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).

More.

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.

Taxpayer Loses Charitable Deduction for Lack of Appraisal

Joseph Mohamed seems a good sort. He and his wife live in Sacramento, California. He is a successful real estate professional. In 1998 they formed the Joseph Mohamed Sr. and Shirley M. Mohamed Charitable Remainder Unitrust II. Tax pros call this a “CRUT.”

QUESTION: What is a CRUT? This is a special trust involving a charity. You can guess that a purpose of the trust is to make a charitable donation. In a CRUT, an annuity goes to the donor (in this case, Joseph and Shirley) for a period of years. At the expiration of that period, the remainder goes to a charity. In the Mohamed’s case, that period is twenty years. Why would you do that in place of simply donating twenty years out? Because the CRUT allows you to claim the charitable deduction now.

In 2003 and 2004 the Mohameds donated several properties to the CRUT. The properties were worth somewhere between $18 million and $21 million. Joseph Mohamed prepared his own taxes. This means he ran into Form 8283 to report the property donations. He did not read the instructions though, as he did not think he had to. The form seemed straightforward enough.

Form 8283 has several parts. Part 1 Section B required a description of the donated property and “can be completed by the taxpayer and/or appraiser.” It also had the following text:

“If your total art contribution deduction was $20,000 or more you must attach a complete copy of the signed appraisal. See instructions.”  

Mohamed was contributing real estate, not art. He read that to mean that he did not have to attach an appraisal. He did attach all types of statements and documentation to his return, including his own valuation of the real estate.

The return gets audited (who is shocked?). The IRS was displeased that Mohamed had self-valued such a large dollar donation of property. The IRS first goes after the valuation. Makes sense. Mohamed then gets an independent appraisal which shows that the properties are worth more than he claimed.

The IRS then pulls back and realizes something. Regulation 1.170A-13(c) requires the following for donations of this nature and amount:

1.      A qualified appraisal must be made not more than 60 days before the donation and no later than the due date of the return.

2.      It must be signed by a qualified appraiser, who cannot be the donor or person claiming the deduction.

3.      The qualified appraisal must contain defined information, such as a description of the property, its basis and fair market value.

Mohamed had a problem. You see, he did not have a qualified appraisal. That requires an independent appraiser, and he obtained that after the filing of his return. There was of course no signature, as there was no qualified appraisal. While he attached numerous statements to his return, they did not completely address the litany of questions that the IRS wanted in Reg 1.170A-13(c).

The IRS disallowed the donations. Mohamed goes to Tax Court and raises three arguments:

1.      The extreme result indicates that the Regulations are invalid.

2.      The IRS-designed Form 8283 misled him.

3.      He substantially complied with the documentation requirements.

The Court quickly dismissed arguments 1 and 2. It went through an analysis (which we will skip) and concluded that the Regulations were valid and reflected Congressional intent. The IRS, for example, was ordered by Congress to issue Regulations requiring appraisals for donations of property in excess of $5,000. A Regulation that implements Congressional intent is difficult to rule invalid. The Court was sympathetic to argument 2, but it pointed out that the form is not the tax law. The Court even added that “a taxpayer relies on his private interpretation of a tax form at his own risk.”

Now we get to argument 3. What does “substantially comply” mean? There was a previous case (Bond) where the Court found substantial compliance, but succeeding cases have ever compressed the reach of that decision. The Court determined that substantial compliance meant complying with the “essential requirement” of the statute. Problem is, the “essential requirement” of the statute is the need to obtain a qualified appraisal. With that verbal loop, there was no way that Mohamed could substantially comply.

Here is the Court:

We recognize that this result is harsh – a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions – all reported on forms that even to the Court’s eyes seemed likely to mislead someone who did not read the instructions.”

MY TAKE: I am sympathetic to the Mohameds, but I am also confused. They must have used a tax professional in the past to establish the CRUT. They then make a near-$20 million donation but do not hire a pro to walk it through? It doesn’t make sense to me.

