Alvin S. Brown & Associates

IRS releases revised audit techniques guide on conservation
easements

 

 

 

 

IRS has revised its Conservation Easement audit technique
guide (ATG), which provides extensive insight into the statutory requirements
for qualified conservation contributions, valuation issues, IRS examination
procedures, penalties, and state tax credits associated with such
contributions.

 

Background. In general, Code Sec. 170(f)(3) bars a
charitable contribution deduction for a contribution of an interest in property
that is less than the taxpayer’s entire interest in the property, but an
exception is made for a qualified conservation contribution, i.e., the
contribution of a qualified real property interest to a qualified organization
exclusively for conservation purposes. The interest in property conveyed by a
facade easement must be protected in perpetuity for the contribution to be a
qualified conservation contribution. ( Code Sec. 170(h) , Reg. §
1.170A-14(b)(2) )

 

Any interest in the property retained by the donor must be
subject to legally enforceable restrictions that will prevent uses of the retained
interest inconsistent with the conservation purposes of the donation. ( Reg. §
1.170A-14(g)(1) )

 

Under Reg. § 1.170A-14(g)(2) , if the property has a
mortgage or other lien in effect at the time the easement is recorded, the
easement contribution is not deductible unless the mortgagee or lien holder
subordinates its rights in the property to the rights of the donee organization
to enforce the conservation purposes of the easement.

 

The value of a conservation easement is its fair market
value (FMV) at the time of contribution, as determined in a qualified appraisal
(see below). Under Reg. § 1.170A-13(c)(2) , which concerns any noncash
charitable contribution exceeding $5,000, the donor must: (1) obtain a
qualified appraisal for the contributed property; (2) attach a fully completed
appraisal summary (i.e., Form 8283) to the tax return on which the deduction is
claimed; and (3) maintain records relating to the claimed deduction, as
required by Reg. § 1.170A-13(b)(2)(ii) .

 

A qualified appraisal must include a detailed description of
the property and its physical condition, the valuation method used to determine
the FMV, and the specific basis for the valuation. ( Reg. § 1.170A-13(c)(3)(ii)
)

 

If the conservation organization requests a cash contribution
from the donor of the conservation easement, the payment is deductible as a
charitable contribution only if it is a voluntary transfer made with charitable
intent. ( Code Sec. 170 ) Charitable intent may exist if the transfer is made
without the receipt of, or the expectation of receiving, a quid pro quo for the
transfer. In general, if the benefits the transferor expects to receive are
substantial, the transfer does not satisfy the charitable intent requirement.

 

Tax issues. The ATG identified a number of issues frequently
associated with deficient conservation easement contribution claims, including
the following:

… failure to meet charitable contribution rules;…
noncompliance with substantiation requirements;… inadequate documentation or
lack of conservation purpose;… failure to provide the donee organization with
a right to proceeds in the event of termination;… use of improper appraisal
methodologies and overvalued conservation easements; and… failure to report
income from the sale of state tax credits.

Following is an overview of some of the key areas agents are
instructed to examine, and steps they should take, when reviewing a return
claiming a conservation easement deduction.

 

Planning the examination. Before contacting the taxpayer,
examiners should review the return, any attachments thereto, and internal and
external sources of information. Form 8283, Noncash Charitable Contributions,
is the “starting point” for examiners to gather information about the
deduction. Examiners are instructed to inspect the form for a number of red
flags, including:

… incomplete or missing information,… missing appraiser
or donee acknowledgments,… inconsistent dates when compared to other
documents,… a short time period between the acquisition of the property and
the donation date,… high valuation of the easement in relation to the basis
of the underlying property or the total acreage of the underlying land, and…
use of an appraiser who does not generally perform appraisals where the easement
is located.

In some cases, taxpayers will also attach baseline studies,
correspondence or other documents related to the easement donation. This
information should be reviewed for unusual items or inconsistencies and
ultimately compared to actual source documents.

 

Examiners should look for the following omissions, each of
which may be a basis for disallowing the charitable contribution: lack of
appraiser’s or donee’s signatures, failure to attach a qualified appraisal, and
failure to include the $500 façade filing fee for easements on buildings in
registered historic districts for which a deduction of more than $10,000 is
claimed. Examiners are also instructed to determine whether there were any
preexisting restrictions on the property such that granting the easement didn’t
impose any new restrictions causing any loss in value.

 

The ATG also addresses complications that can arise in
contexts where the donation originates from a flow-through entity.

 

Conducting the examination. Examiners are instructed to, if
possible, conduct a joint taxpayer interview with the IRS appraiser. If the
taxpayer or representative won’t consent to an interview, then the examiner
should either issue a summons or develop the case based on third-party
contacts, such as representative of the donee organization, the appraiser, the
baseline study author, or other conservation experts.

 

Examiners are also encouraged to inspect the property, if
possible, with the IRS appraiser. During the inspection, the examiner should
note factors including the location of the significant or protected habitat or
species, public access (both physical and visual) to the easement property, and
any inconsistent use of the property. The examiner should ask the taxpayer or
representative to point out the outdoor recreation areas, animals, plants,
scenic views, or historic land and structures that contribute to the
conservation purpose. If the examiner observes an absence of conservation
attributes, lack of access, de minimis public benefit, or use inconsistent with
the conservation purpose, the examiner should ask the taxpayer or
representative for clarification and additional documentation.

 

Document review. The examiner and IRS appraiser should
review documents such as the deed of conservation easement, subordination
agreements, baseline study, appraisals, information provided by the qualified
organization, and documents submitted to the National Park Service.

 

The deed of conservation easement should set out the
property that is being encumbered, the conservation purpose, protection of the
property in perpetuity, public access to the property, reserved rights, and
provisions for subordination and allocation of proceeds. In particular,
examiners should look for any language that negates or contradicts the
perpetuity requirement, whether the taxpayer reserved any property rights that
negate the conservation purpose, whether the taxpayer properly obtained a
subordination agreement from any lender(s) prior to granting the easement, and
whether the lender agreement provides for the donee organization to share in
the proceeds in the event that the easement is extinguished (e.g., by
condemnation or casualty).

 

The Tax Court has
ruled against taxpayers on this point in several recent cases, holding that a
mortgage on the underlying property defeats a façade easement deduction. Since
the bank would have preference to insurance proceeds in the event of a
casualty, the Court held that the façade easement wasn’t protected in
perpetuity. (See 1982 East, LLC, TC Memo 2011-84 , at Weekly Alert ¶  1 04/21/2011 ; Kaufman I, (2010) 134 TC 182 ;
and Kaufman II, (2011) 136 TC 294 .)

 

Penalties. Throughout the examination, the examiner should
be developing relevant facts to determine what penalties may apply and whether
waiver of the penalty may be appropriate (based on reasonable cause). In
particular, examiners should be alert to any indication of fraud and should
consult the Fraud Technical Advisor program analyst if badges of fraud are
identified during the examination.

 

State tax credits. Most states with a conservation tax
credit program determine the amount of the credit based on a percentage of the
FMV of the donated easement. Some programs provide for a carryforward of unused
tax credits over a number of years, and some have transferable tax credits that
can be sold to third parties.

 

Although the issuance of the state tax credit, or use of
same to reduce state tax liability, doesn’t trigger federal gross income to a
taxpayer, sale of a transferable state tax credit is a taxable transaction that
results in gain equal to the excess of the amount realized over the adjusted
basis of the property (typically zero, since the taxpayer didn’t pay anything
to receive the credits). The Tax Court has also held that state tax credits are
capital assets. (See Tempel, 136 TC 341 , at Weekly Alert ¶  45 04/07/2011 ) Although the charitable
contribution of a conservation easement is likely the most significant issue on
the return, examiners should nonetheless be alert to the related issue of
taxpayers’ failure to report income from the sale of state tax credits.

 

Conservation Easement Audit Techniques Guide

Revision Date – September 30, 2011

Note: This document is not an official pronouncement of the
law or position of the Service and cannot be used, cited, or relied upon as
such. This guide is current through the publication date.

Contents

Chapter 1: Introduction to Conservation Easements
……………………………………………………………. 8

Statement of Purpose
……………………………………………………………………………………………………
8

Overview
……………………………………………………………………………………………………………………
8

Getting Started
…………………………………………………………………………………………………………….
9

Definition of Conservation Easement ……………………………………………………………………………..
9

Tax
Issues…………………………………………………………………………………………………………………
10

Chapter 2: Charitable Contributions: Statutory Requirements
…………………………………………….. 10

Overview
………………………………………………………………………………………………………………….
10

Charitable Contribution Definition
……………………………………………………………………………….
10

Qualified
Organization…………………………………………………………………………………………….
11

Charitable
Intent……………………………………………………………………………………………………..
11

Real Estate Contributions
……………………………………………………………………………………………
11

Partial Interest
Rule…………………………………………………………………………………………………….
11

Conditional Gifts
………………………………………………………………………………………………………..
11

Earmarking
……………………………………………………………………………………………………………….
12

Year of
Donation………………………………………………………………………………………………………..
12

Substantiation
…………………………………………………………………………………………………………….
12

Amount of Deduction …………………………………………………………………………………………………
13

Chapter 3: Qualified Conservation Contribution
……………………………………………………………….. 13

Overview ………………………………………………………………………………………………………………….
13

Qualified Real Property Interest
…………………………………………………………………………………..
13

Qualified Organization………………………………………………………………………………………………..
14

Conservation Purpose
…………………………………………………………………………………………………
14

Perpetuity
…………………………………………………………………………………………………………………
14

Recording of Easements
………………………………………………………………………………………….
15

Amendments to Easements
………………………………………………………………………………………
15

Subordination of Mortgages in Lender Agreements
……………………………………………………. 15

Allocation of Proceeds in Deed & Lender
Agreements……………………………………………….. 16

Chapter 4: Qualified Organization
……………………………………………………………………………………
16

Overview ………………………………………………………………………………………………………………….
16

Qualified
Organization………………………………………………………………………………………………..
17

Commitment & Resources
…………………………………………………………………………………………..
17

Special Rules for Buildings in Registered Historic Districts
………………………………………… 17

Cash
Contributions…………………………………………………………………………………………………….
18

Quid Pro Quo Contribution
………………………………………………………………………………………
18

Chapter 5: Conservation
Purpose……………………………………………………………………………………..
19

Overview
………………………………………………………………………………………………………………….
19

Land for Outdoor Recreation or Education
……………………………………………………………………
20

Relatively Natural Habitat or Ecosystem
……………………………………………………………………….
20

Open Space
……………………………………………………………………………………………………………….
20

Scenic Enjoyment
…………………………………………………………………………………………………..
21

Governmental Conservation Policy
…………………………………………………………………………..
22

Significant Public Benefit
………………………………………………………………………………………..
22

Historically Important Land or Structure
……………………………………………………………………….
23

Historically Important Land
……………………………………………………………………………………..
23

Certified Historic Structure
………………………………………………………………………………………
23

Special Rules for Buildings in Registered Historic Districts
………………………………………… 24

Public Access
…………………………………………………………………………………………………………….
25

Inconsistent Uses
……………………………………………………………………………………………………….
25

Baseline Study
…………………………………………………………………………………………………………..
26

Chapter 6: Substantiation
………………………………………………………………………………………………..
26

Overview
………………………………………………………………………………………………………………….
26

Contemporaneous Written Acknowledgment
………………………………………………………………… 27

Form 8283, Noncash Charitable Contributions
……………………………………………………………… 28

Declaration of Appraiser
………………………………………………………………………………………….
29

Donee Acknowledgment
………………………………………………………………………………………….
29

Reasonable Cause Exception
……………………………………………………………………………………
29

Qualified Appraisal
…………………………………………………………………………………………………….
29

Façade Easement Filing Fee(Registered Historic District
Only) ………………………………………. 30

