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.

IRS Extends Key Deadline for 2010 Estates

On September 13, 2011 the IRS announced that estates of 2010 decedents will have until next year to file certain tax forms and pay the related taxes. In addition, the IRS is also providing relief for beneficiaries of those estates.

The timing was critical, as 2010 estate tax returns for decedents dying on or before 12/16/2010 were due Monday, September 19, 2011. Estate tax returns are normally due nine months after death, but there was an exception because of last year’s tax law flux.

Remember there was no estate tax for most of 2010. On December 17, 2010, the President signed a tax bill that reinstated the estate tax retroactively to January 1, 2010. That law set a 35% estate tax rate and provided an estate tax exemption of $5 million. The advantage to this scheme is that estate assets get “stepped-up” to their fair market value at the date of death. This means that the inheritors can (generally) sell the assets right away without incurring any income tax. To complicate matters, the bill also made this scheme an option for 2010. Estates of 2010 decedents could opt out of the new tax and use a modified basis carryover regime. There would be no estate tax, but the heirs received the same basis in assets as the decedent (with a $3 million exception for the surviving spouse and a $1.3 million exception for non-spousal beneficiaries). This opt-out required the beneficiaries to know the carryover basis in the assets inherited, so the IRS created a new form (Form 8939 - Allocation of Increase in Basis for Property Acquired From a Decedent). Opting-out of the estate tax is an irrevocable election.

As I write this, the IRS has not finalized Form 8939, although a draft version is available.

The IRS is providing the following filing relief:

·    If the estate is opting out of the new estate tax regime (that is, an estate of $5 million or more) it will have until January 17, 2012, to file Form 8939. This form was previously due November 15, 2011. The new due date will apply automatically; the estate does not need to file any anything.

·    Estates between 1/1/2010 and 12/16/2010 that request an extension to file their estate tax returns and pay any estate tax due will have until March 19, 2012, to file. The IRS will not assess penalties for either late filing or late payment.  Interest will be due on any estate tax paid after the original due date.

·    Estates between 12/17/10 and 12/31/10 will be due 15 months after the date of death. The IRS will not assess penalties for either late filing or late payment.  Interest will be due on any estate tax paid after the original due date.

·    The IRS is providing penalty relief to beneficiaries who received property from a 2010 decedent and also sold the property in 2010. The taxpayer should write “IRS Notice 2011-76” on the amended return to identify the issue to the IRS.

Confused? It is easy to be.  Some thoughts:

(1)   Seems to me that an estate under $5 million would generally elect-out, especially if the appreciation in estate assets is less than $1.3 million. In that event, we don’t even need the spousal $3 million to protect all the step-up.

a.   Remember that there are assets that do not receive a step-up. These are sometimes referred to as IRD (income in respect of a decedent) assets. The most common – by far – are 401(k) s and IRAs.

(2)   Estates over $5 million are a tougher call.

a.   Even then, it depends on the mix of assets. If the majority of assets are IRD assets, the step-up may be modest, as IRD assets do not step-up. That would incline one to the carryover regime.

b.   We are now balancing the estate tax with looming income taxes when the beneficiaries sell the assets.  If there is modest appreciation, then the carryover regime would appeal. If there is substantial appreciation, then the new tax regime would appeal – maybe.

                                          i.    Why maybe? Because it depends on the tax rate. If the assets would generate capital gains, an Ohio beneficiary would face an approximate 21% income tax rate (15% federal plus 6% Ohio). Why would one pay 35% when one could pay 21%?

c.   Frankly, I am not sure how one could determine the best course of action without assembling the fair market values and basis for all estate assets and considering the intentions of the beneficiaries. If the beneficiary intends to sell the asset right away, then one could incline to a different decision than if the beneficiary intends to retain the asset forever.

d.   There is an issue in the carryover regime that concerns tax practitioners. How do you determine the basis of an asset that has been owned forever and for which cost records do not exist? This is not a small matter, as the default IRS response is to say that the asset has a basis of zero. If this fact pattern is a significant for the estate, then one would be inclined to the new tax regime as the assets would step-up to fair market value on the date of death.