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Who’s Liable for Unpaid Estate Taxes?

California court considers claim of statutory executor, trustee and beneficiaries

In United States v. Paulson, et al., Case No. 15cv2057 (NLS) (S.D. Calif. Sept. 6, 2016), various defendants sought to dismiss a suit brought by the United States to recover unpaid estate taxes, plus penalties and interest. The U.S. District Court for the Southern District of California granted some of the defendants’ motions and rejected others.

Living Trust and Marital Trust

Allen Paulson established a living trust in 1986. Two years later, he entered into a prenuptial agreement with Madeleine Pickens, which defined their separate property and established gifts for her in the event of his death. Over the years, Allen amended his living trust, including incorporating into it a marital trust. The marital trust was to receive a home and all personal property located at a residence in Rancho Santa Fe, Calif. (the Rancho property). The living trust gave Madeleine the right to receive a second residence (the Del Mar property) and its furnishings, as well as all insurance policies related to that property. Under the living trust, Madeleine could elect to receive property under the prenuptial agreement or the marital trust—but not both. The living trust also gave the marital trust 25 percent of the residue of the living trust. 

The living trust named Madeleine, Allen’s son John Michael and Edward White as co-trustees of the marital trust. John Michael was the executor of Allen’s estate. In 2000, Allen passed away. On the date of his death, his living trust held all of his assets, except for his shares in Gold River Hotel & Casino Corporation (Gold River). At the time of his death, the living trust held $24,764,500 in real estate assets; $113,761,706 in stocks and bonds; $23,664,644 in cash and receivables and $31,243,494 in miscellaneous assets, all totaling about $193,434,344.

Tax Returns

After granting an extension request, on Oct. 23, 2001, the IRS received the Form 706 estate tax return, signed by John Michael. The estate elected to use a valuation date of Jan. 19, 2001, reporting a total gross estate of $187,729,626, a net taxable estate of $9,234,172 and an estate tax liability of $4,459,051. The estate elected, under Internal Revenue Code Section 6166, to pay a portion of the estate tax liability ($706,296) and defer the rest ($3,752,755) under a 15-year payment plan. In November 2001, the IRS audited the tax returns.

The Dispute and 2003 Settlement

During the time the IRS was reviewing the tax returns, a dispute arose among John Michael, Madeleine and the other living trust beneficiaries. In February 2003, the parties entered into a settlement agreement that the California Probate Court approved (the 2003 settlement). Under the 2003 settlement, Madeleine chose to receive direct distributions from the living trust, rather than receive property under the prenuptial agreement and living trust. Under the 2003 settlement, Madeleine received the Rancho property, the Del Mar property and stock in the Del Mar Country Club, Inc. Madeleine received these distributions directly as trustee of the Madeleine Anne Paulson Separate Property Trust.

In 2004, John Michael, as trustee of the living trust, distributed almost $6 million in trust assets to certain individuals.

Notice of Deficiency/Removal of Trustees

In 2005, the IRS issued to John Michael, as executor, a notice of deficiency for $37,801,245 in the estate tax return. John Michael petitioned the Tax Court, challenging the additional estate tax owed. At the end of 2005, the Tax Court ruled that the estate owed $6,669,477 in additional estate taxes. The estate agreed to pay this amount under the 15-year installment period under Section 6166(a)(1).

In 2006, John Michael, as trustee of the living trust, distributed $1.25 million. In 2009, the Probate Court removed him as trustee for misconduct. Vikki Paulson and James Paulson became co-trustees. In 2011, they reported that the living trust had assets worth $13,738,727.

In 2010, the IRS issued a notice of final determination, in response to missed installment payments. The notice stated that the extension of time for payments under Section 6166 didn’t apply anymore. In June 2010, the Probate Court removed James as co-trustee for breach of court orders; Vikki was left as the sole trustee of the living trust.

In August 2010, the estate petitioned the Tax Court, challenging the IRS’ termination of the estate’s Section 6166 installment election. In February 2011, Crystal Christensen was appointed co-trustee with Vikki of the living trust, which, at that time, held assets worth about $8.8 million. In May 2011, the Tax Court entered a stipulated decision upholding the IRS’ decision to terminate the installment payment election.

