IMPLICIT in this country's Constitutional framework of federalism are the seeds for state-federal jurisdictional conflicts over property rights. By design, the Federal Government was envisioned as a government of limited enumerated powers. Powers not specifically granted to the Federal Government were reserved to the several states. Yet Article VI of the Constitution states that the laws of the United States are ". . . the supreme law of the land; and the judges in every state shall be bound thereby, anything in the constitution or laws of any state to the contrary notwithstanding...."1
It has long been established that state law creates legal rights and interests in property. The federal revenue acts designate what interests or rights, so created, shall be taxed. despite this well established principle, courts have taken an increasingly active role in determining whether state court decisions have the requisite adversity and whether state trial and intermediate appellate courts apply correct state law in arriving at their conclusions.
The author is Tax Counsel for the Trust Department of the Manufacturers National Bank of Detroit. Previously, he served us Estate and Gift Tax Attorney for the Internal Revenue Service in Detroit. Mr. Wissbrun was awarded a B.S. from Ohio State University, a J.D. from the university of Iowa and an LL.M. in Taxation from Wayne State University. This presentation is adapted from his essay submitted in partial fulfillment of the requirements for the Master of Laws degree.
The federal courts intervention into state-created property rights reflects the federal government's concern with the preservation of the property base federal taxation is predicated upon. In addition, the federal government is concerned with preventing collusive or less than adversary proceedings in a "local court" from determining or characterizing interests for tax saving purposes. At the same time. the state government is concerned with the federal government's intrusion into statecreated property interests. Finally, the taxpayer's consideration is over the possibility of federal taxation of a property interest not recognized by state law.
The intent of this article is to discuss the above mentioned topics in light of the judicial pronouncements of the last fifty years. The specific issues the article is addressed to are as follows: Is the federal government, through its representative agency. the Internal Revenue Service. bound by a state court adjudication (Trial Court, Intermediate Appellate Court, or State Supreme Court) regarding rights or characterization of property interests? ls the federal government bound by state court settlement agreements. lawfully entered into pursuant to local law settlement statutes? Should there be a different standard of adherence to a state court decision by the federal government depending on the level of state court adjudication?
The issues under consideration have a long history. The subject of this presentation is, to a considerable extent, a question of federal jurisdiction;e.g. when is it proper for a federal court to intervene and over-rule a state court adjudication or settlement decree? The United States Supreme Court decided two cases in 1934 and 1937 in the attempt to answer these questions and the circuit courts of appeal have been trying to interpret the proper meaning to these cases since and up until the Bosch case.
The first United States Supreme Court pronouncement came from Freuler v. Helvering. The issue in Freuler was whether depreciation must be apportioned between the income beneficiaries and the remainderman when the decedent's Will was silent and there was no California statute on point. The court held that both groups of beneficiaries, income and remainderman, must apportion depreciation expenses. The Court of Appeals rejected the lower California court's decision since there was no stale statute, and relying on general trust law, found that the remaindermen bore the entire burden of depreciation.
The Supreme Court reversed the Court of Appeals and the importance of Freuler was threefold. First. this was the first decision equating the decision of a trial court with the law of the state. Second, the court rejected the Commissioner's contention that the state court decree was collusive since all the parties joined in a submission of the issues and sought a decision which would adversely affect the government's contention for additional tax. Instead the court emphasized that the case was initiated by the trustee. all parties were given notice, objections to the trustee's account were raised, the issues raised were ones the court regularly dealt with. and the court decided one issue in favor of the remaindermen and one issue against them. Third, since the Commissioner was not a party to the state court decree, the decree was not res judicata and could not be the basis for application of the Federal Constitution's full faith and credit clause. 4 Freuler was reaffirmed three years later in Blair v. Commissioner.5 Subsequent to Freuler and Blair, the Circuit Courts developed numerous different judicial tests of collusiveness and adversity in deciding whether a state court decision was to be upheld. In Saulsbury v. United States, the Fifth Circuit Court of Appeals rejected the binding effect of the stale court decree claiming that the suit was collusive. The court defined collusion to be when all interested parties agreed to the court order because it was to their advantage, taxwise.
