Personal Liability for Estate Taxes

 

Here is a greeting card for a bad day:

… the Internal Revenue Service … determined that the … Estate of Georgia M. Spenlinhauer (estate) is liable for an estate tax deficiency of $3,984,344.”

In general, when I see estate tax numbers of this size, I presume that there are hard-to-value assets. The estate will argue that the assets are illiquid, near unmarketable, and that it would be fortunate to get a thousand or two thousand dollars for them. The IRS of course will argue that the real numbers approach the GDP of many small countries. The Court will often decide somewhere between and call it a day.

Let me see what was at play.

• Whether the estate timely elected an alternative valuation date;
• Whether the estate may exclude $200,000 pursuant to a qualified conservation easement; 
• Whether the value of (yada, yada) was $5.8 million or $3.9 million.

So far it looks like another valuation pay per view Friday night fight.

• Whether the petitioner is liable as transferee for the estate tax deficiency.

That was unexpected.

What happened here?

In February 2005, Georgia Spenlinhauer passed away at the age of ninety-five. She appointed her son as executor. After paying expenses and specific bequests, the son/executor received the residue of the estate. Probate was closed in March 2009.

The executor/son requested and received an extension for the estate tax return until May 2006.

The accountant cautioned the executor/son that he did not have expertise in estate taxation and did not prepare or file estate tax returns as part of his practice.

As a practitioner myself, I get it. The executor/son had to find another practitioner – attorney or CPA – who did estate work.

The executor/son decided not to file an estate return.

COMMENT: I believe we have pinpointed the genesis of the problem.

In 2013 the executor/son filed for bankruptcy.

Through the bankruptcy proceeding, the IRS learned that he had never filed a tax return on behalf of the estate.

In 2017 he finally filed that estate tax return.

The return was audited.

In January 2018, the IRS disagreed with the numbers. It wanted money. It issued a Notice of Deficiency.

Of course.

In March, the IRS made a jeopardy assessment against the estate.

COMMENT:  Whoa! A jeopardy assessment usually indicates that the IRS suspects concealed assets or otherwise anticipates that a taxpayer will make collection difficult. Jeopardy makes the tax, penalty, and interest immediately due and payable. The IRS is authorized to begin immediate collection, without the usual taxpayer safeguards baked into the system.

A jeopardy assessment is not routine, folks.

Did I mention that the IRS was also simultaneously pursuing the assessment against the executor/son personally? Why? Because he had drained the estate to zero with the distribution to himself.

This would not turn out well. There are certain elections - such as an alternate valuation date - that must be made on a timely-filed return. Filing 11 years late is not a timely filing. There were the usual valuation disputes (I can use municipal assessment amounts as asset values! No, you cannot!). There was even a self-cancelling promissory note that got added to the estate (to the tune of $850 grand).

COMMENT: I have not seen a self-cancelling note in a moment. The attorneys worked hard on this estate.

A brutal audit adjustment involved certain litigation fees on an estate asset. The Court decided that the litigation benefited the executor/son and not the estate itself, meaning the estate could not deduct the fees. There went a quick half million dollars in deductions.

Yep, up the asset values, disallow certain deductions. The estate was going to owe - a lot.

And penalties.

The executor/son protested the penalties. To be fair, he had to. His argument?

He had relied on his accountant.

The same accountant who told him that he did not do estate work.

You gotta be kidding, said the Court. They approved the penalties in a hot minute.

There were no assets left in the estate, of course. How was the IRS to collect?

Oh no.

Oh yes.

The executor/son had exhausted the estate by distributing assets to himself. He had transferee liability to the extent of the assets distributed.

Personal liability.

This was not the routine valuation case that I first expected. This instead was closer to a Greek tragedy.

But why? The estate was large enough to obtain creative legal advice. A reasonable person must have suspected that there would be tax reporting, which work was beyond the skill set of the family’s regular accountant. Heck, the accountant was clear that he did not practice in this area. Rather than seek out another accountant (or attorney) with that skill set, the executor/son did … nothing.

