The Tax Court’s denial of a $33 million charitable deduction was affirmed by the D.C. Circuit Court of Appeals in a decision handed down on May 24, 2019.1 While the purported dollar value of the donation makes this case stand out, it involves a number of important issues including gift substantiation, substantial compliance, valuation, and application of penalties. Also interesting is that the case involves Stephen Ross, owner of the Miami Dolphins and the University of Michigan’s largest donor.2
Most of the relevant facts are relatively straight forward. It is the application of the law to those facts which makes this case interesting. The general timeline of events is as follows:
- February 7, 2002:
- RS Hawthorne, LLC (“Hawthorne”) purchased a building in Hawthorne, CA for $42,350,000. The building was under a lease with AT&T ending in May 2016 subject to three, five-year renewal options. As part of financing the purchase, the property appraised for $47 million as of August 16, 2001. Hawthorne, LLC was owned 100% by RS Hawthorne Holdings, LLC (“RSHH”) which was in turn owned 100% by Read Sea Tech I, Inc. (“Red Sea”)
- Red Sea divided its membership interests in RSHH into two interests: (1) an interest for a term of years ending on December 31, 2020 (a term of years interests – “TOYS Interest”), and (2) the remainder interests (a successor member interest – “SMI”)
- Red Sea assigned the TOYS Interest to PVP-RSG Partnership and sold the SMI to RJS Realty Corporation for $1,610,000. Under the relevant agreements, and highly relevant in the case, the owner of the TOYS Interest was not personally liable for any waste on the property. Rather, the SMI holder could only look to the property to recover from any breach of the TOYS Interest holder’s legal obligations.
- March 2002: RERI, LLC (“RERI”) purchased the SMI from RJS Realty Corporation for $2,950,000.
- August 27, 2003: Pursuant to Stephen M. Ross’ pledge of $4 million to the University of Michigan, RERI assigned the SMI to the University of Michigan under an agreement that required the University to hold the interest for a minimum of two years.3
- 2004: RERI filed its 2003 income tax return claiming value of $32,935,000 for the donated SMI based on an appraisal attached to its return along with a Form 8283.4 However, the Form 8283 left blank the portion titled “Donor’s Cost or Adjusted Basis.” The value claimed for the donation generally was determined by obtaining a value of $55 million for a fee interest in the property and applying IRC §7520 tables to arrive at the value of the SMI remainder interest.5
- December 2005: The University of Michigan sold the SMI to HRK Real Estate Holdings, LLC for $1,940,000.6
- March 2008: After audit, the IRS issued a Notice of Final Partnership Administrative Adjustment disallowing $29 million of the deduction by valuing the SMI at $3.9 million.
- April 2008: RERI filed a Petition with the Tax Court challenging the IRS adjustment. In its Answer, the IRS asserted that RERI was not entitled to any deduction as the transaction was “a sham for tax purposes or lacks economic substance” with the alternative argument that the deduction should be limited to the $1,940,000 received by the University upon sale of the SMI. The IRS also asserted a 40% penalty for a gross valuation misstatement under IRC §6662(h)(1).
- July 3, 2017: The Tax Court issued its opinion denying any charitable deduction relating to the SMI in which the Tax Court held that failure to complete the “Donor’s Cost or Adjusted Basis” portion of Form 8283 precluded any deduction and applying the 40% gross valuation misstatement penalty (not agreeing to any of RERI’s reasonable cause defenses to application of that penalty). Interestingly, the Tax Court did not review the sham or economic substance arguments raised by the IRS, rather disallowing the deduction on other grounds.7
The structure of the transaction is as illustrated below:
It is on appeal from the July 3, 2017, Tax Court opinion that the D.C. Circuit Court of Appeals issued its opinion.
Gift Substantiation/Substantial Compliance
As outlined above, RERI failed to complete Form 8283 by leaving blank the line entitled “Donor’s Cost or Adjusted Basis.” The effect of this omission became a central issue in the case (with the IRS alternatively arguing that the appraisal was not a “qualified appraisal” as required which also would have disallowed the deduction). Both the Tax Court opinion and the opinion of the D.C. Circuit cite to RERI’s position that substantial compliance with the regulatory reporting obligations of Treas. Reg. § 1.170A-13 is required, not strict compliance.
