Hornberger v. Commissioner

T.C. Memo. 2000-42

UNITED STATES TAX COURT

EDITH HUNTER HORNBERGER, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 3656-98, 3658-98, Filed February 9, 2000.
3676-98.

Craig D. Bell, for petitioners.

John C. McDougal, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge: In separate notices of deficiency, respondent

determined the following deficiencies and additions to tax:

1
Cases of the following petitioners are consolidated
herewith for purposes of trial, briefing, and opinion: Estate of
Edna B. Hunter, Deceased, Shirley Hunter, Administratrix, docket
No. 3658-98; and EV Hunter Trust, Shirley M. Hunter and T.
William Dowdy, Co-Trustees, docket No. 3676-98.
 - 2 -

Re: Edith H. Hornberger, docket No. 3656-98:

Addition to Tax
Year Deficiency Sec. 6651(a)

1992 $744,724 $47,810

Re: Estate of Edna B. Hunter, Deceased, Shirley M. Hunter
Administratrix, docket No. 3658-98:

Addition to Tax
Year Deficiency Sec. 6651(a)

1992 $722,052 $180,513

Re: EV Hunter Trust, Shirley M. Hunter and T. William Dowdy, Co-
Trustees, docket No. 3676-98:

Addition to Tax
Year Deficiency Sec. 6651(a)

1992 $722,238 $166,397

The deficiency and addition to tax in each of these

consolidated cases is a duplication of the deficiency and addition

to tax in the other cases.

Following concessions by the parties, the issues for decision

are: (1) Whether interest on estate taxes paid by the EV Hunter

Trust (the trust) in 1988 and deducted by the trust’s grantor,

Edith H. Hornberger (petitioner), on her 1988 amended individual

tax return, and refunded by the Internal Revenue Service (IRS) to

the Estate of Edna B. Hunter, Deceased (the estate), in 1992

constitutes income in 1992, pursuant to the tax-benefit rule, to
 - 3 -

the estate, the trust, or petitioner; and (2) whether a section

6651(a) addition to tax for failure to timely file a tax return is

applicable.

All section references are to the Internal Revenue Code in

effect for the year under consideration. All Rule references are

to the Tax Court Rules of Practice and Procedure. All dollar

amounts are rounded.

FINDINGS OF FACT

Some of the facts have been stipulated and are found

accordingly. The stipulation of facts and the attached exhibits

are incorporated herein by this reference.

Background

Petitioner resided in Springfield, Virginia, on the date her

petition was filed. The legal address of both the trust and the

estate was in Springfield, Virginia, at the time they petitioned

this Court.

Decedent and Her Estate

Edna B. Hunter’s (decedent’s) only child, Herbert C. Hunter

(Mr. Hunter), was married to Shirley M. Hunter (Mrs. Hunter). Mr.

and Mrs. Hunter had a daughter, petitioner, who was born on

November 3, 1968. Mr. Hunter was murdered in 1976.

On April 11, 1984, decedent died intestate, leaving an estate

valued at over $20 million to petitioner. Mrs. Hunter qualified

and served as the administratrix of decedent’s estate. Mrs. Hunter
 - 4 -

retained Henry Clay (Mr. Clay), the family accountant and attorney,

to advise her and to prepare legal and tax documents for the

estate.

The Trust

On November 11, 1986, 8 days after her 18th birthday,

petitioner executed a trust indenture2 pursuant to which an

irrevocable trust was established. The trust was to exist until

November 3, 2003 (the date petitioner would turn 35 years old);

however, the terms of the trust indenture could be modified or

amended (and the trust could be terminated) at the end of each 5-

year period during the term of the trust provided the change (or

termination) was agreed to by all of the trustees and petitioner.

Ultimately, all of the assets petitioner inherited from the

decedent were placed into the trust.

The trust had three cotrustees: T. William Dowdy (Mr. Dowdy),

Mrs. Hunter, and Mr. Clay. Mr. Dowdy, an attorney, dealt with real

estate issues (particularly condemnation proceedings and other

matters requiring court appearances). Mrs. Hunter acted as a

liaison between petitioner and Mr. Clay. Pursuant to the

provisions of the indenture, two trustees could act on any matter

within their collective authority; in reality, Mr. Clay alone

determined the amount of the trust distributions.

