Inflexible Tax Rules Devastate Two Taxpayers
(A Lesson in Substantiating Charitable Contributions)
Stan Rose, Managing Director, Tax Practice
Benefits allowed under U.S. tax laws are obtained in a number of ways. For example, an individual filing Form 1040 can obtain a deduction for real estate taxes paid merely by entering the amount paid during the year on Schedule A, Itemized Deductions. While highly advisable to retain documentation supporting the deduction (such as a property tax bill or copy of a cancelled check), simply listing the deduction amount on the form is all that is required to receive that deduction. Other benefits, however, can be obtained only by obtaining or providing additional, very specific material. In those cases, taxpayers should be very aware that although the transfer of cash or other property may have taken place that seemingly should be sufficient to claim the deduction, if the proper documentation is not in place, the IRS can, and often successfully will, deny the deduction – sometimes with devastating consequences to a taxpayer who merely failed to dot an “i” or cross a “t.” A couple of recent court cases serve as excellent examples of just how important it can be to follow the “letter of the law” when it comes to meeting the IRS substantiation requirements.
To appreciate the stories below, readers first must understand some different levels of U.S. tax authority:
- The Internal Revenue Code is the highest source of U.S. statutory tax authority; it contains laws passed by Congress and approved by the President.
- Treasury Regulations are rules that supplement and clarify the Code. They often provide procedural guidance regarding how to meet the requirements of the Code. Unlike the Code, Regulations are written by the IRS, a bureau of the Treasury Department. However, Regulations exist because the Treasury Department was directed by Congress (in Code Section 7805) to write such rules to help enforce the Code. For this reason, Regulations carry the force of law.
- Tax return forms and related instructions are created by the IRS. However, they are not authoritative. Although written by the IRS, they merely represent informal interpretations of the rules.
Many other sources of authority exist, such as Revenue Procedures, Revenue Rulings and court cases, but for purposes of this article, the reader primarily needs to know that the Code and Regulations are authoritative, while the form instructions are not. Although many taxpayers only encounter the forms and instructions, they nevertheless are responsible for complying with the Code and Regulations.
War Story #1
Joseph Mohamed Sr. et ux. V. Commissioner (T.C. Memo 2012-152) dealt with a husband and wife who donated real estate worth close to $20 million to a trust to benefit a children’s hospital, a food bank and a legal foundation. Donations of real estate are legitimate and relatively common, and the law generally allows for deductions equal to the market value of the property at the time of the gift. Because determination of value is subjective, several rules must be followed to prevent abuse. Code Section 170(a)(1) states that “A charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the (Treasury) Secretary.” Those regulations (Sec. 1.170A-13(c)) explain that “No deduction under section 170 (of the Code) shall be allowed with respect to a charitable contribution . . . unless the substantiation requirements described in paragraph (c)(2) are met.” Paragraph (c)(2), in turn, describes many more requirements, including some addressing the timing of the appraisal, a requirement that a “qualified appraiser” sign an appraisal that accompanies the tax return, a prohibition against the donor or donee serving as the appraiser and the need for several assertions to be included.
It is with these various requirements that Mr. Mohamed failed to comply. Form 8283, Noncash Charitable Contributions, is used to report donations such as this. It turned out that the values he reported on the tax return were accurate; in fact, a qualified third-party appraiser later valued most of the donated properties, including the combined total, somewhat higher than Mr. Mohamed reported. But Mr. Mohamed (who himself was a real estate broker and certified appraiser) served as his own appraiser (which is prohibited by the Regulations) and failed to meet some of the detailed requirements of the law. Although the court noted that the Form 8283 instructions were difficult to understand (enough so that the IRS had since changed the instructions to reduce confusion), the court ruled against the taxpayers and denied the entire deduction. In writing its conclusion, the court lamented the unfair result, but noted it was forced to hold as it did because the Treasury Regulations stated that “No deduction . . . shall be allowed . . . unless the substantiation requirements . . . are met,” and it was very clear those requirements were not met. The court noted that it was sympathetic to the Mohamed’s case, but could not hold the IRS responsible for the form instruction’s failings because “the authoritative sources of Federal tax law are in the statutes, regulations, and judicial decisions and not in such information publications.” In this case, the Mohameds truly donated the property and reported a deduction conservatively at somewhat less than its true value, but unnecessarily incurred millions of dollars in tax (through denied deductions) that easily could have been avoided if the rules were followed. The court’s closing comment reads “We recognize that this result is harsh—a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions—all reported on forms that even to the Court’s eyes seemed likely to mislead someone who didn’t read the instructions. But the problems of misvalued property are so great that Congress was quite specific about what the charitably inclined have to do to defend their deductions, and we cannot in a single sympathetic case undermine those rules.”
