Getting A Tax Deduction From A Golf Course

Have you heard about Louis Bacon? He is the manager for the hedge fund Moore Capital Management. No, I am not mentioning his name because I am a client of his firm (I wish), but because I was reading that he donated a conservation easement, meaning that he got a (sizeable, I’m certain) tax deduction. The easement is on his Colorado ranch, Trinchera Blanca, which extends over 90,000 acres.

COMMENT: I wonder how long it takes to reach your house upon turning from the roadway when your property is 90,000 acres.      

This gives us an opportunity to talk about conservation easements. Let’s be upfront, however: this is a high-end tax strategy. This has as much to do with your or my daily life as piloting a fighter jet.  

There are three requirements if you want this deduction: 

• Qualifying real property
• Donated to a qualified organization
•  For conservation purposes

The third requirement includes:

• The preservation of land for substantial and regular use by the public for outdoor recreation or education
• The protection of natural habitat of fish, wildlife or plants
• The preservation of open space, where the preservation is for public enjoyment or pursuant to government conservation policy
• The preservation of historically important land or a certified historic structure

An easement makes sense if you think of real estate as more than just … well, real estate. Let’s say, for example, that you own the last remaining farm in a now heavily-developed suburban area. That farm is more than just soil. It is also a bucolic view, a possible watershed, the remaining redoubt for an endangered amphibian, and the source of great wealth from a potential sale to developers. It has layers, like a good lasagna.

We are going to donate one or more of those layers to a charity. We might be able to fit under the “preservation of open space” category above, for example. You could donate a restriction that the property will never be commercially developed. You still own the farm, mind you, but you have donated one of the rights which as a bundle of rights comprise your full ownership of the property.

We next have to put a value on this layer. This is where the horsepower to the conservation easement kicks in.

Let’s say that our farm has been in the family since before there were telephones. Chances are that its cost is relatively negligible.

COMMENT: Before someone comments, I know that the property’s basis would have been reset to its fair market value when it transferred at an ancestor’s death. Let’s compromise and say that the family is extremely long-lived.

Meet a few qualifications and that pennies-on-the-dollar cost has nothing to do with calculating the deduction. We instead are going to get an appraiser to value the property, and he/she is likely to value the easement as follows:

• The value of the property intact and before any donation, less
• The value of the property after the donation of the easement

The numbers can get impressive.

There is a famous case, for example, about an easement in Alabama.

The story begins with Mr. E.A. Drummond, who bought 228 acres on the Fort Morgan peninsula in 1992 for $1,050,000. Two years later he started a planned resort community featuring a 140.9 acre golf course. He started selling lots in 1995, and in 2002 he transferred the golf course to an entity known as Kiva Dunes.

He then donated a perpetual conservation easement on Kiva Dunes.

Kiva Dunes

He valued the easement at over $30 million.

Kiva Dunes also wrote a check to the charity for $35,000.

The IRS got wind of this and they were unamused. They disallowed the $30 million. They also disallowed the $35,000 cash donation, which seems odd. They must have been having a very cranky week.

The case went to Tax Court. The IRS immediately backed off on the fact of a donation, perhaps because by then they were having a better week. They argued instead on the amount of the easement donation. Mr. Drummond brought in an expert who had lived and worked in the area for decades and performed more appraisal work there than anyone else. The IRS brought an expert from Atlanta who had visited the peninsula only twice, and that was to appraise Kiva Dunes.

You can guess which appraiser was more persuasive. The Court reduced the donation to a little over $28 million, which means they effectively agreed with Mr. Drummond. It was a landmark taxpayer win.

The Administration did not like this result at all. They were quite determined to shut down golf course conservation easements, although little has occurred since. They had a point. After all, we are talking about a golf course.

The benefit of a conservation easement on a private golf course, especially in a luxury development, is likely to accrue to a limited number of people and not to the general public. You or I may not even be permitted to drive through some of these communities, much less see or otherwise enjoy the easement.

On the flip side, I have a friend who used to install golf courses in Cincinnati, primarily on the northern Kentucky side. For the locals, I helped him with one of the greens at Devou Park Golf Course, although I do not remember how he talked me into it. I presume I was temporarily insane. Nonetheless, he was very passionate about golf courses serving as respites and nature sanctuaries in otherwise developed urban environments. Kiva Dunes, for example, included broad swaths of wetlands which served as a stopover for migratory birds, as well as being home for a number of threatened species.

