Using a common estate planning device in California, Anna Smith created a pourover will which provided that all her property not already in her living trust would be transferred to her living trust to be distributed under the terms of her trust. Anna died in 1991 and the trust provided that after all expenses and taxes of the trust were paid, a residual distribution to certain named beneficiaries would occur. A significant asset of the estate was shares of stock in a corporation. Anna’s fiduciaries elected to defer a portion of her estate taxes under Internal Revenue Code §6166.
In 1992, the trustees of the trust distributed assets of the trust to the beneficiaries. Because of the deferral under §6166, the estate taxes were not yet paid in full and the beneficiaries agreed to be responsible for the unpaid estate taxes.
In 2002, the corporation went bankrupt. The beneficiaries received nothing on their shares beyond some minimal amounts received. The next year, after having paid only $5 million of the $6.871 million in taxes due, the estate defaulted on its unpaid estate taxes . The IRS then sought to collect the unpaid taxes from the personal representatives of Anna’s estate (who were also trustees of the Trust), and from the beneficiaries.
There is a lesson here for fiduciaries undertaking a Code §6166 election to defer payment of taxes. The lesson is that with the extension, the estate or trust with the subject assets should retain those assets until after full and eventual payment of the tax liability. Distributing early, unless there are other assets in the estate or trust to fully cover the tax liability, will expose the fiduciaries to personal liability such as that imposed in the Johnson case.
Perhaps if the fiduciaries can adequately secure the beneficiary obligations under the contribution agreement with a pledge and/or mortgage of assets that are unlikely to lose material value, the risk can be minimized.
For tax planning to avoid this type of problem and others like it, call tax lawyer Mitchell A. Port at (310) 559-5259.