The Saulsbury decision represented the all inclusive definition of collusion since the court did not find a need to show fraudulent conduct by the parties in order to have collusion. At the other extreme was the Third Circuit Court's opinion in Gallagher v. Smith.7 The Gallagher court found collusion only when a judgment was fraudulently obtained. In addition to limiting the definition of collusion to the very strict test of absence or presence of fraud, the Gallagher court rejected the importance of adversity and adverse parties in determining whether the stale court decree was binding on the federal government.
The Gallagher and Saulsbury decisions represented the extreme tests in determining the absence or presence of adversity and collusiveness of parties which render state court decisions void as to federal tax matters. There were a significant number of circuit court decisions taking positions between these extremes but their discussion is beyond the scope of this article. Finally, there were a number of lower court cases involving settlements prior to litigation where the presiding court looked to whether the settlement agreement was in conformity with state law, and if it was, the decree was binding on the federal government.
The conflicts between the Circuit Courts of Appeal led the United States Supreme Court to grant certiorari in Commissioner v. Bosch.10 The issue involved was whether the decedent's wife executed a valid release of a general power of appointment over the trust the decedent created in her favor. If the release was effective, the decedent's estate lost the estate tax marital deduction since the widow would have a terminable interest in the trust. While the Tax Court proceeding was pending, the estates representative petitioned the Supreme Court of New York for a determination of the release under state law. The state court found the release to be a nullity and therefore the estate could avail itself of the marital deduction since the widow retained her general power of appointment.
The Commissioner objected to the state court's findings but the Tax court agreed with the state court and held for the taxpayer. The court acknowledged that the various circuit court decisions led to different guidelines but based its decision on the following factors: the New York court had jurisdiction over the parties and subject matter so its decision was binding on the parties. while this court was only a trial court it had statewide jurisdiction and precedential value, the Commissioner had notice of the state court proceeding and could have submitted to the court's jurisdiction. the court rendered a reasoned opinion and reached a deliberate conclusion. and the decision could have adverse consequences on the widow.
The Court of Appeals did not frame the issues as to whether the federal court was bound by a decision of a state tribunal but whether this tribunal had authoritatively determined the rights under state law of a party to the federal action. The appellate court relied on the Gallagher decision which stated that as long as a state court decision was not collusive and fraudulent the decision was binding on the federal government because it was conclusive of the property rights of the litigants. The court affirmed the Tax Court decision.
Bosch reached the Supreme Court along with its companion case Second National Bank of New Haven v. United States 13 in 1967. The court acknowledged the diverse approaches to the issue since its decision in Freuler and stressed that the court adopted a different view of the issue. First. since the Commissioner was not a party to the state proceedings, the principles of res judicata and collateral estoppel were inapplicable against the federal government. Second. since at issues was a federal statute. the court must look to the legislative history to the marital deduction clause. The court quoted from a report of the Senate Finance Committee which used very guarded language in referring to the very issue under consideration. The court reported:"It [the committee] said that proper regard, not finality "should be given to interprct.1tmns of the will" by state courts and then only when entered by a court in a bona fide adversary proceeding S Rep. No. IO13 Pt. 2. 80th Cong. 2d Sess.."" The court concluded from the legislative history that the authors of the bill did not intend to bind the federal courts or agencies to a state trial court's adjudication. Had they chosen to do so, Congress could have so stated. The court also concluded that its test was little more than an application of the Erie Doctrine even though this was not a case involving diversity of citizenship. The court described the crucial test to be as follows: "[W]hen the application of a federal statute is involved, the decision of a state trial court as to an underlying issue of state law should a fortiori not be controlling.... If there be no decision by that court [state's highest court] then federal authorities must apply what they find to be the state law after giving "proper regard" to relevant rulings of Appeals Courts of the State. In this respect, it may be said to be, in effect, sitting as a state court." The Supreme Court concluded that the Court of Appeals in Bosch erred and reversed, finding for the Commissioner.
