Article: Taxpayers Hoisted by Their Own Petard! Lex Dura Lex Sed Lex!!!

Article: Taxpayers Hoisted by Their Own Petard! Lex Dura Lex Sed Lex!!!

Article posted in U.S. Tax Court on 29 June 2012| comments
audience: National Publication | last updated: 5 July 2012
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By Paul Hood

In a fact rich memorandum decision, Judge Holmes of the Tax Court decided that the taxpayers were properly denied charitable contribution deductions for very large and possibly undervalued pre-IRC Secs. 170(f)(11)(C) and (D) donations of real estate to a charitable remainder unitrust because they failed to comply with Treas. Reg. Sec. 1.170A-13(c), which is the regulation that spells out proper appraisals and documentation of charitable contributions of property that exceeds $5,000 in value.  In so doing, the Tax Court expressly found Treas. Reg. Sec. 1.170A-13(c)(2) to be valid under the Chevron test.  The Tax Court declined the taxpayers’ invitation to find the regulation invalid.

Facts

In 2003, the Mohameds donated five very valuable properties to a charitable remainder unitrust (“CRUT”) that they had established back in 1998.  Mr. Mohamed, entrepreneur, a licensed real estate broker and a real estate appraiser, prepared his own 2003 joint income tax return, and he identified the 2003 donations on Form 8283, which he filled out both as donor and donee (he was the trustee of the CRUT), but he left the appraiser declaration blank because it called for an unrelated appraiser to sign that declaration.  Mr. Mohamed attached two additional statements to the return that further identified the properties and set forth more information about their values.  On one of the statements, entitled “Appraised Market Values,” he provided information about some of the property expenses and signed it “Real Estate Broker/Appraiser.”

In 2004, the Mohameds donated a shopping center to the CRUT.  Mr. Mohamed filled out the joint income tax return and the Form 8283 in similar fashion to 2003.  He attached a statement to the 2004 return on his letterhead, which reflected that he was a realtor.  He attached a second statement that listed the income and expenses of the shopping center and used a 6.5% “cap rate” to determine the value.  Mr. Mohemed signed this statement “owner and Licensed Real Estate Broker.”

The IRS audited the 2003 return and was displeased with the self-appraisals.  In response, the Mohameds then obtained independent appraisals that were similar, but not identical, to Mohamed’s own, as shown below:

Year Donated Property  Mohamed appraisal Independent appraisal Sales Price
2003 Rio Linda 1 $296,348 $296,000  
2003 Rio Linda 2 325,000 315,000  
2003 Rio Linda 3 125,000 140,000 $125,000
2003 Rio Linda 4 264,040 220,000 265,000
2003 Calvine Road 14,873,921 16,380,000 23,000,000
2004 Shopping center 2,642,190 2,926,246 2,280,000
Totals   18,526,499 20,277,246  

At first in the Tax Court, the IRS argued that the Mohameds had overstated the values of the properties.  Later, the IRS amended its answer to deny all of the claimed deductions for failure to follow the deduction substantiation guidelines in the regulations.  The Mohameds made two arguments.  First, they claimed that such a harsh result meant that the regulation in question, Treas. Reg. Sec. 1.170A-13(c)(2), must be invalid.  Second, they argued that they substantially complied with that regulation.

Judge Holmes first analyzed the contribution deduction substantiation regulation in question, Treas. Reg. Sec. 1.170A-13(c).  Judge Holmes broke down each requirement in the regulation, finding the most important one being that an appraisal be done by a “qualified appraiser,” which Treas. Reg. Sec. 1.170A-13(c)(5) says can’t be either the donor (as it was in this case) or the donee (also as it was here).  This precluded a finding that the Mohameds had used a qualified appraiser.  Then Judge Holmes determined that the statements that Mr. Mohamed attached to their income tax returns weren’t “appraisal summaries” either, as required by Treas. Reg. Sec. 1.170A-13(c)(4).  Therefore, Judge Holmes determined that the Mohameds had failed to comply with the contribution substantiation regulations.

What about the validity of that regulation?

