Wednesday, August 12, 2015
Minnick v. Commissioner – 9th Circuit Affirms Tax Court, Mortgages Must Be Subordinated When Conservation Easement is Donated
In Minnick v. Commissioner, _ F.3d _ (9th Cir. 2015), the 9th Circuit Court of Appeals affirmed the Tax Court’s holding that, to be eligible for a deduction for the donation of a conservation easement under Internal Revenue Code § 170(h), any outstanding mortgages on the underlying property must be subordinated to the rights of the holder of the easement at the time of the gift. The 10th Circuit held the same in a similar case in January 2015: Mitchell v. Commissioner, 775 F.3d 1243 (10th Cir. 2015) (Mitchell III).
Citing to Mitchell III, the 9th Circuit explained that the plain language of Treasury Regulation § 1.170A–14(g)(2) (the “mortgage subordination” regulation) supports the Tax Court’s interpretation. The regulation specifies that “no deduction will be permitted … unless the mortgagee subordinates its rights in the property.” Strictly construed, said the 9th Circuit, that language makes clear that “subordination is a prerequisite to allowing a deduction.” Since there was no dispute that Minnick’s lender had not subordinated its rights in the subject property when Minnick donated the easement at issue (despite warranties in the easement deed to the contrary), under the plain meaning of the regulation no deduction is permitted.
The 9th Circuit further explained that, even if ambiguity arguably existed in the language of the regulation with respect to when subordination is required, that would not change the outcome. Under Auer v. Robbins, 519 U.S. 452 (1997), courts defer to the IRS’s reasonable interpretation of its own regulations and, said the 9th Circuit, the IRS’s interpretation is reasonable and not plainly erroneous or inconsistent with the regulation. The 9th Circuit quoted the analysis on this point in Mitchell III: “[b]ecause a conservation easement subject to a prior mortgage obligation is at risk of extinguishment upon foreclosure, requiring subordination at the time of the donation is consistent with the Code’s requirement that the conservation purpose be protected in perpetuity.” The 9th Circuit emphasized:
An easement can hardly be said to be protected ‘in perpetuity’ if it is subject to extinguishment at essentially any time by a mortgage holder who was not a party to, and indeed (as here) may not even have been aware of, the agreement between the Taxpayers and a [land] trust.
Mr. Minnick (a former member of the U.S. House of Representatives from Idaho) is suing his attorney for malpractice. The Idaho Supreme Court recently ruled that suit is not barred by the statute of limitations.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law
Friday, July 24, 2015
As previously blogged, the GAO Report to Congress (the full report is here) on the IRS processes for political activity referrals found significant deficiencies with respect to the initial allegations that triggered an audit. In some cases, no case files were found by the GAO. These deficiencies "increase the risk that EO could select exempt organizations for examination in an unfair manner - for example, based on an organization's religious, educational, political or other views." According to Bloomberg BNA, in the hearing before the Ways and Means Oversight Committee in which the GAO report was released, it was determined that for the past six years, "one person working alone at the IRS has been deciding which complaints about the political activities of exempt organizations should be followed up."
Following the above-referenced hearing, IRS Commissioner John Koskinen reported to Bloomberg BNA that final regulations on political campaign activities by exempt organizations will not be in place prior to the 2016 presidential election (see proposed regulations here). The regulations will likely not be effective until January 2017. See prior blog posts on the proposed regulations and political activity regulations generally (April 16, 2014; July 16, 2015).
Lloyd Hitoshi Mayer (Notre Dame and a fellow blogger) has posted "Limits on State Regulation of Religious Organizations: Where We Are and Where We Are Going" to SSRN. Here is a brief abstract of the article:
The breadth of activities and organizational forms among religious organizations rivals that of nonprofits generally, and religious organizations are vulnerable to the same types of problems that justify state regulation and oversight of nonprofits. Such problems include excessive compensation, improper benefits for board members and other insiders, misleading or fraudulent fundraising, employment discrimination, unsafe working conditions, consumer fraud, improper debt collection, and many others. Religious organizations are different, however, in that under federal and state law they enjoy unique protections from state regulation.
This paper describes how such federal and state protections limit state regulation of religious organizations under current case law. It also explores the tension between the general ability of states to apply neutral and generally applicable laws to religiously motivated conduct and the special legal protections provided for some internal actions of religious organizations — particularly employment actions relating to ministers and certain internal disputes. It concludes by exploring how courts are likely to develop such limits in the future.
Thursday, July 23, 2015
IRS Issues Memorandum on Political Activities Referral Committee while determined to be "at risk" by GAO
On July 21, the IRS released a memorandum (TEGE-04-0715-0018) that defines the operation and composition of the Political Activities Referral Committee (PARC) that is charged with reviewing referrals for exempt organization audits. According to Bloomberg BNA, the memorandum was released in advance of a hearing where the Government Accountability Office has now issued a report finding that "poor oversight" places the IRS at risk that its agents could target exempt organizations for audits based on the organization's religious, educational or political views.
The memorandum describes the basic composition of a PARC:
Effective immediately, a PARC will consist of three IR-04 managers (OPM General Schedule (GS) grade 14 equivalent) who will be selected at random. All EO Examinations and Rulings & Agreements front-line IR-04 managers are eligible for selection to a PARC. The managers who are selected to serve on a PARC will receive appropriate training, and will serve on that committee as a collateral assignment for a period of two years. The inventory volume of political activities referrals received will determine the number of PARCs established and the time commitment required by the members of a PARC.
A PARC will review and recommend referrals for audit in an impartial and unbiased manner. A PARC must identify and document to the case file that the referral and associated publicly available records establish that an organization and any relevant persons associated with that organization may not be in compliance with Federal tax law. All PARC members will use the Reporting Compliance Case Management System (RCCMS) to document their activities and conclusions for the duration of their assignment to a PARC. In order for a referral considered by the PARC to be forwarded to an EO Examination group for audit consideration, two out of three PARC members must make that forwarding recommendation (majority rule).
