Abusing A Tax-Exempt

I am looking at a tax-exempt case that went off the rails.

There are rules in the tax-exempt area to encourage one to keep their nose clean. The rules can be different depending on whether the entity is a private foundation or not. The reason is that a foundation is generally considered more susceptible to influence than a “classic” tax-exempt, such as a 501(c)(3), as a foundation generally has a smaller pool of donors.

A doctor (Dr O) organized a 501(c)(3) called American Medical Missionary Care, Inc (AMMC) in 1998. In 2000 it applied for and received tax-exempt status from the IRS. Its exempt purpose was to operate a clinic in Michigan providing medical examination and treatment for individuals unable to afford such services.

Sounds like a great cause to me.

Dr O served as president. His spouse (Mrs O) served on the board of directors as well as secretary and treasurer over the years.

In 2013 AMMC filed its Form 990 reporting compensation of $26,000 paid Dr O and $21,000 paid Mrs O.

AMMC however issued W-2s of $26,000 apiece.

There is a mistake here, but it is not necessarily a big deal. They should tighten down the numbers going forward, though.

On its 2014 Form 990 AMMC reported no compensation to Dr or Mrs O.

Seems odd. Compensation does not tend to turn off and on like a spigot.

Meanwhile, Dr O had gotten in trouble with the Michigan Board of Medicine in 2014. He was required to pay a significant amount of money and also relinquished his medical license. Dr O eventually returned to Nigeria in 2017, leaving his wife in the United States.

The IRS selected the nonprofit for examination.

The revenue agent dug around the AMMC’s various bank accounts for 2014 and found biweekly checks to Mrs O of $1,000 each. There were also certified checks ranging from $6,000 to $10,000. In all, Dr and Mrs O had received cash, checks and money orders from AMMC totaling approximately $130 thousand.

The 990 showed the $130 grand as a loan receivable from Dr O.

Oh please.

Dr O got into trouble and needed cash. He turned to AMMC because that is where the money was. A loan implies an ability to repay and intent to collect, all within the normal course and conduct of business. I seriously doubt that is what we had here.

Dr O and Mrs O had outsized influence over the (c)(3). Who was going to tell them no, much less point out that making loans to officers and board members is minefield territory in the tax Code?

The IRS revenue agent felt the same way and assessed a tier-one penalty.

Penalties in the nonprofit area can be a bit different. There can be penalties on an individual or on the entity itself, for example. The more severe penalties revolve around “excess benefit” transactions and “disqualified persons,” which are – as you might suspect – people with substantial authority or influence over the tax-exempt. Dr O organized AMMC years before and served as its president. He was a poster child for a disqualified person.

The IRS assessed a tier-one penalty of $32,500. It also revoked the exempt status of AMMC.

Let’s walk through the tiered penalty.

The IRS assessed a tier-one penalty of $32,500 on the O's. This is 25% of the $130,000 that Dr and Mrs O drew in 2014. The reason I call it a “tier-one” is that there is a possible “tier two.” To avoid a tier-two, one has to return the money to the tax-exempt.

What happens if one fails to return the money?

The penalty goes to 200%.

This is one of the severest penalties in the tax Code, and Congress intended it that way. Years ago, the only recourse the IRS had was to revoke the entity’s exempt status. Congress felt that this response was a sledgehammer, and it instead created a set of “intermediate” penalties, shifting the burden to the person benefiting from the transaction. With that as background, Congress did not consider 200 percent as excessive.

So the O’s now had another penalty of $230,000.

COMMENT: 200 percent of $130,000 is $260,000, not $230,000. The Court made some tweaks which need not concern us here.

You may be wondering why Dr O would care, if he was safely ensconced in Nigeria.

For one, his wife was still in the United States.

And she was on the Board. She had served as secretary and treasurer. She was a disqualified person in her own right. She was also considered to be a disqualified person by being married to a disqualified person. She was not getting out of this snare.

Mrs O was going to get hammered.

She fielded a last stand:

(1) She argued that much of the money was distributed to needy people to help with rent and utilities, after-school programs for the kids and so forth.

Problem was: she had no records to substantiate any of this. She had not drawn checks in a manner commensurate with this storyline, although she testified that she would hold and re-deposit the certified checks back into the (c)(3) if and as needed. The Court was – by this point – quite skeptical of anything she had to say.