Baseline Study
…………………………………………………………………………………………………………..
30

Exhibit 6-1 – Substantiation Requirements
…………………………………………………………………….
30

Chapter 7: Qualified Appraisal Requirements
……………………………………………………………………
31

Overview
………………………………………………………………………………………………………………….
31

Qualified Appraisal …………………………………………………………………………………………………….
32

Reasonable Cause Exception
……………………………………………………………………………………
33

Qualified Appraiser …………………………………………………………………………………………………….
33

Generally Accepted Appraisal Standards
………………………………………………………………………
34

Uniform Standards of Professional Appraisal Practice
……………………………………………….. 34

Appraisal Fees
……………………………………………………………………………………………………………
35

Chapter 8: Amount of Deduction
……………………………………………………………………………………..
35

Overview
………………………………………………………………………………………………………………….
35

Percentage
Limitations………………………………………………………………………………………………..
36

Individuals…………………………………………………………………………………………………………….
36

Corporations
…………………………………………………………………………………………………………..
37

Special Rules for Farmers and Ranchers
……………………………………………………………………
37

Carryovers
……………………………………………………………………………………………………………..
37

Basis Limitations
……………………………………………………………………………………………………….
38

Contributions of Appreciated Property
………………………………………………………………………….
38

Ordinary Income and Short-Term Capital Gain Property
…………………………………………….. 38

Long-Term Capital Gain Property
…………………………………………………………………………….
39

Bargain Sale
………………………………………………………………………………………………………………
39

Taxable Gain
………………………………………………………………………………………………………….
40

Federal and State Easement Purchase Programs …………………………………………………………
40

Quid Pro Quo and Charitable Intent
……………………………………………………………………………..
40

Rehabilitation Tax Credit
…………………………………………………………………………………………….
41

Recapture of Rehabilitation Tax Credit
……………………………………………………………………..
41

Chapter 9: Valuation of Conservation Easements
……………………………………………………………… 42

Overview
………………………………………………………………………………………………………………….
42

Valuation Process……………………………………………………………………………………………………….
43

Valuation Date
…………………………………………………………………………………………………………..
43

Fair Market Value (FMV) ……………………………………………………………………………………………
43

Before and After Method
…………………………………………………………………………………………
44

Use of Flat Percentage Cannot Be Applied to Before Value
………………………………………… 44

Contiguous
Parcels………………………………………………………………………………………………….
45

Enhancement Rule ………………………………………………………………………………………………….
45

Market Analysis
…………………………………………………………………………………………………………
46

Highest and Best Use (HBU)
……………………………………………………………………………………….
47

Methodology
……………………………………………………………………………………………………………..
48

Sales Comparison Approach
…………………………………………………………………………………….
48

Cost Approach
……………………………………………………………………………………………………….
49

Income Capitalization Approach
………………………………………………………………………………
49

Transferable Development Rights (TDRs)
…………………………………………………………………….
51

Chapter 10: Preplanning the Examination
…………………………………………………………………………
52

Overview
………………………………………………………………………………………………………………….
52

Review of Return
……………………………………………………………………………………………………….
52

Form 8283
……………………………………………………………………………………………………………..
52

Return Attachments
………………………………………………………………………………………………..
54

Other Tax Issues
…………………………………………………………………………………………………….
54

TEFRA Considerations
……………………………………………………………………………………………
55

Internal Sources of Information
……………………………………………………………………………………
55

IRS Intranet
……………………………………………………………………………………………………………
55

Program Analysts ……………………………………………………………………………………………………
56

Integrated Data Retrieval System – IDRS
…………………………………………………………………..
56

Publication 78 ………………………………………………………………………………………………………..
56

Office of Professional Responsibility
………………………………………………………………………..
57

External Sources of Information …………………………………………………………………………………..
57

Internet Research
……………………………………………………………………………………………………
57

Public Records ……………………………………………………………………………………………………….
58

National Park Service
……………………………………………………………………………………………..
59

Interviews …………………………………………………………………………………………………………………
59

Information Document Requests
………………………………………………………………………………….
60

Valuation Expert Involvement
……………………………………………………………………………………..
60

Referral to LB & I Engineering
………………………………………………………………………………..
60

Referral Outcomes
………………………………………………………………………………………………….
61

LB & I Engineering Products
…………………………………………………………………………………..
61

Outside Experts
………………………………………………………………………………………………………
61

Consultation with Counsel
…………………………………………………………………………………………..
62

Coordination with TEGE
…………………………………………………………………………………………….
62

Chapter 11: Conducting the Examination
………………………………………………………………………….
63

Overview
………………………………………………………………………………………………………………….
63

Interviews
…………………………………………………………………………………………………………………
63

Property Inspection
…………………………………………………………………………………………………….
64

Review of Documents
…………………………………………………………………………………………………
65

Deed of Conservation Easement ……………………………………………………………………………….
65

Lender Agreements
…………………………………………………………………………………………………
67

Baseline Study ……………………………………………………………………………………………………….
68

Taxpayer’s Appraisal
………………………………………………………………………………………………
70

Donee Organization ………………………………………………………………………………………………..
70

National Park Service-Form 10-168
………………………………………………………………………….
72

Partnership Documents ……………………………………………………………………………………………
73

Third-Party Contacts
…………………………………………………………………………………………………..
74

Donee Organizations ……………………………………………………………………………………………….
74

Mortgage Lenders
…………………………………………………………………………………………………..
75

Appraiser ……………………………………………………………………………………………………………….
75

Federal, and State Conservation
Agencies………………………………………………………………….
76

Local Government Officials
…………………………………………………………………………………….
76

Real Estate Agents
………………………………………………………………………………………………….
76

Property Owners
…………………………………………………………………………………………………….
77

Chapter 12: Concluding the Examination
………………………………………………………………………….
77

Overview
………………………………………………………………………………………………………………….
77

Issue Identification
……………………………………………………………………………………………………..
77

Substantial Compliance
…………………………………………………………………………………………..
78

Report Writing
…………………………………………………………………………………………………………..
78

Job Aids
……………………………………………………………………………………………………………….
79

Valuation Expert Reports
…………………………………………………………………………………………
80

Penalties
……………………………………………………………………………………………………………….
80

Technical Assistance
……………………………………………………………………………………………….
81

Closing Conference
…………………………………………………………………………………………………….
81

Taxpayer Protests
……………………………………………………………………………………………………….
81

Rebuttals to Taxpayer Protest
…………………………………………………………………………………..
81

Exhibit 12-1 Conservation Easement Issue Identification
Worksheet ………………………………. 82

Chapter 13: Penalties
……………………………………………………………………………………………………..
85

Overview
………………………………………………………………………………………………………………….
85

Accuracy-Related Penalties
…………………………………………………………………………………………
85

IRC § 6662(c) Negligence or Disregard of Rules or
Regulations …………………………………. 86

IRC § 6662(d) Substantial Understatement of Income
Tax………………………………………….. 86

IRC § 6662(e) Valuation
Misstatements…………………………………………………………………….
87

IRC § 6663 Civil Fraud Penalties
……………………………………………………………………………..
88

IRC § 6664 Reasonable Cause Exception
…………………………………………………………………. 88

Return Preparers-IRC §
6694……………………………………………………………………………………….
89

Promoters-IRC §§ 6700 and 6701
………………………………………………………………………………..
90

Appraisers-IRC § 6695A Substantial and Gross Valuation
Misstatements Attributable to Incorrect Appraisals ……………………………………………………………………………………………………
90

Office of Professional Responsibility
Sanctions…………………………………………………………. 91

Chapter 14: State Tax Credits ………………………………………………………………………………………
91

Overview
………………………………………………………………………………………………………………….
91

State Tax Credit Programs
…………………………………………………………………………………………..
91

Sale of State Tax
Credits……………………………………………………………………………………………..
92

Chapter 1: Introduction to Conservation Chapter 1:
Introduction to Conservation Chapter 1: Introduction to Conservation Chapter 1:
Introduction to Conservation Chapter 1: Introduction to Conservation Chapter 1:
Introduction to Conservation Chapter 1: Introduction to Conservation Chapter 1:
Introduction to Conservation Chapter 1: Introduction to Conservation Chapter 1:
Introduction to Conservation Chapter 1: Introduction to Conservation Easements
EasementsEasements

Statement of Purpose

The purpose of this audit technique guide (ATG) is to
provide guidance for the examination of charitable contributions of
conservation easements. Users of this guide will learn about the general
requirements for charitable contributions and additional requirements for
contributions of conservation easements.

This ATG includes examination techniques and an overview of
the valuation of conservation easements. It also includes a discussion of
penalties, which may be applicable to taxpayers, and others involved in the
conservation easement transaction.

This guide is not designed to be all-inclusive. It is not a
comprehensive training manual on the valuation of conservation easements.

Overview

To be deductible, donated conservation easements must be
legally binding, permanent restrictions on the use, modification and
development of property such as parks, wetlands, farmland, forest land, scenic
areas, historic land or historic structures. Current and future owners of the
easement and the underlying property are bound by the terms of the conservation
easement.

Internal Revenue Code (IRC) § 170(h) states that a qualified
conservation contribution is a contribution of a qualified real property interest
(i.e., a restriction granted in perpetuity on the use which may be made of the
real property) to a qualified organization exclusively for conservation
purposes. The IRC and accompanying Treasury regulations outline the
requirements to be met before a contribution is deductible.

Qualified organizations that accept conservation easements
must have a commitment to protect the conservation purposes of the donation and
must have sufficient resources to enforce compliance with the terms of the
easement agreement.

IRC § 170(h)(4)(A) specifies the four deductible types of
conservation easements:

 Preservation of land areas for outdoor recreation by, or
the education of, the general public.

 Protection of a relatively natural habitat of fish,
wildlife, or plants, or similar ecosystem.

 Preservation of open space (including farmland and forest
land).

 Preservation of a historically important land area or a
certified historic structure.

The donation of a conservation easement that meets all
statutory and regulatory requirements, including specific substantiation
requirements, can be claimed as a charitable contribution deduction.

The value of a conservation easement is determined in a
qualified appraisal. The value of the contribution is the fair market value (FMV)
at the time of the contribution. To the extent there is a substantial record of
sales of easements comparable to the donated easement, the FMV is based on the
sales price of such comparables. If there is no substantial record of
market-place sales, the value is generally the difference between the FMV of
the underlying property before and after the easement is transferred. Various
statutory provisions may limit the amount of the deduction.

To conduct a quality examination, in-depth development of
facts is necessary. Examiners have primary responsibility for addressing the
taxpayer’s compliance with all statutory and regulatory requirements. Valuation
is also an important component of this tax issue. A multi-divisional approach,
working with LB&I Engineering, Counsel, and Tax Exempt and Government
Entities (TEGE), may be needed to properly develop tax issues in a conservation
easement examination.

Taxpayers, return preparers, appraisers, and others involved
with an improper or overvalued conservation easement may be subject to various
penalties.

While the charitable contribution of a conservation easement
may be the most significant issue on the tax return, Examiners should be alert
to other related tax issues such as a sale of state tax credits or a recapture
of rehabilitation tax credits.

Getting Started

Information about conservation easements including contacts,
job aids, and other reference materials are on the IRS Intranet at MySB/SE
under Examination, Issues and Procedures.

Definition of Conservation Easement

“Conservation easement”• is the generic term for easements
granted for outdoor recreation, natural habitat, open space, scenic and
historic preservation of land and buildings.

Conservation easements permanently restrict how land or
buildings are used. The “deed of conservation easement”• describes the
conservation purpose(s), the restrictions and the permissible uses of the
property. The deed must be recorded in the public record and must contain
legally binding restrictions enforceable by the donee organization under state
law.

The property owner gives up certain rights but retains
ownership of the underlying property. The extent and nature of the donee
organization’s control depends on the terms of the conservation easement. The
organization has an interest in the encumbered property that runs with the
land, which means that its restrictions are binding not only on the landowner
who grants the easement but also on all future owners of the property.

Tax Issues

Taxpayers must satisfy numerous statutory provisions in
order to claim a noncash charitable contribution deduction for the donation of
a conservation easement. Some deficiencies revealed in examinations of
conservation easements include:

 Failure to meet charitable contributions rules.

 Noncompliance with substantiation requirements.

 Inadequate documentation or lack of conservation purpose.

 Lack of perpetuity evidenced by deeds allowing for
abandonment or termination of easement.

 Reserved property rights inconsistent with the claimed
conservation purpose.

 Failure to comply with subordination rules.

 Failure to provide the donee organization with a right to
proceeds in the event of termination.

 Use of improper appraisal methodologies and overvalued
conservation easements.

 Failure to report income from the sale of state tax
credits.

The IRS has also identified some promoters and appraisers
involved in conservation easement tax schemes.

Chapter 2: Charitable Contributions: Chapter 2: Charitable
Contributions: Chapter 2: Charitable Contributions: Chapter 2: Charitable
Contributions: Chapter 2: Charitable Contributions: Chapter 2: Charitable
Contributions: Chapter 2: Charitable Contributions: Chapter 2: Charitable
Contributions: Chapter 2: Charitable Contributions: Statutory Requirements
Statutory Requirements Statutory RequirementsStatutory Requirements Statutory
Requirements Statutory Requirements Statutory Requirements

Overview

IRC § 170 contains the rules that govern income tax
deductions for charitable contributions, including donations of conservation
easements.

In order to claim a charitable contribution deduction for a
conservation easement, taxpayers must meet the statutory requirements for a
charitable contribution, as well as the specific requirements for conservation
easement donations.

See Publication 526, Charitable Contributions (PDF),
Publication 561, Determining the Value of Donated Property (PDF), and
Publication 1771, Charitable Contributions – Substantiation and Disclosure
Requirements (PDF).

Charitable Contribution Definition

A charitable contribution is a voluntary gift to or for the
use of a qualifying organization. It is a transfer of money or property without
receipt of adequate consideration made with charitable intent. IRC § 170(c).

Qualified Organization

A taxpayer can only deduct contributions made organizations
eligible to accept tax-deductible contributions, which are organizations
described in IRC § 170(c).

An organization accepting tax-deductible contributions of
conservation easements must meet additional requirements to be a qualified
organization.

See Chapter 4 for additional guidance on qualified
organizations.

Charitable Intent

A charitable contribution is a donation or gift to, or for
the use of, a qualified organization. It is voluntary and made without receipt,
or the expectation of receipt, of anything of equal value.

A transfer of money or property is not voluntary if it is
required or is made with the expectation of a direct or indirect benefit. A
benefit received or expected to be received in connection with a payment or
transfer by the taxpayer is called a quid pro quo.

See Chapter 8 for additional discussion of charitable intent
and quid pro quo.

Real Estate Contributions

For a contribution of real estate, including a contribution
of a conservation easement, there is no “transfer,”• and therefore no
deductible charitable contribution, unless there is:

 A deed signed by the donor transferring the property,

 Delivery to the qualified organization, and

 Acceptance by the qualified organization.

Conservation easements must be recorded in the public
record.

Partial Interest Rule

Generally, in order to have a deductible contribution, a
taxpayer must contribute the entire interest in the property. This is known as
the “partial interest” rule. IRC § 170(f)(3)(A).

A qualified conservation contribution is an exception to the
partial interest rule. IRC § 170(f)(3)(B)(iii) and (h).

Conditional Gifts

If the contribution is a conditional gift, the taxpayer
cannot take a deduction.