2
The trust was established at the recommendation of Mr.
Clay. At the time petitioner signed the trust indenture, Mr.
Clay did not explain to her how the trust would operate.
 - 5 -

Mr. Clay managed and controlled the trust, its assets, and all

relevant files relating thereto. He alone (1) assumed

responsibility for investment decisions, (2) made distributions to

petitioner, (3) maintained the trust books and records, and (4)

prepared and filed tax returns and supporting documentation. He

prepared annual accountings of the trust’s finances on behalf of

the cotrustees (depicting distributions from the trust as well as

assets contained in the trust).

As of spring 1993, Mr. Clay had fallen a few years behind in

preparing these accountings because most of the trust assets

consisted of unimproved land near Springfield Mall, which was tied

up in condemnation proceedings.

Mr. Clay believed that petitioner was too young to comprehend

the substantial inheritance she had received. He took the position

that only after petitioner became older would she appreciate the

size and type of assets inherited and be in a position to properly

manage her inheritance. Consequently, Mr. Clay provided petitioner

with minimal information regarding her inheritance: he did not

prepare any statements detailing the size or composition of the

trust assets, the income generated by the trust, or the amounts of

distributions or expenditures of funds that were made on her

behalf. Because of Mr. Clay’s philosophy, petitioner was clueless

as to the size and type of the trust assets. Petitioner was aware

only that the trust assets included real estate, which she believed
 - 6 -

had a value of $1 to $2 million.

The Estate’s Form 706 and Petitioner’s 1988 Amended Return

On January 11, 1985, the estate timely filed a Form 706, U.S.

Estate Tax Return, reporting $7,333,264 as the estate tax due. At

the time the return was filed, the estate remitted $2,833,264 as a

partial payment. The return was audited, and a notice of

deficiency was issued determining an additional estate tax

liability of $4,802,358 and additions to tax of $607,017. The

estate did not contest the deficiency or additions to tax, and they

were duly assessed.

Between January 21, 1985, and October 18, 1988, a total of

$16,403,665 (including the $2,833,264 partial payment remitted with

the return) was paid toward the balance due (pursuant to the estate

tax return, the deficiency and additions to tax, and the statutory

interest). The trust paid a portion of this balance in 1988,

including $2,357,4933 of interest on the estate’s deficiency.

Mr. Clay treated the trust as a complex (taxable) trust in

preparing and filing the trust’s fiduciary income tax returns.4

Accordingly, the trust’s 1988 Form 1041, U.S. Fiduciary Income Tax

Return, reflected a total $2,724,752 deduction for interest paid,

3
In the parties’ stipulation of facts, the figure for
interest paid is erroneously reflected as $2,357,495. We use the
correct figure reflected on the return.
4
A complex trust is a separate taxpayer subject to the
income tax. See sec. 1(e).
 - 7 -

which included the $2,357,493 paid.

In October 1991, the IRS and the estate entered into a

settlement agreement in which the Federal estate tax liability and

additions to tax previously assessed were decreased in the

respective amounts of $4,122,736 and $1,042,403.

In late September 1992, the IRS, the trust representatives,

and petitioner agreed that the trust should have been taxable as a

grantor trust pursuant to sections 671 through 678 since its

inception.5 Accordingly, in November 1992, amended Forms 1041 were

filed for the trust, recharacterizing the trust as a grantor trust.

As a result of this recharacterization, the $2,357,493 of interest

paid on the estate tax was attributed to petitioner and was

reflected as an interest deduction on her 1988 amended income tax

return.6

The Refund Check

On February 18, 1992, the IRS issued a $10,364,431 refund

check (the refund check) made payable to the estate. The refund

check included $2,290,469 in interest that previously had been

5
A grantor trust is not subject to the income tax.
Rather, all of the income and deductions pertaining to a grantor
trust must be taken into account by the grantor. See secs. 671-
678.
6
The “Explanation of Change to Income and Tax Reduction
For 1988" attached to petitioner’s 1988 amended return in
relevant part states: “the administrative expenses of the Hunter
Estate are to be flowed through the E.V. Hunter Trust (grantor
trust) and ultimately reflected on the individual income tax
returns of Edith Hunter Hornberger.”
 - 8 -

assessed against the estate and paid by the trust, as well as an

additional $2,908,823 in statutory interest on the overpayment.

