Record Your Easement: Tax Court Adjusts Timing & Valuation of New York Facade Easement

us_Tax_Court_fasces-with-red-ribbonIn Zarlengo v. Commissioner, T.C. Memo 2014-161, the Tax Court held that a New York facade easement is not protected in perpetuity under IRC § 170(h)(5)(A) until the easement is recorded.  The Court followed its decision in Rothman v. Commissioner, TC Memo 2012-163 and New York state law, specifically NY. Env. Law § 49-0305(4), requiring that a “conservation easement shall be duly recorded and indexed as such in the office of the recording officer for the county or counties where the land is situate in the manner prescribed by article nine of the real property law.”  The Court disallowed the charitable deduction taken in the year before the easement was properly recorded and all carryover deductions from that year.

The taxpayer found some success with their appraisal and valuation experts, as they were able to keep a portion of the charitable deduction claimed after the easement was properly recorded.  They were also able to avoid accuracy-related penalties for years prior to the Pension Protection Act of 2006 by presenting a successful reasonable cause defense.

Read the full opinion here: Zarlengo v. Commissioner, T.C. Memo 2014-161

New Jersey: Toyota Can Reduce Gains on Sale of Leased Vehicles

New Jersey Tax CourtIn Toyota Motor Credit v. Director, Div. of Taxation, Docket No. 002021-2010 (Aug. 1, 2014), the New Jersey Tax Court held that Toyota Motor Credit Corporation (“TMCC”) was entitled to increase its tax basis in leased vehicles to the extent of prior year depreciation deductions that hadn’t produced a New Jersey tax benefit.

TMCC is a California corporation that operates a vehicle leasing business in New Jersey.  In a typical lease transaction, an automotive dealer enters into a lease agreement with a customer for a Toyota vehicle.  TMCC purchases the leased vehicle from the dealer, the dealer assigns the lease agreement to TMCC, and TMCC collects the lease payments from the customer.  At the conclusion of the lease, TMCC sells the vehicle.

During periods prior to 2003, TMCC had depreciation deductions of $2.041 billion in excess of what was needed to reduce TMCC’s entire net income to zero.  This gave TMCC a net operating loss of $2.041 billion prior to the 2003 tax year.  For federal tax purposes, in 2003 and 2004, TMCC disposed of vehicles and recognized depreciation recovery gain of $484 million and $1.278 billion, respectively.  TMCC could not use these losses for New Jersey Corporation Business Tax (“CBT”) purposes in 2003 and 2004 because the CBT prohibited loss carryovers for depreciation in 2003 and 2004.

TMCC initially reported gains for CBT purposes for 2003 and 2004 on the sale of leased vehicles because of its federal adjusted basis.  Relying on the New Jersey Tax Court’s holding in Moroney v. Director, Div. of Taxation, 376 N.J. Super. 1 (App. Div. 2005), TMCC amended its 2003 and 2004 CBT return to eliminate gains of $484 million and $1.278 billion, respectively, by increasing its basis in vehicles sold during those two years by the amount of depreciation that was unused for CBT purposes.  TMCC argued that disallowing the basis adjustment for CBT purposes imposes a tax on phantom income.

Moroney involved individual taxpayers challenging New Jersey’s Gross Income Tax Act (“GIT”).  In Moroney, the taxpayers sold rental properties.  Despite taking federal depreciation deductions on the property during the course of ownership, the taxpayers used the properties’ purchase price as the basis for calculating gain under New Jersey law.  The taxpayers took this position because the operating expenses exceeded rental income in each year the Moroneys owned the properties and the GIT Act prohibits loss carryforwards.  The taxpayers prevailed and TMCC argued that the same principle should apply to its facts under the CBT.

The New Jersey Division of Taxation argued that Moroney did not apply in this case because the CBT Act, unlike the GIT Act, directly ties taxable income in New Jersey to federal taxable income.  The GIT Act has “long been recognized as not mirroring federal statutes.”

