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 million tax deduction it had taken on its 2003 tax return for a charitable gift and was subject to a 40 percent penalty of the $29.5 million difference between the deduction taken and the fair market value (FMV) of the interest gifted. The ruling illustrates the importance of full and accurate compliance when claiming charitable deductions. Here’s what happened:
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 Dec. 31, 2020. Thereafter, the entire Holdings interest reverts 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 million.
RERI then turned around, in August 2003, and assigned the SMI to a university, for which it took a $33 million tax deduction, backed by an appraisal that determined the investment value of the SMI. The qualified appraisal 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 Internal Revenue Code Section 7520 tables.
Two Fatal Errors
As it turns out, RERI’s 2003 tax return contains two fatal errors:
- The Form 8283 appraisal summary attached to the return indicated, correctly, 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 IRC Section 7520 tables, but these tables only apply when 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.” When the standard table factors can’t 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 going to be much lower than the Section 7520 table value.
Unfortunately for the taxpayer in this case, 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 couldn’t 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 wouldn’t be able to recover damages from the TOYS interest holder (due to exculpatory clauses in the agreements). Thus, the Tax Court held, the SMI isn’t a remainder interest subject to the Section 7520 tables and must be valued under the standard willing buyer, willing seller FMV test.
Review of Valuations
While the court appears to find some fault with all of the appraisals presented in the case, it clearly placed more weight on the government’s appraisers. It reviewed the following valuations:
- $33 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 determined an FMV of the SMI of $3.5 million as of August 27, 2003.
Holding that the taxpayer didn’t in “good faith” investigate the value claimed on its 2003 tax return (notwithstanding filing with an appraisal attached), the court found 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 it is, this penalty issue 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.
Lessons Learned
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:
- Full and accurate compliance is crucial when claiming charitable deductions. Clearly, including the actual cost basis of the property donated on the Form 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 toward applying penalties even when 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 Section 7520 applied, the Tax Court appears to imply, the transaction may have worked, and the deduction could have been good.
Unless this decision is reversed on appeal, 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 Internal Revenue Service.
Endnote
1. Treasury Regulations Section 1.7520-3(b)(2)(iii).