Karoly Estates Will Forgery Case Ruling

The Morning Call (Allentown, PA) published a news report entitled Northampton County judge upholds Karoly wills (04/05/13), by Peter Hall, highlighting the most recent development in the Karoly Estates forgery of wills matter: "John Karoly Jr.'s sisters failed to prove he entered forgeries in brother's estate, judge rules."

A Northampton County judge has affirmed a decision that sisters of disgraced Lehigh Valley lawyer John Karoly Jr. failed to prove wills he submitted in his brother Peter Karoly's estate are forgeries. * * * 

In a 31-page opinion Friday, President Judge F.P. Kimberly McFadden rejected criticism of retired Bucks County President Judge Isaac Garb's decision that the wills were authentic.

Garb, appointed as special master of the case, presided over a lengthy trial in 2011 and issued his ruling last August. Karoly's sisters asked McFadden to overturn it. * * *

Garb said the sisters failed to establish "by clear, direct, precise, and convincing evidence" that the 2006 wills were "forged and therefore invalid."

Peter Karoly, a well-known medical malpractice lawyer, and his wife, dentist Lauren Angstadt, died in February 2007 when their private plane crashed on approach to a Massachusetts airport.

The Karolys' three sisters charged that John Karoly Jr. fraudulently created wills dated 2006 for the couple — a conclusion also reached by a 2008 federal grand jury that indicted him, his older son J.P. Karoly, and Dr. John Shane, who witnessed the documents. * * *

Since 2007, these will forgery cases and its progeny have twisted and turned, but now appear near resolution, based upon extensive fact findings and trial court review.

Referencing the "burden of proof" test applied to the facts presented by the contestants, the proceedings are instructive under established will contest principles.  

However, the proceedings drew my attention because the United States Department of Justice became involved after an FBI investigation and federal grand jury findings derived from will forgery allegations.  See: PA EE&F Law Blog postings Will Contest from Bethlehem, PA (04/10/07); Trusts & Estates ... and the FBI: Pt. I. (05/22/07); Trusts & Estates ... and the FBI: Pt. II (05/23/07); and Attorney in PA Indicted for Will Fraud (09/26/08).  See also postings by Professor Gerry Beyer on his Wills, Trusts & Estates Prof Blog: The FBI-Will Contest Interface (05/22/07);  Lawyer fakes brother's will (09/28/08), and Judge upholds Karoly Wills (04/07/13).

The local articles reported alleged conduct and resulting charges as news.  However, unless the recent trial court rulings are reversed on appeal to the Pennsylvania Superior Court or Supreme Court, the will contest allegations appear resolved in favor of the surviving brother, John Karoly.

This extended odyssey shows the depth, detail, and delay involved in will contests.  The present status warns us against prejudgment or sensationalism during its progress.

In my prior posting on September 26, 2008, I pondered other possible effects of these proceedings:

To date, this case involves application of federal fraud and conspiracy laws, investigation by the FBI, examination & prosecution by the U.S. Attorney's Office, with anticipated resolution in a federal court.

This case could become a template for future prosecution of other cases involving intentional fraud in the preparation of testamentary documents offered for probate or for claim.

Although these cases remain very instructive, the collective federal and county court proceedings did not become such a "template" to insert federal laws into state probate matters.  We still rely upon state laws and procedures for resolution of will contests.  In these specific will contests, resolution appears nearly complete.

New Cause of Action under FINRA Found

A decision issued on June 30, 2009, by a three-judge panel of the U.S. Third Circuit Court of Appeals, in Sarah Grammer v. John J. Kane Regional Centers-Glen Hazel (PDF, 23 pages), likely will impact nursing home and rehabilitation facilities that provide care subject to the Federal Nursing Home Reform Amendments (FNHRA).

The decision reversed a ruling by the United States District Court for the Western District of Pennsylvania, and, by its fresh interpretation of FNHRA, recognized new causes of action under those amendments to federal law.

The decision was noted by Professor Katherine C. Pearson, who is the Director of the Elder and Consumer Protection Clinic, of Penn State - Dickinson School of Law, and who now is Chair of the Elder Law Section of the Pennsylvania Bar Association. She sent me an email message with a link to her web article about the decision, and granted me permission to repost it. I do so now (reparagraphing & links applied), with thanks to her.

Should Federal Standards for Care by Nursing Homes be Enforceable
by Private Suits for Damages under Federal Civil Rights Laws?
The Third Circuit Says Yes.

by Katherine C. Pearson

Advocates for elders and disabled persons in nursing homes have long been frustrated by the absence of an express cause of action in federally imposed “Nursing Home Residents Rights,” a key feature of the Nursing Home Reform Act (NHRA) at 42 U.S.C. § 1396r.

On June 30, 2009, however, the Third Circuit Court of Appeals ruled in the case of Sarah Grammer v. John J. Kane Regional Centers-Glen Hazel that a private cause of action does exist under federal civil rights laws, at 42 U.S.C. § 1983, for violation of the resident’s rights under the NHRA. State action, necessary for a civil rights suit, existed because the defendant facility was a county-operated home.

In 1987, Congress enacted key nursing home reform laws in an effort to respond to widespread complaints about quality of care in facilities that were accepting Medicare and Medicaid dollars. Until that legislation, it was not uncommon to hear complaints about aged residents routinely being restrained in beds or chairs to prevent wandering, or being heavily medicated solely to make the residents easier to “manage.”

The Nursing Home Reform Act for the first time mandated that with the exception of emergencies, a doctor’s detailed, written order would be required before physical or chemical restraints could be imposed, and then only when necessary for the physical safety of the residents. The federal law mandated that facilities must care for residents “in such a manner and in such an environment as will promote maintenance or enhancement of [their] quality of life. . . .”

The legislation was widely hailed as ushering in a new era of accountability for institutional caretakers. But individual residents and their families have frequently questioned whether administrative sanctions for violations of the law, such as civil fines or threats of defunding, are sufficient to protect residents.

In the Grammer case, the complaint alleged breach of the duty to ensure quality care under NHRA standards, citing the death of Melviteen Daniels from poor care that resulted in malnourishment, decubitus ulcers and sepsis, and alleging the cause of action under 42 U.S.C. § 1983.

The District Court in the Western District of Pennsylvania dismissed the complaint for damages, finding no cause of action existed at law.

The Third Circuit reversed in a 2 to 1 ruling. In the majority opinion, Circuit Judge Nygard gives a detailed explanation of how the NHRA should be recognized as unambiguously conferring federal, substantive rights on residents to quality care, rights that are enforceable under federal civil rights statutes.

The dissent notes that the NHRA was enacted as part of an Omnibus Budget bill, pointing to Supreme Court decisions that have rejected attempts to infer substantive rights from “Spending Clause” cases.

The Third Circuit's decision in Grammer opens new doors for recovery on behalf of older adults and disabled persons in public facilities, including the potential for attorneys' fees for successful civil rights claimants.

The outcome also suggests a new question, whether privately-owned nursing homes are also subject to a civil rights suit for violations of NHRA-mandated standards of care. Are private owners operating under color of state law when they are certified as Medicare and Medicaid qualified facilities and accept public dollars for their services? At a minimum, does the existence of a federal cause of action against public facilities strengthen the argument by resident-advocates that violation of federal standards constitutes "negligence per se" for common law tort claims?

Another open question is whether mandatory arbitration provisions in nursing home admission agreements will be treated as limiting or barring courtroom litigation of federal civil rights claims.

