An Estate Tax Fantasy (on the Keller case) (9/28/12)

I write a fictional story inspired by a recent decision, Keller v. United States,, 697 F.3d 238 (5th Cir. 2012), here.  That decision gave the taxpayer a big estate tax victory for the uber rich.  I personally think the estate tax benefit achieved in the case was extravagant.  But I do not write on the substantive planning involved.  I write rather to address another feature of the case.  This issue I discuss is present whether the taxpayer wins or loses.  The attorney and other administrative costs paid by an estate in a large estate tax case substantially mitigated by the estate tax savings benefit they can achieve.  I just want students to understand the phenomenon.

The Keller case involved a very large estate.  The marginal estate tax rate was 55% at the time and that is the rate that should be assumed for the issues that I will discuss.  The substantive issue was the common estate planning technique whereby the older generation stuffs assets into a partnership to achieve minority discounts thus shifting real value to the objects of her beneficence without the consequent estate or gift tax cost.  This should be old hat for observers of estate tax schemes -- the minority discount just magically appears without diminution in value.  I would have thought the gambit might not work with highly liquid assets, but Keller tells us otherwise.  In Keller, the gambit just caused, for tax purposes, vast amounts of value to disappear from the tax base when, in fact, in terms of the wealth of the family, it did not disappear.  Never mind for present purposes the validity or invalidity, morality or immorality, of the substantive gambit.  I want to focus on the estate's claims for administrative expenses, including in part here pertinent fees related to the estate tax litigation.

As noted, the estate was a very large estate; not surprisingly, the administration expenses, also very large, would apparently achieve a 55% tax benefit under the rate in effect when the estate tax was due and would magnify that 55% tax benefit by the interim interest that would otherwise be due from the estate.  Among the administrative expenses claimed by the estate were various professional fees related to the litigation.  The one that caught my eye was a $9.5 MM "contingency fee" for the lawyers who handled the estate tax litigation.  Here is the district court's discussion resulting in the contingency fee being disallowed (Keller v. United States, 1010 U.S. Dist. LEXIS 96465 (S.D. TX 20110)).

Legal Fees 
Plaintiffs' Second Amended Submission of Deductions, (Dkt. No. 111, Ex. A), claims a deduction for attorneys' fees in the amount of $12,106,415.68. This amount includes: * * * * 9) $2,439,514.18 in fees paid to Meadows, Owens, Collier, Reed Co.; [and] 10) $9,470,606.00 in a contingent fee to Meadows, Owens, Collier, Reed Co;  * * * * 

A. Contingent Fee  

Defendant claims the contingency fee to be paid to Meadows, Owens, Collier, Reed Co. ("Meadows, Collier") in the amount of $9,470,606.00 is unnecessary.  

On September 11, 2009, after the Court entered its August 20, 2009, Findings of Fact and Conclusions of Law, Plaintiffs and Meadows, Collier executed the "Amended and Restated Fee Agreement." (Dkt. No. 90, Ex. B). Plaintiffs claim this agreement simply memorializes a previous understanding between Meadows, Collier and Plaintiffs regarding continued legal representation and compensation in connection with the Estate's refund claims. Plaintiffs claim that, from the inception of this case, Plaintiffs and Meadows, Collier agreed that the law firm would receive an undefined bonus contingent on the recovery of a sizable refund. Plaintiffs assert that the Amended and Restated Fee Agreement simply quantifies the original bonus agreement and confirms the terms of the continued legal representation. While the Court understands Plaintiffs' claim that this fee agreement not only includes a bonus for work already performed, but also includes yet to be performed work, as the Estate's tax issues were not yet resolved when this agreement was entered into, the Court cannot find that these fees are "necessary" to the administration of the Estate. The Amended and Restated Fee Agreement provides for Meadows, Collier to be compensated on an hourly rate, in addition to the contingency fee. (Dkt. No. 90, Ex. B). The Court finds that the contingency fee is not necessary to the administration of the Estate; rather, it is an attempt by Plaintiffs to increase their deductions. n3  

   n3Defendant also asserts that the contingent fee is invalid because it was not in writing. While Plaintiffs contest this assertion, the Court need not address this objection since the contingent fee is not “necessary.”

