Holmes v. Taxpayer: Pankratz and Unreliable Reliance

On March 3, 2021, the Tax Court issued a new opinion in Pankratz v. Comm’r, T.C. Memo 2021-26. This case is a good reminder of some of the good faith and reasonable reliance rules to avoid penalties. The opinion, authored by Judge Holmes, was a typical Holmes’ opinion. It told a detailed story of the taxpayer, provided thorough insight and analysis, and even included a funny pun. In summary, the case provided that (1) one cannot reasonably rely on a non-professional or inexperienced advice, so as to justify reasonable reliance, in taking a reporting position on a tax return; (2) penalties must be approved by a supervisor;[1] (3) charitable donations over $500,000 must be substantiated by a qualified appraisal; (4) Form 8283 (Appraisal Summary) is a pretty obvious indicator that an appraisal is necessary; and (5) based on the facts of this case, a draft cost segregation study may be relied upon for penalty abatement.[2] However, Judge Holmes is unable to be a man of brevity nor is he one to miss the opportunity to explain the law in a manner helpful to both taxpayers and practitioners alike.

Background

Dr. Duane Pankratz, the taxpayer at issue, was a self-made millionaire. He began his career in preveterinary studies, eventually going on to veterinary school to earn his doctorate. After some time practicing in a large veterinary practice, Dr. Pankratz decided to return to the university to teach in the pathology department.

Dr. Pankratz expressed his frustrations regarding an animal virus, and his colleagues urged him to do so something about it, including inventing a vaccine. Eventually, Dr. Pankratz took a job with the USDA and organized Grand Laboratories, Inc. (“Grand Labs”). Through Grand Labs, Dr. Pankratz invented the vaccine and distributed it across the state of Iowa. The virus vaccine went viral.[3] Dr. Pankratz then left the USDA after a year and began working full-time at Grand Labs. Over time and through some initial success, Grand Labs increased in value and was sold by Pankratz in 2002 to Novartis for $85 million.

Over time, Dr. Pankratz acquired numerous businesses in the South Dakota area, including a museum,  gas station, three restaurants, a campground, ranches, and some motels. The Tax Court noted that Dr. Pankratz kept very small economies in very sparsely populated communities alive and well, helping provide jobs, goods, and services in the rural area. By the time of the years at issue before the Tax Court, he had over a dozen ventures as part of his enterprise.

His bookkeeping for his businesses was originally done by a lady known only by the name “Sue.” After some unsuccessful audits utilizing “Sue”, he hired Casey Peterson and Associates to do bookkeeping for some of his businesses. The firm then chose Kasey Gerlach, CPA, to work on his accounts. Dr. Pankratz had a different bookkeeper for two other businesses, Elaine Nash.

Jim Horning did the bookkeeping associated with the ranches. Jim had an accounting degree and briefly worked at an accounting firm. He had no other credentials. Jim prepared information for Dr. Pankratz’s income tax return every year.

Cost Segregation Study

Gerlach approached Dr. Pankratz about undertaking a cost-segregation study in 2008 in order to accelerate the rate at which Dr. Pankratz could take depreciation deductions with respect to real property. A cost-segregation study breaks out the costs of certain assets to justify their depreciation faster than just depreciating straight line as part of the real property. For instance, door knobs, a roof, and HVAC unit may be able to be depreciated with a shorter useful life than a building. Believing Dr. Pankratz’s positions on his historical returns to be too conservative, she recommended a cost-segregation study. After agreeing to undertake the study, he selected BDO USA, LLP at Gerlach’s recommendation. After peer review, internal review, and a CPA review , a draft study was issued. It was not until 2010 that final reports were issued. Unfortunately, the 2008 drafts were used in preparing the returns at issue. However, the Tax Court noted only insubstantial changes existed between the 2008 draft to the final 2010 opinion.

Non-Cash Charitable Contributions

Dr. Pankratz made several non-cash charitable contributions in 2008 and 2009. These gifts consisted of four oil and gas projects, valued at $2 million, for which no appraisal was obtained, and 5.78 acres of land, given to Rapid City, South Dakota for which Dr. Pankratz also never obtained an appraisal and with respect to which he conceded that the deduction should be disallowed.

2009, he donated a conference center, consisting of both the building and surrounding land. He contracted an appraiser, but the appraiser did not feel he could complete an appraisal pursuant to the Uniform Standards of Professional Appraisal Practice. Instead, Dr. Pankratz just totaled the cost of the conference center and claimed a deduction in that amount.

The Tax Returns

Dr. Pankratz engaged his regular CPA to prepare the 2008 and 2009 returns at issue. In 2008 Horning entered information into the CPA’s software himself. Dr. Pankratz remained consistently uninvolved. This data entry also included information for the required Form 8283 with which the Tax Court took extreme issue.

The Court noted that the two-page form expressly stated an appraisal was required, requested the signature of the appraiser, and was peppered throughout with references to an “appraiser” or “appraisal” in some form or fashion. The CPA noted this issue to Horning, but neither mentioned this to Dr. Pankratz.

In 2009, preparation occurred in a similar manner. The difference here was that Horning phoned Dr. Pankratz and informed him that an appraisal was required if he wanted a deduction for the conference center. They instead elected to just deduct the cost of the building, opting for informal valuation, failing to ask the CPA if such was appropriate.

