If a debt of a taxpayer is cancelled after the death of the taxpayer, the cancellation of debt (COD) income is income to the estate or the non-grantor trust of the decedent and reportable as income on the 1041 return for the estate or non-grantor trust (Reg. 1.108-9(c)(2)) to the extent the estate or non-grantor trust is solvent.

The Code Sec 108(a)(1)(B) insolvency exclusion applies to estates and non-grantor trusts just as it applies to individuals, so the COD income is only taxable to the extent the estate or non-grantor trust is solvent (the extent the assets exceed liabilities) and would be reportable on the 1041 return.

But watch out; the IRS has the authority to assess the beneficiaries of the insolvent estate for the tax owed by the estate where beneficiaries received property from the estate (Sec 6901).

31 U.S.C. 3713 gives priority to claims of the government to be satisfied before other creditors are paid and before distributions are made to beneficiaries. The language of 31 U.S.C. 3713 is “A claim of the United States Government shall be paid first….” Under this provision an executor who distributes estate assets instead of using them to pay the estate’s tax obligations can be held personally liable for the unpaid taxes up to the extent of the distributions. (Sec 6901(a)(1)(B))