A common concern of clients during the initial estate administration process is the debts of the decedent. Clients often wonder, who is responsible for paying the debts? Can the debt be forgiven? What happens if the estate does not have enough money to pay the debts?
These questions are all valid The answers to these questions can be found in case law, the Internal Revenue Code & Regulations and Pennsylvania statutory laws.
To make it easier, let’s answer the questions through the lens of a hypothetical estate - Ester’s estate. Ester, a Pennsylvania resident, died with $50,000 in credit card debt, medical expenses from her final illness, and various utility expenses associated with her West Chester Borough home. Ester’s assets are her home, and funds of $25,000 held in her checking and savings accounts. Ester’s children are the beneficiaries of her residuary estate per her Will.
Pennsylvania law, 20 Pa.C.S.A. Section 3381, states that Ester’s debts don’t just disappear at her death. If the debts don’t disappear, who pays? Only Ester’s Estate is responsible for payment of her debts unless a third-party (family member, neighbor, etc.) co-signed a loan or credit card with Ester. For now, let’s assume no one co-signed any loans with Ester. Ester’s credit card debt, her final medical expenses and her various utility expenses will be paid by her estate from the assets that pass pursuant to the terms of her Will. These assets are Ester’s home and the $25,000 funds from her checking and savings accounts. Ester’s Executor will need to sell the home and use the proceeds from the sale to pay off the credit card debt, final medical expenses and utility bills.
But what happens if Ester’s estate either fails to pay her credit card debts or cannot pay her credit card debt due to insolvency or the Executor attempts to have the credit card discharged?
If you recall, Ester has used her credit cards to purchase items worth $50,000. The borrowed funds used to purchase items are not included in Ester’s gross income because at the time Ester borrowed the funds she also created a corresponding liability to pay back the funds to the credit card companies. Ester’s overall net worth has not increased. Courts have consistently held that borrowed funds are not included in taxpayer’s income. The IRS has consistently agreed with this treatment. So, it would be logical to think that if the credit card companies forgive the debt, the debt should disappear, right? WRONG!!!!!
The general rule under the IRS Rules & Regulations states that the cancellation of a debt for less than adequate consideration causes the debtor to recognize ordinary income in the amount of debt that was forgiven. Section 61(a)(12) of the Internal Revenue Code states that gross income includes “[i]ncome from the discharge of indebtedness.” No matter how you slice it or dice it… “cancellation of indebtedness”, “cancellation of debt”, “discharge of debt”, and “forgiveness of debt” converts to ordinary income! The credit card companies report the forgiveness of debt to the IRS by using a 1099-C – Cancellation of Debt form. Even if the credit card company fails to issue a 1099-C form, the cancellation of debt income is still reportable on the estate fiduciary income tax return.
The $50,000 of credit card debt has been converted into income, which must be reported on the estate’s federal fiduciary income tax return, Form 1041 – US Income Tax Return for Estate and Trusts. Here, at the very least, Ester’s estate has $50,000 in reportable income to the IRS. If an estate has reportable income, it likely has income tax to pay unless the estate’s deductions wipe out income.
Below is a chart that shows the income tax rates for 2018 for an estate and trust:
A review of the chart above clearly shows that the income tax rates are much higher for an estate and trust. Using Ester’s estate as example, the cancellation of Ester’s credit card debt would result in federal income tax liability of $16,886.50 = $3,011.50 + (37% *(50,000-12,500)).
But what if Ester’s estate is insolvent?
Section 108 of the IRS Code provides exceptions for which Ester’s estate may be eligible. Section 108(a)(1)(B) excludes from gross income the cancellation of indebtedness of an insolvent debtor, but only to the extent of the amount of the debtor’s insolvency immediately before the debt was forgiven. Section 108(a)(3). So if Ester’s estate is insolvent prior to the debt being forgiven, the estate may exclude the cancellation of debt using IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.
It’s important to note that only assets that pass through probate are considered for determining insolvency. Recall probate assets are those assets that pass pursuant to the terms of a decedent’s Will. Here, probate assets would be Ester’s West Chester Borough home and the funds held in the checking and savings accounts. An estate with cancellation of debt income and very few probate assets will be insolvent if all assets pass directly to beneficiaries through beneficiary designations (life insurance, IRAs, 401(k)). Designated beneficiaries who receive these kinds of assets are not liable for paying a decedent's debts.
To recap, an estate is responsible for paying the decedent’s debt. If the debt is forgiven it becomes ordinary income reportable on the estate’s fiduciary income return regardless if a Form 1099-C was issued by the creditor. If the estate is insolvent, it may be able to exclude the cancellation of debt under Section 108(a)(3) of the IRC.
Before undertaking an estate administration without an attorney, remember the law is complex because (1) there are usually exception to the rules, (2) the law changes frequently, and (3) multiple areas of law can impact an estate, such as IRS Rules & Regulations, Pennsylvania statutory and case law .
If you have questions regarding debts and estate administration, please contact Mary R. LaSota at 215-345-8888 or email@example.com. Our Wills, Trusts & Estates attorneys have a thorough understanding of the tax laws and provide comprehensive legal services to assist you in all estate administration matters.
The information above is general: we recommend that you consult an attorney regarding your specific circumstances. The content of this information is not meant to be considered as legal advice or a substitute for legal representation.