Analysis of and reflections on recent cases and rulings.
Tax Court allows appraisals that substantially comply with the rules
The Tax Court upheld a real estate developer's charitable deductions for two land contributions to a town, finding that the appraisals for the donations substantially complied with the qualified appraisal requirements for contributions for noncash property over $5,000 and that the contributions were not quid pro quo exchanges.
Peter Emanouil is a Massachusetts real estate developer. In 1999, he purchased 197 acres of undeveloped property called Granite Hill (GH property) in Westford, Mass. Over the next several years, he made various attempts to either develop or sell the GH property.
Finally, in February 2009, Emanouil obtained final approval for an affordable housing project (AHP) including 164 units on 104 of the 197 acres. In order to obtain approval, Emanouil was forced to make a number of concessions to allay Westford's concerns regarding the size of the development (including the number of units and the acreage), potential impacts on the town (including traffic and other impacts), and potential environmental concerns.
In December 2008, as the process for obtaining approval for the project was ongoing, Emanouil donated 16 acres of the remaining GH property to Westford. Before making the donation, he had the property appraised. The appraisal provided a "current market value estimate" of $1.5 million for the 16 acres, based on the highest and best use of the land, which was as a 12-lot subdivision for single-family residential use. The appraisal stated that its purpose was "[t]o inform a potential disposition." It did not include the date that the contribution was to be made or any reference to its being prepared for income tax purposes.
In November 2009, after Emanouil had received final approval for the development project, he donated an additional 71 acres of the GH property to Westford. Before making the donation, he had the property appraised. The appraisal provided a "current market value estimate" of approximately $2.5 million for the land, based on the highest and best use for the land, which was as a 38-lot subdivision. Like the previous appraisal for the 16-acre parcel, the appraisal stated that its purpose was "[t]o inform a potential disposition" and did not include the date that the contribution was to be made or any reference to its being prepared for income tax purposes.
On his 2008 Form 1040, U.S. Individual Income Tax Return, Emanouil reported the land donation as a $1.5 million gift to charity and included a Form 8283, Noncash Charitable Contributions. After the charitable deduction limitation, he claimed a charitable contribution deduction of approximately $700,000 and carried the remainder of the contribution amount forward to be claimed on returns for subsequent years.
On his Form 1040 for 2009, Emanouil reported the second land donation as a $2.5 million gift to charity and included a Form 8283. Due to the charitable deduction limitation, he claimed a deduction of about $660,000 for 2009 from his charitable contribution carry-forward from 2008 and carried forward the remaining contribution amounts from 2008 and 2009. On Forms 1040 for 2010 through 2012, Emanouil claimed deductions for the charitable contribution carryforwards from 2008 and 2009.
The IRS examined the Emanouils' 2010, 2011, and 2012 returns and issued a statutory notice of deficiency disallowing the carryover charitable contribution deductions. The notice stated the grounds for disallowing the deductions as failure to substantiate the reported values of properties transferred and failure to show that the properties were transferred with charitable intent.
Emanouil timely filed a petition in Tax Court to challenge the IRS's determinations. In Tax Court, in addition to the valuation and charitable intent issues, the IRS argued that the appraisals for the donations did not meet all the requirements to be qualified appraisals.
The Tax Court's decision
The Tax Court held that Emanouil was entitled to the charitable contribution deductions he took for his contributions of land from the GH property to Westford. The court found that he had substantially complied with the qualified appraisal requirements for the contributions and he had charitable intent for the donations, so the contributions were not quid pro quo transfers.
Qualified appraisal requirement: Sec. 170(f)(ll)(C) provides that,"[i]n the case of contributions of property for which a deduction of more than $5,000 is claimed," the taxpayer must "obtain a qualified appraisal of such property and attach to the return... such information regarding such property and such appraisal as the Secretary may require." The regulations set out 11 items that an appraisal must include to be a "qualified appraisal." The IRS claimed that Emanouils appraisals for his land donations did not include two of these necessary items--the expected date of the contribution and a statement that the appraisal was prepared for income tax purposes.
The Tax Court explained that where the essential requirements of a statute or regulations can be met without strict compliance by the taxpayer, substantial compliance with the requirements will be sufficient. However, a taxpayer will not be in substantial compliance if the taxpayer furnishes "practically none" of the information required by the statute or regulations.
The court found that the purpose of the qualified appraisal requirements was to prevent the use of overvaluations by taxpayers and to ensure that the correct values of donated property are reported. Thus, the court determined that it followed that if an appraisal generally provides the information required in the regulations to ensure that the correct values of donated property are reported, then the essential requirements of the governing statute are met despite a lack of strict compliance with the regulations' requirements.
