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.

How Choosing The Correct Court Made The Difference

I am looking at a District Court case worth discussing, if only for the refresher on how to select a court of venue. Let’s set it up.

ABC Beverage Corporation (ABC) makes and distributes soft drinks and non-alcoholic beverages for the Dr Pepper Snapple Group Inc. Through a subsidiary it acquired a company in Missouri. Shortly afterwards it determined that the lease it acquired was noneconomic. An appraisal determined that the fair market rent for the facility was approximately $356,000 per year, but the lease required annual rent of $1.1 million. The lease had an unexpired term of 40 years, so the total dollars under discussion were considerable.

The first thing you may wonder is why the lease could be so disadvantageous. There are any number of reasons. If one is distributing a high-weight low-value product (such as soft drinks), proximity to customers could be paramount. If one owns a franchise territory, one may be willing to pay a premium for the right road access. Perhaps one’s needs are so specific that the decision process compares the lease cost to the replacement cost of building a facility, which in turn may be even more expensive. There are multiple ways to get into this situation.

ABC obtained three appraisals, each of which valued the property without the lease at $2.75 million. With the lease the property was worth considerably more.

NOTE: Worth more to the landlord, of course. 

ABC approached the landlord and offered to buy the facility for $9 million. The landlord wanted $14.8 million. Eventually they agreed on $11 million. ABC capitalized the property at $2.75 million and deducted the $6.25 million difference.

How? ABC was looking at the Cleveland Allerton Hotel decision, a Sixth Circuit decision from 1948. In that case, a hotel operator had a disastrous lease, which it bought out. The IRS argued that that the entire buyout price should be capitalized and depreciated. The Circuit Court decided that only the fair market value of the property could be capitalized, and the rest could be deducted immediately. Since 1948, other courts have decided differently, including the Tax Court. One of the advantages of taking a case to Tax Court is that one does not have to pay the tax and then sue for refund. A Tax Court filing suspends the IRS’ ability to collect. The Tax Court is therefore the preferred venue for many if not most tax cases.

However and unfortunately for ABC, the Tax Court had decided opposite of Cleveland Allerton (CA), so there was virtually no point in taking the case there. ABC was in Michigan, which is in the Sixth Circuit. CA had been decided in the Sixth Circuit. To get the case into the District Court (and thus the Circuit), ABC would have to pay the tax and sue for refund. It did so.

The IRS came out with guns blazing. It pointed to Code Section 167(c)(2), which reads:

            (2) Special rule for property subject to lease

If any property is acquired subject to a lease—

(A) no portion of the adjusted basis shall be allocated to the leasehold interest, and

(B) the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease.

The IRS argued that the Section meant what it said, and that ABC had to capitalize the entire buyout, not just the fair market value.  It trotted out several cases, including Millinery Center and Woodward v Commissioner. It argued that the CA decision had been modified – to the point of reversal – over time. CA was no longer good precedent.

The IRS had a second argument: Section 167(c)(2) entered the tax Code after CA, with the presumption that it was addressing – and overturning – the CA decision.

The Circuit Court took a look at the cases. In Millinery Center, the Second Circuit refused to allow a deduction for the excess over fair market value. The Sixth Circuit pointed out that the Second Circuit had decided that way because the taxpayer had failed its responsibility of proving that the lease was burdensome. In other words, the taxpayer had not gotten to the evidentiary point where ABC was.

In Woodward the IRS argued that professional fees pursuant to a stockholder buyout had to be capitalized, as the underlying transaction was capital in nature. Any ancillary costs to the transaction (such as attorneys and accountants) likewise had to be capitalized. The Sixth Circuit pointed out the obvious: ABC was not deducting ancillary costs. ABC was deducting the transaction itself, so Woodward did not come into play.

The Court then looked at Section 167(c)(2) – “if property is acquired subject to a lease.” That wording is key, and the question is: when do you look at the property? If the Court looked before ABC bought out the lease, then the property was subject to a lease. If it looked after, then the property was not. The IRS of course argued that the correct time to look was before. The Court agreed that the wording was ambiguous.

The Court reasoned that a third party purchaser looking to acquire a building with an extant lease is different from a lessee purchaser. The third party acquires a building with an income stream – two distinct assets - whereas the lessee purchaser is paying to eliminate a liability – the lease. Had the lessee left the property and bought-out the lease, the buy-out would be deductible.

The Court decided that the time to look was after. There was no lease, as ABC at that point had unified its fee simple interest. Section 167(c)(2) did not apply, and ABC could deduct the $6.25 million. The Court decided that its CA decision from 1948 was still precedent, at least in the Sixth Circuit.

ABC won the case, and kudos to its attorneys. Their decision to take the case to District Court rather than Tax Court made the case appealable to the Sixth Circuit, which venue made all the difference.