Premature Estate Distributions May Result in Executor Being Liable for Estate's Taxes

(Parker Tax Publishing August 2021)

The Tax Court held that the executor of an estate, who is a licensed attorney and municipal court judge, can 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 IRS settlement officer did not abuse his discretion in rejecting the estate's offer in compromise and including the distributions in the reasonable collection potential formula. Estate of Lee v. Comm'r, T.C. Memo. 2021-92.

Background

Kwang Lee died testate on September 30, 2001, and Anthony Frese, a licensed attorney and municipal court judge, was named executor of the estate. Frese filed the estate tax return on or around May 21, 2003. From July 2003 to February 2007, Frese made distributions to estate beneficiaries totaling $1,045,000 (distributed amounts), of which $640,000 was distributed on February 28, 2007 (February 2007 distribution).

The IRS audited the estate's return and determined a $1,020,129 deficiency in estate tax, plus a $255,032 penalty under Code Sec. 6651(a)(1) for untimely filing and a $204,026 accuracy-related penalty under Code Sec. 6662(a). The IRS mailed a notice of deficiency to Frese on April 26, 2006. Frese timely filed a petition for redetermination of the deficiency with the Tax Court. In 2010, the Tax Court held that there was a $536,151 estate tax deficiency with no addition to tax or penalty. The IRS assessed the unpaid tax against the estate on July 19, 2010. The estate timely requested a collection due process (CDP) hearing. In its request, the estate checked the collection alternative boxes "Installment Agreement" and "Offer in Compromise" (OIC). At the estate's request, however, the Appeals Office held the CDP case in suspense until 2016.

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. In reviewing the estate's OIC and upon the advice of the IRS's Collection Division and Office of Chief Counsel, 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 challenged the SO's determination. Specifically, the estate argued that: (1) the SO's rejection of the OIC constituted an abuse of discretion in that the SO erred in computing the estate's RCP by improperly including the distributed amounts in this calculation and (2) the SO failed to verify that all applicable laws and regulations were followed before issuing the notice of determination. The parties disputed whether the RCP formula should include amounts potentially collectible from third parties, i.e., Frese and the beneficiaries, by reason of distributions from the estate that exceed the outstanding estate tax liability. The estate also suggested, citing Little v. Comm'r, 113 T.C. 474 (1999), that Frese made the February 2007 distribution at least in part upon the advice of the estate's tax adviser and that such reliance absolved him of liability. The estate also argued that the SO was required to independently investigate the amounts, if any, actually collectible from third parties, including an "evaluation of the hazards of litigation" and an analysis of the current financial status of such persons.

Code Sec. 2002 provides that the executor of an estate must pay the estate tax. The executor may be held personally liable under Reg. Sec. 20.2002-1 and 31 U.S.C. Sec. 3713, often referred to as the Federal Priority Statute (FPS), if the executor pays a debt of the estate before satisfying and paying a claim owed to the United States. The term "debt" includes a beneficiary's distributive share of an estate.

Analysis

The Tax Court held that the SO did not abuse his discretion by including the amounts distributed by the estate in the RCP formula. The court noted that before the $640,000 February 2007 distribution, the estate had sufficient assets to satisfy the $536,151 estate tax liability, but following that distribution it retained assets of only approximately $183,000. In determining if an executor is liable for an estate tax deficiency, the court stated, an executor must have had actual or constructive knowledge of the government's claim when the estate had sufficient assets to pay the claim, or notice of such facts as would put a reasonably prudent person on inquiry as to the existence of the government's unpaid claim. A notice of deficiency with respect to estate tax liabilities given to an executor before the executor's distribution of estate assets is sufficient to satisfy this notice requirement, the court said. Thus, the court found that the IRS's notice of deficiency, issued to Frese before he made the February 2007 distribution, was sufficient to create a claim under FPS.

The court found the present situation to be materially distinguishable from Little, a case which involved an executor who did not have the requisite knowledge for purposes of the FPS because the executor, who did not have a college degree, was unaware of any potential or pending government claims against the estate and reasonably relied in good faith upon multiple erroneous reassurances from counsel that the estate had no federal tax liabilities. In the instant situation, the court said, the estate offered no evidence to show that Frese relied upon the advice of the estate's tax adviser as it pertained to his decision to make distributions from the estate, including the February 2007 distribution. Additionally, the court observed, unlike the unsophisticated executor in Little who had no actual or constructive knowledge of the estate's tax liabilities at the time of the distributions, Frese, a licensed attorney and judge, made the February 2007 distribution with direct knowledge that the IRS had determined an estate tax deficiency against the estate (i.e., the notice of deficiency mailed in April 2006) and that an action concerning that deficiency claim was pending before the Tax Court. Under these circumstances, the court said, Frese made the February 2007 distribution at his own peril, and any advice he may have received in this regard cannot absolve him from liability. Thus, the court concluded, Frese may be held personally liable under the FPS for the estate's unpaid estate tax that remains due.

Finally, with respect to the estate's argument that the SO was required to independently investigate the amounts, if any, actually collectible from third parties, the court noted that the estate cited no rule mandating or suggesting that the SO should have taken such exhaustive action as it related to Frese's potential collection amount. The court found that the SO acted diligently in considering the estate's concerns.

For a discussion of an estate executor's potential liability for estate taxes, see Parker Tax ¶228,940. For a discussion of transferee liability, see Parker Tax ¶262,530.

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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