The court held that Emanouil provided sufficient information to permit the IRS to evaluate the reported contributions and to investigate and address concerns about overvaluation and other aspects of the reported charitable contributions. Evidence of this, the court pointed out, was that the IRS did perform that investigation without any impediment arising from the two alleged defects in the appraisals, and the notice of deficiency did not mention the omissions (which were raised for the first time in Tax Court). In its opinion, the court specifically discussed why the deficiencies in the appraisals did not prevent substantial compliance.
While the IRS did not point to any specific reason for the date-of-contribution requirement, the court noted it had previously held that having the date allows a person to compare the appraisal and contribution dates for purposes "of isolating fluctuations" in the property's value between the dates. Given that the appraisal and contribution dates were within 30 days of each other and the appraisals specified they gave a current market value, the court found this was not a significant issue. Furthermore, the court pointed out that in a number of cases, it had held that an appraisal's failure to state a contribution date was not significant when the date is listed on Form 8283, as it was for both of Emanouil's contributions.
The IRS explained in its brief that an income tax purpose statement is required because it helps the appraiser and the client identify the appropriate scope of work for the appraisal and the level of detail to provide in the appraisal, i.e., to make sure that all the information required for relying on the appraisal--for income tax purposes--is included in the appraisal. The court agreed with this general principle but found that a statement of purpose may not always be necessary to achieve substantial compliance, especially not when the appraisal otherwise includes the level of detail necessary to estimate the fair market value (FMV) of the property in question.
The court determined that the appraisal did this. It provided the FMV of the property "to inform a potential disposition," and the word "disposition" had a meaning broad enough to encompass a sale or a donation. The court concluded there was no reason to believe the valuation in the appraisal would have been different if its stated purposes had been "income tax." Moreover, citing a number of cases, it stated that it had not previously held that failing to include a statement of income tax purposes in an appraisal would defeat substantial compliance in the context of the charitable contribution deduction.
Quid pro quo: The Supreme Court in Hernandez, 490 U.S. 680, 701-702 (1989), stated: "The relevant inquiry in determining whether a payment is a 'contribution or gift' under [section] 170 is... whether the transaction in which the payment is involved is structured as a quid pro quo exchange."Therefore, if it is understood that the property will not pass to the charitable recipient unless the taxpayer receives a specific benefit, and, if the taxpayer cannot garner that benefit unless he or she makes the required contribution, then the transfer does not qualify the taxpayer for a charitable contribution deduction. The IRS argued that this requirement was not met because Emanouil used the proposed donations as a "bargaining chip" to induce Westford's Zoning Board of Appeals (ZBA) to approve the permit for his development project and that once the donations had been proposed, they could not be separated from the negotiations.
However, based on the testimony of the witnesses at trial, and the IRS's failure to provide any evidence to the contrary, the Tax Court concluded that the donations were given with donative intent, were received as gifts, and were not an inducement for the ZBA's approval. Rather, the court found that Emanouil had additional land in the GH property he could not use or sell, and he gave the land to Westford not because he could get a benefit from the town but because the town was a known, nearby entity that could receive a tax-deductible contribution that would take the property.
As this case shows, while the qualified appraisal requirements are arguably more detailed than necessary to achieve the purpose behind them, the IRS, which has a demonstrated antipathy toward large charitable deductions, will attempt to use the requirements as a trap for the unwary to disallow charitable deductions. To avoid the time, trouble, and expense of going to court to get a deduction for a valid charitable contribution approved, practitioners should routinely advise clients to consult them about the documentation requirements if they are considering making large charitable contributions.
Emanouil, T.C. Memo. 2020-120
Malpractice lawsuit settlement payment is not a return of capital
The Eleventh Circuit held that a taxpayer who settled an accounting malpractice claim against an accounting firm could not exclude the settlement payment from income as a return of capital, deduct the legal fees from the claim, or take a loss related to the settlement.
Joseph McKenny worked as an independent consultant providing advisory services to car dealerships. In the late 1990s, he hired an accounting firm to advise him on tax strategy and preparation.
The accounting firm recommended that McKenny structure his consulting business as an S corporation for tax purposes. It also recommended that the S corporation be wholly owned by an employee stock ownership plan (ESOP), of which McKenny would be the sole beneficiary. Following this plan would allow McKenny to defer tax on his consulting income, with the income earned by the business passing through the S corporation without being subject to corporate income tax, and then accumulating tax-free in the ESOP until it made distributions to McKenny.
The plan was (supposedly) implemented in 2000. McKenny became the sole employee of an S corporation called Joseph M. McKenny Inc. This S corporation was intended to be owned by the Joseph M. McKenny Inc. ESOP (JMM ESOP), of which the sole beneficiary was McKenny.
According to McKenny, however, the accounting firm did not quite do things as it had promised. McKenny claimed that the firm improperly filed the S corporation election for the company. Furthermore, no ESOP was created or approved because the accounting firm failed to prepare or provide proper documents for the ESOP and the related trust, and failed to take actions to ensure that the ESOP was properly formed and operated.
