Can You Have Reasonable Cause For Filing Late?

I am looking a reasonable cause case.

For the non-tax-nerds, the IRS can abate penalties for reasonable cause. The concept makes sense: real life is not a tidy classroom exercise. If you have followed me for a while, you know I strongly believe that the IRS has become unreasonable with allowing reasonable cause. I have had this very conversation with multiple IRS representatives, many of whom agree with me.

I am looking at one where the penalty was $450,959.

To put that in perspective, a January 29, 2019 MarketWatch article stated that the median 65-year-old American’s net worth is approximately $224,000.

Surely the IRS would not be assessing a penalty of that size without good reason – right?

Let’s go through the case.

Someone died. That someone was Agnes Skeba, and she passed away on June 10, 2013.

Agnes had an estate of approximately $14 million, the bulk of which was land (including farmland) and farm machinery. What the estate did not have was a lot of cash.

On March 6, 2014 the attorney sent an extension form and payment of $725,000 to the IRS.         

COMMENT: An estate return is due within 9 months of death, if the estate is large enough to require a return. Seems within 9 months to me.

The attorney included the following letter with the payment:

Our office is representing Stanley L. Skeba, Jr. as the Executor of the Estate of Agnes Skeba. Enclosed herewith is a completed “Form 4768 — Application for Extension of Time to File a Return and/or Pay U.S. Estate Taxes” along with estimated payment in the amount of $725,000 made payable to “The United States Treasury” for the above referenced Estate Tax.

Additionally, we are requesting a six (6) month extension of time to make full payment of the amount due. Despite the best efforts of this office and the Executor, the Estate had limited liquid assets at the time of the decedent’s death. Accordingly, we have been working to secure a mortgage on a substantial commercial property owned by the Estate in order to make timely payment of the balance of the Estate Tax anticipated to be due.

Currently, we have liquid assets in the amount of $1.475 million and the estimated value of the total estate is $14.7 million. Accordingly, we have submitted payments in the amount of $575,000 to the State of New Jersey, Division of Revenue, for State estate taxes payable and in the amount of $250,000 to the Pennsylvania Department of Revenue for State inheritance taxes payable. We are hereby submitting the balance of available funds to you, in the amount of $725,000, as partial payment of the expected U.S. Estate Taxes for the Estate.

We are in the process of securing a mortgage, which was supposed to close prior to the taxes being due, in the amount of $3.5 million that would have permitted us to make full payment of the taxes timely. Due to circumstances previously unknown and unavoidable by the Executor, the lender has not been able to comply with the closing deadline of March 7, 2014. It is anticipated that the lender will be clear to close within fourteen (14) days and then we will remit the balance of the estimated U.S. Estate Taxes payable.

Additionally, there has been delays in securing all of the necessary valuations and appraisals due to administrative delays caused by contested estate litigation currently pending in Middlesex County, New Jersey.

I would say he did a great job.

But the estate did not pay-in all of its estimated tax ….

A few days later the estate was able to refinance. The estate made a second payment of $2,745,000 on March 18, 2014. This brought total taxes paid the IRS to $3,470,000.

COMMENT: Mrs. Skeba died on June 10^th. Add 9 months and we get to March 10^th. OK, the second payment was a smidgeon late.

Now life intervened. It took a while to get the properties appraised. The executor had health issues severe enough to postpone the court proceedings several times. The estate’s attorney was diagnosed with cancer, delaying the case. Eventually the law firm replaced him as lead attorney altogether, which caused further delay.

As we said: life.

The estate asked for an extension for the federal estate tax return. The filing date was pushed out to September 10, 2014.

The estate was finally filed on or around June 30, 2015.

          COMMENT: Nine-plus months later.

The tax came in at $2,528,838, with estimated taxes of $3,470,000 paid-in. The estate had a refund of $941,162.

Until the IRS slapped a $450,959 penalty.

Huh?

The IRS calculated the penalty as follows: 

$2,528,838 – 725,000 = 1,803,838 times 25% = $450,959

The reason? Late filing said the IRS.

On first pass, it seems to me that the worst the IRS could do is assess penalties for 8 days (from March 10 to March 18). Generally speaking, penalties are calculated on tax due, meaning the IRS has to spot taxes you already paid-in.

In addition, need we mention that the estate was OVERPAID?