(2)  She argued that much of the money represented compensation to either her or both Dr O and her.

This was her best argument, but unfortunately this route was closed to her.

You see, AMMC should have issued W-2s if it intended for the monies to represent compensation. The tax-exempt did not issue W-2s for 2014. It did not even authorize compensation in its minutes. Some things have to be done currently, and this is one of those things.

A W-2 (or 1099) would have saved a penalty equal to twice its face amount. That is, a $26,000 W-2 to Dr O would have saved a penalty of $52,000 ($26,000 times 200%).

It was a worst-case scenario for the O’s.

Then again, they abused AMCC. That money did not belong to the O’s. It belonged to the (c)(3). The exempt purpose of AMMC was to assist the poor with access to medical care, not to enrich its founding family after the loss of a medical license.

Our case this time was Ononuju v Commissioner, T.C. Memo 2021-94.

 

The Tax Doctrine Of The Fruit And The Tree

 

I am uncertain what the IRS saw in the case. The facts were very much in the taxpayer’s favor.

The IRS was throwing a penalty flag and asking the Court to call an assignment of income foul.

Let’s talk about it.

The tax concept for assignment-of-income is that a transaction has progressed so far that one has – for all real and practical purposes – realized income. One is just waiting for the check to arrive in the mail.

But what if one gives away the transaction – all, part or whatever – to someone else? Why? Well, one reason is to move the tax to someone else.

A classic case in this area is Helvering v Horst. Horst goes back to old days of coupon bonds, which actually had perforated coupons. One would tear-off a coupon and redeem it to receive an interest check. In this case the father owned the bonds. He tore off the coupons and gave them to his son, who in turn redeemed them and reported the income. Helvering v Horst gave tax practitioners the now-famous analogy of a tree and its fruit. The tree was the bond, and the fruit was the coupon. The Court observed:

… The fruit is not to be attributed to a different tree from that on which it grew.”

The Court decided that the father had income. If he wanted to move the income (the fruit) then he would have to move the bond (the tree).

Jon Dickinson (JD) was the chief financial officer and a shareholder of a Florida engineering firm. Several shareholders – including JD – had requested permission to transfer some of their shares to the Fidelity Charitable Gift Fund (Fidelity). Why did they seek permission? There can be several reasons, but one appears key: it is Fidelity’s policy to immediately liquidate the donated stock. Being a private company, Fidelity could not just sell the shares in the stock market. No, the company would have to buy-back the stock. I presume that JD and the others shareholders wanted some assurance that the company would do so.

JD buttoned-down the donation:

·      The Board approved the transfers to Fidelity.

·      The company confirmed to Fidelity that its books and records reflected Fidelity as the new owner of the shares.

·      JD also sent a letter to Fidelity with each donation indicating that the transferred stock was “exclusively owned and controlled by Fidelity” and that Fidelity “is not and will not be under any obligation to redeem, sell or otherwise transfer” the stock.

·      Fidelity sent a letter to JD after each donation explaining that it had received and thereafter exercised “exclusive legal control over the contributed asset.”

So what did the IRS see here?

The IRS saw Fidelity’s standing policy to liquidate donated stock. As far as the IRS was concerned, the stock had been approved for redemption while JD still owned it. This would trigger Horst – that is, the transaction had progressed so far that JD was an inextricable part. Under the IRS scenario, JD would have a stock redemption – the company would have bought-back the stock from him and not Fidelity – and he would have taxable gain. Granted, JD would also have a donation (because he would have donated the cash from the stock sale to Fidelity), but the tax rules on charitable deductions would increase his income (for the gain) more than the decrease in his income (for the contribution). JD would owe tax.

The Court looked at two key issues:

(1)  Did JD part with the property absolutely and completely?

This one was a quick “yes.” The paperwork was buttoned-up as tight as could be.

(2)  Did JD donate the property before there was a fixed and determinable right to sale?

You can see where the IRS was swinging. All parties knew that Fidelity would redeem the stock; it was Fidelity’s policy. By approving the transfer of shares, the company had – in effect – “locked-in” the redemption while JD still owned the stock. This would trigger assignment-of-income, argued the IRS.

