In RERI Holdings I, LLC, et al v. Commissioner, the Tax Court has held that a partnership may not deduct a charitable remainder interest that it donated to a university because it omitted its basis in the interest from its Form 8283, Noncash Charitable Contributions. The Court also concluded that the partnership is liable for substantial and gross misstatement penalties.

Background

On its partnership income tax return for 2003, RERI Holdings I (RERI) claimed a $33 million charitable contribution deduction stemming from its transfer of noncash assets to the Regents of the University of Michigan. In a Final Partnership Administrative Adjustment (FPAA) issued in March 2008, the IRS asserted that the contributed property was worth $3.9 million and, as a result, reduced the claimed charitable deduction and determined that the claimed deduction resulted in a substantial valuation misstatement under Section 6662(e)(1). The IRS later amended its answer twice, first asserting alternative arguments that either: (1) RERI was not entitled to any deduction for the contribution because the transaction "was a sham for tax purposes or lacked economic substance"; or (2) the deduction should be limited to the amount ($1.94 million) that the university realized on its sale of the property. Amending its answer a second time, the IRS asserted that the claimed deduction resulted in a gross valuation misstatement under Section 6662(h)(2).

Facts

In October 2000, Intergate leased land and a web hosting facility it owned in Hawthorne, California (Hawthorne property) to AT&T for an initial term of 15.5 years, with options to renew for 5-year terms. The annual rent for this 288,000-square-foot property in the initial lease term ranged from $3.89 million to $5.64 million.

In July 2001, Red Sea Tech I (Red Sea) acquired the Hawthorne property from Intergate. In February 2002, Red Sea assigned the right, title, and interest in its contract with Intergate to RS Hawthorne LLC (Hawthorne). Three days later, Hawthorne purchased the Hawthorne property from Intergate, subject to the AT&T lease, paying $42.35 million. At the time, RS Hawthorne Holdings LLC (Holdings) was Hawthorne's sole member, and Red Sea was Holdings' sole member. An appraisal report, prepared by the bank holding the mortgage that financed Hawthorne's purchase of the Hawthorne property, determined the property was worth $47 million as of August 16, 2001.

In a February 2002 assignment, Red Sea assigned its member interest in Holdings to RJS Realty Corp. (RJS), but reserved an estate that expires December 31, 2020. This term-of-years interest is referred to as a TOYS interest, while the remainder interest is referred to as a successor member interest or SMI. If Red Sea breached the conditions of the assignment, the only recourse would be early forfeiture of the TOYS interest.

In March 2002, RERI contracted with RJS to buy SMI for $2.95 million. The agreement stated that Holdings continued to own 100% of the beneficial interest in Hawthorne, which in turn continued to own the Hawthorne property. Later in March 2002, RJS assigned the SMI to RERI, and in August 2003 RERI assigned the SMI to the University of Michigan.

An appraisal prepared for RERI in September 2003 assigned a $55 million value to the fee interest in the Hawthorne property. The appraiser then multiplied this estimate "by an actuarial factor purportedly provided in [S]ection 7520 to arrive at an 'investment value' of the SMI," which essentially was the amount that RERI claimed as a charitable contribution deduction. The Form 8283 appraisal summary that RERI attached to its 2003 income tax return showed that RERI purchased the SMI in March 2002 but did not provide any amount in the space labeled "Donor's cost or other adjusted basis."

Another appraiser testified on behalf of RERI that the SMI had a $16.55 million market value as of August 2003. Testimony by a third appraiser for RERI "described general consideration relative to determining [the SMI's value in August 2003] tended to support the approach taken by [the second appraiser] and the result he reached."

In contrast, an appraiser testifying for the IRS asserted that "the SMI was worth no more than $1.65 million in April 2002." A valuation and litigation consultant for the IRS estimated the SMI was worth approximately $3.38 million as of August 2003.

Noting that the charitable contribution deduction at issue "is a partnership item that is subject to determination in this partnership-level proceeding," the Court concluded that it had jurisdiction to consider the petition in this case.

