How to Apply the Gross Valuation Misstatement When a Gift is a Sham

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As we are reviewing cases from the past few months for the next update in Saltzman and Book IRS Practice and Procedure I have noted a few developments that we have not discussed in PT. A number involve civil penalties. One case is Fakiris v Commissioner, where in November the Tax Court issued a supplemental opinion from a 2017 opinion where it applied the gross valuation misstatement penalty to a purported charitable contribution of a vaudeville era Staten Island movie theater. Fakiris involves restrictions on that gift, leading the Tax Court to conclude that donation was conditional and that there was no completed gift or contribution under Section 170. That in turn triggered Section 6662(h), which imposes an accuracy-related equal to 40% of the portion of the underpayment of tax attributable to a gross valuation misstatement. Following the 2017 opinion, the IRS filed a motion for reconsideration, arguing that the original opinion improperly applied the 6662(h) accuracy-related penalty.

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The original Fakiris opinion (Fakiris 1) was rich with interesting procedural issues, including affirming that 2006 legislative changes, which lowered the threshold for gross valuation misstatements from 400% to 200% and eliminated the reasonable cause exception, applied when the original contribution arose prior to the law’s effective date but the deduction continued to a year when the taxpayer took a carryover deduction. How could a pre-legislation transaction be covered by legislation that was not retroactive? According to the Tax Court, a taxpayer who takes carryover deductions reaffirms its original misstatement in later post-effective date years.

In addition, Fakiris 1 held that the penalty applied even when the court found that there was no effective contribution or gift for federal tax purposes. It reached that conclusion by citing to and briefly discussing the Supreme Court’s 2013 decision in Woods v United States. Prior to Woods, some courts of appeal had held that when deduction or credit is disallowed in full, any underpayment is not “attributable to” a valuation misstatement for purposes of the accuracy-related penalties. Woods rejected that approach and held that the accuracy-related penalty for valuation misstatements applies when the relevant transaction is disregarded for lack of economic substance. As the Tax Court said in its 2017 opinion, “[w]hen the correct value of contributed property is zero and the value claimed is greater than zero, the gross valuation misstatement penalty applies.”

Despite the IRS’s 2017 win in Fakiris 1, the IRS filed a motion for reconsideration. In its motion, the IRS agreed with the original opinion’s conclusion that the transfer of the theater was not a gift but argued that the original opinion misapplied Woods. In particular the motion argued that the original opinon failed to properly apply the gross valuation misstatement penalty, contrasting how courts have approached the valuation penalty post-Woods in façade and conservation easement cases. 

In a somewhat unusual move, the Tax Court granted the motion for reconsideration. Last year the Tax Court issued its supplemental opinion, which affirmed its prior holding and expanded on its original rationale. As an initial matter, it explained why the original transfer was not effective to be treated as a gift or contribution for tax purposes, with a sharper focus on the degree of dominion and control that the donor/seller maintained over the property. In addition it more closely aligned its analysis with cases analogizing failed gifts to shams. After expanding on its rationale for finding that there was no gift, the supplemental opinion turns to the main issue on reconsideration:

What is the “correct value” of “property” that is claimed to be donated but is not actually donated? Or, more precisely: Is the value that of the property that was reported to have been contributed, as respondent would have it be, or the value of the property that was actually contributed? 

All of this is important because of the triggering rules in Section 6662. Recall that accuracy-related penalties apply when there is a substantial valuation misstatement as per Section 6662(b)(3), The base penalty is 20 percent, but that is doubled in certain cases that involve a gross valuation misstatement, as per Section 6662(h)(1). A “substantial” valuation misstatement arises if the value of transferred property is overstated by 150 percent or more of the correct value. The penalty is classified as a “gross” valuation misstatement and the penalty rate is doubled to 40% if the value is overstated by 200% or more of the correct value. 

The penalty is more important since the Supreme Court decided United States v. Woods, 571 U.S. 31 (2013), which held that a valuation penalty applied even when an entire transaction was disregarded (some courts had previously held that the understatement was not attributable to valuation misstatements when an entire transaction was disregarded). Regulations under Section 6662 also provide that there is a gross valuation misstatement  (and thus a steep 40% penalty) when the correct value of property is zero and the value claimed on the return for such property is greater than zero.

Back to Fakiris 2. The IRS on reconsideration argued that the trigger for the penalty required a comparison between the actual value of the theater and the value of what was in fact transferred to the donee/buyer. Under the IRS’s approach on reconsideration either the 20% substantial misstatement or 40% gross misstatement penalty would not automatically apply to Fakaris. The IRS essentially argued for the court to compare the value of the theater without restrictions with the value of what was in fact transferred, i.e., a theater with substantial restrictions. Under the IRS’s approach, if the value of the theater without any restrictions was greater than or equal to twice the value of the theater with the restrictions, the taxpayer would be subject to a 40% accuracy related penalty. This differed from Fakaris 1, which had held that the gross valuation penalty automatically applied when the court found that the restrictions effectively rendered the purported gift a sham.

The Tax Court disagreed with the IRS, mainly distinguishing two easement cases. While in those cases the courts had disallowed deductions due to donors failing to comply with substantiation requirements there also was a valid transfer of something of value. In contrast on reconsideration the Tax Court held that its holding in Fakiris 1 was directly premised on the finding that the donee transferred nothing: 

In both [easement] cases we proceeded on the assumption that a discernible property right had been validly transferred from the donor to the donee. In other words, some quantum of property rights had been transferred from donor to donee, and the charitable contribution deduction was disallowed for failure to satisfy statutory requirements of substantiation. For that reason, a determination of the value of that quantum of property transferred was necessary to calculate the applicability and amount of the section 6662(h) penalty. The same is not true here; the transfer itself was a sham, with the result that the value of the property claimed to have been contributed is zero for purposes of the penalty.

As a final matter, the Tax Court emphasized that even if it were inclined to accept the IRS’s approach on reconsideration and conclude that there was some transfer/gift for federal income tax purposes, the record “is devoid of any evidence supporting a value for whatever could be said to have been transferred.” 

Conclusion

With the IRS urging a taxpayer friendly interpretation of the valuation misstatement penalty, the procedural posture of Fakiris is somewhat unusual. To be sure, the IRS could effectively disregard the Tax Court’s reasoning and choose to apply penalties regime consistent with what its position on reconsideration. Under Fakiris 1 and 2 if a purported charitable contribution is disallowed due to a finding that restrictions placed on the donee effectively render an initial gift or contribution as incomplete the effect is likely an automatic 40% penalty.

On the other hand, as a practical matter I am not sure that the difference matters much. Once misstatement penalties apply when the disallowance stems from threshold legal determinations in cases where a court (as in Fakiris) find that the donor maintains a degree of control over the supposedly gifted asset, I assume that the value of the asset is likely to be sufficiently low enough to trigger the 40% gross valuation misstatement anyway. 

About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

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