McKenny also acquired a 25% interest in a GMC car dealership in Florida, and, on the advice of the accounting firm, he held this interest in a separate S corporation that, like the other S corporation, was in turn wholly owned by the JMM ESOP. For tax purposes, the accounting firm told McKenny that the car dealership's payments to the S corporation should be characterized as management fees rather than as a share of profits.
Beginning in 2000, McKenny and his wife jointly filed tax returns reflecting the accounting firm's tax strategy, paying little or no federal income tax for several years. Alas, the good times did not last, and the IRS audited the McKennys in 2005. It determined in this audit that between 2000 and 2005 the McKennys had underpaid their federal income taxes. The IRS claimed that McKenny's tax strategy with respect to the car dealership was an unlawful and abusive tax shelter.
In 2007, the McKennys settled their unpaid liabilities with the IRS. In the settlement agreement, they conceded all claimed tax benefits from the ESOP transactions and acknowledged that they owed unpaid taxes as to both the consulting business and the stake in the car dealership. They further agreed to the full amount of the liabilities from the ESOP transactions and ultimately paid the IRS almost $2.25 million in income taxes, interest, and penalties.
In 2008, the McKennys sued the accounting firm in state court, alleging that the firm committed accounting malpractice and was responsible for their unpaid tax liabilities between 2000 and 2005. The complaint alleged that the accounting firm had failed to:
* Submit the ESOP to the IRS for a determination letter;
* Advise the McKennys that annual and continuing contributions would have to be made to the ESOP in order to maintain its qualification on a going-forward basis;
* Provide the McKennys with instructions regarding the timely adoption and execution of the ESOP and related trust documents;
* Advise the McKennys regarding the requirement that the ESOP engage an independent appraiser to perform an annual appraisal;
* Advise the McKennys to maintain annual administrative records for the ESOP;
* Advise the McKennys regarding the removal of the initial trustee;
* Advise the McKennys regarding the nondiscrimination testing requirements under the Code; and
* Provide proper ESOP documents that satisfied the Code's qualification requirements.
In 2009, the accounting firm, though it continued to deny any wrongdoing, settled the suit by paying the McKennys $800,000.
In 2009 through 2011, the McKennys filed tax returns with several deductions and exclusions related to their lawsuit against the firm. On their 2009 tax return, they (1) deducted over $400,000 in legal fees they allegedly paid to litigate the malpractice claim; (2) claimed an unreimbursed loss of $1.4 million representing the difference between the settlement payment they received from the accounting firm and the payment they made to the IRS to settle their audit; and (3) excluded the $800,000 settlement payment from their gross income. Based on these deductions and exclusions, the McKennys claimed a net operating loss, which they carried forward to reduce their tax liability in 2010 and 2011.
The IRS issued a notice of deficiency rejecting all of these claimed deductions and exclusions. The IRS found that the legal expenses were not deductible because they were miscellaneous itemized deductions rather than business deductions, subject to the 2%-of-adjusted-gross-income (AGI) floor; disallowed the loss deduction in its entirety; and denied the exclusion of the settlement payment. These adjustments resulted in the McKennys' having an additional tax liability of a tad over 1800,000.
The McKennys then filed a refund claim for that amount with the IRS, but the Service denied the refund as to the 2009 claim and did not respond to the 2011 claim before the McKennys filed a refund suit in 2016. The McKennys sought a refund of about $586,000--the amount of the disallowed exclusions and deductions for 2009 and 2011. The parties filed cross motions for summary judgment, and the district court granted in part and denied in part both motions.
The district court concluded that the legal expenses incurred in their battle with the accounting firm were not deductible business expenses because the McKennys sued the accounting firm on their own behalf, rather than on behalf of the consulting business. The court also ruled that the McKennys were barred by their 2007 settlement with the IRS from claiming any losses related to the ESOP transactions, so they could not claim the unreimbursed losses. However, the district court agreed with the McKennys that the settlement was a return of capital and therefore excludable from gross income.
This satisfied neither the McKennys nor the IRS. The district court's decision was appealed to the Eleventh Circuit. The parties again filed motions and cross motions for summary judgment regarding the deductions and the exclusion.
The Eleventh Circuit's decision
The Eleventh Circuit, partially reversing the district court, held that in addition to not being entitled to deduct the losses related to the ESOP or to deduct the fees incurred in their legal action against the accounting firm, the couple could not exclude the malpractice settlement payment from income.
Legal fees: The McKennys argued that their legal fees for the malpractice suit were deductible as Sec. 162 business expenses because the lawsuit was related to and regarding McKenny's business. The court agreed that they were related but found that this was not enough to make them deductible business expenses. Instead, the characterization of the expenses depended on the origin and character of the claims for which the expenses were incurred.
