D.C. Circuit Upholds Tax Court's Denial of Charitable Deduction for Remainder Interest

(Parker Tax Publishing June 2019)

The D.C. Circuit affirmed a Tax Court decision holding that a taxpayer was not entitled to any deduction for a claimed charitable contribution of a remainder interest in commercial property, which was valued by the taxpayer at $33 million, because the taxpayer failed to disclose the basis in the donated property and therefore did not meet the substantiation requirements in Reg. Sec. 1.170A-13(c). The D.C. Circuit also upheld the imposition of a 40 percent gross valuation misstatement penalty because the stated value of the property was more than 400 percent of the true value of the property as determined by the Tax Court. Blau v. Comm'r, 2019 PTC 200 (D.C. Cir. 2019).

Background

In March 2002, RERI Holdings I, LLC (RERI), a partnership, paid $2.95 million to acquire a remainder interest in land and a web hosting facility located in California. In a series of transactions, RERI acquired the remainder interest in the property, donated it to the University of Michigan, and claimed a charitable contribution deduction of $33 million. RERI's valuation of the donated property was based on an appraisal which RERI attached to its tax return. RERI also completed a Form 8283, Noncash Charitable Contributions. However, RERI left blank the space for "Donor's cost or adjusted basis." It did not provide any explanation for the omission.

The IRS audited RERI and issued a final partnership administrative adjustment (FPAA) in 2008 to RERI's tax matters partner, Jeff Blau. The FPAA reduced RERI's deduction for the remainder interest on the ground that the contributed property was worth only $3.9 million. A substantial valuation misstatement penalty under Code Sec. 6662(e)(1) was also applied. In 2008, RERI filed a petition for readjustment of partnership items with the Tax Court. In response, the IRS asserted that RERI was not entitled to any deduction for the contribution because it was part of a sham transaction or lacked economic substance. Alternatively, the IRS argued that the deduction should be limited to $1.9 million, the amount which the university realized when it sold the contributed property approximately two years after the donation. The IRS also stated that RERI's claimed deduction resulted in a gross valuation misstatement under Code Sec. 6662(h)(2).

Tax Court's Analysis

The Tax Court held that RERI was not entitled to any charitable contribution deduction and upheld the IRS's assessment of the 40 percent penalty. However, the Tax Court did not base its decision on the lack of economic substance theory advanced by the IRS. Instead, it concluded that RERI failed to substantiate the value of the donated property as required by Reg. Sec. 1.170A-13(c)(2). Under the regulation, a taxpayer claiming a deduction for a noncash charitable contribution over $5,000 must (1) obtain a qualified appraisal, (2) attach an appraisal summary (provided on a Form 8283) to its tax return, and (3) maintain records containing specified information. Under Reg. Sec. 1.170A-13(c)(4), one of the necessary elements in an appraisal summary is the cost or other basis of the property.

The Tax Court held that a taxpayer who substantially complies with the requirements in Reg. Sec. 1.170A-13 is entitled to the deduction, but concluded that RERI's failure to disclose its basis in the donated property was not substantial compliance. The Tax Court also upheld the imposition of the 40 percent gross valuation misstatement penalty because RERI's stated value of the donated property ($33 million) was more than 400 percent of the property's true value, which the Tax Court determined was $3.4 million.

RERI appealed to the D.C. Circuit. It argued that the basis in donated property is not necessary for the IRS to evaluate a charitable contribution because the deductible amount is the fair market value (FMV), and the basis is not an input in calculating the FMV. Alternatively, RERI contended that the omission of a number in a tax filing is typically construed as zero, and that a zero provides the same red flag to the IRS as does an unusually low basis. RERI also objected to the imposition of the gross valuation misstatement penalty. One of its arguments against the penalty was that an accuracy-related penalty applies only to the portion of the underpayment "attributable to" a gross valuation misstatement, but the Tax Court disallowed RERI's deduction based on its failure to properly substantiate the donation. RERI cited decisions in the Fifth and Ninth Circuits concluding that, when there is another reason for disallowing a deduction, the taxpayer's overvaluation becomes irrelevant to the determination of any tax due.

D.C. Circuit Affirms

The D.C. Circuit affirmed the Tax Court's denial of RERI's deduction for lack of substantiation and upheld the imposition of the gross valuation misstatement penalty. Although the D.C. Circuit did not hold that substantial compliance is sufficient to satisfy the Reg. Sec. 1.170A-13 substantiation requirements, it assumed that substantial compliance was sufficient and held that under that standard, RERI failed to comply because it did not disclose its basis in the donated property. The court found that when Congress passed legislation directing the IRS to increase the stringency of its verification requirements, it specifically identified the basis and the date of acquisition as the bare minimum that a taxpayer must provide. The D.C. Circuit also rejected RERI's argument that omission of a number is the same as a zero. The court noted that the regulations require a donor to substitute an explanatory statement if it is unable to provide cost basis information. The IRS therefore reasonably chose not to automatically treat a blank box as a zero, in the court's view.

With respect to the 40 percent gross valuation misstatement penalty, the D.C. Circuit rejected RERI's "attributable to" argument, noting that the Tax Court found both that RERI misstated the value of the donated property and inadequately substantiated the deduction. The court noted that Code Sec. 6662 does not require only a single cause for an underpayment. It also agreed with the First and Federal Circuits that the decisions cited by RERI in the Fifth and Ninth Circuits were based on a misreading of the relevant legislative history. In the D.C. Circuit's view, the correct rule is that, when the IRS disallows two different deductions, but only one disallowance is based on a valuation misstatement, the valuation misstatement penalty should apply only to the deduction taken on the valuation misstatement. The error of the Fifth and Ninth Circuits, according to the D.C. Circuit, was to apply this rule where one deduction is disallowed based on both valuation misstatement and non-valuation misstatement theories. The D.C. Circuit concluded that, because the Tax Court determined that RERI made a gross valuation misstatement and that misstatement was an independent alternative ground for adjusting RERI's deduction, the penalty properly applied. The D.C. Circuit also found that RERI did not qualify for the reasonable cause defense to the penalty because RERI produced no evidence that it conducted a good faith investigation of the property's value beyond the appraisal as required under Code Sec. 6664(c)(3)(B).

For a discussion of the substantiation requirements for noncash contributions over $5,000, see Parker Tax ¶84,190. For a discussion of the accuracy related penalty for substantial or gross valuation misstatements, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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