The parties have stipulated: “Upon receipt of the estate tax

refund check, the administratrix of the Hunter Estate provided the

check to Edith Hunter Hornberger, who negotiated it to the co-

trustees of the Hunter Trust, who deposited it into the Trust bank

account.”

Of the interest component of the refund check, petitioner

reported $2,866,927 (the portion which her representatives

calculated as the interest on the overpayment) on her 1992

individual tax return.7 The remainder of the interest component of

the refund check, $2,290,469, represented a return of a portion of

the $2,357,493 deficiency interest the trust paid in 1988.8

Neither petitioner, the trust, nor the estate reported the

$2,290,469 refund of overpaid assessed interest on her or its

respective 1992 return. No Form 1099-INT or other informational

return was issued to the estate or the trust.

7
The parties now agree that (1) the interest on the
overpayment is $2,908,823, and (2) the balance of $41,896 is also
reportable by petitioner as interest income.
8
On Mar. 18, 1999, respondent provided petitioners with
a copy of the IRS Office of Appeals posting voucher approving the
manual refund of estate taxes, additions to tax, and interest for
the estate refund. This posting voucher notes that the
$10,364,431 total payments included $2,290,469 in interest
previously assessed against the estate. It also specifies an
additional $2,908,823 of statutory interest on the Federal estate
tax overpayment that was included in the refund to the estate.
 - 9 -

Mr. Clay, Keith Hornberger, and the Trust Distributions

Mr. Clay managed the trust assets conservatively. Other than

paying a portion of petitioner’s education and other living

expenses, he gave her a modest monthly cash allowance, which was

deposited directly into her bank account. In 1986, petitioner’s

monthly allowance was $500.

Petitioner attended college part time and worked part time as

a bank teller. On July 2, 1988, she married Keith Hornberger (Mr.

Hornberger). Following her marriage, petitioner no longer attended

school and began working full time. After the couple had children

(in 1989), petitioner ceased working outside their home. At all

relevant times, Mr. Hornberger was unemployed.

Mr. Clay periodically increased petitioner’s monthly allowance

but only after and in response to her requests.9 Mr. Clay did not

approve of petitioner’s marriage to Mr. Hornberger. Mr. Clay

believed Mr. Hornberger to be a freeloader; thus, he kept the trust

financial information from petitioner because he feared that Mr.

Hornberger and his “questionable friends” might try to “milk” the

trust through petitioner.10

9
At the time of petitioner’s marriage to Mr. Hornberger,
she asked Mr. Clay to increase her monthly allowance.
Approximately a week later, Mr. Clay agreed to do so, increasing
her monthly allowance to $1,000.
10
Mr. Clay’s concern arose from an incident in the late
1980's when the trust provided $40,000 to Mr. Hornberger in order
for him to start an automobile detailing business. The funds
(continued...)
 - 10 -

Adding to Mr. Clay’s skepticism, during 1992, Mr. Hornberger

experienced a bipolar mental disorder that became progressively

worse. Mr. Hornberger threatened suicide and violence against his

family (i.e., he told Mrs. Hunter that he would “cut her” or “slice

her up”). Petitioner was forced to move with her children out of

the family home. She did not inform Mr. Hornberger of their

whereabouts. Mr. Hornberger was then hospitalized for observation

several times, and on November 3, 1992, he escaped from a hospital.

After being confronted by police and the possibility of his arrest,

Mr. Hornberger agreed to a 30- to 60-day confinement. He was

placed on medication. In order to be convinced that he was

properly taking his medication, petitioner waited approximately 1

month after his release from the hospital to move back into the

family home in February or March 1993.

Mr. Clay objected to petitioner’s requests that the trust pay

Mr. Hornberger’s hospitalization bills, which, at the time, had

accumulated to approximately $50,000. As a result of her strained

relationship with Mr. Clay, petitioner frequently approached her

mother (as cotrustee) to intercede on her behalf in obtaining

additional funds from the trust. It was only after Mrs. Hunter’s

intervention that Mr. Clay permitted the trust to pay Mr.

