Amended Returns Don’t Help Taxpayer Minimize §6707A Penalties

us_tax_courtIn Yari v. Commissioner, 143 T.C. No. 7, the Tax Court upheld a $100,000 statutory maximum, penalty under IRC § 6707A(b)(2)(A) assessed against the taxpayer for failing to report a listed transaction.  The case presents an issue of first impression on the proper calculation of a penalty under IRC § 6707A(b).

The taxpayer participated in a listed Roth IRA transaction from 2002 to 2007.  The transaction involved the taxpayer forming a disregarded entity, Topaz Global Holdings, LLC, and a Nevada corporation, Faryar, Inc., which elected to be treated as an S-Corporation for federal income tax purposes.  The taxpayer opened a Roth IRA account in 2002 with an initial contribution of $3,000.  The Roth IRA acquired all of Faryar, Inc.’s stock for $3,000 and became the sole shareholder of the corporation.

From 2002 to 2007, Faryar, Inc. reported management fees from related entity Topaz Global Holdings, LLC and interest income of $1,221,778.  Because Faryar, Inc. was an S-Corporation with a Roth IRA as the sole shareholder, the income was not taxed at either the corporate level or the shareholder level.  The structure allowed the taxpayer to exceed Roth IRA contribution limits and decrease the income he otherwise would have reported because Topaz Global deducted the management fee paid to Faryar, Inc.

In IRS Notice 2004-8, the IRS designated these Roth IRA transactions as “abusive.”  The taxpayer filed a federal income tax return for 2004 in on October 17, 2005.  This return did not disclose the taxpayer’s participation in the Roth IRA transaction.  The IRS audited the taxpayer’s returns for 2002 through 2007 and issued notices of deficiency for each year.  The IRS determined that the taxpayer should have included $482,912 from the management fee transaction as income in the 2004 tax year.  After computational adjustments, this increased the taxpayer’s tax liability by $135,215.  The IRS issued notices of deficiency and the taxpayer when to the Tax Court.

During the course of the audit, the taxpayer amended his 2004 tax return to correct reported Schedule K-1 information.  The amended return also included $482,912 from the management fee transaction as income. The taxpayer then filed a second amended return claiming a net operating loss carryback from 2008, and again reporting the $482,912 management fee as income.

The taxpayer and the IRS settled the deficiency cases and entered into a closing agreement in 2011.  The closing agreement required the taxpayer to include certain amounts in his income for each of the tax years, including $482,912 for the 2004 tax year.  The Court entered stipulated decisions in the deficiency cases that reflected the closing agreement.

In September 2008, the IRS issued a IRC § 6707A penalty of $100,000 for the 2004 tax year because the taxpayer failed to disclose his participation in a listed transaction.  The IRS issued a Notice of Intent to Levy in February 2009 and the taxpayer timely requested a Collection Due Process (CDP) hearing.  Prior to the hearing, Congress amended IRC § 6707A as part of the Small Business Jobs Act (SBJA) to change the method of calculating the penalty.  The change was effective retroactively for penalties assessed after December 31, 2006.  The new statute designated a penalty of 75% of the decrease in tax shown on the return as a result of the listed transaction and set minimum and maximum penalties of $5,000 and $100,000, respectively, for individuals under IRC § 6707A(b).

The IRS suspended the CDP hearing to reconsider the calculation of the penalty and determined that the penalty did not need to be modified under the new statute.   The taxpayer took the position that the amended returns should be used to calculate the decrease in tax, and thus the penalty should be the statutory minimum of $5,000 under IRC § 6707A(b)(2)(B).  The revenue agent disagreed and used the original return to calculate the penalty, resulting in a maximum $100,000 liability under IRC § 6707A(b)(2)(A).  At the taxpayer’s request, the settlement officer issued a notice of determination sustaining the collection action.  The taxpayer challenged the calculation of the penalty and petitioned the Tax Court.

