Petitioner is denied $33.0 million tax deduction in its entirety because it left the “Donor’s cost or other adjusted basis” field blank on Form 8283. The Tax Court also, applying recent precedent, holds that gross valuation misstatement penalties may apply even where the taxpayer’s underpayment was also caused by other factors (lack of substantiation, in this case). 7520 tables are ruled inapplicable to remainder interests in property where the holder of the remainder interest lacks certain remedies for breaches of protective covenants. Actual FMV of interest transferred to University is determined at $3.5 million – 40% misvaluation penalty applies to the $29.5 million difference between FMV and claimed deduction.
In RERI Holdings I, LLC, v. Commissioner (149 TC 1), filed July 3, 2017, the petitioner RERI Holdings I, LLC, (RERI) lost the entire $33.0 million tax deduction it had taken on its 2003 tax return for a charitable gift and, also, was awarded a 40 percent penalty of the $29.5 million difference between the deduction taken and the FMV of the interest gifted.
In early 2002, in a complicated set of transactions, RS Hawthorne Holdings, LLC (“Holdings”) acquired indirect ownership of a property in Hawthorne, California, subject to a long-term lease. The property was appraised in 2001 at $47 million and was encumbered by a $43.7 million loan. The sole member of Holdings, then, bifurcated its ownership of Holdings as follows:
- A “term of years” (TOYS) interest reserving, essentially, an estate for itself (the member) for almost 20 years – until December 31, 2020, to be exact. Thereafter, the entire Holdings interest reverted to the holder of:
- A “successor member interest” (SMI). This interest was sold to the petitioner/taxpayer in this case (RERI). RERI and Holdings are related entities. The purchase price paid by RERI for the SMI was $3.0 million.
RERI then turned around (in August 2003) and assigned the SMI to a University. For this donation, RERI took a $33.0 million tax deduction, backed by an appraisal that determined the “investment value” of the SMI. The “qualified appraisal” (QA) for the tax return, first, determined a $55 million value of the property and, then, simply multiplied this value by an actuarial factor derived from the 7520 tables.
As it turns out, RERI’s 2003 tax return contains two fatal errors:
- The Form 8283 appraisal summary attached to the return correctly indicated that RERI purchased the SMI on March 22, 2002. However, it left the space provided for “Donor’s cost or other adjusted basis” blank.
- The QA was based on the section 7520 tables, but these tables only apply where the agreements governing the property provide adequate protection to the holder of the specific interest valued. Specifically, the protections must be “consistent with the preservation and protection that the law of trusts would provide for a (…) remainder beneficiary of a trust” Sec. 1.7520-3(b)(2)(iii), Income Tax Regs.
When the standard table factors cannot be used, the actual FMV of the interest must be determined based on all relevant facts and circumstances and subject to the standard willing buyer, willing seller formulation. The key difference, here, is in the (lower) discount rates that are implicit in the government tables versus the (much higher) discount rates taken in arm’s-length transactions for similar interests and properties. In other words, FMV is much lower than the 7520 table value.
Unfortunately for the taxpayer, the agreements governing Holdings and the SMI/TOYS interests provided the TOYS interest holder with substantial leeway and control over Holdings’ property. Furthermore, in the event that the TOYS holder was to sell or encumber or somehow waste the property, the SMI holder could not sue the TOYS holder for breach of fiduciary duty. While it could, in this event, take possession of a possibly damaged TOYS interest or property, it would not be able to recover damages from the TOYS interest holder (due to exculpatory clauses in the agreements). Thus, the Tax Court holds, the SMI is not a remainder interest subject to the 7520 tables and must be valued under the standard willing buyer, willing seller FMV test.
While the Court appears to find some fault with all of the appraisals presented in the case, it clearly places more weight on the government’s appraisers. The following valuations were reviewed:
- $33.0 million – the original appraisal filed with the tax return.
- $16.6 million and “at least” $16.5 million – taxpayer’s appraisers at trial.
- $1.7 million, $2.1 million, and $3.4 million – government’s appraisers before and at trial.
Using the taxpayer’s expert’s cash flow projections, and a 17.75 percent discount rate (close to the discount rates determined by the government’s appraisers), the Tax Court determines an FMV of the SMI of $3.5 million as of August 27, 2003.
Holding that the taxpayer did not in “good faith” investigate the value claimed on its 2003 tax return (notwithstanding filing with an appraisal attached), the Court finds that the gross misvaluation penalty should apply to the entire excess of the deduction claimed over the FMV. The application of the gross misstatement penalty is supported by a recent (2013) precedent from AHG Invs., LLC v. Commissioner (140 TC 73), which specifically overruled Todd (89 TC 912, 1987) and McCreary (92 TC 827, 1989). The Tax Court decision in AHG being as recent as 2013, this has yet to be resolved by higher courts. Thus, we may perhaps see this particular dispute again in future court decisions for years to come.
This case provides taxpayers with a lesson in the value of a conservative approach to tax management. Pushing the envelope turned out to be very expensive here. Consider the following:
- Full and accurate compliance is crucial when claiming charitable deductions. Clearly, including the actual cost basis of the property donated on the 8283 would have been a “red flag” due to the huge discrepancy between the table value and the price the taxpayer actually paid for the SMI. However, aiming for the higher value claimed by hiding (whether on purpose or in error) the basis, ended up costing the taxpayer the entire deduction.
- The Tax Court can and increasingly will throw the book at taxpayers playing the audit lottery. The Court seems to have felt that RERI had tried to take advantage of the system. The desire for a deterrent effect appears to be behind the recent move towards applying penalties even where the underpayment can also be attributed to reasons other than misvaluation.
- Pay attention to structuring. There may have been no way to remedy the problems with the agreements in this case without negating other desired aspects of the transaction, but if there had been a way to draft the agreements so that Sec. 7520 applied, the Tax Court appears to imply, the transaction may have worked and the deduction could have been good.
Either way, unless this decision is reversed on appeal, these are first and foremost costly lessons: assuming a 40 percent tax rate, a tax benefit of more than $13 million turned into a penalty of more than $11 million and a very good day in court for the IRS.
Note: this is a commentary provided for Leimberg Information Services, Inc. It’s (pre)reprinted here with permission from the publisher. However, this has not been reviewed or edited in any way by LISI. All errors, if any, are our own.