Justice Oliver Wendell Holmes, Jr., said it best: “The life of the law has not been logic; it has been experience.”1 This means the law's ability to accommodate change will always lag behind legal innovation. In the interim, lawyers must fit new round pegs into old square holes. The introduction of alternative dispute resolution (ADR) into estate and trust matters poses precisely this problem.
ADR has made enormous strides in settling complex litigation, taken some of the sting out of divorce proceedings, and played a significant role in numerous legal fields. Now it is beginning to make inroads into settling disputes in trust and estate administration.2 Although ADR has become public policy in federal courts3 and some states have established probate mediation,4 the Internal Revenue Code and Department of Treasury regulations have not caught up. No reported case has dealt directly with the role of mediation in trust and estate administration or with the deductibility of mediation expenses. This comes as no surprise, given the length of audit and judicial processes. And the Internal Revenue Service doubtlessly has more pressing matters, so we cannot expect it to take the initiative any time soon.
That leaves the task of articulating standards of deductibility to others. IRS regulations and caselaw provide some guideposts, but current law only addresses litigation. Modification is, therefore, important and necessary.
After all, mediation is quicker, cheaper and less damaging than litigation.5 Such benefits loom large in the familial context in which most trust and estate disputes arise. Emotions often run white-hot. Families must resolve conflicts in a way that increases the odds they can live together after the dust settles.
Arguably, mediation's lower cost should bring disputants to the table. Unfortunately, better-heeled disputants may assume the cost of litigation will force poorer relatives to capitulate.
On the other hand, the high cost of litigation discourages frivolous or speculative claims. But a mediator who knows the substantive law can terminate the process rapidly where appropriate, leaving the claimant to his legal remedies.
While mediation by no means guarantees a more principled result, it can level the playing field between richer and poorer relatives — and lower costs. Even the wealthier family members will appreciate the difference: getting their just desserts at less cost and facing the prospect of more harmonious future relationships.
How then should the use of mediation be encouraged? It is accepted public policy to use the Internal Revenue Code to promote desirable conduct. If we want to steer disputants towards mediation or other forms of ADR, the only inducement available under the code is to make their costs deductible as administrative expenses.
To what extent do current rules achieve this result? For estates, we must examine IRC Section 2053, its regulations and case law. Sections 2053(a)(2) and 2053(b) provide for the deduction of administration expenses “as are allowable by the laws of the jurisdiction…under which the estate is being administered.” For freestanding trusts, mediation expenses must run a tougher gauntlet under IRC Section 212. Treasury Regulation Section1.212-1(i) allows a trust income tax deduction only for a fiduciary's litigation expenses.
As applied to estate administration, the apparent clarity of the code does not, unfortunately, carry through to the regulations and court cases.
FEDERAL OR STATE LAW?
The first conceptual morass arises out of the interplay between state and federal law. The regulations attempt to set a middle course between the U.S. Supreme Court's rulings in the seminal cases of Erie R. Co. v. Tompkins,6 which established a broad rule of federal court deference to state law and Commissioner v. Bosch,7 which showed a distrust of using state courts to reduce federal tax revenues. Treasury Regulation Section 20.2053-1(b)(1) states that, even if an item is payable under local law, it is not deductible unless it falls within one of the four categories of expenses in IRC Section 2053: funerals, administration, claims against the estate and debts. If local law imposes a limitation on how much can be expended for one of these purposes, the federal deduction may not exceed that amount.
Heading into deeper water, subsection (b)(2) of the regulation tries to refine the interrelationship between federal and state law for these four deductible items. If a state court does not dispute the facts presented, the IRS generally allows the estate to deduct the expenses. The Service does not accept a decree at variance with state law, but it will not deny a deduction in the absence of a court order, if the item was chargeable against the estate under local law. In short, before allowing a federal deduction, the Service reserves the right to review the probate court proceedings and applicable state law.
These general rules leave considerable play. They become even murkier regarding administration expenses. Section 20.2053-3(a) attempts to define administration expenses as those that “are actually and necessarily incurred in the administration of the decedent's estate; that is, in the collection of assets, payment of debts, and distribution of property to the persons entitled to it.” The regulation also says deductible expenses do not include those expenditures that are “not essential to the proper settlement of the estate, but incurred for the individual benefit of the heirs, legatees, or devisees.”
