Substantial Compliance Insufficient to Allow Charitable Deduction

The Seventh Circuit has held that the doctrine of substantial compliance would not allow a trust to take a charitable deduction where the trustee had intended, but failed, to reform the trust as a charitable remainder unitrust (Estate of Tamulis, 7th Cir., 11/30/07, aff’g TC Memo 2006-183).

The Rev’d Anthony Tamulis, a Catholic priest, died in 2000, leaving the bulk of his $3.4 million estate to a living trust. The trust was to continue during the joint lives of Tamulis’s brother and his wife; 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 Tamulis’s two grandnieces. On the termination of the trust the assets—the charitable remainder—would pass to a Catholic diocese.

The estate tax return, filed in 2001, claimed a charitable deduction of $1.5 million. The return described this as the present value of the charitable remainder, the “residue following 10 year term certain charitable remainder unitrust at 5% quarterly payments to two grand nieces.”

The 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 Sec. 664(d)(2). In particular, the trust instrument failed to specify either a fixed dollar amount or the percentage of the trust’s fair market value that would go to the income beneficiaries, as required by Sec. 664. This defect could be cured only by a judicial proceeding to reform the trust, filed within 90 days after the estate tax return was due (Sec. 2055(e)(3)(C)(iii)).

The trustee/executor discovered that the trust did not qualify as a charitable remainder unitrust but never instituted a judicial proceeding in state court to reform the trust. And although the trustee circulated to the income beneficiaries a proposed reformation of the trust to bring it into compliance with the Code, one grandniece did not sign it, and the trust was never reformed. The trustee continued to administer the trust in accordance with the Sec. 664 requirements for qualified unitrusts.

The trustee argued before the Tax Court and the Seventh Circuit 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, even though it was not literal compliance. Under the substantial compliance doctrine, the Tax Court will occasionally excuse taxpayers from strict compliance with tax law requirements as long as the taxpayer has substantially complied with the essential statutory purpose. (See, e.g., American Air Filter Co., 81 TC 709 (1983), and Sperapani, 42 TC 308 (1964).)

The Tax Court and the Seventh Circuit both rejected the trustee’s argument. The Seventh Circuit took a strict view of the substantial compliance doctrine: “[T]he ‘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’” (quoting Prussner, 896 F2d 218, 224 (7th Cir. 1990)). The trustee/executor had no excuse for failing to bring a judicial proceeding in state court to reform the trust. The court found that the requirement is not unimportant and is not unclear or confusing. The trustee/exec-utor was represented by legal counsel. Therefore, according to Judge Posner, writing for the Seventh Circuit, “it makes compellingly good sense to hold a taxpayer to the requirements of the tax code.”