Except that there is a list of cases that look at formalities in situations like this. Fidelity had the right to request redemption – but the redemption had not been approved at the time of donation. While a seemingly gossamer distinction, it is a distinction with tremendous tax weight. Make a sizeable donation but fail to get the magic tax letter from the charity; you will quickly find out how serious the IRS is about formalities. Same thing here. JD and the company had checked all the boxes.

The Court did not see a tree and fruit scenario. There was no assignment of income. JD got his stock donation.

Our case this time was Dickinson v Commissioner, TC Memo 2020-128.

The Stealth Tax On Your Social Security

Social security benefits first became taxable in 1983.

The law was relatively straightforward:

·        Half of one’s social security became taxable as adjusted gross income exceeded

o   $32,000 for marrieds filing jointly,

o   $25,000 for everyone else, except for

o   Marrieds filing separately, whose threshold was zero (-0-)

Clearly the tax law frowned on married social security recipients filing separately.

The Senate Finance Committee Report commented on why any social security was being taxed at all:

… by taxing social security benefits and appropriating these revenues to the appropriate trust funds, the financial solvency of the social security trust funds will be strengthened.”

Uh, sure.

In 1993 Congress laid a second grid on top of the 1983 law:

·        85% of one’s social security as adjusted gross income exceeded

o   $44,000 for marrieds filing jointly

o   $34,000 for everyone else, except for

o   Marrieds filing separately, whose threshold remained at zero (-0-)

Depending on where one is income-wise, part of one’s social security can be taxed at 50% and another part at 85%. Make enough and a clawback kicks-in: all your social security will be taxable at 85%.

Seems a bit complicated for a tax provision that snags ordinary people.

So in 1983, if you were married, filing joint and your income was less than $32 grand, your social security was not taxed.

I was curious: what is the equivalent of $32,000 of 1983 dollars in 2019?

Approximately $82 grand.

Wow!

I was also curious: how have the income thresholds for social security changed over three-plus decades?

Here are the thresholds for 2018:

·        $32,000/$25,000

·        $44,000/$34,000

They have not changed at all.

Meanwhile you need almost three 2019 dollars to equal one dollar from 1983.

So let me get this right.

IRA deductions are indexed for inflation. Gift taxes are indexed for inflation. The income thresholds for the new 20% passthrough deduction are indexed for inflation.

But the tax on social security is not.

What a nice gimmick. Even if you started out below the tax threshold, inflation over time would probably put you above the tax threshold.

The cynicism from our politicians is stunning.

The Kiddie Tax Problem

You may have heard that there are issues with the new kiddie tax.

There are.

The kiddie tax has been around for decades.

Standard tax planning includes carving out highly-taxed parental or grandparental income and dropping it down to a child/young adult. The income of choice is investment income: interest, dividends, royalties and the like. The child starts his/her own tax bracket climb, providing tax savings because the parents or grandparents had presumably maxed out their own brackets.

Congress thought this was an imminent threat to the Union.

Which beggars the question of how many trust fund babies are out there anyway. I have met a few over the decades – not enough to create a tax just for them, mind you - but I am only a tax CPA. It is not like I would run into them at work or anything.

The rules used to be relatively straightforward but hard to work with in practice.

(1)  The rules would apply to unearned income. They did not apply if your child starred in a Hollywood movie. It would apply to the stocks and bonds that you purchased for the child with the paycheck from that movie.

(2)  The rules applied to a dependent child under 19.

(3)  The rules applied to dependents age 19 to 23 if they were in college.

(4)  The child’s first $1,050 of taxable unearned income was tax-free.

(5)  The child’s next $1,050 of taxable unearned income was taxed at the child’s tax rate.

(6)  Unearned income above that threshold was taxed at the parent’s tax rate.

It was a pain for practitioners because it required one to have all the returns prepared except for the tax because of the interdependency of the calculation.

For example, let’s say that you combined the parents and child’s income, resulting in $185,000 of combined taxable income. The child had $3,500 of taxable interest. The joint marginal tax rate (let’s assume the parents were married) at $185,000 was 28%. The $3,500 interest income times 28% tax rate meant the child owed $980.

Not as good as the child having his/her own tax rates, but there was some rationale. As a family unit, little had been accomplished by shifting the investment income to the child or children.

Then Congress decided that the kiddie tax would stop using this piggy-back arithmetic and use trust tax rates instead.

Problem: have you seen the trust tax rates? 

