Late-Filing Penalty Despite Timely Payment of Estate Tax
In Estate of Liftin, 1 the Court of Appeals for the Federal Circuit held that an estate was liable for a late filing penalty despite its reliance on an estate lawyer, who gave wrong advice regarding the filing due date for the return. The court held that the estate could not avoid penalties for having relied on the lawyer's advice that it did not need to file an estate tax return until it had complete information to report to the IRS because there was well-established law to the contrary.
Morton Liftin died on March 2, 2003 survived by his wife, who at the time was a citizen of Bolivia, and his son, who became executor of the estate. To assist in the administration of the estate, the executor hired a lawyer who specialized in estate planning and estate administration.
Pursuant to Section 6075(a), the due date of the estate tax return was December 2, 2003, nine months after the decedent's date of death. Pursuant to Reg. 20.6081-1(b), the estate was entitled to an automatic six-month extension of time to file the estate tax return. Also, pursuant to Reg. 20.6161-1(a)(1) a discretionary extension, not to exceed 12 months, may be granted to pay the estate tax (the IRS can issue up to ten consecutive extensions, each for a maximum of one year, if the executor can show that it is impossible or impractical to pay the full estate tax owed by the due date).
On November 26, 2003, the executor timely sought a six-month extension to both file the estate tax return and to pay the estate tax. The IRS granted the extension, and therefore the new deadline was June 2, 2004. The IRS did not have the statutory or regulatory authority to grant a further extension to file the estate tax return. In January 2004, the executor made an estimated payment to the IRS of estate tax of $877,300.
In preparing the estate tax return, the executor and the lawyer for the estate faced two uncertainties. The first issue was whether the decedent's wife would become a citizen of the U.S. The general rule is that in calculating the value of an estate subject to estate tax, the executor may deduct the value of property that passes to a surviving spouse if the surviving spouse is a citizen of the U.S. unless such property passes in a qualified domestic trust (Q-DOT). This deduction is referred to as the marital deduction.
Pursuant to Section 2056(d)(4), however, a special rule also permits the marital deduction if the surviving spouse becomes a citizen of the U.S. before the estate tax return is filed. Under that provision, the lawyer advised that the estate could not take the marital deduction unless the surviving spouse became a citizen of the U.S. before the estate actually filed its return. The second uncertainty affecting the estate's preparation of the estate tax return arose from the fact that the estate was engaged in litigation with the surviving spouse relating to her rights under a prenuptial agreement.
Neither uncertainty had been resolved as of June 2, 2004, the extended due date for paying the tax and for filing the tax return. The lawyer for the estate advised the executor that an estate tax return could be filed after the extended due date and after the resolution of both the citizenship issue and the prenuptial issue. Relying on the lawyer's advice, the estate did not file the estate tax return by June 2, 2004. In a declaration submitted during the litigation, the lawyer for the estate stated that he based his advice on his review and analysis of a regulation that concerns citizenship and the marital deduction. In his declaration, however, the lawyer for the estate did not recite any basis for delaying the filing of the estate tax return beyond the resolution of the citizenship question.
On August 3, 2005, the surviving spouse became a citizen of the U.S. On February 16, 2006, the surviving spouse and the estate resolved their dispute over the prenuptial agreement. Finally, on 5/9/2006 the executor filed the estate tax return. Thus, the filing of the estate tax return occurred 23 months after the extended June 2004 due date and nine months after the surviving spouse became a naturalized U.S. citizen.
The estate tax return stated a tax liability of $678,572.25, and because the estate's estimated tax payment of $877,300 exceeded the tax liability, the estate sought a refund of $198,727.75. The IRS disagreed and assessed a $135,714.45 late-filing penalty under Section 6651(a)(1). The estate filed an action in the Court of Federal Claims. The issue before the court was whether the executor's reliance on the advice of the estate's lawyer provided reasonable cause for not filing the estate-tax return until May 2006, almost two years after the extended due date of June 2, 2004.
The Court of Federal Claims granted summary judgment for the government. In granting summary judgment for the government, the court divided the two-year delay into two periods:
1. The 14 months up to the August 2005 grant of U.S. citizenship to the surviving spouse.
2. The nine months from then until the May 2006 filing date.
The court concluded that the estate had demonstrated that its failure to file the estate tax return during the 14 months after the extended deadline but before the surviving spouse became a U.S. citizen was due to reasonable cause. In reaching its decision, the court deemed it reasonable under the circumstances for the executor to rely on the lawyer's advice that filing of the estate tax return could wait until the grant of citizenship to the surviving spouse.