"Free Ride" Over for PA DPW in Personal Injury Recoveries?

On March 25, 2009, a U.S. District Court in Pennsylvania issued a Memorandum Opinion in Tristani v. Richman, 2009 WL 799747 (W.D.Pa. Mar. 25, 2009; No. 06-694).

The decision held that that Pennsylvania's Medicaid recoupment, anti-lien, and anti-recovery statutory provisions create enforceable rights under Section 1983; and that such provisions bar recovery by the Commonwealth directly from a Medicaid beneficiary of all personal injury settlement proceeds received in privately-conducted litigation, including that portion attributable to medical care already paid by Medicaid.

The court ruled that if a state wishes to recoup such funds, then it must join the litigation against third-party tortfeasors, along with the other plaintiffs.

Nora E. Gieg, Esq., of Tucker Arensberg, P.C. in Pittsburgh, PA, wrote a brief analysis of this important holding and considered its longer-term effects. I am pleased to post it, with gratitude for her contribution.

Tristani’s Blow
to State Medicaid Agency’s
Third Party Liability Collection Practices

by Nora E. Gieg, Esq.
Tucker Arensberg, P.C.

In a potentially striking blow to the Pennsylvania Medicaid (medical assistance) third-party liability (“TPL”) collection practices, the Honorable Joy Flowers Conti, Judge for the United States District Court for the Western District of Pennsylvania, issued a Memorandum Opinion dated March 25, 2009 in Tristani v. Richman et al. (PAWD Civil Action No. 06-694), a pending class action lawsuit against the Pennsylvania Department of Public Welfare.

The Tristani ruling fills a gap left by the United States Supreme Court’s decision in Ark. Dep’t of Health and Hum. Servs. v. Ahlborn, 547 U.S. 268 (2006) regarding a presumed “exception” in federal law permitting state medicaid agencies to effectuate mandatory TPL recovery through the imposition of liens on Medicaid recipients’ personal injury proceeds.

The United States Supreme Court’s Ahlborn ruling "assumed" that Federal Law created an exception to the Anti-Lien and Anti-Recovery provisions because the parties therein had stipulated as much. Now, the Tristani opinion squarely addresses validity of such an assumed exception, which the United State Supreme Court was forced to “leave for another day”. 547 U.S. 268, 284 n. 13 (2006).

In an opinion as dense as any law school hypothetical wrought with interpretations on due process, civil procedure, qualified immunity, takings, and interpretations of Congressional intent, in her Tristani opinion, Judge Conti reasons that the Federal Anti-Lien and Anti-Recovery provisions, 42 U.S.C. §§1396p(a)(1) and 1396p(b)(1), preempt Pennsylvania state law at 62 Pa. C.S. §§ 1409, et seq. under the Supremacy Clause of the United States Constitution, inasmuch as Pennsylvania’s TPL statute permits liens on the personal injury actions/proceeds of Medicaid recipients.

Finding the Federal Anti-Lien and Anti-Recovery provisions to be unambiguous, the District Court gave no deference to the interpretations of the U.S. Department of Health and Human Services on which the the State Medicaid Agency and Pennsylvania General Assembly ostensibly relied in passing the Pennsylvania TPL statute.

Instead, the District Court found that federal law requires State Medicaid Agencies, like Pennsylvania's Department of Public Welfare, to commence direct actions against liable third parties for the cost of Medicaid to recipients, stating in no uncertain terms that the DPW’s “free ride” was over.

The District Court noted, however, that federal law did not leave State Medicaid Agencies without recourse. The Court reasoned that the Pennsylvania TPL statutory scheme permits DPW to assert its own interests in personal injury actions against third party tortfeasors without violating the Federal Anti-lien and Anti-Recovery Provisions

The Court found that DPW's intervention in -- rather than “liening” of -- settlement actions, was the proper method of recovery. It also held that Pennsylvania’s statutory default calculation of 50% for “unallocated” settlements was a valid amount of recovery.

Plaintiffs in the Tristani action had also asked the District Court to determine whether Pa. C.S. § 1409(b)(7)(iii) contravenes Section 1396k(b). Finding neither named plaintiff able to establish a cause of action in this regard, the Court left open for another day the efficacy of Pennsylvania’s statutory authorization for the collection of managed care organization expenditures, as opposed to capitation payments.

The Tristani ruling, if not altered on appeal, would shake to its core the traditional method of TPL recovery in Pennsylvania. This ruling likely would create long-reaching effects for TPL recovery nationwide, too.

However, review of the docket reveals that steps are already in place to appeal the trial court's ruling. Thus, some uncertainly exists as to the current force of the Opinion, inasmuch as it lacks the force of an "order".

Pending further appellate review of the Tristani opinion, both State Medicaid Agencies (seeking recoupment of funds expended for the fiscally-strained Medicaid programs) and Plaintiffs’ counsel (seeking maintenance funds for their injured clients), may find themselves in a precarious position with unpredictable options in situations which demand action.

Offshore Accounts in Dangerous Waters

According to "IRS: Offshore account holders told fess up to lower penalties" (03/27/09) by Kevin McCoy, published in USA Today, the Internal Revenue Service finally is claiming its tax stake in unreported offshore accounts owned or controlled by U.S. citizens, under severe penalties if voluntary compliance is not forthcoming.

Trying to lure wealthy Americans to disclose assets hidden offshore, the IRS on Thursday announced a six-month program that offers lower penalties to those who come forward and pay taxes due on the secret holdings.

The offer includes clients of UBS, the Swiss banking giant that last month gave federal investigators the names of American owners for about 300 accounts in a continuing federal court showdown.

Along with lower tax penalties, those who comply are expected to avoid criminal prosecution.

"This is a chance for people to come clean on their own," said IRS Commissioner Douglas Shulman.

"For taxpayers who continue to hide their heads in the sand, the situation will only become more dire." * * *

The IRS Commissioner commented on the 2009 Amnesty Program in a posted Press Release entitled "Statement from IRS Commissioner Doug Shulman on Offshore Income" (03/26/09).

In a posting on his Tax Prof Blog, Professor Paul L. Caron noted "IRS Offers Amnesty to Those Who Evaded Tax Through Offshore Accounts" (03/26/09); and he listed articles published about the IRS foreign holdings amnesty program. I've added the articles' titles and authors, and noted some substantive points:

• "IRS increases pressure on Swiss bank clients" (03/26/09) by Devlin Barrel, published by Associated Press, who noted: "[Taxpayers] coming forward are now confronting a list of nearly 30 detailed questions, asking not just about financial documents, but any travel to conduct banking business, documents and correspondence related to the accounts, and which bank employees helped them manage the accounts." * * *
  
• "UBS Offshore Customers Offered Eased Tax Penalties" (03/26/09) by Ryan J. Donmoyer, published by Bloomberg, who noted: "It is legal for Americans to have money in offshore accounts, which many do for legitimate reasons such as when they own a home or business overseas. The accounts must be disclosed to the Treasury Department when they hold more than $10,000, and U.S. taxes must be paid on any income earned."* * *
  
