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Faith-based arbitration clauses are legally enforceable. See Spivey v. Teen Challenge of Florida, Inc., 122 So. 3d 986, 992 (Fla. 1st DCA 2013) (judicial enforcement of religious arbitration agreement did not violate federal or state constitutional rights of personal representative). And they’re growing in popularity.

Hundreds of Christian denominations and organizations offer this kind of dispute resolution service. Peacemaker Ministries, founded in 1982, is reportedly the largest. The Jewish arbitration system is perhaps the most well organized, with branches of standing battei din all over the country. Headquartered in New York and founded in 1960, the Beth Din of America is the most prominent. Although less organized and widespread than Jewish and Christian dispute resolution services, Islamic organizations also offer mediation and arbitration services.

For those of you looking for a general introduction to this kind of arbitration a good starting point is a Fordham Law Review article entitled Faith-Based Arbitration: Friend or Foe? Here’s an excerpt:

In addition to the reasons disputing parties would turn to arbitration in general, there are many benefits specific to faith-based arbitration and other forms of dispute resolution. First, members of a religious community may feel obligated to turn to religious arbitration out of religious conviction. Followers of Judaism believe, for instance, that, according to halakhah, Jews are not allowed to bring their cases to secular courts. Other faiths are simply wary of litigating cases in a court environment. The Qur’an, for instance, urges mediation or arbitration rather than litigation. The Christian faith, too, discourages the use of secular courts, urging instead the private resolution of conflicts. A related, although very different, motivator may be social pressure. For example, in the Jewish faith, if a party tries to gain relief in a secular court, a beth din may issue a seruv, a document noting that a party has chosen to pursue his or her case in a secular court. The seruv can result in the party’s community socially ostracizing him or her. Additionally, sometimes those of a minority religious faith mistrust secular courts, fearing discrimination, and prefer to have their disputes settled internally. Another reason parties may choose religious arbitration is that it is generally more conciliatory in nature than ordinary arbitration. Similarly, many people feel that a faith-based arbitrator will judge the case more on equity and morals than following a precise legal issue.

A significant motivation for many people to turn to faith-based arbitration is that they feel more comfortable presenting their arguments before arbitrators who share their value system. Similarly, just as people prefer bringing commercial disputes to arbitration because the arbitrator will have specific knowledge of the area, parties utilize religious arbitration because the arbitrator is better equipped to deal with religious issues. Furthermore, for nonreligious disputes, because the forum is religious, less attention may be paid to the parties’ religion.

Finally, an important reason for turning to religious arbitration is that an internal system of governance helps preserve minority cultures and community values. Regarding family law issues, for instance, the intertwining of religious belief, legal principles, and family relations that is common among religions leads to a protectiveness regarding the religion’s laws and culture. Furthermore, those practicing a religious faith see the “importance of maintaining a sense of community [and] of viewing each other as an extended family.” Relying on an internal arbitration system can provide a “sense of togetherness and unity in the community.” Finally, utilizing such a system and applying religious principles in practice will clarify the religion’s values.

But just because faith-based arbitration clauses are legally enforceable doesn’t mean they won’t back fire from a tax-planning perspective. That tax question is at the center of the Mikel case discussed below.

Case study

Mikel v. Comm’r, T.C. Memo. 2015-64, 2015 WL 1518063 (U.S.Tax Ct. April 6, 2015)

In 2007 a husband and wife created an irrevocable “Crummey” trust to which they jointly gifted $3,262,000. They each filed separate gift tax returns, in which each claimed a gift-tax annual exclusion under IRC 2503(b) of $720,000 on the grounds that their gift included a $12,000 gift from each of them of a “present interest” to each of the trust’s 60 beneficiaries. In order for a donor to qualify for this exclusion, the donee must receive a “present interest in property,” that is, an unrestricted right to the immediate use, possession, or enjoyment of property. This kind of gift is accomplished in the trust context by granting each trust beneficiary a legally-enforceable withdrawal right. The IRS denied the exclusions assessing over $600,000 in back taxes and penalties against the couple.

According to the IRS, the trust’s faith-based arbitration clause known as a “beth din” in Hebrew coupled with its no-contest or in terrorem” clause worked together in “practical terms” in a way that guaranteed the trust’s beneficiaries would never enforce their withdrawal rights, which meant they didn’t really have a legally enforceable “present interest” in the gifts they received.

The IRS lost this argument big time. If you’re a Florida estate planner what’s interesting about this case isn’t the outcome, it’s how the Tax Court arrived at its final ruling. You can’t use a no-contest clause in a Florida will or trust (they’re not enforceable by statute: F.S. 732.517736.1108) but we can use arbitration clauses (they are enforceable by statute: F.S. 731.401). So it’s the court’s discussion of this clause I found most interesting. Here’s how the trust’s arbitration clause was summarized:

If any dispute arises concerning the proper interpretation of the declaration, article XXVI provides that the dispute “shall be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith.” Such a panel in Hebrew is called a beth din. This panel is directed, in the event of any dispute, to “enforce the provisions of this Declaration * * * and give any party the rights he is entitled to under New York law.” Article XXVI states that the declaration as a whole shall be construed “to effectuate the intent of the parties * * * that they have performed all the necessary requirements for this Declaration to be valid under Jewish law.”

Will a faith-based arbitration clause disqualify your trust for tax purposes? NO!

According to the IRS, a trust beneficiary’s withdrawal right is “legally enforceable” only if the beneficiary can “go before a state court to enforce that right.” Not so, says the Tax Court:

[I]f we adopt [the IRS’s] premise that a withdrawal right must not only be “legally irresistible” under the trust instrument, but also be “legally enforceable” in an extrinsic sense, it is not obvious why the beneficiary must be able to “go before a state court to enforce that right.” Here, if the trustees were to breach their fiduciary duties by refusing a timely withdrawal demand, the beneficiary could seek justice from a beth din, which is directed to “enforce the provisions of this Declaration * * * and give any party the rights he is entitled to under New York law.” A beneficiary would suffer no adverse consequences from submitting his claim to a beth din, and respondent has not explained why this is not enforcement enough.

But even assuming the IRS’s formulation of the Crummey-trust rule is correct, says the Tax Court, an arbitration clause won’t disqualify your trust’s gift-tax exclusion because an arbitration award can always be challenged in court. That’s the law in New York (where this trust was created), and it’s the law in Florida — no matter what your arbitration clause might say (see F.S. 682.13). The IRS argued this right was illusory in this case because of the no-contest clause:

[The IRS] starts by hypothesizing that the trustees might refuse, without legal basis, to honor a timely withdrawal demand. In that event, article XXVI of the declaration would require the beneficiary to submit the dispute to a beth din. If the beth din, again without legal basis, sustained the trustees’ refusal to honor the demand, respondent agrees that the beneficiary could seek redress in a New York court despite the State’s general reluctance to disturb arbitral decisions. But a beneficiary would be extremely reluctant to go to court, respondent insists, because he would thereupon forfeit all his rights under the trust by virtue of article XXVI’s in terrorem clause. Practically speaking, therefore, respondent contends that the beneficiaries’ withdrawal rights are “illusory” and do not constitute a “present interest in property.”

For reasons not all that interesting to us here in Florida, the Tax Court also rejected the IRS’s reading of the no-contest clause. Bottom line, this was a taxpayer victory all around.