Subsection (c) deals with attorneys' fees. Unsurprisingly, the Service permits the deduction of the executor's or the administrator's legal expenses. The regulation blurs when dealing with the expenses incurred by beneficiaries. The Service does not allow the deduction of legal fees incurred by beneficiaries “incident to litigation” — if incurred to protect their own interests and not essential to the estate's administration. The fact that a probate court approved these expenses as payable by the estate will not make them deductible for federal estate tax purposes. This regulation has produced considerable case law and differing standards of deductibility.
Taking the clearer federal-versus-state-law prong, most circuits recognize that the Service is not bound by a state court's decree.8 The U.S. Court of Appeals for the Sixth Circuit disagrees, and follows orders issued by competent state courts.9
The real difficulty arises when there is no way to distinguish between expenses incurred to determine entitlement and those incurred for individual benefit. Consider the typical will contest. Each beneficiary with a significant interest in the outcome retains counsel. The court must decide whether the decedent left a valid will or which of multiple wills should be admitted to probate. Absent such a finding, the court has no guide as to the rightful heirs and the proper distribution of the decedent's property. Of necessity, some parties will gain relative to others, and some may be totally excluded. All entered the suit for self-gain, but resolving this issue is critical to determining general entitlement.
A will construction suit produces the same dynamics and results.
In these two common situations, whose legal expenses should be reimbursed by the estate and which should be deductible under Section 2053? The courts are divided. In Revenue Ruling 74-509,10 the Service held that, when the executor of a will files suit to determine the size of the two residuary shares, the expenses of both beneficiaries are deductible. That ruling cites as support two cases, one in which a disinherited daughter brought suit and the case was settled, and the other in which the beneficiaries sued to recover property for the estate and won. In some cases, unsuccessful disputants in a construction suit have recovered their legal fees; in others, they have not.11 Some cases have turned on whether the estate's assets were enhanced by the lawsuit; other courts have found that standard irrelevant.12 And some cases look to state law for their outcome.13
These inconsistent standards turn beneficiaries into gamblers. Every potential litigant must weigh the stakes, probability of success, estimated expenses and likely source of payment. A beneficiary also must take a bird's eye view to assess whether the litigation serves only his selfish interests or assists in the administration of the estate or trust. Finally, he must guess how a state court and potentially a federal court might assess these factors long after the beneficiary has pulled the trigger.
How does mediation fit in this tangle of rules? Not very well. With trusts, only the trustee's legal expenses are deductible. The estate tax regulations clearly anticipate that disputes will be resolved through litigation. It is unlikely, for example, that any court or the Service would modify the concept of “fees incident to litigation” to include mediation. It seems untenable to posit that ADR expenses, which are designed to prevent or sidestep litigation, are actually incidental to it, especially if litigation never occurs.
Mediation expenses fit within the current regulatory structure only if they fall within the general description of deductible administrative expenses. That entails an administrative or judicial finding that they were necessarily incurred determining the “distribution of property to the persons entitled to it.”
In the interests of encouraging efficiency and speed, the courts and Service should presume the parties' expenses and other costs of mediation are deductible. Assume mediation enables the parties to settle on the admission of the proper will or construction of the will or trust and determine how the decedent's assets should be divided. The fact that the parties themselves arrived at an acceptable solution and avoided litigation ought to be rewarded. The regulation does not predicate deductibility on a judicial determination.
In the ordinary course, only the voluntary participation of all of the parties will lead to mediation. And probably the earlier in the process they mediate, the better. The estate and taxing authorities benefit from the potential of a quick and relatively cheap resolution of disputes. It is not contorting tax policy to posit that mediation expenses should, absent unusual considerations, be borne by the estate or trust and be deductible.
Of course, the case for deductibility is strengthened if state law encourages or a supervisory court orders mediation. Alternatively, the will or trust could require mediation or some other form of ADR. Fortu-nately, there are now model arbitration or mediation clauses that can be incorporated in wills and trusts. Such provisions date back at least to the will of George Washington.14 Given federal policy's tilt toward ADR and a requirement that the mediation expenses be reasonable, the rationale for federal disallowance becomes pretty attenuated.