• "IRS aims to reel in offshore-account holders --Penalties reduced, criminal prosecution unlikely for those who come clean" (03/26/09) by Andrea Coombes, posted on MarketWatch, who noted: "The U.S. loses an estimated $100 billion in tax revenue every year because of money stashed offshore, according to Sen. Carl Levin, D-Mich., who with other lawmakers introduced the Stop Tax Haven Abuse Act in March. * * *
• "I.R.S. to Ease Penalties for Some Offshore Tax Evaders" by Lynnley Browning, published by The New York Times, who noted: " In another shift, the I.R.S. will generally not prosecute taxpayers who come forward voluntarily, provided they are not drug dealers, arms merchants or others with ill-gotten gains. And it will not assess a 35 percent penalty on money secretly transferred to foreign trusts — a common method of tax evasion. The goal, Douglas Shulman, the I.R.S. commissioner, said during a briefing 'is to get taxpayers who have been hiding assets offshore back into the system.'" * * *
  
• "IRS launches crackdown on offshore tax evasion" (03/26/09) by Corbett Daley, published by Reuters, who noted: "IRS memos sent to agency examination staff said offshore tax cases should 'receive priority treatment.' 'Offshore cases sent to the field are work of the highest priority," said one document, which was made public by the IRS. "Examiners should utilize the full range of information gathering tools in properly developing offshore issues with special emphasis on detecting unreported income. This includes interviewing taxpayers, making third-party contacts and timely issuing summonses to taxpayers and third parties." * * *
• "IRS Cuts Penalties to Lure Tax Evaders" (03/27/09) by Evan Perez & Tom Herman, published by The Wall Street Journal, who noted: "A key part of the program, IRS officials said, is 'developing intelligence' on bankers, lawyers, accountants and others who help the rich hide assets from tax authorities. This raises the likelihood that the IRS and the Justice Department could take aim at major financial firms, as they have against UBS AG, the Swiss bank that admitted in a settlement last month that some of its bankers had helped U.S. clients evade taxes." * * *
  

Clearly, past tax law and current tax return forms require that a U.S. citizen who has an interest in, or signature or other authority over, a financial account in a foreign country with assets in excess of $10,000 are required to disclose the existence of such account on Schedule B, Part III of their individual income tax return.

The IRS has made various tax amnesty offers as recently as 2005 and 2003 to enforce these rules. But the political and economic climates have chilled sufficiently to steel the IRS' intentions towards non-reporting citizens.

For those U.S. citizens who have continued to ignore the legal requirements of reporting and paying income tax, the "amnesty" program may be viewed as harsh, but it may be their last chance before criminal prosecution.

This program and the alternative enforcement routes are now supported politically by the new federal law. And it is consistent with prior initiatives by the IRS. See: Abusive Offshore Tax Avoidance Schemes -- An Abusive Scheme Toolkit for External Stakeholders, updated in April, 2009.

Offshore accounts and trusts have been utilized by some Pennsylvanians to avoid both federal and state income tax, as evidenced by a prosecution in Pennsylvania announced recently by the IRS on its website in a posting entitled "Pennsylvania Father and Sons Sentenced in Tax Fraud Scheme."

On March 26, 2009, in Scranton, Pa., Wendall Sollenberger was sentenced to 42 months in prison and ordered to pay $1,274,615 in restitution to the Internal Revenue Service (IRS).

Last week, Avery Sollenberger, Wendall's father, was sentenced to 44 months in prison and Gary Sollenberger, Wendall's brother, was sentenced to 42 months in prison. In September 2008, a jury found Avery, Wendall, and Gary Sollenberger guilty of conspiracy to defraud the IRS. According to court documents, the Sollenbergers own and operate a house framing business in Hanover, Pennsylvania.

Evidence introduced at trial stated that beginning in 1994, Wendall, Gary and Avery began to employ a deceptive scheme consisting of bogus trusts, a foreign corporation and an off-shore bank account in Cyprus to conceal assets from the IRS. The three men have not paid any income tax on their business earnings since 1994.

During the trial, the government also introduced evidence of defendants expenditures including the purchase of a $100,000 race car, a $40,000 custom made motorcycle, a motor boat, gold, silver, rental properties, a second home in Altoona, Pennsylvania, and hunting trips to Idaho. * * *

See also: Press Release, "UBS Client Charged with Filing False Tax Return Boca Raton, Fla. -- Resident Hid Income and Assets in Secret Swiss Bank Account" (04/02/09).

CCH summarized the terms of the amnesty program in its Tax News posting on March 27, 2009 entitled "Voluntary Disclosure Terms."

[The IRS Commissioner] emphasized that the terms being offered for the disclosure of offshore accounts are an outgrowth of current policy and carry penalties at a level consistent with voluntary disclosure programs in the past. Within this framework, Shulman enumerated the amounts that would need to be paid by taxpayers with heretofore undisclosed offshore accounts who "come clean" under the program:

• Back taxes due on newly disclosed assets for the last six years;
• Interest due on these back taxes for the last six years;
• A 20-percent accuracy-related under Code Sec. 6662 or a 25-percent delinquency penalty under Code Sec. 6651 for each tax year at issue;
• Looking to the past six years, a 20-percent penalty on the total balance of all the taxpayer's foreign bank accounts or assets during the year among the past six in which the accounts had their highest aggregate value. * * *
  

In the past, Pennsylvania did not elect to participate in the IRS' Offshore Voluntary Compliance Initiative, and, may not participate in this latest program. Therefore Pennsylvania residents intending to participate in this IRS amnesty program should consider their future interactions, too, with the Pennsylvania Department of Revenue.

James Ruling Impacts Annuities in Medicaid Planning

On November 12, 2008, the United States Third Circuit Court of Appeals issued its decision in James v. Richman (PDF, 15 pages), No. 06-5092, 547 F.3d 214 (3rd Cir., Nov 12, 2008), 2008 U.S. App. LEXIS 23530, aff'd, James v. Richman, 465 F.Supp.2d 395 (M.D. Pa., Nov 21, 2006), which upheld the purchase of a long-term annuity by a "community spouse" that converted excess assets of a couple into a stream of protected income in a pre-DRA setting.

Such federal appellate court decisions on a Medicaid issue are rare. This decision relates to a device previously often used to protect remaining assets of a couple when one spouse faced long-term institutionalized care.

In considering the effect of this case, it should be noted that the Deficit Reduction Act of 2005 (DRA) changed the federal Medicaid law rules regarding annuities. For a case that remains pending regarding a post-DRA situation, see: Weatherbee v. Richman, 1:2007-cv-00134 (US DC PA, 05/30/07). [See also: Comments by Jeff Marshall, Esq. below in an Update.]

For background regarding the changes wrought by the DRA, see: PA EE&F Law Blog postings: "PA DPW's New Policies under DRA" (04/04/07); "DRA to be Effective in PA on Feb 1st ... no ... Mar 1st, 2007" (01/03/07); and "Pre-DRA Annuities in PA" (11/27/06).

Based upon holdings in the James case, the use of annuities in Medicaid planning may find increased flexibility until the annuity matures.

With permission granted by Attorney Jeff Marshall, I repost his article about the ruling and opinion in the James case, edited somewhat by me (including links).

Federal Third Circuit Upholds Use of Annuity
to Protect Community Spouse

Copyright © by Jeffrey A. Marshall, CELA [1]

In a notable decision, the Federal Third Circuit Court of Appeals, in the case of James v. Richman, issued November 12, 2008, upheld the purchase of an annuity by a community spouse that converts excess resources into protected income.

