by William C. Carroll, John “Randy” Randolph
Part I of this article, published in the November Journal, described the various federal and state tax obligations of a decedent and a decedent’s estate and outlined how federal and state law can hold the personal representative (PR) personally liable for these obligations. In this Part II, the authors recommend steps for a PR to take to minimize personal liability for these federal and state tax obligations. It is imperative that counsel for the PR implement steps to identify and mitigate against these liabilities.
Steps Applicable to Both Federal and State Tax Obligations
First and foremost, the PR should file timely and complete tax returns for periods prior to the decedent’s death. In that regard, a PR must gather all of the decedent’s tax and financial information to enable the PR to complete this task accurately.
The first few steps in this important exercise are basic and intuitive. The PR should collect and review the decedent’s federal income tax reporting information (e.g., 1099s) and prior federal (and state, if applicable) income and gift tax returns for the three years preceding death. Florida intangible tax returns for the three years prior to death should also be gathered and reviewed. The decedent’s mail should be forwarded to the PR or the PR’s counsel to ensure that any income tax reporting information is sent to the proper party. Form 56, Notice Concerning Fiduciary Relationship, must be filed with the Internal Revenue Service (see discussion below). The PR should also review all of decedent’s records to identify any correspondence and/or notices from the IRS or the Florida Department of Revenue (FDOR). If an accountant had previously prepared the decedent’s tax returns, the PR should meet with the accountant to discuss all tax issues. In connection with meeting with the decedent’s accountant (if any), the PR should determine who will prepare the income (individual and fiduciary), estate, gift, and intangible tax returns. To the extent that there is any question that one or more returns may not have been filed with the IRS, it may be appropriate to request a transcript of such tax return and/or a copy of such return (using Forms 5406-T and 5406).
As the administration of the estate progresses, it is not uncommon for the PR to uncover information that causes the PR to suspect that prior gift tax returns are either inaccurate or incomplete, or were perhaps never filed as required. Even if the PR has gift tax returns in hand, he or she should review the returns for the proper allocation of the generation-skipping tax exemption.1 If the PR determines that prior gift tax returns were inaccurate, incomplete, or not filed as required, or that the generation-skipping tax exemption was improperly allocated or not allocated at all, the PR needs to determine how to rectify these mistakes and omissions.
The PR should promptly estimate the necessary cash requirements of the estate for the payment of the decedent’s debts (including existing tax liabilities), estate taxes, and administration expenses. The PR should then take prompt steps to raise the cash necessary to meet the obligations of the estate through the sale of estate assets, if necessary.2 Because of the step-up in basis,3 raising cash can usually occur without substantial adverse tax consequences to the estate. Once the PR has raised sufficient cash, the funds should be retained by the estate in conservative cash or cash equivalent investments such as money market accounts or short-term Treasury obligations.
Steps Applicable to Federal Tax Obligations
Because of the relatively short time horizon for the administration of a decedent’s estate (generally two to three years), a PR will want to be sure that he or she is aware of all of the federal tax issues early on in the administration, and that these issues are resolved before the PR makes final distributions (or any sizable interim distributions). Generally, the IRS has three years to assess any deficiencies on income, estate, or gift tax returns filed by the decedent and/or the PR.4 Thus, various assessment periods can run well beyond the typical time frame for settling an estate. Therefore, it is incumbent on the PR to take whatever steps are available to shorten the time period the IRS has to assess any such deficiencies and to be discharged from personal liability for any such potential deficiencies.
The Internal Revenue Code provides several mechanisms a PR can use to his or her advantage either to shorten the time periods in which IRS may assess tax deficiencies or to request a discharge from personal liability for the payment of such taxes.
Notice of Fiduciary Capacity
Treas. Reg. §301.6903-1(a) and (b) state that every fiduciary is required to give notice in writing to the IRS that he or she is acting for another in a fiduciary capacity. The PR can use Form 56 (Notice Concerning Fiduciary Relationship) to provide the required notice. Importantly, if a notice of fiduciary capacity is not filed with the IRS, a notice of deficiency will not be sent directly to the PR, and any notice of deficiency that the IRS sends to the last known address of the decedent is considered sufficient (permitting the IRS to assess the tax and demand payment immediately upon expiration of the 90-day deficiency notice period, even if the PR may never have received the notice).5 Additionally, with respect to the assessment of personal liability against the PR under 31 U.S.C. §3713(b), in the absence of a notice of fiduciary relationship, any notice of §3713(b) liability mailed to the PR at his or her last known address is sufficient.6 (Section 3713(b) liability is discussed in Part I of this article.)
