Trust’s Incorrect Tax Form Forfeited Large Tax Refund Claim: A Lesson For Trustees

Lesson To Learn

So the moral of this tax tale is that you have to be careful about making sure you file the right tax form to get what you want. We’ll elaborate a bit on the key point in the case to provide more background on trust taxation and trusts generally. The broader message of this case might be to be certain that the person, or at least one of the persons, serving as trustee has the professional knowledge to either administer the trust properly or to hire the professionals that can administer a trust properly. This might also be a message of something that not every CPA has detailed knowledge of trust taxation. It’s a specialty. You might have a great CPA that has been a trusted family adviser for decades, even for generations. That is great and you should maintain and foster that relationship. But if you have a complex issue, such as trust taxation, it might make sense to hire a specialist if your general CPA does not have the expertise or a partner that does.

Background on Trust Taxation

First, there are several types of trusts for income tax purposes. There are “grantor trusts” whose income is taxed to the person, the settlor, creating the trust. The QPRT (discussed below) that was how the initial trust in this case was characterized, was a grantor trust. But when the taxpayer who created it died, the character of that trust changed to that of a non-grantor trust. Thus, there are also, as in this case, non-grantor trusts which are also called “complex” trusts. These trusts generally pay their own income tax and the income is not reported by the person creating the trust. Complex trusts “generally” pay their own income taxes as they get a deduction for trust income tax purposes for income distributed to beneficiaries. The beneficiaries receiving distributions then report the income for tax purposes that is included in the income they received from the trust. This is referred to as the trusts distributable net income or “DNI.” In general terms the purpose of DNI is to allocate taxable income as between the trust and the beneficiaries.

The Trusts and Selected Facts in this Case

The trust in this case seems to be the remainder trust after the termination of a Qualified Personal Residence Trust (“QPRT”). A QPRT is a special type of trust that can, in appropriate circumstances, be used to transfer a valuable house out of the taxpayer’s estate to descendants, or a trust for them, at a discount from the trust’s current value. If the taxpayer dies after their house is transferred to the QPRT there is no income tax basis step up on the value of the house in the trust, since it is not included in the taxpayer’s estate. Yet the trust as taxpayer appears to have increased the income tax basis of the house on death. After much back and forth with the IRS the trust paid additional taxes then sought a refund claim for some of those taxes.

What Import is Which Tax Form Used?

The trust in this case had income to report for income tax purposes. That is done on Form 1041, U.S. Income Tax Return for Estates and Trusts. The trust felt that it was entitled to a refund of some of the taxes paid so it filed for a refund. Refund claims are supposed to be filed by amending the trust income tax return, Form 1041. Reg. Sec. 301.6402-3(a)(4). The trust, however, instead filed Form 843 which is a form to make a claim for a refund. What’s in a name? A lot as the Court determined that the trust failed to take the appropriate action and the refund it sought was lost. The trust’s filing did put the IRS on notice of the claim it was the wrong action. Palermo v. U.S., 2023 PTC 215 (S.D. Fla. 2023).

The IRS position was that the taxpayer’s filing of a Form 843 was insufficient as a formal claim because an amended Form 1041 is the proper form. The Court found that the IRS is authorized to demand information in a particular form and to insist that the form be observed. The instructions to Form 1041 indicate that to claim a refund an amended Form 1041 has to be filed. The Form 843 instructions indicate that the form is for a refund of taxes other than income tax. It seems, without meaning to be a Monday morning quarterback, that the trustee or CPAs the trustee hired should have read the instructions.

What Really Happened?

Not sure. Perhaps the trustee did not have sufficient knowledge to serve in that role based on the issues with inappropriately claiming a basis step up that was not warranted then filing a refund claim on the wrong form, and never remedying it. Perhaps the CPA hired by the trustee did not have the background to address these issues properly. It is possible that the heirs of the taxpayer served as trustees and felt competent to handle trust administration when perhaps they weren’t.

What Might Happen Next?

If the trustee was an independent person, not the heirs, the heirs might sue the trustee for improper administration of the trust. If the trustee hired a CPA to advise on the trust tax matters, perhaps the trustee will sue the CPA. Perhaps the beneficiaries will sue both the trustee and CPA.

A Dollar of Perspective on Frugality

Let’s say the family was frugal and saved the cost of hiring a professional or institutional trustee. That could have been more than a few bucks over so many years. Say the trustee was really frugal and decided that the tax returns were so simple that she could handle the tax filings without a CPA. That was perhaps another chunk of dough saved each year. Or perhaps the trustee was a bit smarter and hired a CPA but the CPA didn’t fess up on their limitations on trust income tax work, or the trustee just stuck with their long time CPA. That might have been a savings each year as compared to the cost of having hired a CPA that specializes in trust income taxation.

If the clients were especially frugal they may have also avoided having periodic review meetings with the estate and trust attorney who created the trust. If those meetings had occurred perhaps the attorney would have recognized the basis step-up issue and even the refund issue.

It can be prudent to save costs on trust administration but that always needs to be weighed against the costs that might be incurred dealing with audits, and lost opportunities, such as the tax refund in this case.

The taxpayer in this case was sophisticated, in fact he was a judge. The trustee (at least for the QPRT) was the son of the judge. The taxpayer/judge died in 2015. The house was sold the following year for amount $1.8 million. The IRS demanded $930,127.90 in taxes, penalties, and interest from the Trust. The Trust paid the amount assessed on September 24, 2021. The Court opinion was handed down August 7, 2023. How much in terms of legal and accounting fees were incurred in these years of haggling with the IRS? And those costs would have been in addition to the nearly $1 million of taxes, penalties and interest. It is hard to imagine that the cost of an annual review with the trust attorney and a CPA specializing in trust work could have been more than a tiny fraction of the costs the family ultimately incurred. And all of those costs might even pale by comparison to the legal fees in future lawsuits.

Frugality is a laudable character trait, but it has to be balanced. Trust are kinda like those TV car commercials, you know with the cool sports car zipping around a circuitous mountain road at even cooler speeds. Consider the warning on the TV screen: “Professional driver closed course.” That is probably the right perspective for trusts. Best to have professional drivers.