What You Need To Do When A Decedent Has Outstanding Tax Returns Or Outstanding Tax Liabilities?

A taxpayer who dies with unfiled income tax returns and/or outstanding tax liabilities to the IRS or any State tax agency complicates the administration of the decedent’s estate or trust.  That is because the estate or trust will now be accountable to creditors, including the IRS and State tax agencies given that the decedent’s rights, liabilities, assets and interests transfer to their estate when they pass away. Because the resolution of these tax issues will require the appointment of a personal representative, it is necessary to first open a probate administration.

What is Probate?

Probate is the field of law that determines how an estate must be divided. Each state has its own laws and statutes requirements to determine if and how an estate must be probated. The probate court will supervise the process when a deceased person (a decedent) leaves assets to distribute, such as bank accounts, real estate, and financial investments with or without a will. The probate court provides the final ruling on the division and distribution of assets to beneficiaries.

In many cases, the decedent has established documentation, which contains instructions on how their assets should be distributed after death and designates in such documents who oversees implementing this process.  This involves collecting the deceased’s assets to pay any remaining liabilities on their estate and distributing the assets to beneficiaries. Where a decedent fails to establish such documents while alive, State law and the probate courts will dictate how the estate is administered and to whom assets get distributed to.

Probate With a Will 

A deceased person with a Will is known as a testator and he or she is deemed to have died “testate.” When a testator dies, the person designated as the executor under the Will is responsible for initiating the probate process. The probate process for a testate estate includes distributing the decedent’s assets according to the Will.

Probate Without a Will 

When a person dies without a Will, a person is to have died intestate. An intestate estate can also occur when a written Will is presented to the probate court and the probate court has been deemed the Will to be invalid. The probate process for an intestate estate includes distributing the decedent’s assets according to State law.

What Is The Probate Process?

A probate court proceeding begins with the appointment of an administrator or executor to oversee the estate of the deceased person. Such personal is typically called the “personal representative.”  The personal representative receives all legal claims against the estate and paying off the outstanding debts. Also, the personal representative is tasked with locating any legal heirs of the deceased, including surviving spouses, children, and parents. Then the probate court will assess what assets need to be distributed among the legal heirs and how to distribute them.

Where a personal representative knows that there are outstanding tax liabilities, the personal representative must provide Notice Of Administration to the IRS and applicable State tax agencies which provide instructions for such tax creditor to file a Proof Of a Claim with the probate court.  Where the amounts claimed as outstanding by the tax agencies are incorrect and overstated, the personal representative has the opportunity to dispute such claim which will eventually be heard by the probate court.  Such errors usually occur where the tax agencies did not properly post payments, has yet to process late-filed tax returns or amended tax returns, or the liabilities are based on returns created by the tax agencies and not based on returns filed by the decedent.  It is in the best interest of the personal representative to make sure these tax liabilities are accurate even if it means having the outstanding tax returns prepared or amended income tax returns filed as the failure to cover unpaid taxes from the deceased’s estate is considered to be a breach of fiduciary duty which can impose personal liability on the personal representative.

How Are Outstanding Tax Liabilities Paid?

The collectability of a decedent’s outstanding tax liabilities is typically limited to the value in their estate. Though, there are also situations where a beneficiary may incur tax liabilities for assets he or she receives from the estate such as inheriting real estate owned by the decedent if the personal representative transfers legal title to a beneficiary with unpaid property taxes.

Usually, beneficiaries do not pay income taxes on assets they inherit. There are exceptions regarding retirement accounts, proceeds from life insurance and savings bond interest. Inheritance from an individual retirement account (IRA), 401(k) or 403(b) is taxable if the money was tax deductible at the time the decedent contributed. If there are non-deductible contributions in the account, a portion of the account may be non-taxable. However, a surviving spouse who inherits money from certain retirement accounts of the decedent may roll over the money into their retirement accounts to defer taxes.

Beneficiaries who inherit proceeds from Roth IRAs should not pay taxes on the withdrawals because the contributions made by the decedent were not tax deductible. Furthermore, beneficiaries may not be required to pay taxes on the proceeds that the contributions generate so long as the account is five years old or older.

For life insurance contributions, beneficiaries do not usually pay taxes on the proceeds except on that portion of the proceeds that includes interest. Beneficiaries may also pay taxes if the policy was transferred to them for cash or other valuable consideration. Beneficiaries who inherit savings bonds may pay taxes if the bonds mature and if the beneficiaries redeem the bonds after the original owner deferred the tax. Also, some States have what is called an “inheritance tax” where a beneficiary who inherits from an estate has to pay the State tax on the value that he or she receives. It is the law of the State where the beneficiary resides and not the law where the decedent was domiciled that dictates applicability.

The IRS and any State tax agency can only enforce its claim for unpaid taxes through the decedent’s estate and if the decedent dies without assets or if there are insufficient funds from the estate, those taxes may go unpaid. The IRS cannot transfer the tax liability to another person, except to a surviving spouse when such spouse filed a joint tax return with the decedent, the decedent owed back taxes on a return involving a property they co-owned with the surviving spouse that they filed as married filed separately, or the couple lives in a community property state.

Spouses who believe the IRS or State tax agency is wrongly holding them responsible for their deceased partner’s taxes can apply for innocent spousal relief from the IRS or State tax agency. Innocent spouse relief can protect spouses from paying additional taxes, interest and penalties if the deceased spouse failed to report their income, misreported their income, claimed tax deductions and credits incorrectly, or omitted items on a tax return. Also, a surviving spouse can file a joint tax return for the last year the deceased was alive. Spouses can file as a qualifying widow or widower for two tax years following their spouse’s death if they have a qualifying dependent, which allows surviving spouses to claim standard deductions as a married couple.

How To Determine The Amount Of Back Taxes A Decedent Owes?

For a beneficiary, executor, or administrator to determine the amount of back taxes a decedent potentially owes one must contact the IRS and inform them that you are authorized to receive the decedent’s tax records. This is done by filing a Form 56, Notice Concerning A Fiduciary Relationship. Additionally, a variety of transcripts can be secured from IRS that provides information about the decedent’s previous tax returns and how much they owe.

What Should You Do?

At the Law Offices Of Jeffrey B. Kahn, P.C. we are always thinking of ways that our clients can save on taxes, trusts and estates planning, and probate matters. When there are outstanding tax liabilities or outstanding tax returns, the expertise of a skilled lawyer at the  Law Offices Of Jeffrey B. Kahn, P.C. is needed to help protect the interests of the parties involved. The tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), Los Angeles and elsewhere in California are highly skilled in handling tax and probate matters and can effectively represent at all levels with the IRS and State Tax Agencies including criminal tax investigations and attempted prosecutions, undisclosed foreign bank accounts and other foreign assets, and unreported foreign income. Also, if you are involved in cannabis, check out what our cannabis tax attorney can do for you. Additionally, if you are involved in cryptocurrency, check out what a bitcoin tax attorney can do for you.