When God brings death, the devil brings the heirs – Distribution of an estate without paying the estate’s debts

Traditional inheritance disputes primarily concern the distribution of the deceased’s estate among the heirs. If the estate is insolvent, a dispute regarding inheritance and bankruptcy may arise, where the rights of creditors and the interests of the heirs are in conflict. In the event of an estate bankruptcy, it is crucial to consider the economic interests of the bankruptcy creditors, as these are normally considered more worthy of protection than those of the heirs. If heirs receive an inheritance without accounting for the estate’s debts, this can lead to a legal dispute.

Distribution of an estate without paying debts

It is not uncommon for estates to become insolvent and subsequently be declared bankrupt because funds were not set aside to pay the estate’s latent tax debts—often related to the sale of real estate or other valuable assets—before the inheritance is distributed to the heirs. Because the collection of tax from the estate often occurs a relatively long time after the tax-triggering transaction, several years may have passed since the inheritance was distributed by the time the bankruptcy proceedings actually begin. The typical starting point in the bankruptcy is then an assetless bankruptcy estate with a relatively large (and growing) tax debt.

The primary purpose of bankruptcy is to ensure the equal treatment of bankruptcy creditors by ensuring that all assets of the debtor—the estate in this case—are collectively utilized to satisfy the estate’s debts. However, the purpose of the bankruptcy would often not be achieved if there were no possibilities for the bankruptcy estate to also recover assets that, prior to the onset of bankruptcy, had been transferred to another party in a manner detrimental to the collective body of creditors.

The Bankruptcy Act contains an entire catalog of so-called recovery rules aimed at various types of legal acts, including debt payments, gifts, and divisions of property, that took place within certain given time limits before the bankruptcy application was submitted to the district court. These rules provide the bankruptcy estate with the opportunity to have legal acts, which are in themselves valid under civil law, recovered and thereby restore the debtor’s financial situation to what it was before the act detrimental to creditors was undertaken. However, the recovery rules of the Bankruptcy Act contain several conditions that are difficult to prove and must be met for recovery to be possible, especially regarding legal acts that took place a very long time before the bankruptcy; including bad faith on the part of the counterparty regarding the debtor’s insolvency at the time of the legal act.

There is, however, a special rule in Chapter 21, Section 4 of the Inheritance Code that specifically targets the reversal of an estate distribution, which reads:

“If […] distribution of the estate occurs before the debts of the deceased and other debts of the estate have been paid or funds for their payment have been placed under special care, […] the distribution shall be reversed.”

This reversal rule in the Inheritance Code is very strict toward heirs and is an effective tool for the bankruptcy estate to restore order when a distribution of an estate has occurred without regard for the estate’s remaining debts. The difficult-to-prove conditions surrounding the recovery rules of the Bankruptcy Act do not need to be present when applying the reversal rule in the Inheritance Code. Furthermore, the provision in question is not subject to any time limit but can be applied to challenge estate distributions that took place a very long time before the onset of bankruptcy (aside from, possibly, the general ten-year statute of limitations for claims to the extent that the property requested for return consists of money). If there were debts remaining in the estate after the distribution, the distributed property must be returned to cover these debts regardless of when the distribution took place, even if the heirs did not know (or should not have known) about the debts in question. Period.

Even if it is not explicitly stated in the rules of the Inheritance Code, the bankruptcy estate’s claim for reversal should also include the costs of administering the bankruptcy, at least to the extent that they relate to the work on the reversal claim. It can therefore become an expensive affair for the heirs to distribute the estate without considering remaining debts, as the inheritance in such a situation must be partly used to fund an entirely unnecessary bankruptcy. Interest and yields must also be paid on the returned amount. Because a long time, sometimes several years, has often passed between the incurrence of the tax debt and the onset of bankruptcy, the tax debt has often had time to grow significantly due to ongoing late payment interest. The inheritance may thus also need to be used to cover unnecessarily incurred interest on the tax debt.

If the conditions for the reversal of the estate distribution are met, the heirs are jointly and severally liable for the fulfillment of the reversal, and if the distributed property is no longer in their possession, compensation for its value must be paid instead. However, the joint and several liability for return is limited to the property (or its value) that each of the heirs received at the time of distribution. This can result in an heir being forced to return their entire share of the inheritance to the bankruptcy estate because another heir cannot fulfill their obligation to return—for example, because the other heir’s share of the inheritance has been spent and they otherwise lack assets to fulfill the return. The consequence of this could be that an heir is left empty-handed in terms of inheritance due to their return to the bankruptcy estate and receives only a worthless right of recourse against the other heir who received the full amount at the time of distribution (due to the latter’s inability to fulfill the return of their share). If there were no disputes among the heirs regarding the estate in connection with the distribution, there is a risk that such a dispute will instead flare up after the return to the bankruptcy estate has been completed, when one of the heirs lacks the capacity to return and the other heirs are forced to cover this deficiency with their respective inheritance shares.

In summary, it can be concluded that it is important to make a provision with ample margins in the estate to cover all existing and latent debts before the inheritance is distributed, in order to avoid the inheritance being used for unnecessary bankruptcy costs and expensive late payment interest in addition to the payment of the estate’s debts.

Gustav Kling
Attorney and Partner

[email protected]

Advokatfirman Carler has extensive experience in insolvency management, and our attorneys regularly take on assignments as corporate restructuring practitioners and bankruptcy trustees.