Reasonable Cause: An Estate’s Defense Against IRS’s Late-Filing Penalties
The Internal Revenue Code (the “Code”) contains over 150 civil tax penalties for various conduct and non-conduct. One common group of penalties, associated with the late filing of a tax return and the late payment of tax, are housed in section 6651 of the Code. To avoid these penalties, taxpayers must generally show “reasonable cause,” i.e. that the taxpayer acted reasonably under the particular set of circumstances.
The late-filing and late-payment penalties apply to a variety of tax returns and tax obligations. For example, the late-filing penalty applies when an executor fails to timely file an estate tax return (“Form 706”) and timely pay estate tax payments. But, because a Form 706 filing obligation arises only in certain instances—when the decedent’s gross estate and adjusted taxable gifts exceed a specified floor, which varies year to year—in many cases, an executor may not discover the need for filing until after the deadline. What happens then? Is the estate liable for late-filing and late-payment penalties?
A recent decision in the United States Court of Federal Claims touches on this very issue. See Estate of Leighton v. U.S., Case No. 21-840T, 2021 WL 3486478 (Fed. Cl. Aug. 9, 2021). It is discussed infra.
David Leighton (the “Decedent”) passed away in January 2017. Under section 6075(a) of the Code, the executor, Tom Leighton (“Tom”), was required to file a Form 706 within 9 months of the Decedent’s death. However, on March 13, 2017, an attorney advised Tom that a Form 706 filing was not required because the value of the Decedent’s estate did not exceed $5,490,000. After some additional due diligence, Tom and his team of tax professionals agreed with the attorney, and valued the estate at approximately $1 to $2 million.
Almost two years later, though, on February 26, 2019, the Decedent’s son, David Leighton, Jr. (“David Jr.”) informed Tom that the Decedent “might have” established and funded various trusts during his lifetime. Because these were lifetime gifts, if the value of the trust assets plus the value of the Decedent’s estate exceeded $5,490,000, it would have required Tom to file a Form 706 (now late). Prior to receiving this new information, Tom had requested gift tax returns (“Forms 709”) from the Decedent’s tax professionals but had not received any indication that the Decedent had made gifts or filed Forms 709 with the IRS. Upon a further follow up with the Decedent’s tax professionals, Tom learned that the Decedent filed a Form 709 for his 2012 tax year reporting gifts of $5,094,000.
Recognizing now that the estate had a Form 706 filing obligation, Tom filed a Form 706 on April 9, 2019. With the return, Tom included payment for the estate tax and an estimate of potential penalties for the late filing of the Form 706 and the late payment of estate tax. Tom further included a reasonable cause statement that requested full abatement of the late-filing and late-payment penalties.
The IRS failed to act on the refund claim. Accordingly, Tom filed a refund suit against the United States in the United States Court of Federal Claims. In the complaint, Tom contended that his failure to timely file a Form 706 was “due to reasonable cause and not willful neglect.” The United States subsequently moved to dismiss the complaint under Rule 12(b)(6) of the Federal Rules of Civil Procedure.
As discussed above, late-filing and late-payment penalties do not apply if the taxpayer can demonstrate “reasonable cause.” This defense is fact-driven—it can only be made on a case-by-case basis, taking into account all of the facts and circumstances. See Treas. Reg. § 1.6664-4(b)(1). The Treasury Regulations further provide: “Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” Id. In addition, taxpayers may demonstrate reasonable cause through reliance on a tax professional, provided the reliance is reasonable under the circumstances. Id. But, taxpayers cannot rely on a tax professional to timely file the tax return for them. U.S. v. Boyle, 469 U.S. 241 (1985).
Thus, reasonable cause is generally shown where a taxpayer exercised “ordinary business care and prudence” but nevertheless was unable to file the return or pay the tax within the prescribed time. Treas. Reg. § 301.6651-1(c)(1); see also U.S. v. Boyle, 469 U.S. at 246 n. 4 (reasoning that it must not be the result of carelessness, reckless indifference, or intentional failure).