(More on GAO Report: Washington Post, "Watchdog: IRS at risk for unfairly auditing political groups")
As reported by The New York Times, a charity fraud case in the New York court is a great teaching case reminiscent in part of United Cancer Council, except this case involves potentially both private benefit and private inurement. The National Children's Leukemia Foundation, based in Brooklyn, is accused of paying more than 80% of the $9.75 million it raised from 2009 to 2013 in telemarketing and direct-mail fundraising campaigns. In contrast, the Foundation only expended $57,451 in "direct cash assistance to leukemia patients" in the same time period. The Foundation's "Make A Dream Come True" program, which arranged family trips and celebrity introductions to children with cancer, was primarily a phantom effort, with only $7,866 paid out prior to 2009 and nothing thereafter. The Foundation's claims of maintaining a bone marrow registry and "banking stem cells" were admitted to be mostly false.
Reeking of private inurement, the Foundation was essentially a one-person operation, operated from the founder's basement. The founder extracted a $595,000 salary and $600,000 deferred compensation from 2009 to 2013, along with a future pension. The court petition also accuses the founder of using Foundation funds for personal expenses, including house renovations. A lack of board oversight and internal accounting controls appear to have contributed to the founder's ability to control both operations and raised funds. In addition, the Foundation transferred $655,000 to an Israeli research foundation created by the Foundation's founder.
Monday, July 20, 2015
As reported by The New York Times, Representative Raúl R. Labrador, Republican of Idaho, and Senator Mike Lee, Republican of Utah, along with 130 sponsors, have proposed legislation, the First Amendment Defense Act, that would confer protections for tax-exempt organizations and individuals that object to the Supreme Court's recent gay-marriage ruling on religious or moral grounds. The Act specifically provides that the Federal government cannot take any "discriminatory action" against a person, "wholly or partially on the basis that such person believes in accordance with a religious belief or moral conviction that marriage is or should be recognized as the union of one man and one woman, or that sexual relations are properly reserved to such a marriage." The Act defines a "discriminatory action" to include (i) an action by the Federal government to "alter in any way the Federal tax treatment of, or cause any tax, penalty or payment to be assessed against, or deny, delay, or revoke an exemption from taxation under Section 501(a) of the Internal Revenue Code of 1986 of, any person" referred to above, or (ii) "disallow a deduction for Federal tax purposes of any charitable contribution to or by such person." The Act states that it should be broadly interpreted in favor of a 'broad protection of free exercise of religious beliefs and moral convictions, to the maximum extent permitted" by the Act and the U.S. Constitution.
The Times reports that a bill proposed by "moderates" would attached two pro-gay rights provisions: (i) the Employment Non-Discrimination Act, making illegal workplace discrimination based on sexual orientation, and (ii) an amendment to the Fair Housing Act to include protections on the basis of sexual orientation and gender identity.
The Act, if passed in its present form, would ostensibly address the concerns of churches and other religiously-affiliated organizations that their tax-exempt status could be revoked for discrimination in membership or employment or otherwise on the basis of sexual orientation, even if such organizations' actions are based on their core religious tenets. (See prior blog post here discussing these concerns).
As reported by the Daily Tax Report, a tax law specialist in the IRS's Exempt Organizations office commented in a recent IRS webcast that social clubs must have individual, not corporate, members to qualify for tax-exempt status under Section 501(c)(7). In order to meet the social interaction and recreational purposes of 501(c)(7), individuals are necessary in that "corporate members are incapable of personal contact." If individuals hold memberships sponsored by corporations, the particular country club or sports club will still qualify for tax-exempts status.
As explained by the IRS, "substantially all" of a tax-exempt social club's income must come from dues, fees, assessments or other payments for typical social functions, or facilities that the club provides to its members. The IRS reiterated that this is a key consideration for tax-exempt status under 501(c)(7). The "substantially all" rule does permit a club to receive up to 35 percent of its gross receipts from non-member sources. Within that 35 percent rule, no more than 15 percent of the organization's gross receipts can be from the use of its facilities or services by nonmembers. If the "35-15 test" is not met, the IRS will examine all facts and circumstances to determine if a 501(c)(7) determination is proper.
Pursuant to a July 14, 2015 notice published in the Federal Register, the IRS is seeking comments concerning Form 990, Return of Organization Exempt from Income Tax under Section 501(c), 527, or 4947(a)(1) of the Internal Revenue Code. In the notice, the IRS specifically sought comments on:
- Schedule A (Form 990 or 990-EZ), Public Charity Status and Public Support, used to elicit special information from Section 501(c)(3) organizations; and
- Schedule B (Form 990, 990-EZ, or 990-PF), Schedule of Contributors, which is used by tax-exempt organizations to list contributors and allows the IRS to distinguish and make public disclosure of the contributors list within the requirements of Section 527.
The notice stated that comments should address: (i) whether the collection of information is necessary for the proper performance of the functions of the agency, including whether the information shall have practical utility; (ii) the accuracy of the agency's estimate of the burden of the collection of information; (iii) ways to enhance the quality, utility, and clarity of the information to be collected; (iv) ways to minimize the burden of the collection of information on respondents, including through the use of automated collection techniques or other forms of information technology; and (v) estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.
Thursday, July 16, 2015
This recent article in the New York Times: “IRS Expected to Stand Aside as Nonprofits Increase Role in 2016 Race” should come as no surprise. The gist of the article is that the IRS is a damaged agency in the wake of the Tea Party scandal, and will delay taking any action to curb abuse until after the 2016 election.