Law and analysis

Reg. Section 1.170A-13(c) provides substantiation requirements for charitable contributions of property worth more than $5,000 that partnerships, and certain other donors, have made after December 31, 1984. To meet these requirements, the donor must obtain a qualified appraisal of the property being donated and "attach a 'fully completed' appraisal summary to the return on which the deduction is first claimed"; this summary must include the adjusted cost or other basis of the donated property (Reg. Section 1.170A-13(c)(4)(ii)(E)). Nonetheless, Tax Court precedent (Bond v. Commissioner, 100 T.C. 32 (1993)) provides that the reporting requirements in Reg. Section 1.170A-13 is "directory and not mandatory," meaning that a taxpayer demonstrating substantial compliance may be excused from the requirements.

In the instant case, RERI's failure to fill in the space provided for "Donor's cost or other adjusted basis" on Form 8283 meant the form failed to satisfy the reporting requirements under Reg. Section 1.170A-13(c)(4)(ii)(E). Because the omission prevented the Form 8283 from achieving its intended purpose, the Tax Court concluded that RERI did not substantially comply with the regulatory reporting requirements. Further, the Court added, if the Form 8283 had included the donor's basis, the IRS would have been alerted "to a potential overvaluation of the SMI" based on the "significant disparity between the claimed fair market value and the price RERI paid to acquire the SMI just 17 months before it assigned the SMI to the University." RERI's failure to meet the substantiation requirements of Reg. Section 1.170A-13(c)(2) meant that it was not entitled to any Section 170 deduction for its contribution of the SMI to the university, the Court concluded.

The Court next addressed whether any substantial valuation misstatement penalties under Section 6662(e)(1) or gross valuation misstatement penalties under Section 6662(h)(2) could be assessed when the underpayment resulted from the disallowance of RERI's claimed deduction. In other words, is the underpayment resulting from the disallowance of the deduction "attributable to" a gross or substantial misstatement even though that disallowance results not from RERI's misstatement of value but from the partnership's failure to substantiate the charitable deduction?

The Court began its reasoning by citing a line of cases following Todd v. Commissioner, 89 T.C. 912 (1987), aff'd, 862 F.2d 540 (5th Cir. 1988), in which it ruled that valuation misstatement penalties do not apply to a taxpayer when the misstatement results from the complete disallowance of the taxpayer's deductions on grounds unrelated to valuation, not from a valuation misstatement . In McCrary v. Commissioner, 92 T.C. 827 (1989), the Court extended Todd to a situation in which the taxpayers conceded they were not entitled to claimed investment tax credits in order to avoid the valuation overstatement penalty. Finally, the Court followed Todd in 855 Inv. Co. v. Commissioner, 95 T.C. 159 (1990), to hold that the taxpayers were not subject to the overstatement penalty because the Court disallowed a charitable contribution deduction.

The Court noted, however, that it had essentially overruled these cases in AHG Invs., LLC v. Commissioner, 140 T.C. 73 (2013). In AHG, the taxpayer (like in McCrary) conceded it was not entitled to a disallowed loss because its investment was not at risk under Section 465. The Court found the taxpayer made the concession in an attempt to avoid the gross valuation misstatement penalty. The Court determined that the taxpayer could not avoid the penalty merely by conceding a deduction or credit on a ground unrelated to a valuation issue.

In the instant case, the Court ruled that, "if a taxpayer claims a deduction that overstates by 200% or 400% the value or basis of property, any underpayment resulting from the disallowance of that deduction on grounds unrelated to valuation is nonetheless 'attributable to' the valuation misstatement, within the meaning of [S]ection 6662(b)(3) and (h)(1), to the extent that the underpayment relates to the disallowance of that portion of the deduction that exceeds the property's correct value of basis."

To determine whether the value of the SMI that RERI reported on its return amounted to either a substantial or gross valuation misstatement, the Court looked at whether the value of the SMI must be determined under the prescribed interest rate and actuarial tables of Section 7520. The IRS argued that "the SMI is a restricted beneficial interest and that it does not meet the adequate protection requirement of [Reg. Section] 1.7520-3(b)(2)(iii)." The Tax Court agreed that "the inability of the SMI holder to recover damages for waste or other acts that prejudice its interests exposes the SMI holder to a sufficient risk of impairment in value that the SMI holder does not enjoy a level of protection consistent with that provided by the law of trusts."