Because the United States moved to dismiss under Rule 12(b)(6), the court was not called upon to determine whether the estate had conclusively shown reasonable cause. Rather, the central inquiry was whether the estate had plead sufficient facts to show a claim for relief, i.e., whether the facts, taken as true, could support a plausible claim for reasonable cause. In its motion, the United States made three arguments for dismissal of the complaint, as discussed below.
The Attorney’s Advice to Tom was “Objectively Unreasonable”
First, the United States contended that the advice that the attorney provided to Tom—that a Form 706 was not required—was “objectively unreasonable.” See Stobie Creek Invs., LLC v. U.S., 608 F.3d 1366, 1381 (Fed. Cir. 2010) (requiring “objective reasonableness” when relying on advice of an independent professional advisor). More specifically, the United States argued that the attorney’s advice was “objectively unreasonable” because it was not based “on all the pertinent facts and circumstances” in that such advice did not account for the 2012 gifts made by the Decedent.
The court flatly rejected this argument, finding it “circular” and “unavailing.” According to the court, a finding for the United States on this point would mean that missing information could never constitute reasonable cause because advice would necessarily not be based on all the pertinent facts and circumstances.
Tom is Completely Responsible for the Failure to Timely File.
Second, the United States—as it often does—argued that the Supreme Court’s decision in Boyle precluded Tom’s reasonable reliance argument on an agent for the late filing of the Form 706. However, the court noted that the government’s argument failed to take into account other language in the Boyle decision that suggested (without deciding) that taxpayers may reasonably rely on advice concerning whether—but not when—a return must be filed. See Boyle, 469 U.S. at 250-51. Moreover, the court recognized that the Boyle decision did not address whether reasonable cause can be established when, as in the case before it, the taxpayer and its agents act on incorrect information.
The “Unavailability” of the Decedent’s 2012 Gift Tax Return is Unreasonable
Third, the United States made a catch-all argument that the unavailability of the Decedent’s 2012 Form 709 was unreasonable and could not provide reasonable cause. But, here, the court recognized that “[i]t is a pillar of the tax code that a taxpayer is expected to file a timely return based on the best information available and then file an amended return if necessary.” See Thomas v. Comm’r, 82 T.C.M. (CCH) 449 (T.C. 2001). And, in this regard, in determining whether a taxpayer’s conduct was reasonable, significant considerations include: “[w]hy the records were unavailable and what steps were taken to secure the records,” [w]hen and how the taxpayer became aware that [it] did not have the necessary records,” whether “other means were explored to secure needed information,” whether “the taxpayer contacted the IRS for instructions on what to do about missing information,” and the effort expended to obtain the missing information. See I.R.M. pt. 18.104.22.168.2.2.3. According to the court:
There [was] no dispute that the Decedent’s lifetime gifts impacted whether an estate tax return was required and that Mr. Allen acted promptly once he obtained a copy of the 2012 gift tax return. Thus, the inquiry as to whether [Tom] acted reasonably is largely dependent on the availability of the missing 2012 gift tax return. The United States argues that the 2012 gift tax return was in . . . [the Decedent’s tax professionals’] possession all along, thus it should have also been reasonably known by the Executor. This involves a factual inquiry beyond the record before the Court. The Amended Complaint alleges that the Executor made a diligent effort to identify lifetime gifts made by the Decedent, including making inquiries to [the Decedent’s tax professionals]. What were the circumstances surrounding the gift tax form? Was it misfiled, intentionally hidden, willfully ignored? The Court is unclear at what point the availability of the document and exhaustive search becomes enough to rise to the level of reasonable cause for a late filing. The specific details surrounding the inquiries to [the Decedent’s tax professionals] are not pled before the Court, nor are they required at this stage. At this point, the Amended Complaint alleges sufficient facts to raise an expectation that discovery may reveal evidence to support the Executor’s allegations.
The decision in Estate of Leighton reaffirms that reasonable cause may be a potential defense for the late-filing and late-payment penalties when the taxpayer is unable to secure and locate information related to event-based filing obligations, such as the Form 706. Taxpayers in similar situations to the executor in Estate of Leighton should remember to properly raise the defense in their reasonable cause statements to the IRS.