When the Estate
Cannot Pay Its Debts
If an estate owes more than it owns, the order you pay bills in matters. Federal taxes generally come first, and an executor who pays others or gives money to the family first can end up owing the IRS personally.
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When there is not enough to pay everyone
Many estates have more bills than assets: credit cards, medical bills, a mortgage bigger than the house is worth. As executor, you are not personally responsible for the person’s debts. But you are responsible for paying them in the right order, and the tax rules add a trap that catches a lot of family executors.
Federal taxes generally come first
When an estate cannot pay all of its debts, federal law says taxes owed to the IRS must be paid before most other debts. If you pay other creditors, or give money to the family, yourself included, before paying federal taxes you knew about or should have looked into, you can become personally liable for the unpaid tax, up to the amount you paid out.
Some costs can be paid first: the costs of settling the estate (such as court costs and reasonable attorney and executor fees), reasonable funeral expenses, and certain family allowances. Most other bills, including the last medical bills, wait behind the IRS.
A common order of payment
| Order | Class of claim |
|---|---|
| 1 | Costs and expenses of administration |
| 2 | Reasonable funeral expenses |
| 3 | Debts and taxes with preference under federal law, including federal taxes |
| 4 | Reasonable medical and hospital expenses of the last illness |
| 5 | Debts and taxes with preference under state law |
| 6 | All other claims |
| Then | Anything left goes to the heirs and beneficiaries |
Steps that protect you
- Find out what is owed before paying anyone. We pull the IRS records to see unpaid taxes and unfiled returns.
- File the returns: the person’s final Form 1040 and any earlier years, and the estate’s own Form 1041.
- Ask the IRS to close the books early. After the returns are filed, two requests limit how long the IRS can come back and whether you can be held personally responsible.
- Pay in the right order, and keep money back before paying lower-priority bills or distributing anything to the family.
Two requests to file after the returns
| Request | What it does | Covers |
|---|---|---|
| Form 4810, prompt assessment | The IRS must assess any additional tax within 18 months of the request | The decedent’s returns and the estate’s income tax returns; not the estate tax |
| Form 5495, discharge from personal liability | Once the IRS’s stated amount is paid, or 9 months pass without notice, the executor is released from personal liability for later-found deficiencies | Estate tax, and the decedent’s own income and gift taxes |
Forgiven debts and the house
- Forms 1099-C: creditors that write off the person’s debts may send a 1099-C for canceled debt. It usually does not create tax for an estate that owed more than it owned, but it has to be reported and excluded on the estate’s return, with a calculation showing the estate was insolvent.
- A house worth less than the mortgage: a short sale or foreclosure has tax consequences that depend on the type of loan. In some cases the result is a gain that the insolvency rules cannot cover, so it is worth reviewing before the sale.
- Refunds: a refund on the final return may be taken to pay other government debts before the estate receives it.
What the family does not owe
Family members generally do not have to pay a relative’s debts from their own money, unless they co-signed, shared the account, or live in a state where spouses can be responsible. Debt collectors may not suggest otherwise. But anyone who received estate property before the IRS was paid can be asked to give it back up to what they received, and some states recover Medicaid nursing home costs from the estate after a surviving spouse has died.
The order of payment and creditor deadlines are set by state law, so your attorney should confirm the plan. We handle the tax side and the records that show you paid everything in the right order.
What we handle
- Checking IRS records for unpaid taxes and unfiled returns
- The final 1040, the estate’s 1041, and any back returns
- The requests that limit your personal liability
- Reporting canceled debts and property sales correctly
- An accounting that shows every payment in order
Frequently Asked Questions
Am I personally responsible for the debts of the person who died?
Generally no. The estate’s assets pay the debts, and family members do not have to use their own money unless they co-signed, shared the account, or live in a state where spouses can be responsible. But as executor, you can become personally liable for unpaid federal taxes if you pay other creditors or distribute to the family before paying taxes you knew about or should have looked into.
Which bills get paid first if there is not enough money?
The costs of settling the estate, reasonable funeral expenses, and certain family allowances generally come first. Federal taxes come next, ahead of most other debts, including the last medical bills and credit cards. The exact order is set by state law, so confirm it with the estate’s attorney.
How can I protect myself from IRS liability as executor?
Find out what is owed before paying anyone, file all the required returns, and then file the requests that shorten the time the IRS has to assess more tax (Form 4810) and release you from personal liability (Form 5495). Pay claims in order and keep reserves before paying lower-priority bills or distributing to the family.
A creditor sent a 1099-C for a canceled debt of the person who died. Is that taxable?
Canceled debt can be income, but an estate that owed more than it owned can generally exclude it under the insolvency rule. The 1099-C still has to be reported, and the exclusion claimed with a calculation showing the estate was insolvent, on the estate’s income tax return.