Handling deficiencies and debts in Estate Administration

Sometimes the estate assets do not quite match the Willmaker's expectations when the Will was written. A gift may be made of an asset that no longer exists when the deceased passes, a gift may be financially impossible, or the entire estate may be in deficit (insolvent). This article discusses the issues and solutions for an executor faced with one of these scenarios.

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Estate Insolvency

If the estate has more liabilities than assets, it is insolvent. In that case, no beneficiaries will receive any gifts, and all of the estate will be used to pay creditors. In that situation the estate is distributed in the same way as would have occurred if the deceased had become bankrupt. Distribution in bankruptcy is not like a normal estate administration and the priority of payment of debts is important - paying some debts in priority over others may place the executor in a position of liability to the creditors who have missed out. It is generally safer, in those circumstances, for an executor to renounce their role, and allow a trustee in bankruptcy to be appointed to administer the estate.

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A beneficiary cannot be 'left the debts' - the beneficiaries are not responsible to pay the deficiency amount. A beneficiary can pay money to acquire or release an asset from the estate, but that is voluntary, and the funds paid must be used to pay creditors of the estate. Care is required to ensure that the amount paid is its 'arms length' value - if a beneficiary is allowed to acquire assets for less than their true value, then the executor may be liable to the disappointed creditors for the deficiency.

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An insolvent estate is rife with risk to the executor.

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Partial Shortfall

An estate may be solvent, but be unable to pay all of the gifts that the Will requires.

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For example, an estate with a value of $500,000 is solvent, but cannot comply with a Will direction to give '$1 million to each of my 5 children'. In this case, intuitively, each of the 5 children should receive $100,000.

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This is referred to as 'abatement' and the abatement is applied rateably to all members of the same abatement priority. In the example, the $5 million gift is reduced by $4.5 million, and that shortfall is applied equally to the 5 children: Each receives the gift: $1 million, minus their rateably applied shortfall allocation of $900,000 ($4.5 million divided by 5 = $900,000), producing their final entitlement of $100,000.

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Abatement Priority and Rateable Application

It is simple enough to work out how to apply an abatement when all beneficiaries are equally affected. It quickly becomes more complicated, however, when different beneficiaries are affected differently.

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Extending our example, if our Willmaker's gift was: "$1 million each to my 5 children, $2 miillion to my friend Lucas, and my home to my husband, Henry", we now have three different classes of gift- legacies (monetary gifts), specific gift (the house) and residue.

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Subject to the Will provisions, and any local succession law rules, the residue is first used, then the rest of the gifts are abated rateably. So, to work out how to apply the abatement,  the executor must value the home. If the home is worth $3 million, and the bank savings are  $500,000, we then have:

Total estate = $3,000,000 + $500,000 = $3,500,000

Total gifts = $5,000,000 + $2,000,000 + $3,000,000 = $10,000,000.

The gifts exceed the estate's value by $6,500,000, so the abatement required is : $6,500,000

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To apply that rateably, the abatement must be applied in proportion to the value of the  gift.

The children's gift is $5 million, which is 50% of the total, so their gift must abate by 50% of the required reduction - ie $3,250,000, reducing their total to $1,750,000 and their individual gifts to $350,000.

Lucas' gift is $2 million, which is 20% of the total, so his gift must abate by 20% of the required reduction - ie $1,300,000, reducing his gift to $700,000.

Henry's gift (the home) is worth $3,000,000, so that gift is 30% of the total and must abate by 30% of the required reduction - ie $1,950,000.00, reducing the value of his gift to $1,050,000.

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The new total of the gifts is $3,500,000, which matches the value of the estate.

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The total estate is now divided among the beneficiaries in proportion to their original gifts, though none of them receive as much as the willmaker intended. This is the brutal reality of rateable abatement.

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Note that Henry has a serious problem: He cannot take the house (worth $3 million) because he is now only entitled to $1,050,000. Henry must either accept that the house must be sold and he is paid his gift from the sale proceeds, or Henry must come up with $1,950,000 to contribute to the estate so that he can receive the house. (That $1,950,000, when added to the $500,000 in the estate bank accounts is just enough to allow the payment of the (abated) gifts to the children and Lucas).

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If the home was subject to a secured debt, then its net value, not its gross value, would be used in the calculations. The liability for the mortgage debt passes with the gift as described in the next section.

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Secured Debts

In some cases, an asset is gifted where that asset is security for a debt.

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For example, the Will may give 'the family home to my daughter, Julie' but the home may be subject to a mortgage to a financier. In those cases, unless the Will specifies otherwise, Julie's gift is subject to the debt, and Julie must pay out or refinance the loan to retain it. If she cannot afford to, the home must be sold, and the net proceeds after the mortgage loan is repaid, are paid to Juile.

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The Willmaker can override the usual rule by suitable wording. If, for example, the gift was 'the family home to my daughter, Julie free of all encumbrances' then the executor must use the other estate assets to first clear the debt and release the security, then transfer the gift to Julie, unencumbered.

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Of course, if there is not enough money to clear the debt, then the estate has a partial shortfall, which must be handed as described in the Partial Shortfall section.

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Unsecured Debts

Unsecured debts are paid from the general estate assets (those not specifically gifted to any individual). These must be paid before the estate is distributed. If there is not enough money to pay the debts without reducing the specific gifts and legacies, then the specific gifts and legacies must be abated.

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Subject to Will Provisions

The default rules regarding abatement can be amended by the Will. A Willmaker may specify an asset to be used for the payment of a particular debt or gift, and, if so, those requirements must be followed as far as possible, with the abatement rules taking effect to resolve any shortfall, if required.

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Ademption

Ademption is the name for the failure of a gift because the asset gifted is not owned by the deceased when they die.

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A Will will sometimes gift an asset which was owned at the time the Will was made, but which has been sold or disposed of since that time. For example: a Will may contain a gift like this 'I give my house at 3 Smith Street to my son William'. However, after the Will was made, the house was sold by the Willmaker and spent on holidays and lifestyle. When the willmaker passes away, 3 Smith Street is not an asset of the estate, and cannot be given to William. In those circumstances, the gift fails and William gets nothing.

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Conclusion

An estate may have a deficiency even if it is not insolvent overall. The rules relating to ademption, abatement and secured debts govern how any shortfall is shared amongst the beneficiaries.

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Attestates automatically handles abatement where applicable, with sensible defaults and with provision to allow changing the abatement priority to comply with any special provisions the Will, or local succession laws, may require.