Estate's Reliance on Expert's Wrong Advice Was Reasonable Up to a Point; Subsequent Delay Subject to Penalties (Parker's Federal Tax Bulletin: April 13, 2013)

A number of estate tax cases recently have dealt with whether or not an estate had reasonable cause for missing a filing deadline and thus being excused from penalties assessed by the IRS. The courts generally rule against the estate, holding that reliance on an expert's advice does not negate the penalty because one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. However, in Est. of Liftin v. U.S., 2013 PTC 41 (Fed. Cl. 3/29/13), the court was faced with an interesting situation involving the marital deduction and a non-U.S. citizen spouse. No marital deduction is allowed if the spouse is not a U.S. citizen. Thus, on the advice of an estate tax legal expert, an estate put off filing the return until the spouse became a U.S. citizen and until all ancillary matters were resolved. It turns out that the advice was erroneous but the court found the estate had reasonable cause for the late filing up until the wife became a U.S. citizen. However, there was no reasonable cause for waiting to file nine months after the wife became a citizen and all ancillary matters were resolved.

OBSERVATION: The addition to tax for failure to file timely reaches the statutory maximum if the delinquency continues longer than four months. Therefore, the estate's nine-month delay without reasonable cause was sufficient to subject it to the maximum late-filing penalty.

Facts

Morton Liftin died on March 2, 2003, and his son, John, was appointed as the executor of his estate. The decedent's will provided for direct bequests to, among others, his surviving spouse, Anna Liftin, who was a U.S. resident and a citizen of Bolivia at the time of the decedent's death.

Under Code Sec. 6075(a), the estate was required to file a federal estate tax return by December 2, 2003, nine months after the decedent's death. Code Sec. 6081(a) grants an extension of time of up to six months for the filing of a return, and Reg. Sec. 20.6081-1 provides that the total allowable time for filing, including extensions, is 15 months from the decedent's death. The executor hired his former law partner, John Dadakis, to assist with the estate's federal estate tax return and the administration of the estate's assets, including certain claims by Mrs. Liftin against the estate. At the time, Dadakis was a partner at the law firm of Morrison & Foerster LLP, and had expertise in private wealth services and estate and gift tax planning.

In discussions both before and after the decedent died, Dadakis advised the executor regarding the effect of Mrs. Liftin's citizenship status on the estate's federal tax return. In general, Code Sec. 2056(d)(1)(A) provides that the value of property that passes from a decedent to a surviving spouse may be deducted from the value of the estate that is subject to the federal estate tax. This so-called marital deduction is not available, however, if the surviving spouse is not a U.S. citizen. Nevertheless, Code Sec. 2056(d)(4) provides that, if the spouse becomes a citizen before the estate tax return is filed and has been a resident of the United States at all times after the decedent's death and before becoming a citizen, the estate may take the marital deduction. Thus, after the decedent's death, the estate could take the marital deduction only if Mrs. Liftin was a U.S. citizen when the estate filed its return.

On November 26, 2003, six days before the estate's return and taxes were due, the estate requested a six-month extension to file its return and pay the taxes due. The IRS granted the estate's request, setting a new deadline of June 2, 2004. On January 20, 2004, the estate made a tax payment of $877,300, an amount the estate estimated would be sufficient to satisfy the taxes due even if it were unable to claim the marital deduction.

Thereafter, the executor and Dadakis became aware that Mrs. Liftin intended to apply for U.S. citizenship. The executor knew, however, that Mrs. Liftin's naturalization process might not be completed before the June 2, 2004 deadline. Dadakis, based on his interpretation of Reg. Sec. 20.2056A-1(b), advised the estate, in substance, that its late filing in order to claim the marital deduction would not trigger a penalty as long as the return was filed within a reasonable time after Mrs. Liftin became a naturalized U.S. citizen and other ancillary matters were completed. The executor found this advice to be reasonable, particularly because the estate had already paid more than the amount of tax the executor believed would ultimately be due.

By June 2, 2004, Mrs. Liftin was not yet naturalized. Following Dadakis's advice, the estate did not file a return. On October 4, 2004, the IRS sent a letter to the estate inquiring why it had not filed a tax return. In response, Dadakis wrote the IRS on November 4, 2004, setting forth the estate's position, as well as his rationale for concluding that Reg. Sec. 20.2056A-1(b) allowed a late filing in order to claim the marital deduction. Dadakis's letter did not, however, reference his advice that the estate could wait to file its return until all ancillary matters were completed. Neither the estate nor Dadakis received a response from the IRS.

Mrs. Liftin became a U.S. citizen on August 3, 2005. Approximately seven months later, in February of 2006, the estate entered into an agreement settling Mrs. Liftin's claims against the estate. On May 9, 2006, the estate filed its tax return claiming the marital deduction in the amount of the value of the property passing to Mrs. Liftin and reflecting a tax due of approximately $679,000 and an overpayment of approximately $199,000.

The IRS did not contest the marital deduction, but did assess a penalty under Code Sec. 6651 of almost $170,000 for late filing and late payment. The estate filed a refund claim, which the IRS denied. After an administrative appeal, the IRS granted a partial refund in the amount of $34,000, leaving a claim of approximately $136,000.

In its administrative appeal, the estate argued that the statutes and regulations related to the marital deduction provided reasonable cause for the estate's late filing. The IRS rejected the appeal and the case headed to the Court of Federal Claims.

Federal Claims Court Decision

The Federal Claims court noted that, to avoid a penalty for a late-filed return, the estate had to prove that its failure to file timely was due to reasonable cause and not willful neglect. To prove reasonable cause, the court stated, the estate had to show that it exercised ordinary business care and prudence but nevertheless was unable to file the return within the prescribed time. Willful neglect, the court observed, requires a conscious, intentional failure or reckless indifference.

Citing the Supreme Court's decision in U.S. v. Boyle, 469 U.S. 241 (1985), the court said that when an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. By contrast, one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. In short, tax returns imply deadlines. Thus, the Court of Federal Claims said, the Supreme Court distinguished advice from an attorney involving an interpretation of substantive tax law, which can constitute reasonable cause, from an attorney's assistance in meeting the requirements of unambiguous statutes, which cannot constitute reasonable cause.

The court looked at Dadakis's advice to the executor that a late-filed estate tax return would not trigger a late-filing penalty so long as the tax return was filed within a reasonable time after Mrs. Liftin became a naturalized United States citizen and after all ancillary matters were completed. This advice was subsequently recognized as erroneous.

The Court of Federal Claims held that the executor's reliance on Dadakis's erroneous advice was reasonable to the extent the advice was to wait until Mrs. Liftin became a U.S. citizen. That advice, the court noted, concerned a substantive question of tax law regarding the interaction between the statutes and regulations providing for the marital deduction and the statutes and regulations setting the deadline for filing the estate's return. The executor had no basis to question Dadakis's advice, the court stated. As the circumstances changed, the executor continued to ask whether the estate needed to file sooner, and Dadakis continued to reassure him that the estate could wait until Mrs. Liftin became a citizen. Moreover, the court said, there was no evidence to suggest that the executor was acting in bad faith. Therefore requiring the executor to challenge Dadakis would nullify the very purpose of seeking the expert's advice in the first place.

However, the court concluded that once Mrs. Liftin was naturalized, there was no reasonable cause for the estate to wait an additional nine months to file its estate tax return. Because Dadakis's advice that the estate could delay filing until it could submit an accurate return was not an interpretation of substantive tax law, it could not, as a matter of law, constitute reasonable cause for the delay in filing the estate tax return.

Staff Editor Parker Tax Publishing

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