During 2011, there were several notices of federal tax liens recorded in San Diego and Los Angeles against the estate. Vikki and Crystal filed a petition in the Tax Court for its review of the estate’s due process rights related to the collection procedures. The Tax Court dismissed their petition for lack of jurisdiction because John Michael, who was the executor at the time the petition was filed, didn’t sign it.

The 2013 Settlement

John Michael, Vikki, Crystal, James and other interested parties in the living trust had been engaging in multiple disputes from 2007 to 2013. In 2013, the parties settled their disputes in a settlement approved by the California Superior Court. The court formalized the settlement (the 2013 settlement) through an order and a general release.

Under the 2013 settlement, John Michael received the living trust’s ownership interest in Gold River, along with the trust’s interest in Supersonic Aerospace International LLC. As part of the 2013 settlement, he also resigned as executor, effective Jan. 15, 2013.

As of July 2015, the estate owed estate taxes of $10,261,217. The United States filed a complaint against the estate for unpaid estate taxes, penalties and interest. It sought judgment against John Michael, James, Vikki, Crystal and Madeleine in their individual and/or representative capacities. Several of the defendants moved to dismiss the complaint, and others filed cross-motions for indemnification. 

Madeleine’s Liability as Statutory Executor

The court granted Madeleine’s motion to dismiss the United States’ claim that she was personally liable under 31 U.S.C. Section 3713 (priority of government claims). The United States indicated that it wasn’t in fact pursuing a claim against her for personal liability under that section. As such, to any extent the complaint stated a claim against Madeleine under Section 3713, the court dismissed such a claim.

The court addressed at length Madeleine’s argument that she wasn’t liable for the estate tax as a “statutory executor” under IRC Section 2002, because Allen never appointed her, nor did she ever serve, as the executor of the estate. She argued that John Michael was the court-appointed executor, as the Tax Court in 2013 had rejected Vikki’s and Crystal’s claims that they were executors. The United States agreed that John Michael was the court-appointed executor, but argued that he resigned as of Jan. 15, 2013. 

IRC Section 2001 imposes tax liability on the executor in his individual capacity. Under IRC Section 2003, if there’s no executor, any person in actual or constructive possession of a decedent’s property is the executor. In this instance, John Michael had been the court-appointed executor, but he’d resigned in 2013. Madeleine possessed property that belonged to Allen, the decedent. Madeleine’s reliance on the 2013 Tax Court order of John Michael as executor was based on John Michael being the executor at the time the petition was filed. Once John Michael resigned as the appointed executor, anyone in possession of Allen’s property would be the “executor” under IRC Section 2002, which imposes representative liability. In response, Madeleine claimed that under this theory, every beneficiary would be a statutory executor. She also claimed that John Michael never resigned. 

The court, however, was unpersuaded. It rejected her arguments, noting that the United States sufficiently alleged that once John Paul resigned as the court-appointed executor, Madeleine received property from Allen’s estate. It also noted that claiming that John Michael resigned was contrary to the allegations in the complaint, which are entitled to a presumption of truth at this early stage of the proceedings. Thus, it refused to grant her request to dismiss the Section 2002 claim against her in her representative capacity as a statutory executor.

Madeleine’s Liability as Trustee of Marital Trust

Madeleine claimed that she wasn’t liable under IRC Section 6324(a)(2) as a trustee of Allen’s marital trust. Although she was nominated to serve as co-trustee, she claimed that she didn’t accept the nomination. She further argued that the marital trust was never funded, because she bypassed the marital trust completely. Thus, she contended, the United States failed to state a claim against her in her capacity as trustee of the marital trust.

The United States argued that the living trust “name[d]” Madeleine as a co-trustee. However, the court agreed with Madeleine, noting that because the marital trust was never funded, there could be no claim for relief against Madeleine based on a role she never assumed by virtue of a trust that was never funded. Accordingly, the court dismissed the claim against Madeleine’s based on her role as co-trustee of the marital trust.

Madeleine’s Liability as Transferee or Beneficiary

Madeleine claimed that she wasn’t liable as a beneficiary of the living trust, because trust beneficiaries aren’t liable for estate taxes under Section 6324(a)(2). The United States, however, asserted that the section imputes personal liability for estate taxes to certain individuals—a spouse, transferee or trustee—who receive property at the time of a decedent’s death, if the estate tax wasn’t paid.  