Other than his discussion with Horning related to deducting the cost of the conference center on the 2009 return, Dr. Pankratz was not involved in the preparation of the tax returns and did not so much as review the returns before they were filed. Dr. Pankratz never met face-to-face with his CPA nor did he ever talk to him on the phone. In fact, this roundabout method of tax preparation caused errors in the past. The Tax Court noted that Dr. Pankratz was aware of this issue. The final tally for deficiencies and penalties rang in at about $10 million for all of the issues presented with respect to the 2008 and 2009 individual income tax returns.

Holding

In the end, Dr. Pankratz lost on virtually every issue in his case save for a small win with the draft cost-segregation study.

The charitable gifts failed across the board for failure to attach an appraisal. Though not mentioned, the deductions likely would have been disallowed as a result of an incomplete Form 8283. The Tax Court instead analyzed a statute coming from an old substantiation regulation, Section 170(f)(11)(A)(ii)(II). This provision provides an “escape hatch” for well-intentioned taxpayers if they failed to meet certain requirements (qualified appraisal) if due to reasonable cause. The term reasonable cause, although undefined with reference to that statute, is well defined in other areas, including penalty abatement.

As to the 2008 gifts, Dr. Pankratz argues he hired an accounting firm to prepare a “good” tax return with Horning’s help. Reasonable cause requires a taxpayer to exercise ordinary business care and prudence.[4] In arguing reasonable cause, particularly in a case such as the one presented, a taxpayer needs to show that the professional, upon whose advice he relied upon, was a competent tax advisor with sufficient experience to justify reliance, provision of necessary and accurate information to the professional giving the advice, and reliance in good faith.[5] With respect to a competent tax advisor, it was uncontested as to the CPA’s status, instead Horning’s status was at issue as he was the party the Tax Court identified as providing the advice that Dr. Pankratz relied upon.

The Tax Court applied its practical test looking at the expertise commensurate with the facts of the case.[6] The Tax Court noted that Horning was not a CPA, enrolled agent, tax attorney, or tax professional of any sort, nor did he have sufficient experience preparing tax returns. Thus he was not a professional upon whom Dr. Pankratz could reasonably rely. Dr. Pankratz lost here. His reliance on Horning to provide tax advice was not reasonable based on Horning’s lack of credentials as a tax expert.

As to provision of information required to sustain reasonable cause, the Tax Court noted a bit of a paradox. Dr. Pankratz provided all necessary information to the CPA but also did not provide the required appraisal. The distinction was that the Dr. Pankratz may not have known he was required to provide the appraisals before he prepared his return.

With respect to Dr. Pankratz’ good faith reliance on a his CPA, Dr. Pankratz lost because the CPA told Horning an appraisal was needed but neither Dr. Pankratz nor Horning ever obtained one. The Tax Court noted Dr. Pankratz was credible in his argument that nobody told him that he needed an appraisal. However, the Tax Court also noted he never had a meeting face-to-face with the CPA. Further, Dr. Pankratz admitted he never looked at his return. Noting such was not fatal, the Tax Court went further to see if Dr. Pankratz would have even reasonably noticed the problem if he had reviewed the returns. Here, Form 8283 was as damning as it could be. Plastered with clear language, any literate person could pretty much determine an appraisal would be required for gifts over $500,000 in value. Done. Any reliance by Dr Pankratz on his CPA was not reasonable.

Dr. Pankratz’s deduction with respect to the conference center was disallowed as well. Again, there was no appraisal and the exception (escape hatch) did not apply. Unfortunately, penalties did apply, and the Tax Court next determined the IRS procedurally met its burden of obtaining supervisory approval. Dr. Pankratz was unable to show good faith reliance again for penalty abatement.

Interestingly, the cost-segregation study was reasonably relied upon in good faith. While the parties agreed the deductions were properly disallowed, the reliance upon the draft study was reasonable and could be relied upon for penalty abatement even though the final opinion was not issued until 2010.

In the end, Dr. Pankratz lost tragically in his 2008 and 2009 tax battles. If there is anything positive for him to take home, he had the benefit of an objective review and Judge Holmes going down each potential rabbit hole, applying the law in a seemingly fair manner to offer any potential opportunity for relief after becoming intimately familiar with the facts of the case. Unfortunately, in most cases, relief did not exist for Dr. Pankratz.

[1] IRC §6751(b). Also note that the written approval must have occurred no later than the date of the issuance of the notice of deficiency or the date  an answer or amended answer is filed. See Chai v. Comm’r, 851 F.3d 190,221 (2d Cir. 2017) see also Graev v. Comm’r, 149 T.C. 485, 493-95 (2017)

[2] It is however unclear whether similar treatment will be received with respect to other types of reports for reliance purposes.

[3] https://www.youtube.com/watch?v=ObpcGNCU944

[4] U.S. v. Boyle, 469 U.S. 241, 246 (1985).

[5][5] See Alt. Healthcare Advocates v. Comm’r, 151 T.C. 225, 246 (2018).

[6] CNT Inv’rs, LLC v. Comm’r, 144 T.C. 161, 224 (2015).