The Court, instead, focused on the existing provisions of the CBT Act, which paralleled relevant statutes in the GIT Act.  Specifically, the Court examined N.J.S.A. 54:10A-4(k) also imposes a tax on “net income,” including “profit gained through a sale . . . of capital assets.”  Looking at the legislative intent, the Court found that the CBT Act “expresses the intent to tax only the gain a taxpayer realizes from the sale of property [and] permitting TMCC to employ a Moroney adjustment to the basis of its property would further this statutory objective.”

The Court also found in favor of TMCC regarding income apportionment under New Jersey’s Throw-Out Rule.  The Throw-Out Rule, enacted as part of the Business Tax Reform Act of 2002, amended the receipts factor for CBT apportionment.  It changed the income tax apportionment sales factor from a ratio of New Jersey receipts to total receipts (NJ receipts/total receipts) to a ratio of New Jersey receipts to taxed receipts (NJ receipts/taxed receipts).  The rule excludes receipts from the denominator of the sales factor that would be assigned to a state or foreign country in which the taxpayer is not subject to tax.

The Director removed TMCC’s receipts from the denominator of the receipts factor for Nevada, South Dakota, and Wyoming, because TMCC did not pay tax in those jurisdictions. TMCC had lease receipts in Nevada and paid between $25 million and $56 million in tax from 2003 to 2006. TMCC also had significant receipts in South Dakota and Wyoming. The Director argued that the receipts from each state should be “thrown out” because the tax paid to Nevada was actually a sales tax and TMCC did not pay tax in South Dakota and Wyoming.  The Court rejected the Director’s arguments.  The Court held that “sufficient constitutional nexus is all that is required” to preclude the removal of TMCC’s receipts from the denominator of the receipts fraction in all three states.

Read the full opinion here: Toyota Motor Credit Corp. v. Director, Div. of Taxation, Docket No. 002021-2010 (Aug. 1, 2014)

Supreme Court Upholds Integrity of IRS Summons Process

us-supreme-courtIn a unanimous decision, the U.S. Supreme Court upheld the integrity of IRS summons enforcement proceedings. The high court rejected the IRS position and held that a taxpayer has the right to conduct an examination of IRS officials regarding their reasons for issuing a summons when the taxpayer shows facts raising a plausible inference of bad faith.

The IRS sought to disregard taxpayer affidavits attesting that the IRS issued the summonses to punish the taxpayer for refusing to extend the statute of limitations and that the summons enforcement action was designed to evade limitations on Tax Court discovery. The IRS characterized the taxpayer’s claims as bare assertions.

For more about the underlying matter and the parties’ positions, please see our article in the current issue of the Federal Lawyer: Bare Assertions, Naked Allegations, & Improper Purposes.

The Supreme Court rejected the IRS arguments and established the appropriate standard for reviewing the proper purpose required to enforce an IRS summons. The Court ruled that the taxpayer is entitled to examine an IRS agent as part of a summary enforcement proceeding when the taxpayer “can point to specific facts or circumstances plausibly raising an inference of bad faith.” Stated differently, “the taxpayer need only make a showing of facts that give rise to a plausible inference of improper motive.”

Though the Court dismissed the IRS arguments, it also found the intermediate decision of the 11th Circuit in favor of the taxpayers lacking. The Supreme Court found the 11th Circuit’s brief opinion potentially too far ranging in its result and remanded the matter for a more specific findings on the errors adduced to the district court. It also suggested that certain legal issues discussed in the district court opinion, specifically those related to the interplay between summons enforcement and Tax Court discovery, might be subject to review by the 11th Circuit. So while the taxpayer has secured a certain victory, there likely will be more clarification to come on this issue.

Read the U.S. Supreme Court’s opinion here:
U.S. v. Clarke, 573 U.S. ___ (No. 13-301, June 20, 2014)

Second Circuit Affirms Importance of Proper Valuations for Facade Easements

Second Circuit Court of AppealsOn Wednesday, June 18, 2014, the Second Circuit Court of Appeals affirmed the U.S. Tax Court’s ruling in Scheidelman v. Commissioner, TC Memo 2013-18.