The attorney asked for abatement. Here is part of the request:

Beyond September 10, 2014, the Estate continued to have delays in filing due to the pending and anticipated completion of the litigation over the validity of the decedent’s Will, which would impact the Estate’s ability to complete the filing and the executor’s capacity to proceed. Initially, it, was anticipated that the trial of this matter would be heard before Judge Frank M. Ciuffani in the Superior Court of New Jersey in Middlesex County, Chancery Division-Probate Part in July of 2014. Due to health concerns on behalf of the Plaintiff, Joseph M. Skeba, the Judge delayed these proceedings multiple times through the end of 2014, each time giving us a new anticipation of the completion of the trial to permit the estate tax return to be filed. Upon the Plaintiffs improved health, the Judge finally scheduled a trial for July 7, 2015, which was expected to allow our completion in filing the return.

           

Accordingly, this litigation, which was causing us reason to delay in the filing, gave rise to the estate’s inability to file the return.

Finally, in May of 2015 we were notified of the Estate’s litigation attorney, Thomas Walsh of the law firm of Hoagland Longo Moran Dunst & Doukas, LLP, that he was diagnosed with cancer that would possibly cause him to delay this matter from proceeding as scheduled. In early June, we were notified by Mr. Walsh’s office that his prognosis had worsened and he would be prevented from further handling the litigation of this matter, so new counsel within his firm would be assisting in carrying this matter through trial. Due to the change in counsel, it was deemed that the anticipated trial was no longer predictable in scheduling, so the Estate chose to file the return as it stood at such time.

Displaying the compassion and goodwill toward man of deceased General Soleimani, on or around November 5, 2015 the IRS responded to the attorney’s letter and stated that the reasons in the letter did not “establish reasonable cause or show due diligence.”

Shheeeessshh.

The accountant got involved next. He included an additional reason for penalty abatement:

I do not believe the IRS had knowledge of the extension in place at the time the penalty was assessed, nor did they have a record of the additional payment of $2,745,000. The IRS listed the unpaid tax as $1,803,838 and charged the maximum 25% to arrive at the penalty of $450,959.50. The estate not only paid the entire tax the estate owed by the due date to pay but also had an overpayment. Section 6651(b) bars a penalty for late filing when estimated taxes are paid.

           

The IRS did not respond to the accountant.

The accountant tried again.

Here is the Court:

                To date, IRS Appeals has not responded to either letter.

I know the feeling, brother.

You know this is going to Court. It has to.

The estate’s argument was two-fold:

1.  The estate was fully paid-in. In fact, it was more than fully paid-in.
2.  There was reasonable cause: an illiquid estate, health issues with the executor, issues with obtaining appraisals, an estate attorney diagnosed with cancer, on and on.

The IRS came in with hyper-technical wordsmithing.

Based on § 6151, the Government cleverly reasons that the last day for payment was nine months after the death of Agnes Skeba—March 10, 2014; because no return was filed by that date a penalty may be assessed. Applying the rationale to the facts, the Government contends only $750,000 was paid on or before March 10, 2014, when $2,528,838 was due on that date. Referring back to § 6651(a)(1), a 25% penalty on the difference may therefore be assessed because it was not paid by March 10, 2014. As such, the full payment of the estate tax on March 18, 2014 is of no avail because the “last date fixed” was March 10, 2014. Accordingly, the Government argues that the imposition of a penalty in the amount of $450,959.00 is appropriate.

The Court brought out its razor:

The Government puts forth a valid point that there is an administrative need to complete and close tax matters. Here, the Estate had nine months to file the return, the extension added six months, and Defendant unilaterally added another nine months to file the return. Although there was the timely payment of the estate taxes, the matter, in the Government’s view, lingered and the administrative objective to timely close the file was not met. See generally Boyle, 469 U.S. at 251. There may be a need for some other penalty for failure to timely file a return, but Congress must enact same.

Slam on the wordsmithing.

COMMENT: Boyle is the club the IRS trots out every time there is a penalty and a late return. The premise behind Boyle is that even an idiot can Google when a return is due. The IRS repetitively denies penalty abatement requests – with a straight face, mind you – snorting that there is no reasonable cause for failure to rise to the level of a common idiot.

That said: did the estate have reasonable cause?

Finally, another issue in this case is whether Plaintiff demonstrated reasonable cause and not willful neglect in allegedly failing to timely file its estate tax return. Although the Court has already determined that the penalty at issue was not properly imposed pursuant to the Government’s flawed statutory rationale, it will review this issue for completeness.

In the tax world, folks, that is drawing blood.

In this case, Mr. White submitted his August 17, 2015 letter explaining the rationale for not filing. (See supra at pp. 5-6). For example, in Mr. White’s letter, he indicated that certain estate litigation was delayed due to health conditions suffered by the executor. (Id.). Additionally, Mr. White refers to the Hoagland law firm and one of the attorneys assigned to the case as having been diagnosed with cancer. (Id.). The Hoagland firm is a very prestigious and professional firm and based on same, Mr. White’s letter shows a reasonable cause for delay.

