Federal Tax Claims in Decedent’s Estates – What’s the Liability and Priority?

Upon a decedent’s death, any liabilities for deficiencies on the decedent’s tax returns do not disappear.  Someone must pay those taxes.  In addition, creditors’ claims against the estate must be paid.  If one of the creditors is the IRS, there is a federal tax lien that will come in to play.  In that situation, the question becomes the priority of the lien.  Does the IRS beat out other creditors?  What if the estate administrator is entitled to get paid under state law?   

Tax liability for deficiencies associated with a decedent’s estate and the IRS as an estate creditor – what are the related issues?  That’s the topic of today’s post.

Executor/Transferee Liability

The decedent’s estate, in essence, is liable for the decedent’s tax deficiency at the time of death. Individuals receiving assets from a decedent take the assets subject to the claims of the decedent’s creditors — including the government. Asset transferees (the recipients of those assets) are liable for taxes due from the decedent to the extent of the assets that they receive.  In addition, a trust can be liable as a transferee of a transfer under I.R.C. §6901 to the extent provided in state law.  See, e.g., Frank Sawyer Trust of May 1992 v. Comr.,, T.C. Memo. 2014-59. 

The courts have addressed transferee/executor liability issues in several recent cases.  For instance, in United States v. Mangiardi, No. 9:13-cv-80256, 2013 U.S. Dist. LEXIS 102012 (S.D. Fla. Jul. 22, 2013), the court held that the IRS could collect estate tax more than 12 years after taxes were assessed.  The decedent died in 2000.  At the time of death, his revocable trust was worth approximately $4.58 million and an IRA worth $3.86 million. The estate tax was approximately $2.48 million. Four years of extensions were granted due to a market value decline of publicly traded securities. The estate paid estate taxes of $250,000, and the trust had insufficient assets to pay the balance. The IRS sought payment of tax from the transferee of an IRA under I.R.C. §6324. The court held that the IRS was not bound by the 4-year assessment period of I.R.C.§§6501 and 6901(c) and could proceed under I.R.C. §6324 (10-year provision).  The court determined that the 10-year provision was extended by the 4-year extension period previously granted to the estate, and IRA transferee liability was derivative of the estate's liability. The court held that it was immaterial that the transferee may not have known of the unpaid estate tax. The amounts withdrawn from the IRA to pay the estate tax liability were also subject to income tax in the transferee's hands.

In another recent case, United States v. Tyler, No. 12-2034, 2013 U.S. App. LEXIS 11722 (3d Cir. Jun. 11, 2013), a married couple owned real estate as tenants by the entirety (a special form of marital ownership recognized in some states).  The husband owed the IRS $436,849 in income taxes. He transferred his interest in the real estate to his wife for $1, and the IRS then placed a lien on the real estate.  He died with no distributable assets and there were no other assets with which to pay the tax lien.  His surviving wife died within a year of her his death and the property passed to their son, the defendant in the case.  The son was named as a co-executor of his mother’s estate. The IRS claimed that the tax lien applied to the real estate before legal title passed to the surviving spouse.  Thus, the IRS asserted, the executors had to satisfy the lien out of the assets of her estate. The executors conveyed the real estate to the co-executor son for $1 after receiving letters from the IRS asserting the lien. The son then later sold the real estate and invested the proceeds in the stock market, subsequently losing his investment. The IRS brought a collection action for 50 percent of the sale proceeds of the real estate from the executors. The trial court ruled for the IRS and the appellate court affirmed. Under the federal claims statute, the executor has personal liability for the decedent’s debts and obligations.  The rule is that the fiduciary who disposes of the assets of an estate before paying a governmental claim is liable to the extent of payments for unpaid governmental claims if the fiduciary distributes the estate assets, the distribution renders the estate insolvent, and the distribution takes place after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes.

United States. v. Whisenhunt, No. 3:12-CV-0614-B, 2014 U.S. Dist. LEXIS 38969 (N.D. Tex. Mar. 25, 2014), is another case that points out that an executor has personal liability for unpaid federal estate tax when the estate assets are distributed before the estate tax is paid in full. The court determined that the executor was personally liable for $526,507 in delinquent federal estate tax and penalties, which was the amount of the distribution at the time of the decedent's death.