Truthfully, there is little the IRS can do at this point. The remedy to the problem lies in the hands of Congress. My views are set out at length in an article “Political Activity Limits and Tax Exemption: A Gordian's Knot.”
In a nutshell, and setting aside any IRS management failures, the issue at bottom is not about taxes but about the disclosure of donors (aka, “dark money”). Until Congress provides for uniform donor disclosure rules (which could be to require disclosure, or not), there will be incentives for political speakers to play arbitrage with the tax exemption system – i.e., to plan into a tax classification based on donor tolerance for disclosure.
So the first critical step is to treat political contributions and expenditures alike for disclosure purposes, irrespective of the type of entity that engages in the political activity. Once this is done, the importance of political activity for tax status purposes will greatly diminish, and the IRS will have less reason to care how much political activity noncharitable groups engage in.
The second step is to admit that after the Citizens United decision the tax regulations that define political activity as not furthering noncharitable exempt purposes make no sense. Citizens United, for better or worse, removed the constitutional limit on independent corporate (and labor union) speech, and noncharitable exempts should be allowed to engage in as much political activity as seems fit to further their purposes. The fact is that from a tax perspective, we simply do not care how much political activity a noncharitable exempt engages in. There is no tax “penalty” for losing 501(c)(4) status because of “too much” political activity – the group would simply be reclassified as a political organization, which gets broadly the same tax treatment with respect to political activity. (There are technicalities involved, but the general point is right.)
If there are any lessons from the Tea Party scandal, one is that, as a guiding principle, the IRS should not be tasked with regulating limits on political activity absent significant tax policy goals. In the case of 501(c)(3) organizations, there are important tax policies at stake that require IRS involvement. But for noncharitable exempts such as 501(c)(4)s and others, the extent of the organization’s political activity should not matter and we should not ask the IRS to police this border. Thus, the solution is uniform donor disclosure rules on the one hand, and no definitional limits on political activity by noncharitable exempts on the other.
Wednesday, July 15, 2015
As described yesterday, the Senate Finance Committee’s bipartisan tax working group selected two extender provisions for discussion as consensus items: the IRA distribution provision and conservation easements. The two options on conservation easements signal that there is some consensus that the extraordinary incentives for easement contributions should not be made permanent without reform to the program.
The bipartisan staff says that one option is to reinstate and make permanent the special incentives (increased percentage limitations and carryforwards). The second option, which would be in addition to the first, would add “provisions designed to ensure that conservation easements are properly valued and serve a legitimate conservation purpose.” The implication is that the staff is well aware of the many problems with easement donations. (For some scholarly discussion of why the charitable deduction is a bad fit for the conservation easement program, and an overview of reform options, see Conservation Easements: Design Flaws, Enforcement Challenges, and Reform.)
The main question then should be: if there is consensus that present law (with or without the special incentives) results in excess benefits to donors from overvaluation and uncertain conservation outcomes, why would any rational lawmaker decline to tighten the easement deduction as part of tax reform? And why would any rational lawmaker make the problems worse by permanently increasing the tax benefits without reform? Hopefully, the fact that Congress and the White House are controlled by different parties will not blind lawmakers to the Administration’s proposal (page 188) on easements. The Treasury Department has a number of worthwhile ideas for reform of easement donations (tightening donee eligibility requirements, conservation purpose rules, and appraisal standards and penalties). These should be nonpartisan ideas and hopefully Congressional staff is working with the Treasury.
The bipartisan staff report transitions from easements to a discussion of property contributions generally. The discussion nicely highlights some of the problems with noncash contributions and steps Congress has taken in recent years to curtail fair market value-based deductions for property. As I have argued elsewhere, charitable contributions of property should be viewed as a distinct tax expenditure (distinct from cash) that costs taxpayers billions of dollars each year ($49 billion of deductions were claimed for 2012), induces administrative nausea, is incredibly complex, damages the reputation of the charitable sector, and often produces uncertain benefits to charity. For recent statistics on noncash giving, see IRS data.
The staff report is something of a cliff hanger, however, as it stops almost mid-thought with no indication of what if any steps might lie ahead. Nonetheless, clearly noncash contributions are a consensus item of concern – meaning that proposals like those in the Tax Reform Act of 2014 (a basis deduction for real estate and privately held securities) likely are in play. Perhaps there also is consideration for eliminating (or at least reducing) the ability to deduct unrealized appreciation with respect to other assets and to revisit the extent to which giving incentives are necessary to encourage taxpayers to dispose of used clothing and household goods.
It also is worth noting that the special enhanced deduction for food inventory (which was part of the America Gives More Act) is absent from the bipartisan report. Thus even though food donations generally are a sympathetic and worthy cause, this extra enhanced deduction was not a consensus item, suggesting that staff suspect that the proposed enhancements for gifts of food inventory (special valuation and basis rules) are generous give-aways to donors without sufficient assurances that donee charities (and the hungry) will benefit commensurately.
Tuesday, July 14, 2015
The Senate Finance Committee’s bipartisan tax working group outlined a handful of options on charitable giving last week. The options appear in the report on individual tax provisions.
Considering the breadth of the individual income tax, the report is relatively brief at a mere 48 pages. Charitable giving consumes about 1/3 of the total options. The working group explains the narrow focus in the introduction: “Given the short time allowed for the Working Group process and the complexity associated with individual tax reform, the Working Group chose to focus on the areas that appeared most ripe for possible bipartisan consensus: Homeownership, Charitable Giving, Higher Education, and Tax Administration.”
Changes to the charitable deduction are thus are very much on the table. But it is important to put the options in context. By limiting discussion to consensus items, we should not read too much into the fact that broad structural reforms of the charitable deduction – such as imposition of an AGI-based floor, or conversion of the deduction to a credit – are not mentioned. Surely, they were discussed but no consensus yet reached.