The Supreme Court's opinion was grossly inadequate. It left more questions to be answered than issues it settled. It all but ignored forty years of judicial history that wrestled with the issues of collusion and adversity. While the opinion acknowledged the divergent views of Gallagher, Faulkerson and Pierpont, it did not deal directly with them. The opinion stated that it looked at the issue differently than these three courts and plunged into an analysis of the legislative history behind the marital deduction provision of the Internal Revenue Code.
The result of this analysis of the legislative history was a very mechanical test. If the State Supreme Court had decided the particular issue, the federal courts were bound by the state court decision. The court felt that this test was nothing more than the Erie Doctrine. Yet the Eric Doctrine was promulgated to prevent "forum shopping." It was designed to provide litigants with the same judicial decision in a federal court as they would have received in a state court by applying state substantive law since at issue was a determination of state created rights. In the type of cases Bosch is addressed to, there already is a state court decree fixing the rights of the parties. The parties come into federal court bound by this state court decree. The other part of the Supreme Court test was to attribute "proper regard" to the decisions of state trial and intermediate appellate courts. This test was taken from the excerpt of the legislative history the court quoted. The problem is that the court never gave guidance in defining "proper regard" or what attributes of stale court decisions should be given "proper regard." Since the Bosch decision attributes only "proper regard" to decisions of an intermediate appellate state court, it follows that settlement agreements will be accorded even less weight.
The Supreme Court opinion never addressed itself to the public policy considerations raised by the several dissenting opinions. Justice Douglas relied on the Freuler and Blair decisions but did state that the federal courts would not be bound by a consent decree since its decision was not a determination of the state law. In addition, the federal government was not bound by a decree obtained by fraud or collusion. He emphasized the concern of imposing a federal tax liability upon a property interest the heir or estate did not possess under state law. He felt this type of result would be contrary to the Congressional intent of making federal tax consequences depend upon property rights determined by state law.
Justice Harlan, joined by Justice Fortas wrote a dissenting opinion that emphasized the important interests of both state and federal governments. On one side, the principles of Erie and the Rules of Decision Act would require the federal courts to adhere to state court decisions. The importance of this approach is threefold. First. it would promote uniformity in the administration of law within each state. Second, it reserves to the states the areas of law left to the states by the Constitution. Third, it acknowledges that state courts are in a better position to interpret the meaning of their own laws. On the other side, the justices recognized the federal interest of preserving the federal tax base from the ill considered opinions of a local state court. The justices concluded that as long as the state court decision was adversary, it should be recognized by the federal courts no matter what level of state court was involved.
The majority of the cases leading up to the Bosch decision involved estate tax controversies. Typically the courts have acknowledged bosch to be their authority for making their own independent survey of state law, thereby accepting or rejecting the lower state court decision. in the other words, the courts have applied the mechanical test of bosch without attempting to clarify the important issues of collusion and adversity that led to Bosch. Finally, the bosch decision has been extended beyond the realm of estate taxes and has been cited in a number of income tax cases.
Prior to bosch, a state court decision was a good past mortem estate planning tool since friendly local court would often agree to interpretations that corrected drafting errors. These decisions and settlement agreement have lessened in value due to the Bosch decision, especially where the decision was sought solely for tax saving purposes. This type of tool may still prove useful if the practitioner anticipates other problems upon audit. It might serve the purpose of settling another issues in the trading of issues that often occurs when negotiating with the Internal Revenues Service. In any event, it has been dispositive of the property interests for the parties in suit.
In Kelly's Trust el al v. Commissioner, the parties brought suit in a lower New York court. The parties disagreed with the lower court decision and appealed this decision. The Second Circuit Court of Appeals held that an appeal, by its very nature, prevented a consent judgment and demonstrated the required adversity necessary to uphold a state court decision. Therefore, the practitioner should consider an appeal of the nontax issue if other considerations warrant this action. This appeal might persuade the Internal Revenue Service at the administrative level or the federal court of the bona fide nature of controversy.