Example: If Justin transfers land in Maine to a city
government on the condition that the land is used by the city for an unlikely
use (e.g., alligator habitat), there is no deductible charitable contribution
before the time that the specified use actually occurs.

However, if there is only a negligible chance that the gift
will be defeated, the deduction is allowed. Treas. Reg. §§ 1.170A-1(e) and
1.170A-7(a)(3).

Example: Susan transfers land to a city government on the
condition that the land is used by the city for a public park. If, on the date
of the gift, the city government plans to use the property as a park, and the
possibility that it will not be used as a park is so remote as to be
negligible, the deduction is allowable at the time of the transfer to the city
government.

Earmarking

A taxpayer may not deduct contributions earmarked. (i.e.,
for the benefit of a particular individual or family). Earmarked amounts are
treated as transfers to the earmarked beneficiary and not as transfers to the
qualified organization.

Example: Steven made payments to his church, but they were
earmarked for a named needy individual. Steven cannot deduct the amount of the
payments since the funds are specifically designated for a named individual.

Year of Donation

A taxpayer may deduct contributions paid within the taxable
year. IRC § 170(a)(1) and Treas. Reg. § 1.170A-1(b).

A promise to pay cash or transfer property in the future is
not deductible. The taxpayer may deduct payments made by check when the check
is mailed or delivered to the qualified organization. Treas. Reg. §
1.170A-1(b).

For contributions of real estate, the year of the deduction
is the year in which the real estate is transferred under the law of the state
where the real estate is located thus with respect to conservation easements,
the year of the deduction is the year of recordation.

Example: A conservation easement was granted to a qualified
organization on December 20, 2007, as evidenced by the dated signatures on the
conservation easement deed. However, the easement was not recorded in the
public records until March 12, 2008. The year of donation is 2008.

Substantiation

A charitable contribution is not deductible unless it is
properly substantiated in accordance with the Internal Revenue Code and the regulations.
The documentation requirements vary depending

on the date of contribution, nature of the contribution
(cash or noncash), type of property contributed, and dollar amount claimed.

Required documents may include proof of payment such as a
receipt or cancelled check, a contemporaneous written acknowledgment, a fully
completed Form 8283, Noncash Contributions (PDF) and a qualified appraisal. See
Publication 526, Charitable Contributions (PDF), and Publication 1771,
Charitable Contributions – Substantiation and Disclosure Requirements (PDF) and
Chapter 6 for additional guidance on substantiation requirements.

Amount of Deduction

Factors, which may affect the amount a taxpayer may claim as
a charitable contribution deduction for a conservation easement include:

 Quid pro quo and charitable intent

 Bargain sale

 Type of property (ordinary income, short-term capital
gain, long-term capital gain)

 Basis

 Percentage limitations

 Type of donee organization

See Chapter 8 and Publication 526, Charitable Contributions
(PDF) for additional guidance on specific limitations on charitable
contributions.

Chapter 3: Qualifi Chapter 3: Qualifi Chapter 3: Qualifi
Chapter 3: Qualifi Chapter 3: Qualified Conservation ed Conservation ed
Conservation ed Conservation Contribution Contribution Contribution
Contribution

Overview

IRC § 170(h)(1) defines a qualified conservation
contribution as a contribution of a qualified real property interest to a
qualified organization to be used exclusively for conservation purposes.

Qualified Real Property Interest

A qualified real property interest is any of the following
interests in real property:

 The entire interest of the donor other than a qualified
mineral interest.

 A remainder interest.

 A restriction on the use of the real property granted in
perpetuity (often referred to as a conservation easement).

See IRC § 170(h)(2).

Qualified Organization

The recipient of a conservation easement donation must be a
qualified organization. IRC § 170(h)(1)(B).

Qualified organizations are organizations that include:

 A governmental unit, including the Federal government, a
United States possession, the District of Columbia, a state government, or any
political subdivision of a state or United States possession.

 A publicly charity described in section 501(c)(3) of the
Internal Revenue Code that meets the public support test in section
170(b)(1)(A)(vi) or section 509(a)(2).

A section 501(c)(3) that is classified as a supporting
organization described in section 509(a)(3) and that is operated, supervised,
or controlled by one of the organizations described above.

Note: A conservation easement must be received by an
eligible donee to be deductible. Treas. Reg. § 1.170A-14(c)(1). Not all
qualified organizations are eligible to accept deductible conservation
easements.

See IRC § 170(h)(3) and Chapter 4 for additional information
on qualified organizations.

Conservation Purpose

IRC § 170(h)(4)(A) defines “conservation purpose”• as one of
the following:

 Preservation of land for outdoor recreation by, or the
education of, the general public.

 Protection of a relatively natural habitat of fish,
wildlife, or plants, or similar ecosystem.

 Preservation of open space (including farmland and forest
land) either for the scenic enjoyment of the general public or pursuant to a
clearly delineated governmental conservation policy (both purposes must yield a
significant public benefit).

 Preservation of a historically important land area or a
certified historic structure.

The easement must be created by deed and be exclusively for
conservation purposes. Donations of conservation easements may meet more than
one conservation purpose.

See Chapter 5 for additional information on conservation
purpose.

Perpetuity

A deductible conservation easement must be made in
perpetuity, permanently restricting the use of the property. IRC § 170(h)(2)(C)
and (5)(A) and Treas. Reg. § 1.170A-14(b)(2).

This means that the deed of conservation easement must state
that:

 The restriction remains on the property forever and,

 Is binding on current and future owners of the property.

A deed of conservation easement that does not include these
requirements is not in perpetuity; therefore, the easement is not a deductible
charitable contribution.

Example: Some conservation easement deeds only impose
restrictions for a specific period such as 10 years. These easements are not
deductible since the easement is not in perpetuity.

Recording of Easements

The complete deed of conservation easement must be recorded
in the appropriate recordation office in the county where the property is
located. Under state law, an easement is not enforceable in perpetuity before
it is recorded.

All exhibits or attachments to the deed such as a
description of the easement restrictions, diagrams and lender agreements must
also be recorded.

The effective date of the gift is the recording date. Treas.
Reg. § 1.170(A)-14(g)(1).

In Herman v. Commissioner, T.C. Memo. 2009-205, the taxpayer
recorded a “Declaration of Restrictive Covenant”• for a donation of unused
development rights above a building. The covenant referred to an attached
architectural drawing, which described the easement restrictions but the
drawing was not recorded. The court ruled that because the attached drawing was
not recorded, it could not bind subsequent purchasers, did not protect the
conservation purpose of preserving the apartment building “in perpetuity“• and
failed to meet the requirements of IRC § 170(h)(5)(A).

Amendments to Easements

The restriction on the use of the real property must be
enforceable in perpetuity, meaning that it lasts forever and binds all future
owners. Conservation easements should not be amended except in limited
circumstances such as to correct a typographical error in the original easement
document.

An easement is not enforceable in perpetuity if it allows
amendments that change the nature of the restrictions imposed on the property.
An easement is not enforceable in perpetuity if it ends after a period of years
or if it can revert to the donor or another private party. However, if a remote
future event, like an earthquake, can extinguish the easement, the donation
would nevertheless be treated as in perpetuity. Treas. Reg. § 1.170A-14(g)(3).

Examiners should contact Counsel for assistance if the
conservation easement has been amended or terminated.

Subordination of Mortgages in Lender Agreements

If the property has a mortgage or other lien in effect at the
time the easement is recorded, the easement contribution is not deductible
unless the pre-existing mortgagee or lien holder subordinates its rights in the
property to the rights of the donee organization to enforce the conservation
purposes of the easement. Treas. Reg. § 1.170A-14(g)(2).

The subordination agreement must be recorded in the public
records.

Allocation of Proceeds in Deed & Lender Agreements

In order to claim a charitable contribution deduction for
the donation of a conservation easement, the donor, at the time of the gift,
must agree that the donation of the perpetual conservation restriction gives
rise to a property right, immediately vested in the donee organization, with a
fair market value that is at least equal to the proportionate value that the
perpetual conservation restriction at the time of the gift bears to the value
of the property as a whole. The proportionate value of the donee’s property
rights is a percentage of the value of the entire property that never changes.
Treas. Reg. § 1.170A-14(g)(6)(ii).

Lenders are generally reluctant to give up a priority right
to proceeds. Frequently, the lender agreement merely acknowledges the
conservation easement and agrees to the conservation purposes, but it does not
provide for an allocation of proceeds as required in the Treasury Regulation.

In Kaufman v. Commissioner, 134 T.C. No. 9 (2010), aff’d,
136 T.C. No. 13 (2011), the taxpayers transferred an easement on property that
was subject to a mortgage, and the bank retained a prior claim on any proceeds
on extinguishment (e.g., condemnation, casualty, hazard, or accident) of the
easement. The Tax Court held that the easement was not deductible since neither
the deed of conservation easement nor the lender agreement complied with Treas.
Reg. § 1.170A-14(g)(6)(ii). The Tax Court determined that the contribution was
not a qualified conservation contribution under IRC § 170(h), stating, “the
facade easement contribution thus fails as a matter of law to comply with the
enforceability in perpetuity requirements under section 1.170A-14(g).”•

Examiners should contact Counsel for assistance in review of
deeds and lender agreements to determine if the documents satisfy the
allocation of proceeds requirements of Treas. Reg. § 1.170A-14(g)(6)(ii).

Chapter 4: Qualified Organization Chapter 4: Qualified
Organization Chapter 4: Qualified Organization Chapter 4: Qualified
Organization Chapter 4: Qualified Organization Chapter 4: Qualified
Organization Chapter 4: Qualified OrganizationChapter 4: Qualified Organization

Overview

A taxpayer must transfer the conservation easement to an
eligible donee to qualify for a contribution deduction. An eligible donee:

 Is a qualified organization,

 Must have the commitment to protect the conservation
purpose of the donation, and

 Must have the resources to enforce the conservation
restrictions.

See IRC § 170(h)(3) and Treas. Reg. § 1.170A-14(c).

Qualified Organization

A qualified organization is one of the following:

 A governmental unit, including the Federal government, a
United States possession, the District of Columbia, a state government, or any
political subdivision of a state or United States possession.

 A publicly charity described in section 501(c)(3) of the
Internal Revenue Code that meets the public support test of section
170(b)(1)(A)(vi) or section 509(a)(2).

 A section 501(c)(3) organization that is classified as a
supporting organization 509(a)(3) and that is operated, supervised, or
controlled by one of the organizations described above.

Commitment & Resources

The organization must have the commitment to protect the
conservation purposes of the donation and resources to enforce the restrictions
of the conservation easement. Treas. Reg. § 1.170A-14(c)(1).

A conservation group organized or operated for one of the
conservation purposes in IRC § 170(h)(4)(A) is considered to have the
commitment required to protect the conservation purposes of the donation.
Treas. Reg. § 1.170A-14(c)(1).

Organizations that accept easement contributions and are
committed to conservation will generally have an established monitoring program
such as annual property inspections to ensure compliance with the conservation
easement terms and to protect the easement in perpetuity.

The organization must also have the resources to enforce the
restrictions of the conservation easement. Resources do not necessarily mean
cash. Resources may be in the form of volunteer services such as lawyers who
provide legal services or people who inspect and prepare monitoring reports.

If the organization at the time of contribution does not
have the commitment to protect the conservation purposes of the donation or
resources to enforce the easement restrictions, no deduction is allowed.

See Chapter 11 for suggestions on how to evaluate the
organization’s commitment and resources.

Special Rules for Buildings in Registered Historic Districts

For a contribution made after July 25, 2006 of a qualified
real property interest with respect to a building in a registered historic
district, an additional requirement must be met to satisfy the commitment and
resources test.

IRC § 170(h)(4)(B)(ii) requires the taxpayer and the donee
to certify, under penalty of perjury, in a written agreement, that the donee is
a qualified organization with a purpose of environmental protection, land
conservation, open space preservation, or historic preservation, and that the
donee has the resources to manage and enforce the restriction and a commitment
to do so. Note: This special rule does not apply to properties listed on the
National Register.

See Chapter 5 for a complete discussion of the special rules
for buildings in registered historic districts.

Cash Contributions

A common practice for conservation organizations is to
request a cash contribution (sometimes referred to as a “stewardship fee”•)
from donors of conservation easements. To be deductible as a charitable
contribution, the cash payment must be a voluntary transfer made with
charitable intent to a qualified organization. IRC § 170 (a) and (c).

Charitable intent may exist if the transfer is made without
the receipt of, or the expectation of receiving, a quid pro quo for the
transfer. As a general rule, if the benefits the transferor receives or expects
to receive are substantial, rather than incidental to the transfer,, the
transfer does not satisfy the charitable intent requirement under IRC § 170.
Hernandez v. Commissioner, 490 U.S. 680, 691 (1989); United States v. American
Bar Endowment, 477 U.S. 105, 117 (1986); Singer Co. v. U.S., 196 Ct. Cl. 90,
449 F.2d 413, 422-423 (1971).

If a direct or indirect economic benefit (other than a tax
deduction) is received as a result of making a contribution, the deduction is
limited or disallowed. See Publication 526, Charitable Contributions (PDF).

Quid Pro Quo Contribution

A quid pro quo contribution is a transfer of money or
property made to a qualified organization partly in exchange for goods or
services in return from the charity or a third party.

Many conservation organizations offer some level of services
to facilitate the easement such as conducting baseline studies, completion of
National Park Service applications, preparing legal documents, soliciting
subordination or lender agreements or arranging for appraisals. Depending on
the nature and extent of the services provided, a portion of the claimed
deduction may not be deductible.