Despite stipulations to the Tax Court’s jurisdiction over this matter, the Court determined its jurisdiction over the matter and distinguished this case from Smith v. Commissioner, 133 T.C. 424 (2009).  In Smith, the Court found it lacked jurisdiction to redetermine an IRC § 6707A penalty because the penalty did not fit the statutory definition of deficiency and because the IRS could assess and collect the penalty without issuing a statutory notice of deficiency.  However, the Tax Court held that the Court does have jurisdiction to redetermine a liability challenge asserted by a taxpayer in a Collection Due Process hearing pursuant to IRC § 6330(d)(1).  Notably, the Tax Court reviewed the CDP determination de novo because the underlying tax liability was properly at issue.  Sego v. Commissioner, 114 T.C. 604, 610 (2000).

The taxpayer stipulated that he participated in a listed transaction and that he failed to properly disclose his participation.  The taxpayer argued that the amended returns should be used to calculate the decrease in tax, and thus the penalty should be the statutory minimum of $5,000, rather than the $100,000 maximum assessed by the IRS.  He based his argument on the plain language of the statute, the statutory scheme, and legislative history.

The Court held that “the statute is clear and unambiguous: The penalty is calculated with reference to the ‘tax shown on the return’. IRC § 6707A(b).”  In its analysis of legislative intent, the Tax Court found that Congress intended to penalize the failure to disclose participation in a listed transaction, not the tax savings produced by the transaction.  The Court also noted that Congress could have referenced “a” return in the statute, rather than “the” return, if it intended for the IRS to use amended returns in calculating the penalty under IRC § 6707A.  Thus, the Court upheld the maximum penalty of $100,000 assessed against the taxpayer.

The Tax Court did leave the door open for taxpayers who file an amended return prior to the due date of the original return.

Read the full opinion here: Yari v. Commissioner, 143 T.C. No. 7.

 

 

 

 

 

 

 

Tax Court Rejects Taxpayers’ Reliance on Home Concrete Decision

us_Tax_Court_fasces-with-red-ribbonIn Barkett v. Commissioner, 143 T.C. No. 6 (2014), the Tax Court held that gains reported from the sales of investments (not the amount realized) are used to determine whether the taxpayers understated gross income by more than 25% for purposes of the extended six-year statute of limitations under IRC § 6501(e)(1)(A).  The issue came before the Tax Court on the taxpayers’ motion for partial summary judgment.

In Barkett, the taxpayers realized more than $7 million from the sale of investments in 2006, and reported $123,00 in gain.  In 2007, the taxpayers realized more than $4 million from the sale of investments and reported $314,000 in gain.  The gross income reported in 2006 and 2007 was $271,440 and $340,591, respectively. The IRS issued a Notice of Deficiency more than three years but less than six years after taxpayers filed their 2006 and 2007 returns.

The IRS asserted that taxpayers omitted $629,850 and $432,957 in gross income for tax years 2006 and 2007, respectively.  The taxpayers stipulated to the amounts that were omitted but challenged the validity of the Notice of Deficiency on the grounds that the three year statute of limitations expired under IRC § 6501(a) and the amount omitted from gross income did not exceed the 25% threshold to extend the statute of limitations to six years under IRC § 6501(e).

The taxpayers’ relied upon the Supreme Court’s decision in United States v. Home Concrete & Supply, LLC, 566 U.S. ___, ___, 132 S. Ct. 1836 (2012), which invalidated a portion of Treas. Reg. § 301.6501(e)-1 and held that the six-year statute of limitations under IRC § 6501(e) does not apply to a taxpayer’s overstatement of basis.  The taxpayers argued that amounts realized should be included in the denominator of the 25% omitted calculation for purposes of IRC § 6501(e)(1)(A).

