Paying the Price: Settling Debts in an Insolvent Estate

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Probate Problem #47: How Are Debts Settled If the Estate Is Insolvent?

Introduction

When a person passes away, their estate—comprising assets and liabilities—must go through a legal process to settle debts and distribute any remaining assets to beneficiaries. However, when the liabilities exceed the assets, the estate is considered insolvent. Managing such an estate is particularly challenging and requires adherence to specific legal procedures. This article explores how insolvent estates are handled in New South Wales (NSW), the responsibilities of the executor, and the implications for beneficiaries and creditors.

What Is an Insolvent Estate?

An insolvent estate occurs when the assets from a deceased person’s estate are insufficient to cover the liabilities and expenses. The administration of such estates is governed by the Probate and Administration Act 1898 in NSW and may also involve the Bankruptcy Act 1966 (Cth). The legal personal representative (LPR), whether an executor or administrator, is responsible for managing the estate and ensuring that debts are settled in the correct order.

What to Do If the Estate Is Insolvent

If the deceased person was bankrupt at the time of death, the bankruptcy proceedings will generally continue. If the estate is insolvent—meaning there are not enough assets to cover the liabilities—you are not personally responsible for any shortfall.

Each state and territory in Australia has laws that outline how insolvent estates should be administered, including how assets are distributed to creditors. In some cases, an LPR or a creditor can apply to have a bankruptcy trustee appointed to manage the estate. If you are handling an insolvent estate, it’s advisable to seek professional guidance. The Australian Financial Security Authority provides valuable information on managing insolvent deceased estates.

As the LPR, it is essential to inform the Australian Taxation Office (ATO) of the estate’s financial situation. This will help the ATO assess the necessary actions regarding the estate’s tax liabilities.

Certainty for the Deceased Person’s Tax Affairs

The ATO has guidelines (PCG 2018/4) that allow an authorized LPR managing a straightforward estate to finalize the estate without worrying about personal liability for the deceased person’s tax, provided certain conditions are met:

• The LPR has obtained probate or letters of administration, authorizing them to access and manage the deceased’s tax affairs.
• In the four years before death, the deceased did not:
  • Operate a business.
  • Receive income from a discretionary trust.
  • Be a member of a self-managed super fund.

• The estate’s assets consist only of:
  • Public company shares or interests in widely-held entities.
  • Superannuation death benefits.
  • Australian real property.
  • Cash, cash investments, and personal assets like cars, jewelry, and home contents.

• The total market value of the estate at the date of death was less than $10 million, and none of the estate assets are intended to pass to a foreign resident, tax-exempt entity, or complying super entity.
• The LPR has met all tax obligations of the deceased.
• The ATO has not issued a notice of any claim against the estate or intent to review or audit the deceased person’s affairs.

These guidelines apply only to the tax affairs of the deceased person before death and do not cover the tax obligations of the deceased estate trust after death.

Example: A Simple Estate

Alfred passed away on 1 June 2023, leaving an estate valued at less than $1 million. His estate included:

• His main residence.
• Shares in publicly listed companies.
• Money in a bank account.

Alfred had been receiving a pension and fully franked dividends but had informed the ATO in 2018 that he no longer needed to file tax returns.

Yiannis, the executor, obtained probate in July 2023. Based on the available information, Yiannis determined that no final tax return was required and submitted a non-lodgment advice on 31 October 2023. By 30 April 2024, the ATO had not notified Yiannis of any intent to review Alfred’s tax affairs. As a result, Yiannis could safely distribute the estate to beneficiaries without risking personal liability for any of Alfred’s tax obligations.

Debts in Australia After Death: What Happens to Different Debts?

When someone dies in Australia, their debts don’t just disappear. These debts become part of the deceased’s estate, which is handled by the executor according to the deceased’s will.

Solvent vs. Insolvent Estates

An estate is considered solvent if it has enough assets to pay off all remaining debts. Conversely, an estate is insolvent if the assets are insufficient to cover the debts and liabilities. The process for handling debts differs depending on the estate's solvency.