Thus, in order to comply with the described regulations, and as a defensive step to avoid an assessment due to the failure to provide the IRS with the PR’s name and address, Forms 56 should be filed for the estate and for the decedent. The Form 56 instructions are to file the form with the IRS Center where the person for whom you are acting is required to file tax returns. The instructions make it clear that the PR is acting as a fiduciary on behalf of the decedent and the decedent’s estate. The instructions describe the estate as an entity separate from the decedent. They state that a separate Form 56 must be filed for each person “whom you are acting in a fiduciary capacity.” The instructions provide an example dealing with the decedent’s income tax return for the year of death (final Form 1040). This example states that, with respect to the decedent’s final Form 1040, the PR must file one Form 56 entering the name of the decedent as the person for whom the PR is acting and that another Form 56 must be filed entering the name of the estate as the person for whom the PR is acting. Accordingly, separate Forms 56 for the decedent and the estate should be filed with the IRS Service Center where decedent was filing (or should have been filing) his or her individual income tax returns (for a Florida decedent, this would be the Atlanta Service Center). Forms 56 for the estate should also be filed with the Cincinnati Service Center and with the Ogden, Utah Service Center. These Forms 56 would apply to the gift and estate tax returns (Cincinnati Service Center)7 and to the estate’s income tax returns (Ogden Service Center). With respect to the Forms 56 for the decedent’s income and gift tax returns, generally the authors suggest filing this form for the past three years’ tax returns. It is not necessary to include a copy of the PR’s letters of administration as an enclosure to the Form 56;8 however, the authors nevertheless recommend that the letters be included.
The instructions to Form 56 state that the filing of an additional Form 56 as a notice of termination of fiduciary relationship will “relieve [the PR] of any further duty or liability as a fiduciary.” Treas. Reg. §301.6903-1(b)(1) provides in part that for any notice filed before April 24, 2002, “[w]hen the fiduciary capacity has terminated, the fiduciary, in order to be relieved of any further duty or liability as such, must file with the Internal Revenue Service office with whom the notice of fiduciary relationship was filed written notice that the fiduciary capacity has terminated as to him, accompanied by satisfactory evidence of the termination of the fiduciary capacity.” Treas. Reg. §301.6903-1(b)(2), regarding notices filed on or after April 24, 2002, curiously omits this language; although, as mentioned, the instructions to Form 56 do not reflect the omission. Additionally, I.R.C. §6903(a) continues to state that a fiduciary “shall assume the powers, rights, duties and privileges . . . . until notice is given that the fiduciary capacity has terminated.”
In any case where a PR resigns or is removed by the court, the former PR should file Forms 56 notifying the IRS of the termination of fiduciary relationship. These forms should be filed with each of the service centers with which the PR originally filed notices of fiduciary relationship, and they should specify the name and address of the successor PR. The filing of a termination of fiduciary relationship should provide the former PR with protection against personal liability arising from estate events or actions subsequent to the termination. The termination notices should be filed as soon as possible in order to relieve the former PR from liability for actions that are required to be taken subsequent to the termination, such as filing new tax returns with accompanying tax payments.9 Providing the IRS with notice of the termination of a fiduciary relationship will not protect the PR from personal liability for activities previously undertaken by or required of the fiduciary for the periods in which he or she was serving as PR, such as filing returns or making payments of tax due.10 Because the filing of Forms 56 as notices of termination of a fiduciary relationship does not, in itself, act to absolve the PR from personal liability, the PR must take other steps, as described below, to reduce personal liability.
Discharge from Personal Liability for Decedent’s Income and Gift Taxes
I.R.C. §6905(a) provides that, after a decedent’s individual (but not fiduciary) income or gift tax return has been filed, a PR may make written application to the IRS office where the estate tax return is filed for release of the PR’s personal liability for such income or gift tax. This application is made on Form 5495. If no estate tax return is filed, Form 5495 should be filed where the decedent’s final individual income tax return is required to be filed.11 Treasury Regulations do not impose a time limit for filing Form 5495.
