Blau v. Commissioner of Internal Revenue Service

          Argued November 9, 2018

          On Appeal from the Decision of the United States Tax Court

          Kathleen Pakenham argued the cause for appellant. With her on the briefs were Stephen D. Gardner, Adriana Lofaro Wirtz, and Clint Massengill.

          Jacob Earl Christensen, Attorney, U.S. Department of Justice, argued the cause for appellee. With him on the brief was Richard Farber, Attorney.

          Before: Rogers and Millett, Circuit Judges, and Ginsburg, Senior Circuit Judge.

          OPINION

          GINSBURG, SENIOR CIRCUIT JUDGE

         RERI Holdings, LLC (RERI) claimed a charitable contribution deduction of $33 million on its 2003 federal tax return. The Internal Revenue Service determined that RERI was not entitled to this deduction and imposed a 40% penalty for underpayment of tax. RERI unsuccessfully challenged both rulings before the Tax Court, and now appeals to this court on a variety of grounds. For the reasons set forth below, we affirm the judgment of the Tax Court.

         I. Background

         At a high level of generality, the facts of this case are simple: RERI acquired and donated a future interest in a piece of commercial property to the University of Michigan. RERI maintains the donation is a bona fide deduction that it valued reasonably at $33 million. The IRS says RERI artificially inflated the value of the donated property in order to offset the tax liability of its owners.

         The corporate arrangements and transactions involved in this case are fairly complicated. For the sake of clarity, we lay them out in some detail.

         A. Facts

         On February 7, 2002, RS Hawthorne, LLC - a shell company, whose only member was RS Hawthorne Holdings, LLC (RSHH), the only member of which was Red Sea Tech I, Inc. - purchased a 288, 000 square-foot web-hosting facility located in Hawthorne, California for $42, 350, 000. At the time of the purchase, the Hawthorne Property was leased to AT&T. The lease had an initial term of 15.5 years, ending in May 2016; AT&T then had the option to renew it three times for periods of five years each. The rent for each year during the initial term was spelled out in the lease; if AT&T renewed the lease, then the rent would be re-set at the then-market rate but not less than $14 per square foot per year.

         RS Hawthorne financed its purchase with a mortgage loan from BB&T Bank. In connection with the loan, BB&T had the Hawthorne Property appraised by Bonz/REA, Inc. The appraisal "concluded that the Hawthorne property was worth $47 million as of August 16, 2001." RERI Holdings I, LLC v. Comm'r, 149 T.C. 1, 4(2017).

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         Also on February 7, 2002, Red Sea divided its member interest in RSHH into two temporal interests: (1) a Term of Years (TOYS) interest lasting until December 31, 2020 and (2) the remainder, which the Tax Court refers to as the "successor member interest" (SMI). The SMI in RSHH is the donated property at issue in this case. Red Sea assigned the TOYS interest to PVP-RSG Partnership and sold the SMI to a company called RJS Realty Corporation for $1, 610, 000. The agreement assigning the SMI to RJS imposes several conditions on Red Sea's TOYS interest, which the Tax Court assumed would also bind subsequent assignees. Id. at 6 n.4. First, the TOYS holder is prohibited from "causing or permitting any transfer of the Hawthorne property or the member interest in [RS] Hawthorne or the imposition of any lien or encumbrance on either" and is obligated to "take all reasonable actions necessary" to prevent waste of the Hawthorne property. Id. at 5. Of particular relevance to this appeal, the assignment also contained a non-recourse provision:

In the event of any Breach of the provisions of this Assignment on the part of Assignor or any of its successors in interest hereunder, the recourse of Assignee or any of its successors in interest hereunder shall be strictly limited to the [TOYS interest]. In no event may any relief be granted that imposes on the owner from time to time of the [TOYS interest] any personal liability, it being understood that any and all remedies for any breach of the provisions hereof shall be limited to such owner's right, title and interest in and to the [TOYS interest].

         In March 2002 RERI purchased the SMI from RJS for $2, 950, 000. RERI was a limited liability company that was formed on March 4, 2002 and dissolved on May 11, 2004. RERI Holdings I, LLC v. Comm'r, 107 T.C.M. (CCH) 1488, 1489 (2014).

         In August 2003 Stephen M. Ross, one of RERI's members, pledged a gift of $4 million to the University of Michigan; he later increased the pledge to $5 million. In partial fulfillment of Ross's pledge, RERI assigned the SMI to the University pursuant to a Gift Agreement dated August 27, 2003. The Gift Agreement provided, among other things, that the University "shall hold the Remainder Estate for a minimum of two years, after which the University shall sell the Remainder Estate in a manner and to a buyer of its choosing."

         In December 2005 the University sold the SMI to HRK Real Estate Holdings, LLC for $1, 940, 000 although it had had the property appraised at $6.5 million earlier that year. The parties have stipulated that the sale price did not represent the fair market value of the SMI. The buyer, HRK, was indirectly owned in part by Harold Levine, one of RERI's members. The proceeds of the sale were credited toward Ross's pledge.

