ROBERT E. MCKENZIE, ESQ.ARNSTEIN & LEHR LLP

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Robert E. McKenzie, Esq.

: Heirs and fiduciaries can be held personally liable for unpaid taxes of an estate. The potentialliability arises when the estate fails to pay its estate taxes or it fails to pay taxes which were owed by thedecedent. The unwary fiduciary may end up indemnifying an estate obligation to the government. She musttake steps to assure that all taxes are paid by the estate each time she participates in administration.

Transferee liability for taxes of an estate can arise in several ways. Under state law where a creditor transfersproperty in fraud of creditors, the Service has all the rights of a private credit or to collect a claim for taxes.The rights of the Service and a creditor are defined in such bodies of laws as:

(1) The law of Fraudulent Conveyances;

(2) Rights of creditors in Life Insurance Benefits.

Under the Internal Revenue laws, IRC §6324 makes transferees and donees liable for estate and Gift taxes ofa decedent or donor. Transferee liabilities are also imposed by other federal laws. For example, a fiduciarymay be held personally liable if he pays the debts of an estate before taxes under 31 U.S.C. §192. The IRSmay seek tax of a transferor from a transferee by:

(1) Instituting a civil action against the transferee under state law, for example, to set aside a conveyance asfraudulent under the laws of the state; or

(2) Proceeding to collect the tax of the transferor from the transferee in the same manner as that of adelinquent taxpayer pursuant to the provisions of IRC §6901, for example, by sending the transferee a Noticeof Deficiency asserting her liability under the applicable state laws. Typically, the IRS uses the transfereeliability provisions of IRC §6901, but the use of the procedure itself will depend on state law.

IRC §6901 provides a method of collecting the unpaid tax liability "at law or in equity" of a transferee ofproperty. As a general rule, the liability of the transferee "at law and in equity" is a question of state, notfederal law, Commissioner v. Stern, 357 U.S. 39 (1958), Kathy P. Enters., Inc. v. U.S., 84-2 USTC¶9620(D.C. Az. 1984), aff'd on other issues, 779 F.2d 1143 (9th Cir. 1986). State law normally governswhether there is a transferee liability and the extent of liability, but this general principle is subject to certainqualifications. First, state law may not answer all questions relating to a transferee's liability, and second,where a question is not definitively answered by state law, federal law is consulted. Third, certain transfereeliability issues are not controlled by state law because the supremacy of the federal government prevents theapplication of state law. For example, IRC §6901(c) establishes a Statute of Limitations for the assertion oftransferee liability. The Statute of Limitation applies to a claim by the Service, instead of the shorter stateStatute of Limitations required of other creditors to proceed under the state's law. Finally, the governmentneed not proceed under state law to assert statutory transferee liability in all situations.

Example, if the Service wished to collect an estate and gift tax liability, it can proceed under Section 6324,which creates its own transferee liability, rather than state law. Similarly, where a fraudulent conveyance by abankrupt taxpayer is at issue, the Bankruptcy Code would be applicable.

: THE ELEMENTS OF TRANSFEREE LIABILITY

In most jurisdictions before a transaction may be tagged as fraudulent, prejudice to the rights of creditors mustresult therefrom. Two types of fraud in conveyancing are recognized:

(1) FRAUD IN FACT - Where actual fraudulent intent to hinder or delay creditors exists;

(2) FRAUD IN LAW OR IN EQUITY - Where the terms of any agreement or the nature of the transactionitself evidence a conclusive presumption in law that the conveyance is fraudulent.

If there is insufficient consideration for the Debtor's transfer of property (which exists in any transfer to abeneficiary from an estate) even though there is no proof of intent to defraud, it is presumed "fraud in law orin equity," which is fraud that is presumed from the circumstances. Even if there is apparent sufficientconsideration for the transfer, "fraud in fact" may be established if there is a specific intent to defraudcreditors.

