Debts Owed by Insolvent Taxpayers to the IRS

As we have mentioned on many occasions, Les suggested that we start this blog because of the work we do to update the treatise “IRS Practice and Procedure.”  At the moment Marilyn Ames, my former colleague in IRS Chief Counsel and occasional guest blogger, and I are updating and rewriting Chapter 16 of the treatise dealing with the priority of IRS debtor over other creditors.  In updating the chapter Marilyn found several important cases in the area of the priority of IRS debt for insolvent debtors which we have not written about on the blog.  In this post she discusses several of these cases as well as the general background of the insolvency procedures.  For those of you who use the treatise or who may consider using it in the future, look for major changes to Chapter 16, including major changes to the bankruptcy section, in the next several months.  Keith

Lurking in Title 31 of the United States Code is an unpleasant surprise for all creditors whose debtor also owes a debt to the United States.  This provision, located at 31 USC § 3713 and known as the Federal Priority Statute, has been in force without material change since 1797, and was held to be constitutional in 1805 in United States v. Fisher, 6 US 358 (1805). This statute provides that when a person indebted to the United States is insolvent and some action occurs such as the debtor making a voluntary assignment of his property that threatens the government’s ability to collect its debt, or when a deceased debtor dies and the property of the estate is insufficient to pay all the debts of the debtor, the claim of the United States is to be paid first. Section 3713 does not create a lien; the government’s priority is created solely by the statute. The only statutory exception in Section 3713 was added when the Bankruptcy Code was passed to provide that Section 3713 does not apply in a bankruptcy case brought under Title 11.

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To create an incentive for the United States to receive its priority payment, the fiduciary holding the property of the person or administering the debtor’s estate can be held personally liable if the claim of the United States cannot be paid in full after the fiduciary pays any other debt over which the United States’ claim has priority, provided the fiduciary knew about the debt to the United States when the payment to a lesser creditor was made.

When the claim owed to the United States originates within the Internal Revenue Code, Section 3713 is not as easily applied as appears on its face. Congress later provided protection to third parties, including creditors, against the vast reach of the federal tax lien that arises when a tax debt has been assessed and remains unpaid when it passed the Federal Tax Lien Act of 1966, codified in Section 6324.  In Section 6324 of the Internal Revenue Code, Congress listed various parties who should be given a priority position against a tax debt. So, when the stars align and both the United States and a private creditor claim priority to a debtor’s limited assets under these competing statutes, who should be paid first? In United States v. Romani, 523 US 517 (1998), the Supreme Court addressed this and held that Section 6324 represented Congress’s judgment as to when a federal lien for unpaid taxes is not valid against certain third parties, and that Section 3713 should yield to this later Congressional act when there is not enough money to pay both the United States and the third party.

The courts have also created judicial exceptions that limit the reach of the Federal Priority Act.  The costs of administering the estate of the debtor may be paid before a tax claim, including such expenses as court costs and reasonable compensation for the fiduciary and other professionals such as attorneys. Funeral expenses and spousal allowances have also been allowed before the government’s claim. However, in United States v. McNicol, 118 AFTR2d 2015-5150, 829 F3d 77 (1st Cir. 2016), the court held that the fiduciary must be able to show that the property transferred was used to pay these expenses.

So what is a fiduciary to do when it is unclear who the debtor’s limited funds should go to? One popular remedy is to file an interpleader action, joining all possible adverse claimants to the funds, and allow the court to sort out the priorities. This procedure is illustrated in the case of Karen Field, Trustee of Deshon Revocable Trust v. United States, 129 AFTR2d 2022-1007 (ED Ca. 2022), in which the court determined who had priority to the funds and in what order the claims should be paid – or remain unpaid. In this case, the decedent had embezzled funds, taxes were owed on the embezzled money to both the federal and state governments, and the victims of the embezzlement wanted to be repaid. The Department of Justice Tax Division has a directive that when the tax claim and the claim of the victims of embezzlement arise from the same transaction and the funds at issue can be traced to the victims’ property the victims should be paid before the tax claim. Despite this directive, the court applied Section 3713 and gave the tax claim priority, holding that the directive in question is merely internal agency policy, and not a source of enforceable legal rights for the victims.  The procedural aspects of an interpleader action are also illustrated in Findling v. United States, 121 AFTR2d 2018-1450 (ED Mich. 2018).

In another case involving government policy, the court took a contrary position in Estate of Graham v. Wells Fargo Bank, 2022 WL 2300940 (Cal. App. 3 Dist. 2022), when the executor of an estate asked the trial court to determine the order in which the proceeds from sale of a piece of estate property should be distributed.  The executor requested that the federal taxes be paid first pursuant to Section 3713, but the court held that the federal taxes did not take priority over a purchase money security interest with respect to the property in question. Although Section 6324 says nothing about purchase money security interests, the Service announced in Rev. Rul. 68-57, 1968-1 CB 553 (1968) that a perfected security would be given priority over a federal tax lien with respect to the property the loan was used to acquire. Accordingly, the claim of the bank advancing the money for purchase of the property should be paid before the federal tax liability.

