Becoming Personally Liable For An Estate’s Taxes

 

I had lunch with a friend recently. He is executor for an estate and was telling me about some … questionable third-party behavior and document discoveries. I left the conversation underwhelmed with his attorney and recommending a replacement as soon as possible. There are two other beneficiaries to this estate, and he has a fiduciary responsibility as executor.

Granted, all are family and get along. The risk - it seems to me - is minimal.

It is not always that way. I have a client whose family was ripped apart by an inheritance. I shake my head, as there was not enough money there (methinks) to spat over, much less exact lifelong grudges. However, he was executor and so-and-so received such-and-such back when Carter first started making liver pills and he should have offset someone for … oh, who knows.

Being executor can be a thankless job.

It can also get one into trouble.

Let’s take a look at the Lee estate.

Kwang Lee died testate in September, 2001.

         COMMENT: Testate means someone died with a will.

A municipal court judge was named executor.

The judge filed the estate return in May, 2003.

COMMENT: The return was late, but there was some complexity as both spouses died within six months. There was language in the will about a-spouse-is-considered-to-survive-if that created some confusion.

COMMENT: It doesn’t matter. You know the IRS is coming in with penalties.

The IRS audited the return.

 In April 2006 the IRS issued a Notice of Deficiency for over $1,000,000. 

COMMENT: The IRS also wanted a penalty over $255 grand for late filing.

The executor filed with the Tax Court.

 In February, 2007 the executor distributed $640,000 to the beneficiaries.

COMMENT: Pause on what happened here. The IRS wanted additional tax and penalties. The executor was contesting this in Tax Court. The issue was live when the executor distributed the money.

Is there a risk?

You bet.

What if the estate lost its case and did not have enough money left to pay the tax and penalties?

The Tax Court gave the executor a partial win: the estate owed closer to a half million dollars than a million. The Court also waived the penalties.

The estate did not have a half million dollars. It did have $182,941.

The estate submitted an offer in compromise to the IRS for $182,941.

The IRS looked at the offer and said: are you kidding me? What about that $640,000 you distributed before its time?

The IRS pointed out this bad boy:

31 U.S. Code § 3713.Priority of Government claims

(a)

(1) A claim of the United States Government shall be paid first when—

(A) a person indebted to the Government is insolvent and—

(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;

(ii) property of the debtor, if absent, is attached; or

(iii) an act of bankruptcy is committed; or

(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.

(2) This subsection does not apply to a case under title 11.

(b) 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. 

The effect of Section 3713 is to make the executor personally liable for a debt to the U.S. when: 

o  The estate was rendered insolvent by a distribution, and

o  The executor had knowledge or notice of the government’s claim at the time of the distribution.

The judge/executor did the only thing he could do: he challenged the charge that he had actual knowledge of a deficiency when he distributed the $640,000.

The executor was hosed. I am not sure what more of a wake-up-call the executor needed than an IRS Notice of Deficiency. For goodness’ sake, he filed a petition with the Tax Court in response.

Maybe he thought that he would win in Tax Court.

He did, by the way, but partially. The tax was cut in half, and the penalties were waived.

Notice that the estate would not have had enough money had it lost the case in full. The tax would have been over a million, with additional penalties of a quarter million. Under the best of circumstances, the estate would have had cash of approximately $822 thousand and unable to pay in full.

In that case I doubt Section 3713 would have applied. The estate would have conserved its cash upon receiving a Notice of Deficiency.

But the estate did not conserve its cash upon receiving a Notice of Deficiency.

The executor became personally liable.

Mind you, this may work out. Perhaps the beneficiaries return the cash; perhaps there is a claim under a performance bond.

Still, why would an executor – especially a skilled attorney and municipal judge – go there?

Our case this time was Estate of Lee v Commissioner, T.C. Memo 2021-92.