Generally the elements of fraud in law or in equity which constitute a fraudulent conveyance are:

(a) A gift or sale for less than fair market value;

(b) A then-existing or contemplated indebtedness against the transferor (i.e. accrual of a liability, not anassessment); and

(c) A retention of insufficient property by the transferor to pay his indebtedness (insolvency).

There is no need for the Service to establish an evil motive to assert fraud in law. The Service is not requiredto prove intent but merely the three elements. The transferee may, in fact, have been an innocent recipient viaa bequest in a will, but if the three elements exist, the IRS will prevail. An example would be a father whotransfers most of his assets to a trust for his children and is later audited and assessed with a large deficiencyfor taxes which had accrued prior to transfer. In such an instance, the IRS could attack the trust because thetransfer meets the three tests, even though the father has no intent to defraud the IRS. Obviously, this couldoccur in many estate situations where the decedent had used aggressive estate planning techniques to avoidestate taxes.

In a case where a husband and wife, after tax assessments had been made against them, gratuitouslyconveyed certain real estate to a trust company as trustee and named the wife the beneficial owner, afterwhich the wife transferred her beneficial interest to their son, the transfer was found void and was set asideagainst the United States, U.S. v. Mitchel, 271 F. Supp. 858 (N.D. Ill. 1967).

When relying upon fraud in fact, the IRS must prove an actual intent to defraud in order to set aside aconveyance. Courts will look for "badges of fraud" in making their determination with respect to fraud in fact.Although the badges of fraud may amount to little more than suspicious circumstances, they may be used by acourt to infer a fraudulent conveyance. A transfer may be fraudulent if it is made with actual intent to defraudcreditors (Actual Fraud), even if the transferor is solvent. The conveyance is fraudulent where it is made withactual intent, distinguished from intent presumed in law, to hinder, delay or defraud either present or futurecreditors. This actual intent to defraud is established with the same evidence that constitutes badges of fraud.

Although states vary in badges of fraud which are recognized the following is a list which have been used byvarious courts to infer fraudulent conveyance:

(1) An inadequate or fictitious consideration or a false recital as to consideration;

(2) The fact that property is transferred by a debtor in anticipation of or during a pending suit;

(3) Transactions which are not in the usual course or method of doing business;

(4) The giving of an absolute conveyance which is intended only as security;

(5) The failure to record the conveyance or an unusual delay in recording the payment;

(6) Secrecy and haste are ordinarily regarded as badges of fraud but are not in themselves conclusive offraud;

(7) Insolvency or substantial indebtedness of the grantor;

(8) The transfer of all the Debtor's property, especially when she is insolvent or greatly financiallyembarrassed;

(9) An excessive effort to clothe a transition with the appearance of fairness;

(10) The failure of parties charged with fraudulent conveyance to produce available evidence or to testifywith sufficient preciseness as to the pertinent details, at least in cases where the circumstances under whichthe fraud, transfer took place are suspicious;

(11) The unexplained retention of possession of property transferred by Grantor after conveyance;

(12) The buyer's employment of the seller to manage the business as before, selling the goods which were thesubject of the transfer;

(13) The failure to examine or to take an inventory of the goods bought or the presence of looseness orincorrectness in determining the value of property;

(14) The reservations of a trust for the benefit of the grantor and the property conveyed;

(15) The existence of a blood or other close relationship between the parties to the transfer.

In addition to the particular badges of fraud set out above, various other circumstances, singly or collectivelymay constitute badges of fraud, such as the concealment of an alteration in the attestation clause of the

conveyance; the transferee's failure to keep a record of the dates and amounts of the loans, or advances madeby him to the transferor; failure to demand repayment; misdescription or insufficient description of theproperty transferred; sending the money received from the transferee out of the country; assignment of theproperty to the seller rather than to the purchaser; and the fact that the purchaser, soon after transfer, offeredto resell the property at a much higher price.

