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

Tax Court Denies Taxpayers’ Second Attempt to Avoid Penalties

us_Tax_Court_fasces-with-red-ribbonIn Mountanos v. Commissioner, T.C. Memo 2014-38, the Tax Court denied the taxpayer’s request to consider alternative grounds for disallowing deductions conservation easement conveyance. The taxpayer sought to avoid 40% accuracy-related penalties assessed on the disallowance of the deductions in Mountanos v. Commissioner, T.C. Memo 2013-138 (Mountanos I) (see our Summer 2013 newsletter).

In Mountanos I, the taxpayer claimed a $4.9 million deduction return for conveying a conservation easement to the Golden State Land Conservancy. The IRS challenged the easement on multiple grounds, including valuation. The Tax Court found that the conservation easement had no value because the conveyance had no effect on the “highest and best use” of the property. The Court did not consider the respondent’s alternative arguments and imposed a 40% gross valuation misstatement penalty.

The taxpayer filed a motion seeking reconsideration of the Court’s decision on the 40% penalty. Relying on prior opinions of the court, the taxpayer argued that the Court should consider alternative grounds that the taxpayer fails to concede as the basis for calculating the penalty.

The Tax Court denied the taxpayer’s motion for reconsideration of the penalties because it would allow the taxpayer to “take two bites at the same apple.” Judge Kroupa also questioned the viability of the cases relied upon by the taxpayers in light of the Supreme Court’s decision in United States v. Woods. Woods rejected the taxpayer’s reliance on the “Blue Book” formula in an attempt to avoid the gross valuation misstatement penalty.

Read the full opinion here: Mountanos v. Commissioner, T.C. Memo. 2014-38

Supreme Court Adopts IRS Position on Jurisdiction and Application of Partnership Penalties

Gary Woods and his partner, Billy Joe McCombs, generated substantial tax losses using the COBRA tax shelter. The COBRA shelter used offsetting options to inflate the basis of property distributed by a partnership, which is then contributed and sold to another partnership or pass through entity, resulting in a large tax loss without a corresponding economic loss. Messrs. Woods & McCombs reaped ordinary income losses of $13 million and capital losses of $32 million when they used the COBRA structure to purchase and sell $3.2 million of options.

After the IRS disallowed their losses, Woods filed a refund claim (which was denied) and pursued that claim with a complaint filed in the U.S. District Court. After Woods prevailed on certain issues in the 5th Circuit, the government petitioned the U.S. Supreme Court for certiorari. The case selected by the high court to resolve a split in the circuits. The Fifth, Federal and D.C. Circuits had all found for the taxpayers. Other circuits had adopted the government’s position.

The Supreme Court addressed two questions in an opinion authored by Justice Scalia. The Court first considered whether the district court has jurisdiction under TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) to determine valuation-related penalties at the partnership level. This is important because partnerships are not taxed as entities for Federal income tax purposes. The income and losses determined at the partnership level pass-through to each partner where they are taxed on the partner’s individual or corporate tax return.

One purpose of TEFRA was to allow determinations at the partnership level and prevent the need for multiple proceedings to determine the tax liabilities of items common to all partners in the partnership. The jurisdictional question has been widely litigated and this decision will affect many millions of dollars of pending tax penalties.

The second, related, question was whether the 40% gross valuation overstatement penalty under I.R.C. Sec. 6662 applied when a partnership was found to not have economic substance. A partnership lacking in economic substance ceases to exist for tax purposes.

The Court ruled for the government on both questions. On the first question, the Court held that there was jurisdiction to consider the penalty question at the partnership level. The court essentially adopted the position suggested at oral argument by Deputy Solicitor General Malcolm Stewart that “any question that will necessarily have the same answer for all partners should be presumptively be resolved at the partnership level.” Justice Scalia opined that “deferring consideration of those arguments until partner-level proceedings would replicate the precise evil that TEFRA sets out to remedy: duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners.”