The Eleventh Circuit affirmed the district court's holding that the legal fees were personal expenses deductible as miscellaneous itemized deductions subject to the 2%-of-AGI floor. The court found that the suit against the accounting firm was personal in origin and character because McKenny, not his businesses, was the plaintiff; the malpractice alleged in the complaint was related to services provided to McKenny; and the tax liability at issue was that of McKenny, not his businesses. The court found that the basis of the lawsuit was not that the accounting firm "failed to adequately support the businesses' income-producing activities," but rather that the accounting firm "failed to help the McKennys reduce their personal tax liability."
Loss deduction: The IRS disallowed the deduction because in their audit closing agreement, the McKennys agreed to pay tax attributable to the disallowance of any of the couple's ESOP transactions. The McKennys argued on appeal that their $1.4 million claimed loss was not related to the ESOP transactions. They instead contended that the loss was due to the accounting firm's "failure to fully reimburse" them in the lawsuit.
The Eleventh Circuit stated that this was "a distinction without a difference." The court, observing that the payment was made to settle the tax liability resulting from those transactions, found that the McKennys did not, and could not, dispute that their $2.2 million tax payment to the IRS was related to the ESOP transactions. Thus, their settlement agreement with the IRS barred them from claiming any deduction based on this payment.
Exclusion of malpractice settlement payment: The McKennys argued that the settlement payment was a return of capital that they had lost due to the accounting firm's malpractice and therefore was excluded from their income. To support their position, the couple relied primarily on the Tax Court case Clark, 40 B.T.A. 333 (1939), in which the court held that gross income does not include a payment made as compensation for damages or loss that was caused by a third party's negligence in the preparation of a tax return. The IRS acquiesced to Clark (Rev. Rul. 57-47), and the Tax Court has followed it in a number of cases.
The IRS argued that Clark was distinguishable and that the payment was taxable under Old Colony Trust Co., 279 U.S. 716 (1929), in which the Supreme Court held that a third party's payment of a taxpayer's tax liability is generally included in gross income, regardless of the form of that payment. The IRS further argued that the rule from Clark is limited to situations in which an accountant makes a mistake in preparing a tax return or in advising the taxpayer on how to prepare the return and does not apply to settlements based on claims that an accountant committed malpractice in giving advice about, structuring, or implementing a transaction.
The Eleventh Circuit noted that whether Clark was correctly decided and whether it applied in a situation like the McKennys' were difficult questions. However, it did not address them because it concluded that, even if Clark was correctly decided and it applied to the McKennys' case, the couple had failed to prove that they were entided to exclude the setdement payment from income.
In the district court, the IRS argued that the McKennys could not establish, based on the facts, that they were entided to exclude the malpractice setdement from income. The IRS maintained that the harm the McKennys claimed was entirely speculative and that nothing in the record showed that they would have been entitled to the ESOP or its tax benefits. Consequently, they had not proved that they were entitled to the exclusion or the amount of the exclusion. The district court rejected this argument, explaining that the ESOP strategy was legal at the time that the accounting firm proposed it to the McKennys and the IRS "offered no legal authority for its argument that it might have denied approval" for the ESOP strategy the accounting firm recommended.
On appeal, the IRS continued to argue that the McKennys failed to carry their burden with respect to the exclusion and, additionally, that the district court had erred by assuming critical facts in the couple's favor. The Eleventh Circuit, contrary to the district court, found that the general legality of the S corporation/ESOP strategy at the time in question, by itself, was insufficient for the McKennys to satisfy their burden of proof on their entitlement to the exclusion. The court stated that there is no strict rule for what taxpayers must do to establish their entidement to an exclusion or to establish its amount. However, given that taxpayers must prove a refund claim by a preponderance of the evidence, it was not enough for the McKennys "simply to make a bald assertion, devoid of specifics, that they overpaid taxes or would not have incurred any federal taxes (or penalties)" had the accounting firm correctly implemented the S corporation/ESOP strategy.
The Eleventh Circuit averred that it had no evidence in front of it, other than the McKennys' self-serving statements, regarding what the results of the ESOP strategy would have been if the accounting firm had implemented it correctly. Thus, the court concluded that the McKennys had not proved that the $800,000 malpractice settlement payment was a return of capital that they were entitled to exclude from income.
Although the McKennys may have been wronged, they were not wronged by the IRS, and the Eleventh Circuit correctly thwarts the couple's attempt to ameliorate their losses from their relationship with the accounting firm through income tax deductions and exclusions. If their accounting firm actually caused their tax problems, their recourse for any extra tax, penalties, and interest they paid was against the accounting firm.
McKenny, No. 18-10810 (11th Cir. 9/1/20)
James A. Beavers, CPA, CGMA, J.D., LLM,
James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser's tax technical content manager. For more information about this column, contact email@example.com.