If Form 5495 is properly filed, the IRS has nine months in which to notify the PR of any deficiency for the decedent’s applicable income or gift tax returns. If the PR pays the additional tax, or if no notice is received from the IRS within nine months from the date of filing Form 5495, the PR is then discharged from personal liability.12
If the PR is released from personal liability for any such income or gift tax, the IRS may still assess deficiencies against the PR in his or her fiduciary (not individual) capacity, and may collect the taxes due from assets of the estate (provided the limitations period for assessment and collection has not run).13 The special tax liens on estate assets under I.R.C. §6324 are not released by discharging the PR from personal liability.14
Prompt Assessment for Income and Gift Taxes
In addition to the relief available under I.R.C. §6905(a), a PR may request prompt assessment of any income (individual or fiduciary) tax or gift tax, including any tax that may be due on returns filed by the decedent that are still “open” under the statute of limitations.15 If a request for prompt assessment is made, the statute of limitations for assessment is shortened from three years to 18 months, but not beyond three years after the return was filed.16 Thus, if the statute of limitations will run prior to the shortened assessment period, filing the request for prompt assessment will not extend that period.
The request for prompt assessment may be made using Form 4810, but may also be made in a separate letter filed with the IRS Service Center where the relevant tax returns were filed (not where the estate tax return would be filed, as is the case with Form 5495). If Form 4810 is not used, the request for prompt assessment must a) state the types of taxes and tax periods for which prompt assessment is requested; and b) clearly indicate that the request is being made “under the provisions of Code §6501(d).”17 Pursuant to regulation, the request for prompt assessment, whether on Form 4810 or otherwise, is required to be sent to the IRS separately from any tax return or other forms, including Form 5495.18
If the relevant tax returns were filed as joint returns with the surviving spouse, the filing of a request for prompt assessment by a PR does not shorten the assessment period against the spouse,19 who will remain jointly and severally liable20 for the deceased spouse’s tax liability.21 A request for prompt assessment does not shorten the limitations period on credits and refunds22 and the PR may seek a refund for taxes paid within the shortened assessment period.
How it all can go wrong was demonstrated in Estate of Walker v. Commissioner, 90 T.C. 253 (1988), where a notice of deficiency was mailed to the PR within three years after filing the relevant return but after the estate had been distributed and the PR discharged from liability in the probate proceedings. The PR had not made a request for prompt assessment; the notice of deficiency was therefore held to be timely.
By filing Form 4810 simultaneously (but separately) with Form 5495 the PR benefits the estate and its beneficiaries in addition to providing the PR with the added protection of discharge from personal liability.
Discharge from Personal Liability for Estate Tax
The PR is responsible for the filing of the federal estate tax return and the payment of the estate tax. Although there is no provision in the Code expressly imposing personal liability on a PR, Treas. Reg. §20.2002-1 does so. However, there are provisions whereby a PR (or other fiduciary) may obtain a discharge from personal liability for paying estate tax.
I.R.C. §2204(a) provides that a PR may make written application for the prompt determination of the estate tax and for discharge of personal liability for payment. There is no promulgated form for this request. The PR should make the request in writing to the IRS in letter form to the IRS Service Center where the estate tax return is required to be filed. Upon such request, the IRS has nine months to notify the PR of any estate tax deficiency and, upon payment of such additional tax, the PR is discharged from personal liability. If no such notification is received, the PR is automatically discharged from personal liability. This procedure does not relieve the estate from liability for the payment of additional estate tax, nor does it serve to release the estate tax lien from estate assets. Instead, it only discharges the PR personally, and the PR’s personal assets from liability for payment of the deficiency. Absent such a request, the IRS generally has three years to assess any additional tax due and a much longer period to assert §3713(b) personal liability for its payment against the PR.
I.R.C. §2204 also provides that a fiduciary other than a PR (for example, a trustee of a revocable trust) may apply for discharge of personal liability for estate tax. Upon such a request, the IRS must notify the fiduciary of any estate tax due “upon the discharge of the [PR] from personal liability under subsection (a), or upon the expiration of 6 months after the making of such application by the fiduciary, if later.”23
Although I.R.C. §2204 provides a mechanism for a PR to request discharge from personal liability for estate tax (as does I.R.C. §6905 in the context of income and gift tax), it does not shorten the time for assessment of estate taxes. Compare this to I.R.C. §6501(d), which provides for the reduced assessment period for a decedent’s income and gift tax. There is no comparable provision for estate tax.
