Settling Back Taxes for a Probate Estate

Executors who administer probate estates often have to deal with back taxes that the decedent owed. They may also have to deal with estate tax liabilities owed by the estate.

While the probate process is governed by state law, state law gives way to Federal law when it comes to back taxes. The IRS has several tools in its toolbox that it can use to collect unpaid taxes from the estate.

Some of these tools can also allow the IRS to collect from the executor and the executor’s personal assets. This potential liability usually turns on whether the executor has “actual knowledge” of the IRS debt. This is why probate attorneys may be inclined to advise their executor clients not to ask a lot of questions or make inquiries about back taxes until the IRS takes steps to contact the executor or files a lien notice against the estate.

With that said, the executor usually has a duty to try to preserve the estate for the benefit of the estate beneficiaries. This may include trying to settle the back taxes for less than the amount owed. The executor’s personal liability exposure can greatly complicate this settlement process.

The recent Lee v. Commissioner, No. 21-2921 (3d Cir. 2022) case provides an opportunity to consider executor liability for estate taxes and the “actual knowledge” requirement in the context of trying to settle a tax balance with the IRS for less than the amount owed.

Facts & Procedural History

This case involves a decedent, probate, and the collection of taxes owed by the estate.

The decedent died in September 2001 and the estate tax return was filed in May 2003. Distributions were made to the beneficiaries from July 2003 to February 2007. The IRS estate tax attorney group audited the return and issued a notice of deficiency in April 2006. The estate was unsuccessful in contesting the tax in the U.S. Tax Court and the IRS assessed the tax in July 2010.

The IRS filed a notice of estate tax lien in April 2013 and the estate filed a collection due process hearing request. The CDP hearing was held in late 2016. The IRS Appeals Office has unique procedures for CDP hearings. The basis for the CDP hearing was collection alternatives, including a request for an offer in compromise.

The IRS Appeals Office refused to agree to an offer in compromise and the U.S. Tax Court agreed with the IRS. The current case is an appeal to the Third Circuit Court of Appeals from the prior U.S. Tax Court determination.

Reasonable Collection Potential

The dispute in this case turns on the “reasonable collection potential” for the estate and an offer in compromise the estate submitted to settle its back taxes.

As we have previously covered in other articles, the reasonable collection potential is the amount that the IRS believes it can collect. Generally, the IRS will settle unpaid taxes for the amount it determines the reasonable collection potential to be.

The IRS did not agree to settle the estate balance in this case based on its belief that it could collect the distributed amounts from the executor using a fiduciary liability theory under 31 U.S.C. § 3713 and from the beneficiaries as transferees under I.R.C. § 6324(a)(2). We are going to focus on the executor’s liability under 31 U.S.C. § 3713 in this article.

Executor Liability Under 31 U.S.C. § 3713

The 31 U.S.C. § 3713 statute is not part of the tax code. It is part of the Money & Finance Code.

As relevant here, 31 U.S.C. § 3713(a) says that:

• the claim of the United States shall be paid first when the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.
• a representative of a person or an estate 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.

This liability is in addition to the transferee liability that the IRS may assert under I.R.C. § 6901.

While not part of this statute, the courts have said that the transfers by the executor have to be a lower priority than those set out in I.R.C. § 6323. Section 6323 provides priority to certain third parties, such as purchasers for value who do not have knowledge of the IRS debt. Estate beneficiaries and distributions to the estate beneficiaries are not included in this priority list. Thus, the executor can be liable for distributions to estate beneficiaries that are not afforded priority under I.R.C. § 6323.

The IRS has one year or until the collection statute for the underlying tax liability expires to collect the unpaid taxes from the executor. This limit is also not found in this particular statute. It is found in the transferee liability statute. The collection statute is usually 10 years from the date the tax is assessed. There are exceptions that extend this time, such as the collection due process hearing and court hearings in this case. So distributions to beneficiaries prior to the time the tax debt collection statute expires can result in executor liability.

Actual Notice of the IRS Debt

The courts confirmed that 31 U.S.C. § 3713 can shift a tax liability to the executor. The courts have imposed liability for the amount of transfers after the executor is aware of the IRS debt. The courts have required “actual knowledge.”

It isn’t clear when the executor has actual knowledge of an IRS debt or how the IRS can establish actual knowledge. However, if the IRS files a lien notice for the estate, it can be more difficult for the executor to claim that they do not have actual knowledge. The IRS does routinely file IRS lien notices. It does not always file lien notices for estates.

This brings us back to this case. The executor would have been deemed to be aware of the IRS debt when the IRS Lien Notice was filed. The executor apparently made some distributions after the date of this lien notice. The IRS may have been correct that it could collect an amount equal to these post-notice distributions from the executor.

Liability under 31 U.S.C. § 3713 is not automatic. It cannot be done administratively by the IRS. The IRS would have to file suit against the executor in U.S. District Court or issue a transferee liability notice to the executor. The IRS apparently did not take any of these actions. In this case, the IRS’s mere authority to take these actions was sufficient to include the distributions in the “reasonable collection potential” even though the actions were never taken.

Dissipated Assets

The court case also addressed dissipated assets. The IRS’s policies include so-called dissipated assets in the calculation of the “reasonable collection potential.” A dissipated asset is an asset that was “sold, transferred, encumbered or otherwise disposed of assets in an attempt to avoid the payment of the tax liability.” There usually has to be evidence of “the transfer of assets for less than full value or use of proceeds.”

The court noted that there was no dissipation here as the distributions to the estate beneficiaries were not to avoid paying tax. This isn’t to say that the IRS could not raise this issue if the facts warrant it. It just did not apply given the facts in this particular case. The dissipation rules usually have to be considered in settling back taxes owed by probate estates.

The IRS usually imposes a three-year look-back period in determining whether dissipation has happened. Those settling debts for estates should examine any transfers within this time to see if dissipation occurred. If it did, the estate will need documentation that the transfers were for full value to keep the assets out of the “reasonable collection potential” calculation.

The Takeaway

This case highlights the importance of the IRS’s lien notice. The IRS’s lien notice establishes actual knowledge of the tax debt. This can trigger liability for the executor under 31 U.S.C. § 3713.

Executors who are administering probate estates have to think twice about making distributions after the date of the IRS lien notice. If the state law allows, the executor may be able to avoid this liability by paying the funds into the court’s registry and having the probate court order and make the distribution.

If distributions were made by the executor, those trying to settle the tax debt for the estate may need to establish that there was no actual knowledge of the IRS debt to exclude the distributions from the “reasonable collection potential” under IRS settlement rules.