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Nuances of Estate Tax Lien Priority

In many cases, estate tax obligations have priority over the creditors of an estate, but this general rule has exceptions. It is key for a fiduciary to understand when a creditor may have priority over estate taxes, in order to ensure the fiduciary is properly carrying out its duties to the estate’s creditors.

The primary exception to the general rule is that secured creditors often have priority over an estate tax lien (I.R.C. § 6323). One common example of a secured creditor with priority over estate tax obligations is a lender who provided a purchase money mortgage, which is properly secured by real estate. A secured creditor may have priority over an estate tax obligation if the debt is secured by a security interest that was perfected under applicable state law prior to the decedent’s death. 

To qualify as a security interest and have priority under I.R.C. § 6323(a), a secured creditor must meet additional criteria. Specifically, the creditor must have parted with money or money’s worth in exchange for its security interest. (I.R.C. § 6323(h)(1)). In most cases, a bank issuing a line of credit will not have parted with money or money’s worth simply by issuing the line of credit. Until the line of credit is drawn upon, the bank has only made a firm commitment to provide funds, which does not satisfy the requirement to part with money or money’s worth. (U.S. v. Balice, 116 AFTR 2d 2015-5196 (DC NJ)). For example, if a decedent has a home equity line of credit, which is properly secured by the decedent’s home, but the line is not drawn upon until after death, the estate tax obligation will have priority for payment.

However, if properly documented and secured, a letter of credit (as distinguished from a line of credit) could have priority over any estate tax obligation under I.R.C. § 6323(c)(4), even if the letter of credit is not drawn upon prior to death. A security interest in qualified property under an obligatory disbursement agreement has priority over a tax lien in certain circumstances. An obligatory disbursement agreement is an “agreement (entered into by a person in the course of his trade or business) to make disbursements…” (I.R.C. § 6323(c)(4)(A)). The disbursements must be required to be made as a result of the intervention of rights of a person who is not the taxpayer.  Further, the events leading to the obligation to make disbursements must be beyond the control of the obligor. (Treas. Reg. § 301.6323(c)-3(a)). Applicable authority clarifies that letters of credit are an example of an obligatory disbursement agreement.  (Id. and CCA 2006938005).

While the general rule appears simple and logical, there are exceptions, as well as exceptions to the exceptions. As a result, it is important that a fiduciary handling an estate that may have estate tax obligations, as well as other creditors, have a clear understanding of the priority of each individual obligation.

Copyright Holland & Hart LLP 1995-2020.National Law Review, Volume VI, Number 315


About this Author

Margot Edwards, Estate Tax Attorney, Holland Hart Law FIrm

Ms. Edwards counsels clients on the full spectrum of tax and estate planning issues. With a particular focus on planning for real estate assets, Ms. Edwards creates favorable solutions to her clients' estate planning needs.

Ms. Edwards concentrates her practice on tax and estate planning, wealth transfer planning, and charitable giving techniques. She utilizes vehicles such as trusts, limited liability companies, and marital agreements to achieve tax savings, as well as to meet family and personal objectives.