A Cautionary Tale for Estate Fiduciaries and Beneficiaries of Estates with Closely Held Business Interests
By Maria A. Cestone, Esq.
[Originally published in NJSBA BUSINESS LAW SECTION NEWSLETTER, October 2012; Vol. 36 • No. 2]
The decision in the case of the U.S. v. Johnson et al. (U.S.D.C. Utah) dated May 23, 2012, is mandatory reading for any corporate, tax and estate planning advisor of individuals owning interests in closely held entities. Although this matter arises out of Utah, the Court relied on federal tax statutes in favorably interpreting transferee liability statutes to avoid transferee liability to trust beneficiaries. However, a contribution agreement signed by the beneficiaries was deemed insufficient to avoid personal liability for unpaid estate taxes under the federal claims statute and, consequently, the estate’s legal representatives were held liable.
Anna Smith (the “Decedent”) died testate on September 2, 1991, and was survived by her four children (the “Heirs” or “Beneficiaries”). Prior to her death, she executed her estate planning documents. She prepared a Family Trust (the “Trust”) as well as a Last Will and Testament (the “Last Will”). The Last Will provided for a pourover of her probate assets to the Trust. She named two of her children as co-trustees of the trust and as personal representatives of her Last Will.
Pursuant to the Last Will, the personal representatives were directed to ensure that the “debts, last illness, and funeral and burial expenses be paid as soon after death as reasonably convenient.” The Last Will further directed that “claims against the estate” be settled in the discretion of the personal representatives, although it did not contain an express direction to pay federal estate tax. The “rest and residue” of the estate was to be paid over to the co-trustees, added to the Trust principal and administered as provided by the Trust Agreement, which directed that specific distributions be made from the principal to certain individuals upon the death of the Decedent. The trustees were also directed as follows:
to pay any and all debts and obligations of the Grantor, the last illness, funeral, and burial expenses of the Grantor and any State and Federal income, inheritance and estate taxes which may then be owing or which may become due and owing as a result of the Grantor’s death. [emphasis added].
After these specific distributions were made, the co-trustees were directed to divide one-third of the remaining trust corpus into four equal parts to be distributed to four family limited partnerships (which had been established respectively for each beneficiary). The remaining two-thirds of the principal and undistributed income of the Trust would be distributed equally to the beneficiaries. The Decedent’s non-probate assets consisted of several life insurance policies valued at approximately $370,000 payable to the Decedent’s children.
The trustees thereafter filed the federal estate tax return with the IRS on June 1, 1992. They valued the gross estate at $15,958,765, and calculated the federal estate tax liability to be $6,631,448. The bulk of the Decedent’s estate consisted of 9,994 shares of stock in State Line Hotel (the “Hotel”) which was valued at $11,508,400. As permitted by statute, the trustees elected to defer payment of some of the federal estate tax liability under $6166. Section 6166 allows an estate to defer paying part of its estate tax if more than 35% of the estate is comprised of closely held business interests. Upon receipt of the estate tax return, the IRS assessed the estate for unpaid taxes.
Later that year, on December 31, 1992, the trustees and Heirs executed an agreement (the “Distribution Agreement”) distributing all the remaining trust assets to the Heirs. Specific mention was made of the federal estate tax liability, as follows:
6. Liability for Taxes. Each of the BENEFICIARIES acknowledges that the assets distributed to him or her will accomplish a complete distribution of the assets of the Trust. A portion of the total federal estate tax upon the Estate of Anna Smith is being deferred and is the equal obligation of the BENEFICIARIES to pay as the same becomes due. Likewise, if, upon audit, additional federal estate taxes or Utah Inheritance taxes are found to be owing, the responsibility for any such additional taxes, interest or penalties will be borne equally by the BENEFICIARIES.
The IRS issued a Notice of Deficiency against the Estate on May 30, 1995, having made a determination that the hotel shares were worth $15,000,000 at the date of Decedent’s death in 1991. The Government’s change in valuation resulted in alleged additional estate tax of $2,444,367. The Estate contested the Notice of Deficiency and a settlement was reached by which the Estate agreed to pay an additional $240,381 in additional federal estate tax. The total federal estate tax liability thereafter became $6,871,829.
