Conrad Teitell Warns of Sick Scheme and Charitable Knavery

Conrad Teitell Warns of Sick Scheme and Charitable Knavery

Article posted in Real Property on 18 July 2007| comments
audience: Leimberg Information Services, National Publication | last updated: 18 May 2011
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Summary

In this article from Leimberg Information Services, New York attorney Conrad Teitell is ringing an alarm bell about a major charitable deduction benefit that may be lost thanks to a few greedy tax promoters, donors, and complicit charities who are conspiring to grossly inflate the value of charitable gifts, conceal key elements from the IRS, and avoid the Form 8282 "tattletale" rule.

PGDC Editor's Note: For background information, see the following previous PGDC news stories:



By Conrad Teitell, LL.B., LL.M.

Facts:

Points made in SFC Chairman Baucus's letter to Treasury:

The Scheme

A tax shelter-promoter arranges the purchase of real property that is encumbered by a long-term lease-sometimes as long as 60 years.

The so-called remainder interest in the real property (following the expiration of the lease) is owned by a single-member limited liability company (LLC1).

Apparently the sole membership interest in LLC1 is owned by a separate LLC (LLC2)-in which various investors in the transaction hold membership interests.

LLC2 contributes the sole membership interest in LLC1 to a charity, such as a college or university. For purposes of claiming a charitable deduction, LLC2 claims a value that is several multiples of the price originally paid for the remainder interest. The valuation is based on an appraisal that purports to support the claimed value.

The various member-investors in LLC2 are provided with Forms K-1 showing their respective shares of the apparently inflated charitable deduction.

The remainder interest may be owned by another entity that, in turn, is owned by LLC1. The ownership structure involving several layers of ownership is possibly designed to conceal the identity of the owners or of the promoter.
 
The Plot Thickens

The charities involved in these transactions typically agree not to dispose of the interest in LLC1 for a period of at least two years and one day following the contribution. (This requirement appears to be designed to avoid the legal requirement that certain dispositions of donated property by a charity within two years of the donation be reported to the IRS on Form 8282.) (The Pension Protection Act `06 extended this to three years.)

Following expiration of the time period, the donee-charity may sell its interest in LLC1 to an entity owned or controlled by the promoter for a price substantially below the claimed value of the charitable contribution. Then the promoter may use the same property in another, similar transaction.

It is unclear, says the SFC chairman, whether, at the time of the purported charitable contribution, the charities agree to resell the property to the promoters at the expiration of the agreed holding period.

Abusive Case in Point Cited by SFC Chairman Baucus.

The promoter originally purchased a remainder interest for less than $200,000, and arranged for the remainder interest to be owned indirectly by a single-member LLC. Shortly thereafter, that membership interest in the LLC was contributed to a university for a claimed value of seven times the purchase price.

After the university had held the property for the minimum holding period to avoid reporting the disposition to the IRS, an entity owned or controlled by the promoter repurchased the LLC interest for less than the original purchase price.

Comment:

A Story (Sick and Sordid Tale?) In Progress

Chapter One is Senate Finance Committee Chairman Max Baucus's (D-MT) letter to Treasury.

Chapter Two is Treasury's response.

Chapter Three is yet to be written--but it could well be legislation that allows fair market value deductibility only for gifts of marketable  appreciated securities. That in turn would result in significantly decreased outright and life-income gifts to charity.

The Big Picture

The overwhelming majority of Americans make charitable gifts because they want to help charities and the people they serve. The fair market value charitable deduction for gifts of appreciated property to publicly supported charities-and avoidance of capital gains which would otherwise be incurred on a sale-reduce the out-of-pocket cost of generosity.

But even with the tax savings, donors are better off financially by not making charitable gifts. The tax benefits reduce the cost of generosity, but it still costs plenty. In fact, many donors view the tax savings as a way to make larger charitable gifts than originally imagined.

The Small Picture: Dangers to All When a Few Game the System

Now for the smaller picture that can unfairly and harmfully change the big picture: When a mini-minority games the system, Congress, Treasury and the IRS curb the abuses with new laws-and enforcement of existing ones. That's as it should be.

However, the government doesn't enjoy being snookered. Unfortunately, it often overreacts by legislating so broadly that legitimate and long-standing tax incentives are killed.

