The Toll of Serving as Fiduciary

I often guide clients in naming trustees and personal representatives (collectively “fiduciaries”) as part of the Estate Planning process. These conversations cover many topics including the fiduciary’s duties and responsibilities upon taking office. For example, fiduciaries marshal the assets of the estate or trust; make decisions regarding the distribution of assets to the beneficiaries; and potentially undertake litigation. Fiduciaries may have to appear in court, and certainly, they will have to liaise with the attorney handling the estate or trust. Often, the individuals nominated to serve as fiduciaries have limited or no understanding of their duties and responsibilities, one of which includes the filing of all outstanding income, gift, and estate tax returns for the decedent.

Internal Revenue Code (“Code”) Section 6012 imposes a duty on a fiduciary to file outstanding income tax returns. Treasury Regulation Section 25.6019-1(g) imposes a duty on the fiduciary to file any outstanding gift tax returns for a deceased donor. Finally, Code Section 6018 requires the fiduciary to file an estate tax return if the decedent’s estate exceeds the basic exclusion amount. The Code holds the fiduciary responsible for filing all outstanding tax returns. That the fiduciary may have no independent knowledge regarding whether the decedent was diligent in filing their returns does not matter. For this reason, it’s vital for the fiduciary to prioritize filing of the tax returns and as the rest of the article demonstrates, the payment of any tax liabilities.

Code Section 6321 gives the United States Government (U.S.) a general tax lien on all estate and trust property upon assessment of the tax. In addition, Code Section 6324 provides two special liens for estate and gift taxes that arise upon death, or at the date of the gift, as appropriate. In addition, federal priority statutes provide that the fiduciary must use assets in their custody to pay the U.S. before making other distributions, including distributions to beneficiaries. If the fiduciary fails to pay the government first, he or she may end up personally liable to the IRS for amounts paid to the beneficiaries or any other creditors. Three factors in combination trigger personal liability under the federal priority statute: the fiduciary controlled the assets and distributed the assets to others aside from the U.S.; the fiduciary knew that the U.S. had an unpaid claim; and the fiduciary paid others when the estate was insolvent or the payment made the estate insolvent.

Code Section 2202 and Treasury Regulation Section 22.2002-1 require the fiduciary to pay the estate taxes, even if the fiduciary never had control of those assets. This lack of control causes both a liquidity problem and an unsatisfied tax liability which can be a dangerous combination. The duty to pay taxes extends beyond estate taxes to include unpaid gift taxes, even if the gross estate no longer contains those assets. Many tried and true Estate Planning techniques involve the use of lifetime trusts or planned payment of life insurance proceeds to a beneficiary other than the decedent’s estate, for example, a surviving spouse or an Irrevocable Life Insurance Trust. Estate Planning during life could cause both a liquidity problem along with an unpaid tax problem at death, something that clients and attorneys alike should consider.

Of course, the fiduciary does not remain liable forever. The fiduciary may apply for and receive a discharge from personal liability for estate tax by written application and early determination by the IRS of the amount of tax owed. The IRS must determine within the later of nine months after the executor files the return or nine months after the executor makes a written application. Upon determination and payment of the tax, the IRS will discharge the executor. Code Section 2204(a) allows the executor to receive a discharge if such fiduciary furnishes a bond after determination of the tax. The IRS may issue the notice of discharge later, thereby relieving the executor of personal liability.

If the fiduciary knows that the trust or estate has an unpaid tax liability, then the fiduciary should consider the following steps: ask the IRS to enter into an agreement allowing the fiduciary to make distributions without personal liability; make the IRS aware of each proposed distribution and give the IRS opportunity to object or accept said distribution; maintain current records on solvency; if a court controls the assets, then determine whether the custodian will make distributions pursuant to court order; and finally, consider requesting a private letter ruling to determine whether a distribution may be made without personal liability. If you have concerns about any of the parties that you have named in your documents, reach out to me about your concerns and update your documents. If you have been named as a fiduciary and need help understanding your duties, you can always seek my help to guide you through this complicated process.