The Sale of "American Pie"

Did you see where Don McLean sold his original manuscript for “American Pie” at Christie’s? He sold the work for $1.2 million, and it included his handwritten notes and deletions from the 1971-72 hit that – at 8 ½ minutes – was the longest song to ever top the U.S. charts.

The song of course is famous for its allusions. The “day the music died” refers to the death of Buddy Holly, whereas “the king” supposedly refers to Elvis Presley while “the jester on the sidelines” refers to Bob Dylan after his motorcycle accident. It became an anthem to disillusionment, to the sense of our best days being behind us and the ennui and hopelessness of a society being carted off in the wrong direction.

Sounds eerily contemporary.

He explained that he had forgotten he had the manuscript. He found it in the proverbial old box that had survived several moves. The sale allowed him to provide for his family, now and into the future.

Yes, $1.2 million will do that.

So what are the tax consequences from the sale of his manuscript?

We are talking about intellectual property and a subset we will call creative properties.

For the most part, self-created properties cannot be a capital asset in the hands of its creator. This causes a problem, as one requires a capital asset if one wants capital gains.

Take it a step further. If someone else owns the asset but its tax basis (that is, its cost for purposes of calculating gain or loss) is determined by reference to the creator’s basis, then it cannot be a capital asset.  How can this happen? Easy. You could gift the property, for example, or you could contribute the property to a family limited partnership. In either case the recipient will “take over” your basis in the creative property. Since the basis remains the same, it cannot be a capital asset.

The vocabulary gets tricky when discussing creative property. For example, an author (say Stephen King) may receive a “royalty.” Coincidently, find oil in your backyard and chances are an oil company will also pay you a royalty. Since the word “royalty” is the same, are the tax consequences the same?

The answer is no. If you write a book or score a movie soundtrack, that royalty is probably ordinary income to you. In fact, it is reported on Schedule C of your individual tax return, the same as your self-employment income from Uber. The oil royalty, on the other hand, is reported on Schedule E, along with rents. The Schedule C royalty will trigger self-employment tax. The Schedule E will not. 

OBSERVATION: We have discussed before that sometimes a word will have different meanings as it travels through the tax Code. Here is an example.

As always, there are exceptions. Let’s say you write one book and never write again. The IRS will likely consider that to be ordinary income but not self-employment income. Why? Supposedly it takes two or more books to establish that you are in the trade or business of writing books.

OBSERVATION: I am curious how the IRS would apply this standard to Harper Lee. She published, you will recall, To Kill a Mockingbird in 1960. It was only this year that she published her second work (Go Set a Watchman) – 55 years later. What do you think: is this self-employment income or not?

Remember when Michael Jackson bought the catalog of Beatles music? He bought it as a non-alternative investment, akin to stocks and bonds. Like a stock or bond, Michael Jackson would have had capital gains had he sold the catalog.

This created a fuss among songwriters. If they sold their own compositions, they would have ordinary and self-employment income. Introduce Michael Jackson and the tax result transmuted to capital gains.

So Congress passed Section 1221(b)(3), which incorporated a provision from the Songwriter’s Capital Gains Equity Act, promoted by the Nashville Songwriters Association International (NASI). It extended capital gains to self-created music owned for more than one year. It requires an election, and the songwriter/creative can elect for one musical composition and not for another. It does require the transfer of a musical composition or a copyright in the same; transfer something less and the result defaults to ordinary income.

NASI argued that the industry had changed. By the 1990s many music artists were acting as their own publishers or co-publishers, meaning they had some control over the exploitation of their songs. Gone were the days of Hank Williams and Bill Monroe, when songwriters sold their songs outright to music publishers with no right to ongoing income.

Congress listened.

Don McLean now has a tax option that he did not have years ago when he recorded “American Pie.” I suppose that there could be a scenario where it would be more advantageous to recognize the $1.2 million as ordinary income rather than as capital gains, but I cannot easily think of any that do not require low-probability tax considerations.

I would say he is making the election.