I focus particularly on the bottom-line holding in the district court:  "The Court finds that the contingency fee is not necessary to the administration of the Estate; rather, it is an attempt by Plaintiffs to increase their deductions."

The Government argued in its opposition to the allowance of the contingency fee:\

First, any contingent fee paid to the attorneys here is unnecessary. All the legal work performed by Meadows, Collier had been done on an hourly basis and fully paid for, to the tune of $2,044,135.49. Payment of such a contingency fee, agreed to by the Estate on September 11, 2009, after this Court’s findings were entered on August 20, 2009, is nothing more than an additional award to the attorneys, which, if paid, will most likely be largely paid by the Government, and clearly was not necessarily incurred in the administration of the estate. As a result, such contingent fee is not deductible under section 2053.

So, with this commotion (albeit cryptic) about the contingency fees, I decided to look further into this phenomenon characterized by the Government and the Court as being, in essence, a ploy to have legal fees borne by the Government.  Of course, when legal fees are paid in a setting where some type of tax deduction (whether income or estate) is achieved, economically, it may be said that the Government "bears" the cost of the fees to the extent of the tax that would have been paid had the fees not been incurred.  At least in an income tax setting, this is usually a push for the Government, since the payee law firm (usually its partners) will pay tax on the payment, often at the same effective tax rate as the tax rate for the savings to the payor.  And, with a substantial portion of the economic cost still being born by the payor (rather than the Government), there will be an economic incentive for the payor to pay only necessary and reasonable fees.  This is true even where the payor is in a higher effective rate bracket than the payee.  Note, for illustration, that the estate in Keller was likely in the 55% tax bracket, so an estate tax deduction for administration expenses would, all other things being equal, still cost the estate 45%.  But, in estate tax, all other things are not equal and that is the phenomenon I address here.

In the Keller litigation, neither the Meadows, Collier firm nor any of the persons associated with it were beneficiaries of the estate or related to the estate in any way except for providing legal service.  The estate had no apparent reason for being generous with the law firm.  The phenomenon that resulted in the outsize contingency fee, however, permitted the estate to "incur" the fees without the same check of substantial economic cost to the payor that normally exists in incurring such fees.  In short, the Government could properly object that the Government, not the estate, was bearing the cost of the fees.

The contingency fee agreement, executed after the victory in the case in chief, provided for hourly fees at "our prevailing rate" (which had been paid contemporaneously as earned throughout the litigation as the services were rendered) plus a significant contingency.  The contingency calculation is quite complex, but apparently, when calculated, came out to $9,470,606.90.  Now, just at the surface, the question I had when I looked at this was why would the estate after paying the law firm the prevailing hourly rate (for which the law firm received $2,439,514.18) then, without any obligation and after achieving the victory, agree to a multiple contingency on top?  Usually, a law firm will work without contingency for standard hourly rates (in this case at the top of the market).  And, even when a contingency is the deal will usually charge less of an hourly rate or sometimes no hourly rate at all.  And, when a contingency fee is agreed upon the "contingency" is still at the early stages of controversy before the various contingencies have resolved.  Well, the phenomenon is a confluence of three factors: the deduction of the economic costs of "administration" incurred years after the estate tax is due; the estate tax rate; and the length of time that expires after the date the estate tax is due.

The phenomenon is illustrated in this quote from the district court related to interest fees paid as an administration expense long after the date the estate tax was due (Keller v. United States, 2011 U.S. Dist. LEXIS 46250 (S.D. Tex. 2011)):

n2 As the Government explains, under the terms of the Extended Promissory Note, the first interest payment of $820,800 ($114 million x .0072) would be paid annually on February 15, 2011. If the estate is allowed a deduction of this amount on its Form 706, then it will generate a refund of 98.33 % of the amount paid.

The district court disallowed the contingent fees as an administration (meaning that, probably, the estate could mitigate the damage by claiming them on the income tax return/

That phenomenon is true of any estate administration expense paid many years later, including attorneys fees (contingency or otherwise).

So, my fictional story is this.

