On April 13, 2007, Senate Finance Committee Chair Max Baucus, D-MT, sent a letter to Treasury Secretary Henry Paulson inquiring as to Treasury's knowledge of an abusive transaction involving the contribution of non-cash property to charity and the claiming of a charitable deduction in an amount that substantially exceeds the true fair market value of the property in violation of established tax law.

April 13, 2007

The Honorable Henry M. Paulson, Jr.
Secretary
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220

Dear Mr. Secretary:

The Finance Committee has learned of an abusive transaction involving the contribution of non-cash property to charity and the claiming of a charitable deduction in an amount that substantially exceeds the true fair market value of the property. The transaction not only appears to violate established tax law, but also appears to be carefully crafted to conceal key portions of the transaction from the Internal Revenue Service. I would like to learn what Treasury knows about the transaction and what actions you intend to take to combat it.

As we understand one form of the transaction, a tax shelter promoter arranges the purchase of real property that is encumbered by a long-term lease, sometimes with a lease term 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 (LLC 1).¹ It appears that the sole membership interest in LLC 1 is owned by a separate LLC-LLC 2 -- in which various investors in the transaction hold membership interests. LLC 2 contributes the sole membership interest in LLC 1 to a section 501(c)(3) charity, such as a tax-exempt college or university. For purposes of claiming a charitable deduction, LLC 2 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 LLC 2 are provided with Forms K-1 showing their respective shares of the apparently inflated charitable deduction.²

We further understand that the section 501(c)(3) organizations involved in such transactions typically enter into an agreement not to dispose of the interest in LLC 1 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 charitable organization within two years³ of the donation be reported to the Internal Revenue Service on Form 8282. Following expiration of this time period, we understand that the donee charity may sell its interest in LLC 1 to an entity owned or controlled by the promoter for a price substantially below the claimed value of the charitable contribution, after which the promoter may use the same property in another, similar transaction. It is unclear whether, at the time of the purported charitable contribution, the donee organizations agree to resell the property to the promoters at the expiration of the minimum holding period.

In one such transaction, we understand that the promoter originally purchased a remainder interest in property for less than $200,000, and arranged for the remainder interest to be owned indirectly by a single-member LLC. Shortly thereafter, the sole membership interest in the LLC was contributed to a university for a claimed value as much as seven times the purchase price. After the donee organization had held the property for the two-year-and-one-day minimum holding period to avoid reporting, an entity owned or controlled by the promoter repurchased the LLC interest for less than the original purchase price of the remainder interest.

The above-described transaction may raise a number of issues under present law. For example, if the donor in such a transaction receives or expects to receive a substantial return benefit in exchange for the contribution of the LLC interest, the contribution would be nondeductible in its entirety. Similarly, as discussed above, if the transaction were to involve a contribution of a partial interest in property as described in section 170(f)(3) of the Code, the contribution would be nondeductible. Even 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 a substantial or gross valuation overstatement. An appraiser who prepares an appraisal to support such a contribution may also be liable for penalties or become subject to disciplinary action by the Internal Revenue Service.

Furthermore, 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 section 501(c)(3).⁴ In addition, depending on the facts, certain participants in the transaction could be found to have engaged in fraud or to have aided and abetted the understatement of tax liability.

On its face, the above-described transaction raises a number of serious issues. Leaving aside the question of whether taxpayers are permitted any charitable contribution deduction, it seems clear that the catalyst for the transaction is the ability to derive a significant tax benefit through exploitation of valuation uncertainties. In other words, this appears to be yet another case of taxpayers (and established charities) taking advantage of the often subjective and hard-to-administer area of valuation.

The valuation of property for purposes of claiming a charitable contribution deduction was identified by the staff of the Joint Committee on Taxation in its January 2005 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. 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. If we were to apply a deduction-not-to-exceed basis rule to the above- described transactions, the opportunity for valuation abuse would be erased, as the taxpayers 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 should the Congress not adopt such a basis rule to close the tax gap in this area? Previously, the Congress has addressed valuation abuses on a property-by-property basis. For example, in 2004, we provided that, in general, the charitable contribution deduction for vehicles could not exceed the price for which the charity sold the vehicle. Also in 2004, we adopted a deduction-not- to-exceed basis rule for charitable contributions of intellectual property because taxpayers were claiming values greatly exceeding the property's true worth. Then, last year, we passed new rules for charitable contributions of easements, taxidermy property, and fractional giving, areas where valuation was a factor in abuse. Further, we tightened the deduction-not-to-exceed basis rule that 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. In short, if valuation abuses such as those that appear to have occurred in the above-described transactions 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 section 4965 of the Code), a legislative solution such as a deduction-not-to-exceed basis rule may well be appropriate.

I would appreciate the benefit of your thinking on this matter. To what extent is the IRS aware of the above-described transaction? How pervasive is this transaction? What steps has Treasury taken to curb this abusive transaction? With the 2003 tax year coming to a close, what is the IRS doing to protect the statute of limitations? Would Treasury support a general deduction-not-to-exceed basis rule for non-cash property? Does Treasury have any recommendations for improving compliance in this area?

Thank you for your prompt attention to this matter and I look forward to receiving your response.

cc: The Honorable Eric Solomon, Assistant Secretary for Tax
Policy
The Honorable Mark Everson, IRS Commissioner
The Honorable Don Korb, IRS Chief Counsel
Mr. Tom Barthold, Acting Chief of Staff, Joint Committee on Taxation

¹ In some cases, the remainder interest in the real property may be owned by another entity that, in turn, is owned by LLC 1. In other words, the ownership structure may involve several layers of ownership, possibly designed to conceal the identity of the beneficial owners or of the promoter.

² 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, does not qualify for a charitable deduction. See sec. 170(f)(3). Furthermore, the ownership of property may not be divided between related entities for the purposes of avoiding this "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 LLC 1, in the above example, to ensure that the donor's only interest at the time of a charitable contribution is the remainder interest. See Treas. Reg. 1.170A-7(a)(2)(i). In the transaction described in this letter, it is unclear 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 LLC 1 should be nondeductible.

³ The Pension Protection Act of 2006 extended this time period to three years.

⁴ Other penalties may apply if the promoter is an insider with respect to, or a disqualified person of, the donee charity. See secs. 501(c)(3) and 4958.