Tips of the Trade: the Irs Will Get Its Money, Just Not from Your Client-fiduciary

• Publication year: 2021
• Author: By Michael A. Gorini, Esq.*

TIPS OF THE TRADE: THE IRS WILL GET ITS MONEY, JUST NOT FROM YOUR CLIENT-FIDUCIARY

By Michael A. Gorini, Esq.*

MCLE Article

I. INTRODUCTION

The purposes of a trust administration and a probate administration are identical: settle the decedent's affairs and provide finality for the decedent's successor(s) in interest. This article focuses on a common professional practice that undermines that goal of finality, namely: the withholding of a reserve amount for potential federal estate or income tax liabilities.

This article provides a basic explanation of a fiduciary's exposure to personal liability under Title 31 United States Code section 3713, the current iteration of the "Priority Statute," which provides that when a debtor of the United States is insolvent and not in bankruptcy, it must pay its debts to the government first before paying any other creditor.¹

Although the Priority Statute was first made applicable to an administrator of any insolvent or decedent's estate in 1799,² many practitioners do not understand its application as it relates to fiduciaries administering a probate or trust. Therefore, erring on the side of caution, those same practitioners usually advise their client-fiduciary to hold significant reserves to limit the client-fiduciary's potential exposure to personal liability for unpaid taxes. This article concludes that such advice is not well-founded and may be unwarranted.

II. THE PRIORITY STATUTE

In its current form, the Priority Statute states:

(a)(1) A claim of the United States Government shall be paid first when—

(A) a person indebted to the Government is insolvent and—

(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;
(ii) property of the debtor, if absent, is attached; or
(iii) an act of bankruptcy is committed; or

(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.

(2) This subsection does not apply to a case under title 11.
(b) A representative of a person or an estate (except a trustee acting under title 11) 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.³

The representative liability provision gives the Priority Statute teeth by making a fiduciary that pays a non-federal debt before paying a federal claim personally liable for the amount paid.⁴ Under a literal reading of the Priority Statute, it appears that any fiduciary could be held personally liable for unpaid claims to the government even if the fiduciary had no reason to know of the claims.

Fortunately, the few courts that have interpreted the representative liability provision have appreciated the fact that such a literal interpretation would produce inequitable results and therefore have read into the provision the additional requirement that the fiduciary must have "knowledge of the debt owed by the estate to the United States or notice of facts that would lead a reasonably prudent person to inquire as to [its] existence."⁵

Under that interpretation, a fiduciary will not be held personally liable for the unpaid claims of the U.S. government unless: (1) the estate of a deceased debtor is insolvent or made insolvent by way of payment of a non-federal debt and (2) the fiduciary knew of the debt owed to the U.S. government or had notice of facts that would lead a reasonably prudent person to inquire as to its existence. The Ninth Circuit has not published a case adopting this interpretation. However, the cases discussed in this article are well-reasoned and therefore it appears likely that the Ninth Circuit would follow the reasoning if it were presented with the issue.

A. The Estate of a Deceased Debtor is Insolvent

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For the purposes of the Priority Statute, the term "debt" has been expanded to include the distribution of funds as directed by the decedent's will or trust.⁶ The first element necessary to find personal liability requires a finding that the estate of a deceased debtor was either insolvent at the time of distribution or was made insolvent by the distribution.

Thus, the calculus is straightforward. Will the distribution by the fiduciary result in the estate or trust being unable to pay the debt owed to the U.S. government? If so, the fiduciary can be held personally liable to the extent of the distribution to the non-federal entity.

B. Personal Representative Chargeable with Knowledge

The second element, that the fiduciary knew of the debt owed to the U.S. government or had notice of facts that would lead a reasonably prudent person to inquire as to its existence, requires more analysis. It is the knowing disregard of debts due to the U.S. government that gives rise to personal liability of the fiduciary.⁷

Because knowledge or sufficient notice is required to find personal liability of the fiduciary, Internal Revenue Manual ("IRM") 5.5.3.9 instructs an IRS officer who discovers the...