Issues Raised by this Sick and Sordid Scheme:

Donors and Appraisers Beware
  • If the donor in the transaction receives or expects to receive a substantial return benefit in exchange for the contribution of the LLC interest, the contribution would be entirely nondeductible.
  • If the transaction were to involve a contribution of a partial interest in property described in IRC §170(f)(3), it would be nondeductible.
  • Assuming the contribution is not entirely nondeductible, the transactions appear to involve significantly inflated valuations, raising serious questions about the claimed value of the resulting charitable deductions.
  • The apparently inflated valuations also could result in penalties for substantial or gross valuation overstatements.
  • An appraiser who prepares an appraisal to support the contribution may also be liable for penalties or become subject to disciplinary action by the IRS.
Charities, their Employees, Promoters and Donors Beware
  • If, in connection with the transaction, the donee-charity uses charitable assets for the benefit of private individuals, the donee's tax-exempt status could be at risk. For example, if the charity re-sold an LLC interest to the promoter for less than the fair value of the interest as of the time of the sale, the sale may result in impermissible private benefit in violation of IRC §501(c)(3).
  • Other penalties may apply if the promoter is an insider with respect to, or a disqualified person of, the donee-charity. IRC §§501(c)(3)and 4958.
  • Depending on the facts, participants in the transaction could be found to have engaged in fraud or to have aided and abetted the understatement of tax liability.
But Wait, there's More Danger!

Apart from the serious issues just described, SFC Chairman Baucus says:

The transaction raises the question whether taxpayers are permitted any charitable contribution deduction. The catalyst for the transaction is the ability to derive a significant tax benefit through exploitation of valuation uncertainties. This appears to be yet another case of taxpayers and established charities taking advantage of the hard-to-administer area of valuation. [Emphasis supplied]

And Still More Issues

With few exceptions, a contribution of less than the donor's entire interest in property, such as a contribution of a remainder interest while retaining a present interest, doesn't qualify for a charitable deduction. IRC §170(f)(3).

Further, the ownership of property may not be divided between related entities for the purposes of avoiding the "partial interest" rule--e.g., the ownership of the present interest being retained by the promoter but the ownership of a remainder interest being held in LLC1, in the above example, to ensure that the donor's only interest at the time of a charitable contribution is the remainder interest. See Reg. §1.170A-7(a)(2)(i).

In the above-described transaction, it isn't clear how and at what point ownership of the remainder interest in the real property is separated from ownership of the other interests. If, however, ownership of the remainder interest is separated in order to effect the transaction, arguably the entire contribution of the sole membership interest in LLC1 should be nondeductible.

And If All Those Dangers Are Not Enough...

Here's a point not (yet) made by Sen. Chairman Baucus:  If these gifts are not deductible as income tax charitable contributions, the donors also haven't made gifts that qualify for the gift tax charitable deduction. Thus the donor-perpetrators-in addition to paying back income tax, interest and penalties-will have to pay hefty gift taxes.

Overvaluation Issues Are In Congress's Sights

The valuation of property for purposes of claiming a charitable deduction was identified by the Joint Committee on Taxation's staff in its report on the tax gap, Options to Improve Tax Compliance and Reform Tax Expenditures, JSC-02-05, January 27, 2005. The JCT reported that every time an excess value of property is claimed for purposes of the charitable contribution deduction the tax gap is widened.

The staff of the Joint Committee suggested eliminating the tax gap in this area by allowing taxpayers to claim no more than their basis in contributed property, with exceptions for "easy-to-value" property such as publicly traded securities and property for use in charitable programs [my emphasis supplied]. (Don't think this couldn't happen: In general, a deduction-not-to-exceed basis rule similar to this already applies for contributions of property to private foundations, and for contributions of tangible personal property not for an exempt use.)

According to the JCT, if Congress were to apply a deduction-not-to-exceed basis rule for all gifts (other than marketable securities and related-use gifts), the opportunity for valuation abuse would be erased. The taxpayers in the above described scheme would be able to claim no more than what they paid for the contributed property interest (instead of claiming, as it appears they did, an amount well in excess of the purchase price).

Why Not a "Basis Only" Deduction Rule?

"Why shouldn't the Congress adopt a basis rule to close the tax gap", Sen Baucus asks Treasury?  Previously, says Sen. Baucus, the Congress has addressed valuation abuses on a property-by-property basis. For example, in 2004 Congress provided that, in general, the charitable deduction for vehicles could not exceed the price for which the charity sold the vehicle and adopted a deduction-not-to-exceed basis rule for charitable gifts of intellectual property because taxpayers were claiming values greatly exceeding the property's true worth.

Then, in 2006, Congress passed new rules for charitable contributions of easements, taxidermy property, and fractional giving-areas where valuation was a factor in abuse.