This is Scheidelman’s second, and likely final, visit to the Second Circuit Court of Appeals. See our previous discussion of the Second Circuit’s decision to vacate and remand the case back to the U.S. Tax Court.

Read the full opinion here:  Scheidelman v. Commissioner, No. 13-2650 (2d. Cir., June 18, 2014).

Famous Fridays: Nicolas Cage, Spending A Fortune In Sixty Seconds

nicolas-cage-240

Regardless of your opinions on his talent as an actor, Nicolas Cage amassed a fortune for his consistent roles in movies since 1981. Cage won an Oscar for his performance in Leaving Las Vegas, but he may be best known for his roles in adventure movies Con Air, Face/Off, Gone in Sixty Seconds, Lord of War, and Ghost Rider. He earned more than $150 million from acting between 1996 and 2011, and found a way to spend almost all of it.

Cage accumulated 15 personal homes between 2000 and 2007 ranging from a castle in England to a Bel Air mansion that was taken off the market when nobody could meet Cage’s $35 million asking price. He also spent $7 million on a private island in the Bahamas, purchased 4 yachts, and a $30 million private jet. His car collection would have made Memphis Raines proud with nine Rolls Royces, 30 motorcycles, a $500,000 Lamborghini, and a $1 million Ferrari Enzo.

He earned $40 million and was the fifth-highest paid actor by Forbes in 2009, but on the whole it was a bad year financially for Cage. Even this income wasn’t enough to sustain Cage’s lifestyle. His Bel-Air mansion was foreclosed upon by each of the six lenders supplying six mortgages totaling nearly $20 million. The IRS placed a lien on his New Orleans home to collect over $13 million in unpaid taxes and penalties for tax years from 2002-2007. A large part of the bill stemmed from using a company he owned to write off $3.3 million in personal expenses including costs for limos, meals, gifts, travel, and his private jet. Among other things, the IRS adjusted his taxable income from $430,000 to $1.9 million in 2003 and from $17 million to $18.5 million in 2004. The IRS reduced the expenses for his private jet by over $500,000 in several other tax years.

He fired and sued his business advisor and began making headway on his back taxes by selling some of his properties, a dinosaur skull worth over $250,000 and Action Comics #1 for $2.16 million. In 2012, Cage made a payment of over $6.2 million to the IRS cutting his debt in half. His marketability as an actor and the rumored National Treasure 3, should put Cage well on his way to paying off the IRS.

 

Conservation Easement Yields New Rule on Reasonable Cause Penalty Defense

us_Tax_Court_fasces-with-red-ribbonThe Tax Court disallowed another charitable deduction for the donation of a façade easement in Boston’s South End Historic District. This time the decision was based on valuation principles, not technical foot faults, and the taxpayers were able to avoid certain penalties.

In Chandler v. Commissioner, 142 TC No. 16 (2014), the taxpayers owned two homes in Boston’s South End Historic District, the Claremont Property and the West Newton Property. The homes were purchased in 2003 and 2005, respectively. The taxpayers entered into an agreement in 2004 to grant the National Architectural Trust (“NAT”) a façade easement on the Claremont Property. They then executed a similar arrangement when they purchased the West Newton Property in 2005.

The taxpayers used an NAT recommended expert to value the easements. He valued the Claremont easement at $191,400 and the West Newton easement at $371,250. The taxpayers took charitable deductions related to the easements of more than $450,000 between 2004 and 2006.

The IRS did not challenge the easements’ compliance with §170(h). However, the IRS did allege that the easements had no value because they did not meaningfully restrict the taxpayers’ properties beyond the provisions under local law. The taxpayers’ countered that the easement restrictions were broader than local law because they limited construction on the entire exterior of the home and required the owners to make repairs. Local law only restricted construction on portions of the property visible from a public way and did not require owners to make repairs. The taxpayers’ also noted that the easement subjected the property to stricter monitoring and enforcement of the restrictions. The Tax Court, citing its recent opinion in Kaufman v. Commissioner, T.C. Memo 2014-52, (discussed below), rejected the taxpayers’ arguments because “buyers do not perceive any difference between the competing sets of restrictions.”