So what is mentioned in the report? Broadly, the bipartisan staff appear open to two provisions that have already passed the House (as part of the America Gives More Act) and that have long been part of the annual extenders headache: make permanent (1) the exclusion for distributions from an IRA to a qualifying charity and (2) the special giving incentives for conservation easements. As part of a reform document, these options might induce yawns (and perhaps pique). However, the bipartisan staff’s overall view of both provisions comes across as rather skeptical.
On the IRA distribution provision, the staff cautions that there should be a balance between encouraging charitable giving and ensuring that individuals have enough funds for retirement, thus suggesting a countervailing policy concern. The staff also intimates a factor rarely mentioned in discussion of this provision – namely that donors not only avoid the charitable percentage limitations (which is well known), but also, by excluding the IRA distributions from income, reduce their adjusted gross income for the tax year. A lower AGI generally is taxpayer friendly because AGI is used as a threshold for phaseouts and for various tax benefits. Thus, the staff acknowledges a concern that if the IRA provision is made permanent (and certainly if it is expanded) lawmakers should be clear in weighing the benefits of any increased charitable giving with the tax costs – which are not limited to waiving the charitable percentage limitations but may include other, noncharitable-related tax benefits to donors.
Another intriguing glimpse of the future emerges in the discussion of possible expansions to the IRA distribution provision. The staff seems open to allowing donor-advised funds, supporting organizations, private foundations, and split-interest trusts to become eligible distributees. But the staff also gives credence to present law limits by acknowledging the policy fault-line between charities that conduct active programs as opposed to primarily grant-making charities like private foundations and DAFs. The staff also, perhaps for the first time, suggests that not all DAFs should be treated the same – noting that DAFs sponsored by community foundations perhaps are “better” for this purpose than other DAFs. This also raises interesting definitional questions about how to distinguish among sponsoring organizations for tax purposes. If DAFs sponsored by community foundations are eligible under the IRA provision, how will they be distinguished from DAFs sponsored by commercial financial firms?
In any event, clearly staff is focused on a bipartisan basis on questions not directly raised in the report: the active versus passive charity distinction and whether new rules for DAFs are warranted. Both issues were very much implicated in the Tax Reform Act of 2014 introduced in the House, signaling more to come.
The easement/property proposals will be considered in a future post.
Bosque Canyon Ranch v. Comm’r—Partnerships Denied Deductions for Conservation Easements Allowing Movable Homesites and Taxed on Disguised Sales of Homesites
In Bosque Canyon Ranch v. Comm'r, T.C. Memo. 2015-130, the Tax Court denied $15.9 million of deductions claimed by partnerships for the donation of conservation easements on two grounds: (i) the easements permitted 47 unencumbered 5-acre homesites to move around the easement-protected properties with the holder’s approval and (ii) the partnerships failed to provide the donee with adequate and timely baseline documentation. The court also sustained the IRS’s imposition of gross valuation misstatement penalties with regard to the conservation easement deductions. The court further held that partnerships’ transfers of the 5-acre homesites to limited partners in exchange for purported “capital contributions” were, in fact, taxable disguised sales.
In 2003, Bosque Canyon Ranch, L.P. (BCR I), purchased a 3,744-acre ranch (the Ranch) for just over $4.97 million. In 2005, BCR I contributed approximately 1,866 acres of the Ranch to BC Ranch II, L.P. (BCR II).
BCR I sold 24 limited partnership interests with regard to its 1,877-acre share of the Ranch for $350,000 per unit, or a total of $8.4 million. Each limited partner was entitled to a 5-acre “Homesite parcel,” the right to build a house on the parcel, and the right to use the Ranch for various recreational activities, such as swimming, hiking, biking, horseback riding, and hunting. In 2005, BCR I granted a conservation easement to the North American Land Trust (NALT) with regard to 1,750 of the 1,877 acres and claimed a charitable deduction of $8.4 million.
BCR II sold 23 limited partnership interests with regard to its 1,866-acre share of the Ranch for $385,00 to $550,000 per unit, or a total of over $9.957 million. As with BCR I, each limited partner was entitled to a 5-acre Homesite parcel, the right to build a house on the parcel, and the right to use the Ranch for various recreational activities. In 2007, BCR II granted a conservation easement to NALT with regard to 1,732 of its 1,866 acres and claimed a deduction of $7.5 million.
The terms of the two easements are substantially the same. Both provide that portions of the subject land include habitat of the golden-cheeked warbler (pictured above), an endangered species endemic to and nesting only in Texas. Both prohibit residential, commercial, institutional, industrial, and agricultural uses, but permit BCR I and II to raise livestock; hunt; fish; trap; cut down trees; and construct buildings, recreational facilities, skeet shooting stations, deer hunting stands, wildlife viewing towers, fences, ponds, roads, trails, and wells. The easements also permit the Homesite parcel owners and NALT to mutually agree to modify the boundaries of the Homesite parcels, provided that:
- in NALT’s “reasonable judgment,” the modification will not result in any material adverse effect on the conservation purposes of the easements,
- the size of the Homesite parcels will not be increased,
- the exterior boundaries of the property subject to the easements will not be modified, and
- the overall amount of property subject to the easements will not be decreased.
Following the various transfers noted above, the 47 limited partners of BCR I and II owned approximately 235 acres (the Homesite parcels), which were not encumbered by the easements; 99.2% of the remaining land (3,482 of the remaining 3,509 acres) was subject to the conservation easements; and the Homesite parcels could, subject to the conditions noted above, be moved around the Ranch.
