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IRS Not Liftin the Penalties — Fed Circuit Denies Taxpayer’s Reasonable Cause Argument

Posted on July 8, 2014

A few weeks ago, the Court of Appeals for the Federal Circuit, in a fairly interesting tax procedure case, affirmed the Federal Claims holding in the Estate of M. Liftin v. United States.  The main holding pertains to the reasonable cause exception to the failure to file penalty based on advisor reliance, and includes a potentially taxpayer unfriendly holding.  The discussion of the penalty under Section 6651 also includes reference and discussion to regulations under Section 6664, which could be a bad omen for cases to come.  Finally, although not part of the holding, both the majority and the dissent discuss the imposition of the failure to pay penalty when, in fact, the taxpayer had paid more than the amount due within the extended period to pay that the IRS had granted.  I was initially surprised by this result, as I suspect many practitioners were.  The Service position is unfriendly, and majority’s dicta indicates it could side with the Service. The facts and a discussion of the main holding are found below.  The dissent will be discussed in a follow up post later this week.

The facts

Morton Liftin died in March of 2003, and was survived by his wife.  At the time of his death, his wife was a Bolivian Citizen, and not a citizen of the United States.  Morton Liftin’s son, John Liftin, was named executor.  The estate tax return was due December 2, 2003, and the estate sought an extension of time to file and pay, which the IRS granted until June 2, 2004.  No other extensions were allowed under the law.  As the filing date approached, two issues remained outstanding.  First, there was a disagreement between Mrs. Liftin and the estate regarding what she was entitled to under Morton Liftin’s will and the impact of their prenuptial agreement (now I ain’t sayin’ she a gold digger—that’s unfair, I know nothing about either of them, but I happened to hear that Kanye West song today).  Mrs. Liftin’s citizenship was the second outstanding issue, as it limited the marital deduction for the estate.

The estate hired a well-regarded lawyer to provide assistance with the estate, who informed the estate that if Mrs. Liftin became a citizen before the estate tax return was filed, transfers to her would be entitled to the marital deduction under Section 2056.  See Section 2056(d)(4).  Mrs. Liftin began obtaining citizenship, but the process would not be completed by the extended due date. The estate made an estimated tax payment of the largest possible amount of tax due if Mrs. Liftin did not become a citizen, but did not file the return.  The attorney for the estate indicated that a late return could be filed after the extended due date, which he reasoned to be true so estates could take advantage of the full marital deduction if the citizenship process took longer than the allotted time for filing the return.  I don’t think this was accurate.

Eventually, Mrs. Liftin obtained citizenship; however, the estate failed to file the return for another nine months, waiting for the prenup/will dispute to settle.  The return was finally filed, requesting close to a $200k refund.  The IRS – feeling a bit testy over having to wait so long to see the return – assessed a $169,643 late filing penalty under Section 6651(a)(1).  Ouch! –penalty when you have over paid tax on a timely basis.  The Liftins went to Appeals (lost) and then appealed to the Court of Federal Claims (lost again).  In both, the estate argued reasonable cause for reliance on an advisor, but did not argue, at least not before the court, that the Service could not impose the penalty.

The Court of Federal Claims held for the Service, stating that it was reasonable to rely on the attorney for the filing obligation and waiting until Mrs. Liftin became a citizen, but that it was unreasonable to wait an additional nine months before filing while waiting on the dispute over distribution.  The penalties remained, and the Liftins asked the Federal Circuit to opine.

The Tax Litigation Survey has additional facts here.

Reasonable Cause

The Federal Circuit affirmed the lower court as to the additional nine month period after Mrs. Liftin became a citizen, finding the taxpayer was not then relying on the reasonable advice of a competent advisor.  It, however, specifically declined to review how its holding would apply to the period during which Mrs. Liftin was applying for citizenship, and the tone of the opinion indicates the Court did not agree with the Court of Federal Claims – an unfortunate result for taxpayers.