Here they are for 2018:

          Taxable Income                         The Tax Is

Not over $2,550                         10%

$2,551 to $9,150         $ 255 plus 24% of excess

$9,151 to $12,500       $1,839 plus 35% of excess

Over $12,500              $3,011.50 plus 37% of excess

Egad.

Ahh, but it is just rich kids, right?

Not quite.

How much of a college scholarship is taxable, as an example?

None of it, you say.

Wrong, padawan. To the extent not used for tuition, fees and books, that scholarship is taxable.

So you have a kid from a limited-means background who gets a full ride to a school. To the extent the ride includes room and board, Congress thinks that they should pay tax. At trust tax rates.

Where is that kid supposed to come up with the money?

What about a child receiving benefits because he/she lost a parent serving in the military? These are the “Gold Star” kids, and the issue arises because the surviving parent cannot receive both Department of Defense and Department of Veteran Affairs benefits. It is common to assign one to the child or children.

Bam! Trust tax rates.

Can Congress fix this?

Sure. They caused the problem.

What sets up the kiddie tax is “unearned” income. Congress can pass a law that says that college room and board is not unearned income or that Gold Star family benefits are not unearned income.

However, Congress would have started a list, and someone has to remember to update the list. Is this a reasonable expectation from the same crew who forgot to link leasehold improvements to the new depreciation rules? Talk to the fast food industry. They will burn your ear off on that topic.

Congress should have just left the kiddie tax alone.

The Parking Lot Tax

Last year’s Tax Cuts and Jobs Act created a 21% tax on transportation-related fringe benefits provided by nonprofits.

That does not sound so bad until you consider that qualified transportation fringe benefits include:

1.    Transit passes or reimbursement for the same

2.    Use of a commuter highway vehicle or reimbursement for the same

3.    Qualified bicycle commuting reimbursement

4.    Qualified parking expenses or reimbursement for the same

That last one proved to be a shocker.

What started the issue was the new deduction disallowance for qualified transportation fringe benefits paid by taxable employers. For example, if the employer pays for employee parking, up to $260 per month can be excluded from the employee’s 2018 W-2. In the past the employer could deduct that $260 on its tax return. Now it could not. Congress felt that – if taxable employers were to be affected – then nonprofit employers should also be affected.

But how does a nonprofit even pay tax?

It can happen, and it is called unrelated business income. In general, it means that the nonprofit is veering away from its charitable mission and is conducting an activity that is virtually indistinguishable from a for-profit business next door.

The nonprofit has to separately account for this activity. The IRS then spots it a $1,000 exemption. If it has more than a $1,000 in profit then it has to pay tax at the corporate rate – which is now 21%.

This change entered the tax Code in December, 2017 via Code Section 512(a)(7):

      (7)  Increase in unrelated business taxable income by disallowed fringe.

Unrelated business taxable income of an organization shall be increased by any amount for which a deduction is not allowable under this chapter by reason of section 274 and which is paid or incurred by such organization for any qualified transportation fringe (as defined in section 132(f) ), any parking facility used in connection with qualified parking (as defined in section 132(f)(5)(C) ), or any on-premises athletic facility (as defined in section 132(j)(4)(B) ).

There are three things to note here:

(1)  Congress is treating these disallowed deductions as if they were income to the nonprofit.

(2)  We have to track down the meaning of “qualified parking,” and

(3)  The phrase “deduction is not allowable” has a meaning that is not immediately apparent.

Let’s start with qualified parking, defined as:

… parking provided to an employee on or near the business premises of the employer or on or near a location from which the employee commutes to work …. 

Qualified parking does not include parking provided near the employee’s residence. 

Employer-provided parking includes parking on property an employer owns or leases, parking for which the employer pays, or parking for which an employer reimburses an employee.

So we know that qualified parking is provided near the employer and the employer pays for, reimburses, leases or owns the parking facility.

This makes sense if there is a public garage across the street and the employer pays the garage directly or reimburses an employee who paid the garage. However, how does this work if the employer owns the parking lot?  More specifically, how does this work if the parking lot is available to employees, customers – that is, to everyone and for free?

There is (what appears to be) a Congressional mistake when drafting Code Section 512(a)(7).