A quid pro quo may also be in the form of an indirect
benefit from a third party.

Example: A land developer agrees to grant a conservation
easement to the county or other qualified organization in exchange for the
approval of a proposed subdivision.

If a taxpayer receives a quid pro quo, the cash payment may
be deductible as a charitable contribution, but only to the extent the amount
transferred exceeds the fair market value (FMV) of the quid pro quo, and only
if the excess amount was transferred with charitable intent.

The burden is on the taxpayer to show that all or part of a
payment is a charitable contribution or gift. Treas. Reg. § 1.170A-1(h)(1) and
(2); United States v. American Bar Endowment, 477 U.S. 105, 116-118 (1986); and
Rev. Rul. 67-246, 1967-2 CB 104.

In Scheidelman v. Commissioner, T.C. Memo 2010-151, the
taxpayers claimed a charitable contribution deduction for a cash payment paid
to the donee organization in conjunction with the granting of the conservation
easement. The donee organization had provided services to the taxpayers. The
Tax Court concluded that the taxpayers did not provide sufficient evidence that
they received nothing of substantial value or, if they had received something
of substantial value, what the value was of the benefits received.

Chapter 5: Conservation Purpose Chapter 5: Conservation
Purpose Chapter 5: Conservation Purpose Chapter 5: Conservation Purpose Chapter
5: Conservation Purpose Chapter 5: Conservation PurposeChapter 5: Conservation
Purpose Chapter 5: Conservation Purpose Chapter 5: Conservation Purpose

Overview

A charitable contribution made under the provisions of IRC §
170(h)(4)(A) (conservation easement) must be made exclusively for one of the
following conservation purposes:

 Preservation of land for outdoor recreation by, or the
education of, the general public.

 Protection of relatively natural habitat or ecosystem.

 Preservation of open space, where there is significant
public benefit, and (1) the preservation is for the scenic enjoyment of the
general public, or (2) pursuant to a clearly delineated Federal, State or local
governmental conservation policy.

 Preservation of historically important land area or a
certified historical structure.

The conservation easement must be transferred by deed (or
other legal instrument as appropriate under the law of the relevant state) and
recorded, be exclusively for conservation purposes in perpetuity and meet at
least one of the above conservation purposes.

Public access is generally required to claim a conservation
easement deduction; however, the type of access depends on the claimed
conservation purpose.

If the claimed conservation purpose is for the preservation
of open space under IRC § 170(h)(4)(A)(iii), the contribution must yield a
significant public benefit.

The deed of conservation easement must prohibit inconsistent
use of the property that could permit destruction of a significant conservation
interest, even if the deed accomplishes an enumerated conservation purpose.

A baseline study is used to identify the conservation
attributes and to establish the condition of the property at the time of the conservation
easement donation.

Land for Outdoor Recreation or Education

This category includes the donation of a qualified real
property interest to preserve land for outdoor recreation by, or for the
education of, the general public. IRC § 170(h)(4)(A)(i).

Substantial and regular physical access by the general
public to the preserved land is required. Treas. Reg. § 1.170A-14(d)(2)(ii).

Example: A donation to preserve a lake for use by the
general public for boating or fishing, or to preserve land for a nature
preserve or hiking trail.

See Treas. Reg. § 1.170A-14(d)(2) for additional guidance.

Relatively Natural Habitat or Ecosystem

This conservation purpose is satisfied if the conservation
easement protects a significant relatively natural habitat of fish, wildlife or
plants, or similar ecosystem. IRC § 170(h)(4)(A)(ii). An ordinary tract of land
where a common fish, wildlife or plant community, or similar ecosystem normally
lives does not satisfy this conservation purpose. The conservation easement
must protect a habitat that is significant. Treas. Reg. § 1.170A-14(d)(3).

Significant habitats and ecosystems include, but are not
limited to:

 Habitats for rare, endangered or threatened species.

 Natural areas that are relatively intact and are
considered high quality examples of land or aquatic communities.

 Natural areas that are in or contribute to the ecological
viability of a park, preserve, wildlife refuge, wilderness area, or other
similar conservation area.

For this conservation purpose, limitations on public access
are allowable. For example, a restriction on all public access to the habitat
of a threatened native animal species would not defeat the claimed deduction.
Treas. Reg. § 1.170A-14(d)(3)(iii).

The determination of what specifically meets this
conservation purpose test is based on the facts and circumstances of the
specific case. In Glass v. Commissioner, 124 T.C. 258 (2005), the taxpayer
donated two easements that restricted the development of a fraction of a
10-acre parcel of residential property. The Tax Court held that the
conservation purpose of natural habitat was satisfied where the conservation
easements were placed on property that has possible places to create or promote
a relatively natural habitat of plants or wildlife, and the easements were held
exclusively for conservation purposes as required by section 170(h)(5) because
they were granted to a land trust in perpetuity.

Open Space

The donation of a qualified real property interest to
protect open space (including farmland and forest land) must be (1) for the
scenic enjoyment of the general public, or (2) pursuant to a clearly delineated
federal, state or local governmental conservation policy. This type of
conservation easement must preserve open space and must yield a significant public
benefit. IRC § 170(h)(4)(A)(iii).

Scenic Enjoyment

Preservation of open space may not be for the scenic
enjoyment of the general public if development of the property would impair the
scenic character of the local rural or urban landscape or interfere with a
scenic panorama that can be enjoyed by the public. See Treas. Reg. §
1.170A-14(d)(4)(ii) for additional guidance.

Whether the easement provides scenic enjoyment to the
general public is evaluated based on all the facts and circumstances. The burden
of proof is on the taxpayer to show the scenic characteristics of the property.

Treas. Reg. § 1.170A-14(d)(4)(ii)(A) lists factors to
consider:

 The compatibility of the land use with other land in the
vicinity.

 The degree of contrast and variety provided by the visual
scene.

 The openness of the land (which would be a more
significant factor in an urban or densely populated setting or in a heavily
wooded area).

 Relief from urban closeness.

 The harmonious variety of shapes and textures.

 The degree to which the land use maintains the scale and
character of the urban landscape to preserve open space, visual enjoyment and
sunlight for the surrounding area.

 The consistency of the proposed scenic view with a
methodical state scenic identification program, such as a state landscape
inventory.

 The consistency of the proposed scenic view with a
regional or local landscape inventory made pursuant to a sufficiently rigorous
review process, especially if the donation is endorsed by an appropriate state
or local governmental agency.

A conservation easement of open space preserved for the
scenic enjoyment of the general public does not require physical access. Visual
access to or across the property by the general public is sufficient. Although
the entire property need not be visible to the public in order to qualify for a
deduction, the public benefit from the donation may be insufficient to qualify
if only a small portion of the property is visible to the public. Treas. Reg. §
1.170A-14(d)(4)(ii)(B).

In Turner v. Commissioner, 126 T.C. 299 (2006), the
conservation purpose of open space was not met because the easement deed did
not restrict development and did not include specific provisions to protect the
views of the property. The taxpayer was not entitled to a deduction because the
conservation easement did not satisfy one of the required conservation purposes
in IRC § 170(h)(4)(A).

See Treas. Reg. § 1.170A-14(d)(4)(ii) for additional
guidance.

Governmental Conservation Policy

Conservation purpose includes the preservation of open space
where such preservation is pursuant to a clearly delineated federal, state or
local government conservation policy. IRC § 170(h)(4)(A)(iii)(II).

A broad declaration by a single official or legislative body
that the land should be conserved is not sufficient. The donation must further
a specific, identified conservation project. The fact that the donation was
accepted (or purchased) by a government agency alone is not sufficient to
satisfy this requirement. The more rigorous the review process by the
governmental agency, the more the acceptance of the easement tends to establish
the requisite clearly delineated governmental policy.

The government need not fund the conservation program but it
must involve a significant commitment by the government with respect to the
conservation project.

Public access is not required if the conservation purpose
would be undermined or frustrated by the public access. Treas. Reg. §
1.170A-14(d)(4)(iii)(C).

Example: For a donation pursuant to a local governmental
policy protecting a scenic bluff area, visual access would be required, as the
conservation purpose is to protect the scenic beauty of the bluff.

See Treas. Reg. § 1.170A-14(d)(4)(iii) for additional
guidance.

Significant Public Benefit

A conservation purpose based on the preservation of open
space, whether for scenic enjoyment or pursuant to a governmental conservation
policy, must yield a significant public benefit. IRC § 170(h)(4)(A)(iii).

A determination of whether a conservation easement provides
a significant public benefit must be made based on all facts and circumstances.
Treas. Reg. § 1.170A-14(d)(4)(iv) lists a number of factors that may be
considered:

 Uniqueness of the property to the area.

 Intensity of land development in the area.

 Consistency of the proposed open space use with public and
private conservation programs.

 Likelihood the property would be developed in the absence
of the easement.

 Opportunity of the public to appreciate the property’s
scenic values.

 Importance of the property to preservation, tourism or
commerce.

 Likelihood of the donee acquiring substitute property.

 Cost of enforcing the terms of the conservation
restrictions.

 Population density in the area.

 Consistency of open space use with a legislatively
mandated program identifying particular parcels of land for future protection.

The preservation of an ordinary tract of land would not, in
and of itself, yield a significant public benefit. Treas. Reg. § 1.170A
14(d)(4)(iv)(B). A conservation easement that merely limits the number of lots
that the acreage is divided into does not satisfy the open space requirement of
section 170(h). Turner v. Commissioner, 126 T.C. 299 (2006).

The legislative history underlying section 170(h) shows that
Congress did not intend for every easement to qualify for a deduction. A
deduction is not allowed unless there is an assurance that the public benefit
furthered by the contribution would be substantial enough to justify the
allowance of a deduction. S. Rep. 96-1007, at 9-10 (1980), reprinted in 1980
U.S.C.C.A.N. 6736, 6744-45.

Example: Significant public benefit includes the
preservation of a unique natural land formation for the enjoyment of the
general public or the preservation of woodland along a well-traveled public
highway to preserve the appearance of the area so as to maintain the scenic
view from the highway.

Historically Important Land or Structure

This category includes the donation of a qualified real
property interest to preserve a historically important land area or a certified
historic structure. IRC § 170(h)(4)(A)(iv).

Historically Important Land

Historically important land includes:

 An independently significant land area that meets the
National Register Criteria for Evaluation

 Land where the physical or environmental features
contribute to the historic or cultural importance and continuing integrity of
certified historic structures.

See Treas. Reg. § 1.170A-14(d)(5)(ii) for additional
guidance.

Under the Pension Protection Act (IRC § 170(h)(4)(C)), a
“certified historic structure”• includes a land area listed in the National
Register. The National Register of Historic Places is part of a national
program administered by the National Park Service (NPS) to identify, evaluate
and protect historic and archeological resources worthy of preservation. A list
of properties listed in the National Register can be found on the NPS web page.

Certified Historic Structure

A certified historic structure is:

 Any building, structure, or land area listed on the
National Register, or

 Any building located in a registered historic district and
certified by the Secretary of the Interior as being of historic significance to
the district.

The National Park Service Technical Preservation Services
administers the certification program for the Department of the Interior. This
certification must be done at the time the property is donated or by the due
date (including extensions) of the return for the year of the donation.

A certified historic structure may be a commercial property
or a personal residence. The term “registered historic district”• includes a
district described in IRC § 47(c)(3)(B).

The term “registered historic district”• means:

 Any district listed in the National Register, and

 Any district

o designated under a statute of the appropriate State or
local government, if such statute is certified by the Secretary of the Interior
to the Secretary as containing criteria which will substantially achieve the
purpose of preserving and rehabilitating buildings of historic significance to
the district, and

o which is certified by the Secretary of the Interior to the
Secretary as meeting substantially all of the requirements for the listing of
districts in the National Register.

A building is in a local historic district will meet not the
definition of a certified historic structure unless both the statute and the
district have been certified in accordance with IRC § 47.

Some visual access by the public to the building, structure
or land area is required.

See Treas. Reg. § 1.170A-14(d)(5)(iv) for additional
guidance.

Special Rules for Buildings in Registered Historic Districts

IRC §170(h)(4)(B) imposes additional requirements for
contributions of conservation easements on buildings in registered historic
districts. Note: These special rules do not apply to properties listed in the
National Register.

To qualify, all of the following additional requirements
must be met:

 Effective for contributions made after July 25, 2006:

1. the entire exterior of the building, including the front,
sides, rear, and height, must be restricted, and no changes can be made to the
exterior that are inconsistent with the historical character of the exterior;

2. the donor must enter into a written agreement with the
donee certifying, under penalty of perjury, that the donee is a qualified
organization with a purpose of environmental protection, land conservation,
open space preservation, or historic preservation, and that the donee has the
resources to manage and enforce the restrictions and the commitment to do so.

 Effective for contributions made in tax years beginning
after August 17, 2006, the taxpayer must attach to their return a qualified
appraisal as defined in IRC § 170(f)(11)(E), photographs of the entire exterior
of the building, and a description of all restrictions on the development of
the building.

 For contributions of facade easements on buildings in
registered historic districts, on or after February 13, 2007, donors must pay a
$500 filing fee to the U.S. Treasury if a deduction of more than $10,000 is
claimed. IRC § 170(f)(13). The fee is to be used to enforce the provisions of
IRC§ 170(h).

Public Access

Public access (either physical or visual) to the property is
generally required for the conservation easement to be deductible except with
respect to protection of a relatively natural habitat or ecosystem or pursuant
to specified governmental policies. The type of access depends on the claimed
conservation purpose.

If physical access is required, access must be substantial
and on a regular basis.