When her husband entered a nursing home in August 2005, Josephine James purchased a $250,000 single premium immediate irrevocable annuity. The actuarially sound annuity included an endorsement that “[t]his Contract may not be surrendered, transferred, collaterally assigned, or returned for a return of the premium paid. This Contract is irrevocable and has no cash surrender value. An Owner may not amend this Contract or change any designation under this Contract.”

The purchase of the annuity, combined with the purchase of an automobile, reduced the couples’ resources to within Medicaid resource eligibility limits. But, when Mr. James subsequently applied for Medicaid his application was denied.

The Pennsylvania Department of Public Welfare (DPW) took the position that Mrs. James $250,000 annuity was an available resource which put the couple over the resource limits. In the Department’s view, the annuity had a value of $185,000. In support of its position, DPW eventually produced a declaration from a finance company which expressed interest in purchasing the payments from Mrs. James’ annuity for $185,000.

The Third Circuit’s opinion was written by Senior Judge Jane Roth and joined by Chief Judge Anthony Scirica.[2] The central issue of the case is whether a state Medicaid agency can treat a non-revocable, non-transferable annuity as an available resource for purposes of calculating Medicaid eligibility. Or, in the alternative, can the state agency treat the steam of payments which the community spouse will ultimately receive from the annuity as an available resource.

Could DPW treat the annuity as a resource?

The Court relied on Medicaid law and SSI (Supplemental Security Income) Program regulations to find that DPW could not treat Mrs. James annuity as an available resource. It held that in determining whether an annuity may be treated as a resource a state cannot use a methodology that is more restrictive than that used by SSI. Under 42 U.S.C. § 1396a(a)(10)(C)(i)(III) “the Department can not treat as available resources any assets that the SSI regulations would not treat as available resources.” [Opinion, page 10].

Judge Roth noted that the SSI regulations provide that “if an individual has the right, authority or power to liquidate the property, or his or her share of the property, it is considered a[n] (available) resource.” 20 C.F.R. § 416.1201(a)(1). The SSI Program Operations Manual System (POMS) makes it clear that the “power to liquidate” referred to by the regulation is not simply the de facto ability to accomplish a change in ownership of an asset, but must also include the power to do so without incurring legal liability. See, POMS SI 01110.115. Since, Mrs. James lacks the legal power to change ownership in her annuity without breaching the annuity contract the annuity cannot be treated as an available resource.

Could DPW treat the payments to be received from the annuity as a resource of the community spouse?

DPW’s somewhat novel argument in James was that Mrs. James right to receive income from the annuity could be sold by her and thus could be treated as an available resource. In rejecting this theory Judge Roth noted that “[t]here is no statutory basis for such a theory and, indeed, adopting it would tend to undermine the MCCA rule that ‘no income of the community spouse shall be deemed available to the institutionalized spouse.’ 42 U.S.C. §1396r-5(b)(1). Under such a theory, there is no clear limit on the hypothetical transaction proceeds that could be treated as assets, whether based on the sale of a future stream of payments tied to a fixed income retirement account, social security, or even a regular paycheck.” [Opinion, pages 11-12].

It should be noted that the James annuity was purchased prior to the Deficit Reduction Act (DRA).[3] In a post-DRA case, Weatherbee v. Richman, US DC Western District of Pennsylvania, No1:07-cv-00134, DPW has taken the position that a provision in the DRA has given states the authority to effectively void the spousal income protections of 42 U.S.C. §1396r-5(b)(1) as applied to annuities.[4]

This reading of the section seems strained and appears to be at odds with CMS’s interpretation of this section.[5] Given the Court’s opinion in James, it seems increasingly unlikely that DPW will prevail in Weatherbee. In any event, post DRA spousal annuities do have to comply with the DRA transfer and remainder beneficiary rules set out in 42 U.S.C. § 1396p(c)(1)(G) and 42 U.S.C. § 1396p(c)(1)(F).

Judge Roth also rejected DPW’s argument that the court should look to the underlying purpose of Medicaid rather than relying merely on the words of the federal statute. The courts “do not create rules based on our own sense of the ultimate purpose of the law being interpreted, but rather seek to implement the purpose of Congress as expressed in the text of the statutes it passed. [A]n irrevocable, non-alienable annuity does not fit the statutory definition of an available resource.” [Opinion, page 12]

Footnotes:

1. Certified as an Elder Law Attorney by the National Elder Law Foundation. Attorney of the Marshall, Parker & Associates. Jeff practices law in the same firm as Matthew J. Parker, Esq., who represented the community spouse in the case under discussion. Both are principals of Marshall, Parker & Associates, LLC, a Pennsylvania elder law firm with offices in Williamsport, Wilkes-Barre, Scranton, and Jersey Shore.
2. The third member of the panel, Judge Michael Fisher, would have Court for further fact-finding relevant to the annuity’s marketability.
3. Deficit Reduction Act of 2005 (DRA) (Pub.L.109-171).
4. Section 6012(a) of the DRA added a new section 1917(e) to the Social Security Act. Section 1917(e)(1), codified at 42 U.S.C. § 1396p(e)(4), states that ‘[n]othing in this subsection shall be construed as preventing a State from denying eligibility for medical assistance for an individual based on the income or resources derived from an annuity described in paragraph (1).” Paragraph 1 is the DRA section that requires disclosure on an application for Medical Assistance of a description of any interest the individual or community spouse has in an annuity.
5. Contrary to DPW’s interpretation, CMS appears to interpret § 1396p(e)(4) to mean that the transfer of asset provisions of the DRA do not change the resource and income aspects of an annuity. “The State may take into consideration the income or resources derived from an annuity when determining eligibility for medical assistance or the extent of the State’s obligations for such assistance. This means that even though an annuity is not penalized as a transfer for less than fair market value (see II. Evaluation and Treatment of Purchases of Annuities and Certain Transactions On or After February 8, 2006 below for further information about treating the purchase of an annuity as a transfer of assets), it must still be considered in determining eligibility, including spousal income and resources, and in the post-eligibility calculation, as appropriate. In other words, even if an annuity is not subject to penalty under the provisions of the DRA, this does not mean that it is excluded as income or resource.” CMS State Medicaid Director Letter, SMDL # 06-018, July 27, 2006.

For other information about the decision in the case, see: "James v. Richman -- Decision of Federal Third Circuit Court of Appeals" (11/12/08), posted on the website of Marshall, Parker & Associates, LLC.

Update: 11/17/08 @ 5:30 pm:

After my posting, Jeff Marshall sent me an email message with clarification and further thoughts regarding the effect of the James decision upon the pending Weatherbee case, as follows:

Weatherbee did not find to the contrary. In fact, Weatherbee has not been decided. It is under submission. We think that the Judge for the Weatherbee case has been waiting for the ruling in James to issue his decision.

In my opinion, it is more likely than not that the Court in Weatherbee will rely on James and also find against DPW. DPW basically made the James case arguments in Weatherbee and added a very weak additional argument that a provision in the DRA saying it doesn’t change the income and resource rules therefore gives it the ability to ignore the income and resource rules when an annuity is involved.

It’s hard to imagine that the Weatherbee court will rule in favor of DPW given the very clear ruling in James.

Update: 12/08/08:

The Times-Leader (Scranton, PA) published an article on December 8, 2008, regarding the James decision, entitled "Annuity ruling sets standard" by Terrie Morgan-Besecker, who noted that the "recent decision reaffirms other rulings that [an] annuity can’t be seen as asset in determining nursing home assistance."

The article notes that the effects of the ruling are viewed differently by those seeking to protect Medicaid benefits, versus those funding such benefits in the state budget.