One can argue - if there is a socially-desirable ecological, wildlife or preservation outcome – whether it matters that the benefits will be enjoyed by the few. What is of true import here: ecology, wildlife and preservation or the politics of envy? Non-wealthy people do not donate easements. The alternative, unfortunately, is to do … nothing.  

Kiva Dunes had a point.

However, a $28 million point?

One can see the controversy.

A Baseball Player Gets Hit By A Penalty

I have a question for you: let’s say you are a professional athlete. You have hired a financial advisor and an accountant. You give the financial advisor a durable power of attorney, allowing him/her to pay your bills, manage your money and grow your investments. You ask your accountant to prepare tax returns as necessary keep you out of trouble.

These services are not cheap. They cost you an upfront fee of $150,000 and an ongoing $360,000 annually.

            COMMENT: I am available and open to relocation.

You get robbed for millions of dollars. Tax returns do not get filed.

The IRS now wants big penalties from you.

QUESTION: Do you have “reasonable cause” to have the IRS remove those penalties?

We are talking about Mo Vaughn, who played baseball with the Red Sox, the Anaheim Angels and the New York Mets in the nineties and aughts.  He was the American League MVP in 1995.

In 2004 he hired Ra Shonda Kay Marshall to handle his money matters. She wound up leaving her employer, Omni Elite, and set up her own company, RKM Business Services, Inc. He also hired David Krebs with CPA Advisory Group, Inc. for the preparation of his tax returns.

Something happened, and in 2008 he fired both of them. Vaughn was going through his bank statements when he realized that Marshall had been embezzling. He hired forensic accountants, who determined that from 2004 to 2008 she had embezzled more than $2.7 million.

He then learned that his 2006 taxes were not paid.

Even that was better news than 2007, when his taxes were not even filed, much less paid.

He sued Marshall and RKM Business Services.

He hired new CPAs to get him caught up. The IRS – in that show of neighborliness that we have come to expect – hit him with penalties of $1,037,158 for 2006 and $102,106 for 2007. He had filed and/or paid late, and there were penalties for both.

He owed the tax, of course, but he had to contest the penalties. He went the administrative route – meaning appealing and working within the IRS itself. Striking out, he then took his case to court. He went to district court and then to appeals.

His main argument was simple: he was paying people to keep him out of tax problems. There was a lot of money leaving his account, so he had every reason to believe that a good chunk of it was going to the IRS. He was robbed. The IRS was robbed. Surely robbery is reasonable cause.

The IRS and the court pretty much knew his story at this point, and they knew that he was suing to get his millions back. The court however decided the government was due its money. There was no reasonable cause.

How is this possible?

There is a tax case (Boyle) where the Supreme Court addressed the issue of penalties assessed a taxpayer for his/her agent’s failure to file and pay taxes. The Court stated:

“It requires no special training or effort to ascertain a deadline and make sure that it is met. The failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, and such reliance is not ‘reasonable cause’ for a late filing under [Section] 6651(a)(1).”

The Court was addressing deadlines, and it set a fairly high standard. The Court distinguished relying on an attorney or accountant for advice from relying on an attorney or accountant to actually file the return itself. Reliance on an agent did not relieve the principal of compliance with statutory deadlines, except in extremely limited circumstances.

Vaughn could not clear this standard. He had delegated too much when he turned over responsibility for both preparing and filing his taxes to Marshall and Krebs.

Vaughn had a backup argument: the malfeasance of his agents rendered him unable to pay. He did not have enough money left to pay taxes by the time Marshall was done with him.

He was referring to a tax case (American Biomaterials Corp) where two corporate officers defrauded their corporation, including failing to file and pay taxes. Those two were the only officers with the responsibility to file returns and make payment. The Court held that the corporation was not vicariously liable for the acts of its officers and therefore was not liable for penalties.

There is a limit on American Biomaterials, though: a corporation is not entitled to relief if – by act or omission – its internal controls are so lax that that there was no reasonable expectation that malfeasance would be detected in the ordinary course of business. In other words, the corporation cannot willfully neglect normal checks and balances and expect to be relieved of penalties.

