Tax Law Update: March 2018

David A. Handler and Alison E. Lothes highlight the most important tax law developments of the past month.

• Tenth Circuit decides that a charitable deduction under Internal Revenue Code Section 642(c) is limited to taxpayer’s adjusted basis in the property donated—In Green v. United States (2018-1 U.S.T.C. (Jan. 12, 2018)), the U.S. Court of Appeals for the Tenth Circuit addressed the deduction for a donation of real estate by a trust under IRC Section 642(c).   

The taxpayer was an irrevocable, non-grantor trust established by David and Barbara Green. On its income tax returns for 2004, as amended, the trust deducted the fair market value (FMV) of certain real properties donated to charities, which was around $29 million. The Internal Revenue Service disallowed the deduction, stating that the charitable contribution deduction is limited to the trust’s basis in the properties. The trustee appealed, and the district court granted the trust’s motion for summary judgment, holding that as a matter of law, the deduction under Section 642(c) is based on the FMV of the property contributed to the charity. The IRS appealed to the Tenth Circuit.

Section 642(c) governs the charitable income tax deduction for estates and trusts. It requires that the charitable contribution made by an estate or trust be a qualifying charitable contribution under IRC Section 170(c) from gross income and that the contribution be authorized by the terms of the governing instrument.

The terms of the trust authorized distributions to charities. The trust didn’t direct that charitable contributions were to be paid from income, but the trustee had full power to determine what receipts and expenses constituted or were paid from income or principal.  

The trust owned a 99 percent interest in a limited partnership (LP) that owned retail stores nationwide. The LP made distributions to the trust, and the trust used that income to purchase real estate (through a wholly owned limited liability company), which it then donated to charities.

The question presented to the Tenth Circuit was how to define the amount of the charitable contribution that derived from gross income and was therefore eligible for the deduction. Neither Section 642(c) nor its regulations definitively answered this question. The IRS and the trust both agreed that to be eligible for the deduction, the property donated had to be derived from or traceable to gross income. Here, because the real estate was purchased with gross income, its donation was treated as a donation from gross income and therefore was eligible for the deduction. The trust didn’t specify whether distributions to charity were limited to the trust’s principal or income, but that apparently had no effect, as long as the donation of the properties was, in fact, traceable to income.  

That left the question of valuation. The appeals court ultimately agreed with the IRS’ interpretation, holding that the deduction should be limited to the taxpayer’s adjusted basis in the donated property, which represents the amount of gross income that the taxpayer used to pay for the real estate. The court was persuaded by the IRS’ argument that because the trust never sold or exchanged the properties, it didn’t realize the gains associated with the increase in value. Because it wasn’t taxed on those gains (that is, unrealized appreciation isn’t part of gross income), it shouldn’t be able to benefit by deducting their value. It held that until Congress indicates clear intent that the charitable deduction under Section 642(c) should extend to include unrealized gains, the deduction should be limited to the adjusted basis.  

This case highlights the differences between the rules for charitable deductions for estates and trusts under Section 642(c), which are subject to this requirement that the property contributed derive from gross income, and the rules governing charitable deductions for other taxpayers under Section 170. For example, charitable deductions for trusts are unlimited with no carryforward, but must be paid out of income or traceable to income, while deductions for individuals are subject to limits tied to adjusted gross income with a 5-year carryforward.  

• District court awards attorney’s fees to taxpayer, finding IRS arguments weren’t substantially justified—In Johnson, Smith et al. v. U.S. (Dist. Ct. Utah, (Jan. 8, 2018)), the government sought to collect estate taxes from the beneficiaries of the estate of Anna S. Smith, from beneficiaries of certain life insurance policies and from Johnson and Smith, as trustees of a trust. After years of litigation, the defendants ultimately prevailed on every issue except for liability relating to life insurance benefits received. Johnson and Smith then filed a motion for attorney’s fees and certain costs under IRC Section 7430, which provides that a prevailing party may be awarded a judgment for reasonable litigation costs in a court proceeding brought by the United States in connection with the collection of tax. That section defines a prevailing party to be a person (other than the government) with a net worth of less than $2 million at the time the proceeding commenced and who has substantially prevailed with respect to the amount in controversy or substantially prevailed with respect to the most significant issues presented.

The United States conceded that the defendants met this standard. However, it argued that a statutory exception applied, namely that the government’s position was substantially justified. If the government’s position had a reasonable basis in law and fact, then the defendants wouldn’t be treated as a “prevailing party” under Section 7430, and the fees/costs couldn’t be awarded.

Fortunately for the defendants, the court found that the government’s position wasn’t substantially justified with respect to the claims related to the fees sought. The defendants had segregated the fees sought according to each claim and limited their fee request to those related to just three of the claims. On each of those three claims, the court held that the government’s position wasn’t reasonable.  

The government argued that the defendants didn’t receive a valid discharge of personal liability under IRC Section 2204 by furnishing a IRC Section 6324A special lien because they didn’t make a written request for the discharge. Further, the IRS argued that it was justified in rejecting the defendants’ Section 6324A lien that used closely held stock as collateral. However, the court held that there was no legal support for requiring a discharge application to be in a specific format. The opinion concluded that the government’s discretionary rejection of the special lien was unreasonable, noting that the government contradicted its own guidance, misinterpreted or ignored statutory language and never attempted to show the value of the closely held stock or conclude that such value was insufficient.

In addition, the court held that the government never presented any factual or legal arguments in support of its claim that the trust assets were includible in Anna’s estate and therefore could trigger liability for Johnson and Smith as trustees under IRC Section 6324(a)(2). That IRC section imposes personal liability on certain persons (spouses, transferees, persons in possession, trustees) if estate tax isn’t paid, but only if the assets transferred to or possessed or held by the persons are included in the taxable estate. Without any reasonable basis for including the trust assets in the taxable estate, the court held the government’s position wasn’t substantially justified.

Lastly, the court wasn’t convinced by the government’s arguments to treat itself as a third-party beneficiary of the distribution agreement signed by the estate and its beneficiaries and foreclose on its tax lien. It noted that the government delayed and made numerous mistakes by releasing the tax lien (not just once, but twice). Further, because the defendants had provided a valid Section 6324A special tax lien, there was no lien at all under the distribution agreement on which to foreclose. Calling the government’s actions a “parade of legal and factual errors,” the court held that the defendants were entitled to reimbursement for all the requested legal costs, totaling over $300,000.

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