1. The IRS asserts a large estate tax liability, let's say $100 MM.
2. The estate decides to litigate the tax liability in the Tax Court, the prepayment forum.  (Keller was presented in a refund context, but the concepts are the same since the underpayment and overpayment interest rates are the same).
3. It engages law firm XYZ to litigate the case at its standard hourly fee rates.
4. The litigation goes on for 10 years.
5. The estate prevails in the litigation.
6. The estate is happy with the result.  
7. The lawyers have been fairly compensated for they have earned and been paid timely their regular hourly rates.  
8. The law firm, seeing an opportunity to win the Government lottery, comes to the estate and says, you know, we did one hell of a job for the estate, and our standard hourly rates do not reflect the real value we brought to the successful conclusion of the case.  We would like more.
9. If you give us more, we [the law firm] can show you that the estate will not only have no economic cost to paying us a whopping contingency fee; indeed it is possible that the estate will be better off economically by paying us a a whopping contingency fee.
10. We [the law firm] don't want to be too greedy about exploiting this phenomenon -- this is a hypothetical -- so let's cap the contingency fee at 4 times the fees (our regular exorbitant fee rate) we earned over the course of this rather lengthy engagement.
11. The estate through its executors says, we get your point; you did one hell of a job for which your standard hourly rates (however exorbitant) are not truly reflective of the value of your services seen particularly through the prism of the benefit to the estate.  
12. The deal is struck and put in writing, all ex post facto to the result.

Of course, we all know that, if the contingency fee agreement were backdated, there would be some issues familiar to readers of this blog.  And, there might be some issues if there were some unstated side agreement or understanding that the contingency fees would not be paid if they are disallowed as an estate tax deduction.  Rather, assume that the deal is straight up (the estate incurs an unconditional obligation to pay the contingency fees and the agreement is not backdated), does anyone see any exposure in the hypothetical for the law firm or the estate?  Would it make any difference if the estate had at least some material economic cost -- maybe only the fabled peppercorn in classic contract law?  (Please assume that I raise the question only in the context of the hypothetical; I have no knowledge whether some of the key assumptions in this hypothetical are the Keller facts.)

I suppose we could vary the facts a little bit.  What if the payee were an executor or related to an executor?  The Keller court rejected that genre of claim also.

What if the estate loses the suit for refund.  Could the estate still incur, after the loss, the contingency fee and claim it as a deduction against the estate?  (I suppose the claim would be that the lawyers -- fine lawyers indeed -- lost the case with more creativity that other more mediocre lawyers would have lost case and thus are entitled to a "kicker" (a double meaning metaphor).  Keep in mind that the benefit to the estate (and the lawyers) from the payment of the contingency fee is the same win or lose; and the loss -- the "kick," so to speak -- to the Government is the same.

What if, in the example, the court denies the fee as an unnecessary administration expense (like the Judge did in Keller) can the executors then have to pay what has been found to be an unnecessary fee?  What about the state bar implications of the lawyers receiving a fee that was unnecessary for their legal services?  (Perhaps it is a gift from the estate.)

And, although I have not worked the numbers on the complex contingency fee formula, I suspect that some portion of the contingency fee would be payable only if the contingency fee were allowed as an administration expense.

I suppose that, given this phenomenon based on a combination of high estate tax rates, the length of time to finally close out the estate and differential tax rates between payor and payee, the estate and the lawyers could agree on the frontside of what will likely be protracted dispute that some type of bonus / contingency would be paid in addition to regular hourly rates based on some sliding scale based on the passage of time (say zero in month one and increasing 1% per month).  Would that suffice to clear the necessary hurdle.  And, presumably, agreement to some reasonable contingency fee in advance (although in anticipation that the economic phenomenon of the Government actually bearing the cost of it) might make the fee more cosmetically palatable to a court.

Now, the phenomenon could still present itself even if the estate loses.  What if, rather than wrapping the extra compensation to the attorneys in a contingent fee, the estate had just agreed, after the trial court decision, to pay the attorneys 4 times for all work (past, present and future) they hourly rates without contingency.  Even if the estate then lost, the same quantum of fees would be paid and the same economic cost (miniscule) to the estate.

Isn't this fun?