Vaughn got smacked on his second argument. The Court noted the obvious: in American Biomaterials there was no one left in the company to file and pay the taxes. This was not Vaughn’s situation. While he had delegated responsibility, there was someone left who could and should have stepped in: Mo Vaughn himself. He did not. That was his decision and provided both reason and cause to impose penalties.

And so Vaughn lost both in the district and the appeals courts. He owed the IRS enough penalties to allow either you or me to retire. He lost because he delegated the one thing the tax Code does not allow one to delegate, except in the most extreme cases: the duty to file the return itself.

Nails, REITs And Coffins

I am reading an article that includes the following sentence:

If these deals become widespread, they’d be another nail in the coffin of the corporate income tax.”

That sounds ominous.

It turns out that the author is writing about real estate investment trusts, more commonly known as REITs (pronounced “reets”).

I do not work with REITs. The last time I came near one was around 2000, and that was in a limited context. My background is entrepreneurial wealth and is unlikely to include REIT practice – unless said wealth is selling its real estate to said REIT.    

REITs have become popular as an investment alternative in an era of low interest rates, as they are required to pay dividends. Well, to be more accurate, they are required IF they want to remain REITS.

REITS are corporations, but they have access to a unique Code section – Section 857. Qualify and the corporation has an additional deduction not available to you or me – it can deduct dividends paid its shareholders from taxable income.

This is a big deal.

Regular corporations cannot do this. Say you and I own a corporation and it makes a million dollars. We want the money. How do we get it out of the corporation? We have the corporation pay us a million-dollar dividend, of course.

Let’s walk through the tax tao of this.

The corporation cannot deduct the dividend. This means it has to pay tax first. Let’s say the state tax is $60,000, which the corporation can deduct. It will then pay $320,000 in federal tax, leaving $620,000 it can pay us.

In a rational world, we would not have to pay tax again on the $620,000, as it has already been taxed.

That is not our world. The IRS looks around and say “the two are you are not the corporation, so we will tax you again.” The fact that you and I really are the corporation – and that the corporation would not exist except for you and me – is just a Jedi mind trick.

You and I are taxed again on the $620,000. Depending upon, we are likely to bump from the 15% dividend rate to the 20% rate, then on top of it we will also be subject to the 3.8% “net investment income” surtax. The state is going to want its share, which should be another 6% or so.

Odds are we have parted with another 29.8% (20% plus 3.8% plus 6%), which would be approximately $185,000. We now have $435,000 between us. Not a bad chunk of change, but the winner in this picture is the government.

Think how sweet it would be if we could deduct the million dollars. The corporation would not have any taxable income (because we paid it out in full as dividends). Yes, you and I would be taxable at 29.8%, but that is a whole lot better than a moment ago. We just saved ourselves over $260,000.

Congress did not like this. This is referred to as “erosion” of the corporate income tax base and is the issue our author was lamenting. Yes, you and I keeping our money is being decried as “erosion.” Words are funny like that.

Back to our topic.

Real estate has to represent at least 75% of REIT assets. In a similar vein, rental income must comprise at least 75% of REIT income. Get too cute or aggressive and you will lose REIT status – and with it that sweet dividends-paid deduction. For years and years these entities were stuffed with shopping malls, apartments and office complexes. They were boring.

Someone had to push the envelope. Maybe it was a tax planner pitching the next great idea. Maybe it was a corporate raider looking to make his or her next billion dollars. All one has to do is redefine “real estate” to include things that are not – you know – real estate.

For example, can you lease the rooftop of an office building and consider it real estate? What about pipelines, phone lines, billboards, data centers, boat slips?

In recent years the IRS said all were real estate.

Something that started as a real estate equivalent to mutual funds was getting out of hand. Pretty soon a Kardashian reality TV show was going to qualify as real estate and get stuffed into a REIT.

In the “Protecting Americans from Tax Hikes Act of 2015,” Congress put a chill on future REIT deals.

To a tax nerd, getting assets out of a corporation into another entity (say a REIT) is referred to as a “divisive.” These transactions take place under Section 355, and - if properly structured - result in no immediate taxation.