Granted, the tax was the tax, whether the return had been timely filed or not. The additional weight was the penalties and interest. What were the penalties? I saw them near the beginning ….

$524,520.

Wow.

Our case this time was Estate of Spenlinhauer v Commissioner, T.C. Memo 2025-134.

Inheriting A Tax Debt

 I am looking at a decision coming from a New Jersey District Court, and it has to do with personal liability for estate taxes.

Clearly this is an unwanted result. How did it happen?

To set up the story, we are looking at two estates.

The first estate was the Estate of Lorraine Kelly. She died on December 30, 2003. The executors, one of whom was her brother, filed an estate tax return in September, 2004. The estate was worth over $1.7 and owed $214 grand in tax. Her brother was the sole beneficiary.

OK.

The estate got audited. The estate was adjusted to $2.6 million and the tax increased to $662 grand.

COMMENT: It does not necessarily mean anything that an estate was adjusted. Sometimes there are things in an estate that are flat-out hard to value or – more likely – can have a range of values. I will give you an example: what is the likeness of Prince (the musician) worth? Reasonable people can disagree on that number all day long.

The estate owed the IRS an additional $448 grand.

The brother negotiated a payment plan. He made payments to the IRS, but he also transferred estate assets to himself and his daughter, using the money to capitalize a business and acquire properties. He continued doing so until no estate assets were left. The estate however still owed the IRS.

OK, this is not fatal. He had to keep making those payments, though. He might want to google “transferee tax liability” before getting too froggy with the IRS.

He instructed his daughter to continue those payments in case something happened to him. There must have been some forewarning, as he in fact passed away.

His estate was worth over a million dollars. It went to his daughter.

The daughter he talked to about continuing the payments to the IRS.

Guess what she did.

Yep, she stopped making payments to the IRS.

She had run out of money. Where did the money go?

Who knows.

COMMENT: Folks, often tax law is not some abstruse, near-impenetrable fog of tax spew and doctrine descending from Mount Olympus. Sometimes it is about stupid stuff – or stupid behavior.

Now there was some technical stuff in this case, as years had passed and the IRS only has so much time to collect. That said, there are taxpayer actions that add to the time the IRS has to collect. That time is referred to as the statute of limitations, and there are two limitations periods, not one:

·      The IRS generally has three years to look at and adjust a tax return.

·      An adjustment is referred to as an assessment, and the IRS then has 10 years from the date of assessment to collect.

You can see that the collection period can get to 13 years in fairly routine situations.

What is an example of taxpayer behavior that can add time to the period?

Let’s say that you receive a tax due notice for an amount sufficient to pay-off the SEC states’ share of the national debt. You request a Collections hearing. The time required for that hearing will extend the time the IRS has to collect. It is fair, as the IRS is not supposed to hound you while you wait for that hearing.

Back to our story.

Mrs. Kelley died and bequeathed to her brother.

Her brother later died and bequeathed to his daughter

Does that tax liability follow all the way to the daughter?

There is a case out there called U.S. v Tyler, and it has to do with fiduciary liability. A fiduciary is a party acting on behalf of another, putting that other person’s interests ahead of their own interests. An executor is a party acting on behalf of a deceased. An executor’s liability therefore is a fiduciary liability. Tyler says that liability will follow the fiduciary like a bad case of athlete’s foot if:

(1)  The fiduciary distributed assets of the estate;

(2)  The distribution resulted in an insolvent estate; and

(3)  The distribution took place AFTER the fiduciary had actual or constructive knowledge of the unpaid taxes.

There is no question that the brother met the Tyler standard, as he was a co-executor for his sister’s estate and negotiated the payment plan with the IRS.

What about his daughter, though?

More specifically, that third test.

Did the daughter know – and can it be proven that she knew?

Here’s how: she filed an inheritance tax return showing the IRS debt as a liability against her father’s estate.

She knew.

She owed.

Our case this time was U.S. v Estate of Kelley, 126 AFTR 2d 2020-6605, 10/22/2020.