         B. Procedural History

         Because RERI is treated as a partnership for federal income tax purposes, it filed a 2003 federal income tax return for informational purposes only; the actual taxpayers are the owners of shares in the LLC. RERI claimed a charitable contribution deduction of $33, 019, 000 for the transfer of a noncash asset, $32, 935, 000 of which represented the purported value of the donated SMI. (The remaining $84, 000 was for appraisal and professional fees.) The valuation of approximately $33 million derives from an appraisal conducted by Howard Gelbtuch of Greenwich Realty Advisors, dated September 2003. As required by Treasury regulations, RERI attached the Gelbtuch appraisal to its return. RERI also completed a Form 8283 for Noncash Charitable Contributions; however, RERI left blank the space for "Donor's cost or adjusted basis." It did not provide any explanation for the omission.

         The IRS thereafter selected RERI for audit and in March 2008 issued a Notice of Final Partnership Administrative Adjustment (FPAA). It disallowed $29 million of RERI's deduction, based upon its determination that the SMI was worth only $3.9 million. Accordingly, it also imposed a penalty equal to 20% of the tax underpayment for a substantial valuation misstatement, pursuant to IRC § 6662(e)(1).^[1]

         In April 2008 RERI filed a petition in the Tax Court challenging the FPAA. In its answer, the IRS revised its determinations, asserting RERI was entitled to no deduction for a charitable contribution on the ground that the transaction giving rise to the deduction was "a sham for tax purposes or lacks economic substance." It argued in the alternative that the deduction should be limited to $1, 940, 000, the amount the University had realized from the sale of the SMI. Finally, the IRS claimed the valuation misstatement was "gross" rather than merely "substantial," triggering a penalty equal to 40% of the tax underpayment. See IRC § 6662(h)(1).

         After a four-day trial, the Tax Court issued a judgment sustaining both the IRS's determination that RERI was not entitled to any charitable contribution deduction and its assessment of the 40% penalty. The Tax Court, however, did not base its decision upon the "lack of economic substance" theory advanced by the IRS; instead, it concluded that RERI had failed to substantiate the value of the donated property as required by Treasury regulations.^[2] 149 T.C. at 17. Nonetheless, on its way to affirming the penalty for a gross valuation misstatement, the Tax Court found the SMI was worth $3, 462, 886 on the date of the donation. The court also held RERI did not qualify for the "reasonable cause" exception to accuracy-related penalties. See IRC § 6664(c).

         II. The Charitable Contribution Deduction

         RERI first challenges the Tax Court's ruling that it was not entitled to a charitable contribution deduction.

         A. Statutory Framework

         Section 170 of the Internal Revenue Code permits a taxpayer to claim a deduction for a contribution to a charitable organization. This deduction can be abused by a taxpayer who inflates the valuation of the donated property. For that reason, IRC § 170(a)(1) provides that "[a] charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the Secretary."

         In the Deficit Reduction Act of 1984 (DRA), the Congress directed the Secretary of the Treasury to increase the stringency of its requirements for verification. Pub. L. No. 983-69, § 155(a)(1), 98 Stat. 494, 691. Specifically, the DRA instructs the Secretary to promulgate regulations that require a taxpayer claiming a deduction for a noncash charitable contribution

A. to obtain a qualified appraisal for the property contributed,

B. to attach an appraisal summary to the return on which such deduction is first claimed for such contribution, and

C. to include on such return such additional information (including the cost basis and acquisition date of the contributed property) as the Secretary may prescribe in such regulations.

         In fulfillment of this mandate, the Secretary promulgated 26 C.F.R. § 1.170A-13, subsection (c) of which is most relevant to this case. Paragraph (c)(2) instantiates the three statutory requirements: The donor must (A) "[o]btain a qualified appraisal"; (B) "[a]ttach a fully completed appraisal summary ... to the tax return"; and (C) "[m]aintain records" containing specified information. Paragraph (c)(3) defines a "qualified appraisal" and paragraph (c)(4) details the necessary elements of an "appraisal summary," one of which is "[t]he cost or other basis of the property." § 1.170A-13(c)(4)(ii)(E). The taxpayer must provide the appraisal summary on IRS Form 8283. § 1.170A-13(c)(4)(i)(A).

         A deduction is typically disallowed if these requirements are not met. There is an exception, however, "[i]f a taxpayer has reasonable cause for being unable to provide the information ... relating to the manner of acquisition and basis of the contributed property" in the appraisal summary. § 1.170A-13(c)(4)(iv)(C)(1). In that case, the deduction will still be allowed if the donor attaches "an appropriate explanation" to the appraisal summary. Id.

         B. Application

         The Tax Court disallowed RERI's charitable donation deduction on the ground that it failed to comply with the substantiation requirements. First, the Tax Court held "the reporting requirements of section 1.170A-13, Income Tax Regs., are directory and not mandatory," such that a taxpayer who "substantially complies" with the requirements is entitled to the claimed deduction. 149 T.C. at 15 (citing Bond v. Comm'r, 100 T.C. 32, 40-41 (1993)) (cleaned up). The court went on to conclude that RERI failed substantially to comply because it did not disclose its basis in the donated property.

         The IRS urges this court to affirm the Tax Court on the alternative theory that substantial compliance with the regulation does not suffice, so that RERI's failure to include the basis on Form 8283 was automatically fatal. RERI, for its part, does not dispute that it failed to supply its basis in the SMI and to provide an explanation for the omission. Instead, RERI maintains that the substantial compliance doctrine does apply here, and that providing its basis in the donated property is not necessary for compliance. It emphasizes that both the Second Circuit and the Tax Court have concluded the ...