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.

Change In Innocent Spouse Tax Relief

You may have read or seen that the IRS has ‘changed” the rules for innocent spouse relief. 

While this is not wrong, it is incomplete. How? Because there are three ways to request innocent spouse status, and the IRS has changed one of them. The other two remain as they were before.

Being married and filing a joint tax return with your spouse is what creates this issue. You later divorce or separate from your spouse. You and your (now ex) spouse are audited by the IRS. Remember, the IRS lags a year or two before they select returns for audit. The IRS finds unreported income and assesses additional tax.  The income triggering the tax belongs to your ex-spouse.

Let’s return to the joint tax return you filed. A joint return means that you are “jointly and severally liable.”  The IRS can proceed against you alone, against your spouse alone or against the two of you.  The IRS can, and likely will, proceed against you (for at least 50%) even if it wasn’t your fault. From their perspective, why not? They have nothing to lose, and it doubles their chance of getting someone to pay.

This is the point of innocent spouse relief. You want to separate your tax from that of your ex-spouse. Ideally, you want to completely separate your tax, so that the IRS leaves you alone for any additional tax, penalties and interest.

There are three types of innocent spouse relief.

Type I is “general” relief:

(1)   You filed a joint return.

(2)   The return has an “understatement of tax” due to “erroneous” items of your spouse (or ex-spouse).

(3)   You can show that at the time you signed the joint return you did not know, and had no reason to know, that there was an understatement of tax.

(4)   Considering all the “facts and circumstances,” it would be unfair to hold you liable for the understatement of tax.

An “erroneous” item is IRS-speak for not reporting income or for overstating deductions.

The third requirement can be a tough to meet.  It is possible that you did not know, but that is not enough. The IRS wants to be sure that you had no reason to know. For example, you and your spouse reported $60,000 of income. That year you and your spouse bought a Colorado chalet and a Bugatti Veyron. Unless you had savings to tap into or one of you inherited, expect the IRS to be very skeptical of you denying any “knowledge.” They will figure that you should have known.  And it doesn’t have to be as dramatic as a Swiss chalet. Perhaps you and your ex moved to a nicer neighborhood. Or enrolled the kids in a private school. Or started showing horses.  A quick review of your income and savings would prompt one to wonder how you paid for everything. Expect the IRS to argue that you had “constructive” knowledge. That is, you “had reason to know.”

Type II is “separation of liability.”

Under this method, you separate your income and deductions from your (ex) spouse’s income and deductions. You then calculate your separate tax on such separate income. You are trying to get the IRS to agree that your share of the joint tax is that amount and not more.

It does have the advantage of appearing “fair.”

Oh, the IRS requires that you be divorced, legally separated or at least living apart for the 12-month period preceding the innocent spouse filing. Don’t be surprised if your tax planning includes advice to get divorced.

What is going to sour the IRS on this deal, other than their general reluctance to let anyone off the hook?  Well, that “knowledge” requirement we discussed previously will derail you, with one important distinction: you must have actually known of the tax understatement. The “you should have known” argument is not good enough to deny you the second type of innocent spouse relief.

A second thing that will sink the separation of liabilities is transferring assets for the main purpose of avoiding payment of tax. You can expect the IRS to want to review every significant asset move between you and your ex.

You must request Type I and Type II innocent spouse relief within 2 years after the date on which the IRS first begins collection activity against you. This is not the same as the date you filed the return. Rather it is the date that the IRS sends you a letter or asks you to go downtown for a meeting.

Type III is “equitable relief.”

Equitable relief is only available if you meet the following conditions:

• You do not qualify for innocent spouse relief or separation of liability.
• The IRS determines that it is unfair to hold you liable for the understatement of tax taking into account all the facts and circumstances.

Well, unfair is in the eye of the beholder, isn’t it? What facts and circumstances will the IRS consider as they ponder whether to be fair or unfair?

·        

• Current marital status
• Abuse
• Reasonable belief of the spouse requesting innocent spouse, at the time he or she signed the return, that the tax was going to be paid; or in the case of an understatement, whether that  spouse had knowledge or reason to know of the understatement
• Current financial hardship or inability to pay basic living expenses
• Legal obligation to pay the tax liability pursuant to a divorce decree or other agreement to pay the liability
• To whom the liability is attributable
• Significant benefit received by the spouse asking for innocent spouse
• Mental or physical health of the spouse requesting innocent spouse on the date that spouse signed the return or requested relief
• Compliance with income tax laws following the taxable year or years to which the request for relief relates

The IRS had previously held Type III relief to the same time limit as Types I and II. While not in the Code itself, the IRS inserted the time limit into its Regulations and battled hard to have the courts accept its position.

The IRS lost a high profile case (Lantz) on this issue in 2010. Lantz was the former wife of an Indiana dentist. In 2000 her then-husband was arrested for Medicaid fraud. Shortly thereafter came a $900,000 IRS bill. She didn’t file for innocent spouse because he told her that he had taken care of it. He did not, of course. Shortly thereafter he died.

And of course more than two years had gone by…

Mrs. Lantz filed for Type III innocent spouse. In 2009 the Tax Court sided with her. In 2010, however, the Appeals Court sided with the IRS.

The IRS Taxpayer Advocate howled at what was happening to Mrs. Lantz. Forty-nine members of the House of Representatives sent a letter to the IRS Commissioner demanding a stop to such behavior.  

The IRS did, and in 2011 it announced that it was backing-off the two-year requirement for Type III innocent spouse claims. 

The IRS has now published Regulations formalizing what it announced back in 2011.   

So how long do you have now to file a Type III innocent spouse claim? You have ten years – the same period as the IRS has to collect taxes from you.

Note though that Type I and Type II still have the two-year requirement. It is only Type III that has changed. Why the difference? Because for Types I and II, the two-year requirement is written into the law.

My Thoughts: To hold an innocent spouse to a two-year window – when the law passed by Congress said nothing about a two-year window for Type III relief – was a clubfooted mistake by the IRS. It is a bit late, but the IRS finally got it right.

By the way, if you have been turned down for innocent spouse – and you are still within the ten-year window – please consider filing again under the new rules.