: PROCESS OF LAW

A transferee includes, by judicial interpretation, "one who takes property of another without full, fair andadequate consideration to the prejudice of creditors." By way of illustration, Section 6901 states the termtransferee includes:

(1) Donees;

(2) Heirs;

(3) Legatees;

(4) Devisees; and

(5) Distributees.

The regulations expand the classes of transferees by adding:

(6) Distributees of a decedent's estate;

(7) Shareholders of a dissolved corporation;

(8) Assignees or donees of an insolvent person;

(9) Successors of a Corporation;

(10) A party to a reorganization as defined

in Section 368 in the Internal Revenue Code; and

(11) All other classes of distributees.

The most important class of transferees are successors of or distributees from corporations and those havingdealings with an estate as fiduciary or beneficiary.

: FIDUCIARIES AND BENEFICIARIES

The liability of a fiduciary for any tax owed to the United States is based upon Sections 3713(a) and 3713(b)of the Revised Statutes. Fiduciary liability is entirely distinct from transferee liability, although §6901provides summary assessment and collection procedure against both the transferee and the fiduciary. Ingeneral, the liability of a fiduciary arises from the fiduciary's payment on behalf of an estate of debts that donot have priority over the debts to the United States. On the other hand, transferee liability is asserted where

the transferee takes property of the transferor, without full, fair and adequate consideration to the prejudiceof the United States as a creditor. Both an estate and the executor or the administrator of the estate in hisrepresentative capacity can be liable as transferees of the assets of the deceased under §6901, Estate of HarryMiller, 42 TC 593 (1964); Estate of Robert Harrison, 16 TC 727 (1951); Estate of Irving Smith, 16 TC 807(1951); Estate of L.A. McKnight, 8 TC 871 (1947); Ewart v. Commissioner, 84 TC 912 (1985), aff'd 814 F.2d321 (6th Cir. 1987); (co-executor who received the property from the estate was held liable as transfereeunder Ohio law because transfer rendered the estate insolvent). The estate and its executors are relieved onlywhere notice of transferee liability has not been received before the assets have been distributed and theexecutor or administrator dismissed under local law. The executor may apply for release from personalliability by written application and payment of the amount of tax determined under this provision of IRC§6905(a).

Transferees who receive property includable in the gross estate of decedent are personally liable for unpaidestate taxes and donees of property are personally liable for gift taxes pursuant to the provisions of IRC§6324. One method of enforcing this personal liability is by advising the transferee of the assessmentprocedures of §6901, although these procedures are not exclusive. Where the tax involved is decedent'sunpaid income taxes, a transferee liability may be asserted against beneficiaries of an estate if the estate isinsolvent or has been completely distributed. (If an executor fails to pay taxes and allows distributions to bemade to the beneficiaries which result in an assertion of a transferee liability against the beneficiaries by theIRS, that executor can be assured that the beneficiaries will probably seek to sue the executor for violating hisfiduciary duties.) The basis of liability is that a beneficiary is a transferee of a transferee, that is, the decedenthas transferred property to the estate, which in turn, has transferred property to the beneficiary. Under thesecircumstances, if either the decedent or the estate was insolvent and the property was distributed to thebeneficiaries, the transfer would be a fraudulent conveyance and the executor or administrator would bepersonally liable under Section 3713(b) for paying a legacy or devise before a debt to the United States.

A cotenant in jointly owned property who acquires the entire property upon the death of a deceased taxpayerhas generally been held not to be a transferee for purposes of Section 6901. Since the surviving joint tenant ortenant by entirety takes the full estate by virtue of the creation of the tenancy not on the death of thecotenant, the survivor is not a transferee and is not liable for unpaid income taxes of a decedent, Tully v.Commissioner, 121 F.2d 350 (9th Cir. 1941). But that cotenant may become liable for estate taxes via IRC§6324. However, where individual partners transferred property to their partnership, although the partnershipwas a separate entity and the property became partnership property, the individual partners were held to betransferees, Commissioner v. Kuckenberg, 305 F.2d 202 (9th Cir. 1962).