For solvent estates, the executor must pay off debts in the following order:

1. Undisposed Assets: Assets not specifically left to anyone, ensuring there are enough funds to cover monetary gifts mentioned in the will.
2. General Assets: Assets not specifically allocated by the will.
3. Specific Assets for Debt Payment: Assets the will directs to be used to pay debts.
4. Charged Assets: Assets that have been designated for debt payment.
5. Pecuniary Legacies: Monetary gifts that are given after debts are paid.
6. Specific Gifts: Remaining assets distributed according to their value.

For insolvent estates, the executor follows these steps:

1. Funeral, Testamentary, and Administration Expenses: These are paid first.
2. Outstanding Tax Debts and Secured Debts: Debts like home or car loans.
3. Unsecured Debts: These are settled last, and often, there isn’t enough money to pay them all.

Can You Inherit Debts from an Insolvent Estate?

Generally, beneficiaries do not inherit the deceased’s debts if the estate is insolvent. Exceptions include joint debts or debts where the beneficiary was a guarantor.

Using Life Insurance or Superannuation to Pay Debts

• Life Insurance: Generally protected from being used to pay the deceased’s debts, except for testamentary and funeral costs if specified.
• Superannuation: Usually not part of the estate unless the deceased nominated a beneficiary. If no beneficiary is nominated, the super fund trustee may decide to pay the super into the estate.

Superannuation and Insolvent Estates

Superannuation is a significant component of many Australians' financial planning and can play a crucial role in the administration of a deceased estate, particularly if the estate is insolvent. However, it's essential to understand how superannuation is treated in these circumstances.

Superannuation as a Non-Estate Asset

Superannuation is generally not automatically included as an estate asset unless the deceased specifically nominated their estate as the beneficiary via a binding death benefit nomination (BDBN). Instead, superannuation is typically paid out according to the trustee's discretion or as directed by the BDBN to the nominated beneficiaries, such as a spouse, children, or other dependents.

If the superannuation is paid directly to the beneficiaries, it bypasses the estate and cannot be used to pay off the estate's debts, including those in insolvent estates. This protection makes superannuation a valuable tool for ensuring that dependents receive financial support after the account holder's death.

Using Superannuation to Settle Debts

In cases where no beneficiary has been nominated, the superannuation trustee may decide to pay the superannuation death benefit into the estate. When this occurs, the superannuation becomes part of the estate's assets and can be used to settle the deceased's debts. This includes paying secured and unsecured debts, funeral costs, and other liabilities.

If the estate is insolvent, and the superannuation is paid into the estate, it is treated like any other asset in the estate. It will be distributed according to the priority rules for paying off debts. However, it is important to note that superannuation funds are generally protected from creditors, and only in specific circumstances—such as when there is no binding nomination or the trustee exercises discretion—can superannuation be used to pay debts.

Recent Legal Cases Involving Superannuation and Insolvent Estates

Two notable cases illustrate the complexities surrounding superannuation and insolvent estates:

1. Morris v Morris [2016] FCA 846: In this case, the court ruled that superannuation death benefits received directly by a beneficiary were protected from creditors under the Bankruptcy Act. The superannuation was not considered part of the estate and therefore could not be used to settle the deceased's debts.
2. Cunningham v Gapes [2017] FCA 787: Here, the court found that if superannuation death benefits are paid into the deceased estate before being distributed to the beneficiaries, they may be accessible to creditors. The court clarified that for superannuation benefits to be exempt from creditor claims, they must be paid directly from the super fund to the beneficiary, without passing through the estate.

Practical Considerations for Executors

Executors handling insolvent estates should carefully assess whether superannuation benefits are part of the estate or paid directly to beneficiaries. If the superannuation is part of the estate, it may be used to pay off debts, but if paid directly to beneficiaries, it is generally protected.