The potential danger to a fiduciary in not paying a tax claim entitled to priority is illustrated in the recent case of Estate of Lee v. Comm’r of Internal Revenue, 2022 WL 3594523 (3rd Cir. 2022), a CDP case in which 3713 played a pivotal role.  The estate taxes owed by the petitioner in this case had been miscalculated, resulting in a deficiency, and the estate requested that the Internal Revenue Service accept an offer-in-compromise as the estate assets had been distributed to the beneficiaries, including over $640,000 paid out after the notice of deficiency was issued.  The Service rejected the offer made, taking the position that the reasonable collection probability was greater than the amount offered.  The Tax Court agreed that the IRS did not abuse its discretion in rejecting the OIC, and the Third Circuit agreed, pointing out that the government could seek to collect from the fiduciary, who had distributed assets after learning of the tax claim and so could be held personally liable.

For a statute that clearly states that the United States should be paid first, and that a fiduciary who fails to do so may need to pay the claim from the fiduciary’s funds, Section 3713 is not as clear as a mere reading would make it seem.  Given the holding in Estate of Romani, the judicially created exceptions for administrative expenses, and the question of whether a government policy directive waiving the right to payment first applies – or doesn’t – any professional even dealing tangentially with insolvent debtors or estates should be familiar with the existence of Section 3713 and its implications on when the United States should be paid before other creditors.

Burden of Proof in Fiduciary Liability Case

I recently wrote about a fiduciary liability case in which the fiduciary of a trust was held personally liable for the unpaid taxes of a trust.  In that post I discussed the requirements that 31 U.S.C. 3713(b) imposes on a fiduciary.  On March 14 of this year, Judge Nega of the Tax Court rendered an opinion in Singer v. Commissioner, T.C. Memo 2016-48 in which he determined that the executor of a decedent’s estate was not liable for unpaid estate taxes.  In the opinion the judge grappled with the issue of who bore the burden of proof on the issue of insolvency.  It is surprising both that this issue still exists regarding a statute that traces its roots back to 1789 and that in resolving this issue the Tax Court assigned the case to its non-precedential grouping of cases.


Before focusing on the burden of proof issue, the facts of the case and the resolution of an offer in compromise deserve some attention. The decedent was a lawyer in New York City and a partner in the law firm of Sacks and Sacks.  He accumulated a fair amount of assets and income tax liabilities during his life.  He must have lived an interesting life based on the distribution of his assets.  He was married at the time of his death but had not lived with his wife for over 25 years.  He lived primarily with Ms. Atwell whom he never married but also lived at times with Ms. Parker.  He purchased property with both Ms. Atwell and Ms. Parker as joint tenants with rights of survivorship.  Perhaps it is not surprising that he was not paying his taxes given his other obligations.  At the time of his death in 1990, he owed income taxes for several years totalling something between $1.7 and $4 million.

The first issue that the Court addressed involved the compromise of the income tax debt by the estate. The confusion over whether a compromise occurs casts significant doubt on the business records of the IRS.  Just as its business records were cast into doubt in the case of Grauer v. Commissioner discussed in the post written recently by Les, the issue of whether the IRS compromised the income tax liabilities of Mr. Singer formed the basis for a dispute between the parties one would expect the business records of the IRS to resolve.  The IRS argued that it never received the $1 million dollar payment from the estate to consummate the offer and the Court finds that it did.  That’s a pretty big discrepancy and failure of proof and should concern the IRS.  Taking an offer from an estate is a bad practice in my opinion.  The estate assets are fixed.  The estate has a duty to pay all of the taxes to the extent estate assets exist allowing it to do so.  For the same reason that the IRS has a policy of refusing to consider offers in compromise during bankruptcy cases because a statutory regime exists for the payment of the taxes, I could never see any benefit in entering into a compromise with a decedent’s estate.  Nonetheless, the IRS did so here agreeing to compromise a liability described in the offer documents as exceeding $4 million dollars for a payment of $1 million.  The existence of the agreement is clear in the record but the IRS says it never received payment.  The Tax Court finds that it did.  While this is not the focus of the case, this finding is somewhat remarkable as a statement of the business records of the IRS and its inability to prove that it did not receive a payment of this amount.  The compromise of the debt becomes important in the application of 3713(b) because it impacts the insolvency calculation.

