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.

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.

When Your Employer Bungles Your Retirement Plan Loan

I admit that I am not a fan of borrowing from an employer retirement plan, except perhaps as a next-to-last step before being evicted.

Things go wrong.

Lose your job, for example, and not only are you looking for work but you also have a tax bill on a loan you cannot pay back.

You do not even have to lose your job.

Ms. Frias participated in her company’s retirement plan. She was getting ready to go on maternity leave when she borrowed $40,000 from her 401(k). Her employer was to withhold from her paycheck (to be paid biweekly), and there was a make-up provision allowing her to correct any shortfall by the end of the following month.

COMMENT: Retirement plan proceeds are normally tax-free if repaid over a period of five years or less.

She went on leave on or around August 1^st.  She was drawing on her accumulated vacation and sick time.  Sounds pretty routine.

She returned to work October 12th.

In November, she learned that her employer had failed to withhold any monies for her 401(k) loan.

She immediately wrote a $1,000 check and increased her withholding to get caught-up.

Nonetheless, at the end of the year the plan administrator (Mutual of America Life) sent her a $40,000 Form 1099R on the loan.

They however sent it to her electronically. Having no reason to expect one, she did not realize that she had even received a 1099. Goes without saying it was not on her tax return.

You know the IRS matched this up and sent her a notice.

What do you think: does she have a tax issue?

No question her employer messed up.

And that she tried to correct it.

However, the law is strict:

Although a loan may satisfy the section 72(p) requirements, “a deemed distribution occurs at the first time that the requirements … of this section are not satisfied, in form or operation.”

Her first payment was due in August, the month following the loan. If she had a deemed distribution, it would have occurred then. A distribution – even a “deemed” one – would be taxable.

There remained hope, though:

The plan administrator may provide the plan participant with an opportunity to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period.”

This is a nice safety valve. If the employer gives you a “cure” period, you can still avoid having the fail and its associated tax.

What was her cure period?

The end of the following month: September.

When did she write a check?

November, when she realized that there was a problem.

Too late.

She had one last long shot: a “leave of absence” exception.

Which is Code section 72(p)(2)(C), and it provides for interruption in a loan repayment schedule if one is not drawing a paycheck or not drawing enough to meet the minimum loan payment.

Her argument? She was not receiving her “regular” paycheck. She instead was drawing on her vacation and sick time bank.

Problem: she nonetheless received a check, and the Court was unwilling to part-and-parcel its source. She was collecting enough to make the loan payments.

She was hosed.

She did nothing wrong, but her employer’s negligence cost her somewhere near $15 grand in unnecessary taxes.

The 2014 Tax Act and Professional Employer Organizations (PEOs)

We know that Congress passed, and the President signed, the Tax Increase Prevention Act of 2014 at the end of last year. This is the tax bill that retroactively resurrected certain tax deductions that many taxpayers have become used to, such as deducting sales taxes (rather than state income taxes)  should one live in Tennessee, Florida or Texas or deducting (a certain amount of) tuition payments if one’s child is in college.

There is something else this bill did that was not as well publicized.

It has to do with professional employer organizations, known as PEO’s. These are companies that provide human resource (HR) functions, such as the paperwork involved in hiring, as well as running payroll and depositing payroll taxes and other withholdings.

There has long been a hitch with PEOs and payroll taxes: the IRS considered the underlying employer to still be liable for withholdings if the PEO failed to remit or failed to do so timely. The IRS took the position that an employer could not delegate its responsibility for those withholdings. To phrase it differently, the employer could delegate the task but could not delegate the responsibility.

You can guess what happened next. There were cases of PEO’s diverting withholdings for their own use, then going out of business and leaving their employer-clients in the lurch. If you were one of those employer-clients, the experience proved to be very expensive. You had paid payroll taxes a first time to the PEO and then a second time when the IRS held you responsible.

The answer was to watch over the PEO like a hawk. The IRS encouraged employer-clients to routinely go into the electronic payment system (EFTPS), for example, to be certain that payroll taxes were being deposited.

That unfortunately collided with many an employer’s reason to use a PEO in the first place: to have someone else “take care of it.”

Back to the tax bill. Stuck in with the tax extenders was something called the ABLE Act, which is a Section-529-like-plan, but for disabled individuals rather than for college expenses.

Stuck (in turn) onto the ABLE Act was a brand-new Code section just for PEOs. The provision requires the IRS to establish a PEO certification program by July 1, 2015. There will be a $1,000 annual fee to participate, but – once approved – the IRS will allow the PEO to be solely responsible for the employer-client’s payroll taxes.

You have to admit, this is a marketing bonanza if you own a PEO. It will separate you from a non-PEO who is bidding on the same prospective client.

The PEO will have to post a bond in order to participate in the program. In addition the PEO will have to be audited annually by a CPA. The PEO will have to submit that audited financial statement to the IRS.

I do not know the answer as of this writing, but I have a strong suspicion the AICPA was in the room when that audit requirement was included. Why do I say that? Because only CPAs are allowed to render an opinion that financial statements are “presented fairly in accordance with generally accepted accounting principles.” 

NOTE: That would be CPAs who practice as auditors. There are CPAS who do not. For example, I specialize in taxes.

There is – by the way – risk to the PEO. This is not a one way street. The PEO will be responsible for the payroll taxes, even if the employer-client does not pay the PEO.

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.

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.