The Tax Court found that substantial compliance is what is required.8 Therefore, even if a taxpayer fails to strictly comply with the regulations, the taxpayer still may prevail by showing substantial compliance. The test is “whether the donor provided sufficient information to permit the Commissioner to evaluate the reported contributions, as intended by Congress.”9 The IRS urged the D.C. Circuit to usethe more stringent test which would only excuse anything other than strict compliance if “(1) the taxpayer had a good excuse for failing to comply with the regulation, and (2) the regulation’s requirement is unimportant, unclear, or confusingly stated in the regulations or statute.”10
In the end, both the Tax Court and the D.C. Circuit found it unnecessary to evaluate the appropriate test for substantial compliance (or even whether substantial compliance can excuse failures to comply with Treas. Reg. § 1.170A-13) by finding that RERI’s omission could be excused regardless of what rule applies. Congress has specifically directed that cost basis be required in substantiation of charitable gifts.11 Further, the Court noted that cost basis information has “the broader purposes of assisting the IRS in detecting and deterring inflated valuations.” And that “there was in fact ‘a significant disparity between the claimed fair market value [$33 million] and the [$3 million] RERI paid to acquire the SMI just 17 months before it assigned the SMI to the University.’” As such, failure to report cost basis would not satisfy substantial compliance under any test.12
Having completely denied any charitable deduction due to failing to properly substantiate the value of the gift, valuation became relevant in determining application of penalties. Although the valuation issue was important only for this issue, it can be important for planners to understand the method of valuation accepted by the Court. Generally, tables published under IRC § 7520 are used to value “any annuity, any interest for life or a term of years, or any remainder or reversionary interest.”13 There are, however, exceptions to the use of the section 7520 tables.14 Relevant for RERI is the prohibition on the use of the section 7520 tables unless the legal documents “assure the property will be adequately preserved and protected (e.g., from erosion, invasion, depletion, or damage) until the remainder or reversionary interest takes effect in possession and enjoyment.”15 Otherwise, those risks are not reflected in the table assumptions. In the absence of the tables, “the actual fair market value of the interest (determined without regard to section 7520) is based on all facts and circumstances.”16
Using the section 7520 tables, based on the discount rate applicable at the time of the gift and the $55 million fair market value of the property, the gift would equal the value of the charitable deduction taken by RERI.17 Here, however, the relevant legal documents protected the TOYS Interest holder from liability for waste on the property. The SMI holder could only recover against the property by requiring an early forfeiture of the property, on which waste already would have occurred, from the TOYS Interest holder. Based on this, the Court found that RERI is prevented from using the 7520 tables because of a failure to assure that the property would be protected from waste.
Once the determination was made that the section 7520 tables could not be used to value the SMI, the Court was left to weigh the opinions of expert witnesses who testified at the Tax Court regarding the property’s value. Values determined by those experts ranted from $2,090,000 to $16,550,000. The differences related to primarily to projected cash flows and the applicable discount rate. In the end, the Court found the value of the SMI contributed to the University of Michigan to equal $3,462,886.
After discussion about certain procedural requirements for the assessment of penalties, the Court then analyzed the Tax Court’s assessment of the 40% gross valuation misstatement penalty.18 The “gross” valuation misstatement penalty applies if a taxpayer claims the value for a charitable deduction that is 400% or more than the true value.19 In such cases, a penalty of 40% of the resulting understatement applies.20
Other than as otherwise mentioned, at issue in the case were two primary legal issues: (1) the “attributable to” requirement of section 6662(h)(1), and (2) application of the “reasonable cause” exception to the imposition of penalties.
Since the accuracy-related penalty only applies to the portion of the underpayment “attributable to” the valuation misstatement, can the penalty apply when the underpayment is due to other reasons? Here, for example, RERI was denied a deduction for failing to properly substantiate the gift on Form 8283. Therefore, how could the underpayment be “attributable to” its valuation misstatement?
The Court analyzed that there can be multiple reasons for adjusting a charitable deduction. There is authority which indicates that a complete denial of the charitable deduction precludes satisfying this “attributable to” requirement, but the law in this area is not perfectly clear or uniform among the various Courts of Appeals.21 The Court reasoned that “a penalty is meant to deter and punish abuse of tax laws; those purposes would be frustrated if it were interpreted in such a way as to reward a taxpayer for committing multiple abuses.”22 The Court ultimately held that when alternative grounds for disallowing the deduction are supported based on a valuation misstatement, then the IRS should not be precluded from assessing the penalty against a taxpayer even when the ultimate denial is based on other grounds. The penalty assessment was upheld.
A taxpayer can avoid imposition of the valuation misstatement if the taxpayer can prove there was “reasonable cause” and the taxpayer acted “in good faith.”23 The statute goes on to require: (1) a qualified appraisal by a qualified appraiser, and (2) a good faith investigation by the taxpayer into the value of the contributed property.24 Without discussing whether there was a qualified appraisal by a qualified appraiser (something the IRS had denied in arguing RERI failed to satisfy its substantiation obligations), the Court found RERI did not act in good faith. As a separate requirement under the statute, good faith requires more than reliance on an appraisal. While RERI had certain arguments in its favor, the Court ultimately noted that the Tax Court record contained nothing which showed reliance on anything other than reviewing prior appraisals. There was no evidence of any investigation performed by RERI into the true value. As such, it failed to carry its burden of proof required to satisfy this exception.