In addition, Mr. White’s prior letter of March 6, 2014 notes that there was difficulty in “securing all of the necessary valuations and appraisals. . . caused by the contested litigation.” (Hayes Cert., Ex. C). Drawing from my professional experience, such appraisals often require months to prepare because a farm located in Monroe, New Jersey will often sit in residential, retail, and manufacturing zones. To appraise such a farm requires extensive knowledge of zoning considerations. Thus, this also constitutes a reasonable cause for delay.

I hope this represents some whittling away of the Boyle case. That said, I wonder whether the IRS will appeal – so it can protect that Boyle case.

I would say the Court had little patience with the IRS clogging up the pipes with what ten-out-of-ten people with common sense would see as reasonable cause.

Our case this time for the home gamers was Estate of Agnes R. Skeba vs U.S..

The Income Awakens

Despite the chatter of politicians, we are not soon filing income taxes on the back of a postcard. A major reason is the calculation of income itself. There can be reasonable dispute in calculating income, even for ordinary taxpayers and far removed from the rarified realms of the ultra-wealthy or the multinationals.    

How? Easy. Say you have a rental duplex. What depreciation period should you use for the property: 15 years? 25? 35? No depreciation at all? Something else?

And sometimes the reason is because the taxpayer knows just enough tax law to be dangerous.

Let’s talk about a fact pattern you do not see every day. Someone sells a principal residence – you know, a house with its $500,000 tax exclusion. There is a twist: they sell the house on a land contract. They collect on the contract for a few years, and then the buyer defaults. The house comes back.  

How would you calculate their income from a real estate deal gone bad?

You can anticipate it has something to do with that $500,000 exclusion.

Marvin DeBough bought a house on 80 acres of land. He bought it back in the 1960s for $25,000. In 2006 he sold it for $1.4 million. He sold it on a land contract.

COMMENT: A land contract means that the seller is playing bank. The buyer has a mortgage, but the mortgage is to the seller. To secure the mortgage, the seller retains the deed to the property, and the buyer does not receive the deed until the mortgage is paid off. This is in contrast to a regular mortgage, where the buyer receives the deed but the deed is subject to the mortgage. The reason that sellers like land contracts is because it is easier to foreclose in the event of nonpayment.

 

 DeBough had a gain of $657,796.

OBSERVATION: I know: $1.4 million minus $25,000 is not $657,796. Almost all of the difference was a step-up in basis when his wife passed away.  

DeBough excluded $500,000 of gain, as it was his principal residence. That resulted in taxable gain of $157,796. He was to receive $1.4 million. As a percentage, 11.27 cents on every dollar he receives ($157,796 divided by $1,400,000) would be taxable gain.

He received $505,000. Multiply that by 11.27% and he reported $56,920 as gain.

In 2009 the buyers defaulted and the property returned to DeBough. It cost him $3,723 in fees to reacquire the property. He then held on to the property.

What is DeBough’s income?

Here is his calculation:

Original gain		157,796
Reported to-date		(56,920)
Cost of foreclosure		(3,723)
		97,153

I don’t think so, said the IRS. Here is their calculation:

Cash received		505,000
Reported to-date		(56,920)
		448,080

DeBough was outraged. He wanted to know what the IRS had done with his $500,000 exclusion.

The IRS trotted out Section 1038(e):

         (e)  Principal residences.

If-

(1) subsection (a) applies to a reacquisition of real property with respect to the sale of which gain was not recognized under section 121 (relating to gain on sale of principal residence); and

(2)  within 1 year after the date of the reacquisition of such property by the seller, such property is resold by him,

then, under regulations prescribed by the Secretary, subsections (b) , (c) , and (d) of this section shall not apply to the reacquisition of such property and, for purposes of applying section 121 , the resale of such property shall be treated as a part of the transaction constituting the original sale of such property.

DeBough was not happy about that “I year after the date of the reacquisition” language. However, he pointed out, it does not technically say that the $500,000 is NOT AVAILABLE if the property is NOT SOLD WITHIN ONE YEAR.

I give him credit. He is a lawyer by temperament, apparently.  DeBough could find actionable language on the back of a baseball card.

It was an uphill climb. Still, others have pulled it off, so maybe he had a chance.

The Court observed that there is no explanation in the legislative history why Congress limited the exclusion to sellers who resell within one year of reacquisition. Still, it seemed clear that Congress did in fact limit the exclusion, so the “why” was going to have to wait for another day.