Until this point, the estate administration proceeded normally; however, in January 2002 (eleven years after the Decedent’s date of death), the Hotel filed Chapter 11 bankruptcy in Nevada. According to the Court’s recitation of events, the bankruptcy court approved the sale of all Hotel assets to a third party “free and clear of all liens, claims, and encumbrances.” The Heirs received no value for their Hotel shares, but each did receive $126,000 annually for signing a two-year non-compete agreement. In addition, each Heir reported losses of over $1,000,000 in connection with the Hotel stock that he or she owned (which was used to offset taxable income).
By 2003, the Estate defaulted on its federal estate tax liability, after having paid $5,000,000 of the total amount due and owing. By 2005, the IRS issued a Notice and Demand for payment of the tax liability to the personal representatives. Notwithstanding the IRS’ notice and demand, full payment was not made and Collections failed to make collections through levies on the estate, the Trust and the defendants. This resulting court action—based on allegations of personal and transferee liability—was deemed to be a continuation of the government’s attempts to collect the outstanding tax liability.
Interestingly, the government brought this action against the Estate distributees—the Heirs and the co-trustees. It relied on §6324(a)(2) as the basis for claiming that each heir is liable for the estate tax and that this statute imputes personal liability for federal estate taxes to individuals receiving property from the estate at the time of a decedent’s death. That section names as potential liable parties as, inter alia, a spouse, transferee, trustee, surviving tenant, and beneficiary. The co-trustees admitted to falling within this statute’s application. Additionally, the Heirs admitted that as beneficiaries of the life insurance proceeds, they fell within the scope of §6324(a)(2) as well. However, the Heirs denied that they became distributees when property from the Trust corpus was distributed to them and, consequently, denied all liability arising from their status as Trust beneficiaries.
In addition to personal liability, the government focused on transferee liability in an effort to affix liability. Three constituent parts of transferee liability were examined:
Timing of distributions. The government had contended that the Heirs were personally liable for the estate tax because they became transferees when property from Trust corpus was distributed to them. The Heirs argued that they were not transferees because the property was not distributed to them immediately upon the Decedent’s death. The Court agreed and interpreted this section in favor of the Heirs, holding that a person falls within §6324(a)(2) only if he/she has or received property from the gross estate immediately upon the date of a decedent’s death rather than at some point thereafter.
Trustees Received Trust Corpus Upon Decedent’s Death. The government posited that the existing line of cases on point address trust beneficiaries who were entitled to trust income and not trust corpus itself. The Court, however, disagreed and found that the immediate right to the Trust corpus did indeed belong to the trustees upon the Decedent’s death and not to the Heirs. The Court further stated that “whatever inchoate property interest” the Heirs may be said to have received upon the Decedent’s death did not position them to be held personally liable for the estate tax. Further, the co-trustees were directed to distribute the remaining principal and undistributed income of the Trust only after the estate’s debts and obligations were satisfied (and the specific distributions were made).
Subsequent Transferees. The Court addressed the status of the Heirs as transferees using the lens of §6324(a)(2), as follows:
Any part of such property transferred by (or transferred by a transferee of) such spouse, transferee, trustee, surviving tenant, person in possession or beneficiary to a purchaser or holder of a security interest shall be divested of the lien…and a like lien shall then attach to all the property of such spouse, transferee, trustee, surviving tenant, person in possession, or beneficiary, or transferee of any such person, except any part transferred to a purchaser or a holder of a security interest.
The Court interpreted Congressional intent to conclude that the term “transferee” does not apply to subsequent transferees who receive property from a distributee following a decedent’s death; accordingly, the Heirs were not deemed to be transferees under §6324(a)(2).
With regard to their status as beneficiaries, the Heirs did not dispute their status as beneficiaries of the Decedent’s life insurance policies but did challenge the interpretation that this statute applied to them as Trust beneficiaries. The Court found that the term “beneficiary” was only meant to refer to insurance beneficiaries and not Trust beneficiaries. While the government expressed concern with abuses that could ensue, the Court expressed satisfaction that the trustee’s potential liability would help curb abuses envisioned by the government.
For example, one of the Heirs, Eve H. Smith, was sued in her capacity as a beneficial transferee of certain assets distributed from the estate through the Trust and as a partner of the James W. Smith Family Limited Partnership. While the government had asserted that Ms. Smith was a recipient of assets and cash, she was shown to have received neither and, further, she was not a party to the Distribution Agreement. The Court stated that “the assertion that Ms. Smith should bear liability because she was a partner of certain limited partnerships is an even more attenuated argument than that made against the Heirs and direct beneficiaries of the Trust”.