This is an interesting case for a variety of reasons. Of course, any case where a $33 million deduction is denied will get some attention. Further, cases involving high profile taxpayers increase interest. Added to these elements is the involvement of a public university in a purported sham tax shelter. A handful of publications have written about this.25
Another issue for consideration here is the involvement of the University of Michigan. Consider the following:
- Stephen M. Ross has either given or pledged the University over $300 million.
- The University agreed to accept the gift without an appraisal of its value, contrary to University policy.
- The University agreed to hold the SMI for two years prior to resale, contrary to University policy to dispose of non-cash gifts promptly.
- The University ultimately sold the SMI to an entity bearing some relationship to Mr. Ross (his attorney and CPA) for a one-third of its appraised value after pressure from Mr. Ross in spite of University policy to sell property at fair market value.26
The University denies any wrongdoing, and maybe they are right.27 However, these and other facts raise questions about whether the University simply was willing to voluntarily assist a major donor in claiming unsustainable charitable deductions.
Certainly, the facts here raise eyebrows. RERI purchased the SMI for approx. $3 million around a year and a half before donating it to the University of Michigan. Just over two years after the gift, the University sold the SMI for approx. $2 million (sold to Mr. Ross’ attorney and CPA after threats by Mr. Ross, fulfilling only part of his pledge). However, notwithstanding these sales between $2 million and $3 million, RERI claimed a deduction for approx. $33 million. This is more than ten times the higher of the two actual sales prices and follows a series of transactions which at least appear to violate University policy.
How can something which sells between $2 million and $3 million generate a $33 million charitable deduction? The answer is by reliance on the section 7520 tables. Assuming the $55 million valuation was correct, then it the $33 million deduction may have been valid absent the terms of the applicable legal documents. It is clear that the section 7520 tables do not produce exactly accurate valuations but are used in the interests of certainty and efficiency. In cases where that inaccuracy benefits the taxpayer, taxpayers and their advisors may seek to use the section 7520 tables to take advantage of that inaccuracy. While I have seen cases where the section 7520 tables produce favorable results, the numbers in this case illustrate a major departure from reality.
Seeing the huge disparity in this case, the IRS pursued action. This case is one in a line of cases where the IRS (and Department of Justice) has actively pursued litigation involving what it perceives as abusive charitable planning.28 However, RERI may have gotten away with its deduction. If the relevant legal documents had not precluded use of the section 7520 tables and the Form 8283 had been fully completed, it is quite possible there would have been no grounds on which to deny the deduction. Although the IRS alleged the transaction was “a sham for tax purposes or lacks economic substance,” would the IRS have taken the case to trial on those arguments alone? What would the IRS’ arguments have been to substantiate those positions? Would the courts have sided with the IRS, especially when valuation based on section 7520 tables are specifically sanctioned by statute?
The IRS has its sights on what it perceives to be abusive charitable deductions. Taking a deduction of ten times the SMI’s true value puts this transaction squarely within those types of transactions. While the form of the transaction may be permissible, RERI failed to avoid technical problems which were its undoing (i.e. use of 7520 tables and complete Form 8283). Anyone engaging in tax planning which attempts to benefit from permitted legal structures in a way the IRS may perceive as abusive is well served to ensure that every single element of the plan is fully compliant with the intended benefit. As stated above, had RERI done so, it is possible it could have prevailed even though the results seem to be “too good to be true,” abusive, or whatever other description anyone may prefer to use. However, it also is possible the IRS could have prevailed on its arguments of sham transaction and lack of economic substance. From these cases, we do not know. Taxpayers engaging in this type of planning must beware of the potential pitfalls.
- Blau v. Commissioner of Internal Revenue Service, 2019 WL 2236815 (D.C. Cir. May 24, 2019). https://www.cadc.uscourts.gov/internet/opinions.nsf/24259E66C2EAE51F85258404004EBA72/$file/17-1266.pdf
- Dolan, Matthew and David Jesse, How Stephen M. Ross’ Gift to the University of Michigan Ended up in Tax Court, Detroit Free Press, August 27, 2017, https://www.freep.com/story/news/local/michigan/2017/08/27/stephen-ross-tax-break-gift-michigan/563170001/ (last visited June 2, 2019).
- This two-year requirement was presumably to prevent the University from being required to file a Form 8282 with the IRS disclosing a sale of the SMI which, among other items, would state the price received by the University in a sale of the SMI.
- A Form 8283 is required for noncash gifts exceeding $500. See Treas. Reg. §1.170A-13(c).
- For an example of how this calculation works, see IRS Publication 1459.