In 1994 the IRS published a rule in Notice 94-3, conveniently titled “IRS Explains Rules For Qualified Transportation Fringe Benefits.” Here is Question 10 and its example:

EXAMPLE. Employer Z operates an industrial plant in a rural area in which no commercial parking is available. Z furnishes ample parking for its employees on the business premises, free of charge. The parking provided by Z has a fair market value of $0 because an individual other than an employee ordinarily would not pay to park there.

The answer makes sense. Anyone can park on that lot for free. If an employee parks there, it seems reasonable that the value of the parking would be zero (-0-).

That is not what Code Section 512(a)(7) did:

Unrelated business taxable income of an organization shall be increased by any amount for which a deduction is not allowable ….

There is no reference here to value. To the contrary, the reference is to a deduction – which to an accountant means cost. Parking may be free to the user, but it will cost something to maintain that parking facility. The cost may be a lot or a little, but there is a cost.

The Notice 94-3 rule that tax practitioners had gotten used to was overturned.

Needless to say, there were many questions on what the new rules meant and how to apply them. Consider that a nonprofit is supposed to make quarterly estimated tax payments against any expected unrelated-business-income tax, and guidance was needed sooner rather than later. On December 10, 2018 the IRS published interim guidance (Notice 2018-99) on qualified transportation fringe benefits. 

It started with the easiest example:

A taxable employer pays a garage $12,000 annually so that its employees can park. None of this exceeds the $260 monthly threshold per employee for 2018. The entire $12,000 is non-deductible by the employer.

Introduce any complexity and there are steps to the calculation:   

(1)  Calculate the cost for reserved employee spots.

a.     These costs are disallowed.

(2)  Calculate the primary use of the remaining spots.

a.     If more than 50% is for customers, clients and the general public, the calculation ends.

                                                             i.     Any remaining cost is fully deductible.

b.    If more than 50% is for employees, there is math:

                                                             i.     Calculate the cost for reserved nonemployee parking; these costs are allowed.

                                                           ii.     Calculate the cost for nonreserved employee parking; these costs are disallowed.

Let’s go through an example from the Notice.

An accounting firm leases a parking lot for $10,000 next to its office. The lot has 100 spaces, used by clients and employees. The firm has 60 employees.

(1)  There are no reserved employee parking spaces

a.     We have zero (-0-) from this step.

(2)  The primary use is for employees (60/100).

a.     We have math.

(3)  There are no reserved nonemployee parking spaces (think visitor parking).

a.     We have zero (-0-) from this step.

(4)  One must use a reasonable allocation method. The accounting firm determines that employee use constitutes 60% (60/100) of parking lot use during business days, with no adjustment for evenings, weekends or holidays. The disallowance is $6,000 ($10,000 times 60%).

An accounting firm is a taxable entity, so the $6,000 is not deductible on its return.

What if we were talking about a nonprofit? Then the $6,000 magically “transforms” into unrelated business taxable income. The IRS spots $1,000 exemption, so the taxable amount is $5,000. Apply a 21% tax rate and the tax on the parking lot is $1,050.

What if the employer owns the parking lot? What costs could there be to a parking lot?

The IRS thought of this:

For purposes of this notice, “total parking expenses” include, but are not limited to, repairs, maintenance, utility costs, insurance, property taxes, interest, snow and ice removal, leaf removal, trash removal, cleaning, landscape costs, parking lot attendant expenses, security, and rent or lease payments or a portion of a rent or lease payment (if not broken out separately). A deduction for an allowance for depreciation on a parking structure owned by a taxpayer and used for parking by the taxpayer’s employees is an allowance for the exhaustion, wear and tear, and obsolescence of property, and not a parking expense for purposes of this notice.

At a minimum, I anticipate that one is allocating insurance and taxes.

So a nonprofit can have tax because it provides parking to its employees. You may have heard this referred to as the “church parking lot tax.” Yes, churches are 501(c)(3)s, meaning they are nonprofits just like the March of Dimes. Granted, there are additional tax breaks to being a church, such as not having to file a Form 990. The unrelated business income tax is not filed on a Form 990, however; it is filed on a Form 990-T. They both have “990” in their name, but they are separate tax forms. Who knows how many churches will have to file a Form 990-T for the first time for 2018, even though their board has never filed – or even seen - a Form 990.

How can a church have income from its parking lot?

If it charges for parking, obviously. That however is a low probability event.

Another way would be to have reserved employee parking spaces. Those are allocated cost (which morphs into income) immediately.