The ruling by the Third Circuit Court of Appeals is the latest in a series of court cases brought by welfare officials in Pennsylvania and other states. The cases challenge a loophole in the Medicaid law that officials say has allowed affluent couples to use annuities to shelter assets that otherwise would be available to pay for an institutionalized spouse’s care.

The decision, issued last month in the case of Josephine James, is significant because it reaffirms prior court rulings, said James’s attorney, Matthew Parker of Williamsport. It will affect all residents in the states covered by the Third Circuit – New Jersey, Pennsylvania and Delaware.

But Jason Manne, chief deputy counsel for DPW, said the court’s ruling is fact-specific to the James case. Even though the department lost, Manne contends the legal reasoning the court employed will help DPW challenge the use of annuities in calculating Medicaid benefits.

The ruling is being closely monitored by attorneys on both sides of the issue as the stakes are huge. The average annual cost of nursing home care for one person is $60,000, according to DPW. Last year, Pennsylvania’s Medicaid fund paid out more than $3 billion to nursing homes.

While providing health care coverage to all persons is a laudable goal, DPW says, it has an obligation to ensure that Medicaid is utilized for those who truly need it. * * *

The article also notes that applicable rules may be changed by federal legislation. I think that this is likely, just as the rules were changed in 2006 (as noted in my prior postings).

For a different view as to the key holding of the James case, see "3d Cir.: A favorable Medicaid annuity decision under § 1983" posted by the National Senior Citizens Law Center, which focused more on litigant standing and review rights, rather than upon the substantive issues regarding the effect of an annuity purchase upon eligibility for Medicaid.

DCBA Gun Session with a Heller of a Difference

On Tuesday, July 8, 2008, from noon to 1 p.m., the Dauphin County (PA) Bar Association will host a "Lunch & Learn" session for lawyers entitled "Weapons in an Estate or Trust: What to do with the Guns" at DCBA Headquarters, presented by Neil E. Hendershot and Joshua G. Prince.

This session will be a reprise of the popular presentation made on April 25, 2008, at the Cumberland County (PA) Bar Association, but with one key difference: the decision rendered by the U.S. Supreme Court on June 26, 2008, in District of Columbia v. Heller (PDF, 172 pages).

We will cover all the information outlined in the EE&F Law Blog posting "Guns in Estates & Trusts" Seminar (04/25/08).

At the conclusion of the session, we will speculate about the impacts of this decision, as Josh & I did in our three-part series "Right to Keep and Bear Arms" posted on this Blog after issuance of the Heller decision:

• Right to Keep and Bear Arms: Part I (06/27/08);

• Right to Keep and Bear Arms: Part II (06/30/08); and

• Right to Keep and Bear Arms: Part III (07/01/08).

This is a historic debate that will continue beyond our own time into decades of clarifying litigation to be conducted in federal and state courts. For one commentary, see "The Future of Gun Control" by Alex Altman, posted on Jun. 26, 2008, by Time Magazine.

One compendium of resources on these issues is The Journalist's Guide to Gun Policy Statements and Second Amendment Scholars.

Tax Court Upholds FET Savings Clause

On February 1, 2008, Steve R. Akers, Associate Fiduciary Counsel, Bessemer Trust, Dallas, Texas, circulated by email the summary of his article entitled "Estate of Christiansen v. Commissioner: Formula Disclaimer That Operates Much Like A Defined Value Transfer Clause Does Not Violate Public Policy", together with a link for his full analysis.

The Memorandum Opinion of the U. S. Tax Court, issued January 24, 2008 in this case, is available online. See: Estate of Helen Christiansen, deceased v. Commissioner of Internal Revenue, Docket No. 15190-05, 130 T.C. No. 1 (PDF, 57 pages).

In short, the Tax Court upheld the effectiveness, for purposes of a federal estate tax charitable deduction, of a "savings clause" (in this case, a formula disclaimer) that caused an increase in the value of the gross estate on audit to pass to a charity, which was exempt from application of the tax.

With his permission, I repost Steve's summary observations about the Christiansen case.

Estate of Christiansen v. Commissioner:
Formula Disclaimer That Operates
Much Like A Defined Value Transfer Clause
Does Not Violate Public Policy

Copyright © 2008 by Bessemer Trust Company, N.A. All rights reserved.
[Reparagraphing applied]

In Estate of Christiansen v. Commissioner, 130 T.C. No. 1 (January 24, 2008), the full Tax Court renders what may become a bellwether case for defined value clauses.

The case involves a formula disclaimer. The decedent’s daughter made a “formula disclaimer” of everything in the estate in excess of $6.35 million. The excess passed to a foundation and a charitable lead annuity trust.

A technical disclaimer issue prevented the disclaimer from being effective as to the CLAT, but that technical issue did not apply to the amount disclaimed to the foundation. But for the technical disclaimer problem, if all of the disclaimed assets had passed directly to the foundation or another charity in a manner that qualified for the estate tax charitable deduction, the IRS would not have collected any additional estate tax no matter what value it placed on the gross estate, because all of the excess value over $6.35 million would have been offset by a charitable deduction.

The IRS argued that the disclaimer to the foundation should not be recognized on the same grounds that it has objected to defined value transfer clauses: (1) the disclaimer was subject to a condition subsequent, and (2) the disclaimer should be invalid on public policy grounds.

Every Tax Court judge who participated in this opinion agreed that neither of those arguments invalidated the formula disclaimer. The Tax Court in McCord seemed to go out of its way to avoid the issue of whether a defined value gift transfer violated public policy. While the court’s specific reasoning arguably might not cover all defined value transfers, the Christiansen case suggests that the Tax Court will likely reject the IRS’s public policy argument when it arises again in the context of a defined value transfer.

Although the Fifth Circuit gave effect to a defined value transfer in McCord, the court did not address the public policy issue (the IRS did not make that argument before the Fifth Circuit, perhaps because it perceived the Fifth Circuit as a taxpayer friendly Circuit and it did not want its public policy issue being decided first in that Circuit).

A major uncertainty after McCord is how courts will respond to the public policy issue, and perhaps Christiansen represents the first domino to fall. Time will tell.

To read Steve's more detailed analysis of the Christiansen case, click here (PDF, 6 pages; January, 2008), or contact him at: Akers@bessemer.com.

For Steve's earlier discussion about the McCord case, see: PA Elder, Estate & Fiduciary Law Blog posting "McCord: 5th Circuit Respects Defined Value Clause & Allows New Type of Gift" (09/08/06).

IRS Wins Rudkin Case in U.S. Supreme Court

On January 16, 2008, the United States Supreme Court issued its decision in Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue Service. (No. 06–1286; PDF, 16 pages). In short, the IRS won. But the drama may not be over.

This is the summary of the Court's holding: "Investment advisory fees generally are subject to the 2% floor when incurred by a trust."

The case, on appeal from the Second Circuit Court of Appeals, was argued before the U.S. Supreme Court on November 27, 2007. The case was decided unanimously by the Court in an opinion written by Chief Justice Roberts. The result favored the position advocated by the Internal Revenue Service.

The Court's opinion summarized the setting and issues as follows:

Individuals may subtract from their federal taxable income certain itemized deductions, 26 U. S. C. §63(d), but only to the extent the deductions exceed 2% of adjusted gross income, §67(a).