Relying on the “plain language” of the penalty the Court also held that the 40% substantial or gross valuation penalty applied to the overstated basis of the partners. “[O]nce the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in the partnership greater than zero.” The Court adopted the observation of Fifth Circuit Judge Prado that “the basis understatement and the transaction’s lack of economic substance are inextricably intertwined” and therefore the penalties were “attributable to” the overstatement of basis that occurred once the partnership ceased to be recognized for tax purposes.

In an final note of interest to tax practitioners, Justice Scalia rejected the taxpayer’s reliance on the “Blue Book” – a publication of the Joint Committee of Taxation often published after the enactment of tax legislation explaining the legislative history of the statute – and clearly stated that this publication is not a relevant source of Congressional intent.

Read the entire opinion here:
U.S. v Woods, 517 U.S. __, No. 12-562 (Dec. 3. 2013).

IRS Resumes Field Exams & Collections

irs-sealThe Internal Revenue Service is back and has released guidance on the resumption of field audits and collection activities. Here are some highlights:

  • If you received an audit report requesting a response in 10 days but were unable to respond because of the shutdown you may still respond.  However, your auditor also should re-establish contact before taking additional actions in your case.
  • If you received a 30 day letter, you should continue to adhere to the deadline.  You may contact your auditor to discuss your options.
  • Failure to pay and failure to file penalties are statutory and are charged from the due date of the return until the date of payment.  These penalties will not be abated during the period of the shutdown.

Please visit IRS.gov for more information or read the FAQs here:

FAQs: Resumption of Field Exam Activities

FAQs: Resumption of Field Collections Activities

Tax Court Reminder: Hours Alone Do Not Turn a Hobby into a Business

430_horse0One of my best friends emailed me yesterday. He’s up for partner at one of the largest law firms in the world. He has dedicated many hours to the practice of law since our days together as law clerks at the Tax Court.

However, the key to partnership in the modern practice of law requires more than substantial legal skill – it takes a business plan. He has been asked to write one and I have no doubt that it will be thorough, detailed and realistic. That is, it will be the product of the same skills that have made him a great lawyer already. When he is invited into the partnership of his firm, which I am confident that he will be, I know that he will be expected to execute on that business plan, and I know that he will. After all, the objective of a law firm is to provide excellent legal services and make a profit while doing it.

Yesterday, the Tax Court issued a fairly lengthy Summary Opinion reminding us that the same standard applies to every business. A Summary Opinion is not a legal precedent and cannot be cited for authority, but Craig v. Commissioner amply shows that lengthy hours and dedicated labor alone are not enough to turn an activity into a business. The opinion is instructive for those who might be unsure about the right standard. There must be a plan to make money – and some profits along the way won’t hurt either.

Ms. Craig worked 25-40 hours per week as a real estate agent. She worked 25-30 more hours per week attending to her several horses – an activity for which she claimed losses for the tax years in question. She also worked part time preparing tax returns for H&R Block. The IRS denied Ms. Craig’s losses from the horse breeding activity and she challenged the Commissioner’s determinations by filing a pro se petition in Tax Court.

The Tax Court accepted the fact that Ms. Craig dedicated many hours a week to cleaning stalls, feeding, grooming, training, and otherwise caring for her horses. It did not, however, accept the fact that Ms. Craig engaged in any of those efforts with “an actual and honest objective of making a profit.”

Notable was Ms. Craig’s business plan for the horse-breeding activity. It was prepared in early 2011, months after the IRS began its examination of Ms. Craig’s tax returns, and listed a total of 10 items (all of which are reproduced in the Court’s opinion). From the time the business plan was written until the date of trial in November 2012, Ms. Craig had accomplished only one item on the business plan (she finished training one horse for handling).