Be Careful If You Are An Executor For An Estate

I infrequently see estate returns. Granted, the fact that one does not need to file a federal estate return until one’s taxable estate exceeds $5,250,000 has a lot to do with it. Ohio has also helped by eliminating its estate tax, which used to apply with estates as low as $338,000. Some practitioners call this the “estate estate” return, as one is being taxed for owning property.

Then there is the estate “fiduciary” return. If you consider the estate return as a snapshot of one’s net worth at death, then the estate fiduciary is the income that net worth throws off until assets are finally transferred out of the estate and to the heirs.

One can have a sizeable estate and have no estate fiduciary return. How? Simple. One way is for the assets to transfer independent of a will, such as by joint ownership or by beneficiary designation. For example, a house owned jointly with a spouse will transfer automatically and without intervention of a probate judge. The same goes for IRAs with designated beneficiaries.

We have seen several times this year an estate with an estate fiduciary issue, although no “estate estate” return was required. What caused it? The deceased did not designate a beneficiary for his/her 401(k) at work or IRA outside work. The default is that the 401(k) or IRA goes to the estate. The attorney then holds up distributing cash because of other issues, such as bickering heirs.

Remember: the estate is filing an income tax return, the same as you are next month. An accountant has some discretion over picking the estate’s taxable year, but we cannot make its annual tax filings magically go away. If the estate gets that 401(k) and parks on it, it also gets the tax consequence of a 401(k): that is, there is tax due. There is no difference in tax because it goes to an estate rather than to you.

An estate – like a trust – however is an odd tax animal, as it can “give away” its taxable income. You and I cannot (for the most part) do that. It does so by distributing cash to the heirs, and any taxable income attaches to the cash like a bad cold.  

The estate wants to distribute cash the same year as it receives the 401(k). Why? To pull the income out of the estate fiduciary. Granted, this shifts the income to the heirs, but then again they received the cash.

We were dangerously close in a couple of cases where the attorney was delaying distributing cash and running out of days remaining in the estate tax year.

Then there is the worst-case scenario: the probate takes several years and the attorney holds up distributions until issues are resolved. The attorney finally sends the paperwork to the accountant, who is now reviewing transactions from years before. There is no planning possible. It is too late.

Let’s say that the estate received $700,000 of IRA proceeds in 2012.

The estate finally closed probate in 2014. Perhaps it was held up because of real estate. The attorney writes checks all around, holding back just enough money to pay the accountant.

And the accountant clues the attorney that the estate had tax on the IRA in 2012. So what, says the attorney; he/she made distributions to the heirs. Don’t distributions pull income with them?

Well, yes, but in the same taxable year. 2012 is not the same taxable year as 2014. The estate was supposed to pay tax for 2012. The heirs would like this result, as there would be no tax to them upon distribution in 2014.

But there is no cash left in the estate, says the attorney. What is the downside?

I am looking at U.S. v Shriner, a District Court case from Maryland. The facts are not complicated:

·       Mrs. Shriner passed away in June 2004.

·       She had failed to file income tax returns for 1997 and years 2000 through 2003.

·       The executors (Robert and Scott Shriner) hired a law firm to sort it out.

·       The law firm did and filed tax returns.

·       The IRS informed the law firm that over $230,000 was due in taxes.

·       The estate distributed over $470,000 to Robert and Scott, meaning that …

·       … the estate did not have enough cash to pay the IRS.

Robert and Scott were in trouble. They distributed assets of the estate, rendering it insolvent and unable to pay its taxes. They had better get the Court to believe that they did not know this would happen – and they could not have known this. They however failed to do so. The result? They were personally liable for the tax.

Wait a minute, you say. You mean that someone – let’s say you – could be liable because someone distributed estate assets to you, rendering the estate insolvent? How could you possibly know that?

No. What I am saying is that - if you are the executor and distribute assets in sufficient amount to leave the estate insolvent – you will be personally liable. You are the executor. You are supposed to know these things.

Combine that outcome with above-discussed tax due on a previous year IRA distribution. I have little doubt the attorney was writing distribution checks shortly after our conversation.