Let’s tweak Section 355 and change that no-immediate-taxation thing:

* Unless both (or neither) the distributing and the distributed are themselves REITs, the divisive will be taxable.

* If neither are REITS, then neither can elect REIT status for 10 years.

This tweak is intended to be a time-out, giving the IRS time. It is, frankly, an issue the IRS brought upon itself The IRS has issued multiple private letter rulings that seem to confound “immoveable” with “real estate.” The technical problem is that there are multiple Sections in the tax Code - Sections 168, 263A, 1031, and 1250 for example – that affect real estate. Each may be addressing different issues, and grafting definitions from one Section onto another can result in unintended consequences.

Again we have the great circle of taxation. Somebody stretches a Code section to the point of snapping. Eventually Congress pays attention and changes the law. There will be another Code section to start the process again. There always is.

Does The IRS Want 1099s For Your Contributions?

I have been thinking about a recent IRS notice of proposed rulemaking. The IRS is proposing rules under its own power, arguing that it has the authority to do so under existing law.

This one has to do with charitable contributions.

You already know that one should retain records to back up a tax return, especially for deductions. For most of us that translates into keeping receipts and related cancelled checks.

Contributions are different, however.

In 1993 Congress passed Code section 170(f)(8) requiring you to obtain a letter (termed “contemporaneous written acknowledgement”) from the charity to document any donation over $250.  If you do not have a letter the IRS will disallow your deduction upon examination.

Congress felt that charitable contributions were being abused. How? Here is an example: you make a $5,000 donation to the University of Kentucky and in turn receive season tickets – probably to football, as the basketball tickets are near impossible to get. People were deducting $5,000, when the correct deduction would have been $5,000 less the value of those season tickets. Being unhappy to not receive 100 percent of your income, Congress blamed the “tax gap” and instituted yet more rules and requirements.

So begins our climb on the ladder to inanity.

Soon enough taxpayers were losing their charitable deductions because they failed to obtain a letter or failed to receive one timely. There were even cases where all parties knew that donations had been made, but the charity failed to include the “magic words” required by the tax Code.

Let’s climb on.

In October, 2015 the IRS floated a proposal to allow charities to issue Forms 1099s in lieu of those letters. Mind you, I said “allow.” Charities can continue sending letters and disregard this proposal.

If the charity does issue, then it must also forward a copy of the 1099s to the IRS. This has the benefit of sidestepping the donor’s need to get a timely letter from the charity containing the magic words.

Continue climbing: for the time-being charities have to disregard the proposal, as the IRS has not designed a Form 1099 even if the charity were interested.  Let’s be fair: it is only a proposal. The IRS wanted feedback from the real world before it went down this path.

Next rung: why would you give your social security number to a charity – for any reason? The Office of Personnel Management could not safeguard more than 20 million records from a data hack, but the IRS wants us to believe that the local High School Boosters Club will?

Almost there: the proposal is limited to deductible contributions, meaning that its application is restricted to Section 501(c)(3) organizations. Only (c)(3)s can receive deductible contributions.

But there is another Section 501 organization that has been in the news for several years – the 501(c)(4). This is the one that introduced us to Lois Lerner, the resignation of an IRS Commissioner, the lost e-mails and so on. A significant difference between a (c)(3) and a (c)(4) is the list of donors. A (c)(3) requires disclosure of donors who meet a threshold. A (c)(4) requires no disclosure of donors.    

You can guess how much credibility the IRS has when it says that it has no intention of making the 1099 proposal mandatory for (c)(3)s - or eventually extending it to also include (c)(4)s.

We finally reached the top of the ladder. What started as a way to deal with a problem (one cannot deduct those UK season tickets) morphed into bad tax law (no magic beans means no deduction) and is now well on its way to becoming another government-facilitated opportunity for identity theft.

The IRS Notice concludes with the following:

Given the effectiveness and minimal burden of the CWA process, it is expected that donee reporting will be used in an extremely low percentage of cases.”

Seems a safe bet.

UPDATE: After the writing of this post, the IRS announced that it was withdrawing these proposed Regulations. The agency noted that it had received approximately 38,000 comments, the majority of which strongly opposed the rules. Hey, sometimes the system works.