Once the Court disposes of the income taxes by determining the parties had a consummated offer in compromise, it turns its attention to the primary focus of the case which is the liability of the executor for paying out estate assets while not paying the federal estate taxes. At issue is whether the executor made payments that rendered the estate insolvent and unable to pay the estate taxes.  To determine if the executor made the type of distributions that will result in a personal liability for him, the Court must look at the three tests necessary to create 3713(b) liability: 1) knowledge of tax owing – not an issue here; 2) a distribution from the estate – not an issue here; and 3) insolvency at the time of distribution.  The third test, the only issue in this case, requires examine the value of the estate at the time of the distributions and the amount of the distributions.  The insolvency test used in 3713(b) is a balance sheet test that looks at whether the liabilities exceed the assets.

On April 15, 1999, the executor asked the surrogate court for permission to pay $753,321 from a brokerage account of the estate to three parties: 1) $251,107 to the estate of the wife of Mr. Sacks; 2) $446,772 to the IRS; and 3) $171,587 to the New York tax department.  The IRS argued that the payments to Mr. Sack’s wife’s estate and to New York breached his fiduciary duty to pay the estate taxes.  If these payments rendered the estate insolvent or were made when it was insolvent, then the executor would have a 3713 problem.  The IRS said that the burden was on the executor to show that the estate was not insolvent at the time of or as a result of these distributions.  The executor countered that the IRS had the burden to show insolvency and that it had the burden to show that the executor had knowledge that the debts for the taxes existed.  It seems as though a statute of the age of this one would have a clear answer to this question but apparently it does not either in the language of the statute or in the decisional law over the past two centuries.  So, the Court must decide this basic question of procedure before it can move forward to evaluate the proof offered.

The Court looked at some very old cases and some newer cases in deciding that the burden of proof of insolvency rested with the IRS. Even though the Court designated that its decision here should be a non-precedential memorandum opinion, the opinion itself cites to several memorandum opinions provided to it by both sides because of the lack of a precedential opinion in the Tax Court on this issue.  Add to that list yet one more non-precedential opinion for future litigants to cite as precedent for who has the burden of proof.  Is it time yet to rethink the role of precedent in Tax Court cases?  Has the exception for what is precedential overtaken the rule.  For anyone who has not yet read the previous discussion of the Tax Court’s nominal rules concerning what is and what is not precedent, here, here, here and here are links to Andy Grewal’s posts on this issue.

After taking several pages to set the scene, the Court gets down to deciding whether the distribution in this case will result in personal liability to the executor. Under New York law if a fiduciary must pay federal or state taxes related to property in the gross estate the amount of the tax is “equitably apportioned among the persons interested in the gross taxable estate.”  Here, several individuals received property included in the gross estate and therefore bore responsibility for paying a portion of the estate’s taxes.  Property from the gross estate went to two women with whom he bought property as joint tenants, some went to a former law partner and some to grandchildren.  The Second Circuit requires valuing the contingent subrogation and contribution rights as assets in determining insolvency.  The Court found that the IRS did not prove that the value of the subrogation and contribution rights was so low that the estate was insolvent at the time of the distribution.  So, the executor does not end up with a personal liability as a result of the distributions.


Trustee Personally Liable Based on Application of Insolvency Statute

We have not previously done a post on the insolvency statute. Our failure to cover this topic cannot be the source of the problem for Randy Read in the case, recently decided against him, which was brought by the United States.  Perhaps someone reading this post will be saved from the personal liability that has now befallen Mr. Read.

The insolvency statute is not found in title 26 with the rest of the internal revenue laws and is not found in title 11 with the bankruptcy laws but rests in title 31 at section 3713. This statute can trace its roots back to the very beginning of the United States and was one of the first laws passed when we formed as a nation.  It can trace its roots back further into English common law and the statement “the King’s debtor dying, the King comes first.”  The insolvency statute does not apply only to tax debts but to all debts owed to the United States.  The application of the insolvency statute to tax debts, in fact, took a nasty turn for the IRS almost 20 years ago in a Supreme Court case named Romani.


Before the Supreme Court decision in Romani, the IRS took the position that it could defeat other creditors to whom it might otherwise lose if the party over whom the IRS was fighting for scraps to satisfy its liability was insolvent and not in bankruptcy.  The insolvency statute does not apply in bankruptcy cases which provide a more specific regime for resolving the priority of creditors.  The application of the insolvency statute, at least in tax cases, comes up most frequently in the circumstances of insolvent decedent’s estates.  In Romani, a judgment creditor properly recorded a judgment before the IRS recorded its notice of federal tax lien.  In the absence of the application of the insolvency statute, the judgment creditor would defeat the IRS in a fight for the taxpayer’s assets because of 6323(a) which gives priority to judgment creditors who record prior to the filing of the notice of federal tax lien.