A third way is the employee:nonemployee calculation. That calculation would be tricky because of the uneven use of a church over an average week. One would somehow weight the use of the parking lot. Church employees are there Monday through Friday. The congregation is there on Sunday and (maybe) one night during the week. Perhaps employee parking is weighted using a factor of eight (hours) and congregational use is weighted using a factor of 2.5 (hours). Hopefully the result is to get congregational use above 50%. Why?

Remember: if nonemployee use at step (2) is more than 50%, the calculation ends. All the church would have to pay tax on is income from reserved employee parking. If that is below $1,000, there is no tax.

There is an effort to include a repeal of Code Section 512(a)(7) on any extender or other bill that Congress may pass, but that would require Congress to be able to pass a bill – any bill – in the near future.

The Notice also has one of the more unusual “make-up” provisions I have seen. Say that you want to do away reserved employee parking (that is, step (1)) because the tax gets expensive. It is way too late to do anything for 2018, as the guidance came out in December. The Notice allows you to make the change by March 31, 2019 and consider it retroactive to January 1, 2018.

Our church would have no step (1) income as long as it did away with reserved employee parking by March 31, 2019. That would mean taking down the sign saying “Pastor Parking Only,” but that may be the best alternative until Congress can correct this mess.

The Abbott Laboratories 401(k)

Something caught my eye recently about student loans. A 401(k) is involved, so there is a tax angle.

Abbott Laboratories is using their “Freedom 2 Save” program to:

… enable full-time and part-time employees who qualify for the company's 401(k) – and who are also contributing 2 percent of their eligible pay toward student loans – to receive an amount equivalent to the company's traditional 5 percent "match" deposited into their 401(k) plans. Program recipients will receive the match without requiring any 401(k) contribution of their own.”

Abbott will put money into an employee’s 401(k), even if the employee is not himself/herself contributing.

As I understand it, the easiest way to substantiate that one’s student loan is 2% or more of one’s eligible pay is to allow Abbott to withhold and remit the monthly loan amount. For that modest disclosure of personal information, one receives a 5% employer “match” contribution.

I get it. It can be difficult to simultaneously service one’s student loan and save for retirement.

Let’s take this moment to discuss the three main ways to fund a 401(k) account.

(1)  What you contribute. Let’s say that you set aside 6% of your pay.

(2)  What your employer is committed to contributing. In this example, say that the company matches the first 4% and then ½ of the next 2%. This is called the “match,” and in this example it would be 5%.

(3)  A discretionary company contribution. Perhaps your employer had an excellent year and wants to throw a few extra dollars into the kitty. Do not be skeptical: I have seen it happen. Not with my own 401(k), mind you (I am a career CPA, and CPA firms are notorious), but by a client. 

Abbott is not the first, by the way. Prudential Retirement did something similar in 2016.

The reason we are talking about this is that the IRS recently blessed one of these plans in a Private Letter Ruling. A PLR is an IRS opinion requested by, and issued to, a specific taxpayer. One generally has to write a check (the amount varies depending upon the issue), but in return one receives some assurance from the IRS on how a transaction is going to work-out taxwise. Depending upon, a PLR is virtually required tax procedure. Consider certain corporate mergers or reorganizations. There may be billions of dollars and millions of shareholders involved. One gets a PLR – period – as the downside might be career-ending.

Tax and retirement pros were (and are) concerned how plans like Abbott’s will pass the “contingent benefits” prohibition. Under this rule, a company cannot make other employee benefits – say health insurance – contingent on an employee making elective deferrals into the company’s 401(k) plan.

The IRS decided that the prohibition did not apply as the employees were not contributing to the 401(k) plan. The employer was. The employees were just paying their student loans.

By the way, Abbott Laboratories has subsequently confirmed that it was they who requested and received the PLR.

Technically, a PLR is issued to a specific taxpayer and this one is good only for Abbott Laboratories. Not surprisingly there are already calls to codify this tax result. Once in the Code or Regulations, the result would be standardized and a conservative employer would not feel compelled to obtain its own PLR.

I doubt you and I will see this in our 401(k)s.  This strikes me as a “big company” thing, and a big company with a lot of younger employees to boot.

Great recruitment feature, though.

Spotting A Contribution

Do you think you could spot a tax-deductible donation?