If only visual access is required, the entire property need
not be visible to the public for a donation to qualify, although the public
benefit from the donation may be insufficient to qualify for a deduction if
only a small portion of the property is visible to the public.

See Treas. Reg. § 1.170A-14(d) and discussion below for
specific access requirements.

Inconsistent Uses

A donation must be exclusively for conservation purposes,
and the deed of conservation easement must prohibit all inconsistent uses. An
inconsistent use allows for the destruction or potential destruction of
significant conservation interests in conflict with a conservation purpose.

Some inconsistent uses are permitted if necessary to protect
the conservation interests that are the subject of the easement.

Most conservation easement donors reserve some rights to the
property. Depending on the nature and extent of these reserved rights, the
claimed conservation purpose may be eroded or impaired to such a degree that
the contribution may not be allowable. A determination of whether the reserved
rights defeat the conservation purpose must be determined based on all facts
and circumstances.

Example: The conservation purpose of the easement as
described in the conservation easement deed was to protect the relatively
natural habitat for scrub jay, a threatened bird. The deed of easement allows
the taxpayer to use pesticides that would destroy the natural food source for
the scrub jay. The taxpayer is not entitled to a deduction because the allowed
activity is an inconsistent use.

See Treas. Reg. § 1.170A 14(e)(2) and (e)(3) for additional
guidance.

Baseline Study

If the donor reserves rights that may impair the
conservation interests associated with the property, the donor must provide
baseline documentation (sometimes referred to as the baseline study) to the
donee prior to the time the donation is made. Treas. Reg. § 1.170A-14(g)(5).
This documentation should provide specific information about the conservation
values of the property.

The baseline documentation is generally prepared by a person
with specific training or skills in the assessment of conservation values such
as a biologist, botanist or historian. The baseline study may be prepared by a
person affiliated with the donee.

This documentation may include:

 Survey maps from the United States Geological Survey,
showing the property line and other contiguous or nearby protected areas.

 A map of the area drawn to scale showing all existing
man-made improvements or incursions (such as roads, buildings, fences, or
gravel pits), vegetation and identification of flora and fauna (including, for
example, rare species locations, animal breeding and roosting areas, and
migration routes), land use history (including present uses and recent past
disturbances), and distinct natural features (such as large trees and aquatic
areas).

 An aerial photograph of the property at an appropriate
scale taken as close as possible to the date the donation is made.

 On-site photographs taken at appropriate locations on the
property.

The documentation must be accompanied by a statement signed
by the donor and a representative of the donee organization affirming that the
documentation of the natural resources is an accurate representation of the
protected property at the time of the transfer. Treas. Reg. §
1.170A-14(g)(5)(i).

Chapter 6: Substantiation Chapter 6: Substantiation Chapter
6: Substantiation Chapter 6: SubstantiationChapter 6: Substantiation Chapter 6:
Substantiation Chapter 6: Substantiation

Overview

A charitable contribution for a conservation easement is not
deductible unless properly substantiated in accordance with the Internal
Revenue Code and applicable regulations, including:

 IRC § 170(a)(1)

 IRC § 170(f)(8)

 IRC § 170(f)(11)

 IRC § 170(f)(13)

 Treas. Reg. § 1.170A-13

 Treas. Reg. § 1.170A-14

These code sections and corresponding regulations describe
the specific recordkeeping and substantiation requirements for donors of
charitable contributions. See also Notice 2006-96.

A donor cannot claim a charitable contribution deduction
unless the donor maintains a record of the contribution. The kind of records
required to substantiate a charitable contribution vary depending on the
amount, date of contribution, type of property contributed and whether the
donation was a cash or noncash contribution. There are also special rules with
respect to buildings in registered historic districts.

The burden is on the taxpayer to demonstrate that the cash
or property transferred to the qualified organization is a deductible
contribution. See Treas. Reg. § 1.170A-1(h)(1) and (2); United States v.
American Bar Endowment, 477 U.S. 105, 116-118 (1986); and Revenue Ruling
67-246, 1967-2 CB 104.

See Publication 1771, Charitable
Contributions-Substantiation and Disclosure Requirements (PDF), and Publication
526, Noncash Contributions (PDF), for additional information.

See Exhibit 6-1 for summary of substantiation requirements.

Contemporaneous Written Acknowledgment

A contemporaneous written acknowledgment (CWA) by the
qualified donee organization is required for all contribution deductions of
$250 or more (in cash or property).

“Contemporaneous”• means that the taxpayer must obtain the
acknowledgment by the earlier of the date on which the taxpayer files his or
her tax return claiming the charitable contribution deduction, or the due date
(including extensions) for the return. IRC § 170(f)(8) and Treas. Reg. §
1.170A-13(f)(3).

This acknowledgment by the qualified donee organization must
contain:

 Amount of any cash contribution,

 Description (but not the value) of the conservation
easement granted,

 Statement that no goods or services were provided by the
organization in return for the contribution (if this was the case),

 Description and good faith estimate of the value of goods
or services, if any, that an organization provided in return for the
contribution, and

 A statement that goods or services (if any) that an
organization provided in return for the contribution consisted entirely of
intangible religious benefits (if this was the case).

Section 170(f)(8) requirements must be complied with for a
deduction to be allowed. See Addis v. Commissioner, 374 F.3d 881 (9th Cir.
2004), affg. 118 TC 528 (2004) (“the deterrence value of section 170(f)(8)’s
total denial of a deduction comports with the effective administration of a

self-assessment and self-reporting system”•), cited in
Viralam v. Commissioner, 136 T.C. No. 8 (Feb. 14, 2011); Schrimsher v.
Commissioner, T.C. Memo 2011-71 (March 28, 2011).

The following CWA does not meet the statutory requirement of
IRC § 170(f)(8) since it does not make an affirmative statement that no goods
or services were provided (or describe if good or services were actually
provided) in exchange for the contribution.

 

Example: “Thank you for your contribution by deed of a
conservation easement on XYZ property and $10,000 cash contribution for
maintenance of the easement that ABC Conservation received on May 5, 2008.”•

In Schrimsher v. Commissioner, the Court held that where the
donee provided no goods or services, the CWA must say that in order to satisfy
the statutory requirements. The Court noted that a deed stating that the donee
provided consideration of $10 plus “other good and valuable
consideration” does not satisfy the statutory requirement.

Note: Taxpayers and return preparers frequently confuse the
CWA requirement with the filing of Form 8283, Noncash Charitable Contributions
(PDF). This form is not a substitute for the contemporaneous written
acknowledgment; both are required. Failure to meet either requirement may
result in disallowance of the charitable contribution deduction.

Form 8283, Noncash Charitable Contributions

Section B of Form 8283, Noncash Charitable Contributions
(PDF), referred to in the Deficit Reduction Act of 1984 and the Treasury
Regulations as an “appraisal summary,”• must be fully completed and attached to
the return for all noncash donations greater than $5,000.

Note: If the donation originates from a flow-through entity
(such as S-corporation or partnership), the partner or shareholder who receives
an allocation of the charitable contribution must attach a copy of the
flow-through entity’s appraisal summary (Form 8283) to the tax return on which
the deduction for the contribution is first claimed. Treas. Reg. §
1.170A-13(c)(4)(iv)(G).

Section B of Form 8283 is often incomplete or improperly
completed by taxpayers and return preparers. Common errors include:

 Inadequate description of the property

 Missing information

 Lack of signatures

 Inconsistent dates

A description of the property must have sufficient detail
for a person unfamiliar with the type of property to ascertain that the
property being appraised is the property that was contributed. Treas. Reg. §
1.170A-13(c)(4)(ii)(B).

The remainder of Section B, Part I, requests additional
required information regarding:

 Acquisition date of the property

 How the property was acquired by the donor

 Donor’s cost or adjusted basis

 Bargain sale

 Appraised fair market value of the easement donation

The instructions to Form 8283 require a statement that
identifies the conservation purpose, shows fair market value before and after,
states whether the donation was made in order to get an approval or was
required by contract, and whether the taxpayer or related person has any
interest in nearby property. This statement must be attached to the Form 8283.

See Instructions for Form 8283, Noncash Charitable
Contributions (PDF), and Treas. Reg. § 1.170A-13(c)(4) for detailed discussion
of the appraisal summary (Form 8283) requirements.

Declaration of Appraiser

Section B, Part III, Declaration of Appraiser, must be
completed by the qualified appraiser for donations in excess of $5,000. Treas.
Reg. § 1.170A-13(c)(4)(ii)(K) and (L).

Donee Acknowledgment

Section B, Part IV, Donee Acknowledgment, must be signed by
an official authorized to sign the tax or information returns of the donee
organization or a person specifically designated to sign Form 8283. Treas. Reg.
§ 1.170A-13(c)(4)(iii).

Reasonable Cause Exception

Examiners should solicit from the taxpayer a fully completed
Form 8283 if not attached to the return. The failure to file Form 8283 or the
filing of an incomplete Form 8283 should result in disallowance of the
charitable contribution deduction for the conservation easement unless:

 Such failure was due to reasonable cause and not willful
neglect or was due to a good-faith omission,

 The taxpayer otherwise complies with Treas. Reg. §
1.170A-13(c)(3) and (c)(4), and

 The taxpayer submits a fully completed form within 90 days
of an IRS request.

In rare and unusual circumstances in which it is impossible
for the taxpayer to obtain the signature of the donee, the taxpayer’s deduction
will not be disallowed for that reason provided that the taxpayer attaches a
statement to the Form 8283 explaining, in detail, why it was not possible to
obtain the donee’s signature. Treas. Reg. § 1.170A-13(c)(4)(iv)(C)(2).

Qualified Appraisal

Qualified appraisals are required for all noncash
contribution deductions of conservation easements greater than $5,000. IRC §
170(f)(11)(C).

If a charitable contribution deduction of more than $500,000
is claimed for a noncash contribution made after June 3, 2004, the taxpayer
must attach a copy of a qualified appraisal of the property to the return in
the year of donation. IRC § 170(f)(11)(D).

Special rule: For contributions of façade easements in
registered historic districts made in tax years beginning after August 17,
2006, a qualified appraisal must be attached to the return regardless of the
dollar amount claimed for the conservation easement. IRC §
170(h)(4)(B)(iii)(I). Note: This special rule does not apply to properties
listed on the National Register.

See Chapter 7 for additional information on qualified
appraisals.

Façade Easement Filing Fee(Registered Historic District
Only)

For contributions of façade easements made on or after
February 13, 2007, donors must pay a $500 filing fee with their return in the
taxable year of the contribution to the U.S. Treasury for donation of easements
on buildings in registered historic districts if a deduction of more than
$10,000 is claimed. IRC § 170(f)(13). The fee is to be used to enforce the
provisions of IRC § 170(h).

Payment is transmitted to the IRS using Form 8283V, Payment
Voucher for Filing Fee under Section 170(f)(13) (PDF).

Baseline Study

A donor of a conservation easement where rights are retained
must give the qualified organization documentation (baseline study) that
establishes the condition of the property at the time of the gift, the types of
natural habitat on the property (if the conservation purpose is for natural
habitat), and the existing restrictions on the property. Treas. Reg. §
1.170A-14(g)(5)(i). The documentation generally includes maps, surveys and
photographs of the property and must be provided prior to the time the donation
is made.

See Chapter 5 for additional information on baseline
documentation.

Exhibit 6-1 – Substantiation Requirements

Form

Criteria

Due Date

Attach to Return

Contemporaneous Written Acknowledgment

All $250 or more

Earlier of Return filing date or Due Date (with extensions)

No

F8283 (Appraisal

All >$500 Part A

Return filing date

Yes

Form

Criteria

Due Date

Attach to Return

Summary)

All >$5,000 Part B

Also attach statement per Form 8283 Instructions

Qualified Appraisal

All >$5,000

No earlier than 60 days prior to date of contribution but no
later than original/amended return filing date

Yes If over $500,000 or an easement on a building in a
registered historic district

Façade Filing Fee

All easements on buildings in registered historic districts
>$10,000

Return filing date

No Mail in with Form 8283V

Baseline Study

Required to be given to donee organization to establish
condition of property

Prior to donation

No

Chapter 7: Qualified Appraisal Chapter 7: Qualified
Appraisal Chapter 7: Qualified Appraisal Chapter 7: Qualified Appraisal Chapter
7: Qualified Appraisal Chapter 7: Qualified Appraisal Chapter 7: Qualified
Appraisal Chapter 7: Qualified Appraisal Chapter 7: Qualified Appraisal
Requirements Requirements RequirementsRequirementsRequirements

Overview

Generally, noncash charitable contributions for which a
deduction of more than $5,000 is claimed must be substantiated with a qualified
appraisal prepared by a qualified appraiser in accordance with generally
accepted appraisal standards. IRC § 170(f)(11)(C) and (E)(i)(II).

The Pension Protection Act of 2006 (PPA) amended IRC §
170(f)(11)(E), which provides definitions of qualified appraisal and qualified
appraiser, effective for appraisals prepared for returns or submissions filed
after August 17, 2006. See Notice 2006-96, 2006-2 C.B. 902 for transitional
rules.

IRC § 170(f)(11)(E) and corresponding Treas. Reg. §
1.170A-13(c)(3) set forth substantiation requirements that must be met for the
appraisal to be considered a qualified appraisal.

This chapter discusses the requirements for a qualified
appraisal, a qualified appraiser and generally accepted appraisal standards.

See Publication 561, Determining the Value of Donated
Property (PDF) and Treas. Reg. § 1.170A-13 for additional guidance on qualified
appraisals requirements.