What about a participant who bargains in bad faith? First, someone who is convinced that he will prevail in litigation will not elect mediation. He stands to have his expenses reimbursed through litigation, and mediation would diminish his share of the trust or estate without any offset. He can achieve his goals by either accelerating the litigation process or dividing and conquering through settlement with each potential adversary.
Second, if someone does mediate in bad faith and causes the process to fail, it appears counter-productive to reward his behavior with the trust or the estate's money. Once the mediator detects such a problem, he can exclude that party from further involvement — if that is possible. When a participant sabotages the mediation by acting in bad faith, the mediator should report that party's conduct to the supervisory court, which presumably will allow only the other parties to recoup their expenses. The mediator's judgment could be final. Allowing the party alleged to have acted in bad faith a right to appeal the mediator's conclusion would necessitate a hearing of limited scope. Ideally such a hearing would involve just the single party, but at most it should be open only to the affected parties.
Confidentiality lies at the core of mediation. As is true with settlement discussions, all proposals made or positions taken are privileged.15 Having a mediator report an instance of bad faith would represent a minimal exception that should affect very few mediations, discourage destructive behavior, and enhance the likelihood of success. The actual content of any communication or proposal made by the party alleged to have acted in bad faith (or any other party) would remain confidential and privileged; any hearing should focus on motive.
MEDIATION FOR TRUSTS
Income tax rules under Section 212 govern trusts not intertwined with the administration of an estate.
First, the entire trust should not bear the cost of a dispute between a single beneficiary and a trustee over, for example, the trustee's exercise of discretion if there are other beneficiaries. Only the disputed share should pay mediation expenses.
The trust also should bear all parties' mediation expenses, and not just the trustee's, if the trust instrument requires construction that affects all of the beneficiaries. With litigation, state law currently leaves the matter of trust reimbursement to the court's discretion. The single Treasury regulation on the subject permits the trust to pay only the trustee's legal expenses and to deduct those expenses on the trust's income tax return. Several cases have held that the beneficiary may deduct the costs of litigation individually under Section 212 as expenses incurred either to collect future income or to manage, conserve and maintain property held for the production of such income.16
Any distribution by the trust, even a reimbursement for mediation expenses, will carry out distributable net income (DNI) to the extent it is still available.17 Preservation of principal and predictability of income typically represent values shared by the trustee and the beneficiaries. An existing trust is unlikely to generate as many disputes as a trust funded shortly after the death of the grantor. A supervisory state court may conclude that the fairest result is to have the trust reimburse all parties' mediation (and litigation) expenses. Then, assuming the trust otherwise distributes all of its DNI, the beneficiaries would receive a share of the trust principal for federal income tax purposes (and probably under applicable fiduciary accounting rules). When a state court concludes that reimbursement of mediation or litigation expenses is unwarranted or is otherwise not in the best interests of the trust or its beneficiaries, the beneficiaries ought to be able to deduct at least their mediation expenses under Section 212. Of course, this might make mediation expenses deductible when litigation expenses are not. Although conceptually troublesome, such a peculiar result would only enhance the attraction of mediation and the value of its success.
Only time will tell whether the IRS and the courts will grant full recognition to the virtues of mediation. Given its growing prevalence and advantages, amendments of the existing regulations or, preferably, legislation would provide parties across the country with reassurance that choosing mediation and committing to its success will be appropriately rewarded.
- The Common Law, p.1 (1881).
- Ray Madoff, “Mediating Probate Disputes: A Study of Court-Sponsored Programs,” 38 ABA Real Property, Probate and Trust J. 697 (2004); Douglas Lawrence, “Mediation and Arbitration under Washington's Trust and Estate Dispute Resolution Act (RCW 11.96A.300-.310)” and Bruce Ross, “The Parameters of Mediation and Special Problems,” the last two papers presented at the summer 2003 meeting of The American College of Trust and Estate Counsel.
- The Alternate Dispute Resolution Act of 1998, Pub. L. No. 105-315, 112 Stat. 2998, at Section 2 (105th Cong. 2d Sess.).