The Mohameds made a very clever argument: they posited that Treas. Reg. Sec. 1.170A-13(c) was arbitrary and capricious because it literally allows a taxpayer who overvalues a gift to keep some of the deduction, while penalizing a taxpayer, like the Mohameds, who accurately valued the properties but who failed to follow the substantiation procedure.  Judge Holmes began by noting that the Treasury Department had been delegated the authority by Congress to promulgate regulations so that the Treasury Department, not Congress, was the sole arbiter of whether a deduction was properly substantiated, so Treas. Reg. Sec. 1.170A-13(c) was a legislative regulation.  Therefore, Judge Holmes concluded that under the Chevron decision of the U.S. Supreme Court, no court can invalidate a regulation similar to Treas. Reg. Sec. 1.170A-13(c) unless the court finds that the regulation is arbitrary, capricious or manifestly contrary to the statute, in this case, IRC Sec. 170.

Judge Holmes began by noting that no court has directly addressed whether Treas. Reg. Sec. 1.170A-13(c) fails the Chevron test.  He noted that in the Deficit Reduction Act of 1984 (“DEFRA”), the Congress exhibited clear intent that contributions of property that exceeded $5,000 in value be verified by a qualified appraiser in order to be deductible.  Thus, Judge Holmes expressly found that the meaning of “verified” in DEFRA was accurately reflected in Treas. Reg. Sec. 1.170A-13(c).  Even though under Chevron, that should have been the end of the analysis, requiring that the regulation be upheld, Judge Holmes also determined that Treas. Reg. Sec. 1.170A-13(c) was consistent with IRC Sec. 170(a)(1) in that it matched the congressional interpretation set out in DEFRA.

Substantial Compliance?

Judge Holmes then examined whether the Mohameds had substantially complied with the regulation.  He then surveyed the case law that clearly showed that taxpayers who argued for substantial compliance usually lost, and he chronicled a list of “fatal mistakes.”  Judge Holmes concluded that the case law required a qualified appraisal, which the Mohameds’ appraisals could not be because Mr. Mohamed, the taxpayer, did the appraisals himself.  Nevertheless, Judge Holmes analyzed each of the various mistakes that the Mohameds made in their appraisals to see if those mistakes were insignificant (and therefore passable under Bond) or were fatal on a property-by-property basis.  Judge Holmes concluded that the Mohameds had made fatal mistakes under the case law that precluded a finding of substantial compliance.

 

The IRS form made me do it!

Finally, Judge Holmes addressed another clever argument that the Mohameds made: Form 8283 was confusing in that it didn’t indicate anywhere on its face that a taxpayer had to get independent appraisals of property worth more than $5,000, with the sole exception of artwork worth at least $20,000.  Judge Holmes noted that while he was sympathetic to the Mohameds’ complaint here, and that the IRS had since modified its form to clarify that point, he brushed aside the argument and ruled in favor of the IRS.  Judge Holmes concluded this way:

We recognize that this result is harsh--a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions--all reported on forms that even to the Court’s eyes seemed likely to mislead someone who didn’t read the instructions. But the problems of misvalued property are so great that Congress was quite specific about what the charitably inclined have to do to defend their deductions, and we cannot in a single sympathetic case undermine those rules.

Comments

Ouch!  This is a high dollar case, so it wouldn’t surprise me if the Mohameds appeal, although I see little chance, if any, of success on appeal.  Although it wasn’t discussed in the Tax Court’s opinion, how could anyone who holds himself out to be an appraiser, like Mr. Mohamed did, not be aware of the USPAP requirement that appraisers be independent?  USPAP, which governs real estate appraisals, as well as appraisals of business interests and personal property, is replete with requirements of independence.  For example, USPAP Standards Rule 2-3 requires the following certification (among others that are required) for a real estate appraisal report:

I have no (or the specified) present or prospective interest in the property that is the subject of this report and no (or the specified) personal interest with respect to the parties involved. [emphasis added]

How clearer does the rule need to be?  I have a hunch that Mr. Mohamed thought that he was a better appraiser than anyone else who he could get, so why should he spend the money on an independent appraisal?  This is the perfect case as the poster child to show stubborn, niggardly clients who are questioning your exhortations that they hire and pay for a qualified, independent appraiser to substantiate either gifts or charitable contributions of property.