Qualified Appraisal

IRC § 170(f)(11), effective for contributions made after
June 3, 2004, requires a qualified appraisal for property donations of more
than $5,000.

IRC § 170(f)(11)(D) requires the attachment of a qualified
appraisal to the return if the deduction claimed exceeds $500,000. For
contributions of façade easements in registered historic districts made in tax
years after August 17, 2006, a qualified appraisal must be attached regardless
of the dollar amount claimed as a deduction. IRC § 170(h)(4)(B) (iii)(I). Note:
This special rule does not apply to properties listed on the National Register.

IRC § 170(f)(11)(E) was amended in 2006 to include
definitions of the terms “qualified appraisal”• and “qualified appraiser .”•
Notice 2006-96 provides transitional guidance and safe harbors to be used until
proposed regulations are finalized.

An appraisal is treated as a qualified appraisal within the
meaning of IRC § 170(f)(11)(E) if the appraisal complies with all of the
requirements of Treas. Reg. § 1.170A-13(c) (except to the extent the
regulations are inconsistent with IRC § 170(f)(11)). See also Notice 2006-96.

A qualified appraisal must:

 Be prepared no earlier than 60 days before the date of
contribution nor later than the due date (including extensions) of the tax
return on which the charitable contribution deduction is first claimed. Treas.
Reg. § 1.170A-13(c)(3)(i)(A).

 Be prepared, signed and dated by a qualified appraiser.
Treas. Reg. § 1.170A-13(c)(3)(i)(B).

 Not involve a prohibited appraisal fee. Treas. Reg. §
1.170A-13(c)(6).

 Include information required by Treas. Reg. §
1.170A-13(c)(3)(ii).

Treas. Reg. § 1.170A-13(c)(3)(ii) outlines specific items
required to be included in an appraisal report:

 A detailed description of the property.

 The property’s physical condition (for a contribution of
tangible property).

 The date or expected date of the contribution.

 The terms of any agreement relating to the property’s use,
sale or other disposition.

 The appraiser’s name, address, and taxpayer identification
number, and that of the appraiser’s employer or partnership.

 The qualifications of the appraiser, including the appraiser’s
background experience, education and membership in professional appraisal
associations.

 A statement that the appraisal was prepared for income tax
purposes.

 The date the property was appraised.

 The appraised fair market value of the property on the
date or expected date of the contribution.

 The method of valuation used to determine the fair market
value.

 The specific basis for the valuation (such as specific
comparable sales transactions or statistical sampling, including a
justification for using sampling and an explanation of the sampling procedure
used).

Reasonable Cause Exception

The charitable deduction will not be denied if the
taxpayer’s failure to comply with the requirements of IRC § 170(f)(11) was due
to reasonable cause and not willful neglect. IRC § 170(f)(11)(A)(ii)(II).

Qualified Appraiser

The term “qualified appraiser”• as defined in IRC §
170(f)(11)(E)(ii) means an individual who:

 Has earned an appraisal designation from a recognized
professional appraiser organization or met minimum education and experience
requirements as set forth in the regulations,

 Regularly performs appraisals for which the individual
receives compensation, and

 Meets such other requirements as prescribed by the
Secretary in regulations or other guidance.

An individual is not a qualified appraiser unless the
individual demonstrates verifiable education and experience in valuing the type
of property subject to the appraisal and the individual has not been prohibited
from practicing before the IRS any time in the 3-year period ending on the date
of the appraisal. IRC § 170(f)(11)(E)(iii).

Notice 2006-96 offers transitional guidance on the qualified
appraiser requirements. The Notice provides that:

 The appraisal designation from a recognized appraiser
organization must be based on demonstrated competency in valuing the type of
property for which the appraisal is performed.

 The appraiser is treated as having demonstrated verifiable
education and experience in valuing the type of property if the appraiser makes
a declaration in the appraisal that, because of the appraiser’s background,
experience, education and membership in professional associations, the
appraiser is qualified to make appraisals of the type of property being valued.

 The appraiser will be treated as having met minimum
education and experience requirements if, for real property:

 For returns filed on or before October 19, 2006, the
appraiser is a “qualified appraiser”• under IRC § 1.170A-13(c)(5) to appraise
the type of property valued.

 For returns filed after Oct. 19, 2006, the appraiser is
licensed or certified for the type of property being appraised in the state in
which the appraised real property is located.

For returns filed on or before August 17, 2006, the term
“qualified appraiser”• is defined in Treas. Reg. § 1.170A-13(c)(5) as an
individual who declares that he or she:

 Holds himself or herself out to the public as an appraiser
or performs appraisals on a regular basis;

 Is qualified to make appraisals of the type of property
being valued;

 Is not a person specifically prohibited from being a
qualified appraiser of particular property (such as the donor, the donee, or
others with a connection to the donor or donee); and

 Understands that he or she can be subject to civil
penalties for aiding and abetting a tax understatement due to an intentionally
false or fraudulent value overstatement.

An individual is not a qualified appraiser with respect to a
particular donation if the donor had knowledge of facts that would cause a
reasonable person to expect the appraiser to falsely overstate the value of the
donated property. Treas. Reg. § 1.170A-13(c)(5)(ii).

The appraiser’s certification, which is typically included
in the appraisal, provides a good starting point to assess whether the
appraiser is a qualified appraiser. The resume provides information on their
experience and professional designations. It will also typically indicate in
which jurisdictions the appraiser holds a license or certification.

License information regarding jurisdictions, history and
disciplinary actions can be found on The Appraisal Foundation Web page. You can
search for information on a specific appraiser by selecting the “find an
appraiser”• button or utilize this link: Find an Appraiser. Some states also
provide appraisal licensing information online. Examiners or IRS appraisers can
contact the various state boards via telephone to determine if there are any
past or pending disciplinary actions against the appraiser. The Office of
Professional Responsibility (OPR) publishes a list of practitioners, including
appraisers, who have been subject to disciplinary actions by the IRS.

Generally Accepted Appraisal Standards

IRC § 170(f)(11)(E)(i)(II) states that a qualified appraisal
is an appraisal conducted by a qualified appraiser in accordance with generally
accepted appraisal standards and any regulations or other guidance prescribed
by the Secretary.

Section 3.02(2) of Notice 2006-96 states that an appraisal
will be treated as having been conducted in accordance with generally accepted
appraisal standards if, for example, the appraisal is consistent with the
substance and principles of the Uniform Standards of Professional Appraisal
Practice (USPAP), as developed by the Appraisal Standards Board of The
Appraisal Foundation.

Uniform Standards of Professional Appraisal Practice

In 1989, The Appraisal Foundation, a nonprofit organization,
adopted licensing and appraisal standards for the appraisal industry. The
Uniform Standards of Professional Appraisal Practice (USPAP) are the minimum
acceptable appraisal standards for federally regulated transactions.

USPAP is recognized throughout the United States as the
generally accepted standards of professional appraisal practice.

Although USPAP was intended for appraisals prepared for
federally regulated transactions, all states have adopted USPAP for appraisals
completed by licensed or certified appraisers. USPAP is applicable to an
appraisal assignment in three ways:

 By law or regulation,

 By client request or requirement, or

 By choice.

In addition, various appraisal organizations such as The
Appraisal Institute (AI), National Association of Independent Fee Appraisers
(NIAFA), American Society of Appraisers (ASA), and American Society of Farm
Managers and Rural Appraisers (ASFMRA) have additional standards and ethics
that their membership (both designated and undesignated) is required to follow.
For the most part these organizations require adherence to USPAP as part of
their standards and ethics requirements.

IRC § 170(f)(11)(E)(i)(II) does not specifically mandate
compliance with USPAP but does require the appraisal to be prepared in
accordance with generally accepted appraisal standards. Qualified appraisers
holding themselves out to the public as appraisers generally would be required
to comply with USPAP by virtue of their appraisal licenses and professional
designations.

In assessing whether an appraisal is a qualified appraisal
for returns filed after August 17, 2006, Examiners and IRS appraisers must
consider whether the appraisal is consistent with the substance and principles of
USPAP and, if not, whether the appraisal satisfies the generally accepted
appraisal standard requirement. For returns filed before this date, compliance
with appraisal valuation standards including USPAP is considered in assessing
the reliability, credibility and overall accuracy of the appraisal.

Appraisal Fees

Appraisal fees that a taxpayer pays to determine the fair
market value (FMV) of donated property are not deductible as charitable
contributions. However, taxpayers can claim appraisal fees, subject to the two
percent of adjusted gross income (AGI) limit, as a miscellaneous itemized
deduction on Schedule A, Itemized Deductions (PDF), of Form 1040, U.S.
Individual Income Tax Return (PDF).

Chapter 8: Amount of Deduction Chapter 8: Amount of
Deduction Chapter 8: Amount of Deduction Chapter 8: Amount of DeductionChapter
8: Amount of DeductionChapter 8: Amount of Deduction Chapter 8: Amount of
DeductionChapter 8: Amount of Deduction Chapter 8: Amount of Deduction Chapter
8: Amount of Deduction

Overview

Several factors may affect the amount a taxpayer may claim
as a charitable contribution deduction for a conservation easement:

 Percentage limitations

 Basis limitations

 Type of property (ordinary income, short-term capital
gain, long-term capital gain)

 Bargain sale

 Quid pro quo and charitable intent

 Rehabilitation tax credits

Any charitable contribution amount that cannot be utilized
by the taxpayer in the year of donation of the conservation easement can be
carried over and claimed on subsequent year tax returns, generally for five
years. Depending on the year and type of the donation and the identity of the
donor (i.e., a qualified farmer or rancher), an extended carryover period may
exist.

Percentage Limitations

For charitable contributions by individuals of property
other than cash, the amount of the deduction a taxpayer may claim is subject to
percentage limitations based on:

 The type of property donated,

 The type of qualified organization, and

 The use of the property by the qualified organization.

See Publication 526, Charitable Contributions (PDF), for
additional guidance on percentage limitations.

Individuals

In general, deductible contributions may not exceed 50% of
the individual’s contribution base, but lower percentages apply in the case of
appreciated property and contributions to certain private foundations.

A 30% limit applies to contributions of long-term capital
gain property donated to 50% limit organizations (those described in IRC §
170(b)(1)(A)), and a 20% limit applies for similar gifts to 30% organizations
(those described in IRC § 170(b)(1)(B)).

Contribution base for individuals is defined in IRC §
170(b)(1)(G) as adjusted gross income (computed without regard to any net
operating loss carryback to the taxable year under IRC § 172).

Qualified organizations accepting conservation easements are
generally 50% organizations. A conservation easement is considered long-term
capital gain property if the underlying property is a capital asset held for
more than a year. Accordingly, the 30% limit would generally apply to the
donation of conservation easements where the holding period is greater than one
year.

Note: For tax years beginning after December 31, 2005, and
on or before December 31, 2011, an individual may deduct a qualified
conservation easement contribution up to 50% of the individual’s contribution base
(after reducing the contribution base by other contributions). IRC §
170(b)(1)(E)(i).

The maximum percentage limitation for contributions of cash
is 50%.

Corporations

For corporations, in general, the maximum amount allowable
as a charitable contribution deduction for any taxable year is 10% of the
corporation’s taxable income for that year, computed with certain adjustments
described in IRC § 170(b)(2)(C).

Special Rules for Farmers and Ranchers

An individual who is a qualified farmer or rancher may deduct
up to 100% of the individual’s contribution base (after reduction by other
contributions) for the donation of a qualified conservation contribution.

A qualified farmer or rancher is an individual whose gross
income from the trade or business of farming within the meaning of IRC §
2032A(e)(5) is greater than 50% of the individual’s gross income for the
taxable year.

For any contribution after August 17, 2006, of property that
is used in agriculture or livestock production, the 100% limitation applies only
if the contribution is subject to a restriction that provides the donated land
remains available for agriculture or livestock production. IRC §
170(b)(1)(E)(iv)(II). If the contribution is not subject to such a restriction,
the 50% limitation applies.

A corporation that is a qualified farmer or rancher may make
a qualified conservation contribution of property used in agriculture or
livestock production (or available for such production) and deduct up to 100%
of the corporation’s taxable income provided the donated land remains available
for such production. IRC § 170(b)(2)(B).

Note: This provision was only applicable for certain
contributions of conservation easements beginning after 2005 and before 2012.

Carryovers

In general, taxpayers (both individuals and corporations)
can carry over unused charitable contributions for up to five years.

For contributions made in tax years beginning after December
31, 2005, and on or before December 31, 2011, the following rules apply:

 An individual with a qualified conservation contribution
or a qualified farmer or rancher may carry over deductions for 15 years. IRC §
170(b)(1)(E)(ii).

 A corporate qualified farmer or rancher may carry over a
deduction for a qualified conservation easement for 15 years. IRC § 170(b)(2)(B)(ii)

Basis Limitations

The deduction for a charitable contribution of property
generally is equal to the fair market value (FMV) of the property, but in some
cases may be limited to the lesser of FMV or basis.

In the case of tangible property, the deduction is limited
to the lesser of FMV or basis if the use of the property transferred is
unrelated to the charitable purpose of the qualified organization, for example,
donation of a piece of art work to a conservation land trust. IRC §
170(e)(1)(B)(i)(I).

Contributions of Appreciated Property

If a taxpayer contributes property with a FMV that is more
than the taxpayer’s basis, the taxpayer may have to reduce the FMV by the
amount of appreciation when determining the amount of the deduction. IRC §
170(e)(1). Different rules apply to determining the deduction, depending on
whether the property is:

 Ordinary income property

 Short-term capital gain property

 Long-term capital gain property

See Publication 544, Sales and Other Dispositions of Assets
(PDF), for additional guidance.