The Mohameds donated valuable property to three deserving charities, including a children’s hospital. That donation entitled them to tax savings of millions of dollars that were completely lost due to what some would describe as “technicalities.” Mr. Mohamed does not appear to have attempted to do anything wrong; he likely was doing nothing more than trying to save the cost of paying for appraisals by doing it on his own. He was qualified to do so, as he was a licensed appraiser. Even the IRS had to acknowledge that his efforts were accurate, and in fact, a bit conservative. However, failing to follow the letter of the law, whether deliberately or through unfortunate unawareness of it, cost him very dearly.
War Story #2
Donations of real estate are not made by many taxpayers, but substantiation rules apply to some more commonly-encountered scenarios too. One good example relates to routine cash contributions to charitable organizations. The law requires the donor to obtain contemporaneous, written acknowledgement from the charitable organization noting the amount of any cash donations and containing, among other things, an assertion that no goods or services were provided in exchange for the gift. This acknowledgement is not merely good support to have on hand; Code Section 170(f)(8)(A) explains that deductions are not allowed unless this substantiation is obtained. This, too, has been tried in court, with unfavorable results for taxpayers who did not comply. For example, in David P. Durden, et ux. v. Commissioner (TC Memo 2012-140), we learn of a husband and wife who donated cash exceeding $22,000 to a church, and received a contemporaneous acknowledgement from the church documenting the amount of the contributions. However, that acknowledgement lacked a statement indicating that no goods or services were provided in exchange for the gifts. For that reason, the IRS denied their deductions. During the audit, the Durdens obtained a second letter from the church verifying that no goods or services were provided. However, by that point, the documentation no longer was contemporaneous, rendering it useless and the deduction disallowed.
Whom do we blame for the ridiculous outcome of these two cases? Congress undoubtedly saw the potential for significant abuse with charitable contribution claims, and chose to beef up the paperwork required for deductions. (Allow me to rabbit-trail a bit: A college professor told me of an IRS audit, perhaps predating some of these rules, in which a taxpayer produced numerous checks written to several churches on a weekly basis in support of bogus charitable contributions deducted on his tax return. The agent was suspicious of the odd amounts. It turns out, the taxpayer had told the churches he was a coin collector, and had arranged to buy the coins collected in the offering plate at face value each week. The churches obliged, thereby avoiding carrying a sack of coins to the bank every Monday!) Whether or not that story was true, Congress has a vested interest in distinguishing true contributions from the purchase of services, products or tickets to events from charities, and the Code is designed to curb such potential abuse. The IRS is a frequent target of blame, but in my practice, I have found that the IRS is generally quite accommodating of reasonable explanations, and that they act favorably if they have the discretion to do so. However, in the cases described above, the IRS agents had no such discretion because both laws contain the wording that “no deduction shall be allowed . . . unless” certain requirements are met. This is stronger wording than is found in much of the Code and Regulations, and it arguably is speaking as much to the enforcers of the law as it is to those trying to comply with it. While it is hard to blame the taxpayers for these outcomes, the sad truth is they failed to follow long-standing rules and were burned as a result . . . and it could happen again.
There are many other examples of substantiation requirements in federal and state tax rules that are not discussed here, such as travel costs and other business expenses, but we have focused here only on charitable contributions, in light of these recent cases. The message I hope you take from this is twofold: (1.) While some substantiation failures may be of little consequence, others, including those related to charitable contributions, can be very significant. To ensure that you receive the benefit you earned, be sure to take the paper-shuffling rules seriously. (2.) Be sure to know the rules. While tax return form instructions and IRS publications may (or may not!) contain straightforward language, they do not represent authoritative rules. Instead, the Internal Revenue Code, Treasury Regulations, certain rulings or other pronouncements and even case law may need to be consulted. Anything else is merely one party’s interpretation of the law, and a simple misstep can produce truly hideous results.
If you would like to discuss further, please call your BNN advisor or Stan Rose.
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