The only remaining issue was valuation. The taxpayers abandoned their original appraisals and presented new expert testimony at trial. The taxpayers’ new expert used the comparable sales approach to calculate a before value of $1,385,000 for the Claremont Property and $2,950,000 for the West Newton Property. The taxpayers’ expert chose seven properties for comparison: four properties in Boston and three properties in New York City. On the basis of data from these properties, he estimated that the taxpayers’ easements diminished the value of both properties by 16%.

The Tax Court found the taxpayers’ expert unpersuasive. The Court dismissed the three New York City comparables because they “tell us little about easement values in Boston’s unique market.” The court also found that three of the four Boston properties were “obviously flawed.” The Court took particular exception to the expert’s use of a comparable unencumbered property that was not actually unencumbered. The Court stated that the “error undermines [the expert’s] credibility concerning not only this comparison, but the entire report.”

The Tax Court also found the respondent’s expert report unpersuasive. The respondent’s expert examined nine encumbered Boston properties that sold between 2005 and 2011. He compared the sales prices immediately before and after the imposition of the easements. Each property sold for more after it had been encumbered by the easement. However, the expert failed to account for significant renovations that took place on many of the properties after they were encumbered. Thus, the Court found the expert’s analysis unpersuasive because “it does not isolate the effect of easements on the properties in his sample.” However, in the final analysis, the Court sided with the IRS and disallowed the taxpayer’s deductions.

However, the Court did accept the taxpayers’ reasonable cause defense for gross valuation misstatement penalties in 2004 and 2005. Unfortunately, the reasonable cause exception for gross valuation misstatements of charitable contribution property was eliminated with the Pension Protection Act of 2006, so the Court denied the taxpayers’ reasonable cause defense for the 2006 tax period.

Read the full opinion here: Chandler v. Commissioner, 142 T.C. No. 16

Reliance on Tax Attorney & Licensed Appraiser Helps Taxpayer Preserve Deductions & Avoid Penalties

us_tax_courtIn Palmer Ranch v. Commissioner, a TEFRA partnership avoided accuracy-related penalties even though the Tax Court reduced the fair market value of its conservation easement by $3.98 million.

The taxpayer claimed a $23.94 million charitable contribution deduction on its 2006 partnership return. The IRS disallowed $16.97 million of the value under exam. At trial, the parties presented valuation experts who relied upon the comparable sales method to set the before and after value of the property. The taxpayer’s expert valued the land at $307,000 per acre, while the IRS expert came in at at $94,000 per acre. The Tax Court reviewed the four properties used by both experts and compared the property’s then-current use with its highest and best use. The taxpayers’ contended that 360 multifamily dwelling units could be developed on the 82-acre parcel. The IRS disagreed, emphasizing: a failed rezoning history; environmental concerns; limited access to outside roads; and neighborhood opposition. The Court rejected each of these arguments and found that “there is a reasonable probability that [the parcel] could have been successfully rezoned to allow for the development of multifamily dwellings.”

The IRS also argued that the real estate market was softening in 2006. Judge Goeke accepted the idea of a declining real estate market and reduced the taxpayer’s pre-encumbrance appraisal of the land from $25.2 million to $21 million. Using the same “after” value percentage (5% of the unencumbered property) the Court found that the fair market value of the conservation easement was $19.96 million.

Following the framework set forth in the U.S. Supreme Court’s recent decision in United States v. Woods, the Court determined that it had jurisdiction to consider the IRC § 6662 penalties. The Court then accepted the taxpayers’ reasonable cause defense and disallowed the 20% penalty because the taxpayer: retained a tax attorney to advise them on the tax aspects of the easement donation; hired a credible, licensed appraiser, and made a good-faith attempt to determine the easement value.

