Noncompliance with Substantiation Rules Bolsters Deduction

Noncompliance with Substantiation Rules Bolsters Deduction

News story posted in U.S. District Court on 22 October 1999| comments
audience: National Publication | last updated: 18 May 2011
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Summary

A District Court affirmed in a Motion for Summary Judgment the donors' valuation expert and the charitable income tax deduction even though the donors purchased the equipment for $40,000 in the aggregate and deducted approximately $1 million in the aggregate for a subsequent charitable contribution of the equipment.

PGDC SUMMARY:

A hospital filed a voluntary petition under Chapter 11 of the Bankruptcy Code in April 1987. Two businessmen ("Plaintiffs") and their friend desired to reopen the hospital for the community and formed a limited liability company, recruited a hospital board, and worked with various federal, state, and local officials to accomplish this goal. They learned that the interim administrator of the hospital was planning to auction off all of its equipment and hoped to clear $37,000 after paying the costs of the auction. The bankruptcy court accepted the Plaintiffs' offer to buy all of the hospital's equipment for $40,000 and each of the Plaintiffs contributed $20,000 for the purchase in October 1988. In December 1990 the Plaintiffs donated the equipment to Johnson County Hospital, Inc., the hospital-to-be.

One of the Plaintiffs' accountants suggested that they get the equipment appraised so that they could each take a charitable deduction for the gift. The Plaintiffs asked the hospital's administrator to find some people to do the appraisals, and in December 1990, the equipment's fair market value was estimated to be $1,037,348 by one appraiser while another appraiser estimated the resale value of the equipment at $1,002,380 in January 1991. The Plaintiffs each claimed a charitable contribution deduction in the amount of $501,190, one-half of the lower estimate, for tax year 1990, and carried the excess contribution deduction forward to tax years 1991, 1992, and 1993.

The IRS audited the Plaintiffs and allowed each a charitable contribution deduction for tax year 1990 in the amount of $20,000, representing each Plaintiff's share of the purchase price of the equipment, and imposed a gross valuation misstatement penalty.

The IRS initially argued that the Plaintiffs are not eligible for any charitable deduction. The U.S. District Court for the Eastern District of Tennessee found that the IRS had previously indicated that the Plaintiffs are, in fact, entitled to charitable deductions and may not suggest otherwise at this late stage of the proceedings. The Court stated that the only issue, therefore, is the determination of the fair market value of the donated property and the propriety of the gross misstatement of value penalties.

The Court did not agree with the IRS' position that the bankruptcy court was a willing seller not compelled to sell and that the price the Plaintiffs paid for the equipment is relevant to the determination of the fair market value of the donated property. The evidence suggests that the sale of the equipment was made in haste, without objection from the creditors, and without a hearing on valuation. Furthermore, the Court noted that while the Weitz case had used the bankruptcy sale price for valuation purposes, it is distinguishable on its facts and was therefore inapplicable in the present case.

Even though the Court recognized that the appraisal did not meet all of the technical requirements of a "qualified appraisal," it stated such failure actually bolsters the Plaintiffs' position. The Court found the appraiser fully qualified and noted that, when asked to survey and evaluate the equipment at the hospital, the appraiser had no idea that his report would be used for tax purposes. Furthermore, the Court took note that the appraiser was not paid for his services and had no reason to overvalue the donated equipment because there was a possibility his company would have to replace the equipment in the future.

Accordingly, the Court stated that it was justified in relying on the appraisal for deciding the issue of valuation and held that the fair market value of the equipment was $1,002,380. In addition, the Court found no basis for penalizing the Plaintiffs under Section 6662(a) of the Code for a gross valuation misstatement in light of accepting the appraised amount. Therefore, the Court granted the Plaintiffs motion for summary judgment and held that the Plaintiffs are entitled to a refund of the additional federal income tax, interest, and tax penalties assessed against them.