A trust may also take such deductions subject to the 2% floor, §67(e), except that when the relevant cost is “paid or incurred in connection with the administration of the . . . trust” and “would not have been incurred if the property were not held in such trust,” the cost may be deducted without regard to the floor, §67(e)(1).

After petitioner Knight (Trustee), the trustee of a testamentary trust (Trust), hired the Warfield firm to advise as to Trust investments, the Trust deducted in full on its fiduciary income tax return the investment advisory fees paid to Warfield.

Respondent Commissioner found the fees subject to the 2% floor and therefore allowed the deduction only to the extent the fees exceeded 2% of the Trust’s adjusted gross income.

The Tax Court decided for the Commissioner, and the Second Circuit affirmed, holding that because such fees were costs of a type that could be incurred if the property were held individually rather than in trust, their deduction by the Trust was subject to the 2% floor. * * * [Text reparagraphed.]

For prior discussion about this case and related IRS rulemaking activities, see PA EE&F Law Blog postings: "Rudkin" Regulations Proposed During Appeal (08/02/07); Bankers Associations File Amicus Brief in Rudkin Case (08/24/07); and IRS Gets Comments on "Rudkin" Regs Proposed (11/19/07).

The Court's opinion stated the issue: "In the case of individuals, investment advisory fees are subject to the 2% floor; the question presented is whether such fees are also subject to the floor when incurred by a trust."

The Court answered that question: "We hold that they are and therefore affirm the judgment below, albeit for different reasons than those given by the Court of Appeals."

But note, tax preparers, that this ruling affects more than trusts; it applies to estates too. Footnote No. 1 advised: "Because this case is only about trusts, we generally refer to trusts throughout, but the analysis applies equally to estates."

The opinion reviewed the arguments of the Trust and the IRS regarding Section 67(e)(1) of the Internal Revenue Code, and the resolutions by the circuit courts that considered the issue. It resolved the interpretation of that section as follows:

Thus, in asking whether a particular type of cost “would not have been incurred” if the property were held by an individual, §67(e)(1) excepts from the 2% floor only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur.

Having decided on the proper reading of §67(e)(1), we come to the application of the statute to the particular question in this case: whether investment advisory fees incurred by a trust escape the 2% floor. * * *

The Court concluded:

[I]t is quite difficult to say that investment advisory fees “would not have been incurred” — that is, that it would be unusual or uncommon for such fees to have been incurred — if the property were held by an individual investor with the same objectives as the Trust in handling his own affairs. * * *

There is nothing in the record, however, to suggest that Warfield charged the Trustee anything extra, or treated the Trust any differently than it would have treated an individual with similar objectives, because of the Trustee’s fiduciary obligations. * * *

It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor.

Here, however, the Trust has not asserted that its investment objective or its requisite balancing of competing interests was distinctive. Accordingly, we conclude that the investment advisory fees incurred by the Trust are subject to the 2% floor. * * * [Text reparagraphed.]

What will the effect of this decision be upon the pending IRS proposed regulations on the same matters? See: Internal Revenue Bulletin 2007-36, issued September 4, 2007 (REG-128224-06), "Notice of Proposed Rulemaking and Notice of Public Hearing Section 67 Limitations on Estates or Trusts".

Bob Wolf, Esq., of Pittsburgh, PA, provided some initial thoughts in a message to his P & T Hot Tip Emailees on January 16, 2008, after he recited the case holding (reproduced with his permission):

Since investment advisory fees are commonly incurred by individuals, they are subject to the 2% floor. If there had been a quantifiable cost for investment advisory fees as they dealt specific with unique trust issues, the Court left the door open for a full deduction without the 2% floor. These will be unusual, however, given the Court's opinion.

Very importantly, the IRS wanted to go much further than this and did so in its Proposed Regulations, which would have required trustees to literally unbundle their fees to determine which portion of a unified trustee's fee was truly unique to their functioning as a trustee -- such as accountings or fiduciary income tax return preparation, etc. This would have caused a great deal of trouble in the trust world, and led some also to wonder whether attorneys' fees would have to be "unbundled" in the same way!!

It seems quite unlikely that the IRS will feel encouraged to finalize their proposed regulations, given the specifically unfavorable comments by the Supreme Court in this decision to so draconian a set of rules. Thus at first blush, one would expect the Final Regulations to shift course, and if not, a second battle at the High Court would without doubt be in the offing.

Note also, that in a trust account in which there are not a lot of capital gains realized in a particular tax year, this is not the biggest deal in the world for the taxpayer. If the income in the trust, including capital gains incurred, were 6%, then 2% times the 6% would be a mere 12 basis points of deduction lost out of the investment advisory fee that in most cases is around 1%, depending upon the size of the account. The Rudkin Trust had $624,000 in income in a year in which the trust had a value of $2.9 Million. A little excessive turnover maybe?

So it is clear that investment advisory fees incurred by a trust will be ordinarily be subject to the 2% floor on itemized deductions absent special circumstances, but the likelihood that trustees and attorneys will have to unbundle their normal trustees and counsel fees to engage in highly artificial quantifications has been significantly reduced in this writer's opinion.

The issuance of this decision was noted immediately by Professor Paul L. Caron, of the University of Cincinnati College of Law, on the Tax Prof Blog, in his posting "Supreme Court Issues Unanimous Opinion in Knight: Deduction of Trust's Investment Expenses Is Limited by § 67's 2% Floor" (01/16/08).

He noted that the U. S. Supreme Court "thus followed the position of the Tax Court and Second, Fourth, and Federal Circuits, and rejected the position of the Tenth Circuit." He also posted some resource links about the issues in the case and the proposed, outstanding rulemaking of the IRS.

From among those links, I highly recommend reading the article entitled "The Section 67 Question: Are Fees for Investment Advice Fully or Partially Deductible by Trusts?", by Professor James F. Loebl, of Valparaiso University School of Law, as posted on the Social Science Research Network.

Professor Loebl had correctly predicted the outcome of this case in the U. S. Supreme Court; and he further suggested where the next drama might, or should, play -- in Congress.

Update: 01/17/08:

The Wall Street Journal noted the Rudkin decision in its article entitled "Investment-Advice Fee Ruling", by Mark H. Anderson, published January 17, 2008.

The U.S. Supreme Court yesterday unanimously ruled that investment-advice fees incurred by trusts and estates are subject to routine limits if claimed on federal tax returns.

The opinion, written by Chief Justice John Roberts, affirms a lower court ruling that denied a full deduction to more than $20,000 in investment-advice fees spent by a trust set up in 1967 under the will of Henry A. Rudkin, who, with his wife, founded food company Pepperidge Farm.

Chief Justice Roberts, in the opinion, said in most instances trust or estate investment fees must exceed 2% of adjusted gross income to be deductible. The opinion said investment fees may be fully deductible in some instances, such as when additional fees are incurred for fiduciary obligations. * * *

The WSJ article apparently provided a link for readers to this Blog's posting.

Update: 01/18/08:

Professor Gerry Beyer noted this posting in his own, dated January 18, 2008, entitled "Supreme Court Holds Trust Investment Advisory Fees Subject to the 2% Floor", which appeared on the Wills, Trusts & Estates Prof Blog.

Update: 01/24/08:

Commerce Clearning House (CCH) posted an excellent summary & analysis of the Rudkin (a/k/a/ Knight) case on January 17, 2008, in its Daily Tax News Update, in an article by George L. Yaksick, Jr. & Deborah Petro, of the CCH News Staff, entitled "Supreme Court Limits Trust's Deduction of Investment Advisory Fees to Two-Percent Floor; IRS Likely to Repropose Regulations (Michael J. Knight, Trustee of William L. Rudkin Testamentary Trust, SCt)".

