What’s Your Priority?

A prospective client’s loved one just passed away. The IRS has claims against the decedent’s assets for unpaid income taxes which threaten insolvency. Fiduciaries, unaware of the intricacies of the Probate Code, often overlook the significance of debts owed to the United States. The IRS can use the Federal Priority Statute much like an ace of spades to trump the priority of all creditors who have claims against estate assets. A lawyer’s recommendation that a fiduciary take the step to administer an estate, threatened with insolvency from tax liabilities, can be a slippery slope. This article provides an overview of the Federal Priority Statute and some steps you can take to help your fiduciary clients avoid its pitfalls.¹

The Federal Priority Statute² (Priority Statute) provides the United States with a superior right to payment of taxes.³ by an insolvent debtor’s estate.⁴ Stripped to its basics, a fiduciary that pays the debts of the estate’s creditors before discharging debts of the United States is exposed to personal liability to the extent of the payments. Personal liability extends to any person who exercises “complete control”⁵ over the order of payment of debts and has actual or constructive knowledge of the government’s claim.⁶

Knowledge is established if there are facts that would cause a reasonably prudent person to inquire into the existence of unpaid United States claims.⁷ This means that once a fiduciary is aware the United States has a claim for unpaid taxes, the fiduciary has a duty to discharge the claim first.
The Priority Statute supports a federal policy to secure revenue for the U.S. Treasury that dates back at least as early as the 18th century.⁸ The first priority statute was enacted in a July 31, 1789 Act that concerned bonds posted by importers.⁹ The 1789 enactment provided that the “debt due to the United States” must be discharged first “in all cases of insolvency, or where any estate in the hands of executors or administrators shall be insufficient to pay all the debts due from the deceased…”¹⁰

The Priority Statute, as presently enacted, is limited by its terms to the “representative of a person or an estate.” Under a previous version of the Priority Statute, personal liability extended beyond representatives of the person or estate to include executors, administrators, assignees or “any other persons” who paid a debt owed by the person or estate before paying debts due to the United States.¹¹ The current version of the Priority Statute no longer requires that “any other persons” involved have control and possession of the debtor’s assets, but the case law still supports the requirement.¹²
A fiduciary that is indebted to the United States for unpaid taxes may use estate assets to pay certain classes of claims before the tax debt.¹³ The excepted classes include reasonable administrative expenses, funeral expenses, and homestead or family allowances.¹⁴

It is important for the practitioner to understand that the term “insolvency” depends on the context of the administration. In the context of an estate administration, insolvency means that the sum of an estate’s liabilities, regardless of their speculative nature, exceeds the sum of an estate’s known assets.¹⁵ The term “insolvency” in a trust administration, on the other hand, means that the trust’s assets are insufficient to pay its liabilities and the expenses of administration. Determining insolvency in the correct context early in the representation is important because the earlier the practitioner determines the estate will be insolvent, the earlier she or he can assess costs and benefits of a client accepting the appointment as a fiduciary.

The risks to court-appointed fiduciaries are lessened¹⁶ because probate procedural rules restrict the distribution of estate assets. With a court-supervised probate proceeding, if a decedent’s estate is insolvent, the decedent’s debts must be prorated by the court.

Nevertheless, the federal government may seek collection of taxes from transferees of distributed assets and fiduciaries as alternatives.¹⁷

You can help reduce your client’s exposure to personal liability for unpaid income taxes by doing some of the following:

Before Appointment as Fiduciary

1. Caution client against exercising control over the order in which the decedent’s debts are paid and transferring assets to pay debts or expenses.
2. Review the decedent’s asset and liability information to assess the solvency of the estate.
3. Determine if notifying the tax authorities of unpaid taxes will lead to insolvency.
4. Weigh the costs and benefits of the fiduciary initiating a formal probate proceeding. Negotiating the priority of payment of administrative expenses with the IRS and recovering executor fees may be the only benefit for the fiduciary.

After Determining Fiduciary Will Accept Appointment

1. Complete IRS Form 2848, Power of Attorney and Declaration of Representative to represent the fiduciary before the IRS. Franchise Tax Board (FTB) Form 3520 is the equivalent California form, but you can also file Form 2848 with the FTB.
2. Get copies of previously filed returns by using IRS Form 4506, Request for Copy of Tax Return. Form 3516 is the equivalent California form. The IRS provides copies of tax returns for $50 each. The FTB charges $20 for each tax year.
3. Determine the decedent’s gross income by using IRS Form 4506-T, Request for Transcript of Tax Return. Form 4506-T will allow you to obtain the decedent’s W-2 transcript, filed tax return transcript, and 1099 transcript for the relevant tax years.
4. Determine if the tax return preparer that prepared the decedent’s returns before death is the best choice to prepare all returns still due.
5. After the tax return is filed, request a prompt assessment under Treas. Reg. 301.6501(d) using IRS Form 4810. Form 4810 can be filed with the IRS or FTB.¹⁸
6. Notify the FTB if the IRS adjusts or corrects gross income or deductions.
7. Request release from personal liability for the personal representative using IRS Form 5495.
8. File IRS Form 56 with the IRS and FTB to revoke or terminate prior notices.

[1] The Federal Priority Statute is codified under 31 U.S.C. § 3713. Emphasis is given to the priority of claims for tax indebtedness under federal law, but the same principles apply to claims under the Probate Code. The priority of claims provisions in the Probate Code are set out in §§ 11420- 11429.
[2] Also called the “Insolvency Statute.”
[3] Taxes included within the scope of the rule include all taxes for which the estate, the decedent, or anyone for whom the fiduciary is acting. See 2-33 Rhoades & Langer, U.S. Int’l Tax’n & Tax Treaties § 33.04.
[4] The Federal Priority Statute covers decedents’ estates and is codified under 31 U.S.C. § 3713.
[5] See United States v. Whitney (9th Cir. 1981) 654 F.2d 607, 612.
[6] See United States v. Marshall (5th Cir. 2014) 771 F.3d 854, 875.
[7] Id.
[8] See United States v. Fisher (1805) 6 U.S. 358, 385.
[9] 1 Stat. 29. (1789)
[10] Id. at 42.
[11] See King v. United States (1964) 379 U.S. 329, 333.
[12] See United States v. Whitney (9th Cir. 1981) 654 F.2d 607, 612; also similar to IRC § 2203 which defines the term of “executor” for estate tax purposes, but see Allen v. Commissioner (1999) Tax Ct. Memo LEXIS 438, at 27, applying the requirement of possession and control of debtors assets in income tax context.
[13] See Rev. Rul. 80 – 112 and United States v. Weisburn (E.D.Pa. 1943) 48 F.Supp. 393, 397.
[14] See Probate Code § 11420(a) sets forth the priority of payment of debts except for the debts of the United States or California.
[15] See Estate of Anderson (1977) 68 Cal. App. 3d 1010.
[16] Risks may not be lessened if there is pending litigation that could result in a fiduciary making a distribution to beneficiaries after the insolvent probate estate is closed.
[17] 26 U.S.C. § 6901(c).
[18] Form 4810 shortens the federal assessment period from 3 years to 18 months. Form 4810 also shortens the California assessment period from 4 years to 18 months.