On Appeal from an Order of the Commissioner of the Internal Revenue (Action No. 81-26622) Argued on January 31, 1997
Before: BECKER,*fn1 Chief Judge and Roth, Circuit Judges, and BARRY,*fn2 District Judge
The opinion of the court was delivered by: Roth, Circuit Judge:
In this case, we must decide whether an estate is entitled to a theft loss deduction under the federal tax code for funds wrongfully paid out from an estate and never returned. The decedent, Philip Meriano, left an estate that included over one million dollars worth of bearer bonds. The bonds had been stolen from Meriano but were later returned to the estate. Excessive fees and costs were charged against the estate by the stockbroker and the attorney/investigator who had retrieved the bonds and administered the estate. The IRS assessed the estate with a deficiency. The estate then claimed before the U.S. Tax Court that the stockbroker and the attorney/investigator had committed theft under Pennsylvania state law and that the estate was therefore entitled to a deduction for its loss pursuant to 26 U.S.C. § 2054. The tax court denied the deduction and the estate appealed. For the following reasons, we will reverse the tax court's decision and allow the estate its deduction.
The facts of this case were set forth in great detail by the tax court. We will recount only those facts that are relevant to the issues on appeal. Philip Meriano died on November 14, 1977. Four months earlier, a fire at Meriano's residence had destroyed documentation of his ownership of municipal bearer bonds with a face value of approximately two million dollars. Not long after the fire, Meriano notified the Philadelphia Police Department that the bonds themselves were missing from a safe located in an area of the residence damaged by the fire.
When Meriano died, his elderly sister, Mary Orlando, was appointed administratrix of his estate, under the assumption that he had died intestate. With the help of her husband, Anthony, Mary Orlando attempted to locate the missing securities. She was not successful until her husband asked Edward Reardon, a stock broker, for help. Reardon, in turn, contacted John Lynch, an attorney and investment banker who had experience in the field of municipal bonds.
On August 7, 1978, Mary Orlando signed a contingent fee agreement with Lynch to compensate him in the event he recovered any of the missing securities. Under the agreement, Lynch was to receive one-third of the face value of any securities recovered prior to the filing of a lawsuit. If any securities were recovered after suit was filed, Lynch was to receive forty percent of the face value. Orlando and Lynch both signed the document; Orlando's husband, Anthony, and her daughter, Connie Kates, both signed as witnesses. The agreement contained no provision for Reardon's payment, nor did Reardon sign it. See Appendix, at 52.
Shortly after executing his agreement with Orlando, Lynch entered into a separate agreement with Reardon, under which Reardon would assist Lynch with his search for the stolen bonds and Lynch would compensate him with 15 percent of the face value of any of the securities that were recovered.
Lynch and Reardon eventually traced the securities to an account held by Philip Meriano's former housekeeper, Italia Bossi. Based on information from Reardon and Lynch, the FBI on May 1, 1979, was able to confiscate bearer bonds having a value of $1,823,000 from the Bossi's residence in San Diego. Bossi and her husband were brought back to Philadelphia, where they were charged with arson and theft. Their trial resulted in a hung jury. After the government failed to convict them, the Bossis requested that the FBI return the bonds to them.
In December 1979, Lynch retained his brother's law firm, Groen, Smolow and Lynch, to assist the estate in any civil suits necessary to protect the value of the recovered bearer bonds. Lynch also retained Groen, Smolow as general counsel for the estate. When the U.S. Attorney decided in 1980 to forego a second trial of the Bossis, the estate and the Bossis both filed civil actions in the U.S. District Court for the Eastern District of Pennsylvania to get control of the securities.
That same year, the estate settled the suits with the Bossis. Under the settlement agreement, the estate recovered securities with a face value of $1,623,000 and a fair market value of $1,146,446. Without the help of Lynch and Reardon, the estate would have not recovered these securities.
Along with the Green, Smolow law firm, Lynch continued to represent the estate. On April 10, 1980, Lynch and Anthony Orlando deposited the recovered securities in a safety deposit box at the Provident bank. That same day, Lynch and Reardon signed a "hold harmless" agreement with Mary Orlando. The agreement stated in pertinent part:
Dated as of this 10th day of April, 1980, in consideration of the disbursement of certain funds deemed earned as professional fees pursuant to prior agreements with Mary Orlando, in her capacity as the duly appointed Administratrix of the Estate of Philip Meriano, Edward J. Reardon, Jr. and John T. Lynch Jr., Esquire, agree(s) to INDEMNIFY AND HOLD HARMLESS the Estate of Philip Meriano and Mary Orlando, the Administratrix of the Estate and against any and all claims and loss, which the Estate and/or the Administratrix may hereafter suffer or pay by reason of any claims against the Estate or the Administratrix or as a result of the disbursement of said funds of the Estate in payment of professional fees and hereby agree to repay any and all amounts received that are determined by a court of proper jurisdiction to be returnable to the Estate.