The Court of Federal Claims, however, drew the opposite conclusion for the remaining nine months and concluded that the delay in filing after the surviving spouse became a U.S. citizen was not due to reasonable cause. The court did not find reasonable cause in the executor's reliance on the lawyer's advice that filing could be delayed past the citizenship determination. The court based its decision on the fact that the executor did not argue that he received, from the estate's lawyer at the time, specific advice for a further delay after the granting of citizenship to the surviving spouse. The estate then timely appealed the decision of the court.
The Court of Appeals for the Federal Circuit noted that the Code establishes a penalty for the late filing of estate tax returns even when full payment of the estate tax is timely made. Section 6651(a)(1) automatically assesses a late-filing penalty if the federal estate tax return is not filed on time (including any extension granted), unless the failure to file is due to reasonable cause and not due to willful neglect. The penalty is 5 percent for each month (or fraction thereof) that the tax return is late, up to a maximum of 25 percent. Because the aggregate penalty may not exceed 25 percent of the tax due, it takes only five months to reach the maximum penalty.
The Federal Circuit affirmed the decision of the Court of Federal Claims and found that the legal advice given to the executor did not provide reasonable cause for the delay in filing the estate tax return after the surviving spouse had become a U.S. citizen since that advice, which was unexplained to the executor at the time, rested on an assumption that was not legally reasonable. Because the court's conclusion as to the nine-month delay following the surviving spouse becoming a citizen of the U.S. supported the full penalty assessed, the court did not address the reasonableness of the advice of the estate's lawyer in delaying the filing of the estate tax until the surviving spouse became a U.S. citizen.
The court began its analysis with a review of Reg. 1.6664-4(c), which provides that the advice of counsel is reasonable cause for the elimination of penalties under Section 6664(c) for the underpayment of tax under Section 6662(a) if the advice of counsel was not based on unreasonable factual or legal assumptions. The court stated that this approach looks at the substance of the advice offered, not just the qualifications of the advisor, and demands that it rise above a threshold level of reasonableness even though such advice was incorrect. The court stated that in applying the reasonable cause provision of Section 6651(a)(1) involved in this case, it was appropriate to borrow the IRS's regulatory implementation of reasonable cause in the closely analogous setting of Section 6664(c).
The court supported its finds by stating that if legal advice eliminated the statutory penalty even when such advice rested on unreasonable legal assumptions, there would be a substantial risk of abuse by taxpayers because a risk would arise that taxpayers would secure baseless advice as protection against penalties. The court recognized that it was quite unlikely that the lawyer would be penalized for giving such advice if the advice excuses the IRS penalty against the taxpayer because the taxpayer will have suffered no harm on which to base a claim against the lawyer for bad advice.
The court found no support in the tax law for the lawyer's advice that, even after the surviving spouse became a naturalized U.S. citizen in August 2005, the estate could continue to wait to file an estate tax return until the litigation regarding the prenuptial agreement was resolved. The court found that the advice of the lawyer rested entirely on the assumption that the return could be delayed until the litigation matters were resolved because a fully accurate return could not be filed until then. The court held that there was no basis in tax law for the assumption that incomplete information justified a delay in filing an estate tax return.
The court pointed to Reg. 20.6081-1(d), which addresses the possibility of incomplete information by providing that a return as complete as possible must be filed before the expiration of the extension period. It adds that, while the return may not be amended once the extension period ends, supplemental information may subsequently be filed that may result in a finally determined tax different from the amount shown as the tax on the return. Accordingly, the court concluded that the advice of the estate's lawyer was based on assumptions that were unreasonable, and therefore the estate could not rely on such advice for reasonable cause in not filing the return timely.
There was a dissenting opinion in this case. The dissenting judge believed that the late-filing penalty was not justified because the estimated estate tax payment was greater than the tax liability reported on the return. The dissenting judge based his opinion on the fact that the penalty under Section 6651 is calculated on the net tax due on the return, and in a situation where the taxpayer has made estimated tax payments in excess of the tax liability shown on the return, no tax is due. It is interesting to note that the majority opinion did not directly address the dissent's arguments.
This case highlights the importance for tax advisors of being certain in the advice they provide. The tax laws are very complex in many respects and are constantly being subjected to interpretation by the courts and the IRS. Therefore, it is important to stay current with developments in the tax law and to research issues with which the advisor is not completely certain. The advisor in this case may have reached the conclusion, as did the dissent, that no penalty would be due because a significant estimated tax payment had been made that exceeded the tax liability that would ultimately be due. The cautionary note here is that timely payment may not avoid a late filing penalty.
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more on filing estate tax returns, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the October 2014 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.