May 26, 2015

Estate trustees and beneficiaries often focus on the positive – the many and varied assets of an estate which will soon be distributed to the beneficiaries. It is only after the estate administration is underway that the full financial picture emerges – an estate that appeared flush may actually have more debts than there are assets to pay them. Administering an insolvent estate carries unique challenges and can lead to greater exposure for the estate trustee. As a result, individuals should be warned – do not jump into the role of estate trustee without first investigating the circumstances of the estate.

At the outset, it should be noted that there is a legal distinction between an “insolvent” estate and a “bankrupt” estate. A bankrupt estate has gone through the formal process of declaring bankruptcy under the Bankruptcy and Insolvency Act, whereas an insolvent estate simply lacks sufficient assets to pay all its debts in full. All bankrupt estates are insolvent; not all insolvent estates are bankrupt.

Below are common pitfalls for estate trustees. However, the list is not exhaustive – each situation is unique and will present its own challenges to estate trustees. Estate trustees of an insolvent estate are wise to consult with a professional from the outset of their administration.

Pitfall #1 – Paying Beneficiaries before Estate Creditors

Estate trustees have an ongoing, fiduciary obligation to pay all estate debts in full. Estate debts include not only the debts of the deceased (for example, unpaid credit card or utility bills), but the costs of administering the estate (accounting fees and compensation for estate trustees). For this reason, it is possible for an estate to become insolvent as the administration progresses and debts are incurred.

Estate assets, plus any additional funds collected into the estate during the course of the administration (for example, judgments debts collected after the deceased died), must be used to pay the estate creditors before there can be any distribution to the estate beneficiaries. If an estate trustee pays the beneficiaries before the estate creditors, the estate trustee becomes personally liable for paying the estate debts (up to the amount paid out to the beneficiaries).

Before making an interim distribution to the beneficiaries, make sure there is a sufficient holdback to pay estate debts in full. If there is any doubt whether the estate will have enough money to pay all its debts, no distribution should be paid out to the beneficiaries.

Pitfall #2 – Paying Some Creditors Before Others

Estate trustees cannot favour one creditor over another creditor of the same rank (as explained below). If there are not enough estate assets to pay all debts in full, each creditor should be paid out proportionately (for example, the estate trustee should pay 50% of each debt, as opposed to paying one creditor in full and nothing to the second creditor). The “even hand” rule applies equally to estate creditors as beneficiaries, with some modification. By paying one creditor in full, the estate trustee becomes liable for paying all the creditors in full.

However, some creditors/debts are given priority over others. Estate trustees are allowed to pay a higher ranked creditor (for example, a secured creditor) before a lower ranked creditor (for example, an unsecured creditor). The ranking of creditors is determined by the applicable law: if the estate is insolvent, then the common law, Trustee Act, Estate Administration Act, and Estates Act apply. If the estate has declared bankruptcy, then the Bankruptcy and Insolvency Act applies. Although an insolvent estate and a bankrupt estate rank creditors differently, in both cases funeral costs form a first charge against the estate.

Pitfall #3 – Taxes

The Bankruptcy and Insolvency Act explicitly ranks municipal taxes (which are distinct from provincial or federal taxes) at the same level as other unsecured creditors (at s. 136). However, the law applying to insolvent estate is less settled on this point.

In practice, taxes are generally given special priority relative to other unsecured creditors of an insolvent estate. This means the estate trustee can (and should) pay the deceased’s tax debt before paying credit card debt, for example. However, because there is still some ambiguity in the law on this point, the estate trustee should reach out to the estate’s unsecured creditors to let them know (a) that the estate does not have enough money to pay all debts in full and (b) that the estate trustee is planning to pay the estate taxes before paying the other debts. This will give the creditors a chance to agree or to raise an objection, if they have one.

Pursuant to s. 102 of the Bankruptcy and Insolvency Act, the trustee in bankruptcy must call a meeting of creditors (note that a trustee in bankruptcy is different than an estate trustee, which is why bankruptcy can be an attractive option to estate trustees who find themselves out of their depth). Payment of the estate’s debts is discussed at the meeting(s).

Estate trustees of an insolvent estate also have the option of calling a meeting of creditors (pursuant to s. 59 of the Trustee Act). This will give the estate trustee the opportunity to discuss the estate’s insolvency directly with the creditors. Payment of the estate’s tax debt can be raised during this meeting.