A recent Tax Court opinion[1] highlights one of the risks of serving as executor or administrator of an estate, potential liability for a decedent’s tax obligations. The case involves application of the federal priority statute[2] applicable to fiduciaries.[3] That statute provides, in relevant part, that “a representative of a person or an estate (except a trustee acting under title 11) paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government.”[4] This places a high burden on an executor to ensure that the decedent’s tax obligations are satisfied prior to distributing assets of an estate to beneficiaries.[5]
In Estate of Lee, the Tax Court found that an executor could be held personally liable for the estate tax obligation of a decedent relating to a $536,151 deficiency.[6] Critical to the determination that the executor could be liable was that the executor made a distribution after notice of the potential tax liability in excess of the total tax liability.[7] At the relevant time, the executor sought an offer in compromise to reduce the estate’s tax obligations since the estate only held $183,000 in assets. The offer in compromise was rejected due to the ability to seek collection against the executor.
Requirements for Liability
There generally are three criteria which must be established for personal liability to attach to the executor:
- By virtue of the insolvency of the estate, the priority of 31 U.S.C. § 3713(a) applies due to the executor paying debts of the decedent or the estate[8] in violation of the government’s priority;
- The executor’s liability is limited to debts actually paid prior to satisfying liability to the government; and
- The fiduciary must know or have reason to know about the existence of the government’s claim.[9]
As a result of these rules, an executor who knows of a “claim” by the government against a decedent or a decedent’s estate who makes a distribution from the estate which renders the estate unable to satisfy the government’s claim may be held personally liable.
While it may be tempting for someone serving as executor, or other fiduciary, to avoid knowledge by intentionally remaining ignorant about the decedent’s tax obligations, it is not so easy. Fiduciaries assume the powers, rights, duties, and privileges of the decedent until notice to the government that the relationship has terminated.[10] While statutes do not necessarily require notifying the government of the fiduciary relationship, regulations adopt this requirement.[11] The Tax Court has recognized this as sufficient for placing liability on the fiduciary.[12] In the absence of such notice by the fiduciary, notices by the IRS to the decedent’s last known address is effective to deem the executor with knowledge of the claim.[13]
There may, however, be an avenue for relief from liability in the narrow circumstance where good faith reliance is made on a tax professional’s advice. In the Little case[14], an executor without a college degree or other formal knowledge about estate administration received Forms W-2 and 1099 which were held sufficient to put him on notice of the government’s claims even though he lacked actual knowledge. However, the estate’s attorney stated that “because of the estate’s size, the estate had no income tax liabilities.”[15] Given the lack of sophistication of the executor and his reasonable reliance on the estate’s attorney, he was relieved from liability. Although the executor in Estate of Lee attempted to escape liability on similar arguments, the Tax Court noted that the executor put on no proof of his reliance on any tax adviser and, furthermore, was an attorney and judge with actual knowledge of the government’s claim. As such, his arguments in this regard failed.[16]
Protection of Executor
In light of this potential liability, what can an executor do to minimize his or her exposure? There are a number of tools at the disposal of the well advised executor. Some of those include the following:
- File IRS Form 56, Notice Concerning Fiduciary Relationship as well as Termination of Fiduciary Relationship:[17] This is issued under IRC § 6903 to notify the IRS that the executor has been appointed, and after filing the IRS will submit correspondence directly to the executor regarding the decedent’s tax liabilities. This avoids the executor missing important IRS notices which, as stated above, may deem the executor to have knowledge of the claim. Further, upon termination of the fiduciary relationship, an executor is relieved of this liability. The filing of Form 56 upon termination of the fiduciary relationship notifies the IRS that any future claim against the decedent should not be satisfied against the executor.
- Request Decedent’s Prior Tax Returns on IRS Form 4506:[18] If the executor does not have copies of prior tax returns, a copy may be requested from the IRS. This may be useful in demonstrating good faith efforts to determine the decedent’s tax obligations in the event what the executor knew or should have known becomes important.
- Request Prompt Assessment by Filing IRS Form 4810:[19] IRC § 6501(d) allows an executor to request prompt assessment of income, gift, and estate tax liabilities. This reduces the statute of limitations for assessment from 3 years to 18 months except in the case of non-filing, fraud, or failure to report 25% of gross income or gifts. Since some believe filing Form 4810 increases the likelihood of audit, it may be advisable to file primarily when there is reason to suspect tax liabilities may be outstanding. In any event, a request for prompt assessment is one of the tools in an executor’s toolbox to avoid personal liability.
