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Yet Another Cautionary Tale on Fiduciary Liability

In a case worthy of Dickens, the Tax Court issued what may be the final ruling in a series of nearly two decades of filings, decisions and appeals.

In Lee v. Commissioner (T.C. Memo. 2021-92), the Tax Court addressed whether, in evaluating an estate’s offer to compromise on outstanding estate tax liability, the executor’s possible liability for distributed assets may be considered in calculating the estate’s reasonable potential for collection. 

The spouse (Spouse) died on Aug.15, 2001.  Forty-six days later, the decedent (Decedent) died on Sept. 30, 2001.  The executor (Executor), a licensed attorney and municipal judge, filed an estate tax return on behalf of the estate on May 21, 2003 (one year and 21 days after the 9-month deadline). 

Corresponding provisions in the wills of Spouse and Decedent treated Spouse as surviving Decedent if Decedent were to die within six months of Spouse.  Based on those provisions, the return reported funding a credit shelter trust with Decedent’s available credit amount and claimed a marital deduction for the residuary property purportedly transferred to Decedent’s spouse. ( Note that this case began in the pre-portability Era).  Executor here was attempting a DIY version of portability, as Spouse died with significantly fewer assets than Decedent. 

Executor began making distributions pursuant to the Decedent’s estate plan in July 2003 and distributed $405,000 of estate assets over the next three years. 

Notice of Deficiency Issued

On April 26, 2006, the Internal Revenue Service mailed a notice of deficiency to Executor, asserting a $1,020,129 deficiency in estate tax, as well as a $255,032 penalty for untimely filing and a $204,026 accuracy-related penalty.

On July 27, 2006, Executor timely filed a petition for redetermination of the deficiency with the Tax Court. 

On Feb. 28, 2007, Executor distributed an additional $640,000 pursuant to Decedent’s estate plan (the February Distribution).

Marital Deduction Disallowed

On Dec. 20, 2007, the Tax Court disallowed the claimed estate tax marital deduction based on Spouse having in fact predeceased Decedent.

On March 25, 2010, the Tax Court entered a decision, finding a $536,151 deficiency in estate tax but asserting no penalties.  The IRS assessed the unpaid tax against the estate on July 19, 2010 and issued a notice of a federal tax lien filing on April 16, 2013. 

The estate timely submitted a request for a hearing on the collection process, which was held in suspense until 2016 at the estate’s request.  In December 2016, the estate asserted that the only available estate asset was a checking account with a balance of $182,941 and submitted an offer to the IRS to compromise for the same amount. 

Doubt as to Collectability

Internal Revenue Code Section 7122(a) and its related regulations authorize the IRS to compromise on outstanding tax liability when there’s doubt as to liability or collectability or when a compromise would promote effective tax administration.  Tax liability may be compromised based on doubt as to collectability when the taxpayer’s assets and income render full collection unlikely. An officer is generally directed to reject an offer premised on doubt as to collectability where the offer is substantially below an estate’s reasonable collection potential (RCP).

The settlement officer (the Officer) assigned to the case concluded that: (1) the distributed amounts were collectable from Executor under a fiduciary liability theory, (2) the period of limitations to collect from the Executor was still open, and (3) these amounts must be included in the estate’s RCP in evaluating an offer to compromise.  After including the distributed amounts in calculating the estate’s RCP, the Officer rejected the estate’s offer to compromise.

The estate argued that the Officer erred in doing so.

Executor’s Liability

IRC Section 3713 imposes personally liability on an executor who pays a debt of the estate before paying a claim owed to the United States when: (1) the estate was insolvent or rendered insolvent by the distribution, and (2) the executor had knowledge or notice of the government’s claim at the time of the payment.  The related regulations (Treasury Regulations Section 20.2002-1) interpret “debt” to include a beneficiary’s distributive share of an estate. An executor will satisfy the “knowledge or notice” requirement of Section 3713 if the executor has actual or constructive knowledge or notice of such facts as would put a reasonably prudent person on inquiry as to the existence of the government’s unpaid claim.  

Here, the February Distribution rendered the estate unable to satisfy the $536,100 estate tax deficiency claim.  The estate asserts that Executor lacked the requisite notice of the claim at the time of the distribution. 

However, a notice of deficiency with respect to estate tax liabilities, such as the one issued in April of 2006 to Executor, constitutes notice of such facts as would put a reasonably prudent person on inquiry as to the existence of the government’s claim.  Furthermore, Executor filed a petition disputing such deficiency claim in July 2006, indicating actual knowledge of the deficiency in advance of the February Distribution.  Therefore, the court found that Executor may be held personally liable under Section 3713 for the unpaid estate tax due following the February Distribution.

Period of Limitations

IRC Section 6502(a)(1) provides a 10-year period of limitations for the collection of assessed estate tax. 

Section 6901(a) in turn provides that a fiduciary’s vicarious liability for payment of estate tax is subject to the same limitations as the underlying taxes.  Section 6901 further provides that the period of limitations for fiduciary liability is the later of one year after the liability arises or the expiration of the period for collection of the underling tax. 

Here, the outstanding estate tax liability was assessed against the estate on July 19, 2010, thereby beginning the 10-year limitations period for collection from the estate or Executor.  This period hadn’t expired when the officer determined the estate’s RCP calculation in 2018. Moreover, the ten-year period was suspended following the estate’s request for a hearing in 2013 and appeal of such decision.

Therefore, the court found that the officer properly considered potential collectability from Executor in determining the estate’s RCP. 

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