Neither the concise and late-breaking business plan nor the lackadaisical approach to execution helped Ms. Craig’s case. It also didn’t help that she also didn’t maintain a separate bank account for the alleged horse breeding business, instead preferring to run expenses through her personal checking account, and reported gross receipts from the business in only one of seven years ($950 of revenue, not even profit). All of these factors contributed to the Court’s conclusion that Ms. Craig’s horse activities were a hobby and not a business. The Court also sustained a 20% accuracy-related penalty against Ms. Craig. A timely-written and well-executed business plan might not have changed the outcome of Ms. Craig’s case, but it certainly wouldn’t have hurt.

Read the entire opinion here:
Craig v. Commissioner, T.C. Summary Opinion 2013-58

Supreme Court Allows Foreign Tax Credits for U.K. Windfall Tax

us-supreme-courtThe U.S. Supreme Court has resolved a split in the circuits on the U.S. tax treatment of U.K. windfall tax payments made by U.S. utilities. In a unanimous opinion authored by Justice Thomas, the Court held that the windfall tax qualified as a “creditable tax” for U.S. foreign tax credit purposes. The result is that the appellant here, PPL, and Entergy, who had the companion case, will be able to take a credit against their U.S. income taxes for the amounts paid to the United Kingdom.

The central issue was whether the U.K. tax was a tax on income, the general standard for creditable foreign taxes. The ultimate decision was a bit more nuanced and scholars surely will continue to debate the issue including the algebra (don’t see that often in the tax world) and the potential distinction between the regulatory phrase “in the U.S. sense” and Justice Thomas’ phrase “if enacted in the U.S.”

Practitioners, being the practical folks that they are, will look to expand the decision for the benefit of other clients that may have paid taxes similar to the windfall tax but not received the benefit of foreign tax credits against their U.S. income.

This is what happens when the Supreme Court issues a tax opinion. There will be more to come, as the estate tax case that may decide the fate of DOMA has been heard and likely will be decided this year and another tax case (on overpayment penalties) is being briefed for the Supremes right now. Expect a decision in the latter case, U.S. v. Woods, sometime in 2014.

Read the PPL opinion here:
PPL Corp. v. Commissioner, Docket No. 12-43 (U.S.S.C. May 20, 2013)

4th Circuit: District Court Abused Discretion by Allowing Evidence of CPA’s Personal Tax Situation in Tax Shelter Promoter Case

The Fourth Circuit Court of Appeals vacated portions of a jury’s findings, including imposition of a $2.6 million penalty, because the District Court allowed the introduction of evidence of the defendant CPA’s personal tax situation (he didn’t file returns) during the penalty phase of the trial.

The Fourth Circuit held that the District Court abused its discretion by permitting the evidence into the record over the defendant’s objection. The Court of Appeals further held that the personal tax information was not relevant to the tax shelter promotion penalty in question and the effect of allowing it into evidence was highly prejudicial. The lower court’s error was not harmless.

The appellate court concluded that the evidence “bears all the indicia of garden-variety “bad acts” evidence with no other purpose than to emotionally inflame the jury against the defendant.”

Read the opinion here:
Nagy v. U.S., No. 10-2072 (4th Cir. Mar. 29, 2013)

U.S. Supreme Court to Hear Tax Penalty Case

us-supreme-courtThe Supreme Court has granted the government’s petition for certiorari in United States v. Woods, No. 12-562. The high court will decide whether the IRC §6662 overstatement penalty applies to underpayments of tax that are “attributable to an overstatement of basis” when the basis has been disallowed because the transactions that established the basis lacked economic substance.

The Court also asked the parties to brief an additional issue related to the procedural history of the case. Specifically, the Court is interested in whether the district court had jurisdiction under IRC §6226 to consider the substantial valuation misstatement penalty. This question, which arises under the procedural guidelines that govern large partnerships in TEFRA, has been raised in many cases over the course of the last decade. The heart of the matter is what issues are appropriate for resolution in a partner-level proceeding and which should be resolved at the partnership level.

Read the court’s order here:
12-562 U.S. v. Woods