- Request Discharge from Personal Liability by Filing IRS Form 5495:[20] An executor is permitted to apply to be released from personal liability under IRC § 6905 for income and gift taxes and IRC § 2204 for estate taxes. The IRS has 9 months from this filing to inform the executor of any tax due. If that tax is paid, or the IRS provides no such notice, then the executor is relieved of personal liability. Note that this is different than requesting prompt assessment in that, here, assessment still may be made under the generally appliable statute of limitations. Instead, the executor, in his or her capacity as such, merely may not be held personally liable for those tax obligations.
- Request Refunding/Indemnification from Beneficiaries: In making distributions from an estate, executors may request beneficiaries agree to refund the distribution to the extent needed to satisfy tax obligations of the decedent or decedent’s estate. Similarly, the executor may seek indemnification from the beneficiaries against his or her personal liability. Of course, these rights are only as good as the ability of the beneficiary to satisfy those obligations. Further, beneficiaries may simply refuse to agree to these arrangements. However, the executor may urge them to do so in order to allow the estate to be more quickly settled versus holding estate assets until the executor can be certain no claims may be due.
There may be other methods of limiting the exposure of an executor to personal liability for the decedent’s tax obligations. However, the list above provides some common and easy-to-use strategies.
Conclusion
Serving as the executor or administrator of an estate is wrought with pitfalls. The executor may end up working for many months (sometimes years) only to end up defending claims of beneficiaries, lacking adequate compensation, and experiencing other unfortunate consequences as a result of serving in that role. One of the significant pitfalls is exposure to personal liability for the tax liabilities of the decedent or the decedent’s estate. As listed above, there are numerous steps an executor may take to minimize this risk. Each executor and his or her advisors will need to determine how the circumstances dictate these risks should be handled. In any event, the unwitting executor without experienced counsel can end up in a very unfortunate position. The Tax Court’s opinion in Estate of Lee is a recent illustration.
[1] Estate of Lee, TC Memo 2021-92.
[2] 31 U.S.C. § 3713, see also Treas. Reg. § 20.2002-1.
[3] This writing does not discuss various other avenues the IRS may have to pursue a claim against a fiduciary for unpaid taxes including, but not limited to, transferee liability under IRC §§ 6324 and 6901, breach of fiduciary duty, and violation of fraudulent transfer laws.
[4] This liability can apply to estate tax, income tax, tax penalties, and other obligations to the US Government, all being “claims of the Government.”
[5] Note that, while this writing focuses on executors and administrators of estates, this liability applies to many types of fiduciary relationships.
[6] Determined under a prior Tax Court dispute decided in Estate of Lee, TC Memo 2009-84.
[7] The notice of deficiency was issued on April 26, 2006 and this distribution was made on February 28, 2007.
[8] Such debts include a beneficiary’s share of the estate. See Treas. Reg. § 20.2002-1.
[9] For a discussion of these requirements, see U.S. v. Renda, 709 F.3d 472 (5th Cir. 2013) (phrased there with respect to a corporation rather than an estate, citing U.S. v. Coppola, 85 F.3d 1015, 1020 (2d Cir. 1996), as requiring the corporation’s president: (1) pays a non-federal debt; (2) before paying a claim of the United States; (3) at a time when the corporation was insolvent; and (4) if he had knowledge or notice of the claim); and U.S. v. McNicol, 829 F.3d 77 (1st Cir. 2016).
[10] IRC § 6903(a).
[11] Treas. Reg. § 301.6903-1(a).
[12] Fletcher Trust Co., 1 T.C. 798 (1943).
[13] Treas. Reg. § 301.6903-1(c).
[14] Little, 113 T.C. 474 (1999).
[15] Id. 113 T.C. 474, 480.
[16] See also U.S. v. Shriner, 2014 WL 992300 (U.S.D.C. D. Maryland March 13, 2014).
[17] https://www.irs.gov/forms-pubs/about-form-56.
[18] https://www.irs.gov/forms-pubs/about-form-4506.
[19] https://www.irs.gov/forms-pubs/about-form-4810
[20] https://www.irs.gov/forms-pubs/about-form-5495