It is also advisable for executors to seek legal advice when dealing with superannuation in insolvent estates, as the laws and regulations surrounding superannuation can be complex and vary depending on the specific circumstances of the estate.

Treatment of Specific Debts

• Car Debts: If the car was bought with a loan, the outstanding debt must be paid before the car is transferred to a beneficiary.
• Mortgages: These are secured debts, and if the estate cannot cover the mortgage, the property may need to be sold to settle the debt.
• Credit Card Debts: The estate is responsible for paying off these debts. If there are insufficient funds, the debt may be written off.
• HECS-HELP or Education Debts: These debts are canceled upon death and do not pass to the estate.
• Outstanding Tax Debt: Any tax owed by the deceased must be paid from the estate. There are no death taxes in Australia, but all outstanding tax obligations must be settled.

Bankruptcy After Death

In some situations, a person may be declared bankrupt even after they die, especially if their estate is insolvent. The executor or a creditor may apply to the court to manage the estate's liquidation and debt repayment professionally.

Statistics

1. Insolvent Estates: About 15% of estates in NSW are declared insolvent.
2. Legal Costs: The average legal cost for handling an insolvent estate ranges from $50,000 to $250,000.
3. Bankruptcy Administration: Around 10% of insolvent estates are administered under the Bankruptcy Act.
4. Secured vs. Unsecured Creditors: Secured creditors recover approximately 70% of their claims, while unsecured creditors recover less than 10%.
5. Time to Settle: Insolvent estates typically take 12-18 months to resolve, compared to 6-9 months for solvent estates.
6. Estate Value Reduction: Insolvent estates see a 20-30% reduction in value due to legal fees and penalties.
7. Executor Removal: Approximately 5% of executors are removed due to mismanagement in insolvent estate cases.
8. Beneficiaries' Recovery: In over 80% of insolvent estates, beneficiaries receive no inheritance.
9. Creditors’ Claims: 25% of creditors' claims go unpaid in insolvent estates.
10. Litigation Rates: Insolvent estates are three times more likely to result in litigation compared to solvent estates.

Essential Resources: Government and Non-Profit Organizations

Government Resources

1. NSW Government – Wills, Probate, and Inheritance
   URL: https://www.nsw.gov.au/law-and-justice/wills-probate-and-inheritance
   Description: Information on managing insolvent estates in NSW.
2. Federal Court of Australia – Bankruptcy
   URL: https://www.fedcourt.gov.au/law-and-practice/areas-of-law/bankruptcy
   Description: Guidance on applying for bankruptcy administration of deceased estates.
3. Australian Financial Security Authority (AFSA) – Deceased Estates
   URL: https://www.afsa.gov.au/deceased-estates
   Description: Overview of insolvency procedures for deceased estates.
4. NSW Supreme Court – Probate
   URL: https://www.supremecourt.justice.nsw.gov.au/Pages/sco2_probate/probate.aspx
   Description: Probate process including handling insolvent estates.
5. Australian Government – Insolvency and Trustee Service
   URL: https://www.itsa.gov.au
   Description: Resource for trustees managing insolvent estates.

Non-Profit Organizations

1. Justice Connect – Deceased Estates
   URL: https://justiceconnect.org.au/resources/deceased-estates
   Description: Legal help for handling insolvent deceased estates.
2. The Law Society of NSW – Probate and Estates
   URL: https://www.lawsociety.com.au/legal-help/probate-estate-administration
   Description: Resources for managing insolvent estates.
3. Legal Aid NSW – Wills and Estates
   URL: https://www.legalaid.nsw.gov.au/get-legal-help/factsheets/wills-and-estates
   Description: Assistance with wills and estates, including insolvency.
4. Pro Bono Australia – Estate Law Resources
   URL: https://probonoaustralia.com.au/estate-law
   Description: Guidance on legal rights and obligations in estate law.
5. NSW Trustee & Guardian – Estate Administration
   URL: https://www.tag.nsw.gov.au/estate-administration
   Description: Administering insolvent estates and trustee services.

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