POINTS TO PONDER:

There is a difference between perception and reality. We likely will never know what really happened in this case. With respect to perception, it is clear that the IRS made at least one fatal litigation flaw - it did not present its own independent appraisal of value of the equipment. In this case, good facts presented at trial make a good result for the donors. However the strength of this case as precedent is questionable.

FULL TEXT:

DANIEL L. HERMAN AND BARBARA J. HERMAN
v.
UNITED STATES OF AMERICA
and
PAUL BROWN
v.
UNITED STATES OF AMERICA
UNITED STATES DISTRICT COURT FOR THE
EASTERN DISTRICT OF TENNESSEE
AT GREENEVILLE
ORDER

The plaintiffs in these consolidated actions, Mr. and Mrs. Daniel L. Herman and Mr. Paul G. Brown, are seeking to recover federal income taxes, tax penalties and related interest which they contend was erroneously assessed and collected from them in connection with charitable deductions taken for their contributions of medical equipment to Johnson County Hospital, Inc. The case is now before the Court on cross-motions for summary judgment.

BACKGROUND

Johnson County Memorial Hospital, Inc., located in Mountain City, Tennessee, filed a voluntary petition under Chapter 11 of the Bankruptcy Code in April of 1987. Plaintiffs Herman and Brown, and a friend of theirs named Tommy Walsh, Mountain City businessmen, were anxious to re-open the hospital for the community. They formed a limited liability company, recruited a hospital board, and worked with various federal, state, and local officials to reopen the hospital. They learned that the interim administrator of the defunct hospital was planning to auction off all its equipment and was hoping to clear $37,000.00 after paying the costs of the auction. /1/ The plaintiffs approached the bankruptcy court and offered to buy all the equipment for $40,000.00. The offer was accepted and, in October of 1988, each plaintiff contributed $20,000.00 toward its purchase. In December of 1990, they donated the equipment to Johnson County Hospital, Inc. for the hospital-to-be. Mr. Brown's accountant suggested that they have the hospital equipment appraised so that they could each take a charitable deduction for the gift. They asked the hospital's administrator if he could find some people to do the appraisals. In December of 1990, George Garrick of Mountain Medical Equipment estimated the fair market value of the equipment to be $1,037,348.00. Rick Rader, then of Skyland Hospital Supply, estimated the resale value of the equipment at $1,002,380.00 in January of 1991.

The Hermans claimed a charitable contribution deduction on their federal income tax return for the year 1990, in the amount of $509,932.00 using the average of the Rader and Garrick appraisals. They later determined that the Garrick appraisal had been in error and that the lower, Rader, appraisal set forth the correct market value of the hospital equipment and amended their return to claim a deduction in the amount of $501,190.00. Under the 30% limitation on the use of charitable contribution deductions pursuant to Section 170(b), the excess contribution deduction was carried forward to tax years 1991, 1992, and 1993.

Paul Brown claimed a charitable contribution deduction on his federal income tax return for the year 1990 in the amount of $501,190.00 (based on the Rader appraisal) and, like the Hermans, carried the excess contribution forward to the years 1991, 1992, and 1993.

On audit, the IRS allowed the Hermans a charitable contribution deduction for the year 1990 in the amount of $20,000.00, representing their share of the purchase price of the equipment from the bankruptcy court and disallowed the remaining deduction. The IRS also imposed the "gross valuation misstatement" penalty in the amount of $23,218.80, pursuant to 26 U.S.C. Section 6662. On audit, the IRS allowed Paul Brown the same charitable deduction of $20,000.00 for tax year 1990 and disallowed the remaining deduction. It imposed upon him a gross valuation misstatement penalty in the amount of $13,472.40.

