IRS challenges the authority of state courts to determine reasonableness of administrative fees.by Gezelter, Bertram
The recent case of United States of America, et al. v. James M. White, as attorney for and executor of the Estate of Helen P. Smith, deceased, 88-2 USTC <12,777,--F2d--(Ca-2, 1988); revising 87-1 USTC <13,710, 650 F. Supp. 904 (USDC, WDNY 1987) is being characterized by some writers as a major challenge by the IRS to the authority of a state court to determine executor's and attorney's fees and expenses as reasonable.
Under Sec. 2053 all reasonable and necessary expenses of administration are deductible in computing the portion of the estate subject to U.S. Estate Tax. In White, the executor obtained a Decree Judicially Settling Accounts from the Monroe County Surrogate's Court after filing his Account of Proceedings and related papers. This Decree was obtained in a nonadversarial proceeding in which all of the heirs of the estate consented to the issuance of the Decree and to the claims made by the executor (James M. White) for commissions and attorney's fees in the Account of Proceedings as filed.
Helen P. Smith died on November 10, 1982, leaving a gross estate in excess of $455,000. James M. White, Esq., was named executor of the estate and chose to act as the attorney for the estate as well; a practice permitted under state law. Ms. Smith's will was admitted to Probate by the Monroe County Surrogate's Court, and the U.S. Estate Tax Return was duly filed by Mr. White as executor. On that return, Mr. White claimed a deduction for $16,530 of attorney's fees in addition to his executor's commissions of $17,548. After filing the U.S. Estate Tax Return, Mr. White filed a Petition for a judicial settlement of the estate, requesting fixation of attorney's fees. He submitted releases from all residuary legatees, which releases indicated, by the acceptance of the accounting, the legatees' approval of the fees for Mr. White, including the attorney fee of $16,530. After reviewing the accounting and the tax returns, the Monroe County Surrogate's Court on July 17, 1984 issued a Decree of Judicial Settlement of the Smith estate which had the effect of settling the executor's Accounting, approving the Distribution of assests to those interested in the estate and fixing and approving the executor's commissions and attorney's fees both of which were payable to Mr. White. After the issuance of this decree, an IRS agent met with Mr. White to review the U.S. Estate Tax Return. In the course of this examination, the IRS Agent requested justification for the legal fees claimed, particularly requesting the following information:
1. The amount involved;
2. The time and effort of attorney;
3. Seriousness of the problems;
4. Results obtained;
5. Experience and ability of attorney;
6. Length of administration.
The IRS sought Mr. White's time records or an itemized list of all legal work performed, time expended for each service, and the hourly rate charged. In lieu of supplying the above information, Mr. White obtained from the Monroe County Surrogate a letter stating:"...that executor's commission was fixed by statute, and the attorney's fee was set...
...in keeping with our ordinary
and customary guidelines which
have been followed in this Court
for several years. Moreover, it
conforms to the criteria established by
the Court of Appeals in this state
as enunciated in Matter of Freeman,
34 NY2d 1 and Matter of Potts, 241
NY 593. I might say, parenthetically,
that the attorney fee
approved was some $700 less than
what would have been approved. I
set these matters forth fully aware
that you were both executor and
attorney for the estate. In those
instances, I personally have been
careful to attempt to keep the fees
for attorney-executors below a full
commission. In this particular
estate, you have complied..." (87-1
The above letter was forwarded to the IRS. The examining agent was not satisfied with the letter and issued an IRS summons to Mr. White as executor and attorney for the estate of Helen P. Smith, which sought the production of any and all records and documents relating to the administration of the estate of Helen P. Smith, including records of Mr. White's activities, both as attorney and as executor. Mr. White refused to furnish the requested information.
Subsequently, after issuing a second summons, the IRS issued a deficiency notice against the estate, and apart from other adjustments, disallowed the legal fees of $16,530, and somewhat slightly reduced the commissions payable. The executor paid the additional tax and filed a claim for refund challenging some of the adjustments.
In its opinion, the District Court denied the IRS enforcement of its summonses, requiring that the IRS respect the decision of the Surrogate setting the amount of the attorney's fees and executor's commissions in the proceeding judicially settling the estate. In looking at this federal/state conflict situation, the District Court conceded superior authority in the administration of estates, a matter involving state administration and clearly dealt with in state law, to the state Surrogate's Court. The District Court concluded based on Reg. Sec. 20.2053-1(b)(2) that once the legal fee was passed upon by the Surrogate and absent any showing that the Surrogate's decision was motivated by factors other than those upon which deductibility depends, such as fraud or overreaching, the IRS was bound by the Surrogate's decision.
In reversing the District Court and holding the summonses enforceable, the Court of Appeals for the Second Circuit stated:
"...However, the facts of this case
do not implicate the eleventh
amendment, full faith and credit,
principles of collateral estoppel, or
other doctrines arising from principles
of federalism and comity;
consequently, federal authorities
are not bound to give preclusive
effect to the Surrogate's decree..."
Besides dismissing the potential for federal/state conflict, the Court of Appeals held that such regulation did not preclude an independent assessment of the deductibility of the fees by the IRS.
The Court found that, although the language in the regulation instructs IRS personnel to ordinarily accept a local court decree, they are not required to do so. The IRS can make an independent assessment of the deductibility of fees under state law.
The Court held that in light of the circumstances, the IRS Summonses were enforceable since they were meant to serve a legitimate purpose, i.e., to help determine the amount of legal fees properly deductible in computing the U.S. Estate Tax, and did not require a showing of probable cause.
The fact that the matter was now in a refund status, with the burden of proof on the taxpayer to prove the reasonableness of the fee, did not persuade the Court of Appeals that the Summonses Proceedings were inappropriate. The Court of Appeals looked only to the right of the IRS to obtain the information being sought.
The still unanswered question in this matter is whether the IRS would be bound by a Surrogate's Court decision fixing the attorney's fees had the proceeding been more adversarial in nature, with even one heir challenging the attorney's fees or with the IRS having been made a party to the accounting proceeding. It also remains unclear as to whether the result here will affect future administrative policy by the IRS.
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