Postfiling administrative expenses reduce estate tax fraud penalty.

In a fully reviewed opinion with two dissents, the Tax Court recently held that, for purposes of computing the fraud penalty under Sec. 6663, an estate's underpayment of tax must take into account all deductible expenses, not merely those reported on the estate tax return (Estate of Trompeter, 111 TC No. 2 (1998) (Trompeter II)).

In Estate of Trompeter, TC Memo 1998-35 (Trompeter I), the Tax Court sustained the IRS's determination that an estate was liable for the Sec. 6663 fraud penalty. The estate had, among other things, substantially undervalued reported assets and failed to report other assets on its estate tax return.

In Trompeter II, the estate argued that in computing the underpayment subject to the penalty, it was entitled to deduct the professional fees it paid to prosecute Trompeter I, as well as deficiency interest. The Service countered that such postfiling expenses, while deductible in computing the estate tax deficiency, did not reduce the fraudulent underpayment.

The IRS relied on cases that held that a carryback does not reduce an underpayment for purposes of computing a penalty and on Sec. 6663'S reference to "any underpayment of tax required to be shown on a return" in support of the argument that the fraudulent underpayment must be measured with regard to the tax properly reported on a taxpayer's filed return.

The Service also contended that allowing postfiling deductions to reduce the fraudulent underpayment was bad tax policy. By running up administration costs through tax controversy fees, an estate could eliminate the penalty, which is supposed to reimburse the government for the costs of investigating fraud.

Judge Laro, writing for the majority, and noting that the issue was one of first impression, agreed with the estate. The carp/back cases were distinguishable; they rested on the annual accounting concept and stood for the proposition that a taxpayer may not reduce or eliminate a penalty by reason of events occurring in a later tax period. In contrast, the estate tax is not computed on an annual basis; rather, it is a one-time excise whose determination may encompass postfiling administrative expenses. The IRS's position could lead to incongruous results; for example, an estate that overpaid the estate tax could be liable for the fraud penalty.

Judge Laro also found the Service's statutory argument unpersuasive. Sec. 6663, he held, essentially constituted a recodification of old Sec. 6653(b). The court found nothing in the legislative history of the latter statute to indicate that Congress intended to give the words "tax required to be shown on a return" any temporal significance. In the court's view, Congress merely sought to differentiate taxes payable by return from those payable by stamp.

As to the IRS's policy argument, Judge Laro believed that such concerns were better addressed by Congress. He also noted that only legitimate and reasonable administrative expenses could be deducted for estate tax purposes.

Comment: Trompeter II is obviously good news for estates faced with the Service's assertion of the fraud penalty. The Tax Court's logic can also be extended to the Sec. 6662(a) negligence penalty. Like Sec. 6663(a), the negligence penalty has its roots in old Sec. 6653 and applies to "an underpayment of tax required to be shown on a return." Thus, for purposes of computing the negligence penalty, postfiling administrative expenses should similarly reduce the penalty base.

Still, a few words of caution are appropriate. First, Judge Ruwe wrote a vigorous dissent that may spur an IRS appeal. Among other things, he argued that the majority's reading of the carryback cases was too narrow. In his view, those cases establish that a taxpayer may not reduce or eliminate a penalty by virtue of postfiling events, regardless of the tax period in which they take place. Further, Judge Ruwe maintained that the majority's holding might create an inconsistency in the way the Sec. 6651(f) failure-to-file fraud penalty and the Sec. 6663 fraud penalty are computed.

Read in conjunction with Sec. 6651(a)(1), Sec. 6651(f) imposes a 15% per month (up to 75%) penalty in the case of a fraudulent failure to file a return. The penalty base is "the amount required to be shown as tax on such return." According to Judge Ruwe, this language indicates that the Sec. 6651 (f) fraud penalty is based on the tax required to be shown on a return at the time it was due, not as later recomputed to take into account subsequent deductions.

Second, the Tax Court underscored that only legitimate and reasonable expenses of administration may be deducted for estate tax purposes. In a concurring opinion, Judge Swift explained that if an estate filed a grossly fraudulent return and failed to concede the fraud when first raised by the Service on audit, further expenses incurred to fight the IRS should be considered unreasonable and disallowed. Such remarks may stimulate future challenges by the Service to the deductibility of postfiling tax controversy expenses in estate tax fraud cases on reasonableness grounds.

FROM RONALD A. STEIN, LL.M., CPA, CHICAGO, IL