Appendix, at 109 (emphasis added). Both Reardon and Lynch signed the agreement.
Sometime after this agreement was executed, Lynch transferred the securities from the safety deposit bank to an account at Kidder, Peabody & Co. On April 29, 1980, Mary Orlando signed an agreement authorizing Lynch to buy, sell or otherwise transact business with the securities. Under the terms of this agreement, Orlando agreed that she would "waive notification . . . of any of the aforementioned transactions and delivery of any statements, notices, or demands pertaining thereto and hereby ratify any and all transactions heretofore or hereafter made by [Lynch] on or for [the] account." Appendix, at 110.
In addition to creating the estate's account, Lynch and Reardon also established individual accounts with Kidder, Peabody. Over the next three years, Lynch transferred some of the estate's bonds to his individual account. From this account, Lynch liquidated the securities and used the proceeds to pay himself and Reardon, and also to pay the Groen, Smolow law firm, which sought fees for general services to the estate and for costs associated with the recovery of the stolen bonds. The trial record reflects that Lynch did not keep organized records of the transfers of the bonds from the safe deposit box to the estate's Kidder, Peabody account. Similarly, Lynch did not record in an organized fashion the withdrawals from the estate's account at Kidder to his own individual account. See Appendix, at 272-273.
On December 9, 1980, Mary Orlando filed a petition with the Orphans' Court for approval of attorney and related fees paid to Lynch and Reardon. Because there was some uncertainty as to the proper personal representative of the estate (see Discussion below), the Orphans' Court deferred action on the petition until the estate filed an accounting with the auditing Judge of the court. See Appendix, at 87. Notwithstanding the court's deferral, however, Orlando approved payment of $418,250 to Lynch and $250,950 to Reardon in a document signed by Mary Orlando and witnessed by her husband and her daughter.*fn3
In August of 1980, Anita Panepinto, a niece of Meriano's deceased wife, discovered a will executed by Meriano and dated November 17, 1973. She also found a codicil, dated December 2, 1973. The will and codicil named Panepinto and another niece, Elaine Hernardi, as beneficiaries of the estate. On August 30, 1980, Panepinto presented the will to the Register of Wills in Philadelphia.
Two years later, the will recovered by Anita Panepinto was admitted to probate. The Register of Wills then revoked Mary Orlando's position as administratrix and appointed Panepinto as administratrix, c.t.a (cum testamento annexo).*fn4 In 1983, Panepinto filed a motion in the tax court to substitute herself for Mary Orlando as the estate representative in the present proceeding.
Orlando and Kates contested the will. By 1986, however, Panepinto and Orlando had resolved their differences and agreed to settle their competing claims to the Meriano estate. Under the terms of the settlement, Panepinto agreed to release Orlando and her surety, INA, from any future surcharge liability. Orlando and Kates withdrew their will contest on December 19, 1986.
The Orphans' Court Proceedings
On March 30, 1983, Panepinto filed two petitions with the Orphans' Court, which sought reimbursement of all fees paid to Lynch and Reardon. According to Panepinto, the fees were grossly excessive, and the agreements signed by Orlando, the former administratrix, were unconscionable as a matter of law.
In an attempt to determine what was left in the estate and what Lynch had disbursed to himself and his colleagues, the Orphans' Court ordered Mary Orlando to file an accounting with the court. Orlando, who was by this time represented solely by Lynch and no longer by the Groen Smolow law firm, did not do so. As a result, the Insurance Company of North America (INA), which had acted as surety on Orlando's administratrix bond, filed the requested accounting with the court. According to the testimony of Robert Boote, an attorney retained by INA, Lynch had failed to maintain organized records for the estate and had not been forthcoming in providing appropriate records.
Boote prepared a First and Final Account of Mary Orlando, which INA, as surety, filed on March 30, 1983. That account showed that the estate had paid Reardon $220,000 in fees and Lynch $415,761 in fees. INA eventually attributed additional fees to Lynch, for a total of $500,761.19. Reardon also received an additional $30,950 from Lynch on April 15, 1981, for a total of $250,950. See Appendix at 584.
Judge Kendall Shoyer of the Orphans' Court conducted an audit of the estate between May 2, 1986, and March 24, 1987. Judge Shoyer then considered Panepinto's motion to reduce or deny part or all of the fees paid out by the estate to Lynch and Reardon. As a result of the audit, Judge Shoyer ordered Lynch and Reardon to reimburse a portion of their fees to the estate. In doing so, Judge Shoyer criticized Lynch's poor ethics as an attorney, particularly Lynch's unilateral removal of the securities from the estate, his failure to keep adequate records, and his failure to cooperate with ...