In many estates the PR elects to pay the estate tax attributable to a closely held business in annual installments pursuant to I.R.C. §6166. Until the final installment is made, the PR remains subject to potential personal liability under §3713(b). Even though the estate tax is to be paid in installments in the future, the PR can still make a request under I.R.C. §2204 to be discharged from personal liability. However, in order to be discharged the PR must furnish a bond for the amount of estate tax deferred under I.R.C. §6166 or the PR can elect that a lien be imposed with respect to certain property, which is described as “§6166 lien property.”24
Estate Tax Deficiencies Caused by Omission of Taxable Gifts
Among a PR’s many responsibilities is the obligation for filing and paying any unreported gifts made by the decedent during the decedent’s lifetime.25 Frequently this puts a PR in the unenvious position of having to report prior unreported gifts, thereby reducing the available credit for estate tax or, worse, obligating the estate to pay gift taxes. I.R.C. §2204(d) provides that a PR or other fiduciary may in good faith rely on written transcripts of gift tax returns requested from the IRS for all but the most recent three years prior to death. The PR remains personally liable for the filing and payment of gift taxes for the three tax years prior to death. Recall that I.R.C. §6905 permits a PR to request discharge from personal liability for specific gift tax returns filed (see discussion above). The good faith requirement ensures that a PR with actual knowledge of unreported gifts may not be relieved of liability merely by requesting transcripts from the IRS.
If a PR relies in good faith on a transcript of gift tax returns furnished by the IRS, under I.R.C. §6103(e)(3) the PR is relieved from personal liability for additional estate taxes due by reason of gifts made more than three years before the date of decedent’s death and not shown on the return.26 The PR remains liable for unreported gifts made within three years before death, or for unreported gifts in other years in which the PR has actual knowledge.
Steps Applicable to State Tax Obligations
As mentioned in Part I of this article, F.S. §198.23 generally holds a PR personally liable for the Florida estate tax to the extent that the PR made distributions to the beneficiaries before satisfying the Florida estate tax. F.S. §198.19 allows a PR who “files a complete return” to make a written application to the FDOR for a determination of the amount of tax and a discharge from personal liability. Upon application by the PR, the FDOR is required as soon as possible, and in any event within one year of receipt of the application, to notify the PR of the amount of the tax and upon payment of the tax, the PR is discharged from personal liability for any additional tax thereafter found to be due. Pursuant to F.S. §198.19, the PR is entitled to receive from the FDOR a receipt in writing showing his or her discharge from personal liability with respect to the Florida estate tax.
Generally, F.S. §198.28 states that the assessment and the commencement of a collection proceeding with respect to the Florida estate tax must occur within the later of four years from the filing of the return or 90 days after the last day which the IRS may assess a federal estate tax deficiency. This statute of limitations should also apply with respect to the collection of taxes from the PR personally. It specifically states that “no suit or other proceedings for the collection of any tax due under this chapter shall be begun after such date.” (Emphasis added.)27 The personal liability statute, F.S. §198.23, is in the same chapter (Chapter §198) as is this limitations period statute (§198.28). Thus, a written application under F.S. §198.19 could shorten the period in which a PR can be held personally liable by at least three years.
A PR’s exposure to personal liability for taxes owed by a decedent or by the estate can be reduced through: 1) the PR’s familiarity with the multitude of federal and state tax obligations imposed on a PR, as a fiduciary; 2) promptly obtaining a firm handle on the decedent’s and the estate’s tax liabilities and the current status and accuracy of filed and unfiled tax returns; 3) the immediate liquidation of estate assets to pay all of the decedent’s taxes and debts and the estate’s taxes and administration expenses; and 4) the implementation of measures to reduce exposure to personal liability. These measures include the filing of a Form 56 (at the commencement and termination of the PR’s fiduciary relationship), a Form 4810 (Request for Prompt Assessment for Income and Gift Taxes), and a Form 5495 (Request for Discharge from Personal Liability for Decedent’s Income and Gift Taxes); the use of I.R.C. §2204(d) to reduce personal liability attributable to a decedent’s gift taxes; and the written application to the FDOR under F.S. §198.19 for a discharge from personal liability for Florida estate taxes. A PR who timely and thoroughly completes these tasks goes a long way to protecting the PR from personal liability for the payment of federal and state taxes that may be imposed on the decedent or the decedent’s estate.
