Handling Debts In An Estate

The financial stress on both families and businesses as a result of the Covid-19 pandemic means an increasing level of debt for both. In reviewing estate plans today, one of the issues to consider is what would happen if a client who has significant debts, or is liable for debts incurred by their business, suddenly falls ill and dies? There is a process for handling debts of a decedent in estates, but it requires careful planning.

Handling claims against an estate are either simple or complicated. Simple, if the estate is solvent and complicated, if the estate is not solvent. Here, I am focusing on estates in the U.S. since estate administration under Civil Law is quite different.  Even within the U.S., there are significant differences from state to state; so, you should seek advice from a local estate planner or asset protection advisor.

An executor, or personal representative, of an estate has a duty to marshal both the assets and the debts of estate. Usually, this is relatively simple since it involves 1) making an inventory of the decedent’s debts, 2) determining their validity, and 3) paying them. Validity of the debts is often clear-cut: the decedent either contracted for services rendered or purchased goods that were in his or her possession at the time of death. The validity of other debts can be less clear-cut, such as claims based on a verbal agreement.

When an estate is not solvent, statutorily preferred claims are paid first, in the proper order. That order is:

●      Administrative Expenses. The costs and expenses of administration, such as legal and accounting fees and the costs of securing and appraising the estate assets,

●      Reasonable Funeral Expenses,

●      Debts or taxes with preference under federal law,

●      Reasonable and necessary medical bills of the last illness of the deceased,

●      Debts and taxes with preference under the state law,

●      Reimbursement of payments of benefits (such as Medicaid here in the US) and,

●      All other claims. 

The assets of the estate are applied to the payment of debts in a reverse priority, starting with assets passing by intestacy. If there is a will, then the debts are paid first from assets passing under the residuary clause of the will, then assets passing under a general gift under the will and finally assets passing under a specific gift under the will. So, for example, if your will says “I give my coin collection to my nephew, then I give $50,000 each to my nieces and nephews, and then the rest and remainder of my estate to my siblings,” you would first use the rest and remainder of the assets, then the cash necessary to make the general gift of $50,000 to each niece and nephew, then proceeds from the sale of the coin collection specifically gifted to the nephew.

         This is how unsecured debts are handled. Secured debts, such as mortgage loan or a car loan, are handled differently since the bank or other creditor can foreclose on the debt, usually a note, and can force the sale of the asset to satisfy the debt. A personal representative can, but is not obligated to, pay off secured debts in the estate except when the proceeds of the sale of the asset does not cover all of the secured debt. 

         There are other claims against the estate, such as the statutory rights of a surviving spouse or dependent children, which have to be balanced against the claims of the creditors of the deceased. Claims based on environmental damage also are handled differently. This applies only to probate assets. Non-probate assets, such as assets in an irrevocable trust, may not be subject to claims of creditors in the estate, if they have a spendthrift or other asset protection clause.  

         There are also specific processes that a creditor has to take to make a claim on the estate. Those processes vary from state to state and, if the proper procedure is not followed, the claim is disallowed. Foremost among these is that for unsecured debts, the creditor must make the claim in the proper forum within one year of the date of death. In the UK, a notice needs to be published to ensure that creditors know that the short statute of limitations is running, and similar notice is required to be published in the US, but of the administration of the estate rather than a specific notice to creditors.   

         There are ways to protect assets from claims of creditors in an estate, and ways of shifting the risk of unexpected death through the purchase of life insurance.  You should inform your estate planner of existing or potential debts you owe and include in your plans how your personal representative will handle paying off your creditors. Exactly how you do that will depend not only on what you have and what you want, and how your estate is administered.

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