In both Mohamed and Durden there was no question that contributions were made; there were also no question as to the amounts. The taxpayer may have felt comfortable thinking: what are they going to do, put me in jail? No, they won’t put you in jail, but they will take away your charitable deduction. Don’t think that a court will bail you out, as there may be limits to what a court can do.

What is the answer? I would encourage the use of a tax professional if there is even a whiff of a question on your return. I know – it costs money. The problem is that you may not know you have hit a slick spot until after the IRS contacts you. As Mohamed and Durden have shown, that may be too late.

Something New In Gifting of Family Limited Partnerships

Let’s talk this time about gift taxation.

Let’s say that you have a family-owned company.  You desire to pass this on to your kids and grandkids. There are ways to do this, but the method best for you is annual gifts of $13,000, which is the amount of the gift tax annual exclusion. Both you and your spouse can give away $13,000 per beneficiary, so you are transferring $26,000 at a clip. Enough beneficiaries and this can add up.

You ask: what could go wrong?

What if the IRS challenged the value of the gift? Remember, partnership or LLC units generally do not have the same value as a direct and uninterrupted transfer of the asset(s) in the partnership or LLC.

Why is that? Well, if you are a limited member, you have to obtain the general member’s permission to asset. If you are my daughter and I am the general member, rest assured that permission is not happening for a while.  My daughter may “own” $26,000 (2 annual gifts of $13,000) in the LLC, but is it really worth $26,000?  Remember: you need my permission to get to the $26,000. Would you pay her $26,000 today on the hope and prayer that someday I will distribute $26,000 to you? 

Let’s say that IRS comes in says that the LLC units are not worth $26,000. Instead the units are worth $40,000.  What just happened? What happened is that I have to amend my gift tax return. I am now using my lifetime exemption so as not write a check to the IRS. Had I already used-up my lifetime exemption, I would be writing a check. I would not be happy.

What if I changed the terms of the gift? Instead of saying that my wife and I transferred X number of units, we say we transferred units (or fractions thereof) worth $13,000 to our daughter. If the IRS adjusts the gift value upward, then – as far as I am concerned - I “actually” gifted fewer units. Remember, I gifted $13,000 in value, NOT a set number of units. Brilliant!

Except that the IRS thought it too brilliant. This tax technique is called a “defined value clause,” and the IRS has pursued these cases on multiple grounds, including being against public policy.

One of the first cases was Proctor. There the donors gifted remainder interests using the following clause:

“In the event it should be determined … that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of the taxpayer.”        

The Fourth Circuit of Appeals nixed the Proctor clause as being after-the-fact. It was a condition subsequent. The IRS continued its win streak with Ward and with Harwood.

Those cases are easy to understand: you cannot undo what has already been done. Let’s make it more challenging.

What if you are not trying to undo anything?  What if you have two beneficiaries: your family and any excess going to charity? Think about this for a moment. If the IRS revalues the gift, the revaluation would be “excess” and go to the charity. There is no gift tax on transfers to charity. There would be little motivation for the IRS to pursue you. The IRS still did not like this and litigated the matter in Christiansen, McCord and Petter. This time, they were not as successful.

What if you like the result in McCord but it is not your intent to include a charitable beneficiary? Congratulations. You are Dean and Joanne Wandry. The Wandry’s gifted partnership units worth $1,099,000 on January 1, 2004. The actual number of units was not fixed, pending a later valuation. The valuation was completed July 26, 2005. The IRS examined the gift tax returns and issued the tax assessment in February, 2009.

The IRS argued that

·         The descriptions on the gift tax returns sounded like a transfer of units and not dollars

·         The entry the accountant made to the books sounded like a transfer of units and not dollars

·         The attorney’s documents sounded like a transfer of units and not dollars

·         It was against public policy to transfer dollars and not units, and

·         In any event the taxpayers smelled funny.

The Wandry’s took the matter to Tax Court. They won their case this past March, and they are now famous as being the first taxpayers to win against the IRS using a formula clause that doesn’t have a charitable element. Granted, this is not the same as winning the Peyton Manning sweepstakes, but it is something.

My take: I expect to see Wandry clauses as standard boilerplate in FLP transfer documents from this point on.