Friday, July 28, 2017

RERI-ng Its Ugly Head - Part One

Here is the Court:
The action involves RERI Holdings I, LLC (RERI). On its 2003 income tax return RERI reported a charitable contribution of property worth $33,019,000. Respondent determined that RERI overstated the value of the contribution by $29,119,000.”
That is considerably more than a rounding error.

The story involves California real estate, a billionaire and a university perhaps a bit too eager to receive a donation.

The story is confusing, so let’s use a dateline as a guide.

February 6, 2002 
Hawthorne bought California real estate for $42,350,000. Technically, that real estate is in an LLC named RS Hawthorne LLC (Hawthorne), which in turn is owned by RS Hawthorne Holdings LLC (Holdings).
Holdings in turn is owned by Red Sea Tech I (Red Sea). 
February 7, 2002 
Red Sea created two types of ownership:
First, ownership for a period of time (technically a “term of years,” abbreviated TOYS).
Second, a future and successor interest that would not even come into existence until 2021. Let’s call this a “successor” member interest, or SMI. 
QUESTION: Why a delayed ownership interest? There was a great lease on the California real estate, and 2021 had significance under that lease.
March 4, 2002     
RERI was formed.
March 25, 2002
RERI bought the SMI for $2,950,000.
August 27, 2003
RERI donated the SMI to the University of Michigan.
A key player here is Stephen Ross, a billionaire and the principal investor in RERI. He had pledged to donate $5 million to the University of Michigan. 

Ross had RERI donate the SMI. 
The University agreed to hold the SMI for two years, at least, before selling.
Do you see what they have done? Start with a valuable piece of leased real estate, stick it in an LLC owned by another LLC owned by another … ad nauseum, then create an LLC ownership stake that does not even exist (if it will ever exist) until 2021.

What did RERI donate to the University of Michigan?

You got it: the thing that doesn’t exist for 18 years.

I find this hard to swallow.

“Successor” LLC interests are sasquatches. You can spend a career and never see one. The concept of “successor” makes sense in a trust context (where they are called “remaindermen”), but not in a LLC context. This is a Mary Shelly fabrication by the attorneys.

So why do it?

Technically, the SMI will someday own real estate, and that real estate is not worth zero.

RERI hired a valuation expert who determined it was worth almost $33 million. This expert argued that the lease on the property – and its reliable series of payments – allowed him to use certain IRS actuarial tables in arriving at fair market value (the approximately $33 million).

Wait. It gets better.

The two years pass. The University sells the property … to an entity INDIRECTLY OWNED by Mr. Ross for $1,940,000.

This entity was named HRK Real Estate Holdings, LLC (HRK).


HRK had already prearranged to sell the SMI to someone else for $3 million.

Still more.

That someone donated the same SMI and claimed yet another deduction of $29,930,000.
REALITY CHECK: This thing sells twice for a total of approximately $5 million but generates tax deductions of approximately $63 million.
Yet more.

Who did the valuation on that second donation? Yep, the same guy who did RERI’s valuation.

The IRS disallowed RERI’s donation to zero, zip, zilch, nada. The IRS was clear: this thing is a sham.

And there begins the litigation.

How something can simultaneously be worth $33 million and $2 million?

This is all about those IRS tables.

Generally speaking, the contribution of property is at fair market value, usually described as the price arrived at between independent buyers and sellers, neither under compulsion to sell or buy and both informed of all relevant facts.

Except …

For annuities, life estates, remainders, reversions, terms of years and similar partial interests in property. They are not full interests so they then have to be carved-out and adjusted to present value using IRS-provided tables.
OBSERVATION: Right there, folks, is why the attorneys created this Frankenstein. They needed to “separate” the interests so they could get to the tables.
RERI argued that it could value that real estate 18 years out and use the tables. Since the tables are concerned only with interest rates and years, the hard lifting is done before one gets to them.

Not so fast, said the IRS.

That real estate is in an LLC, so it is the LLC that has to be valued.  There are numerous cases where the value of an asset and the value of an ownership interest in the entity owning said asset can be different – sometimes substantially so. You cannot use the tables because you started with the wrong asset.

But the LLC is nothing but real estate, so we are back where we started, countered RERI.

Not quite, said the IRS. The SMI doesn’t even exist for 18 years. What if the term owner mortgages the property, or sells it, or mismanages it? That SMI could be near worthless by the time some profligate or incompetent is done with the underlying lease.

Nonsense, said RERI. There are contracts in place to prohibit this.

How pray tell is this “prohibited?” asked the IRS.

Someone has to compensate the SMI for damages, explained RERI.

“Compensate” how? persisted the IRS.

The term owner would forfeit ownership and the SMI would become an immediate owner, clarified RERI.

So you are making the owner of a wrecked car “whole” by giving him/her the wrecked car as recompense, analogized the IRS. Can the SMI at least sue for any unrecovered losses?

Uhhhh … no, not really, answered RERI. But it doesn’t matter: the odds of this happening are so remote as to not warrant consideration.

And so it drones on. The case goes into the weeds.

Who won: the government or the billionaire?

It was decided in a later case. We will talk about it in a second post.

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