers.” Id. at 1970.
(2) Federal Fraudulent Transfer Statutes
The Federal Debt Collections Procedures Act of 1990 (FDCPA), 28 U.S.C. §§ 3001-3308, enables the IRS to seek three (3) types of remedies against transferees of insolvent estates for federal income tax obligations if the transfers were for less than “reasonably equivalent value”:
(1) avoidance of the transfer or obligation to the extent necessary to satisfy the debt to the United States;
(2) a remedy under this chapter against the asset transferred or other property of the transferee; or
(3) any other relief the circumstances may require. 28 U.S.C. § 3306(a).
The definition of “insolvent” set forth § 3302(a) of the FDCPA is very similar to the aforementioned definition in the UFTA (and under Oklahoma law). In particular, the FDCPA specifies that “a debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets at a fair valuation.” Section 3302(b) also sets in place a presumption that “[a] debtor who is generally not paying debts as they become due is presumed to be insolvent.”
Although there remain a number equitable principles, e.g., the trust fund doctrine or the concept of alter ego, through which the IRS can seek to recover an estate’s unpaid federal income tax obligations from a transferee, the IRS uses such causes sparingly since the enactment of 26 U.S.C. § 6901.
Minimizing a Personal Representative’s Personal Liability to Pay Taxes
There are three (3) risk-management tools every personal representative should ask his or her attorney or CPA about:
●IRS Form 56,
●IRS Form 4810, and
●IRS Form 5495.
IRS Form 56. A Form 56 needs to be filed twice: when you first get appointed as the personal representative to let the IRS know that you are the personal representative and where to send all tax notices; and again when you finish the job as the personal representative and you are discharged. What we’re doing here is making sure that any correspondence from the IRS having to do with the decedent’s taxes gets you right away; the last thing you want to happen is to get sued for failing to pay the decedent’s back taxes because the deficiency notices went to the wrong address. Also, the instructions to Form 56 state that the filing of a Form 56 when the personal representative or executor is discharged will “relieve [the personal representative or executor] of any further duty or liability as a fiduciary.”
IRS Form 4810. Not only do you want to make sure the IRS knows you exist as the personal representative and that you are the person they need to contact for all matters related to the decedent, you’ll also want to “shake the bushes” to make sure there are no unpaid back taxes involving the decedent. You do this by filing a Form 4810 (Request for Prompt Assessment for Income and Gift Taxes). As a cautious personal representative , you will wait for the IRS to respond to this assessment request prior to making any distributions to the estate’s beneficiaries. You don’t want all the cash to go out the door only to be surprised by some huge tax assessment that puts you in the uncomfortable position of having to ask the beneficiaries to give money back to pay back taxes.
IRS Form 5495. At the same time you file a Form 4810, you’ll also want to simultaneously (but separately) file a Form 5495 (Request for Discharge from Personal Liability for Decedent’s Income and Gift Taxes). This is another way to make sure you get the heads up on any of the decedent’s unpaid back taxes. If Form 5495 is properly filed, the IRS has nine (9) months in which to notify you of any deficiency for the decedent’s applicable income or gift tax returns. If you pay the additional tax, or if no notice is received from the IRS within nine (9) months from the date of filing Form 5495, you are then discharged from personal liability.
The bottom line is that both the personal representative and the beneficiaries have the potential for personal liability for unpaid estate tax debts, but such risk could be minimized so that the personal representative doesn’t have to be put in the position of asking the beneficiaries to give money back to such unpaid estate tax debts.
If you are a personal representative or beneficiary of an estate with unpaid estate tax debts, and you would like to discuss how you can avoid personal liability for such back taxes, feel free to call me at (405) 254-5005.