The Tightening Continues

The deduction-not-to-exceed basis rule (enacted in 2006) applies for charitable contributions of tangible personal property by recapturing the fair market value-based deduction if the donee-charity sells the contributed property within three years of the contribution date.

Sen. Baucus concludes:

If valuation abuses such as those that appear to have occurred in the above-described transaction (involving a remainder interest after the lease expiration) cannot easily and quickly be stopped by the IRS (for example, by listing the transaction, thus making an exempt organization that was party to it potentially subject to excise taxes under IRC §4965), a legislative solution such as a deduction-not-to-exceed basis rule may well be appropriate.

The Four (Plus Two) Questions

SFC chairman Baucus asks Treasury these six questions:

  1. To what extent is the IRS aware of the above-described abusive transactions?
  2. How pervasive are they?
  3. What steps has Treasury taken to curb this abusive transaction?
  4. With the 2003 tax year coming to a close, what is the IRS doing to protect the statute of limitations?
  5. Would Treasury support a general deduction-not-to-exceed basis rule?
  6. Does Treasury have any recommendations for improving compliance in this area?
The IRS's Response to SFC Chairman Baucus (On Behalf of Treasury Secretary Henry Paulson)

The IRS first became aware of the transactions in August 2006. Later that year, New York state provided documents to IRS which indicate that in a typical transaction: (1) a piece of real property subject to a long-term lease is purchased through a tier of closely-held flow-through entities owned by a group of investors; and (2) approximately a year later, the so-called remainder interest in the property (restructured as an interest in one of the closely held flow-through entities) is donated to a charity at an apparently inflated value. In some cases, the donor may have reacquired the donated interest from the charity two years later at a significantly lower cost.

To date, the IRS has identified 48 entities participating in transactions involving deductions of approximately $271 million. Most of the entities are based in New York, but the investors in these entities appear to be geographically dispersed.

The IRS has assigned audit teams to all entities known to have contributed and claimed deductions for the 2003 tax year and have secured consents to extend the statutes of limitation on assessment.

The IRS is working to identify all taxpayers who might have claimed charitable deductions using this type of transaction and to determine whether the transaction was actively promoted and, if so, how widely.

In the cases under active audit, the facts as developed so far have raised questions about the propriety of the charitable deductions claimed and the role some charities played in receiving the donations.

All appropriate offices within the IRS are coordinating as the IRS seeks information on additional entities involved and their investors, and linkages to charitable contribution deductions claimed after 2003.

The IRS's Chief Counsel is developing all the facts necessary to determine the appropriate tax treatment and promptly address the transaction, including whether the transaction violates the charitable contribution and tax-exempt organization rules and whether substantial valuation misstatements are involved.

The IRS will also work with the Office of Tax Policy to evaluate legislative proposals including the JCT's proposal for a general deduction-not-to-exceed-basis rule.

The IRS is considering a listing notice under existing reportable transaction regulations or a "transaction of interest" notice under proposed regulations that the IRS hopes to finalize this summer.

Charities-Don't Let the Stealth Inflated Contribution Knavery (SICK) Scheme Be the Death Knell for Gifts of Appreciated Property Now Legitimately Deductible at Fair Market Value.

What should charities do to stave off restrictive legislation for legitimate gifts?

I strongly urge that

  • national umbrella organizations of charitable organizations, individual national organizations and charities of every stripe let the Senate Finance Committee, the IRS and the Treasury know that they find the remainder interest-LLC scheme to be abhorrent.
  • All available sanctions-both civil and criminal-should be imposed against participating charities and their employees.
  • The sanctions should not be limited to the "donors," their advisers, tax-shelter promoters and appraisers.
  • Ask that the current rules for fair-market-value deductibility not be changed for legitimate gifts.
Inaction Poses Great Risk!

One thing is for sure. Charities shouldn't idly stand by and hope that the other shoe won't drop. If charities don't act, it will drop-and while charities are sleeping.

Don't expect any notice of hearings. The deduction-limited-to-basis rule for all appreciated property gifts (other than marketable securities) could well be added to other legislation. History lesson:  The elimination of fair market value deductibility for many gifts was enacted in 2004 as part of the JOBS Act and in 2006 as part of the Pension Protection Act.

If Charities Don't Act Now, There May Not Be a When!

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Conrad Teitell

Edited by Steve Leimberg

Cite As:

Steve Leimberg's Charitable Planning Newsletter # 124  (June 28, 2007) at http://www.leimbergservices.com.


PGDC Editor's Note:

Leimberg Information Services provides comprehensive commentary and analysis on a broad array of financial, estate and charitable planning topics. We encourage you to visit www.leimbergservices.com for more information.

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