Anchors Aweigh for Reasonable Cause

Estate and Gift Tax

The following estate and gift tax case is a reprint from the “Rulings & Cases” section in the 2022 Federal Tax Workbook, Volume A, Chapter 3. It focuses on what determines a reasonable cause for a delayed filing of Form 706 and whether or not it is considered reasonable that acting in good faith and relying on guidance from professional tax advisors is sufficient.

Facts

Commander David T. Leighton played a critical role in developing the United States’ nuclear submarine capability, serving for many years under Admiral Hyman Rickover, known as the “Father of the Nuclear Navy.” During his life he established scholarships at MIT, and funded professorships at the U.S. Naval Academy and MIT, among other charitable gifts.

When Commander David Leighton died in 2017, his son Frank assumed duties of the executor of his father’s estate. The estate used the services of three advisors to conclude that it had no filing requirement for Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, because Commander Leighton’s assets did not reach the exemption amount. The advisors included:

• Mr. Leighton’s tax preparation firm, Freshwater Consultants;
• A family office, JDJ Family Office Services; and
• Attorney Richard Allen.

Mr. Allen advised Frank that an estate tax return was only required if the value of the 2017 decedent’s estate exceeded $5,490,000. Mr. Allen, Frank, and JDJ worked together and determined that Commander Leighton’s estate held assets in the range of $1–$2 million. However, they did not consider the possibility that Commander Leighton had made lifetime gifts, and Freshwater did not search its records for any Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Return. No Form 706 was filed for the estate.

In 2019, David Leighton, Frank’s brother, brought up the possibility that their father might have established trusts during his life and funded them with gifts that would count toward the exemption amount. Freshwater Consultants responded with a copy of a 2012 Form 709 when Mr. Allen specifically asked if one existed. That return reported gift s in 2012 of $5,094,000, triggering the requirement to file a Form 706.

Armed with this new knowledge, Frank filed a Form 706 on April 9, 2019, over one year late. The estate paid $1,626,928 in estate taxes, penalties, and interest. The IRS subsequently calculated an estate tax liability o f$1,145,387, a late-filing penalty of $257,712, a late payment penalty of $85,904, and interest of $87,859. It refunded the overpayment of $50,066 less than two months later.

Having complied to the best of his ability with the requirement to file an estate tax return, Frank filed a claim for  a refund with the Court of Federal Claims. This claim asserted that the penalty was not reasonable because Frank took reasonable steps to determine the size of his father’s estate and reasonably relied on his attorney’s advice. None of the parties were aware at the time of the lifetime gifts.

Issues

The issue in this case is whether the estate had reasonable cause for not filing Form 706 on a timely basis.

Analysis

IRC §6651(a) states that the failure to file penalty should not be imposed if the failure to file is due to reasonable cause and not willful neglect. The regulation associated with this section states, “If the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time, then the delay is due to a reasonable cause.”

The court noted that reliance on the advice of an advisor does not necessarily establish reasonable cause unless such reliance was reasonable, and the taxpayer acted in good faith. The taxpayer must allege and prove that the late filing or payment, in the words of U.S. v. Boyle, “was the result neither of carelessness, reckless indifference nor intentional failure.” A failure to file must be beyond a taxpayer’s control to avoid the penalty. The executor in the Boyle case knew that an estate return had to be filed and presented the tax return preparer with the relevant information. The tax preparer for the Boyle estate overlooked the filing.

The court’s opinion described as “circular” the IRS’s logic that the advice received by the executor was objectively unreasonable. The United States made this assertion because Mr. Allen’s advice was not based on all pertinent facts and circumstances. The court opined that finding for the United States on this point would mean that missing information could never constitute reasonable cause. The court concluded that this argument is an invalid reason to decide the case in favor of the United States and against the estate of Commander Leighton. The court’s opinion contrasted the Leighton case with the Boyle case. While taxpayers cannot delegate the responsibility to file timely returns, the court stated the Boyle case does not address whether they must file a return. The court decided that the arguments advanced by the United States failed because they presuppose that the taxpayer or one of their advisors “should have known” that the estate’s valuation exceeded the exemption amount. The court stated, “Tax advisors cannot reasonably give advice on unavailable information.”

Holding

The court found that Commander Leighton had sufficient factual allegations to establish a viable claim for the reasonable cause exception in §6651(a).

Practitioner Planning Tip

If a Form 706 with a portability election had been filed for Commander Leighton’s wife when she died several years before him, his estate might have owed no tax. Practitioners should consider implementing a standard practice of discussing with surviving spouses the possibility of filing estate tax returns to preserve any unused estate tax exemptions. For more information on estate issues, including unused estate tax exemptions, see the 2022 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: Tax Considerations in the Distribution of Estate Assets.

Sources:

IRC §2010(a).
Treas. Reg. §301.6651-1(c)(1).
U.S. v. Boyle, 469 U.S. 241, 246 (1985).