10
(...continued)
were quickly spent, and no business was created. From that point
on, Mr. Clay took a hard-nosed position with petitioner whenever
she requested additional funds from the trust.
 - 11 -

Hornberger’s medical expenses. By 1992, Mr. Clay increased

petitioner’s monthly allowance to $2,500.

Mr. Clay’s Demise

From 1986 to 1992, Mr. Clay prepared the annual tax returns

for petitioner and the trust. Petitioner usually went to Mr.

Clay’s office to sign her individual tax returns. She generally

was not provided an opportunity to review the returns; rather, Mr.

Clay had the return open to the signature page, and petitioner was

instructed to sign it. Mr. Clay alone signed the trust fiduciary

income tax return; petitioner never saw this return.

During the fall of 1992 (at the age of 88), Mr. Clay suffered

several heart ailments; his strength and physical endurance

weakened. On several occasions during the latter part of 1992, Mr.

Clay fell in the parking lot outside his law office. His falls and

physical condition resulted in his hospitalization on several

occasions in late 1992 and in early 1993.

Concurrently, Mr. Clay was the care provider for his wife, who

suffered from Alzheimer’s disease. In late November 1992, they

moved from the family home to the Palm Springs Retirement

Community. Mr. Clay continued practicing law, going to his office

when possible.

In early 1993, Mrs. Hunter and Mr. Dowdy were aware of Mr.

Clay’s deteriorating health and periodically discussed with him the

progress he had made regarding the preparation and filing of the
 - 12 -

required returns. Mr. Clay, who had remained mentally alert,

assured them that he was progressing in the usual manner in

preparing the 1992 fiduciary income tax return and the allocation

statement for petitioner. During March and April of 1993,

petitioner inquired about her tax return with Mr. Clay and her

mother; she was told that the tax returns and grantor trust

allocation statements were being prepared.

Mr. Clay informed the cotrustees that sufficient estimated tax

payments had been previously made. He specifically informed Mr.

Dowdy that if he was unable to complete and file the 1992 returns,

he would prepare and file appropriate extension forms.

Mr. Clay’s health continued to decline through the spring of

1993. On July 1, 1993, he was moved to a convalescent home, where

he died 5 days later.

As a result of Mr. Clay’s deteriorating health, he neither

completed the 1992 information return for the trust nor filed the

necessary 1992 returns for petitioner, the estate, or the trust

within the prescribed period. (No extensions were requested.)

Following Mr. Clay’s death, the surviving cotrustees retained a

certified public accountant to prepare and file 1992 tax returns

for the estate, the trust, and petitioner. On February 2, 1994,

the returns (a Form 1040 for petitioner and Forms 1041 for the

estate and the trust) were filed for all three taxpayers’ 1992 tax

year.
 - 13 -

Notices of Deficiency

Separate notices of deficiency were mailed to petitioner, the

trust, and the estate. The “Explanation of Items” attached to each

of the notices stated:

Recovery of Prior Deduction

Per return $ -0-
As Corrected 2,290,469
Adjustment 2,290,469

Since you, and/or pass-through entities of which you are
beneficiary, recovered an amount deducted in a prior
year, we included it in your income. Under the tax-
benefit rule and pursuant to the duty of consistency,
this amount is income to you. In accordance with
Internal Revenue Code section 61 income from whatever
source is taxable.

Interest Income from IRS

Per return $2,866,927
As Corrected 2,908,823
Adjustment 41,896

Since you, and/or pass-through entities of which you are
a beneficiary, received interest income on a refund from
the Internal Revenue Service, we have included the amount
shown in your income.

Each notice also determined a section 6651(a) addition to tax.

ULTIMATE FINDINGS OF FACT

1. In 1992, petitioner received a refund of $2,290,469 in

interest that she had deducted as interest expense on her 1988

amended return.

