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Trustees and Executors Should Worry When Taxes are Owed: The Federal Insolvency Statute

What is the Federal Insolvency Statute?

Where the delinquent taxpayer is insolvent but has not filed a petition in bankruptcy, the IRS’ prior right to payment is established by the Federal Insolvency Statute, 31 U.S.C. § 3713(a). That statute states, in relevant part:

(a)(1) A claim of the United States Government shall be paid first when –
(A) a person is indebted to the Government and is insolvent and –
(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;
(ii) property of the debtor, if absent, is attached; or
(iii) an act of bankruptcy is committed; * * *

The statute is rooted in English common law and embodies the philosophy that “The king’s debtor is dying, the king shall first be paid.” Magna Carta, 1225, 9 Hen. 3, c. 18; See also United States v. Moore, 423 U.S. 77, 81-82, 96 S. Ct. 310, 313 (1975); United States v. State Bank of North Carolina, U.S. 29 (1932). The statute is liberally construed to effect the purpose of securing adequate revenue to the United States Treasury. Moore, 423 U.S. at 86.

Can an Executor, Conservator, or Trustee of a Trust or Estate that owes taxes be personally liable?

In certain circumstances, yes. Under subsection (b) the federal insolvency statute, “A representative of a person or an estate (except a trustee acting under title 11) 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.” 31 U.S.C. § 3713(b). Thus, an executor, conservator, or trustee whose estate or trust is insolvent and who, after an “act of bankruptcy,” does not pay a priority claim of the IRS first, will be personally liable. The Federal Insolvency Statute is applicable in tax cases. It is well settled that taxes are claims of the United States. See, e.g., Price v. United States, 269 U.S. 492, 46 S. Ct. 180 (1926) (applying predecessor to section 3713, stating that “the claim for taxes is paramount to all other claims against the citizen”).

Also, an estate or trust is insolvent as required by part (a)(1)(A) when it owes more than it has in assets. “Insolvent” has long been understood to mean insolvent in the bankruptcy sense, which is when the debtor does not have enough property to pay all debts. United States v. Oklahoma, 261 U.S. 253, 260-61 (1923) (applying predecessor to section 3713); United States v. Key, 397 U.S. 322, 328 n. 7 90 S. Ct. 1049, 1053 n. 7 (1970) (same). See also Lakeshore Apartments, Inc.v. United States, 351 F.2d 349, 353 (9th Cir. 1965). When the total of the tax debt plus other debts exceeds the property of a trust or estate, it is insolvent.

Placing assets in the control of the probate court, in a conservatorship, over an estate and distributing assets to the conservatee and to creditors satisfies the “act of bankruptcy” requirement under subpart (iii). See United States v. New York Ins. Dep’t., 657 F. Supp. 27, 29 n.2 (S.D.N.Y. 1986) (finding that government would also be entitled to priority under section 3713 on claim to money held in conservatorship); In re Taxable Municipal Bond Securities Litigation, 1991 WL 197 164 *5, 1991 U.S. Dist. LEXIS 13449 *16 (E.D. La. 1991) (“A predominant function of the conservatorship proceeding is to prioritize claims… .”); United States v. Oxner, 229 F.Supp. 58, 60 (E.D. Ark. 1964) (predecessor statute to 31 U.S.C. 3713 applied to state court guardianship proceedings, and therefore, guardian who made payment to her ward did so at her peril and became personally liable for United States’ claim); Conservatorship of Hume v. Hume, 139 Cal . App. 4th 393, 400 (2006) (traditionally, state courts subject local assets to their probate administration to protect local creditors); Lakeshore Apts., Inc., 351 F.2d at 353 (acts of bankruptcy includes giving preference to creditors).

But, the IRS is not always first. Under 26 U.S.C. § 6323(a), the exception to the Federal insolvency statute exists when a judgment creditor has a perfected lien recorded before the Federal tax lien is recorded.

When a trustee, conservator, or executor of an estate is concerned with their own liability due to potential decisions to pay those other than the IRS, an interpleader action is often considered. Interpleader actions are authorized by 28 U.S.C. § 1335 and Rule 22 of the Federal Rules of Civil Procedure where persons holding funds to property upon which conflicting claims are being made by others may deposit the funds with the District Court and require the other parties to litigate their interests.  Libby v. City Nat’l Bank, 592 F.2d 504, 507 (1978). Because the risk of handling these issues wrong can be high, it is important to consult with or retain experienced counsel.

Posted on 3/12/2019 by Daniel W. Layton. Mr. Layton is a tax attorney with offices in Newport Beach and Manhattan Beach, California, whose experience includes the IRS Office of Chief Counsel and the U.S. Dept. of Justice, U.S. Attorney’s Office, Tax Division.