What of Mr. Mohamed’s argument that the tax form misled him?  He gets nowhere with me on that one.  For starters, he admitted on the stand that he hadn’t read the instructions to the form, despite the fact that the top of Form 8283 says to refer to the instructions!  If you’re going to be your own tax preparer, like Mr. Mohamed was, you’ve simply got to read the instructions or at least be familiar with them like professional return preparers.  Was this too a case of “you get what you pay for?”  I strongly suspect so.

There are a few takeaways from this decision, which was very methodical and well done by Judge Holmes.  First, the contribution substantiation requirements in Treas. Reg. Sec. 1.170A-13(c) are rigid but are very specific; very little leeway is accorded taxpayers who attempt to comply but who fall short of the mark.  The bottom line: follow Treas. Reg. Sec. 1.170A-13(c) to the letter.

Second, even though Mr. Mohamed was very close in most of his appraisals to the prices for which some of the properties sold not too long after the valuation date, according to Hood’s Rules of Appraisal No. 1: “actual value is irrelevant.”  In every case, Hood’s Rules of Appraisal No. 3 (the last of three such rules) says “perceived, defensible value is everything.”  And for those of you who are curious about Rule No. 2, it is “actual value is unknown at the valuation date.”

Finally, and this is incredible, of one of the independent appraisals, which was of the shopping center, the Tax Court had serious questions about its real independence even though it was late and could not be considered a “qualified appraisal.”  For starters, the appraiser wrote “[m]y valuation is per your instructions” on the report!  The appraiser further indicated that instead of performing an independent analysis of the market and the property, which you would expect an independent appraiser to do, the report indicated that the appraiser got his information from Mr. Mohamed.

Mr. Mohamed also severely limited the scope of the appraiser’s work to that of performing an analysis of only the income approach, instead of considering all three approaches to valuation: market, cost and income.  Mr. Mohamed obviously meddled in the appraiser’s work, thereby cutting off at the legs any chance that the appraiser’s work would be given any appreciable level of credibility.  The bottom line:  Clients need to chill out and let the professionals do their work and stay out of the way.

The common theme of today’s parable is that Mr. Mohamed was his own worst enemy by trying to do everything himself and control that which he didn’t do, and it cost him dearly.  Resolve not to let one of your clients make similar mistakes.

 

Cites:

Mohamed v. Comr., T.C. Memo 2012-152 (May 29, 2012); IRC Secs. 170(a)(1); IRC Secs 170(f)(11)(C) and (D) (both added by the American Jobs Creation Act of 2004); Treas. Reg. Sec. 1.170A-13(c); Chevron, U.S.A., Inc. v. Natural Res. Def. Council, 467 U.S. 837 (1984); Mayo Found. For Med. Educ & Research v. United States, 562 U.S. ___, 131 S. Ct. 704 (2011); Deficit Reduction Act of 1984, Sec. 155.

____________________________________________

About the Author

Paul Hood is presently a speaker, consultant and commentator on estate planning issues.  A former estate planning and tax attorney in Louisiana, Paul received his undergraduate and law degrees from LSU and his LL.M. in taxation from Georgetown University Law Center.  He is a frequent speaker and his articles have appeared in a number of publications.  He is now teaching a course on estate planning for the online masters in taxation program for Northeastern University.  From 1996-2004, Paul served on the Louisiana Board of Tax Appeals, a three member board that has jurisdiction over all Louisiana state tax matters.  Paul and Tim Lee wrote a book on business valuation that John Wiley & Sons published in the spring of 2011, and he and Emily Bouchard wrote a book on estate planning for blended families that was published by Self-Counsel Press in the spring of 2012.  Paul and his estate planning attorney wife, Carol Sobczak, reside in Napa, California.  He can be reached at 504.452.7574 or at paul@paulhoodservices.com or paulhood@acadiacom.net. See also www.paulhoodservices.com.

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