2. Petitioner had reasonable cause for the late filing of

her 1992 Federal income tax return.
 - 14 -

OPINION

Issue 1. Tax-Benefit Rule

Respondent contends that the tax-benefit rule requires

petitioner to include in her 1992 income the $2,290,469 refund of

interest which was deducted on her 1988 amended tax return. In

the alternative, respondent asserts that that amount is includable

in the income of either the estate or the trust.11

The tax-benefit rule requires an amount to be currently

included as income to the extent that: (1) The amount was properly

deducted in a year prior to the current year; (2) the deduction

resulted in a tax benefit; (3) an event occurs in the current year

that is fundamentally inconsistent with the premises on which the

deduction was originally based; and (4) a nonrecognition provision

of the Internal Revenue Code does not prevent the inclusion in

gross income. See, e.g., Hillsboro Natl. Bank v. Commissioner, 460

U.S. 370, 383-384 (1983); Frederick v. Commissioner, 101 T.C. 35,

41 (1993). A current event is an event that is fundamentally

inconsistent with the premises on which the deduction was

originally based when that event would have prevented the deduction

11
The deficiencies and additions respondent determined
against the estate and trust are alternatives. Neither a
deficiency nor an addition to tax will be due from either entity
should we hold that petitioner realized income pursuant to the
tax-benefit rule.
 - 15 -

if the event had occurred in the year of the deduction. See

Hillsboro Natl. Bank v. Commissioner, supra; Frederick v.

Commissioner, supra at 41.

Petitioner maintains that the tax-benefit rule is not herein

applicable. She posits that the estate and petitioner are

different persons–-petitioner claimed the interest deduction on her

1988 amended tax return; the refund check was payable to the estate

in 1992 (as the estate’s recovery in 1992 of the amount deducted).

Continuing, petitioner asserts that it is of no consequence that

the trust (or petitioner) ultimately received the proceeds from the

refund check because it was the estate which had title to, and

possessed, the refund.

Respondent asserts petitioner’s position is flawed, relying on

the stipulation agreed to by the parties: “Upon receipt of the

estate tax refund check, the administratrix of the Hunter Estate

provided the check to Edith Hunter Hornberger, who negotiated it to

the co-trustees of the Hunter Trust, who deposited it into the

trust bank account.” Respondent contends that although the refund

check was payable to the estate, the funds were returned in 1992 to

petitioner (who had taken the interest deduction on her 1988

amended return).12 According to respondent, it is inconsistent for

12
Respondent points to the stipulated fact that the 1992
refund check included “$2,290,468.85 [which] represented a return
of part of the $2,357,493 deficiency interest paid by the trust
in 1988.” Moreover, the parties stipulated that the amended
(continued...)
 - 16 -

petitioner to have claimed a deduction on her 1988 amended return

and not reported the 1992 refund she received. We agree with

respondent.

The trust originally paid the interest on the tax deficiency

and deducted that amount, $2,724,752, as an interest expense on its

1988 fiduciary return. When this return was amended to reflect the

agreement among the IRS, the trust representatives, and petitioner

to recharacterize the trust as a grantor trust, the interest

expense deduction the trust had claimed was allocated to petitioner

and was reflected on her amended 1988 income tax return. The

deduction resulted in a tax benefit in proportion to the full

amount of the deduction. And the amount was ultimately returned to

petitioner (via the refund check) in 1992.13

In sum, the refund of the interest on the tax deficiency,

previously deducted, gives rise to taxable income under the tax-

12
(...continued)
return attributed “to Edith Hunter Hornberger all trust income
and deductions, including the deduction for the $2,357,495.08 of
interest paid on the estate tax.”
13
In Hillsboro Natl. Bank v. Commissioner, 460 U.S. 370
(1983), the Hillsboro Bank paid State taxes and deducted them
when paid, pursuant to sec. 164(e). Later, the State refunded
the taxes directly to the bank’s shareholders. The Government
sought to include the shareholders’ refund of the State taxes in
the income of the bank. See id. at 372-374. The Supreme Court
concluded that “unless a nonrecognition provision of the Internal
Revenue Code prevents it, the tax benefit rule ordinarily applies
to require the inclusion of income when events occur that are
fundamentally inconsistent with an earlier deduction.” Id. at
372.
 - 17 -

benefit rule. The $2,290,469 petitioner deducted on her amended

1988 return went from the trust, to the IRS, to the estate, to

petitioner, and back to the trust. Petitioner and the trust parted

with no money; consequently, it would be inconsistent to permit

petitioner to retain the benefit of the $2,290,469 deduction when

that amount was refunded to her. See, e.g., Frederick v.