Another possibility is insuring the State Taxing Department is represented in the state court litigation. In Dake's Estate v. Tax Commissioner was represented. The issue was whether property qualified for the New York marital deduction. The federal district court found that the state proceeding had the requisite adversity and was therefore binding on the federal government since the New York State Tax Commissioner actively participated to defeat the marital deduction in the state court proceedings.
An alternative to litigation at the state court level would be suit in United States District Court over a nontax matter if the requisite diversity of citizenship jurisdiction is satisfied. This is no guarantee that the Service will feel bound by the decision since it is a federal court and the federal court may be less sympathetic to the client's view. It should be remembered that, in either the state or federal court suit of nontax matter, there is no way to bind the Internal Revenue Service to the decision. The Commissioner has for years resisted attempts to make the Service a party by making a special appearance to remove the Service from the proceeding.
In light of the above discussion of state court litigation. It must be remembered that under the Bosch decision, the federal government is bound only by a decision of the State Supreme Court. Therefore, in considering litigation, a view of taking the issues to the highest court in the state should be considered and agrees upon prior to the onset of litigation. This requirement that the State Supreme Court decision is the only binding authority on the federal government will present problems in some jurisdictions. State Supreme Court as matter of Right while states which have an intermediate appellate court system may have access to the State Supreme Court only by certiorari.
Assuming the practitioner has a state court decision in his favor. The question is how to proceed upon the estate tax audit with Internal Revenue Services. Unless the practitioner has a substantial court record which demonstrates the bona fide nature pf the state court decree, he may encounter problems at the audit level. At this level. most examiners are estate tax attorneys and are aware of the judicial precedent of Bosch.
They are also cognizant of Treasury Regulation 20.2056(e)-2(d)(2)2 which was filed nine years before the Bosch decision. The regulation concerns the qualification of property for the marital deduction. The regulation sets forth three principles. First, the interest acquired will be recognized as passing from the decedent only it the surrender was a bona fide recognition of enforceable rights of surviving spouse in the decedent's estate. Second, a bona fide recognition will be preserved when the property passing was pursuant to a decision of local count upon the merits in an adversary proceeding following a genuine and active contest. Third, the federal government is not bound by a settlement agreement not to contest the will. Armed with the Bosch decision to support its regulation, the Internal Revenues Service will be reluctant to concede in this area of the estate tax decahenry involved
If agreement at the field audit level cannot be reached, the practitioner must choose between District Conference or the Appellate Conference. District Conferees do not have the discretion afforded to the Appellate Staff. While they have been given greater latitude in handling cases where the tax liability is not on excess of $2,500.00 they are formally required to follow he Commissioner's Official position as announced in the Treasury Regulations and Revenue Rulings. Furthermore, administratively, they are under the Office of the District Director and therefore. like that if the Field Audit Division, are subject to various internal policy positions promulgated from that office. Thus, issues that are at variance with the official Internal Revenues Service position will not be received more favorably at District Conference than at the Field Audit Division.
Where the issue at controversy is strictly a legal one, or is it at variance with the official policy expressed in the Treasury Regulations or Revenue Rulings, it is often best to skip District Conference and proceed to Appellate for several reasons. First, Appellate is staffed with more experienced personnel who are often attorneys. Second, Appellate is permitted to consider hazards of litigation in all controversies, and with this in mind, is permitted to make settlements. Third, these settlement can vary from the official Internal Revenue Service position. Fourth, since the Appellate level is the final administrative tier before recourse to litigation and the possible damage of unfavorable precedent provides the motivation on the part of the Appellate Conferees to settle a tax controversy. Fifth, since Appellate is not structurally under the Office of the District Director, but rather under the Assistant Regional Commissioner, they are further removed from the Audit Division and are completely independent of this division. This independence removes any institutional pressure to uphold lower level administrative decisions.
If the practitioner fails to settle with the Appellate Division, litigation is the next step. Some commentators advocate the payment of the accessed deficiency and suit for refund in the United States District Court instead of suit in the United Stated Tax Court. There have been some statistics which support this view that District Courts are more sympathetic to the taxpayer than the Tax Court. Such generalizations can be dangerous. The author would suggest that the practitioner research the issues to see just what the two courts have held and proceed accordingly