Third Circuit Affirms That Executor Can Be Held Liable for Estate Tax Deficiency

(Parker Tax Publishing September 2022)

The Third Circuit affirmed the Tax Court and held that the IRS was entitled to collect an estate tax liability by means other than an offer of compromise in a situation where the estate tax due had been miscalculated and the error was not discovered until after much of the estate's assets had been distributed, although $640,000 was distributed shorting after the estate's executor receive the notice of deficiency. Est. of Lee v. Comm'r, 2022 PTC 253 (3d Cir. 2022).

Background

Kwang Lee died testate in 2001. The Executor of Lee's Estate (the Estate) is Anthony Frese, a licensed attorney and municipal court judge. Frese sought legal advice on the implications of a survivor provision in Lee's will, and after receiving guidance, miscalculated the estate tax owed. The Estate subsequently received an IRS notice of estate tax deficiency in 2006 and a formal assessment followed in 2010. However, by then, much of the estate money was gone because between 2004 and 2010, the Estate distributed over $1 million to Lee's beneficiaries. Of this amount, $640,000 was distributed shortly after Frese received the IRS's notice of deficiency. In 2010, the Tax Court held that there was an estate tax deficiency of more than $536,000. With the tax still owing in 2013, the IRS filed a tax lien. In response, the Estate made an offer in compromise (OIC) of the Estate's remaining assets. However, the IRS thought it could collect more than the estate offered so it declined the OIC. The Estate challenged that decision, exhausting its administrative remedies before petitioning for relief in the Tax Court.

In December 2016, the estate submitted Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, which showed that the estate's only asset was a checking account with a balance of $182,941. The estate also submitted an OIC in the same amount to the Appeals Office settlement officer (SO) assigned to the estate's CDP case. The SO determined that: (1) the IRS could potentially collect the distributed amounts from Frese using a fiduciary liability theory under 31 U.S.C. Sec. 3713 and from the beneficiaries as transferees under Code Sec. 6324(a)(2); (2) the statute of limitations to collect from both Frese and the beneficiaries remained open; and (3) these potentially collectible amounts had to be included in the estate's reasonable collection potential (RCP) calculation for purposes of reviewing the estate's OIC per the Internal Revenue Manual. Including the distributed amounts in the RCP formula yielded a collection potential that exceeded the estate's unpaid estate tax liability. Consequently, the SO rejected the estate's OIC and sustained the filing of the notice of federal tax lien.

The Estate petitioned the Tax Court and in Estate of Lee v. Comm'r, T.C. Memo. 2021-92, the Tax Court granted summary judgment to the IRS and held that Frese could be held liable for the estate's tax deficiency because he made distributions to the estate's beneficiaries even though he had knowledge of a potential estate tax deficiency. The court concluded that the SO did not abuse his discretion in rejecting the estate's OIC and including distributions from the estate in the estate's RCP calculation. The IRS also argued that it could collect from the decedent's children but the Tax Court did not rule on that issue.

Estate taxes take priority over other obligations, including the distribution of property to beneficiaries. If tax liabilities exceed assets, an estate may make an OIC under Code Sec. 7122(a) and Reg. Sec. 301.7122-1. However, the IRS is under no obligation to compromise and can reject an OIC if, in its determination, it falls below the RCP. One source the IRS may look to is the estate's executor because, when an executor transfers property before satisfying a known estate tax, 31 U.S.C. Sec. 3713(b) and Code Sec. 6901(a)(1)(B) provide that the executor may be held personally liable.

The Estate appealed to the Third Circuit. First, the Estate argued that the time to collect from Frese had run, so the amount collectible from him should not have been included in the RCP. For support, the Estate pointed to the Internal Revenue Manual (IRM) Section 5.8.5.18(2), which provides that generally, a three-year time frame will be used to determine if it is appropriate to include a dissipated asset in RCP. And because the IRS did not bring its action within that time, the Estate argued that the RCP was inflated. Second, the Estate argued that non-probate stock options that were transferred to the beneficiaries by operation of law, rather than by Frese's actions, meant he escaped liability under Section 3713. Finally, the estate argued that Frese could not be held personally liable because he relied on professional advice.

Analysis

The Third Circuit affirmed the Tax Court and held that the IRS did not abuse its discretion in refusing the Estate's OIC and the Tax Court did not err in granting summary judgment to the IRS.

With respect to the Estate's argument about the running of the statute of limitations, the court said the claim regarding the time frame for including "dissipated assets" in an RCP was not relevant. Citing I.R.M. Section 5.8.5.18(1), the court observed that dissipation occurs where it can be shown the taxpayer has sold, transferred, encumbered, or otherwise disposed of assets in an attempt to avoid the payment of the tax liability and that an "attempt to avoid" payment is normally defined as the transfer of assets for less than full value or use of proceeds. The IRS did not allege dissipation, the court noted, which would increase RCP but not involve potential third-party liability. Since there was no allegation of dissipation under I.R.M. Section 5.8.5.18(2), the court concluded that the three-year statute of limitations period did not apply. Also, the court said, even if dissipated assets were relevant, the three-year look-back period is not mandatory as the I.R.M. is not a regulation with the force of law. Instead, the Manual guides the behavior of service agents and the IRS is thus not bound by this three-year period.

Next, with respect to the Estate's argument regarding the transfer of non-probate stock options, the court noted that this argument was not raised before the Tax Court. As a result, it said it would not consider it in the instant case.

Finally, with respect to the argument that Frese cannot be held personally liable because he relied on professional advice, the court observed that Frese consulted counsel in preparing the Estate's tax returns, not later when the assets were distributed. And even assuming the legal advice was relevant to the later distributions, the court said that there is no professional reliance defense when an executor has actual knowledge of the tax deficiency.

For a discussion of an estate executor's potential liability for estate taxes, see Parker Tax ¶228,940.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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