Estate tax issues add to practice and procedure developments.

Tax practice and procedure developments evolve from various types of tax controversies. Recent developments originated in matters involving the calculation or payment of Federal estate taxes but have broad application beyond the estate tax area. In one instance, the IRS National Office issued technical advice that an estate's refund claim was limited to the installments of estate tax actually paid within two years of its filing. In another case, the Tax Court held that, for penalty computation purposes, an estate tax deficiency is based on all deductible expenses, not just those reported on the estate tax return.

Refund Limited to Estate Tax Actually Paid Within Last Two Years

In Letter Ruling (TAM) 9828002, the IRS National Office advised that estate tax paid in installments pursuant to a Sec. 6166 election was not deemed paid for refund claim purposes when the final installment was remitted. Rather, because the estate failed to follow Rev. Proc. 81-27, Sec. 6511 (b)(2)(B) limited the amount of refund to the portion of estate tax actually paid within two years before the filing of the refund claim.

In late 1978, the decedent's estate timely filed an estate tax return. The estate elected to defer payment of a portion of the estate tax attributable to an interest in a closely held business, pursuant to Sec. 6166. The estate made interest-only payments for the first four years; for the next 10 years, the estate made tax payments plus interest. The final installment was made in late 1993.

In 1995, the estate filed a claim for refund of the interest paid between 1982 and 1993 and of estate tax paid beginning in 1986. The Service agreed that the estate had overpaid its estate tax and interest; however, because the estate had not filed supplemental Forms 706 or protective refund claims pursuant to Rev. Proc. 81-27, the National Office observed that the IRS was limited to refunding only those overpayments actually made in the last two years of the installment period. Rev. Proc. 81-27 offered procedures for estates to follow to avoid potential statute of limitations problems when paying estate tax and interest in installments. The estate's failure to follow these procedures in filing either supplemental estate tax returns or protective refund claims limited its ability to obtain a refund of overpayments of tax and interest remitted more than two years earlier.

Fraud Penalty Is Based on All Deductible Expenses, Not Just Those Reported on the Estate Tax Return

In a case of first impression, the Tax Court held an estate's deficiency for purposes of computing the Sec. 6663(a) fraud penalty is based on all deductible expenses, not just those reported on the estate tax return (Est. of Trompeter, 111 TC No. 2).

Emanuel Trompeter died in 1992, and a Federal estate tax return was filed by his estate. The Service determined that the estate tax return either failed to report or underreported the value of numerous assets (including stock, gold coins, jewels and other artifacts), resulting in an estate tax deficiency of $22.8 million. The IRS added a $14.9 million fraud penalty under Sec. 6663(a), bringing the total deficiency to $37.7 million. The estate petitioned the Tax Court. After redetermining the fair market value of the taxable estate, the court found that the executors had filed the estate tax return intending to conceal, mislead and otherwise prevent the collection of tax, and upheld imposition of the 75% penalty for fraud under Sec. 6663(a) in Est. of Trompeter, TC Memo 1998-35.

The Tax Court directed the parties to prepare a tax computation based on Tax Court Rule 155, taking into account the court's decision on the Sec. 6663(a) fraud penalty. In making the Rule 155 computation, the estate reduced the redetermined value of the estate by all deductible expenses, including deficiency interest and professional fees arising after the return was filed. The Service challenged this computation; according to the IRS, the estate was required to compute its underpayment based solely on the expenses reported on the estate tax return.

A majority of the Tax Court judges agreed with the estate. In a reviewed decision, the court explained that Sec. 6663(a) imposes a 75% penalty on the portion of "any underpayment of tax required to be shown on a return...due to fraud." While "underpayment" is defined by Sec. 6664(a) as "the amount by which any tax... exceeds ... the amount shown as the tax by the taxpayer on his return" the Tax Court found that nowhere in the Code or regulations is an estate's underpayment computed based solely on deductions that appear on Form 706. Rather, the estate tax is a one-time charge, based on the value of the decedent's gross estate less certain deductions--deductions that often cannot be determined until after the return is filed. The court also found that the phrase "underpayment of tax required to be shown on a return" did not mean that the estate was limited to only those items that could have been properly deducted on the date the Form 706 was filed. Instead, looking to legislative history and previous law, the court interpreted this phrase as merely referring to the type of tax subject to the fraud penalty.

The Service, by analogy, had relied on a line of cases holding that a net operating loss (NOL) carryback could not reduce the amount of an income tax underpayment for purposes of computing a penalty or an addition to tax. The Tax Court took this opportunity to distinguish NOLs from an estate's deductions, pointing out that (unlike NOL carrybacks) the deductions of an estate do not depend on unrelated, unforeseen or fortuitous circumstances that may occur in later years. Rather (in contrast to determining Federal income tax liabilities), determinations of estate tax may be computed by taking into account later expenses, even expenses incurred at or after a trial held for determining an estate's true liability (see, e.g., Est. of Bailly, 81 TC 246, supplemented by 81 TC 949 (1983)).

The Tax Court was quick to reject the IRS's rationale that' the fraud penalty must be computed based on the underpayment shown on the return. The Tax Court reiterated that the fraud penalty cannot apply without an underpayment of tax. In other words, if there is no deficiency, there can be no fraud.

Concurring opinions: In concurring opinions, Judges Chabot, Swift and Halpern offered additional support. Judge Chabot pointed out that accepting the IRS's position (that deductions from the gross estate are limited to only those reported on the estate tax return) might cause prudent executors to load up estate tax returns with speculative deductions. Judge Halpern noted that the phrase "tax required to be shown on a return" was a general qualification, since the indefinite article "a" was used, instead of the definite article "the," in the statute.

Dissenting opinions: Judge Ruwe, joined by Chief Judge Cohen, dissented. The dissenting opinion stressed that a more reasonable interpretation of Sec. 6663(a) would impose a penalty on the amount of the fraudulent underpayment of tax shown on the return at the time the fraudulent return was filed, rather than focusing on the type of tax to which Sec. 6663(a) applies. As Judge Ruwe pointed out, the fraud being penalized is based on the facts and circumstances at the time the fraudulent return was fried; therefore, it makes sense to consider the same facts in determining the amount of the penalty.

Comment: As noted in the concurring opinions, Sec. 6662 uses similar language for determining impositions of accuracy-related penalties--"an underpayment of tax required to be shown on a return." When facing a penalty assessment, determine whether all allowable deductions (even those not reported on the return) have been taken into account in determining the base underpayment on which the penalty will be computed. If not, recompute the tax deficiency after considering these deductions.

Editor's note: Mr. Ely chairs the AICPA Tax Division's TAx Practice & Procedures Committee. Mssrs. Johnson, Feit, Stein and Field, and Ms. Allen are members of the committee.