Straightening Out an Upside-down Estate

One of the main responsibilities of an Executor or Trustee (“Fiduciary”) is to pay off all of the decedent’s debts and then distribute the balance of the estate to the beneficiaries. The assumption is that the decedent will die leaving more assets than debts. In the current economy, this is not always the case. If an estate has more debts than assets, the Fiduciary has a difficult – and sometimes thankless – task.

When an estate’s debts exceed its assets, debts of the United States or of California (i.e., unpaid taxes) have top priority. After those debts are satisfied, the California Probate Code divides the remaining debts into certain classes as follows:

1.  Expenses of Administration: this class typically includes attorney fees, Fiduciary fees, and out-of-pocket costs necessary in order to settle the estate (i.e., recorder fees, bank fees, etc.).

2. Obligations Secured by a Mortgage, Deed of Trust, or other Lien: this class includes the outstanding mortgage on a real property or other debt that is secured by collateral. This category is limited to the asset that is held as collateral. If the secured debt exceeds the value of the asset that is held as collateral, the excess debt will fall into the classification of “General Debts” as described below.

3. Funeral Expenses.

4. Expenses of Last Illness.

5. Family Allowance: this is a term of art as defined by the Probate Code that allows certain individuals (such as the parent or minor children of the decedent) a certain amount out of the estate to handle their personal expenses. The amount varies by the individual’s circumstances and is subject to Court approval.

6. Wage Claims.

7. General Debts: this class includes all debts not previously classified.

The Fiduciary’s responsibility is to determine which debts fall into which of the aforementioned classes and then to pay the debts of each class in the order listed above. There is no priority of debts within the same class and no debt of any class may be paid until all those of prior classes are paid in full. For example, the Fiduciary must not pay any debt that falls within the class of “Expenses of Last Illness” until all the debts classified as “Funeral Expenses” and all debts of the prior classes are paid.

If the assets of the estate are insufficient to pay all the debts of any class in full, each debt of that class must be paid a proportionate share.

Not only must the Fiduciary deal with dividing the debts into the various classes, but the Fiduciary also must deal with creditors who might be unhappy with the fact that they either won’t be satisfied at all or will only be given a small fraction of what they are owed and heirs/beneficiaries who are unhappy that they won’t be receiving anything from the estate.

Historically, the silver lining in an insolvent estate was the fact that the creditors were generally limited to the value of the estate and could not pursue claims against family members of the decedent. However, as a recent case from Pennsylvania dramatized, nursing homes and other health care providers might attempt to pursue claims against family members of a decedent who left an insolvent estate based on “filial responsibility laws” which are on the books in California but have rarely been enforced. This is potentially a new “wild card” that could dramatically reshape the settlement of insolvent estates.