If a debt of a taxpayer is canceled after the death of the taxpayer, the cancellation of debt (COD) income is income to the estate or the non-grantor trust of the decedent and reportable as income on the 1041 return for the estate or non-grantor trust (Reg. 1.108-9(c)(2)) to the extent the estate or non-grantor trust is solvent.
The Code Sec 108(a)(1)(B) insolvency exclusion applies to estates and non-grantor trusts just as it applies to individuals, so the COD income is only taxable to the extent the estate or non-grantor trust is solvent and would be reportable on the 1041 return. Section 108 does not apply to partnerships or a disregarded entity (Reg. 1.108-9(a)(1)) and thus the COD income is passed through to the partners or a Schedule C owner (i.e., a single member limited liability company not electing to be taxed as a C corporation). With regards to Sub S corporations, the Sec108(a)(1)(B) insolvency exclusion applies at the corporation level (Sec 108(d)(7)(A)).
Generally, COD income is taxable to the estate under Section 61(a)(12) and reported on Form 1041. The resulting tax liability is payable by the estate. However, if the estate is insolvent, COD income is excludable to the extent section 108 applies, i.e., to the extent the estate’s liabilities exceed its assets.
But watch out; the IRS has the authority to assess the beneficiaries of the insolvent estate for the tax owed by the estate under the transferee provisions of IRC Sec 6901. A transferee for purposes of Sec 6901 includes beneficiaries who have received property from the estate. While the transferee assessment and collection process is the same under Sec 6901, strict statute of limitations periods apply and the burden of proof is on the IRS. (See Section 6902)
31 U.S.C. 3713 gives priority to claims of the government to be satisfied before other creditors are paid and before distributions are made to beneficiaries. The language of 31 U.S.C. 3713 is “A claim of the United States Government shall be paid first….” Under this provision an executor who distributes estate assets instead of using them to pay the estate’s tax obligations can be held personally liable for the unpaid taxes up to the extent of the distributions. (Sec 6901(a)(1)(B))