Denial of § 170(h) Deductions
The Tax Court denied the deductions claimed with regard to the easement donations on two grounds. First, the boundary modifications to the Homesite parcels could cause property that was protected by the easements at the time of their donation to subsequently lose that protection. Accordingly, citing the 4th Circuit’s opinion in Belk v. Commissioner, the Tax Court held that the easements were not "restrictions (granted in perpetuity) on the use which may be made of the real property" as required under IRC § 170(h)(2)(C). For a similar holding, see Balsam Mountain v. Commissioner (also involving NALT as donee).
The Tax Court also found that BCR I and II did not satisfy the Treasury Regulation’s “baseline documentation” requirement, which provides, in part, that:
for a deduction to be allowable … the donor must make available to the donee, prior to the time the donation is made, documentation sufficient to establish the condition of the property at the time of the gift. Such documentation is designed to protect the conservation interests associated with the property, which although protected in perpetuity by the easement, could be adversely affected by the exercise of the reserved rights.... The documentation...must be accompanied by a statement signed by the donor and a representative of the donee clearly referencing the documentation and in substance saying 'This natural resources inventory is an accurate representation of [the protected property] at the time of the transfer.' Treas. Reg. § 1.170A-14(g)(5)(i).
The court explained that the baseline documentation requirement "ensures that the conservation interests are not 'adversely affected by the exercise of the reserved rights' and that 'the donor will be able to deduct only what the donee organization actually receives.'"
The court found that the baseline documentation NALT prepared with regard to the easements was “unreliable, incomplete, and insufficient to establish the condition of the relevant property on the date the respective easements were granted.” The documentation was also untimely, parts having been prepared well before and parts having been prepared well after the date of the donations. In addition, in “rambling, incoherent testimony,” the president of NALT “failed to clarify these glaring inconsistencies.” The required donor acknowledgments in the baselines, which provide that the baseline was fully reviewed by the donor and accurately describes the condition of the property at the time of donation, also were not executed by the donor prior to the donation (this was apparent with regard to the 2007 easement and seemed to be the case with regard to the 2005 easement). Unsurprisingly given the extent of the deficiencies, the court found meritless and rejected the taxpayers’ argument that they had substantially complied with the baseline documentation requirement.
The Tax Court held that both partnerships (BCR I and II) had, in effect, sold the Homesite parcels and appurtenant rights to the limited partners in taxable transactions. The court found that the distributions of the Homesite parcels to the limited partners were made in exchange for the limited partners’ payments and were not subject to the entrepreneurial risks of the partnerships’ operations. Accordingly, BCR I and II were required to recognize and include in their gross income any gains relating to the disguised sales. IRC § 707—the disguised sale provision—prevents use of the partnership provisions to render nontaxable what would in substance have been a taxable exchange if it had not been "run through" the partnership. For similar holdings involving the disguised sale of state income tax credits generated by conservation easement donations, see Route 231, LLC v. Commissioner and SWF Real Estate, LLC, v. Commissioner.
Gross Valuation Misstatement Penalties
Each of BCR I and II was also found liable for a gross valuation misstatement penalty with regard to the charitable deduction it claimed for its easement donation. The court determined that zero was the correct value relating to the easements because BCR I and II were not entitled to deductions for the donations. Accordingly, each had made a gross valuation misstatement on the return on which it claimed the deduction. The fact that the deductions were disallowed for failure of the easements to qualify under IRC § 170(h) rather than on overvaluation grounds did not matter. The Tax Court explained that, in Woods v. United States, 134 S. Ct., 557 (2013), the U.S. Supreme Court “reject[ed] the distinction between legal and factual valuation misstatements."
Moreover, neither BCR I nor BCR II was eligible for the reasonable cause exception to the gross valuation misstatement penalty. For returns filed after August 17, 2006, as BCR II’s was, the gross valuation misstatement penalty is a strict liability penalty (i.e., there is no reasonable cause defense). Also, even though BCR I was entitled to raise the reasonable cause defense (because it filed its return before the August 17, 2006, date), it did not qualify for the defense. Although the court found that the appraisal BCR I used to substantiate its deduction was a qualified appraisal and BRC I’s reliance on the appraisal constituted a good faith investigation of the 2005 easement’s value, that was not good enough. Because the baseline documentation for the easement was insufficient, unreliable, and incomplete, BCR I’s submission of the baseline to NALT "did not constitute a reasonable attempt to comply with section 170 and the related regulations." BCR I failed to effectively supervise or review NALT’s “slipshod preparation” of the baseline and “failed to make any plausible contentions sufficient to establish reasonable cause." Accordingly, BCR I was also liable for the gross valuation misstatement penalty.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah College of Law
Monday, July 13, 2015
Last week the Senate Finance Committee released reports on tax reform from its various bipartisan working groups. The Business Tax Working Group Report, A-68 to A-75, had three “options” relevant to exempt organizations, none of which break new ground. One would require all tax-exempt organizations to file returns in the 990 series electronically. Another would permit any 501(c) organization to obtain a declaratory judgment regarding determinations by the IRS of its tax exempt status. A third would replace the two-tiered tax on the net investment income of private foundations with a single tax, at a rate of 1 percent.
On the merits, electronic filing generally is a good idea, as it should lead to more accurate, accessible, and complete filing of information returns. Hopefully, any legislation will be coordinated with the IRS to make sure the agency has the wherewithal and the funding to accommodate efiling.
Extension of declaratory judgment procedures is an old idea (dating at least to the 1990s), though the need for it is not clear. Proposed as part of “good government bills” in the 2000s, it has previously passed the Senate but never been enacted. Presumably, its recent reappearance on both sides of Congress is related to the Tea Party scandal and the delay 501(c)(4) groups have had in getting determinations from the IRS. The thinking must be that if noncharitable exempts are able to seek a declaratory judgment on an exempt status determination, the IRS would have an incentive to issue a determination within 270 days to avoid going to court. Further, groups would be able to appeal adverse determinations. On balance, however, it is difficult to know whether this would be useful. One negative effect could be that the IRS might yield on close (or even not so close) cases to avoid the costs of defending a court challenge, further diluting the noncharitable exempt category. On the other hand, by throwing some noncharitable exempt status questions to the courts, over time additional law could develop on the scope of tax-exempt status.
