Incompetent Legal Counsel Doesn't Excuse Estate from Late Filing Penalties

(Parker Tax Publishing October 2016)

An estate could not recover more than $1.2 million in penalties and interest paid as a result of the late filing of its federal estate tax return, even where the executor was a high-school educated homemaker and her legal counsel was incompetent. The Sixth Circuit held that, although the circumstances in the case were unfortunate, case law makes it clear that the duties to file a tax return and pay taxes are non-delegable and mere good-faith reliance does not constitute reasonable cause to avoid late filing penalties. Specht v. U.S., 2016 PTC 363 (6th Cir. 2016).

Background

Virginia Escher died on December 30, 2008, and her estate was worth approximately $12.5 million. Escher's cousin, Janice Specht, was asked to be the executor of the estate. Specht, then 73, was a high-school-educated homemaker who had never served as an executor, never owned stock, and had never been in an attorney's office. Specht selected Escher's attorney, Mary Backsman, to assist her. Backsman had over 50 years of experience in estate planning, but unbeknownst to Specht, was privately battling brain cancer. In January 2009, Backsman informed Specht that the estate owed approximately $6 million in federal estate taxes, and that the estate would need to liquidate its shares in United Parcel Service, Inc. (UPS) in order to pay the liability. Backsman informed Specht that the estate taxes were due nine months following Escher's death, on September 30, 2009. Backsman also suggested that her law firm could pay the liability on the estate's behalf and seek reimbursement later.

Whenever Specht asked about the filing of the tax return and payment, Backsman assured her that an extension had been obtained. However, Specht did not ask for proof that an extension had been obtained, and Backsman's assurances turned out to be false; she had not in fact even requested an extension. Before the IRS filing deadline, Specht received four notices from the probate court informing her that the estate had missed probate deadlines. She responded to the notices by calling Backsman and asking why the deadlines had been missed. Specht then unquestioningly accepted Backsman's repeated response that she had obtained an extension and was handling the matter. The September 30, 2009, estate filing deadline came and passed without the estate filing its tax return and paying the federal estate tax.

In July 2010, Specht received a call from friends of Escher who had also hired Backsman as an attorney for a family member's estate. They warned Specht that Backsman was incompetent, and told Specht they were seeking to have Backsman removed as co-executor of their family member's estate. Specht scheduled a meeting with Backsman and again accepted Backsman's representation that the execution of the estate was going smoothly. However, after receiving notices from the state of Ohio saying that the estate was delinquent in filing its Ohio estate tax return, Specht fired Backsman and hired another attorney. That attorney liquidated the UPS stock and filed the estate's federal tax return in January of 2011, paying the tax liability and interest due.

The IRS assessed penalties against the estate for failing to meet the September 30, 2009, deadline, which the estate paid. The estate had also paid penalties to the Ohio Department of Taxation; however, the state fully refunded those penalties due to the hardship caused by Backsman's representation. The estate settled a malpractice action against Backsman in 2012, and Backsman surrendered her law license.

Suit Against the IRS in District Court

Code Sec. 6651(a)(1) and (2) provide for the assessment of penalties for failure to file a tax return and failure to pay a tax liability. These penalties are mandatory unless the failure is due to reasonable cause and not due to willful neglect. To escape the penalty, the taxpayer must prove both (1) that the failure did not result from willful neglect, and (2) that the failure was due to reasonable cause.

Specht and a co-fiduciary filed suit against the IRS in a district court seeking to recover the almost $1.2 million in penalties and interest on the penalties that the estate paid. The district court held for the IRS, concluding that Specht's reliance on Backsman to file the tax return and pay the tax liability was not a reasonable cause for the missed deadline. The district court also found that Specht's failure to supervise Backsman, despite the many warning signs of Backsman's deficient performance, constituted willful neglect of her duty to file the tax return and tax payment.

Specht and the co-fiduciary appealed to the Sixth Circuit, arguing that in light of Specht's age, education, and inexperience, her reliance on Backsman to file the tax return and pay the tax liability was a reasonable cause for the estate's failure to meet the deadline. The estate also argued that Specht's continued reliance on Backsman throughout the process did not constitute willful neglect of her duty to file the tax return and pay the tax liability.

Sixth Circuit Sides With IRS

The IRS, citing the Supreme Court's decision in U.S. v. Boyle, 469 U.S. 241 (1985), maintained that courts have recognized a non-delegable nature of the duty to make timely filings of tax returns and have held that reliance on counsel is not sufficient to constitute reasonable cause for the failure to file a return or pay a tax. The estate attempted to distinguish Boyle on the basis that Specht was unqualified to be an executor, and her reliance on Backsman was thus more reasonable than the taxpayer's reliance in Boyle and the taxpayers' reliance in cases following Boyle.

The Sixth Circuit affirmed the district court and held that the estate showed neither reasonable cause nor an absence of willful neglect to excuse the late filing and payment. To be sure, the court said, the Boyle Court left open the possibility that an executor's qualifications might impact the reasonableness analysis, and Justice Brennan's concurrence in the case cited taxpayers suffering from "senility, mental retardation or other causes" as examples of exceptional cases that might render an individual unable to comply with the statutory deadlines. But, the Court observed, the overwhelming majority of individuals are capable of complying with the deadlines.

Practice Tip: For tax practitioners with clients serving as executors or fiduciaries of estates or trusts, it's important to emphasize to them that penalties for late filings cannot be avoided by simply relying on others. They may want to ask those charged with preparing returns or legal filings, which could generate penalties if not timely filed, what back up plans are in place in case they are incapacitated and cannot perform their duties.

For a discussion of the abatement of penalties for failing to file a timely return and pay the tax due on time, see Parker ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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