The Tax Court rejected the taxpayers’ interpretation of Home Concrete and held that gross income stated in the return only includes gains reported from investment property – the excess of the amount realized over the basis in the assets sold.  The Court cited Insulglass v. Commissioner, 84 T.C. 203 (1985) and Schneider v. Commissioner, T.C. Memo. 1985-139, stating that “capital gains, not the gross proceeds, are to be treated as the amount of gross income stated in the return for purposes of section 6501(e).”  The Court distinguished this case from the Intermountain line of cases that led to the Supreme Court’s decision in Home Concrete because those cases addressed when gross income is omitted from the return, not how to calculate gross income (the issue in this case).

Read the full Tax Court opinion here: Barkett v. Commissioner, 143 T.C. No. 6 (2014).

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

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).

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

North Dakota Conservation Easements Prohibited by State Law

us_tax_courtIn a case that highlights the potential conflict between state law and the requirements for the deductible donation of a conservation easement, the Tax Court in Wachter v. Commissioner held that a North Dakota conservation easement failed the “in perpetuity” requirement under IRC § 170(h)(2)(C) because North Dakota state law limits the duration of an easement to 99 years.

The taxpayers, comprised of two sets of couples filing joint returns for the tax years in question, owned varying interests in two partnerships, WW Ranch and Wind River, LLC. The partnerships entered into a cooperative agreement with the Commodity Credit Corporation and the American Foundation for Wildlife to sell conservation easements on multiple parcels from 2004 through 2006.

The taxpayers made three cash gifts to the North Dakota Natural Resource Trust (NRT) totaling $485,650 from 2004-2006. On its partnership returns, WW Ranch reported bargain sales of conservation easements as charitable contributions of $349,000 for 2004, $247,550 for 2005, and $162,500 for 2006. The parties obtained two appraisals to each contributed parcel. Each appraisal valued the property according to a different land use, and the taxpayers used the difference in appraised values to determine the value of the conservation easements.

The IRS issued notices of deficiency disallowing the charitable contribution deductions for both the cash payments to NRT and the property contributions. The IRS filed a motion for partial summary judgment.

Under IRC § 170(h)(1) a contribution of real property is a qualified conservation contribution if:

  1. The property is a “qualified property interest”,
  2. The contributee is a “qualified organization”, and
  3. The contribution is “exclusively for conservation purposes.”

The IRS argued that because the North Dakota state law restricts easements to 99 years the conservation easements cannot satisfy the first and third requirements of IRC § 170(h)(1). The parties agreed that the state law here is unique; it is the only state with a statute that provides for a maximum duration that may not be overcome by agreement.

Under IRC 170(h)(2)(c) a “qualified property interest” means “a restriction (granted in perpetuity) on the use which may be made of the real property. The taxpayers argued that the possibility that the land would revert back to them, WW Ranch, or their successors in interest is the same as a remote future event under Treas. Reg. § 1.170A-14(g)(3) that will not prevent the easements from being perpetual.

A remote future event under Treas. Reg. § 1.170A-14(g)(3) if “on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible.” The Tax Court cited its opinion in 885 Inv. Co. v. Commissioner, defining “so remote as to be negligible” as “a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction.”

The Court granted partial summary judgment on the conservation easement issue in favor of the IRS finding that “on the dates of the donations it was not only possible, it was inevitable that AFW would be divested of its interests in the easements by operation of North Dakota law.” The case will continue to trial on the deductibility of cash contributions to NRT.

Read the full opinion here: Wachter v. Commissioner, 142 T.C. No. 7

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

Shea Homes v. Commissioner: Tax Court Allows Homebuilder to Defer Recognition of Income from Home Sales

us_Tax_Court_fasces-with-red-ribbonIn Shea Homes, Inc. v. Commissioner, the Tax Court allowed a homebuilder to defer the recognition of income, using the completed contract method under IRC § 460(e)(1)(A), from home sales in a newly constructed development until the entire development was nearly complete.

The specific facts and contracts in Shea were crucial to the court’s determination.

Read the entire opinion here:
Shea Homes, Inc. v. Commissioner, 142 T.C. No. 3 (2014).