A recent (unpublished) federal district court case out of New Jersey, decided on October 22, 2020, United States v. Estate of Kelley, 2020 WL 6194040, highlights the treacherous pitfalls to which an inexperienced estate representative may be exposed when assets are distributed to beneficiaries before Uncle Sam collects his taxes.
Lorraine Kelley died in 2003, leaving an estate with co-executors, one of whom was her brother, Richard Saloom. Richard was also the sole beneficiary of her estate. In 2004, the co-executors filed a federal estate tax return, IRS Form 706, reporting a gross estate of more than $1.7 million and an estate tax liability of $214,412. After an examination of the estate tax return was initiated by IRS, Richard consented to the assessment of an additional $448,367 in tax, based on a corrected gross estate of $2.6 million, bringing the total tax due to $662,780.
In 2004, Richard and his co-executor sold Lorraine’s primary residence for $450,000. In addition, Richard received more than $1 million from an annuity, giving $50,000 of the proceeds therefrom to his daughter, Rose Saloom. Richard used the remainder of the proceeds to run his business as well as to purchase and develop other property, leaving Lorraine’s estate with no assets by January 2008, despite the estate’s still owing more than $400,000 in federal estate tax.
Richard had entered into an installment agreement with the IRS in late 2007, and made several significant payments toward the tax liability. Rose also made several payments on behalf of Richard, in March 2008, at his request and prior to his death. Upon Richard’s death, his gross estate was valued at more than $1.1 million. Rose, who was the executrix and sole beneficiary of Richard’s estate, filed an inheritance tax return listing Richard’s debts, which included $456,406, described simply as “indebtedness for federal tax purposes.” Rose distributed and received all the property from Richard’s estate. By the time that IRS filed suit against Rose and Richard’s estate, Richard’s estate no longer had any assets and Rose no longer had any property from his estate.
The United States District Court for the District of New Jersey granted summary judgment against Richard’s estate based on transferee liability under Internal Revenue Code Section 6324(a)(2), which “imposes liability on the transferees of the decedent’s estate when the estate itself fails to pay its federal taxes.” In addition, summary judgment was granted against Richard’s estate and Rose based on fiduciary liability pursuant to IRC Section 3713(b). That section imposes personal liability on the executor of an estate who pays the debts of the estate or distributes the estate to himself before paying debts owed to the United States, which is entitled to priority. To establish the executor’s liability, the IRS must show: (1) the fiduciary distributed the assets of the estate; (2) the estate was rendered insolvent as a result of the distribution; and (3) the distribution occurred after the fiduciary had actual or constructive knowledge of the tax liability. The court found that both Richard and Rose had distributed to themselves the assets of the estate for which they were executors, rendering the estate insolvent, and both had at least constructive knowledge of the estate tax liability. Richard had indicated his knowledge of the estate tax debt by entering into an installment agreement to satisfy the liability and making payments. Rose also made payments on Richard’s behalf and had listed the indebtedness for federal tax on her New Jersey inheritance tax return. Thus, the court held that there was no genuine issue of material fact as to whether the IRS had satisfied the three elements necessary to establish fiduciary liability under IRC Section 6324(a)(2).
Within nine months after filing the federal estate tax return (to allow time for processing), personal representatives should request and wait to receive an estate tax closing letter before distributing the estate assets to beneficiaries. Also, if state-level tax returns are to be filed, estate tax closing letters should be requested from each such state’s taxing authority. Failure to do so could result in personal liability for any estate taxes due. Because of restrictions due to COVID-19, IRS will accept a request for an estate tax closing letter only by facsimile to (855) 386-5127 or (855) 386-5128. Alternatively, an account transcript available online to authorized tax professionals, reflecting the acceptance of Form 706 and the completion of an examination, may be an acceptable substitute for a closing letter.
The probate laws in some states require filing estate tax closing letters with the probate court, such that an account transcript may not be an option in those states. If beneficiaries are demanding distributions before the personal representatives have received the estate tax closing letters, the personal representatives should consider utilizing a receipt, release, refunding and indemnification agreement in which the beneficiaries agree to refund and indemnify the personal representatives for an overpayment or erroneous distribution in return for an early partial distribution of the beneficiaries’ shares. The amount of the partial distribution is ultimately the decision of the personal representatives and depends on how much personal risk they are willing to assume.