According to Prof. John A. Bogdanski (Lewis & Clark Law School), the most intriguing valuation controversy making its way through the Tax Court is a charitable contribution case that has progressed much further than might have been expected. Bogdanski discussed it during his recent webinar, “Business Valuation in the Federal Tax System in 2014.”
‘Convoluted’ facts: This is essentially a tax shelter case, Bogdanski says, and the facts are appropriately “convoluted.” The donor, an LLC called RERI, was a partnership for tax purposes. During its short life, it donated an interest in another LLC, known as Holdings, to a university. A corporation originally was the sole member of Holdings, but in 2002 it split its membership interest into two “temporal interests.” Holdings’ only asset was the sole membership interest in another LLC, Hawthorne, which, in turn, owned property in Southern California that it leased to AT&T as a web hosting facility.
The donor acquired its partial interest in Holdings for $2.95 million and, in August 2003, pledged a $5 million gift to a university. The university agreed to hold the interest for at least two years and then sell it, with the proceeds to be credited against the gift pledge. On its tax return, the donor claimed a value for the donated interest of $32.94 million.
In December 2005, the university sold the Holdings interest to another LLC controlled by the donor for $1.94 million, which sold the interest to an unrelated individual buyer for $3 million. That buyer then contributed the Holdings interest to another charity, claiming a value for it of $29.93 million.
Huge value gap: The donor arrived at its value by using present-value tables promulgated under the Tax Code’s section 7520. It hoped to exploit a feature of the provision which assures that the values of the present interest and future interest add up to the value of the property underlying the time-divided interests, without discounts.
The IRS balked and sought dismissal of the case on summary judgment. The valuation was improper as a matter of law for two reasons. One, the tables were inapplicable to the situation at hand. The donated interest was in Holdings, but the appraiser valued the underlying property that belonged to Hawthorne. Also, the interest was not a “standard” remainder, as specified in section 7520, but was a “restricted beneficial interest.” The donation imposed a two-year hold-and-sell requirement on the university.
The court found the IRS had not shown as a matter of law that the restriction was of consequence to the valuation of the interest. It noted that neither party had addressed the huge discrepancy in value between the claimed value of the Holdings interest and the consistently low prices it commanded during multiple actual sales. On its face, that gap seemed “violative of the unrealistic and unreasonable fair market value standard,” the court allowed. But, barring further exploration of the facts, it could not conclude that the application of section 7520 in this case was unreasonable and unrealistic.
Two, the IRS argued that the donor’s valuation did not meet the “qualified appraisal” standard. For one, the appraiser valued the wrong property—the underlying real estate rather than the donated Holdings interest. Also, the appraisal did not mention the hold-and-sell restriction. And, the appraiser employed “investment value,” instead of the fair market value. The court found that all of these arguments were material factual disputes requiring resolution at trial.
Unusually ‘forgiving’: As Bodganski sees it, just in terms of the appraisal alone, Judge Halpern was unusually “forgiving.” A stricter Tax Court judge (and they exist) flat out would have disallowed an appraisal that failed to meet the requirements on so many levels. The appraiser’s invocation of the “investment value,” as opposed to fair market value, could have triggered a ruling for the IRS, Bogdanski says. Trial is set for April. The main issue is whether the hold-and-sell requirement substantially changed the value of the interest the university got in Holdings from that of the appraised underlying real property. If the IRS can show that, Bogdanski says, it may yet win the war.
Stay tuned. The court’s opinion of RERI Holdings I, LLC v. Comm’r., 2014 U.S. Tax Ct. LEXIS 34 is available at BVLaw.