In sum, the Court found the following regarding the transferee issue:
• the co-trustees fell within the scope of §6324(a)(2) to the extent of the value of the property in trust at the time of the Decedent’s death;
• the heirs were deemed to beneficiaries under §6324(a)(2) to the extent of the life insurance proceeds and beneficiary status was limited to that property only; and
• the Heirs did not meet the definition of transferee under §6324(a)(2) and, therefore, were not liable as trust beneficiaries or as transferees.
Statute of Limitations
The Defendants conceded that the trustees and beneficiaries of the life insurance proceeds would ordinarily be subject to liability under §6324(a)(2), but that claims here were time-barred. Typically, the IRS has ten years to collect the assessed taxes; in this case, the return was filed on June 1, 1992 and the IRS assessment was made on July 13, 1992. As a result, the ten years would have run until July 13, 2012. However, the ten year period was extended when the estate made the election to defer estate taxes under §6166(a), and the first installment would be payable five years after making the election. As a result of the election, the statute of limitations could be tolled for up to fifteen years from the date of election. Rather than tolling the statute of limitations until 2007, however, the statute started running again in 2003 when the estate defaulted in making its yearly payment. This was not contested by the Defendants.
Applicability of §6901 to action against Estate Distributees
Instead of suing the estate, however, the IRS chose to commence an action against the Distributees of the estate who, in point of fact, never received an assessment. Section 6901 governs the method and procedure for collecting taxes from transferees who received estate assets. For purposes of §6901, the term “transferee” is defined as “donee, heir, legatee, devisee, and distributee, and with respect to estate taxes, also includes any person who, under 6324(a)(2), is personally liable for any part of such tax.” [emphasis added]. Hence, the term “transferee” would be broader under §6901 than it is under §6324(a)(2) and, further, it encompasses the co-trustees and the life insurance beneficiaries in this particular case.
The government also contended that the personal representatives of the Estate would be liable for the state tax pursuant to 31 U.S.C. §3713(b) which states as follows:
A representative of a person or an estate … paying any part of a debt of the person or estate before paying a claim of the government is liable to the extent of the payment for unpaid claims of the Government.
As a result, if the estate has insufficient assets to pay its debts or is insolvent, a personal representative must give priority to the United States and first pay that liability. If this is not done, the representative can be held liable.
In this case, the personal representatives admitted to distributing Estate assets prior to satisfying the government’s claim. They claimed, inter alia, that the Distribution Agreement should bind the distributees, not them, on account of the right of contribution language it contained. They further claimed as a defense that there had been sufficient monies to pay the tax originally. The Court, however, rejected the accounting/timing issue and, instead, interpreted the statute as providing recourse when a representative distributes assets of an estate before paying estate taxes. The Court held:
Were courts to excuse personal representatives from liability when they secure contribution agreements, the Government would have to bring an action in contract, prove it is a third-party beneficiary of the agreement, and then establish its right of contribution.
Here, the co-trustees admitted distributing assets to themselves and two relatives rather than applying them to the tax liability with the acknowledgment that the distribution would result in a complete distribution of the Trust. The Court re-characterized the Distribution Agreement as a “hold harmless” agreement to protect the personal representatives from tax liability in the event the Heirs failed to pay estate tax. Lastly, even though the agreement stated that the Heirs would be responsible to pay taxes, this was not the ‘right of contribution’ agreement contemplated by court cases through the years and, in fact, this particular Distribution Agreement was deemed “immaterial” in determining liability under §3713(b).
The Court agreed that §3713(b) is a straightforward analysis and that it was designed to collect unpaid taxes from the very individuals who dispersed the estate’s assets without satisfying the estate’s tax liability. The Court further stated that those individuals who distributed the Estate’s assets did indeed accept the risk that the Heirs might fail to pay the tax. The Court further stated that the Personal Representatives, rather than the Government, were in the best position to seek reimbursement from individuals who accepted the assets when a deferred obligation to pay the tax was in place.
Though couched in the form of a summary judgment motion, this case is truly a lesson for fiduciaries who undertake a §6166 election to defer payment of estate taxes. Even with a §6166 election in place, the estate or trust fiduciaries would be wise retain those assets until full and final payment of the estate tax liability. An early distribution where other trust and/or estate assets do not exist to satisfy the tax liability will expose fiduciaries to personal liability as described. The risk might be minimized if fiduciaries could, for example, obtain a pledge of assets that are unlikely to lose significant/material value in the context of a contribution agreement; however, that risk can only be minimized, not avoided, even with a contribution agreement in effect.