The age-old axiom of no job being finished until the paperwork is done always resonates at this time of year. In this article, Burgess J.W. Raby, Esq., and William L. Raby, CPA, both associated with the Raby Law Office, Tempe, Ariz., discuss recent cases dealing with the rules for substantiating charitable contributions.

by Burgess J.W. Raby, Esq. and William L. Raby, PhD, CPA

Norman and the Nurse

Norman John Haas III, who worked for Honeywell International Inc., and Susan Renee, a registered nurse, married in 1996. In Norman John Haas III et ux. v. Commissioner, T.C. Summ. Op. 2006-9, Doc 2006-1596, their 2001 income tax return was at issue. Among the specific itemized deductions on that return was $15,663 for charitable contributions. That amount consisted of $300 of "gifts by cash or check," $11,347 as gifts "other than by cash or check," and "$4,106 in carryover contributions from a prior year." The IRS allowed the carryover and $5,000 of the current-year gifts, and it proposed a section 6662 negligence penalty. The Haases disagreed, petitioned the Tax Court, and represented themselves.

At trial, the Haases explained to Judge Dean that after they were married, they had "combined two adult households into one small house." Thus many of their donations were the result of having to make hard choices because of limited space. They testified that they valued the gifts "based upon what one would pay at a thrift shop or a rummage sale." As evidence, they submitted an itemized list, as to which Judge Dean commented:

But Judge Dean did not disallow the entire $6,347 of property donations. He applied the Cohan rule, used his judgment, and allowed $2,000 for the property donations.

As to the cash donations, the Haases said they gave cash to their church from time to time but had nothing to substantiate that but their own testimony. "I mean you put the money in the basket," said Mr. Haas. The church has no way of identifying the donors of such loose cash. Judge Dean was not convinced that that was enough under reg. section 1.170A-13(a)(1) because the taxpayers had nothing in the way of records and:

Finally, Judge Dean concluded, "Petitioners failed to establish that they were not negligent in failing to retain documentation for their itemized deductions. . . . We sustain respondent's determination that they are liable for the accuracy-related penalty for 2001."

Otto Bischel and his wife owned a cattle ranch in New Mexico that they sold in 1998. In addition to the land they owned, they also had a permit to graze livestock on the Apache Creek allotment in the Gila National Forest. The permit was for 10 years, but according to its terms and Forest Service regulations, the permit didn't transfer to a buyer when the underlying fee property was sold. When the fee property was sold, the regulations required that the permit be waived back to the United States, which normally would then reissue it to the land purchaser. Accordingly, the Bischels waived the grazing permit back to the United States on sale of the ranch.

The sale of the ranch was reported on the Bischels' 1998 federal income tax return. But then the Bischels got to thinking: That grazing permit was a valuable asset, amounting to the right to use the land for a relatively low fee, and they had transferred it back to the United States for no consideration. Wasn't that a contribution of something valuable to the United States? They filed an amended return, Form 1040X, for 1998 and claimed a charitable contribution deduction for $40,000. The IRS denied their claim.

In Otto Bischel et ux. v. United States, No. 2:04-cv-1537, Doc 2006-4043 (D.C. Nev. 2006), District Judge Roger L. Hunt considered the nature of the grazing permit. The Supreme Court, he pointed out, has held that "the provisions of the Taylor Grazing Act . . . make clear the Congressional intent that no compensable property might be created in the permit lands themselves as a result of the issuance of the permit." United States v. Fuller, 409 U.S. 488, 494 (1973). In Fuller, the government had condemned some of a property owner's fee land and the owner wished to value the condemned property by adding the value of the grazing permit. The Ninth Circuit had held he could include that value in the appraisal of the condemned land.

However, the Supreme Court, after explaining that Congress intended "that no compensable property interest might be created in the permit lands," reversed the appeals court:

409 U.S. at 494.

The Bischels argued that the Fifth Amendment prohibition against taking private property for public use without just compensation meant that their grazing permit had value. Judge Hunt did not agree:

In case that conclusion was not enough to deny the deduction, Judge Hunt went on and tested the waiver against the charitable contribution documentation rules. All the Bischels had as documentation was a letter from the Forest Service's district ranger discussing the surrender of the lease. That was not the type of letter acknowledging a charitable contribution contemplated by the regulations. Nor was the "appraisal" the Bischels submitted adequate to support a deduction. Judge Hunt explained:

Howard Kaplan et ux. et al. v. Commissioner, T.C. Memo. 2006-16, Doc 2006-2101, involved the three members of a limited liability company: Mssrs. Kaplan, Marceron, and Caldwell. The LLC had claimed a charitable contribution deduction for 1999 that it passed through to them. The deduction was for the donation of property in Helena, Ohio, that the LLC had purchased in 1997 for $105,041. On the property as they purchased it had been a remodeled school building surrounded by 2.04 acres of land. The LLC leased the property on an as-is and net/net/net basis to Texas Migrant Council Inc. (TMC), a tax-exempt section 501(c)(3) organization that provided Head Start services to migrant families in, among other places, Ohio. TMC used the leased property to conduct Head Start activities in Helena. Under the lease, TMC was responsible for keeping the property "in good and reasonable operating condition and repair."

TMC got a federal grant, put in some of its own money, and spent $660,000 on major upgrading and remodeling of the property in 1998, including the addition of a new building. The grant money, from the U.S. Department of Health and Human Services, carried with it a notice of federal interest for the property. That notice, which was filed with the county recorder's office for Sandusky County, Ohio, included a warning that "this property may not be sold, transferred, or its title encumbered, without approval from the Department of Health and Human Services." The notice was still on file and had not been canceled as of May 12, 2005.

What was the property worth after all that work? The members of the LLC wanted to know and engaged an appraiser to find out for them. His answer was a preliminary valuation letter dated December 17, 1999, that concluded that the fair market value was $1,025,000. The letter did not mention the notice of federal interest that was on file, nor did it indicate that the letter had been prepared to substantiate a charitable contribution for tax purposes, although that was how it was used.

The LLC obtained a legal opinion, dated December 30, 1999, that the improvements, including the new building, belonged to the LLC, not TMC. The opinion was based on a review of the lease agreement in the context of Ohio law. That letter was provided to a tax principal at Ernst & Young from whom the LLC had asked for an opinion as to its ability to take a charitable contribution deduction if it transferred ownership of the improvements to TMC but did not otherwise modify the lease. However, neither the attorney who prepared the legal opinion nor the tax principal at E&Y were made aware of the notice of federal interest. Kaplan, the managing member of the LLC, testified later in the Tax Court trial that the LLC was not even aware of the notice at that time.

No tax opinion was actually prepared. Rather, the tax principal provided an inconclusive discussion of the facts and some of the arguments for and against there being a deduction for $1,025,000 for transfer of title to the improvements to TMC. However, E&Y prepared the LLC's partnership return for 1999 on which the deduction was claimed based on the information provided by the LLC. The preparer talked to the LLC's attorney about the legal opinion, and the attorney indicated that claiming a charitable contribution deduction for the $1,025,000 would be a "push" in the sense that there was a substantial risk that the IRS would disallow any such claim.

The LLC had been instructed by E&Y that TMC had to complete Part IV (Donee Acknowledgement) of the Form 8283 that was to accompany the return. The LLC itself sent the return to the IRS, but it did not have TMC complete and sign the donee acknowledgement. Nor did the LLC complete some other required portions of the Form 8283.

Tax Court Judge Carolyn P. Chiechi, in a 54-page opinion, analyzed the various documents involved, the testimony in the record, and pertinent Ohio law. She found that the bill of sale for the improvements was not properly executed in accordance with Ohio law, because it was not acknowledged by the signer before a proper official. She also noted that the bill of sale itself was not turned over to TMC until March 27, 2000, so title could not have passed under Ohio law, in any event, until then. As a result, she concluded that:

The IRS added a section 6662 substantial understatement penalty to the deficiencies for each of the LLC members. The members argued that the LLC "made a good faith and reasonable effort to obtain qualified professional advice regarding its ability to claim a tax deduction for the charitable contribution and the requirements to sustain that deduction."

Judge Chiechi rejected their argument based on the record before her:

When the IRS audits a return, it takes seriously the requirements for documenting charitable contribution deductions, as do the courts for those relatively few cases that get to court. However, sometimes the courts, especially the district courts, find that taxpayers have "substantially complied" although the IRS did not believe they had. Take, for example, the provision in the regulations requiring an appraisal to substantiate property contributions above $5,000.