: INSURANCE PROCEEDS

Where a beneficiary receives life insurance proceeds under a policy owned by the deceased taxpayer, he isliable as a transferee at law for unpaid estate taxes by virtue of the provisions of Section 6324. The liability ofa life insurance beneficiary for the decedent's income taxes depends upon whether or not the taxes have beenassessed before the death of the decedent. If there has been a tax assessment and a lien has attached to allproperty and rights of property of the decedent before his death, then the beneficiary merely takes theproceeds of the policy subject to the lien. However, only the amount of the proceeds equivalent to the cashsurrender value of the policy at the time of the decedent's death is subject to the lien. The balance does notconstitute property or rights of property of the insured, to which the tax lien would have attached at the timeof his death, United States v. Best, 357 U.S. 51 (1958). Where there is no prior federal tax lien, state lawdetermines the existence and extent of the beneficiary's liability. Where state law exempts the beneficiary ofa life insurance policy from the claims of the insured's creditors, the beneficiary is not subject to transfereeliability, Commissioner v. Stern, 357 U.S. 39 (1958). However, if under state fraudulent conveyance law, it

can be shown that the deceased taxpayer paid premiums with the intent to defraud creditors, the beneficiaryis liable as a transferee for the amount of the premiums paid plus interest, but not the balance of proceeds ofthe policy, United States v. Truax, 223 F.2d 229 (5th Cir. 1955). In Stern, the beneficiary of the insurancepolicy was the wife of the decedent. Where decedent's estate is the beneficiary of the policy and the proceedsare paid to the estate, which in turn pays them to the widow, the widow is the transferee of the estate and nota beneficiary of the life insurance policy. Accordingly, the widow would be liable for transferee in equity ifthe estate were insolvent, Kieferdorf v. Commissioner, 142 F.2d 723 (9th Cir. 1944) cert. denied, 323 U.S.733 (1944).

: SECTION 6324 - THE SPECIAL ESTATE TAX LIEN

A general tax lien attaches to all property belonging to the taxpayer after assessment, demand andnon-payment of the tax and secures payment of all types of federal taxes, including estate taxes. To securepayment of estate taxes, a second type of lien called the "special estate tax lien," also exists in favor of thegovernment without assessment or notice and demand, the special estate tax lien comes into existenceautomatically on the date of death. It continues for ten years unless, before the end of the ten-year period, theestate tax is paid in full or becomes unenforceable by expiration of the Statute of Limitations for collection,IRC §6324(a).

The Supreme Court held in Detroit Bank v. United States, 317 U.S. 329, 337 (1943) that the special estate taxlien was based upon Congress' belief that there is a greater need of a lien in advance of assessment anddemand for payment of estate tax and property passing at or distributed in consequence of death than forother types of taxes. The Court also said that there was less need to protect third parties by way of a recordednotice of lien because the property passing at death is normally dealt with by probate and estate taxproceedings of public notoriety. Purchasers of property from an estate must exercise extreme caution becausea special estate tax lien encumbers the property if an estate does not pay estate tax subsequently found to bedue. Careful practitioners representing buyers take such precautions as asking the estate representative forevidence that all estate taxes have been paid, seeking the discharge of the special estate tax lien on theproperty being purchased, and securing indemnity from the estate, should any estate tax liability arise.However, the assurance of obtaining a discharge of property from an estate tax lien or a release of lien fromthe Service is no longer available in every situation because the estate may not be (at least initially) subject toestate tax. Absent evidence that the Service has been paid, reliance in some form of an indemnity from theestate seems to be the method left to protect purchasers of estate property.