Ordinary Income and Short-Term Capital Gain Property

If the property is ordinary income property or short-term
capital gain property, the deduction generally is limited to basis. IRC §
170(e)(1)(A).

Property is ordinary income or short-term capital gain
property if its sale at FMV on the date of contribution would result in
ordinary income or short-term capital gain.

An example of ordinary income property is real property
(land and anything built on it) held by a real estate dealer/developer, if the
donated real property is primarily held for sale to customers in the ordinary
course of trade or business. If the property is ordinary income property in the
hands of the donor, then the deduction would be limited to basis.

Gain on the disposition of depreciable real property is
treated as ordinary income to the extent of additional depreciation allowed or
allowable on the property. Additional depreciation is the amount of the actual
depreciation over the depreciation figured using the straight line method. See
Publication 544, Sales and Other Disposition of Assets (PDF) and Form 4797
(PDF) and the related instructions.

Another example is capital gain property (such as real
estate held for investment) held for a year or less.

Example: Jefferson contributes a conservation easement on a
parcel that he held for 11 months. The conservation easement is short-term
capital gain property, and Jefferson’s deduction is limited to the lesser of
his basis in the easement or its fair market value.

The amount of basis allocable to the conservation easement
bears the same ratio to the total basis of the property as the FMV of the
conservation easement bears to the FMV of the entire parcel.

Example: Mary paid $80,000 for a parcel held for investment,
which has a FMV of $100,000. She decides to donate a conservation easement with
a FMV of $5,000.

If Mary’s parcel is held for less than one year, her
deduction for the easement is $4,000 ($5000/$100,000 x $80,000 = $4,000).

If Mary held the property for more than a year, her
deduction is the easement’s FMV or $5,000.

Long-Term Capital Gain Property

If property is long-term capital gain property, the
deduction generally is not limited to basis and may be as much as FMV. IRC §
170(e)(1).

Property is long-term capital gain property if its sale at
FMV on the date of the contribution would result in long-term capital gain.

Long-term capital gain property is property held for more
than a year.

An example is real estate held for more than a year for
investment or a personal residence held for more than a year.

Bargain Sale

A bargain sale of property to a qualified organization is a
sale or exchange for less than the property’s fair market value (FMV). In a
bargain sale, the taxpayer has charitable intent and, therefore, purposely
accepts less than FMV for the property. IRC § 1011(b).

If a taxpayer contributes property subject to a debt (such
as a mortgage), and the debt is assumed by the qualified organization, the
taxpayer must reduce the FMV of the property by the amount of the debt.

A bargain sale is treated as partly a charitable
contribution and partly a sale or exchange. To determine the FMV of the
contributed part, subtract the amount paid by the qualified organization from
the property’s FMV at the time of the gift.

FMV of property transferred less mortgage assumed (if
applicable) Less: Amount paid by the qualified organization Equals FMV of
charitable contribution

Taxable Gain

The part of the bargain sale that is a sale or exchange may
result in a taxable gain. The amount of taxable gain is determined by
allocating basis (under IRC § 1011(b)) between the portion of the property sold
and the portion of property contributed.

For more information on determining the amount of any
taxable gain, see “Bargain Sales to Charity” in Publication 544,
Sales and Other Dispositions of Assets (PDF), and IRC § 1011(b).

Example: Betty sells a conservation easement (on property
held for investment for more than one year) to a conservation organization for
$10,000. The FMV of the easement is $12,500. Her charitable contribution
deduction from the bargain sale is $2,500 ($12,500 – $10,000) provided that all
requirements to claim a conservation easement deduction have been met.

See Treas. Reg. § 1.170A-14(h)(3)(iii) for additional
guidance on allocating basis.

Federal and State Easement Purchase Programs

Many states and some other federal agencies have land or
conservation easement purchase programs. The purchase price may be at fair
market value (FMV) or at a discounted price depending on the specific program.
If the conservation easement was purchased at FMV, then there would be no
charitable contribution for the conservation easement.

The Farm and Ranch Land Protection Program (FRPP) is one
example of an easement purchase program. This program is a financial
assistance-matching program administered through the U.S. Department of
Agriculture (USDA). The Federal Government provides up to 50% of the appraised
fair market value to an eligible entity for the acquisition of an easement. The
entity must provide a minimum of 25% of the purchase price. The property owner
may contribute up to the remaining 25% of the appraised FMV of the conservation
easement.

The donation must meet all of the statutory and regulatory requirements
for a qualified conservation easement contribution in order for the taxpayer to
claim a noncash charitable contribution for the donation portion of a bargain
sale.

Quid Pro Quo and Charitable Intent

Charitable intent exists if the transfer was made without
the receipt of, or the expectation of receiving, a quid pro quo for the
transfer. As a general rule, if the benefits received or expected to be
received are greater than those that inure to the general public, the transfer
does not satisfy the charitable intent requirement under IRC § 170. Hernandez
v. Commissioner, 490 U.S. 691 (1989); United States v. American Bar Endowment,
477 U.S. 105, 118 (1986); Singer Co. v. U.S., 196 Ct. Cl. 90, 449 F.2d 413,
422-423 (1971).

If the donor or a related person receives, or can reasonably
expect to receive, a substantial financial or economic benefit, but it is
clearly shown that the benefit is less than the amount of the transfer, then a
deduction is allowable for the excess of the amount transferred over the amount
of the financial or economic benefit received or reasonably expected to be
received by the donor or related person.

Example 1: Steven is a real estate developer. He contributes
a conservation easement with the expectation that it will result in his
receiving preferential zoning treatment from the city zoning board. Steven is
not allowed a charitable contribution deduction.

Example 2: Jeanie lives along a scenic highway. In order to
secure a variance on her property, the zoning board requires an easement on 10
percent of her property. Jeanie decides to place an easement on 25 percent of
her property. Jeanie may deduct as a charitable contribution the value of the
easement she placed on 15 percent of her property.

The burden is on the taxpayer to show that all or part of a
payment is a charitable contribution or gift. Treas. Reg. § 1.170A-1(h)(1) and
(2); United States v. American Bar Endowment, 477 U.S. 105, 116-118 (1986); and
Revenue Ruling 67-246, 1967-2 CB 104.

In Scheidelman v. Commissioner, T.C. Memo 2010-151, the
taxpayer claimed a charitable contribution deduction for a cash payment to the
donee organization in conjunction with the granting of the conservation
easement. The Tax Court concluded that the taxpayer did not provide sufficient
evidence that she received nothing of substantial value or, if they had
received something of substantial value, the value of the benefits received.

Rehabilitation Tax Credit

IRC § 47 is an investment tax credit intended to encourage
rehabilitation of historic buildings for urban and rural revitalization. The
rehabilitation tax credit is a two-tier credit with a 20% credit available for
certified historic structures and a 10% credit for any qualified rehabilitated building
other than a certified historic structure, first placed in service before 1936.

The National Park Service and the IRS in partnership with
State Historic Preservation Offices jointly administer the Historic
Preservation Tax Incentives Program. See the Rehabilitation Tax Credit Market
Segment Specialization Program Guide (PDF) for additional information.

Recapture of Rehabilitation Tax Credit

IRC § 50(a)(1) provides for recapture of the investment tax
credit upon disposition.

When a façade easement is conveyed during the same year that
a qualified rehabilitated building is placed in service, the taxpayer will not
be entitled to claim the portion of the rehabilitation tax credit attributable
to the façade easement. See Rev. Rul. 89-90, 1989-2 C.B. 3, and Rome I, Ltd. v.
Comm., 96 T.C. 697 (1991).

Under IRC § 50, if a taxpayer claims a rehabilitation tax
credit with respect to property and subsequently makes a qualified conservation
contribution (i.e., contributes a façade easement) with respect to the property,
the charitable contribution is a partial disposition of the property. This
event will trigger recapture of all or part of the credit if the contribution
is made within the recapture period (5 years from the placed in service date).

Under § 170(f)(14), if, during the 5 years preceding the
date of a façade easement contribution, a rehabilitation tax credit under IRC §
47 was claimed for the building, the amount of the charitable contribution
deduction must be reduced by the ratio of the sum of the credits allowed for
those 5 years over the fair market value of the building on the date of
contribution.

See the Rehabilitation Tax Credit Market Segment
Specialization Program Guide (PDF) for additional information.

Chapter 9: Valuation of Conservation Chapter 9: Valuation of
Conservation Chapter 9: Valuation of Conservation Chapter 9: Valuation of
Conservation Chapter 9: Valuation of Conservation Chapter 9: Valuation of
Conservation Chapter 9: Valuation of Conservation Chapter 9: Valuation of
Conservation Chapter 9: Valuation of Conservation Chapter 9: Valuation of
Conservation Chapter 9: Valuation of Conservation Easements EasementsEasements

Overview

To determine the fair market value (FMV) of a conservation
easement, appraisers must have a clear understanding of IRC § 170 and the
accompanying Treasury regulations. The appraiser also must meet the definition
of a “qualified appraiser.”•

The value of a conservation easement is the FMV at the time
of contribution and depends on the particular facts and circumstances of the
property. Treas. Reg. § 1.170A-14(h)(3)(i).

IRC § 170(f)(11)(E) and Treas. Reg. § 1.170A-13(c)(3) impose
special substantiation requirements that must be met for the appraisal to be
considered a qualified appraisal.

Treas. Reg. § 1.170A-14(h)(3)(i) requires that, if there is
a substantial record of sales of comparable easements, those sales are used to
value conservation easements. Since easements are not typically sold, there
usually are insufficient sales to use a comparable easement sales approach. In
that case, the “before and after” method of valuing a conservation
easement generally is used.

The scope of this chapter is to provide a general overview
on the valuation of conservation easements and generally accepted appraisal
standards. A comprehensive discussion of valuation is beyond the scope of this
ATG.

See Treas. Reg. §§ 1.170A-13 and 1.170A-14 of the Income Tax
Regulations, Notice 2006-96, 2006-2 C.B. 902, Publication 526, Charitable
Contributions, Publication 561, Determining the Value of Donated Property
(PDF), Form 8283, Noncash Charitable Contributions (PDF), and the Instructions
for Form 8283 (PDF) for more information about valuation, qualified appraisers,
qualified appraisals, and other requirements.

Valuation Process

Valuation, as defined by the Dictionary of Real Estate,
Fifth Edition, is the process of estimating the FMV of an identified interest
in a specific parcel or parcels of real estate as of a specified date. It is a
term used interchangeably with appraisal. The valuation process is a systematic
procedure and entails:

 Defining the problem/scope of work,

 Data collection and property description,

 Data analysis,

 Application of the approaches to value,

 Reconciliation of value indications and final opinion of
value, and

 Reporting the defined value.

Critical to the completion of any valuation assignment,
especially the valuation of a conservation easement, is clearly defining the
problem and determining the scope of work. A detailed scope of work should be
presented in the appraisal to allow a reader to understand exactly what steps
and procedures were utilized by valuation experts in their analyses and FMV
determinations.

Appraisers must have a thorough understanding of which
rights were “given up”• or relinquished and which rights were retained by the
donor in order to properly value the conservation easement.

Valuation Date

The value of a conservation easement contribution is the
fair market value of the easement at the time of the contribution. Treas. Reg.
§ 1.170A-14(h)(3)(i). The qualified appraisal must state, among other things,
the date or expected date of the contribution. Treas. Reg. §
1.170A-13(c)(3)(ii)(C).

Fair Market Value (FMV)

The value of the donated easement must meet the definition
of FMV as defined by Treas. Reg. § 1.170A-1(c)(2):

The fair market value is the price at which the property
would change hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or sell and both having reasonable knowledge of
relevant facts.

A common error found in appraisals submitted for federal tax
purposes is that the FMV definition utilized in the appraisals is not correct.
Definitions from other sources, such as The Appraisal Foundation, Financial
Institutions Reform, Recovery and Enforcement Act or 1989 (FIRREA), or from an
appraisal organization, frequently are used. Those definitions, while similar,
differ from the definition in the Treasury Regulation because, for example, the
value

conclusion is tied to an exposure time. An appraisal
prepared based on an alternative FMV definition could affect the value of the
conservation easement and should not be used.

The FMV of the property must decrease as a result of the granting
of the conservation easement in order for a taxpayer to claim a charitable
contribution deduction. In some instances, the grant of a conservation easement
may not have a material effect on the value of the property. Treas. Reg. §
1.170A-14(h)(3)(ii).

Before and After Method

The best evidence of FMV of a conservation easement is the
sale price of easements comparable to the donated easement. An appraiser should
research the market to determine if there are any sales of comparable
easements; however, in most instances, there are no comparable easement sales.

If there are no comparable easement sales, the “before
and after” method of valuing a conservation easement is used.

FMV of the property before the easement Less: FMV of the
property after the easement Equals FMV of the easement

In essence, an appraiser must determine the highest and best
use (HBU) and the corresponding FMV of the subject property twice: first,
without regard to the conservation easement (“before”• value), and then again
after considering the specific restrictions imposed on the property by the
easement document (“after”• value).

In determining the “before”• value of the property, an
appraiser must consider the current use of the property but also objectively
assess the likelihood that the property would be developed absent the
conservation easement restriction. Existing zoning, conservation, historic
preservation, or other laws and restrictions may limit the property’s potential
HBU. Treas. Reg. § 1.170A-14(h)(3)(ii).

In determining the “after”• value of the property, an
appraiser must consider both the specific restrictions imposed by the
conservation easement being valued and the specific restrictions imposed by
easements on any “comparable”• properties.