Let’s begin by acknowledging that the qualifier “tax-deductible” kicks it up a notch. Give $300 to the church on Christmas Eve service and you have made a donation. Fail to get a letter from the church acknowledging that you donated $300, receiving in return only intangible benefits, and you probably forfeited the tax deductibility.

Let’s set it up:

(1)  There was a related group of companies developing a master-planned community in Lehi, Utah.

(2)  There were issues with density. The company had rights to develop if it could receive approval from the city council.

(3)  The city council said sure – but you have to reduce the density.

a.     Rather than reduce the number of units, the developer decided to donate land to the city – 746.789 acres, to be exact.

I see couple of ways to account for this additional land. One way is to add its cost to the other costs of the development. With this accounting you have to wait until you sell the units to get a deduction, as a slice of the land cost is allocated to each unit.

That wasn’t good enough for our taxpayer, who decided to account for the additional land by …

(4) … taking a charitable donation of $11,040,000.

What do you think? Does this transaction rise to the level of a deductible contribution and why or why not?

In general, a contribution implies at least a minimal amount of altruism. If one receives value equivalent to the “donation,” it is hard to argue that there is any altruism or benevolence involved. That sounds more like a sale than a donation. Then there is the gray zone: you donate $250 and in turn receive concert tickets worth $60. In that case, one is supposed to show the contribution as $190 ($250 - $60).

Sure enough, the IRS fired back with the following:

(1)  The transfer was part of a quid pro quo arrangement to receive development approvals.

That seems a formidable argument, but this is the IRS. We still have to bayonet the mortally wounded and the dead.

(2)  The transfer was not valid because [taxpayer] did own the development credits (i.e., someone else in the related-party group did).

(3)  The contemporaneous written acknowledgement was not valid.

(4)  The appraisal was not a qualified appraisal.

(5)  The value was overstated.

Yep, that is the IRS we know. Moderation is for amateurs.

A quid pro quo reduces a charitable deduction. Quid too far and you can doom a charitable deduction. Judicial precedence in this area has the Court reviewing the form and objective features of the transaction. One can argue noble heart and best intentions, but the Court was not going to spend a lot of time with the subjectivity of the deal.

The taxpayer was loaded for bear: the written agreement with the city did not mention that taxpayer received anything in return. To be doubly careful, it also stated that – if there was something in return – it was so inconsequential as to be immeasurable.

Mike drop.

The IRS pointed out that – while the above was true – there was more to the story. The taxpayer wanted more than anything to have the development plan approved so they could improve the quality of life make a lot of money. The city council wanted a new plan before approving anything, and that plan required the taxpayer to increase green space and reduce density.

Taxpayer donated the land. City council approved the project.

Nothing to see here, argued the taxpayer.

The Court refused to be blinkered by looking at only the written agreement. When it looked around, the Court decided the deal looked, waddled and quacked like a quid pro quo.

The taxpayer had a back-up argument:

If there was a quid pro quo, the quid was so infinitesimal, so inconsequential, so Ant-Man small as to not offset the donation, or at least the lion’s share of the donation.

I get it. I would make exactly the same argument if I were representing the taxpayer.

The taxpayer trotted out the McGrady decision. The facts are a bit peculiar, as someone owned a residence, a developer owned adjoining land and a township was resolute in preserving the greenspace. To get the deal to work, that someone donated both an easement and land and then bought back an odd-shaped parcel of land to surround and shield their residence. The Court respected the donation.

Not the same, thundered the Tax Court. McGrady had no influence over his/her deal, whereas taxpayer had a ton of influence over this one. In addition, just about every conservation easement has some incidental benefit, even if the benefit is only not having a crush of people on top of you.

The quid quo pro was not incidental. It was the key to obtaining the city council’s approval. It could not have been more consequential.

And it was enough to blow up a $11,040,000 donation.

Whereas not in the decision, I can anticipate what the tax advisors will do next: capitalize the land into the development costs and then deduct the same parcel-by-parcel. Does this put the taxpayer back where it would have been anyway?

No, it does not. Why? Because the contribution would have been at the land's fair market value. Development accounting keeps the land at its cost. To the extent the land had appreciated, the contribution would have been more valuable than development accounting.

Our case for the home gamers was Triumph Mixed Use Investments II LLC, Fox Ridge Investments, LLC, Tax Matters Partner v Commissioner, T.C. Memo 2018-65.