The court rejected the United States’ argument, citing U.S. v. Johnson, 2013 WL 3925078 (D. Utah July 29, 2013), which held that “trustee” was understood to be a trustee of a trust (which Madeleine wasn’t), and “beneficiary” was narrowly construed to be a beneficiary of a life insurance policy (which Madeleine wasn’t). Accordingly, the court granted Madeleine’s motion to dismiss this claim against her as a beneficiary or transferee of the living trust.

However, Madeleine also argued that the property she received under the Madeleine Anne Paulson Separate Property Trust was transferred from the estate to her in the capacity as a creditor or beneficiary of the Madeleine Anne Paulson Separate Property Trust—not as a trustee. The United States disputed this assertion, noting that she received assets from the living trust as its trustee. As trustee, she was liable in her individual capacity for the value of the transferred assets. Given that the complaint clearly alleged she was the trustee and she did, in fact, receive assets from the living trust, the court denied Madeleine’s motion to dismiss under IRC Section 6324(a)(2), and the claim against her in her individual capacity was sustained.   

Madeleine’s Liability for Indemnification

She also argued that she wasn’t liable for taxes because of the 2003 settlement, of which the United States wasn’t a third-party beneficiary. The United States countered by citing parts of the 2003 settlement under which Madeleine was liable for estate taxes arising out of the living trust distributions. The court denied Madeleine’s motion to dismiss this claim, stating that it wouldn’t engage “in the contractual interpretation and determination of the merits as urged by the parties.”

Madeleine’s Liability for Interest

Finally, she argued that she wasn’t liable for prejudgment and postjudgment interest. This argument was based on her claims that she didn’t have any liability for estate taxes under IRC Section 6324(a)(2). Because the court didn’t adjudicate her liability for estate tax, it ruled that it was premature to dismiss the United States’ claims against her for interest.

Vikki/Crystal’s Liability as Statutory Executors

Both Vikki and Crystal argued that they weren’t statutory executors under IRC Section 2002 and therefore, couldn’t be held liable for the estate taxes. The court noted that it already concluded that the complaint had adequately alleged that John Michael resigned as executor. Using reasoning similar to its reasoning to deny Madeleine’s motion to dismiss under Section 2002, the court rejected Vikki’s and Crystal’s motion to dismiss as statutory executors.

Vikki/Crystal’s Liability as Transferees/Trustees

Vikki and Crystal asserted that they weren’t liable as transferees or trustees because they didn’t receive property the day that Allen died. They argued under Johnson that a trustee or transferee must be in possession of estate property on the date of a decedent’s death. The United States disputed their claim, stating that Section 6324 doesn’t have such requirement. 

The court granted Vikki and Crystal’s motion to dismiss this claim. It noted that to be a transferee under Section 6324, a person must have property of the gross estate on the date of the decedent’s death. Because the complaint never alleged that Vikki or Crystal had property from Allen’s estate on his death, the United States failed to state a claim against Vikki or Crystal as trustees or transferees.

Vikki/Crystal’s Liability Under California Probate Code

California Probate Code Section 19001 states that on the death of a settlor, his/her property is subject to claims of creditors and to the expenses of administration of the probate estate to the extent the estate is inadequate to satisfy those claims and expenses. The court refused to dismiss the claim against Vikki and Crystal under this section, finding that it wasn’t bound by the allegations in the complaint to determine whether estate tax constitutes an “expense of administration.”

Vikki/Crystal’s Liability for Breach of Third-Party Contract

Vikki and Crystal asserted that the complaint lacked factual allegations to support the theory that they breached an “unspecified third-party contract.” The United States, however, argued that its third-party beneficiary theory was based on Vikki's and Crystal’s roles as the current trustees of the living trust. Under the living trust, they were obligated as trustees to pay all estate taxes owed by the estate. The court found that because Vikki and Crystal were current co-trustees of the living trust, the United States stated a claim against them; the court therefore denied their motion to dismiss on this ground.

James’ Liability as Statutory Executor

The court found, as with the other defendants, that there were sufficient facts alleged to state a claim for relief against James as the statutory executor of the estate. The United States alleged that John Michael resigned as court-appointed executor, and James acted as co-trustee of the living trust. Given that this was enough to state a claim against James, the court rejected his motion to dismiss on this ground.

Similarly, the court found that the United States sufficiently alleged personal liability under Section 6324(a)(2) against James in his role as co-trustee of the living trust, because he received assets that were included in Allen’s gross estate. As such, the court rejected James’ motion to dismiss on these grounds.

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