Trustee Liability for Unpaid Trust Taxes

In Sarasota and Manatee Counties, a large share of estates never see the inside of a probate courtroom. Assets were titled in a revocable living trust, and at death a successor trustee takes over. It is efficient and private. It also means the successor trustee is doing much of what an executor would do, often without realizing it carries the same kinds of tax risk.

Two kinds of trust taxes

A trustee can face two different tax problems:

1. The trust's own taxes. After death, a revocable trust becomes irrevocable and becomes its own taxpayer. It earns income and owes income tax on Form 1041.
2. The decedent's taxes. Income taxes the decedent owed during life, gift taxes the decedent owed, and federal estate tax if the estate is large enough. The trust usually holds the money that has to pay them.

The rules for each are different, and the trustee's exposure depends on which one is unpaid.

The trust's own income tax

While the grantor was alive, a revocable trust was a grantor trust under IRC 671 through 679, specifically IRC 676 for revocable trusts. The grantor reported its income on a personal Form 1040. At death, that ends.

The trust now needs its own employer identification number. Under IRC 6012(a)(4), a trust must file a return if it has any taxable income, or gross income of $600 or more. The trustee files and signs Form 1041. Trusts generally must use a calendar year, unless the trustee and executor make the election under IRC 645 to treat the trust as part of the estate. See revocable trusts after death and the section 645 election.

Estimated tax gets a break. IRC 6654(l)(2)(B) exempts, for two years after death, a trust that was treated as owned by the decedent and that receives the residue of the estate under the will, or, if there is no will, is primarily responsible for paying the decedent's debts, taxes and administration expenses.

The trust's income tax is paid from trust assets. A trustee who files and pays on time has done the job. A trustee who lets years pass without filing, or distributes everything and leaves the trust unable to pay, has created a problem with the IRS and probably with the beneficiaries.

The decedent's estate tax

This is where trustee exposure is most direct.

The trustee may be the executor. IRC 2203 defines "executor" for estate tax purposes as the appointed executor or administrator, or if none is appointed, qualified and acting within the United States, any person in actual or constructive possession of any property of the decedent. With no probate, that is usually the successor trustee. Under IRC 2002, the executor is responsible for paying the estate tax.

The trustee may be personally liable. IRC 6324(a)(2) provides that if estate tax is not paid when due, a trustee who receives or has on the date of death property included in the gross estate under sections 2034 through 2042 is personally liable for the tax, up to the date-of-death value of that property. Revocable trust assets are included in the gross estate under IRC 2038. The statute names trustees specifically.

The special estate tax lien also attaches to trust property included in the gross estate, for ten years from death.

A trustee in that position should file the Form 706 on time, pay or arrange to pay the tax, and not distribute trust property until it is handled.

The decedent's income and gift taxes

For a decedent's unpaid income or gift taxes, the analysis runs through the estate. Those debts are owed by the decedent's estate, and the executor has the federal priority duty described in executor personal liability.

Florida law matters here. When the probate estate is not enough to pay the decedent's debts and expenses, Florida Statutes 733.707(3) makes a revocable trust liable for them, and Florida Statutes 736.05053 directs the trustee to pay the amounts the personal representative certifies are needed. So a Florida trust cannot simply sit on the sidelines while the estate's tax debts go unpaid.

And if a trustee distributes trust property to beneficiaries while the decedent's federal taxes go unpaid, the beneficiaries can face transferee liability under IRC 6901, and the trustee can face questions about why the money left before the IRS was paid.

Protective steps for trustees

1. File Form 56 for the trust and, if acting as the de facto executor, for the decedent. See Form 56.
2. Get an EIN for the trust and update the accounts.
3. Pull the decedent's transcripts to identify unpaid taxes and unfiled years.
4. Coordinate with any executor. If probate is open, agree in writing who files what and who pays what.
5. Reserve before distributing. Hold enough to cover realistic tax exposure until returns are filed and the assessment windows close or the IRS confirms acceptance.
6. Use the discharge tools. IRC 2204(b) lets a fiduciary other than the executor apply for a determination of estate tax for which the fiduciary may be personally liable, and for discharge. The guide to Form 5495 covers the process.
7. Get receipts and refunding agreements from beneficiaries for distributions made before the tax picture is final.

Co-trustees and professional trustees

Many Florida trusts name co-trustees, often two adult children, or a family member and a bank. Each co-trustee is a fiduciary. The IRS does not care which one handled the paperwork. If trust property was distributed while estate tax went unpaid, each trustee who received or held that property can be within the reach of IRC 6324(a)(2), up to the value involved.

Co-trustees should agree in writing on who files what, keep each other informed, and make sure every distribution is approved with the tax picture in view. A professional trustee will usually insist on reserves and releases before distributing. Family trustees should do the same, even when siblings push back. The siblings will forgive the delay. The IRS will not forgive the distribution.

Where the beneficiaries fit

Beneficiaries who receive trust distributions also receive Schedule K-1s for their share of the trust's income. If those K-1s are late or wrong, the IRS notices go to the beneficiaries, not the trustee, and the beneficiaries call the trustee. See beneficiary K-1 problems.

The trustee's own discharge request

IRC 2204(b) is written for fiduciaries like successor trustees. A fiduciary other than the executor can apply in writing for a determination of the estate tax for which the fiduciary may be personally liable, and for discharge. The application must include a copy of the trust instrument, a description of the property the fiduciary holds, and any other information the regulations require.

The IRS responds after the executor is discharged under IRC 2204(a), or six months after the trustee's application, whichever is later, by notifying the trustee of the amount for which it is liable or that it is not liable. When the trustee pays that amount, or receives a no-liability determination, the trustee is discharged from personal liability for any later deficiency. That is the trustee's clean exit.

Irrevocable trusts created during life

Trusts created during life, such as gift trusts for children, have their own issues. They file Form 1041 annually unless they are grantor trusts. Their funding may have required gift tax returns. And if the grantor retained interests or powers, the trust assets may be pulled back into the grantor's gross estate at death, bringing the trustee into the estate tax picture. The guide to when a Form 709 is required covers the funding side.

If you are a successor trustee and there are unpaid taxes in the picture, call (813) 229-7100 before you distribute. Let's talk.