Tax Court Disallows Charitable Deduction of Remainder Interest

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In a very significant case, the United States Tax Court found that a limited liability company (LLC) was not entitled to a charitable contribution deduction for the donation of a remainder interest in real property because it failed to adequately substantiate its claimed deduction.

The Form 8283 (appraisal summary for noncash charitable contributions) the LLC attached to its 2003 tax return showed no amount in the space provided for the “Donor’s cost or other adjusted basis.” What the taxpayer in this case failed to understand (or perhaps they did and omitted the information intentionally) is that the missing information is used by the Internal Revenue Service to evaluate the propriety of the valuation of the donated property.

In this case, the numbers are large but it is important to understand that the same rules, and assessment, apply to all gifts of property with a value in excess of $500.

In RERI Holdings I, LLC, 149 TC No.1, Dec. 60,954 (2017), the LLC acquired the property in March 2002 for approximately $3 million. The taxpayer claimed a charitable contribution deduction of about $33 million for its assignment of the property to a university in August 2003. Had it been disclosed, the significant disparity between the claimed fair market value and the price the LLC paid to acquire the property just 17 months before the assignment would have alerted the Internal Revenue Service to a potential overvaluation of the property.

However, the omission of that information prevented the Form 8283 from achieving its intended purpose; thus, the court could not excuse the omission on the grounds of substantial compliance. Therefore, the charitable deduction was denied in full for failure to comply, either strictly or substantially, with the requirements of applicable Treasury regulations.

As such, the LLC was subject to the gross valuation misstatement penalty under the Internal Revenue Code. Moreover, the interest did not meet the adequate protection requirement to allow use of standard actuarial factors provided under Code Sec. 7520 in valuing a remainder interest. Therefore, the court determined the property’s value using the rules for a restricted beneficial interest (actual fair market value determined without regard to Code Sec. 7520 on the basis of all facts and circumstances).

The court used variations of the cash flow projection for rental of the property provided by an expert for the taxpayer and the discount rate used by the Internal Revenue Service expert to determine that the property was worth $3,462,886 when the LLC contributed it on August 27, 2003.

Thus, any underpayment of tax resulting from the disallowance of the claimed charitable contribution deduction would be attributable to a gross valuation misstatement to the extent that the underpayment reflects the excess of the $33,019,000 claimed over $3,462,886.

The court dismissed the LLC’s reasonable cause exception claim because it found the LLC did not make a good faith investigation into the property’s value, noting that the “the taxpayer must do more than simply accept the result of a “qualified appraisal,” and that “[m]arshaling evidence of a property’s value months or more before a gift is simply not sufficient as a matter of law to qualify as a good-faith investigation into the value of the property at the time of the gift.”

Valuation of property in conjunction with the federal estate and gift tax (or as in this case, the income tax), generally requires that an independent valuation be completed by a qualified appraiser resulting in a qualified appraisal. Here, however, it appears that the court was presented with a qualified appraisal prepared on the taxpayer’s behalf.  Unfortunately, not all qualified appraisals are the same, and this appraisal, if one were to critique it closely, is not likely to have met the professional standards for the appraisal professions. It is noteworthy that the qualified appraisal rules that are in place today were added to the Internal Revenue Code after the tax years in question in this case.

Great care must be taken in the appraisal of property in conjunction with any tax planning. The level of expertise within the Internal Revenue Service has risen substantially over the last 25 years, and the days when any valuation would be defendable are gone. In every case, valuator compliance with professional standards is a must. But, it is also important to note that, expertise (both learned and gathered through experience) is critical to a defendable result and a successful tax planning strategy. It is important to utilize the services of qualified professionals.

Should you have questions or comments, please contact Bob Grossman, Don Johnston or Melissa Bizyak at 412-338-9300.

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