- See the Madoff article and Lawrence paper, supra note 2, and the Washington statute, RCW 11.96A.260, quoted in the latter.
- The basic text is Roger Fisher, William Ury and Bruce Patton, Getting to Yes: Negotiating Agreement Without Giving In (Penguin Books, 2d ed., 1991). The American Bar Association Section of Dispute Resolution recently published Bennett Picker's Mediation Practice Guide: A Handbook for Resolving Business Disputes (2d ed. 2003), which describes mediation's advantages. See also Harry Mazadoorian of Quinnipiac University Law School's essays in Mediation Practice Book: Critical Tools, Techniques and Forms (Law First Publishing and Quinnipiac University School of Law, 2002) at pp. 43-50. A well-phrased statement in favor of settling family disputes appears in First Topeka Bank v. United States, 233 F. Supp. 19 (D. Kan. 1964).
- 308 U.S. 64 (1938).
- 387 U.S. 456 (1967).
- The cases are gathered in Edward Jay Beckwith and Turney P. Berry, 840-2nd T.M., Estate Tax Deductions — Sections 2053 and 2054, part II (C). Estate of Grant v. Commissioner, 294 F.3d 352 (2d Cir. 2002); United States v. White 853 F.2d 107 (2d Cir. 1988), cert. denied, 493 U.S. 5 (1989); Pitner v. United States, 388 F.2d 651 (5th Cir. 1967); Hibernia Bank v. United States, 581 F.2d 741 (9th Cir. 1978). For a scholarly attempt to make sense of this morass, see Paul L. Caron, “The Estate Tax Deduction for Administration Expenses: Reformulating Comple-mentary Roles for Federal and State Law under I.R.C. §2053(a)(2),” 67 Cornell L. Rev. 981 (1982).
- Estate of Park, 475 F.2d 673 (6th Cir. 1973); Cadden v. Welch, 298 F.2d 343 (6th Cir. 1962).
- 1974-2 C.B. 302.
- Estate of Pridmore v. Commissioner, T.C. Memo 1961-12; Dulles v. Johnson, 273 F.2d 362 (2d Cir. 1959) (allowing legal fees to all contestants in construing will); Estate of Peter Reilly v. Commissioner, 76 T.C. 369 (1981) arguing for a liberal standard on attorneys' fees generally; Sussman v. United States, 236 F.Supp. 507 (E.D.N.Y. 1962) (compromise payments).
- Pitner v. United States, supra note 8, 388 F.2d at 660; Porter v. Commis-sioner, 49 TC 207 (1967) (the fact that some beneficiaries gained is not grounds for disallowance if the collection of assets benefits all); in Estate of Bartberger v. Commissioner, T.C. Memo 1988-21 a beneficiary's lawyer did some of the executor's work.
- See the cases cited in note 9 and Schmalstig v. Conner, 46 F. Supp. 531 (S.D. Ohio 1942); Estate of Jenner v. Commissioner, 577 F.2d 1100 (7th Cir. 1978); Estate of Bullock v. Commissioner, T.C. Memo 1960-204; Rev. Rul. 77-443, 1977-2 C.B. 327. Cf. Gordon v. United States, 163 F.2d 542 (W.D. Mo. 1958).
- The text can be found at the following Internet address: www.gwpapers.virginia.edu/will.
- See, for example, Chapter 2 of the California Evidence Code set out in Ross, supra note 2; Standard V of The Model Standards of Conduct for Mediators adopted by the Section of Litigation and the Section of Dispute Resolution of the American Bar Association, the American Arbitration Association, and the Society of Professionals in Dispute; William Logue, “Confidentiality in Mediation” 131-144 in Mediation Practice Book: Critical Tools, Techniques and Forms, supra note 5.
- See, for example, on somewhat unusual facts involving the revocation of a trust arising out of the original Standard Oil Company, Matthews v. United States, 425 F. 2d 738 (Claims Court 1970); Barr v. Commissioner, T.C. Memo 1989-420; Reynolds v. United States, 1964-2 USTC paragraph 9702 (S.D.N.Y.), aff'd, 338 F.2d 1 (1964).
- Sections 652(b) and 662(a) and the regulations thereunder.