Spring 2010 Newsletter
How To Limit An Executor’s Personal Liability For A Decedent’s Unpaid Taxes
By: Jeffrey D. Chadwick
Being an executor can often be a demanding and thankless task. In addition to coping with the loss of a close friend or family member, executors are routinely charged with navigating estate plans through an unfamiliar and intimidating course of administrative hazards. And to add another worry, unwitting administrators can inherit dad’s unpaid income and gift tax liabilities, and not just his car or stock portfolio.
This article explains how executors can incur personal liability for a decedent’s unpaid taxes and, more importantly, how they can avoid it. The first section traces the executor liability standard through the Internal Revenue Code (the “Code”) and the courts, while the second section lists the steps an executor should take, as well as the IRS forms he or she should file, when he or she knows or suspects the decedent has unpaid taxes.
I. EXECUTOR LIABILITY FOR DECEDENT’S UNPAID TAXES
Pursuant to Code § 6901(a) and 31 U.S.C. § 3713(b), an executor is personally liable for a decedent’s unpaid income and gift taxes if the executor: (1) knew the debt existed, and (2) distributed the estate without first paying the taxes.1 If the executor does distribute estate assets in excess of the federal tax debt, the executor is only liable to the extent of the improper distribution.2
Knowledge of the tax debt requires “actual knowledge of the liability or notice of such facts as would put a reasonably prudent person on inquiry as to the existence of the unpaid claim of the United States.” 3 If the government makes a prima facie showing, the burden of proof is on the executor to establish that he or she was unaware of the decedent’s debts.4
Before paying a decedent’s federal taxes, the executor can pay certain estate expenses and make distributions to creditors having priority over the federal government.5 In Private Letter Ruling 8341018, the Service identified funeral and administrative expenses, exempt property allowances, and family allowances as costs that can be paid before federal tax liens.6 Administrators, however, cannot pay state and local taxes before paying federal taxes owed by the decedent.7
Typically, an executor can pay the debts of secured creditors before paying the United States.8 But an executor cannot exhaust estate assets satisfying the claims of general lienholders in derogation of outstanding federal tax liabilities.9 If an estate with insufficient assets owes debts to multiple creditors, therefore, the executor and his or her counsel must analyze each claim to determine the priority of the estate’s liabilities.
II. STEPS TO AVOID EXECUTOR LIABILITY
The best way for an executor to avoid personal liability for the taxes of a decedent is to notify the IRS of the fiduciary relationship, investigate the extent of the tax assessment, and apply for discharges from personal liability for the gift, income, and estate taxes of the decedent. Listed below are five steps an executor should take if she knows or suspects an estate has an outstanding tax liability:
A. File Notice of Creation of Fiduciary Relationship (IRS Form 56).
The executor can file a notice of fiduciary relationship under Code § 6903 and corresponding Treasury Regulation § 301.6903-1. The notice requests that the Commissioner send all tax-related documents concerning the decedent to the executor, and not to the last known address of the decedent. Executors must file the notice in the district where the decedent resided prior to his or her death and, if necessary, the district where the executor currently resides. To comply with the Regulations, executors can use Form 56.
B. Request Decedent’s Prior Tax Returns (IRS Form 4506).
If the executor does not have the decedent’s prior tax returns, she can request these by sending Form 4506 to the IRS. Filing Form 4506 confirms whether the decedent filed returns and demonstrates the executor’s good faith in determining the extent of the tax liability.
C. Request a Prompt Assessment (IRS Form 4810).
Code § 6501(d) permits executors to request a prompt assessment of income and gift taxes, including penalties, owed by the decedent. The request shortens the statute of limitations on future assessments from three years to eighteen months, except in cases where no return was filed, the return filed was false or fraudulent, or the return failed to report 25% of the gross income or gifts.10 While the request does provide an accurate overview of the decedent’s tax liabilities, it often invites audit and should be filed only when an audit is forthcoming or expected. To comply with Treasury Regulation § 301.6501(d)-1, the executor can complete Form 4810.
D. Apply for Discharge from Personal Liability of Decedent’s Income, Gift, and Estate Tax (IRS Form 5495).
An executor may apply to be released from personal liability for the decedent’s income, gift, and estate tax pursuant to Code §§ 2204(a) (estate) and 6905(a) (income and gift). Executors can apply for discharge from all three taxes by completing Form 5495. For income and gift taxes, executors must apply after the relevant return has been filed.11 For estate taxes, executors can apply at any time, though the government may require a bond if it has already extended the time for paying the tax.12
The Service has nine months from receiving an application under Code §§ 2204(a) or 6905(a) to inform the executor if any tax is due. If the executor pays the tax, or if the Commissioner fails to respond within nine months, the executor is discharged from personal liability. Even if the request is granted, the IRS can still assess deficiencies against the estate or its beneficiaries, heirs, and transferees.13
E. File Notice of Termination of Fiduciary Relationship (IRS Form 56)
An executor can shield herself from future liabilities by notifying the IRS when she has completed her duties as administrator of the estate. Executors can file the same form, Form 56, used to inform the Service that a fiduciary relationship has been created.
Jeffrey D. Chadwick is an associate at Williams Mullen in Richmond, Virginia. His practice focuses on estate planning, trust administration, and business taxation. He earned his juris doctor degree from the University of Richmond School of Law and his bachelor of science degree from Baylor University.
1. See Kasner, Strauss & Strauss, Post Mortem Tax Planning ¶ 2.05(1); cf. United States v. Bartlett, 186 F. Supp. 2d 876, 885 (C.D. Ill. 2002) (setting forth a five-part test); Allen v. Commissioner, 78 T.C.M. (CCH) 828 (1999) (suggesting a three-pronged inquiry). 2. 31 U.S.C. § 3713(b).
3. Little v. Commissioner, 113 T.C. 474, 480 (1999).
4. See McCourt v. Commissioner, 15 T.C. 734, 738 (1950).
5. See Kasner, Strauss & Strauss, Post Mortem Tax Planning ¶ 2.05(1).
6. I.R.S. Priv. Ltr. Rul. 8341018 (July 11, 1983) (citing Rev. Rul. 80-112, 1980-1 C.B. 306).
7. See United States v. Irby, 97 A.F.T.R. 2d 2006-437, 441 (S.D. Ala. 2005).
8. See, e.g., United States v. Estate of Romani, 523 U.S. 517 (1998) (finding that a judgment creditor with a valid state law lien had priority over the government’s tax lien).
9. See W.T. Jones & Co. v. Foodco Realty, Inc., 318 F.2d 881, 885 (4th Cir. 1988) (noting that the federal government has “absolute priority over the claims of all general lienholders”); Rev. Rul. 79-310, 1979-2 C.B. 404 (holding an executor personally liable for paying mortgages and general creditor claims before satisfying federal tax debts).
10. Code § 6501(c)-(d).
11. See Treas. Regs. § 301.6905-1(a).
12. Treas. Regs. § 20.2204-1(b).
13. See Kasner, Strauss & Strauss, Post Mortem Tax Planning ¶ 2.05(2)(d).