Although many people name family and friends as trustees or personal representatives in their legacy plan, it’s probably safe to assume that the people being appointed don’t have an understanding of the high level of responsibility inherent in carrying out their fiduciary duties. One of the greatest fiduciary responsibilities is payment of a trust’s or estate’s income tax liability. This obligation to pay the income tax on behalf of the trust or estate is unlikely to come as a surprise, but potential personal liability – that could come as a rude awakening.
Under Code §6901, fiduciaries are personally liable for payment of the trust’s or estate’s income tax, including penalties imposed for failure to file a return or failure to pay the tax. The federal priority statute provides that the U.S. government may collect a fiduciary’s liability for an unpaid claim of the U.S. government. [1] Estate assets in the custody of a fiduciary must be used to pay the U.S. government before making any other distributions. If a fiduciary fails to pay the IRS first, he or she may be personally liable to the IRS for the amounts paid to others. Personal liability under the federal priority statute is triggered if three conditions are met: (1) the fiduciary had control of the assets and distributed them to others besides the U.S. government; (2) the fiduciary knew that there was a claim by the U.S. government which had not been paid; and (3) at the time the fiduciary made payments to others besides the U.S. government, (a) the estate was insolvent or (b) the payment made the estate insolvent. Generally, the U.S. government has the burden of proving this three part test.[2]
To avoid potential personal liability, a fiduciary should consider taking the following steps when he or she knows that a trust or estate has unpaid income taxes:
- Ask the Internal Revenue Service (the IRS) to enter into an agreement allowing the fiduciary to make certain distributions without personal liability;
- Before a distribution is made, make sure the IRS is aware of every proposed distribution and has the opportunity to express its objections or acceptance;
- Maintain current records on solvency to provide to the IRS and the court – if a court controls any assets;
- If a court controls assets, determine whether the custodian of the assets (e.g., a bank; a broker, etc.) will make distributions pursuant to a court order;
- Consider requesting a private letter ruling on whether or not a distribution may be made without personal liability as the IRS will be bound by such ruling.
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[1] 31 U.S.C. §3713.
[2] Singer v. Commissioner, T.C. Memo 2016-48.