The option to replace the two rates of excise tax on tax-exempt private foundations with a single rate is supported by just about everyone (including the House, the Administration, and private foundations). The only issue seems to be the rate – whether it should be say 1% as prosed by the House and the working group, or a revenue neutral rate, as proposed by the Administration. There are policy reasons to support a rate reduction, namely that under the current two-tiered structure, foundations can face a tax increase if payout goes up. But that said, fiddling with the tax rate and structure is to tinker with a tax that has never served its purpose, which was to fund IRS exempt organization oversight. If the tax is to be retained at all, the purpose should be reconsidered. Is the tax on private foundation investment income intended as a penalty for not paying out? Is it now just punitive – reflecting decades old distrust of private foundations? Or is it meant to be a tax on income accumulations? What is notable in this regard is the absence in the working group of any notion of extending the tax to private operating foundations or endowments of educational institutions, as proposed last year as part of the Tax Reform Act of 2014 on the House side.
Relatedly, the three options from the Finance Committee working group stand in stark contrast to the myriad of proposals in the Tax Reform Act of 2014. Absent are reforms to intermediate sanctions, supporting organizations, rules on executive compensation, payouts on donor-advised funds, changes to the unrelated business income tax rules, or increases to penalties for noncompliance – all of which featured prominently in the House offering. It could be that the Senate staff was just not interested in the House approach. More likely, however, was that for purposes of a bipartisan staff report, the only consensus items would be the non-controversial, fairly easy ones. Whether there is interest on the Senate side in taking on some of the broader reforms contemplated by the House remains to be seen.
Thursday, July 9, 2015
The ABA's Real Property, Trust and Estate Section has a series called "Professors' Corner," which puts on some really great free webinars for ABA members (sorry - no CLE, but what do you want for free?) on real estate and T&E topics from both academic and practitioner view points. This Wednesday I was in the midst of a road trip, during which I dialed in to the latest in the series on an update to UPMIFA. (Don't worry, I pulled over to a Tim Horton's to dial in. And get coffee. Because road trip.)
The webinar featured Susan Gary from UOregon and Terry Knowles, the Assistant Director of Charitable Trusts in the New Hampshire Attorney General's office. Many of you may know that Susan was the Reporter for UPMIFA with the Uniform Law Commission, and that Terry was an advisor (I believe on behalf of NASCO but I could be wrong on that.) In any event, it was really interesting to hear both of them talk about what's happened in the nine years (has it really been nine years!!!) since UPMIFA was passed by the ULC.
I highly recommend listening to the whole webinar (I think that it will archive soon so ABA should be able to access it) but here are three big picture take aways:
- FIGHT! The lawyers and accountants continue to use different definitions when dealing with endowed funds, which causes confusion all over the place. Susan talked about how the accountants have defaulted to having their clients use historic dollar value to define restricted assets, even thought that isn't required anywhere and actually sort of undercuts what UPMIFA is trying to do. Often, if there is professional advice to small nonprofits, it's from the accounting folks and not the legal folks, so this problem really has cause some issues. I was happy to hear from Susan that FASB is looking to revise this, and that it has some draft rules out for comment.
- UNSAFE HARBORS. As some of you may know, the original UPMIFA draft from the ULC has a provisions that says that endowment spending in excess of 7% is subject to a rebuttable presumption of unreasonableness. Many states didn't adopt - it was interesting to hear that one of the professed rationales for not adopting the 7% rules was the concern that it would cause a safe harbor for 6.99% and under. It was also intersting to hear Terry talk about what her office sees as overcoming that presumption - "we needed it because our budget is short" is insufficient!
- WHAT IS THIS IPS OF WHICH YOU SPEAK? Again, it was interesting to hear Terry talk about what her office needs to do when evaluating spending decisions from endowments. If an endowment is supposed to be perpetual, it really is important to take into account inflation as a factor for consideration, even if there is no magic in how you do it exactly. It seems like the AGs are really looking for a thoughtful process and adherence to an investment policy statement.
In any event, I do recommend the webinar to anyone interested in the endowment spending issue (which seems to be getting some attention from Congress and otherwise as of late - I've linked to Brian Galle's thought-provoking paper on endowment spending) and I really recommend the webinar if you find yourself with lots of time on I-90.
Safe summer travels, all.
Monday, July 6, 2015
In the wake of Obergefell, the Internet was a dangerous place to be as a tax lawyer. Oh, a nickel for all the posts that lamented the loss of tax-exempt status for churches that didn't perform same sex marriages forthwith! Of course, I was sure to correct them all right away, because you know, nothing on the internet can be wrong, right?
There's been a lot of coverage by the news media on this issue as we've had some more time to discuss the issues, as discussed previously here at the Nonprofit Tax Prof Blog. Here's the latest in the coverage from the Baltimore Sun, which discusses the tax exempt status of religiously-affiliated universities. The article hedges on the issue of tax-exempt status, but I think both sides of the tax argument can find some common ground in the discussion found there. Under a Bob Jones University analysis, I'm not sure that we are there yet - there being that discrimination on the basis of sexual orientation is so fundamentally against public policy as to cause loss of tax-exempt status. While Obergefell certain makes it a stronger case, I think we will need to see more from the other branches of government before we get to that level. That being said, I agree with the Sun article in the thought that even if we aren't there now, I think we may be within my lifetime.
