A U.S. District Court case is a useful reminder that a personal representative can become personally liable for the decedent’s income tax debt. Although a slam-dunk for the IRS, the case highlights how to preserve funds for the family allowance and/or administrative expenses and, more importantly, how not to become individually liable for the tax debt.
In U.S. v. Reitano, 2014 WL 4384486 (9/4/14), the personal representative distributed estate assets after she had knowledge that the estate owed the decedent’s federal income tax debt. The decedent died owing more than $300,000 in federal income taxes. He also died holding stock in two corporations. He wholly owned the first corporation and held fifty percent of the second corporation with his wife holding the other half. Each corporation held, as its sole asset, a commercial fishing boat. The value of the corporate shares equaled about $127,000: the value of the boats held by the corporations, less secured debt on one boat. The decedent’s wife was the personal representative, and even though she knew of the debt her husband owed in back taxes, she transferred the stock to herself. In its complaint, the IRS argued that the personal representative was personally liable for the value of the transfer under the Federal Priority Statute, 31 U.S.C. § 3713, because the transfer left the estate insolvent.
The Federal Priority Statute states that a personal representative is personally liable to the government in the amount of wrongful payments when the personal representative pays creditors or heirs of the estate before paying a claim of the government and the payments leave the estate insolvent. Certain exceptions to this fiduciary liability have developed in judicial and administration precedent that soften the sweeping language of the statute. A personal representative may pay prior secured debt, funeral expenses, family allowances and other administrative expenses that have priority under state law before paying debts owed to the federal government. The personal representative/wife in Reitano wanted to offset the personal liability imposed by the Priority Statute with the family allowance and her administrative expenses. Her huge mistake was that she transferred the property to herself instead of leaving “the assets in the estate and (paying) the family allowance and expenses therefrom.” Accordingly, the Reitano court refused to give her credit for the administration expenses against the value of the transferred property. Her tax liability became the full value of the transferred stock with no offset.
The fiduciary liability is triggered when a personal representative transfers assets with notice or knowledge of the tax debt. Knowledge includes knowledge of facts that would, or should, lead to further inquiry. In Reitano, the wife was well aware of her late husband’s existing tax liabilities. In a case where the estate is distributed before the IRS audits the decedent’s return, the IRS may be able to follow the assets but will not be able to hold the personal representative personally liable in the absence of “knowledge.” Of course, a personal representative is obligated to file income tax returns on behalf of a decedent which may lead to “inquiry notice” as to other open years. The safe course would be for a personal representative to request a discharge of personal liability from the IRS (under § IRC 6905 and 2204) before transferring assets to heirs and, in the case of a border-line solvency situation, before paying other creditors. Many writers, however, believe that filing a discharge request may trigger an audit so the exercise of reasonable judgment is required.
Those have always been the rules. Reitano, however, is a good reminder that transfers in the face of a known tax liability will result in a personal liability on the fiduciary.