DeBough lost his case. He owed tax.

And the Court was right. The general rule – when the property returned to DeBough – is that every dollar DeBough received was taxable income, reduced by any gain previously taxed and limited to the overall gain from the sale. DeBough was back to where he was before, except that he received $505,000 in the interim. The IRS wanted its cut of the $505,000.

Yes, Congress put an exception in there should the property be resold within one year. The offset – although unspoken – is that the seller can claim the $500,000 exclusion, but he/she claims it on the first sale, not the second. One cannot keep claiming the $500,000 over and over again on the same property.

Since Debough did not sell within one year, he will claim the $500,000 when he sells the property a second time.

When you look at it that way, he is not out anything. He will have his day, but that day has to wait until he sells the property again.

And there is an example of tax law. Congress put in an exception to a rule, but even the Court cannot tell you what Congress was thinking.

Distinguishing Capital Gains From Ordinary Income

The holy grail of tax planning is to get to a zero tax rate. That is a rare species. I have seen only one repeatable fact pattern in the last few years leading to a zero tax rate, and that pattern involved not making much money. You can guess that there isn’t much demand for a tax strategy that begins with “you cannot make a lot of money….”

The next best plan is capital gains. There is a difference in tax rates between ordinary income (up to 39.6%) and capital gains (up to 20%). A tax geek could muddy the water by including phase-outs (such as itemized deductions or personal exemptions), the 15% capital gains rate (for incomes below $457,600 if you are married) or the net investment income tax (3.8%), but let’s limit our discussion just to the 20% versus 39.6% tax rates. You can bet that a lot of tax alchemy goes into creating capital gains at the expense of ordinary income.

The tax literature is littered with cases involving the sale of land and capital gains. If you or I sell a piece of raw land, it is almost incontrovertibly a capital gain. Let’s say that you are a developer, however, and make your living selling land. The answer changes, as land is inventory for you, the same as that flat screen TV is inventory for Best Buy.

Let’s say that I see you doing well, and you motivate me to devote less energy to tax practice and more to real estate. At what point do I become a developer like you: after my second sale, after my first million dollars, or is it something else?

The tax Code comes in with Section 1221(a), which defines a capital asset by exclusion: every asset is a capital asset unless the Code says otherwise.

For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1)  stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

Let’s take Section 1221(a)(1) out for a spin, shall we? Let’s talk about Long, and you tell me whether we have a capital asset or not.

Philip Long lives in Florida, which immediately strikes me as a good idea as we go into winter here. From 1994 to 2006 he operated a sole proprietorship by the name of Las Olas Tower Company (LOTC). Long had a drive and desire to build a high-rise condominium, which he was going to call Las Olas Tower.

He is going to build a condo, make millions and sit on a beach.

Problem: he doesn’t own the land on which to put the condo. Solution: He has to buy the land.

He finds someone with land, and that someone is Las Olas Riverside Hotel (LORH). LORC and LORH are not the same people, by the way, although “Las Olas” seems a popular name down there. Long enters into an agreement to buy land owned by LORH.

Long steps up his involvement: he is reviewing designs with an architect, obtaining government permits and approval, distributing promotional materials, meeting with potential customers. The ground hasn’t even been cleared or graded and he has twenty percent of the condo units under contract. Long is working it.

LORH gets cold feet and decides not to sell the land.

Yipes! Considering that Long needs to land on which to erect the condo, this presents an issue. He does the only thing he can do: he sues for specific performance. He needs that land.

He is also running out of cash. A friend of his lends money to another company owned by Long to keep this thing afloat. Long is juggling. Who knows how much longer Long can keep the balls in the air?

In November, 2005 Long wins his case. The Court gives LORH 326 days to comply with the sales agreement.

But this has taken its toll on Long. He wants out. Let someone finish the lawsuit, buy the land, erect the condo, make the sales. Long has had enough. He meets someone who takes this thing off his hands for $5,750,000. He sells what he has, mess and all. 

    QUESTION: Is this ordinary or capital gain income?

The difference means approximately $1.4 million in tax, so give it some thought.

The closer Long gets to being a developer the closer he gets to a maximum tax rate. The Courts have looked at the Winthrop case, which provides factors for divining someone’s primary purpose for holding real property. The factors include:

1. The purpose for acquisition of property
2. The extent of developing the property            
3. The extent of the taxpayer’s efforts to sell

The Tax Court looked and saw that Long had a history of developing land, had hired an architect, obtained permits and government approvals and had even gotten sales contracts on approximately 20% of the to-be-built condo units. A developer has ordinary income. Long was a developer. Long had ordinary income.