Federal Estate Tax Lien

Another recent case illustrates additional peril for estate executors.  In In re Estate of Simmons, No. 1:15-cv-01097-TWP-MPB, 2017 U.S. Dist. LEXIS 120487 (S.D. Ind. Jul. 31, 2017), the decedent died in 2014.  He and his wife had one son in 1991 and then divorced in 1998.  The decedent remarried, and the second wife was the surviving spouse at the time of the decedent’s death.  The primary asset of the estate was the decedent’s home.  The claims against the estate amounted to $1.8 million, including those of the decedent’s first wife, two of the decedent’s former employees for unpaid wages and benefits of approximately $800,000, and two noteholders for which the decedent had defaulted on the notes.  Those amounted to about $250,000 in total.  The state of Indiana also filed a tax lien, and the IRS lien was just shy of $600,000.  However, the state court determined that the estate was insolvent.  The estate only contained assets of $266,873.  A state court order required that the estate assets be sold and be distributed in accordance with the priority stated in Indiana law.  The state court order indicated that the IRS lien was in a seventh priority position. 

On the motion of the IRS, the case was removed to federal district court.  The federal district court determined that the IRS had a first priority lien and ordered that the net proceeds of from the sale of the residence ($245,766) go to the IRS.  Neither the surviving spouse nor the executor were pleased with this conclusion.  The surviving spouse expended substantial funds to get the home ready to be sold, and the executor (and the attorney for the estate) was entitled to be paid in accordance with state law.  That’s the normal course of events – administrative expenses and fees generally have priority over other creditors, including the IRS. 

However, there is another principal that can come into play.  The Supremacy Clause of the Constitution (Article VI, Clause 2) says that state law is subject to federal preemption if there is a federal law on point that would override state law.  That’s where the federal priority statute for governmental claims comes into play. 31 U.S.C. §3713. Under this provision, a federal governmental claim has first priority when a decedent’s estate has insufficient funds/assets to pay all of the decedent’s debts.  However, courts have generally held that administrative expenses (e.g., fees of the executor and attorney for the estate) are not actually the decedent’s “expenses” with the result that they take priority over governmental claims.  But, the In re Estate of Simmons court said that when the IRS files a federal tax lien I.R.C. §6321 comes into play.  Under that statute, the federal government has a blanket priority lien on the assets of the estate.  The limited exceptions of I.R.C. §6323 don’t apply to claims involving administrative expenses.   

Conclusion

The federal court’s determination would seem to have a chilling effect on person’s assuming administrative tasks, including legal counsel for estate’s that have insufficient funds to pay all outstanding taxes, and it’s not the first time a court has reached the same conclusion.  See, e.g., Estate of Friedman v. Cadle Co., 3:08CV488(RNC), 2009 U.S. Dist. LEXIS 130505 (D. Conn. Sept. 8, 2009).  But, the In re Estate of Simmons court did note that the Internal Revenue Manual, at Section 5.5.2.4(3) says that the IRS has discretion to not assert its priority position so that reasonable administrative expenses can be paid to the persons entitled to them.  In In re Estate of Simmons, the IRS stated that it intended to pay the executor’s unreimbursed expenses.  That was enough for the court to go ahead and give the IRS priority on its lien. 

The discretion of the IRS to allow the payment of reasonable administrative expenses is not terribly reassuring.  It’s also troubling that it’s solely up to the IRS to determine what is “reasonable.”  From a practitioner’s standpoint, when considering the representation of an estate with sizable outstanding unpaid federal taxes, it’s probably a good idea to first conduct a search for federal tax liens.  Also, there probably is also a duty to advise the executor of the potential impact of a federal tax lien. 

Executors (and their counsel) already have a mess on their hands in large estates where Form 706 must be filed and the new basis consistency reporting rules are triggered.  Those rules already provide a disincentive to serve as an executor.  The federal tax lien statute may create another reason not to handle certain estates.