THE PLAITIFFS' MOTION

The plaintiffs point out that the United States has already admitted that they are entitled to a charitable deduction under Section 170 of the Internal Revenue Code and that the government is merely challenging their valuation of the donated equipment. They claim that their proof of the fair market value, based upon Mr. Rader's appraisal, is the only real evidence on that issue and that, therefore, they should be entitled to a judgment in their favor as a matter of law. They offer the deposition of Mr. George Garrick to show that, when he advised the Bankruptcy Court that they could get $37,000.00 for the equipment, he was talking about its liquidation value -- what he would pay for it if he were planning to turn around and re-sell it. They also point out that neither appraisal obtained by the hospital's administrator, Harry Peterson, was paid for by them or as a percentage of the valuation assessed.

THE UNITED STATES' MOTION

The United States first takes the position that the plaintiffs are not eligible for ANY charitable deduction because they failed to satisfy the substantiation requirement of Section 170(a)(1). This argument is based upon the government's assertion that Mr. Rick Rader was not a "qualified appraiser" /2/ within the meaning of Income Tax Regulation section 1.170A-13(c)(5) and that his appraisal was not a "qualified appraisal" conforming with the many requirements of that same regulation. /3/

The United States justifies the penalties imposed by arguing that the plaintiffs cannot show a reasonable cause for their gross overvaluation of the equipment because they did not rely on a qualified appraisal by a qualified appraiser and they did not make a reasonable inquiry into the value of the equipment when the appraisals they obtained indicated a valuation which was approximately 25 times what they had paid for it.

Then, presumably admitting that the plaintiffs nevertheless are entitled to a charitable contribution deduction, the United States argues that the fair market value of the donated hospital equipment should be the $40,000.00 amount paid to the Bankruptcy Court for its purchase. It suggests that this was an arms- length transaction made between a willing seller and a willing buyer and therefore gives the best evidence of what the property was worth. It argues the case of Weitz v. Commissioner, T.C. Memo 1989-99 (1989), for the proposition that the donated hospital equipment should be based on the price the taxpayers paid for the equipment in the bankruptcy sale.

DISCUSSION

The United States has previously indicated that the plaintiffs are, in fact, entitled to charitable deductions and may not suggest otherwise at this late stage of the proceedings. Accordingly, the plaintiffs are correct that the issues remaining for determination are the fair market value of the donated property and the propriety of the gross misstatement of value penalties.

The propriety of the penalties is, of course, linked to the question of fair market value. Therefore, the question of valuation must be decided first.

For purposes of Section 170 of the Internal Revenue Code, the "fair market value" of an item is the hypothetical sale price that would be negotiated between a knowledgeable and willing buyer and a knowledgeable and willing seller, neither of whom are compelled to buy or sell. The Court does not agree that the bankruptcy court was a willing seller not compelled to sell and does not agree that the price the plaintiffs paid for the equipment is relevant to the determination of the fair market value of the donated property. The evidence concerning the bankruptcy sale suggests that the sale of equipment was made in haste, without objection from the creditors, and that there was no hearing on valuation. The Court has read the Weitz case where the bankruptcy sale price was used for valuating donated property but finds that Weitz is distinguishable on its facts.

There is no question that that decision turned on the fact that the donee hospital frequently purchased its equipment at bankruptcy sales and the fact that the plaintiffs were participating in a tax shelter scheme. There is no suggestion in this case that the plaintiffs even considered the tax consequences of their actions when they purchased and then donated the equipment and there is no evidence that the Johnson County Hospital routinely or ever purchased equipment at bankruptcy sales.

If the bankruptcy court's sale price cannot be used to determine the fair market value, the Court must decide whether Mr. Rader's appraisal may be relied upon to fix the value of the plaintiffs' gift.

The United States has argued that he is not a qualified appraiser and that his appraisal is not a qualified appraisal for tax purposes. However, Mr. Rader's affidavit indicates that he is accredited in medical sales by Health Industries Distribution Association's Education Foundation; that he has 30 years of experience in buying and selling new and used medical equipment; and that he regularly performs appraisals of hospital and medical equipment. The Court finds him fully qualified to make the appraisal in question.