Because the value of the SMI, for purposes of determining the amount of the deduction that RERI would have been allowed if it had complied with the statutory substantiation requirements, "would not have been the SMI's present value determined under [S]ection 7520," the deductible amount would have been the fair market value of the SMI on the date RERI assigned it to the university, which the Court concluded to be $3.46 million. Finding that the $33 million charitable contribution deduction RERI claimed exceeded the $3.46 million fair market value by 953.5%, the Court concluded that RERI had both substantially (by more than 200%) and grossly (by more than 400%) misstated the value of the SMI contribution.

Further, the Court concluded that the Section 6664(c)(4) reasonable cause exception did not apply to excuse a valuation misstatement in the instant case, because the claimed value of the deduction was not based on a qualified appraisal.

Implications

This is an interesting case for several reasons. First, the Court affirms its recent position in AHG that valuation misstatement penalties apply even when the deduction or credit is disallowed in its entirety. Thus, as here, even when valuation is not a deciding factor in the primary issue before the court, the court must determine valuation for purposes of applying the valuation penalties, which the Todd Court concluded "would prolong and multiply litigation, is contrary to sound judicial administration and appears contrary to congressional intent to reduce our case load." The Court's reversal of judgment seems to stem from a desire to prevent taxpayers from avoiding the valuation penalties simply by conceding that they were not entitled to the claimed deduction or credit.

Second, and more importantly, this is another case in which the Tax Court concludes procedural foot-faults are fatal to the deductibility of a contribution (whatever the value), even though the regulations and instructions to Form 8283 provide express opportunities to correct or explain foot-faults.

Reg. Section 1.170A-13(c) requires the taxpayer to provide: (1) a qualified appraisal of the property being donated and (2) "a 'fully completed' appraisal summary (a/k/a/ Form 8283) [attached] to the return on which the deduction is first claimed." Although it is well settled that the failure to have (1) is fatal, the RERI Court seems to say that the failure to have (2) is fatal, as well, without indicating whether the IRS provided the taxpayer the opportunity to explain or correct its incomplete appraisal summary.

Opportunity to explain reasonable cause: Reg. Section 1.170A-13(c)(4)(iv)(C)(1) directs a taxpayer that "has reasonable cause for being unable to provide the information required by paragraph (c)(4)(ii)(D) and (E) of this section (relating to the manner of acquisition and basis of the contributed property)" to attach "an appropriate explanation … to the appraisal summary." The regulations emphasize that the "taxpayer's deduction will not be disallowed simply because of the inability (for reasonable cause) to provide these items of information." Apparently RERI did not provide this statement, but the Court didn't expressly say so. It would have been helpful it if did.

The instructions to the Form 8283 are also clear: "If you have reasonable cause for not providing the information in columns (d), (e), or (f), attach an explanation so your deduction will not automatically be disallowed."

Opportunity to correct: Reg. Section 1.170A-13(c)(4)(iv)(H) allows a taxpayer to correct a procedural error regarding the inclusion of a fully completed appraisal summary, providing that, "[i]f such a request is made and the donor complies with the request within the 90-day period, the deduction under section 170 shall not be disallowed for failure to attach the appraisal summary, provided that the donor's failure to attach the appraisal summary was a good faith omission and the requirements of paragraph (c)(3) and (4) of this section are met (including the completion of the qualified appraisal prior to the date specified in paragraph (c)(3)(iv)(B) of this section)."

Note, as well, that the regulations and the instructions allow the taxpayer to claim the deduction even if a Form 8283 is not attached to the return, as long as it is provided to the IRS within 90 days of an IRS request. In other words, although initial omission of the Form 8283 is not fatal, the RERI Court seems to say that filing an incomplete Form 8283 is fatal.

Ultimately, we do not know whether the IRS requested that RERI: (1) submit the "fully completed" appraisal summary within 90 days of the request; or (2) explain its failure to include the basis amount on Form 8283. If the IRS did not request a fully completed appraisal summary, there is some question as to whether the Court could rightly deny the deduction because the IRS did not follow the regulation.

All of the technical and procedural issues aside, the IRS could view this holding as allowing it to categorically disallow charitable contributions if certain information is missing from the Form 8283 attached to the taxpayer's return. If it does, we hope that it will exercise administrative restraint. As Spiderman's Stan Lee famously noted, "With great power comes great responsibility."

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