The special estate tax lien attaches to the property includable in the gross estate of decedent. The term grossestate is a creation of the estate tax provisions of the Code, IRC §§2031-2044. Since a general lien attachesonly to property and rights to property owned by decedent at the time of death and thus passing to probate,the special lien is far broader than the general lien. Therefore, where probate property is sold by an estateowing estate tax, the purchaser has bought property encumbered by the special lien. Even if the executor ofthe estate asks for a discharge from personal liability under §2204 and has been discharged from personalliability, the special lien is not extinguished. It continues, but shifts from the property transferred to theconsideration received by the heirs, legatees, devisees and distributees provided that the property has beentransferred to a purchaser or holder of a security interest. The shifting lien comes into play under IRC§6324(a)(3) only where the executor or other fiduciary has been discharged from personal liability, bycomplying with §2204. If there has been no application and discharge, the special lien continues to encumberthe transferred property. The special lien attached to such non-probate property as dower or curtesy interest,property transferred in contemplation of a death, transfers with a retained life estate, transfers taking effect atdeath, revocable transfers, annuities, joint interests, powers of appointment and the proceeds of life insurance.

Property may be discharged or divested from the effects of a specialized tax lien but circumstances ofdischarge are dependent on whether the property is probated or not probated. Where probated property isinvolved a special tax lien is divested automatically from property included in the gross estate that the probateor other court having jurisdiction of the estate allows it to be used to pay charges against the estate andadministration expenses, U.S. v. Security First National Bank, 30 F.2d 113 (S.D. Cal. 1939). Although thisapproval need not be obtained prior to payment of an expenditure, the automatic divesture provision onlyapplies where the expenditures are allowed by a court of competent jurisdiction.

There is another discharge provision peculiar to the special tax lien called the "shifting lien." Certain thirdparties are protected against the effects of the general lien by the requirement that the lien be publicly filed inorder to be valid against them. The special lien, on the other hand, does not require a notice to be filed for itto be effective. Rather, property sold or transferred to a purchaser or holder of security interest isautomatically discharged or divested from the effect of the lien, but the lien shifts to the considerationreceived from the purchaser or the secured lender. The shifting lien attaches to the consideration received,even if the fiduciary obtains a discharge from personal liability after audit of the estate tax return.

IRC §6325(c) allows the estate to apply for discharge upon the sale of property. The application for dischargemay be made on Form 4422 (Application For Certificate to Discharging Property Subject to estate Tax Lien).

A lien may be foreclosed against the property that it encumbers in a judicial proceeding. Payment of theestate tax secured by the special lien is also insured by the imposition of personal liability. There are sixcategories of persons who have received property subject to the special lien and are personally liable for theamount of the estate tax:

(1) The decedent's spouse;

(2) The decedent's transferee;

(3) A Trustee;

(4) A surviving tenant;

(5) A person in possession of the property by reason of the exercise or non-exercise and release of power ofappointment; or

(6) Beneficiary (IRC §6324(a)(2)).

Each of the categories of persons are jointly and severally liable as transferees of property includable in thegross estate.

The categories of persons personally liable for the unpaid estate tax seem broad enough to include any personhaving received property includable in the gross estate. A trustee is specifically named as a person havingpersonal liability; thus, it has been held that the trustee of an inter vivos trust, not the beneficiaries, ispersonally liable under Section 6324(a)(2), Higley v. Commissioner, 69 F.2d 160 (8th Cir. 1934).

Personal liability imposed by Section 6324 is transferee liability. The term "transferee" includes with respectto estate taxes "any person who, under §6324(a)(2), is liable for any part of such (estate) tax," IRC §6901(h).Transferee liability is enforced by two methods:

(1) legal action without assessment; or

(2) assessment under the general transferee provision, §6901.

: THE SPECIAL LIEN FOR ESTATE TAX

WHERE PAYMENT IS DEFERRED

Section 6324A provides for a special tax lien in lieu of the special tax lien of §6324 where payment of theestate tax has been deferred under Section 6166. If the executor: (1) makes an election under §6324A and (2)files a lien agreement signed by each person has an interest in property designated in the agreement ascollateral for the payment of the deferred amount, a lien arises for the deferred amount. The lien agreement isa written agreement signed by each person who has an interest in the property designated in the agreement inwhich the signing person: (1) consents to the creation of a lien against the property; and (2) designates aresponsible person as the agent for the beneficiaries of the estate and signatories in dealings with the Serviceon matters arising under Sections 6166 or 6324A.

