When a person dies in a state of insolvency they may leave behind an insolvent estate.
This means their liabilities are greater than any assets and therefore, despite their death, creditors are still owed money.
In this article we’ll explore the rules around insolvent estates and what it may mean for you.
What Happens With an Insolvent Estate?
Debts still need to be dealt with after death. According to the law in England and Wales this means the responsibility to deal with the situation falls to the ‘personal representative’ (the executor or administrator).
The personal representative will have the task of settling the insolvent debt via the appropriate legal means. This may mean taking professional advice initially, but afterwards the first step will be to ascertain what type of debts remain outstanding.
For example, if a debt was held jointly with another person, that person remains liable for the whole of it. Where the borrowing was joint and several, as most joint loans and accounts are, the lender can also claim against the estate.
If the debts were held only by the deceased, it may be that a life insurance policy could pay the debts off.
Where no insurance exists, the Personal Representative then has the task of administering the estate in the interests of those creditors owed money.
Deceased Insolvents
Despite popular misconception, death does not mean someone’s debts disappear. Rather, the situation continues as with a normal bankruptcy, with some points of difference.
If a bankruptcy petition had already been presented, or a bankruptcy application made, before the person died, the bankruptcy usually carries on as if they were still alive, with some changes made by the 1986 Order.
Where this is not the case, things proceed as per the rules laid out in the Administration of Insolvent Estates of Deceased Persons Order, 1986.
What is an Insolvency Administration Order?
There are two ways an insolvent estate can be dealt with, and the formal one is not compulsory.
The law allows the personal representative to administer the estate without a court order, provided they apply the statutory order of priority set by the Administration of Insolvent Estates of Deceased Persons Order 1986. We would not normally advise it.
The order of priority is rigid, and the personal representative carries the risk personally. Pay an unsecured creditor ahead of a preferential one, or pay a beneficiary anything at all while the estate is insolvent, and you can be made to find the shortfall out of your own money. The protections are narrow. Statutory notices to creditors protect you against claims you did not know about. A payment made in good faith, before you had any reason to think the estate insolvent, does not make you liable to other creditors of the same rank. The court can also excuse a representative who acted honestly and reasonably. None of these is something to plan around. That is a heavy thing to ask of someone who has just lost a relative and has never done this before.
The formal route is an Insolvency Administration Order. It puts a trustee in charge of paying the creditors, and it takes the risk of getting the order of priority wrong off the person who applied for it. Unless the estate is very simple and no creditor is in dispute, take advice before you pay anyone, and expect that advice to point at the formal route.
This is a legal mandate from the court which appoints a trustee to pay creditors.
In fact, creditors themselves can apply for this. The debt owed to the creditor, or the total owed to the creditors who apply, must be at least the bankruptcy level of £5,000. The debt must be a fixed sum and unsecured, unless the creditor gives up its security or values it and petitions only for the unsecured balance. The court must also be satisfied that there is a reasonable probability that the estate is insolvent.
In What Order are Creditors Paid From an Insolvent Estate?
It may be that not all creditors can be paid from an insolvent estate. With what money is available the following hierarchy of payment must be adhered to:
Secured creditors sit outside the order. A lender with a mortgage or other security takes what it is owed out of the asset it holds security over. Only the balance goes into the estate, and if the security does not cover the debt the shortfall drops back in as an ordinary unsecured claim. That is why it is not step one of the list.
What is left is then paid in this order:
- Reasonable funeral, testamentary and administration expenses. These rank ahead of everything below, including preferential debts, which is why they are called pre-preferential. Administration expenses are the costs of dealing with the estate itself.
- Preferential debts: certain employee claims if the deceased was an employer (unpaid wages up to a set limit, accrued holiday pay and pension contributions) and, as secondary preferential debts, HMRC claims for VAT and for tax the deceased deducted from others, such as PAYE and employee National Insurance.
- Ordinary unsecured debts, which is most of them: credit cards, utility bills, overdrafts, any shortfall left by a secured lender.
- Interest on those debts from the date of death.
- Deferred debts, which are usually money owed to a spouse or civil partner.
One practical warning for the personal representative. If you are claiming funeral, testamentary or administration expenses, put the claim in before a final dividend is declared. The trustee is entitled to distribute without them if you have not asked, and you will have paid for the funeral out of your own pocket with no way back.
Is Personal Debt Inherited by Family Members After Death?
Debt is generally not inherited. The main exceptions are these, and the list is not complete:
- the family member gave a guarantee for the borrowing, or was a joint borrower, in which case the liability is their own and always was;
- the family member is the personal representative and pays the estate out in the wrong order, in which case they can be answerable for the shortfall they caused;
- the family member takes mortgaged or charged property, in which case they take it subject to the security.
What is not among those exceptions is receiving a gift. A gift within seven years of death does not make you liable for the deceased’s debts, and it is worth saying so plainly because the seven-year rule is so familiar from inheritance tax that people assume it works the same way here. It does not.
What can happen is that the gift itself is challenged. The 1986 Order applies the bankruptcy recovery provisions to an insolvent estate, so a trustee can ask the court to unwind a transaction at an undervalue, or a preference given to one creditor over others, or a transaction entered into for the purpose of putting assets beyond creditors’ reach. Each has its own statutory test and its own look-back period, measured back from the date of death. As a guide rather than a complete test, a transaction at an undervalue can be looked at over five years, a preference over six months, and a preference in favour of an associate over two years. A transaction entered into to put assets beyond creditors’ reach has no fixed period of its own. None of these is an automatic clawback. For a gift or transaction at an undervalue within two years of death, and for a transaction made to put assets beyond creditors’ reach, the trustee does not need to show the deceased was insolvent at the time. The remedy is the return of the property or its value — not the transfer of the deceased’s debts to the person who received it.