Commissioner, supra. Further, we are mindful that respondent’s tax

benefit analysis is consistent with the September 1992 agreement

that the trust had been a grantor trust since its inception, as

reflected on the 1988 amended returns for the trust and petitioner.

Accordingly, we hold that the $2,290,469 refunded constitutes

income to petitioner pursuant to the tax-benefit rule for her 1992

tax year.

Issue 2. Section 6651(a) Addition to Tax

We now address whether the imposition of the section 6651(a)

addition to tax for failure to timely file a return is herein

appropriate. The section 6651(a) addition to tax can be avoided if

the taxpayer’s failure to file was: (1) Due to reasonable cause,

and (2) not due to willful neglect. See sec. 6651(a); Rule 142(a);

United States v. Boyle, 469 U.S. 241, 245-246 (1985); United States

v. Nordbrock, 38 F.3d 440 (9th Cir. 1994). “Reasonable cause”

requires a taxpayer to demonstrate that he exercised ordinary

business care and prudence and was nevertheless unable to file a

return within the prescribed time. See United States v. Boyle,
 - 18 -

supra at 246; sec. 301.6651-1(c)(1), Proced. & Admin. Regs.

Willful neglect means a conscious, intentional failure to file or

reckless indifference. See United States v. Boyle, supra at 245.

Petitioner argues that personal problems and the

unavailability of records constituted reasonable cause for

petitioner’s failure to timely file her 1992 return. Respondent,

on the other hand, contends that petitioner could have obtained

sufficient information if she had so desired. We agree with

petitioner.

We are satisfied that petitioner was ignorant of the trust’s

large income and assets. She was not provided with any

documentation that would inform her what, if any, funds she

received from the trust were taxable income. Mr. Clay, as

principal trustee of the trust, possessed and controlled the

financial records pertaining to the trust. The uncontradicted

testimony reveals that Mr. Clay was extremely secretive with regard

to these records because of his concern about petitioner’s young

age as well as the undesirable qualities Mr. Hornberger exhibited.

He refused to hand over relevant information regarding the trust.

In addition, Mr. Clay did not permit Mr. Dowdy or Mrs. Hunter

access to the financial records.

Moreover, given Mr. Clay’s previous track record, there was

nothing to suggest that he would be late in performing his

fiduciary responsibilities. Petitioner, Mrs. Hunter, and Mr. Dowdy
 - 19 -

testified that although Mr. Clay was physically ill during 1992 and

1993, he remained mentally sharp until his death. Petitioner and

the cotrustees frequently inquired as to Mr. Clay’s progress

regarding the necessary tax documents. Mr. Clay repeatedly assured

them of his progress. Absent Mr. Clay’s illness, undoubtedly, the

appropriate documents would have been prepared and filed.

We have held that the inability of a taxpayer to obtain

records may constitute reasonable cause to justify setting aside

the failure to timely file addition to tax. See, e.g., Berenbeim

v. Commissioner, T.C. Memo. 1992-272; Connor v. Commissioner, T.C.

Memo. 1982-302. We conclude that petitioner was unable to obtain

the necessary trust records from Mr. Clay, and consequently had

reasonable cause not to file her 1992 individual tax return, and

did not willfully neglect her duty to do so.

On the basis of the record before us, we conclude that

petitioner exercised “ordinary business care and prudence”, but

because of circumstances beyond her control, she was unable to file

her tax return timely. Accordingly, we hold that petitioner is not

liable for the addition to tax and respondent's section 6651(a)

determination is not sustained.
 - 20 -

To reflect the foregoing and the parties’ concessions,

Decision will be entered

under Rule 155 in docket No.

3656-98.

Decision will be entered

for petitioner Estate of Edna B.

Hunter, Deceased, Shirley

M. Hunter, Administratrix in

docket No. 3658-98.

Decision will be entered

for petitioner EV Hunter Trust,

Shirley M. Hunter and T. William

Dowdy, Co-Trustees in docket

No. 3676-98.