I do think that it is important to point out that Bob Jones University specifically talked about racial discrimination in education as being the fundamental public policy at issue and that the case involved the tax-exempt status of a university, not a church. Note that this article only talks about colleges and universities - the question of the tax-exempt status of churches is much more complicated. I don't believe there there is a case that we know of that where a church lost its tax-exempt status on the basis of religious discrimination. Can any of my Tax Prof or Nonprofit Prof Blog colleagues think of any example?
Friday, June 26, 2015
We have been following the Sweet Briar College litigation and settlement on this blog (see here and here). I thought readers might be interested in knowing precisely what the Virginia Supreme Court stated in its order leading up to the settlement. First, let’s be clear on the context of the Virginia Supreme Court order. This high court was considering an order of the circuit court (a lower court) that had granted in part and denied in part a motion for a temporary injunction, filed by the Commonwealth, to restrain the college from facilitating its closure during the legal proceedings. The state supreme court characterized the lower court’s order as having been based, “at least in part, upon the legal conclusion that the law of trusts cannot apply to a corporation.” The Virginia Supreme Court called this conclusion of the lower court “erroneous.” Said the high court:
The law of trusts can apply to a corporation. Jimenez v. Corr, 288 Va. 395, 411, 764 S.E.2d 115, 122 (2014) ("When . . . a trust exists, it is not a separate legal entity being referred to, but a fiduciary relationship between already existing parties, be they real persons or other legal entities."); Restatement (Second) of Trusts § 96(1) (1959) ("The extent of the capacity of a corporation to take and hold property in trust is the same as that of a natural person except as limited by law."); Restatement (Third) of Trusts § 33(1) (2003) ("A corporation has capacity to take and hold property in trust except as limited by law, and to administer trust property and act as trustee to the extent of the powers conferred upon it by law."); see also, e.g., Code § 64.2-706(C) (establishing rules governing the principal place of administration for certain "corporate trustee[s]"). The charitable, non-profit, or non-stock status of a corporation does not alter this legal principle. See Dodge v. Trustees of Randolph-Macon Women’s College, 276 Va. 10, 16, 661 S.E.2d 805, 809 (2008) (holding that Randolph-Macon Woman's College was not subject to the Uniform Trust Code because the College was not a trustee of a trust to which the Uniform Trust Code applies, and not simply because the College is a non-stock charitable corporation).
Accordingly, the circuit court erred to the extent it exercised its discretion in acting upon the motion for a temporary injunction based upon this erroneous legal conclusion.
What the Virginia Supreme Court ruled is not that a charitable corporation is necessarily governed by the law of charitable trusts. Rather, the Court concluded that a charitable corporation can serve as the trustee of a charitable trust under state law. The two are very different legal propositions.
Thursday, June 25, 2015
The Supreme Court has issued its opinion in King v. Burwell today. In a majority opinion authored by Chief Justice John Roberts (and joined by Justices Kennedy, Ginsburg, Breyer, Sotomayor, and Kagan), the Court interpreted the Affordable Care Act (ACA) to provide tax credits to those who enroll in an insurance plan through a federal exchange in a state that has not established its own exchange. The decision is of interest to the nonprofit health care sector for obvious reasons. The decision is also of interest to legal scholars because of its non-reliance on the interpretation of the ACA offered by the Internal Revenue Service, the agency charged with administering the tax credit, and its emphasis on purpose and context as tools of statutory interpretation. The remainder of this post discusses the opinion in more detail.
The Supreme Court majority opinion describes the precise issue as follows:
The issue in this case is whether the Act’s tax credits are available in States that have a Federal Exchange rather than a State Exchange. The Act initially provides that tax credits “shall be allowed” for any “applicable taxpayer.” 26 U. S. C. §36B(a). The Act then provides that the amount of the tax credit depends in part on whether the taxpayer has enrolled in an insurance plan through “an Exchange established by the State under section 1311 of the Patient Protection and Affordable Care Act [hereinafter 42 U. S. C. §18031].” 26 U. S. C. §§36B(b)–(c) (emphasis added).
The IRS addressed the availability of tax credits by promulgating a rule that made them available on both State and Federal Exchanges. 77 Fed. Reg. 30378 (2012). As relevant here, the IRS Rule provides that a taxpayer is eligible for a tax credit if he enrolled in an insurance plan through “an Exchange,” 26 CFR §1.36B–2 (2013), which is defined as “an Exchange serving the individual market . . . regardless of whether the Exchange is established and operated by a State . . . or by HHS,” 45 CFR §155.20 (2014).
The plaintiffs in the case, residents of a state (Virginia) that did not establish its own exchange, did not want health insurance. They argued that the federal exchange operating in Virginia failed to qualify under the ACA as “an Exchange established by the State,” and therefore they were entitled to no tax credit for the purchase of insurance. Without the credits, now provided by Section 36B of the Internal Revenue Code, the plaintiffs’ cost of insurance would exceed eight percent of their income, and thus the ACA would exempt them from the ACA’s general mandatory coverage. Under the IRS’s interpretation of the ACA, however, the exchange operating in Virginia was a state exchange under the ACA, and thus the plaintiffs qualified for the credit and were not exempt from mandatory coverage. As the Court observed, “[t]he IRS Rule therefore requires petitioners to either buy health insurance they do not want, or make a payment to the IRS.”
The Court first declined to defer to the IRS’s interpretation of the statute. I reproduce the key language in full:
When analyzing an agency’s interpretation of a statute, we often apply the two-step framework announced in Chevron, 467 U. S. 837. Under that framework, we ask whether the statute is ambiguous and, if so, whether the agency’s interpretation is reasonable. Id., at 842–843. This approach “is premised on the theory that a statute’s ambiguity constitutes an implicit delegation from Congress to the agency to fill in the statutory gaps.” FDA v. Brown & Williamson Tobacco Corp., 529 U. S. 120, 159 (2000). “In extraordinary cases, however, there may be reason to hesitate before concluding that Congress has intended such an implicit delegation.” Ibid.
