Side Agreement by Charity to Return Contribution in the Event of IRS Disallowance of Deduction Results in Denial of Charitable Income Tax Deduction for Donation of Easement and Cash

Side Agreement by Charity to Return Contribution in the Event of IRS Disallowance of Deduction Results in Denial of Charitable Income Tax Deduction for Donation of Easement and Cash

News story posted in U.S. Tax Court on 15 January 2014| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 15 January 2014

by Richard L. Fox, Esq.

In a recent case decided by the Tax Court, Graev, 140 TC No. 17, because of the attendant risk of an IRS disallowance of charitable deductions taken in connection with an contribution of an easement, the donor, a New York attorney, entered into a side agreement that required the charity to return his cash contribution and remove the easement from the property’s title if the deductions were disallowed by the IRS. Thus, by entering into the agreement, the donor was assured that he would attain the benefit of the tax deductions associated his contributions or, if he didn’t attain such benefit because of an IRS disallowance, his contribution would simply be returned. The IRS disallowed the charitable contribution deduction, not based on the easement contribution failing to qualify, but because both the cash and easement contribution were conditional and therefore nondeductible. The Tax Court agreed, concluding that the charity’s promises in the side agreement made the gifts conditional, and that the chance that the condition would occur wasn't “so remote as to be negligible.” 

The case involved Lawrence Graev, an attorney, who purchased a historic property in New York City in 1999 for $4.3 million. He was the sole fee simple owner of the property and he held it subject to a mortgage. In 2004, Mr. Graev was contacted by National Architectural Trust (“NAT”), which the parties stipulated was a qualified organization under IRC § 170(h)(3) to which a charitable contribution of an easement can be made that is deductible for income tax purposes.  In its solicitation materials, NAT would feature the tax benefits that potential donors could receive for contributing a façade conservation easement and corresponding cash endowment (usually 10% of the appraised easement value), and it would as a matter of “standard Trust policy” return a cash contribution to the extent that IRS disallowed a deduction for it.

Mr. Graev apparently had a neighbor who had contributed a façade easement to NAT and received a “side letter” promising the return of contributions if deductions were disallowed. Mr. Graev was interested in making an easement contribution, but was concerned when his accountants referred him to IRS Notice 2004-41, which was issued earlier in the same year in which Mr. Graev made the contributions.  This notice stated that some taxpayers were claiming inappropriate charitable contribution deductions under IRC § 170 for cash payments or easement transfers to charitable organizations.  In response to his concerns, NAT stated that the IRS notice was referring to a distinct practice where the non-profit acquires property, puts an easement on it, and sells it for a reduced price plus a tax-deductible contribution.  It further stated that none of the over 400 donations made to it in New York City had been disallowed.

On September 20, 2004, Mr. Graev executed a façade conservation easement application to NAT, and expressly referenced the “side letter” in his correspondence. A side letter was sent from NAT to Mr. Graev on September 24, 2004. The side letter didn't indicate that Mr. Graev would have to sue NAT in order to remove the easement if IRS disallowed his contribution, but rather only indicated that the easement would be removed from the property's title. The property was subsequently appraised at $9 million, with the easement reducing its value by 11% (or $990,000). The conservation deed was executed in late 2004 and recorded on February 17, 2005. Mr. Graev also made a $99,000 contribution to NAT to cover its current operating costs and to fund its long-term monitoring and administration needs.

In August of 2005, NAT sent Mr. Graev a letter informing him that the terms of the side letter may affect the deductibility of his cash contribution, and offering to withdraw the provision that it would return the contributions in the event that IRS disallowed the corresponding deductions. Mr. Graev did not ask NAT to withdraw the provision.  On Mr. Graev's 2004 return (filed jointly with his wife), he claimed a deduction for the $99,000 cash contribution and claimed a charitable contribution deduction with respect to the façade easement of $544,449 (due to the limits in IRC  § 170(b)(1)(C)). The remaining $445,551 was claimed as a carryover deduction on their fx2005 return.

In 2008, the IRS issued a deficiency notice disallowing the cash and easement charitable contribution deductions for both years, stating that the contributions were “made subject to subsequent event(s)” given that the contributions were conditioned upon the IRS not subsequently disallowing the deductions.  In response, Mr. Graev, in an attempt to salvage the deductions, claimed that the very side letter he had executed was unenforceable under New York law because the conditions were not included in the recorded deed. As a result, he claimed that the side letter was a null and void and that the contribution therefore was not conditional. 

In its analysis, the court specifically pointed to Reg. § 170A-1(e), which provides that if an interest in property passes to, or is vested in, charity on the date of the gift and the interest would be defeated by the subsequent performance of some act or the happening of some event, the possibility of occurrence of which appears on the date of the gift to be so remote as to be negligible, the deduction is allowable. Thus, the court noted the deduction may be available notwithstanding a possibility that the contribution will be defeated by a subsequent event, but only if that possibility is “so remote as to be negligible.”  The court emphasized that a fundamental principle underlying the charitable contribution deduction is that the charity actually receive and keep the contribution and that Reg. Reg. § 170A-1(e) clarifies that principle: no deduction for a charitable contribution that is subject to a condition (regardless of what the condition might be) is allowable, unless on the date of the contribution the possibility that a charity's interest in the contribution “would be defeated” is “negligible”.  The court stated, therefore, the Graevs' deductions are not allowable unless the possibility that NAT's interests in the easement and cash would be defeated was “so remote as to be negligible”.

The Tax Court concluded that NAT's promises in the side letter made the gifts conditional, and that the chance that the condition would occur wasn't “so remote as to be negligible.”  The court looked to prior cases, noting that it has generally defined “so remote as to be negligible” as “a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction.” With this definition in mind, the court found that on the date of the contribution, the possibility that IRS would disallow the deductions and NAT would return the cash did not satisfy this standard.  First, the court found that the possibility of disallowance by IRS wasn't negligible, noting that IRS had publicly announced its intent to scrutinize charitable deductions for façade easement contributions. It also noted that Mr. Graev was obviously aware of this risk and didn't consider it negligible, given his insistence on a side letter. The court found that since the risk of IRS disallowance was non-negligible, so was the prospect that NAT would be called on to honor its side letter. The court also was not convinced by Mr. Graev's claim that the side letter was unenforceable, noting that NAT reserved the right to abandon the easement in the deed. According to the court, this reserved right meant that NAT had the ability to honor the promises made in the side letter, and the possibility that it would actually do so was more than negligible.

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