Is this the answer you expected?

It wasn’t the answer Long expected. He appealed to the Eleventh Circuit.

What were the grounds for appeal?

Think about Long’s story. There is no denying that a developer subdivides, improves and sells real estate. Long was missing a crucial ingredient however: he did not have any real estate to sell. All he had was a contract to buy, which is not the same thing. In fact, when he cashed out he still did not have real estate. He had won a case ordering someone to sell real estate, but the sale had not yet occurred.

The IRS did not see it that way. As far as they were concerned, Long had found a pot of gold, and that gold was ordinary income under the assignment of income doctrine. That doctrine says that you cannot sell a right to money (think a lottery winning, for example) and convert ordinary income to capital gains. You cannot sell your winning lottery ticket and get capital gains, because if you had just collected the lottery winnings you would have had ordinary income. All you did was “assign” that ordinary income to someone else.

The problem with the IRS point of view is that someone still had to buy the land, finish the permit process, clear and grade, erect a building, form a condo association, market the condos, sell individual units and so on. Long wasn’t going to do it. There was the potential there to make money, but the money truck had not yet backed into Long’s loading dock. Long was not selling profit had had already earned, because nothing had yet been “earned.”

Long won his day in Appeals Court.

He had ordinary income in Tax Court and then he had capital gains in Appeals Court.

Even the pros can have a hard time telling the difference sometimes.

The Mexican Fideicomiso and Foreign Trusts

This topic originated with Karl, who owns a condo in Puerto Vallarta, Mexico.

Karl was incredulous when I had him file a foreign trust tax return for his Mexican condo a couple of years ago. Why? Because the IRS was increasing their attention to foreign matters (think FBAR and FATCA, for example), and the penalties for failure to file had marched full-throated into extortion territory – at least for my clients, as I do not represent P&G, Toyota or their executives.

Under the Mexican constitution, noncitizens cannot directly own real estate within 50 kilometers of the coastline. This means that a U.S. citizen (Karl for example) has to use an agent to purchase the real estate. This agency is called a fideicomiso. Mind you the fideicomiso does nothing other than hold title – there is no bank account to pay taxes or insurance or repairs or anything.

The tax issue with the fideicomiso is whether or not the IRS would consider it to be a foreign trust. For many years practitioners (including me) considered it the equivalent of an Illinois land trust. The IRS treats the Illinois land trust as though it doesn’t exist; a technical way to say it is that the owner has a direct interest in the real estate and reports accordingly.

When the IRS tightened up its foreign reporting, it became unclear how they would treat fideicomisos. I called the National Office, for example, but received no clear-cut answer or leaning. This put me in a difficult spot, as the penalties for failure to file a return when assets are transferred to a foreign trust are the greater of $10,000 or 35% of the assets transferred. There is also an annual filing requirement (it is assumed that the trust is not funded annually), and those penalties are the greater of $10,000 or 5% of the value of the trust assets.

You can see how this gets very expensive.

So I had Karl file a tax return to report the funding (Form 3520) as well as an annual tax return (Form 3520-A). I am uncertain what the IRS got out of this, but Karl racked up additional tax compliance fees.

The IRS has recently published a Private Letter Ruling (PLR 201245003) stating that a fideicomiso is not a trust as that term is intended in IRS Reg. 301.7701-4(a), and that the beneficiary of the trust is to be treated as the direct owner. In other words, the fideicomiso is “invisible” to the IRS.

There are issues with PLRs, primarily that the IRS does not consider them as precedent to anyone other than the person to whom the PLR was issued. That means that – while tax advisors can look to them for markers as to IRS positions – they are not a failsafe if the IRS goes against you.  Karl is not completely protected unless he obtains his own PLR. Those cost money, of course. The filing fee alone can be several thousand dollars. Then you have my fee.

Don’t get me wrong: I have used PLRs in IRS representation before, and I have gotten greater or lesser traction depending on the examiner, manager or appeals officer and the magnitude of the specific issue to the exam. I suspect that, in the case of fideicomisos, the IRS is waving the flag and giving advisors a clue on their position and enforcement intentions. But one cannot be sure, and there’s the rub.

So how would you have me advise Karl? Would you advise him/her to get his/her own PLR (for thousands of dollars), would you rely on the issued PLR or would you have Karl continue filing Forms 3520/3520-A?

And remember: all we are talking about is a condo. A nice one, granted, but this "trust" has never even been near Switzerland.