This is one of those cases. The tax credits are among the Act’s key reforms, involving billions of dollars in spending each year and affecting the price of health insurance for millions of people. Whether those credits are available on Federal Exchanges is thus a question of deep “economic and political significance” that is central to this statutory scheme; had Congress wished to assign that question to an agency, it surely would have done so expressly. Utility Air Regulatory Group v. EPA, 573 U. S. ___, ___ (2014) (slip op., at 19) (quoting Brown & Williamson, 529 U. S., at 160). It is especially unlikely that Congress would have delegated this decision to the IRS, which has no expertise in crafting health insurance policy of this sort. See Gonzales v. Oregon, 546 U. S. 243, 266–267 (2006). This is not a case for the IRS.
It is instead our task to determine the correct reading of Section 36B.
The Court then found that the phrase, “an Exchange established by the State under [42 U. S. C. §18031],” is ambiguous. Consequently, the Court concluded that it “must turn to the broader structure of the Act to determine the meaning of Section 36B.” The Court rejected the plaintiffs’ statutory interpretation “because it would destabilize the individual insurance market in any State with a Federal Exchange, and likely create the very ‘death spirals’ that Congress designed the Act to avoid.” The Court further opined that the structure of Code section 36B supported its interpretation, for under the contrary view, “Congress made the viability of the entire Affordable Care Act turn on the ultimate ancillary provision: a sub-sub-sub section of the Tax Code.” The concluding substantive paragraph of the majority opinion summarizes the decision as follows:
Congress passed the Affordable Care Act to improve health insurance markets, not to destroy them. If at all possible, we must interpret the Act in a way that is consistent with the former, and avoids the latter. Section 36B can fairly be read consistent with what we see as Congress’s plan, and that is the reading we adopt.
The New York Times has published a piece exploring how nonprofits could be affected by the pending Supreme Court decision in Obergefell v. Hodges, which raises the issue of whether the United States Constitution establishes a right to enter into a gay marriage. The gist of the article is that private religious schools across the nation impose codes of sexual conduct, including prohibitions of same-sex relationships, and these schools fear that their policies could risk the loss of their federal income tax exemption. Why? If the Court recognizes a constitutional right to enter into gay marriage, the Internal Revenue Service could find school policies on sexual conduct to violate fundamental public policy under Bob Jones University v. United States.
Although many legal scholars seem to doubt that schools would face this risk in the near term, the schools do have cause for concern. As I have written and illustrated previously in two law review articles, the public policy doctrine is poorly defined and easily manipulated. Further, the NYT article observes that, during oral argument in Obergefell, Justice Alito posed the question of how the decision would affect the tax exemption of private religious schools to Solicitor General Donald B. Verrilli Jr. In an exchange that we previously covered on this blog, Mr. Verrilli admitted at oral argument that the exemption question “is going to be an issue.”
Wednesday, June 24, 2015
Skadden, Arps Requests Guidance on Taxation of Retirement Payments to Providers of Pro Bono Legal Services
As reported in Tax Notes Today (subscription required), Skadden, Arps has written the Assistant Secretary (Tax Policy) in Treasury and the IRS Chief Counsel to request inclusion in the 2015-2016 Priority Guidance Plan of published guidance addressing the tax treatment of retirement payments to retired law firm partners who provide pro bono legal services to the poor and to charitable organizations that serve them. The following paragraph of the firm's letter explains the legal issue:
[T]he question is whether pro bono services provided by retired partners constitute "services with respect to [a] trade or business carried on by [the law firm] partnership," such that the retirement payments would no longer qualify for the exception to the definition of "net earnings from self-employment." Section 1402(a)(10(A) provides that if a retirement plan meets certain requirements, any payments made pursuant to that plan are excluded from a partner's net earnings from self-employment so long as, among other things, the partner "rendered no services with respect to any trade or business carried on by such partnership . . . during the taxable year of such partnership . . . in which such amounts were received." The issue raised by the Chief Judge's pro bono initiative focusing on retired partners is whether a retired partner who is currently receiving retirement payments that otherwise qualify for the Section 1402(a)(10(A) exclusion could be treated as "rendering services with respect to any trade or business" of the law firm partnership by taking on a pro bono legal representation that is connected to the law firm, whether it involves supervision of other law firm lawyers and staff, use of law firm resources (office space, computer and other equipment), and/or coverage under the law firm's malpractice insurance.
The letter argues that “uncertainty surrounding the tax treatment of the retirement payments presents a significant impediment to the retired partner's provision of pro bono services, thereby serving to discourage important pro bono work by retired law firm partners who would not otherwise be subject to self-employment tax on their retirement payments, but for their pro bono assistance to needy underserved individuals and communities.”
Electronic Citation: 2015 TNT 121-18
Tuesday, June 23, 2015
We previously blogged about the legal challenge to the attempted closing of Sweet Briar College. As reported in the Richmond Times-Dispatch, Bedford County Circuit Judge James Updike approved a mediated settlement to three lawsuits that had been filed to prevent the closing of the private women’s college. The story reports the following salient details:
[Judge] Updike accepted three consent orders presented by Attorney General Mark R. Herring, whose office brokered a mediation effort that continued over nearly six weeks.
The orders, which take effect today, will allow the transfer of leadership to a new president and board of directors under a plan that requires the alumnae group Saving Sweet Briar Inc. to provide $12 million, with $2.5 million due by July 2.
Herring will release restrictions on $16 million from the college’s endowment, which he said will be a sufficient amount to operate the college for the next academic year.
According to the article, the new president of the school will be Phillip C. Stone Sr.
For a copy of the Memorandum of Understanding serving as the basis of the settlement agreement, click here.