In Estate of Helen P. Richmond et al. vs. vs. Commissioner T.C. Memo. 2014-26, February 11, 2014, the Tax Court addressed reasonably straightforward estate tax valuation questions in a reasonably predictable manner. The additional tax imposed because of a higher valuation was not particularly surprising to me, and probably not to others who regularly practice in this area.
However, the Tax court decided to also assess a 20% penalty for a substantial valuation understatement. The Tax Court was willing to not assess the penalty in a different situation, but the Court was unimpressed with the estate’s valuation documentation. The Court explained the penalty rules and their applicability as follows:
“Generally, a 20% penalty is imposed on “any portion of an underpayment of tax required to be shown on a return” where the underpayment is attributable to a substantial estate tax valuation understatement. Sec. 6662(a), (b)(5). An estate tax valuation understatement is treated as “substantial” where the value of any property required to be reported on an estate tax return is reported at 65% or less of the correct value. Sec. 6662(g)(1). The Commissioner bears the burden of production with respect to the penalty determined under section 6662. …
However, the 20% penalty under section 6662(a), (b)(5), and (g) will not apply to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.” See sec. 6664(c)(1). The regulations provide that whether an underpayment of tax is made in good faith and due to reasonable cause will depend upon the facts and circumstances of each case. 26 C.F.R. sec. 1.6664-4(b)(i), Income Tax Regs. Reasonable cause may involve reliance on a professional tax advisor, but such reliance does not necessarily demonstrate reasonable cause and good faith…”
In this case, the Court assessed a penalty because of (i) who performed the valuation, and (ii) how the appraisal conclusion was documented. The situation described by the Court is actually quite common, since taxpayers prefer the less costly approach of using an existing accountant to provide a value. However, the large penalty could have likely been avoided had additional attention (and cost) been provided. The Court explained:
“… we cannot say that the estate acted with reasonable cause and in good faith in using an unsigned draft report prepared by its accountant as its basis for reporting the value of the decedent’s interest in PHC on the estate tax return. Mr. Winnington is not a certified appraiser. The estate never demonstrated or discussed how Mr. Winnington arrived at the value reported on the estate return except to say that two prior estate transactions involving PHC stock used the capitalization-of-dividends method for valuation …”
The morale of the story is simple. Spend the money for a professional appraisal, and you will have a much better chance of avoiding a valuation understatement penalty, even if the appraisal turns out to not be correct. Additionally, the professional appraisal and its up-front disclosure to the IRS may allow you to avoid getting audited in the first place.