The reasonable cause exception to the failure to pay and failure to file penalties has received significant prior attention from our blog.  Posts can be found here (Ohana), here (Shriner), here (Thouron) and here (Knappe).  A brief review will help frame this discussion.  For Liftin’s purposes, Section 6651(a)(1) states the penalty will not be imposed if “it is shown that [the failure to file on time] is due to reasonable cause and not due to willful neglect.”  The Supreme Court addressed this exception in Boyle, holding that taxpayers cannot delegate the filing of returns.  The Court also noted that it may be reasonable if a competent advisor indicates no return is due.  In Boyle, the Court noted that it was not addressing another set of cases on whether or not it would be reasonable for a taxpayer to rely on the advice of an advisor regarding a potential due date, which is the issue in Liftin.

In reviewing the delay after the citizenship had been obtained, the Court began its analysis with Treas. Reg. 1.6664-4, which contains guidance regarding the reasonable cause exception for the penalties imposed under Section 6662.  I do not recall seeing these regulations brought into discussions of reasonable cause for the failure to pay and failure to file penalties under Section 6651 lately, and some quick research did not turn up any cases; although, I have to believe there are some cases looking to those regulations in reviewing Section 6651.  Overall, the use of those regulations could be a problematic development for taxpayers.

The regulations state that “advice must not be based on unreasonable factual or legal assumptions.”  The Court found that these regulations should apply to the other reasonable cause exceptions because the regulations under those Sections do not contain a definition and the terms of the exception are substantially similar.  In looking to the cases reviewing the applicable regulations, the Court found that reasonable cause excludes advice that depends on legal assumptions that are outside the range of reasonable.  Specifically, the Court stated this approach looks to the substance of the advice offered and not just the qualifications of the advisor.

The Court also stated, “[f]ocusing on the objective reasonableness of the advice in the present context makes good sense, given the likely practical consequences of doing otherwise,” which the Court went on to state was taxpayers shopping for poor advice.  I agree that could be a concern (probably also the reasoning for the Canal Corp decision a few years ago), but I also have substantial concern about the “objective reasonableness.”  I fear that is actually a fairly subjective analysis, and could result in what Boyle viewed as untenable; hiring advisors to check your advisors.  The tenor of the holding gives the impression that the Court did not agree there was reasonable cause for relying on the advice of the attorney indicating the estate did not have to file until after the widow became a citizen.  When I initially read the lower court case, I thought the advice sounded foolish, but I paused and wondered if such an exception actually existed –why? Because the Code, Regs. and annotations take up a wall of bookshelves in my office.  This stuff is complicated.  It did not strike me as outside the bounds of possibility that such an exception could exist.  The Court did note that that what is reasonable would depend on the complexity of the situation, so I could be reading into this too much, but I am still troubled by requiring taxpayers to determine the reasonableness of the legal advice received.

In determining the reasonableness of the advice, the Court likens the standard for determining reasonable attorney advice to that of malpractices cases, highlighting that even if the taxpayer is stuck paying the penalties the advisor will probably be responsible.  This again seems unfair to the taxpayer, who then has to go through two sets of lawsuits to become whole again.  Further, the standard may be similar, but legal malpractice can be a difficult case to make.  All agree the system is complicated, and the reasonable cause exception for reliance on a competent advisor is there to mitigate that complication.  This forces the taxpayer to sue the advisor to become whole, which can be very difficult and time consuming.  Perhaps the onus should be on the Service to impose the penalty on the advisor.  Keith suggested that perhaps some consideration should be given to a penalty holding the practitioner and taxpayer jointly liable, so the dynamics before the IRS and a trial would provide a disinsentive for the taxpayer and practitioner to work together, and bring the malpractice insurance into the picture earlier. It would add some risk to signing as preparer, and returns that are knowingly filed late would need some type of mechanism to ensure the preparer wasn’t harmed.  Could also put a greater burden on the IRS and Courts, but an interesting idea.

This is a difficult issue, and one that has been around for a long time.  Even between the PT editors there are some differences of opinion on how much of a burden should be on the taxpayer.  I agree to some extent that the taxpayer should be responsible for picking qualified advisors, but I think selecting unbiased, qualified advisors should provide some protection given the difficulty in complying with the tax law.

As stated above, there will be a second post in the near future on the dissent in this case, which provided a favorable taxpayer position, but did not carry the day.

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