Doctrine of “Substantial Compliance” Has A High Bar To Satisfy

Those of us with federal tax problems in California are governed by the court decisions made the Ninth Circuit Court of Appeals; decisions by other Circuit Courts do not necessarily apply to California’s taxpayers directly. But in a recent decision Estate of Tamulis v. Comm’r of Internal Revenue by the Seventh Circuit Court of Appeals involving the tax treatment of a charitable remainder trust-a trust in which the income goes to individuals during their lifetime (or some other period) but what remains after their rights expire goes to charity – the Court held against carrying out the charitable intent of the donor.

Here’s the story. Father Tamulis, a Catholic priest, died in 2000, leaving an estate of $3.4 million. His will left the bulk of his estate to a living trust that he had created. The trust was to continue for the longer of 10 years or the joint lives of Tamulis’s brother and the brother’s wife. During that period they would have a life estate in a house owned by the trust and the trust would pay the real estate taxes on the house.

The net income of the trust, as “determined in accordance with normal accounting principles,” would go to two of the brother’s and sister-in-law’s grandchildren (that is, Tamulis’s grandnieces), minus $10,000 a year, which would go to their third child until she graduated from medical school. Upon the termination of the trust the assets would pass to a Catholic diocese.

The estate tax return, filed in 2001, claimed a charitable deduction of $1.5 million, represented to be the present value of the charitable remainder, which was described on the return as the “residue following 10 year term certain charitable remainder unitrust at 5% quarterly payments to two grand nieces.” In each of the years 2001 through 2004, the trust distributed no more than 5 percent of the fair market value of the trust’s assets, as valued at the beginning of each year, to the grandnieces and for the payment of the real estate taxes on their parents’ home.

The Internal Revenue Service refused to allow the charitable deduction. The charitable remainder, as defined in the trust instrument, was not a charitable remainder unitrust as defined in the Internal Revenue Code. In particular, the trust instrument did not specify either a fixed dollar amount, or the percentage of the trust’s fair market value, that would go to the income beneficiaries- to the grandnieces in cash and to their parents in the form of a life estate in the house and payment of the real estate taxes on it, which would be paid out of the trust’s income.

This was a fundamental defect, fixable only by a judicial proceeding to reform the trust, filed within 90 days after the estate tax return was due. The trustee (who was also the executor of Father Tamulis’s will) and the diocese realized that there was a problem. But more than eight months elapsed before the executor prepared a complaint to file in an Illinois state court (the trust is governed by Illinois law) to reform the trust. And for unexplained reasons the complaint was never filed. Instead, in 2003 the executor circulated to the income beneficiaries a proposed reformation of the trust to bring it into compliance with the Code. But the third grandniece did not sign it, and so the trust has never been reformed, with or without a judicial proceeding, although the trustee continues to administer it in accordance with the requirements of the Code, as her predecessor (the original trustee, who has died) had said in the estate tax return that he was doing.

Her argument, rejected by the Tax Court and renewed before the Seventh Circuit, is that the statement in the return, coupled with the trustee’s continued administration of the trust as if it were a qualified unitrust, should be deemed substantial compliance with the Code, although she concedes that it is not literal compliance.

There is a doctrine of substantial compliance with the often intricate and obscure provisions of the Internal Revenue Code. The Seventh Circuit has criticized the Tax Court’s articulation of the doctrine for formlessness, and, noting that the courts of appeals do not defer to the legal rulings of that court any more than they do to the rulings of a district court, has ruled that the “doctrine of substantial compliance should not be allowed to spread beyond cases in which the taxpayer had a good excuse (though not a legal justification) for failing to comply with either an unimportant requirement or one unclearly or confusingly stated in the regulations or the statute.”

Tamulis’s charitable remainder trust flunks this test. The executor-trustee, represented by counsel, as he was, and well aware that a substantial tax deduction was at stake, had no excuse for failing to bring the required judicial proceeding to reform the trust. The requirement is not unimportant; it protects against efforts to bend trust law to get a tax benefit. Nor is the requirement stated unclearly or confusingly in the Code or in any regulation-it is perfectly clear. Until the trust was reformed, compliance with the spirit of the Code’s provisions dealing with charitable remainder trusts had depended largely on the good faith of the trustee.

When the conditions for applying the doctrine are not satisfied, it makes good sense to hold a taxpayer to the requirements of the tax code. The doctrine of substantial compliance “seeks to preserve the need to comply strictly with regulatory requirements that are important to the tax collection scheme and to forgive noncompliance for either unimportant and tangential requirements or requirements that are so confusingly written that a good faith effort at compliance should be accepted.” The doctrine is therefore inapplicable to this case.

Do you think you qualify to have the doctrine of substantial compliance apply to you? Speak with a California tax attorney and call Mitchell A. Port at 310.559.5259.