1 I.R.C. §2632.
2 Fiduciaries have an obligation to immediately liquidate sufficient assets so that there is cash on hand to pay the projected estate tax, debts, and administration expenses. Fiduciaries cannot “play the market” and try to gauge the optimum time during the nine-month period from the date of death until the estate tax is due. The reason for this is that, over the long term, equity stocks generally can be counted on to increase in value, but in time periods as short as nine months there is no statistical support that market timing will be successful. For a detailed discussion of this topic, see Roger C. Gibson, Asset Allocation: Balancing Financial Risk (Irwin Professional Publishing) (2d ed. 1996).
3 I.R.C. §1014(a)(1).
4 I.R.C. §6501(a).
5 Treas. Reg. §301.6903-1(c). “In the absence of Notice to the Secretary under §6903 of the existence of a fiduciary relationship, notice of a deficiency in respect of a tax . . . if mailed to the taxpayer at his last known address, shall be sufficient . . . even if such taxpayer is deceased . . . . ” I.R.C. §6212(b)(1).
6 I.R.C. §6901(g).
7 Prior to 2001, gift tax returns for Florida residents were required to be filed with the Atlanta IRS Service Center. In 2001, the IRS specified that gift tax returns were to be filed with the Cincinnati Service Center. Ann. 2001-74, 2001-2 C.B. 40. Thus, for pre-2002 gift tax returns it may be advisable to also file a Form 56 with the Atlanta Service Center.
8 Treas. Reg. §301.6903-1(b) and the Instructions to Form 56 state that a fiduciary must retain satisfactory evidence of his or her authority to act for any other person in a fiduciary capacity and be prepared to furnish evidence that substantiates such fiduciary authority.
9 Howard M. Zaritsky & Norman H. Lane, Federal Income Taxation of Estates and Trusts ¶16.01 (Warren, Gorham and Lamont, a division of RIA 2003).
11 Treas. Reg. §301.6905-1(a).
12 I.R.C. §6905(a).
13 Treas. Reg. §301.6905-1(a).
15 I.R.C. §6501(d).
17 Treas. Reg. §301.6501(d)-1(b); see also Instructions to Form 4810.
18 Treas. Reg. §301.6501(d)-1(b).
19 Rev. Rul. 72-338, 1972-2 CB 641.
20 I.R.C. §6013(d)(3).
21 Severt v. Commissioner, TC Memo 1998-34; see also Garfinkel v. Commissioner, 67 TC 1028 (1977).
22 Rev. Rul. 72-540, 1972-2 CB 641.
23 I.R.C. §2204.
24 I.R.C. §2204(a) and (c) and I.R.C. §6324A. The §6324A election would give the U.S. Government a lien on property, which need not be included in the decedent’s gross estate, and would allow the PR to avoid personal liability for the deferred estate taxes without furnishing a bond under I.R.C. §§2204 and 6165.
25 I.R.C. §2502; Treas. Reg. §25.2502-2.
26 I.R.C. §2204(d).
27 FLA. Stat. §198.28.
William C. Carroll is an associate with the law firm of Edwards & Angell, L.L.P. in West Palm Beach. His practice focuses exclusively in the areas of estate planning and estate and trust administration. Mr. Carroll received his J.D. and LL.M. in taxation from the University of Denver College of Law. He is board certified in both wills, trusts and estates law and tax law.
John “Randy” Randolph is a shareholder in Pressly & Pressly, P.A., West Palm Beach, where he devotes his practice exclusively to trust and estate matters. He is a board certified wills, trusts and estates lawyer as well as a board certified tax attorney. Mr. Randolph is a graduate of the University of Florida College of Law, with honors, and received his LL.M. from the University of Miami in estate planning.
The authors thank Jennifer Gurevitz, law clerk at Pressly & Pressly, for her assistance in preparing this article.
This column is submitted on behalf of the Real Property, Probate and Trust Law Section, Laird A. Lile, chair, and William P. Sklar and Richard R. Gans, editors.