Mr. Romani passed away. His estate contained an asset of some value but not enough value to satisfy both the judgment lien and the tax lien.  The IRS argued that it defeated the judgment lien based on the insolvency statute even though it would lose under 6323(a).  The judgment creditor did not like that result and the case worked its way to the Supreme Court which found that the Federal Tax Lien Act of 1966 establishing the currently applicable lien law in the internal revenue code created a more specific statement of Congressional intent than the general provision of the insolvency statute.  Construing the statutes, the Court found that the specific should take precedence over the general and the IRS loses when competing against a judgment lien creditor that would defeat it under the statute scheme of 6323 specifically designed to decide priority fights between the tax lien and other creditors.  The Romani decision certainly disappointed the IRS but it does not completely eliminate the insolvency statute from the federal tax world as Mr. Read found out to his sorrow.

In 1999 Mr. Read established a trust for his children with himself as trustee. His wife had some stock options with which the trust was settled.  The trust had a value of over $700,000 in 1999.  In 2000 the trust filed a request for extension to file its return indicating a liability of over $121,000.  Mr. Read was aware of this liability.  By June 2001, at which time the trust still owed the taxes, the value of the trust had dropped to about $163,000.  Between July 5 and July 30, 2001, Mr. Read made four payments totaling $25,000 for home improvements.  These seemed to be improvements on his home and not the home of one of the children beneficiaries.  The opinion does not state whether the repairs specifically benefited the children by creating a home theater.  I got the impression Mr. Read was using the trust for personal rather than trust reasons but that may be an inappropriate assumption.  He then disbursed another $25,000 on July 31 to himself bringing the value of the trust to $108,000.  From that time until January 2010, the value of the trust never exceeded the amount owed to the IRS which remained unpaid throughout this period.  Market gains during this period allowed him to disburse almost $200,000 from the trust which was used for renovating his house, investing in real estate (I assume investing by him and not the children), paying for private preschool education and summer camp.  He wrote about $80,000 in checks directly to himself which is not a good fact for him in this situation.

The opinion does not state what efforts the IRS made to collect the tax during this decade long use of trust funds to primarily benefit Mr. Read while not paying the taxes of the trust, but at some point the IRS must have tired of corresponding with the trust. Like many of my clients, Mr. Read may have concluded that the IRS primarily exists to send correspondence.  Because it sends so much correspondence before it starts taking people’s stuff, many people seem to think they can ignore the correspondence and one day the IRS will just go away.  So, I imagine that one day a revenue officer in Connecticut sent a suit referral to the District Counsel’s office in Hartford, which, in turn, sent a suit referral letter to the Department of Justice Tax Division, in Washington, D.C., which in turn brought suit against Mr. Read in Federal District Court citing to the insolvency statute and seeking to hold him personally liable for the unpaid taxes of the trust allegedly established for his children.  I imagine Mr. Read was surprised when the suit was served on him but maybe not.  After filing the suit, the government moved for summary judgment.

The Court started with the statutory language of 31 U.S.C. 3713(a)(1)(A)(i) by saying “an insolvent person who is indebted to the United States must first pay the claims of the United States before voluntarily assigning property to others.” It followed this statement of the general rule that applies to insolvent debtors with a quote from 31 U.S.C. 3713(b) concerning those responsible for the insolvent debtors: “A representative of [an insolvent] person or an [insolvent] estate (except a trustee acting under [the Bankruptcy Code]) 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.”  The court found that Mr. Read would have personal liability under the insolvency statute if, as trustee, he distributed trust assets while the trust was insolvent and he knew or had notice of the debt due to the United States.  The government put on the evidence of the liability and his knowledge of the liability and his payments from the trust.  Mr. Read did not refute the evidence of the government.  The court found that he owed the full amount of the outstanding federal tax debt, which now stands at over $213,000 because of interest and penalty accruals over the years.  He made total distributions of over $197,000.  He has since made payments of about $22,000, so it entered a judgment against him for $175,042.16.

The government did not stop at that point but also requested prejudgment interest. This type of interest is not routinely awarded and the district court has a fair amount of discretion in deciding whether to award it.  The court found that most insolvency statute cases decline to award prejudgment interest.  Here, the court found such interest appropriate citing several factors: 1) the need to fully compensate the wronged party; and 2) considerations of fairness because he was self-dealing.  In many cases in which individuals get hit with personal liability, they make a poor business decision with assets of an estate or trust or they distribute to beneficiaries when they should have paid taxes.  This type of action can trigger the liability but the individuals held liable are frequently sympathetic and often are serving in a fiduciary capacity for the first time.  Here, Mr. Read evoked little or no sympathy.  Whether the IRS ultimately gets paid is another question but Mr. Read now has a personal judgment against him that will stay there for a very long time.