While the decision dashed the hopes of many trust and estate administrators that the Court would allow these fees to be fully deductible, the Court did not adopt the analysis of the Second Circuit Court of Appeals on which the IRS based controversial proposed regulations (NPRM REG-128224-06, I.R.B. 2007-36, 551; TAXDAY, 2007/07/21, I.2). It is likely the IRS will have to repropose the regulations to reflect the Supreme Court's decision, several experts told CCH.

"The decision puts us back to square one," Carol A. Cantrell, co-counsel for the trustee in Rudkin , told CCH. Cantrell, a shareholder with Briggs & Veselka Co., Bellaire, Texas, and a member of the AICPA Fiduciary Accounting Task Force, predicted more litigation as trusts proceed on a case-by-case basis. * * *

Update: 03/04/08:

Attorney Bob Wolf, of Pittsburgh, PA, analyzed the "interim guidance" on these matters, issued by the Internal Revenue Service on February 27, 2008, in this PA EE&F Law Blog posting, "IRS Issues Interim Guidance for Fid Inc Tax Returns" (03/04/08).

IRS Gets Comments on "Rudkin" Regs Proposed

On November 14, 2007, at 10 a.m., a hearing was held by the Internal Revenue Service at its offices in Washington, D.C., to receive comments about the Notice of Proposed Rulemaking on Section 67 Limitations on Estates or Trusts (Internal Revenue Bulletin No. 2007-36), issued September 4, 2007.

That Notice was summarized as follows:

This Notice contains proposed regulations that provide guidance on which costs incurred by estates or non-grantor trusts are subject to the 2-percent floor for miscellaneous itemized deductions under section 67(a). The regulations will affect estates and non-grantor trusts. This document also provides notice of a public hearing on these proposed regulations.

The Notice acknowledged inconsistent federal court decisions from various circuits interpreting IRC Section 67(a).

The issue in each case has been whether the trust’s costs (specifically, investment advisory fees) “would not have been incurred if the property were not held in such trust or estate.”

In O’Neill v. Commissioner, 994 F.2d 302 (6th Cir. 1993), the Court of Appeals for the Sixth Circuit held that investment advisory fees paid for professional investment services were fully deductible under section 67(e)(1) where the trustees lacked experience in managing large sums of money. The court found that, under state law, the trustee was required to engage an investment advisor to meet its fiduciary obligations and to incur fees that the trust would not have incurred if the property were not held in trust. The court held that estate or trust expenditures that are necessary to meet specific fiduciary obligations under state law are not subject to the 2-percent floor.

In contrast, in Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001), Scott v. United States, 328 F.3d 132 (4th Cir. 2003), and Rudkin v. Commissioner, 467 F.3d 149 (2d Cir. 2006), the courts held that investment advisory fees are subject to the 2-percent floor.

These courts read the language of section 67(e)(1) differently than the Sixth Circuit. Specifically, the courts in Scott and Mellon Bank concluded that a trust expense is subject to the 2-percent floor if it is an expense “commonly” or “customarily” incurred by individuals; and the court in Rudkin looked to whether such an expense was “peculiar to trusts” and “could not” be incurred by an individual. * * *

The result of this lack of consistency in the case law is that the deductions of similarly situated taxpayers may or may not be subject to the 2-percent floor, depending upon the jurisdiction in which the executor or the trustee is located. * * *

The IRS determined to issue proposed regulations to resolve the situation.

That was quite unusual -- and somewhat controversial -- because the Supreme Court of the United States already had granted a review of these conflicting federal circuit court decisions. For background about the dispute involving William L. Rudkin Testamentary Trust v. Commissioner (PDF, 19 pages), 467 F.3d 149, 98 AFTR2d 2006-7368 (2d Cir. 10/18/06), see PA EE&F Law Blog postings: "Rudkin" Regulations Proposed During Appeal (08/02/07); and Bankers Associations File Amicus Brief in Rudkin Case (09/24/07). Furthermore, the proposed regulations would create rules going beyond even supportive court decisions.

In anticipation of the October 24th deadline for submission of written comments about the proposed regulations, the American Bar Association sent a letter, dated October 23, 2007 (PDF, 1 page), relating to the "Proposed Regulations Relating to Limitation on Estates or Trusts Deductions (REG-128224-06)".

The comments, derived from its Tax Section and its Real Property, Trusts & Estate Law Section, were brief:

The interpretation of section 67(e) will be before the United States Supreme Court in the current term (Rudkin v. Commissioner, 467 F.3d 149 (2nd Cir. 2006), cert. granted sub nom. Knight v. Commissioner (S. Ct. Doc. No. 06-1286)).

Therefore, we respectfully request that the Treasury and the Service consider deferring 1) the submission date for the comments on the Proposed Regulations, 2) the hearing date for the comments on the Proposed Regulations, and 3) any action on the Proposed Regulations all until after the Court has issued its decision in the Knight case.

This will afford the public the opportunity to take into account the effect, if any, of the Court's conclusions when submitting comments on the Proposed Regulations.

The American Bankers Association also submitted comments consistent with its general position on trust taxation issues:

In particular, the IRS calls for the unbundling of fees and a list of what fees are deductible and what fees are not. This requirement goes beyond the scope of the statute.

This issue was raised in the Rudkin case for which the Supreme Court recently granted certiorari and on which the ABA has filed an amicus brief.

However, the letter, dated October 24, 2007, sent by the American Bankers Association (PDF, 6 pages), provided far more detail in its substantive objections to the proposed regulations. That letter then concluded, similarly:

At a minimum, the IRS should not move forward with this proposal until the Supreme Court has had an opportunity to rule on the merits of the case before it.

In addition, we would strongly urge the IRS to abandon this proposal, as it ignores the significant fiduciary duties of trustees and leads to far greater burdens than benefits.

On November 16, 2007, Susan D. Snyder, Esq., of Northern Trust Corporation, posted on the listserv of the American College of Trust & Estate Counsel (ACTEC) the following summary, which was circulated by the American Bankers Association post-hearing:

The panel consisted of three attorneys in the IRS's Passthroughs and Special Industries section (Danielle Grimm; Brad Poston; and Jennifer Keeney) and one person from Treasury, Catherine Hughes, Attorney Advisor in the Office of Tax Policy.

Seven people testified: Robert Balter, attorney; Joseph Mooney, representing the American Bankers Association; Richard Weber, representing the AICPA; Grace Allison, Northern Trust; Diana Zeydel, attorney; Barbara Sloan, attorney; and Randall Harris, attorney.

Generally, the speakers made these arguments: (1) extend the comment period until 90 days after the Supreme Court has issued a decision; (2) plain meaning of Sec. 67(e) allows a full deduction of the entire trust fee, including investment management fees; (3) the unbundling requirement will be very costly and burdensome to trustees; (4) trustees are held to fiduciary principles, individuals are not; (5) in drafting the proposed regulation, the IRS is engaging in linguistic manipulation of the statute.

Susan also posted the testimony presented by her co-worker, tax attorney Grace Allison, Esq., on behalf of Northern Trust Corporation, at that hearing.