: SUMMARY

Estate and trust administration contain many traps for the unwary which might lead to personal liability. Afiduciary who distributes the estate prior to completion of the estate tax audit could become personally liable.The fiduciary also can become liable as a result of his or her failure to secure a discharge from the IRS uponconclusion of the IRS examination. Because of the extensive nature of the estate tax lien, a person acting in afiduciary capacity could incur liability when liquidating property of the estate.

Another risk which was not developed within this discussion is the fact that if a beneficiary or distribute of anestate becomes the subject of a transferee liability investigation by the IRS, there is a great probability thatthat beneficiary will sue the executor for errors and omissions in her fiduciary capacity. Congress has giventhe IRS great power to pursue tax obligations due from the decedent and the estate and the unwary fiduciarymight become the target of that power. Therefore, it is incumbent upon each fiduciary to fully review eachestate for all tax obligations, both apparent and hidden. Upon completion of the IRS examination, thefiduciary should seek discharge of her obligation. Even that may not prevent later litigation by thebeneficiaries of the estate if they should become the subject of an IRS investigation.

THE DISAPPEARING ASSET

ESTATE

ARISES

|

|

ESTATE CONSISTS OF A

IRS PURSUES

HEIRS AND EXECUTOR FOR

BALANCE OF TAXES

HEIRS

SUE

EXECUTOR

$6 MILLION SECURED NOTE AND

$2 MILLION IN LIQUID ASSETS

ESTATE PAYS PART OF

ESTATE TAX - RECEIVES

§ 6161 EXTENSION

ESTATE DISTRIBUTES

REMAINDER OF

LIQUID ASSETS

TO BENEFICIARIES

DAUGHTER DEFAULTS ON NOTE

ESTATE FORECLOSES

COLLATERAL

IRS SEIZES COLLATERAL

AND SELLS FOR SMALL PERCENT

OF VALUE

THE MISSING TAX RESEARCH

TAXPAYEROWES

TAXES

TAXPAYER DIES

OWING

TAXES

IRS PURSUES

HEIRS

AND

EXECUTOR

HEIRS

SUE

EXECUTOR

ESTATE COMMENCES

EXECUTOR IS UNAWARE OF

TAX LIABILITY

EXECUTOR FAILS

TO CHECK WITH IRS

REGARDING PRIOR TAXES

ESTATE DISTRIBUTES

ALL ASSETS TO

HEIRS

THE POST ESTATE AUDIT OFDECEDENT

1992

ESTATE ARISES

WITH MORE THAN

$600,000

1992

ESTATE

DISTRIBUTES

TO

HEIRS

1993

IRS AUDITS

DECEDENT'S

PERSONAL INCOME

TAX RETURNS

AND ASSERTS

LARGE DEFICIENCY

1994

IRS PURSUES

HEIRS FOR

TRANSFEREE

THE PREMATURE DISTRIBUTION

ESTATE

ARISES

706 FILED

WITH FULL

PAYMENTS

ESTATE

DISTRIBUTES

ASSETS

TO HEIRS

IRS AUDITS

ASSERTS LARGE

DEFICIENCY

TAX COURT

FINDS FOR IRS

IRS

PURSUES

HEIRS AND

EXECUTORS

THE THWARTED ESTATE PLAN

1992

TAXPAYER CREATES TRUST FORCHILDREN AND CONVEYS MOST

ASSETS

1993

IRS AUDITS

1990, 1991 & 1992

INCOME TAX RETURNS ANDASSERTS A LARGE LIABILITY

1994

IRS PURSUES TAXPAYER

AND IS UNABLE TO COLLECTBECAUSE HE IS INSOLVENT

1994

IRS PURSUES TRUST

AND BENEFICIARIES WHO HAVERECEIVED DISTRIBUTIONS

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2/12/2007