In Herman v. U.S., 84 AFTR2d 99-6561, Doc 1999-33384, 1999 TNT 202-7, (E.D. Tenn. 1999) the IRS asserted that the appraisal obtained by the taxpayers for a large property contribution to a hospital was not performed by a "qualified appraiser" and that it was not a "qualified appraisal" as those terms are used in reg. section 1.170A-13(c)(5). It was not performed by a qualified appraiser because Rick Rader, of Skyland Hospital Supply, did not hold himself out to the public as an appraiser and did not perform appraisals on a regular basis. It was not a qualified appraisal because, among other things, the report did not indicate the date of the contribution to the donee, did not indicate it was prepared for income tax purposes, did not indicate the method of valuation used to determine fair market value, did not give the specific basis for the valuation (for instance, any specific comparable sales transactions), and did not report the appraiser's fee arrangement with the taxpayer. Those are all required by the regulation.

The IRS had succeeded in getting a contribution deduction disallowed because of the absence of a qualified appraisal in John T. Hewitt v. Commissioner, 82 AFTR2d 98-7184, Doc 98-34000, 98 TNT 227-3 (4th Cir. 1998), aff'g 109 T.C. 258, Doc 97-29748, 97 TNT 210-12 (1997), even though it was undisputed that the amount claimed was, in fact, the fair market value of the closely held stock donated. District Judge Thomas Gray Hull took a "substantial compliance" approach in the Herman case, however:

As to the appraisal itself, Judge Hull recognized that "his appraisal does not meet all the technical requirements of a 'qualified appraisal' but the reason for this failure helps, rather than hurts, the plaintiffs in this instance." It helped because the reason Mr. Rader did not try to comply with the reg. section 1.170A- 13(c) requirements was that he had no idea his report would be used for income tax purposes. He did not discuss his fee arrangement because he was not paid anything for doing the appraisal. He expected that when the hospital reopened, his company would become the prime vendor for its consumable products. "This fact makes his report more reliable rather than less so," wrote Judge Hull. Judge Hull explained that:

Tax return preparers and taxpayers alike sometimes take the charitable contribution deduction substantiation rules lightly. In part, that has been because of the heavy focus on tax avoidance with the resulting absence of many in-depth audits of individual taxpayers. However, it also has been, in part, the result of taking a common-sense approach to documentation, as reflected in the Haas discussion of the cash contributions dropped into the church collection plate. The taxpayer knows that the contributions were made, but the IRS wants some form of documentary evidence to back up the claim that $300 in cash was dropped into the collection at church in the course of a year. Why was no use made of the pew envelopes provided by the church, which would have resulted in the church at least maintaining a record of the Haas contributions? Why not save the church bulletin for that date with a written notation, such as "$25 Cash, 3/12/06," to memorialize the amount given? Why not write checks instead of dropping in cash?

We have seen returns on which the cash contributions included "Misc. cash contributions (each under $25)" with amounts ranging from $50 to $500. That is not to say that people don't drop cash into the Salvation Army kettle at Christmas and make other similar spur-of- the-moment cash contributions. But some record should be maintained when possible, such as some literature from the organization on which the date and the amount can be noted. One lady who drops cash into various collections that get taken up outside the grocery supermarket where she shops makes notations on the cash register tapes for that trip and keeps them with her tax receipts. If she gets a sticky piece of paper, such as from the heart drive, to put on her blouse to show that she gave, she transfers that to the tape next to the notation. Tax practitioners can help their clients who are inclined to claim miscellaneous amounts by emphasizing the relatively painless ways in which those donations can be documented.

The property donations are more of a problem. Lists should be made in reasonable detail. The sources of prices used in arriving at estimates of value should be documented. When the value of an individual item gets above $250, the receipt for that item from the donee should strictly adhere to the requirements of the regulation that it state that no thing or services of value were received by the donor. The practitioner should be familiar with the regulations, take them seriously, and, in obtaining information from the taxpayer to use in return preparation, let the taxpayer know what the rules are and what needs to be done to abide by them. When the documentation requirements are not met, the tax practitioner may be liable for a preparer penalty on the grounds that failure to ask questions about documentation was a failure to exercise due diligence in preparing the return. While the information provided by the taxpayer can be relied on, that is not quite as true when the code or regulations contain specific documentation requirements. At a minimum, the tax practitioner needs to ask the taxpayer enough questions to determine that the taxpayer both understands what documentation was needed and has the required documentation. In that sense, the charitable contribution deduction has become similar to the travel and entertainment expenses covered by the documentation requirements of section 274.

Copyright Burgess J.W. Rab, Esq. and William L. Raby, PhD, CPA. Used by permission.