Since I cannot find these comments on either the Northern Trust Corporation website or the American Bankers Association website, I requested to repost them. Susan graciously consented; and I do so, with thanks to her, Grace, & their employer.

Ladies and Gentlemen:

Thank you for the opportunity to make this presentation today.

I represent Northern Trust Corporation (“Northern Trust”), which has been in the business of administering trusts since its founding in 1889. Today, Northern is one of the largest trust companies in the world, with a network of 85 offices in 18 U.S. states, administering more than 15,000 irrevocable trusts nationwide.

In my position as Vice President in the Personal Financial Services Division of Northern Trust, I have worked closely with trust administrators, investment managers and ancillary personnel on a wide range of trust matters. I am a tax attorney, admitted to the Illinois bar and to practice before the Tax Court.

As a member of the Illinois Bankers Association, Northern Trust endorses the amicus brief filed on August 23, 2007, by The American Bankers Association in Knight v. Commissioner, U.S., No. 06-1286, as well as the comments submitted by The American Bankers Association in connection with this hearing.

It is our view that the proposed regulations should be replaced with regulations adopting the rationale articulated by the Sixth Circuit in O’Neil v. Commissioner, 994 F.2d 302 (6th Cir. 1993).

Additionally, we submit that the plain language of section 67(e) fails to provide any basis whatsoever for the requirement that trustees “unbundle” their fees and that the proposed regulations, to the extent they so require, are invalid as an abuse of administrative authority.

The Plain Meaning of Section 67(e)

Section 67 generally provides that an itemized deduction is allowed only to the extent that it exceeds 2% of a taxpayer’s adjusted gross income. Subsection (e) of that section, however, permits a full deduction (without application of the 2% floor) for “costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such estate or trust . . ..”

This plain language, and the legislative history behind it, permit a full and undiminished deduction for all trust fees (including fees for custody and investment advice) to the extent that such costs are paid in connection with the administration of the trust and would not have been incurred if the property were not held in the trust. Indeed trustee fees can only be incurred in connection with property held in a trust. Regardless of whether we incur costs to achieve good business practice and reputation or to comply with strict requirements of local fiduciary law, there is no question that we incur them in order to administer our trusts.

We are not talking here about abusive pass-throughs of inappropriate expenses—such as stadium tickets or airfare to China. The fees that are the proper subject of this hearing relate to integral trust functions. There is no authority for excluding legitimate trustee fees from the coverage of section 67(e).

Disparate Treatment of Mutual Fund Fees.

It is also important to note that the proposed regulations, if made final, have the potential to disrupt the financial markets (and create another tax loophole) by providing a new incentive for all trusts to invest in mutual funds. This undoubtedly unintended consequence is caused by the asymmetry between the treatment of investment costs incurred by mutual funds and the treatment, under the proposed regulations, of trust investment fees.

The former are, pursuant to section 67(c)(2)(B), allowed as a direct offset to the fund’s investment income; the latter, by regulation, would now be allowed only to the extent they exceed a 2% floor. To put it plainly, Treasury lacks the authority to require trustees to “unbundle” their fees, just as it would lack the authority to require mutual funds to pass their unbundled fees through to trust investors.

Impracticality.

In addition, the requirement to “unbundle” fees imposes an impractical burden on all trust companies, large and small, and would set a standard impossible to meet with any degree of precision. Put in an historical context, the proposed regulations rival the ill-fated carryover basis rules in the degree of administrative complexity they would entail if made final as proposed.

When providing trust services (whether as sole trustee or co-fiduciary), trustees must pay keen attention to the needs of beneficiaries. This means that services must be individualized—and the exact service mix will depend on a variety of factors, including the complexity of the family situation, the number of beneficiaries, the terms of the trust, and the type of assets under administration. For example, a trust administrator may spend many, many hours on a trust established for a disabled child or a distraught widow. In the same vein, a trust with 40 beneficiaries has different needs from a trust that benefits a single individual.

Some of our accounts are simple trusts, requiring that all income be paid annually, with no discretion to distribute principal. In other trusts, however, distributions of both income and principal are left to the discretion of the trustee, with complex distribution standards requiring hours of fact-finding and analysis.

In several of our large trust relationships, the predominant asset is closely-held stock of a family business; with this type of asset, discussions of family values are often as important—and far more difficult—than straight-forward investment briefings.

As a consequence, the percentage of time devoted to trust administration fluctuates widely from trust to trust and from year to year—and would be most difficult to quantify.

In pertinent part, the preamble to the proposed regulations states that: “whether costs are subject to the 2-percent floor . . . depends on the type of services provided, rather than on taxpayer characterizations or labels for such services.”

Read literally, this would require Northern to detail its services on a minute-by-minute account-by-account basis. This is an impossibility in a corporate trustee environment, where some services are rendered to hundreds of trusts at the same time—and other services are required for more than one purpose.

Is the cost of tax lot accounting, for example, most properly allocated to trust accounting (not subject to the 2% floor), to tax return preparation (not subject to the 2% floor) or to investment management (subject to the 2% floor)?

Proposed Safe Harbors.

The preamble to the proposed Regulations notes that the IRS and the Treasury Department “invite comments on whether any safe harbors or other guidance, concerning allocation methods or otherwise, would be helpful.”

In the unfortunate event that IRS and Treasury cannot be persuaded to withdraw the proposed regulations, we reluctantly suggest consideration of the two safe harbors described below.

For a few of its largest and most complex trust relationships, Northern Trust enters into highly individualized arm’s length written contracts detailing annual fees for specific services such as custody, investment management and trust administration. It would be helpful if the proposed regulations clarified that, in such situations, the terms of the actual written contract should form the basis for any fee allocation.

In addition, for the thousands of our accounts where there is no such individualized agreement, the addition of a bright-line safe harbor would provide necessary practicality in applying these proposed regulations. Given the diversity of our trusts, and the corresponding diversity of services needed to protect them, we have found it impossible to arrive at a single allocation percentage. Rather, our experience leads us to conclude that an allocation range would be most appropriate, with between 53 and 62.5 percent of total trustee fees allocated to trust administration services not subject to the 2 percent floor. This proposed safe harbor is based on our actual experience as a corporate trustee and, to the best of our ability, on the definitions of “unique” and “not unique” services found in the proposed Regulations at section 1.67-4(b).

We recognize that, in some trust situations, the safe harbors described above will not accurately reflect actual trust services rendered, and will, for that reason, not achieve a fair result for our clients. We would hope, however, that in the bulk of our situations, the safe harbors we suggest would further administrative efficiency—and would help ensure that all clients of all trustees are treated equally.

Conclusion.

In conclusion, we strongly urge Treasury and the IRS to withdraw the proposed Regulations, which are neither contemplated nor sanctioned by section 67, as ill-advised, impractical and expensive—both to the taxpayer and to the IRS.

Update: 12/05/07:

A weekly update email message sent by the American College of Trust & Estate Counsel (ACTEC) to its members provided a further useful resource on this issue: a link to the transcript of the oral argument held on November 27, 2007, before the U.S. Supreme Court, in the matter of Knight v. Commissioner (Rudkin).

The transcript is available here (PDF, 66 pages).

Update: 01/17/08:

On January 16, 2008, the United States Supreme Court issued its decision in Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue Service. (No. 06–1286; PDF, 16 pages). In short, the IRS won. But the drama may not be over, either.

See: PA EE&F Law Blog posting "IRS Wins Rudkin Case in U.S. Supreme Court" (01/17/08).