The Court recognizes 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. When Mr. Rader was asked by Mr. Peterson to survey and evaluate the equipment at the hospital he had no idea that his report would be used for tax purposes and he was not paid for his services. He thought he was going to determine what the hospital's needs were with the expectation that his company, Skyland Hospital Supply, Inc., would fill those needs and become the hospital's prime vendor for its consumable products. In this Court's judgment, this fact makes his report more reliable rather than less so. Presumably he would not want to overvalue equipment that his company could be expected to replace. For this reason, despite the fact that the appraisal does not conform to all the tax appraisal regulations, the Court finds that it is a qualified appraisal.

Because we have in the record a qualified appraisal made by a qualified appraiser, the Court is justified in relying upon it in deciding the valuation question. Mr. Rader's appraisal was made during the relevant time frame and it does not differ significantly from Mr. Garrick's appraisal which was made at the same time. Accordingly, the Court FINDS that the fair market value of the hospital equipment in question was $1,002,380.00, as indicated by Mr. Rader.

Because the Court has adopted Mr. Rader's appraisal, there is no basis for penalizing the plaintiffs pursuant to Section 6662(a) of the Internal Revenue Code for a gross valuation misstatement.

The Court fully recognizes that the extreme discrepancy between what the taxpayers paid for the hospital equipment and the valuation they claimed as charitable deductions is suggestive of fraud. The Court has very carefully examined all of the evidence in the record with this in mind but finds no fault on the part of the taxpayers. They appear to have recognized that a great deal of potentially valuable hospital equipment was about to be sold at a very low price and lost to the hospital they were hoping to bring into existence. They were not capitalizing on the distress sale price so they could resell the equipment at a profit but merely acting to keep it in place so that they could give it to the new hospital when it came into existence.

Later, when they were taking their tax deductions, they relied upon two appraisals which did not differ substantially. These appraisals were made by people selected by the hospital administrator, were not paid for by the taxpayers, and were not made for tax purposes. Neither appraiser can be said to have been acting as an advocate for the plaintiffs. In each case professional tax advisors examined the appraisals for the plaintiffs and found them to be appropriate. While it is true that these apparently altruistic efforts resulted in an income tax windfall for the plaintiffs, this does not mean that they acted with an intent to defraud or that they are not entitled to the benefit of this windfall. Rather, the facts of this case suggest that the debtor-hospital's Trustee grossly undervalued the equipment in question to the detriment of the hospital's creditors.

Accordingly, the plaintiffs' joint motion for summary judgment is hereby GRANTED and the court FINDS they are entitled to a refund of the additional federal income tax, interest, and tax penalties assessed against them. Assuming the unchallenged figures offered by the plaintiffs are correct, the Hermans are entitled to a judgment in their favor in the amount of $191,870.34, plus interest, and Mr. Brown is entitled to a judgment in the amount of $318,888.65, plus interest.

Thomas Gray Hull
United States District Judge

FOOTNOTES

/1/ Attorney B. Gail Reese, who represented Johnson County Memorial Hospital, Inc. in the bankruptcy proceedings, has testified by affidavit that the figure of $37,000.00 was the result an appraisal of the equipment's liquidation value made by George Garrick of Mountain Medical Equipment.
/2/ Because, according to the IRS, he does not hold himself out to the public as an appraiser and does not perform appraisals on a regular basis.
/3/ His appraisal did not give the expected date of the contribution to the donee; did not give the terms of any agreement or understanding entered into by or on behalf of the donor or donee that relates to the use, sale, or other disposition of the property contributed; did not indicate that it was prepared for income tax purposes; did not give the date or dates upon which the property was appraised; did not give the appraised fair market value as of the expected date of its contribution; did not indicate the method of valuation used to determine the fair market value; and did not give the specific basis for the valuation, such as any specific comparable sales transactions. In addition, the appraiser did not report his fee arrangement with the taxpayer to ensure that it was not based upon a percentage of the appraised value.

END OF FOOTNOTES

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