- Although not relevant for the Court’s decision, the SMI was purchased from the University by an entity beneficially owned by Mr. Ross’ attorney and CPA, both ow whom later pled guilty to felony obstruction and tax evasion for their participation in a number of unrelated transactions. See supra Note 2.
- RERI Holdings I, LLC v. Commissioner, 149 T.C. 1 (2017).
- Here, the Tax Court cited to Bond v. Commissioner, 100 T.C. 32, 40-41 (1993).
- Citing Smith v. Commissioner, 94 T.C. Memo 2007-368.
- This test has been adopted by the Fourth, Fifth, and Seventh Circuits. See Volvo Trucks of N. Am., Inc. v. United States, 367 F.3d 204, 210 (4th Cir. 2004); McAlpine v. Comm’r, 968 F.2d 459, 462 (5th Cir. 1992); Prussner v. United States, 896 F.2d 218, 224 (7th Cir. 1990).
- Deficit Reduction Act of 1984 (DRA), Pub. L. No. 983-69, §155(a)(1), 98 Stat. 494,691.
- See also Belair Woods, LLC v. Commissioner, T.C. Memo 2018-159. We previously wrote on this case the “Another Technicality Attack by the IRS in Belair Woods,” https://esapllc.confit.dev/another-technicality-attack-irs-belair-woods/.
- IRC §7520(a).
- IRC §7520(b) and Treas. Reg. §1.7520-3.
- Treas. Reg. §1.7520-3(b)(2)(iii).
- Treas. Reg. §1.7520-3(a)(1)(iii).
- I note here that the valuation was of the property owned by Hawthorne, not of the membership interests in RSHH. Since the SMI was not an interest in real property but rather a remainder interests in LLC membership interests, I also question the viability of an appraisal of the underlying real property rather than of the LLC interests.
- This discussion centered on the IRC § 6751(b)(1) requirement for personal approval of a supervisor prior to assessment of penalties and RERI’s failure to raise its objection before the Tax Court. See Graev v. Commissioner, 147 T.C. 460, 478 (2016). We previously have written about this issue in “IRS Wins Short Sale Case but Makes a ‘Graev’ Error in a Case Where the Tax Court Acknowledges the Turbo Tax Defense,” https://esapllc.confit.dev/irs-wins-short-sale-case-but-makes-a-graev-error-in-a-case-where-the-tax-court-acknowledges-the-turbo-tax-defense/.
- IRC §6662(h)(2)(A).
- IRC §662(a) and (h)(1).
- See Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988); McCrary v. Commissioner, 92 T.C. 827 (1989); and 885 Inv. Co. v. Commissioner, 95 T.C. 156 (1990). But see AHG Invs., LLC v. Commissioner, 140 T.C. 73 (2013), which overruled these prior decisions. Note also that the Fifth and Ninth Circuits may continue to apply this rule. See Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 2012); Bemont Invs., LLC v. U.S., 679 F.3d 339 (5th Cir. 2012) (at least two judges, however, indicated the rule “may be misguided”); Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990); and Keller v. Commissioner, 556 F.3d 1056 (9th Cir. 2009) (also indicating in dicta that the rule may not be impenetrable).
- Citing Fidelity Int’l Currency Advisor A Fund, LLC v. U.S. 661 F.3d 667 (1st Cir. 2011).
- IRC §6664(c).
- IRC §6664(c)(3).
- See, e.g., supra Note 2; Reilly, Peter J., Billionaire Stephen Ross and the Ten for One Charitable Deduction, Forbes, July 17, 2017, https://www.forbes.com/sites/peterjreilly/2017/07/17/billionaire-stephen-ross-and-the-ten-for-one-charitable-deduction/#689780e12bca (last visited June 2, 2019); Reilly, Peter J., Denial of $33M Deduction that Yielded $2M to University of Michigan Upheld on Appeal, Forbes, May 26, 2019, https://www.forbes.com/sites/peterjreilly/2019/05/26/denial-of-33m-deduction-that-yielded-2m-to-university-of-michigan-upheld-on-appeal/#7bf6fa394ebe (last visited June 2, 2019); Harring, Alex, Court of Appeals Reaffirms Stephen Ross, Associates Overstated Property Value, The Michigan Daily, May 24, 2019, https://www.michigandaily.com/section/government/court-appeals-finds-stephen-ross-associates-overstated-donation-value (last visited June 2, 2019).
- Supra Note 2.
- Id. (see attached letter from the University’s counsel).
- See, e.g., supra Note 12; and our articles “IRS Continues Aggressive Stance on Charitable Contributions,” https://esapllc.confit.dev/chrem-case/; “DOJ vs. Ecovest Capital, LLC – A New Frontier in Tax Shelter Litigation?, ” https://esapllc.confit.dev/doj-vs-ecovest-capital-llc-a-new-frontier-in-tax-shelter-litigation/.