Read the Tax Court opinion here: Palmer Ranch v. Commissioner, T.C. Memo. 2014-79

Tax Court Rejects Expert Value, Imposes Penalties

us_Tax_Court_fasces-with-red-ribbonIn what may be the last word on Kaufman v. Commissioner, the Tax Court sustained the IRS’s complete disallowance of charitable deductions claimed for the donation of a façade easement. The case returned to the Tax Court on remand from the First Circuit Court of Appeals to determine the value of the easement and the application of accuracy-related penalties.

The taxpayers’ owned a 150 year-old row house in a designated historic district in Boston, Massachusetts subject to the South End Landmark District Residential Standards (“South End Standards”). In 2003, taxpayers’ entered into an agreement with the NAT to donate a façade easement over the property. The taxpayers contacted an appraiser, recommended by NAT, who appraised the value of the easement. The appraisal concluded that the total loss of value, including the easement and the value of the unused development rights, was $220,800. The taxpayers deducted that amount on their 2004 and 2005 tax returns as a charitable donation of a qualified conservation easement. The Commissioner challenged the deductions with a statutory notice of deficiency.

In Kaufman v. Commissioner, 134 T.C. 182 (2010) (Kaufman I), the Tax Court ruled for the IRS in a motion for partial summary judgment. The Court held that the conservation easement failed to satisfy the “in perpetuity” requirements of the Treasury Regulations. The Court then issued a second opinion making additional findings, disallowing other items and imposing penalties on the remaining issues (Kaufman II). The taxpayers’ appealed. The U.S. Court of Appeals for the First Circuit rejected the Tax Court’s ruling that the taxpayers’ mortgage lender agreement undercut the regulation’s “in perpetuity” requirement as a matter of law (Kaufmann III) and remanded for further consideration of the taxpayers’ charitable contribution deductions under the facts.

The primary issue on remand was the proper valuation of the façade easement. The taxpayers’ valuation expert used a sales comparison analysis with data from three comparable properties. Using the before-and-after method, he determined that the value of the property was $1,840,000 before the grant of the easement. The expert used a “method unique to him and not a generally accepted appraisal or valuation method” to determine that the total value of the property was reduced by 12% or $220,800 when encumbered by the façade easement.

The IRS’s expert discredited the taxpayer’s valuation stating that it was “the fruit of an inappropriate valuation methodology employing a wholly unsupported adjustment factor.” Notably, both the IRS expert and the taxpayer’s expert agreed, “neither the preservation agreement nor the preexisting restrictions hamper the potential for developing the property to its highest and best use…as a single family home.”

The Tax Court gave no weight to the taxpayers’ expert because of his close relationship with NAT, his limited experience appraising façade easements, and his use of a “unique” valuation methodology. The Court also conducted its own comparison of the façade easement restrictions and the South End Standards. The Tax Court found that the agreements were “basically duplicative” and there were no significant additional restrictions placed on the property by the façade easement.

The Court held in favor of the IRS finding that the façade easement had no fair market value when conveyed to NAT. The Tax Court also upheld the IRS’s imposition of accuracy-related penalties.

Read the full opinion here: Kaufman v. Commissioner, T.C. Memo. 2014-52

IRS Releases Guidance on Convertible Virtual Currency: Bitcoin Treated As Property for Federal Tax Purposes

opengraphThe IRS released Notice 2014-21 on Tuesday, March 25th to provide guidance on the treatment of convertible virtual currencies, like Bitcoin, as property, not currency, for Federal tax purposes.

The IRS distinguishes between virtual currency, a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value, and convertible virtual currency, which has an equivalent value in real currency or can act as a substitute for real currency. The Notice specifically mentions Bitcoin as an example of a convertible virtual currency.

Notice 2014-21 only applies to convertible virtual currency. The Notice provides additional instructions for determining basis, calculating gain or loss, and necessary forms for reporting transactions using convertible virtual currency.

You can read the full Notice here:
IRS Notice 2014-21