Notifying the Court
An estate's executor usually knows relatively early in the probate process that the estate is going to come up short financially. One of the first steps in probating an estate is to collect and inventory the decedent's assets. Next, the executor must notify creditors of the deadline for claims for any money the decedent owed them. If these debts are more than – or even equal to – the value of the assets, the estate is probably insolvent. In addition to debts, the executor must also pay any taxes due for the decedent's last year of life, operating costs of the estate, and decedent's funeral expenses. This can create even more of a shortfall. Rather than proceeding with the normal probate process, the executor must notify the court that there's not enough money to pay everyone. The exact procedure for doing this may differ from state to state, but it usually involves asking the court to make an official declaration that the estate is insolvent.
Order of Payment
Few estates have absolutely no assets or cash resources at all, so after the court has declared the estate insolvent, the executor must figure out which expenses she can pay with the limited funds. Statutory law usually determines this. Some expenses and debts have higher priority than others and receive payment first. When the money runs out, creditors with the lowest priority may not receive anything at all. Your state might require that you file an additional motion with the probate court at this point, asking for permission to distribute payment according to your state's order of priority.
Closing the Estate
State laws vary regarding the exact procedure an executor must follow to close the estate, and this is particularly true when the estate is insolvent. After you've distributed what payments you can, you migth have to file a final report or accounting with the court, showing who received payment and how much. There could be a final court hearing, where the judge will approve your accounting. You might have to notify creditors and all interested persons of the date and time. Normally, after the hearing, you would be free to distribute the remaining assets and bequests to the beneficiaries named in the decedent's will. However, beneficiaries can't inherit from an insolvent estate because there's nothing left over after paying taxes, creditors and expenses to the extent possible. An exception sometimes exists for the surviving spouse and minor children. Some states allow these close relatives a living allowance for the first year or so after the decedent's death. This is usually a priority payment, made before other expenses and creditors receive anything.
Risk to Executors
If you're the executor of an insolvent estate, you might want to confer with a lawyer as soon as you realize what you're up against. If you make a mistake, the court might hold you personally responsible for funds you pay to a low-priority creditor at the expense of a creditor with higher priority. You might think you're doing the right thing by paying a medical bill for the decedent's last illness, but if your state's law dictates that other expenses must be paid first, you might have to reimburse the estate out of your own pocket.