Use of Flat Percentage Cannot Be Applied to Before Value

There is no standard value or percentage impact on the
“before”• value of the property due to the granting of a conservation easement.
Each conservation easement must be valued before and after the granting of the
easement, based on the particular facts and circumstances of that property, and
the value must be substantiated with a qualified appraisal.

The Internal Revenue Service will not accept an appraisal to
substantiate the FMV of a conservation easement if the appraisal merely values
the property before the donation and then

applies a set percentage thereto without explanation and
without reference to the specific attributes of the property and the easement
(I.R.S. CCA 200738013 (August 9, 2007)).

Contiguous Parcels

The amount of the charitable contribution deduction due to
the granting of a conservation easement covering a portion of a contiguous
property owned by the donor and the donor’s family (as defined in IRC
267(c)(4)) is the difference between the FMV of the entire contiguous parcel of
the property before and after the granting of the restriction. Treas. Reg. §
1.170A-14(h)(3)(i).

Section 267(c)(4) defines the term “family”• as including
only an individual’s “brothers and sisters (whether by the whole or half
blood), spouse, ancestors and lineal descendants.”• Parents, children,
grandparents, grand children, half-brothers and half-sisters are included in
the definition of family but cousins, nieces, nephews, in-laws, and step
relations are not included.

Example: John Smith owns a 1,000-acre farm. Mr. Smith
decides to put a conservation easement on the southern 500 acres. The entire
1,000 acres would need to be valued before and after the easement is imposed
because the same donor owns the property and the unencumbered parcel is
contiguous to the encumbered parcel.

In order to properly determine what properties should be
valued, an appraiser must identify and determine the ownership of any
contiguous parcels at the outset of the appraisal assignment. Next, the
appraiser must assess whether the owners of any contiguous parcels are the
donor or donor’s family as defined in IRC § 267(c)(4).

Application of the contiguous parcel rules can be complex.
IRS appraisers should contact a program analyst or Counsel for guidance.

Enhancement Rule

An appraiser must also consider any enhancement to the value
of any other property owned by the donor or a related person resulting from the
conservation easement. The amount of the conservation contribution deduction is
reduced by the amount of the increase in the value of the other property,
whether or not that other property is contiguous. Treas. Reg. §
1.170A-14(h)(3)(i).

A related person, for purposes of applying the enhancement
rule, is defined in IRC §§ 267(b) or 707(b). Application of the related party
rules can be complex. IRS appraisers should contact a program analyst or
Counsel for guidance.

There are two important distinctions between the contiguous
parcel and the enhancement rules. First, the contiguous rule applies only to
contiguous property, but the enhancement rule can apply to both contiguous and
noncontiguous property. Second, the contiguous rule only applies to contiguous
property owned by the donor or the donor’s family (as defined in IRC §
267(c)(4), but the enhancement rule applies to contiguous or noncontiguous
property owned by a related

party under §§ 267(b) or 707(b), which are broader.
Therefore, the appraiser must consider the impact the easement has on both
contiguous and noncontiguous parcels.

Appraisers must inquire about contiguous or nearby
properties owned by the donor, the donor’s family, and other related parties or
entities and consider any possible enhancement.

Example: John Smith owns a 1,000-acre farm. Mr. Smith
decides to put a conservation easement on the southern 500 acres. The entire
1,000-acre parcel would need to be valued based on the application of the
contiguous parcel rule. John Smith also owns a noncontiguous 50-acre parcel
located within a quarter mile of the subject property. Because of the conservation
easement, the 50-acre parcel will have superior views of the river that lies
beyond the 500-acre parcel. As a result, the 50-acre parcel would need to be
valued and the conservation easement contribution would be reduced by the
amount of the increase in value (if any) to the 50-acre parcel.

Application of the enhancement rules can be complex. IRS
appraisers should contact a program analyst or Counsel for guidance.

Market Analysis

Market analysis is defined as a process for examining the
demand for and supply of a property type and the geographic market area for
that property type. This is a critical step in the highest and best use
analysis. The six-step market analysis process described below is data required
for the four test criteria (physically possible, legally permissible,
financially feasible and maximally productive). See The Appraisal of Real
Estate, 13th Edition, The Appraisal Institute, Chicago, Ill., 2008, page 279.

An appraiser can use current and historical market
conditions to infer future supply and demand conditions. In addition, to
forecast subject-specific supply, demand, absorption and capture over a
property’s projected holding period, the appraiser can augment the analysis of
current and historical market conditions with fundamental analysis. Given the
fact, that, in the majority of conservation easement cases, development of the
property has not taken place, then there should be more emphasis on a
fundamental analysis.

Most market analysis can be performed using a six-step process:

Step 1-Property Productivity Analysis: Physical, Legal and
Location Attributes Step 2-Market Delineation: Competitive Market Area Step
3-Demand Analysis: Demand Segmentation, Historical Growth & Demand Drivers
Step 4-Supply Analysis: Existing, Under Construction and Proposed Competition
Step 5-Interaction of Supply and Demand: Competitive and Residual Demand Step
6-Forecast Subject Capture: Reconciliation of Inferred and Fundamental
Forecasts

Layman’s terms: The appraiser analyses how competitive the
subject is or will be in its market area. The current and future demand for
similar properties is estimated and compared to the estimated current and
future supply within the market area.

Appraisers using a residential subdivision method may not
always adequately quantify the market demand and supply for the proposed lots
and/or houses. The lack of market analysis for demand and supply may be an
issue in some conversion of warehouse properties to residential condominiums
appraisals. The Appraisal of Real Estate, 13th Edition, The Appraisal
Institute, Chicago, Ill, 2008, pages 173 – 203 (Chapter 9) provides a detailed
discussion on completing a market analysis for a variety of property types and
serves as a good reference tool.

When appraisers fail to follow the six-step process, and do
not support demand, supply and a capture rate for the subject property, it can
lead to erroneous conclusions in the highest and best use analysis.

Highest and Best Use (HBU)

The determination of the property’s highest and best use
(HBU) is vital to the valuation of any real estate including conservation
easements.

All professional appraisal organizations recognize the HBU
of the property is a key element to a proper valuation. To qualify as the HBU,
a use must satisfy four criteria:

 Physically Possible – The land must be able to accommodate
the size and shape of the ideal improvement or in terms that are more common:
What uses of the subject site are physically possible?

 Legally Permissible – A property use that is either currently
allowed or most probably allowable under applicable laws and regulations. What
uses of the subject site are permitted by zoning, deed restrictions,
environment restrictions, and government restrictions?

 Financial Feasibility – The ability of a property to
generate sufficient income to support the use for which it was designed. Among
those uses that are physically possible and legally permissible, which uses
will produce a net return to the owner?

 Maximally Productive – The selected use must yield the
highest value of the possible uses. Among the feasible uses, which use will
produce the highest net return or the highest present worth?

An appraiser’s HBU analysis and conclusion should be
documented in the appraisal report with a comprehensive discussion supported by
relevant market data or other information sources to adequately support their
conclusions.

At times, an appraiser may rely in part on the analysis by
another professional such as a land planner or geologist , however, an
appraiser is required by generally accepted appraisal standards to exercise due
diligence with respect to the assumptions put forth by the other professional.
An appraiser must have a reasonable basis to believe that the other
professional’s work product is credible and should disclose such reliance.

Methodology

Treas. Reg. § 1.170A-14(h)(3)(i) and (ii) allow for two
different types of valuation: direct comparison or indirect analysis.

Direct comparison is to analyze sales of comparable
properties to arrive at a conclusion as to value. A direct comparison is based
on direct sales of easements meaning the price paid by purchases of easements
having the same or similar restrictions.

Conservation easements are sold infrequently and even if the
appraiser is able to identify sales of easements they may not be appropriate
comparables, accordingly, most conservation easements are valued by indirect
analysis.

There are three recognized valuation methodologies within
the appraisal industry:

 Sales Comparison Approach (SCA)

 Cost Approach (CA)

 Income Capitalization Approach (ICA)

All three approaches should be considered in every appraisal
assignment. This does not mean that all three approaches need to be applied.

Example: If the appraiser is valuing the impact of granting
a conservation façade easement on a single-family home in an area in which
single-family homes are typically not rental income properties, then it is not
necessary to complete the income capitalization approach. Generally, a
statement that due to the lack of market information the income capitalization
approach was not completed would be sufficient. Given the age of the property’s
improvements (must be at least 50 years old to qualify), it is also acceptable
if the cost approach is not completed on the subject property due to the
subjective nature of the depreciation estimate (if a similar statement is made
in the appraisal).

The following brief descriptions of the three approaches
(i.e., Sales, Cost and Income Capitalization Approaches) were taken from The
Dictionary of Real Estate Appraisal, Fifth Edition, which was published by The
Appraisal Institute of Chicago, Illinois copyright 2010.

Sales Comparison Approach

A set of procedures in which a value indication is derived
by comparing the property being appraised to similar properties that have been
sold recently, then applying appropriate units of comparison and making
adjustments to the sale prices of the comparables based on the elements of
comparison. The sales comparison approach is the most common and preferred
method of land valuation when an adequate supply of comparable sales are
available.

Elements of comparison are defined by The Appraisal of Real
Estate, 13th Edition, The Appraisal Institute, Chicago, Ill, 2008, page 309 as
“the characteristics or attributes of properties

and transactions that help explain the variances in the
prices paid for real property.”• They are divided into two categories:
transactional adjustments and property adjustments.

Transactional adjustments are:

 Real property rights conveyed

 Financing terms

 Conditions of sale

 Expenditures made immediately after purchase

 Market conditions

These adjustments are “generally applied in the order
listed”• and are successive.

Property adjustments are:

 Location

 Physical characteristics

 Economic characteristics

 Use

 Non-realty components of value.

Property adjustments are usually applied after the
transactional adjustments, but in no particular order and are not successive.

Layman’s terms: The appraiser compares the subject property
to recent sales of sold properties. Adjustments are made to the sales to
account for differences between the properties to estimate the FMV of the
subject property. If there are sufficient sales, this is the preferred
valuation methodology for land.

Cost Approach

A set of procedures through which a value indication is
derived for the fee simple interest in a property by estimating the current
cost to construct a reproduction of (or replacement for) the existing
structure, including an entrepreneurial incentive, deducting the depreciation
from the total cost, and adding the estimated land value. Improvement cost
estimates can be done with national cost manuals (e.g., Marshall Valuation
Service Manual), builder cost estimates or market extraction. National cost
manuals provide a cost new for the improvements and therefore in utilizing
these manuals, the valuation must include an analysis for all forms of
depreciation present in the improvements.

Layman’s terms: The appraiser estimates the FMV of the subject
property’s improvements “as is”• and adds the depreciated improvement value to
the land value to estimate the FMV for the entire property. This approach is
typically not utilized for vacant land because there are no improvements to
value.

Income Capitalization Approach

A set of procedures through which an appraiser derives a
value indication for an income-producing property (i.e., rental property) by
converting its anticipated benefits (cash flows and reversion) into property
value. This conversion can be accomplished in two ways. One year’s net income
expectancy can be capitalized at a market-derived capitalization rate.
Alternatively, the annual cash flows for the holding period and the reversion
can be discounted at a specified yield rate.

Layman’s terms: The FMV of the subject property is estimated
based on the anticipated net income to the property. The appraiser estimates
the potential gross income and subtracts vacancy and collection loss as well as
operating expenses to estimate the net income to the property. If one year’s
net income is estimated then that income is capitalized via a market-derived
capitalization rate to provide an indication of the FMV of the subject
property. If multiple years’ net income is estimated, then the cash flows and
reversion are discounted at a specified yield rate to provide a FMV indication.

Subdivision Development Method

In the valuation of land conservation easements, many
appraisals include a land residual analysis using a Subdivision Development
Method. Although appraisers have referred to this approach as a different
valuation methodology, this approach is an adaptation (or subset) of the income
capitalization approach. The reason appraisers refer to it as “another”•
approach is because the analysis utilizes a combination of both the sales
comparison and cost approaches described above.

This method estimates land value assuming that subdivision
and development of the property is the HBU of the parcel of land being
appraised. When all direct, indirect costs, and entrepreneurial incentive
(expected rate of return on investment) are deducted from the anticipated gross
sales price of the finished lots, the resultant net sales proceeds are then
discounted to present value at a market-derived rate over the development and
absorption period to indicate the value of the raw land (The Dictionary of Real
Estate Appraisal, Fifth Edition, The Appraisal Institute of Chicago, Illinois
copyright 2010, pages 188).

Layman’s terms: The FMV of the subject property is estimated
by first estimating what the “finished”• lots would sell for in the market
place. Costs, including anticipated profit, are then deducted to estimate the
anticipated net income to the property. The projected net income (i.e., cash
flow) is discounted (for the time necessary to get approvals, finish the lots
and sell the lots) at a specified discount rate (a/k/a yield rate) to provide a
FMV indication.

Example: Parcel C is a 100-acre parcel that is zoned
residential and the appraiser has concluded that the HBU of the property is for
a 50 lot residential subdivision. Typically, the appraiser will use the sales
comparison approach to determine the market value of the “finished”• lots. The
appraisal would provide information on similar projects in order to estimate
the absorption period to sell the lots. Next, the appraiser deducts the costs
to improve the property (development costs) necessary for the subject property
to attain the finished lot status that was valued. Finally, the cash flows over
the absorption period are discounted back to the valuation date (this accounts

for the time get the approvals, take the lots to the
finished lot stage, and to sell all of the lots) to provide an estimate of the
present value of the subject property as raw land.

The Subdivision Development Method is a complex procedure
and requires a significant amount of data such as development costs, profit
margins, sales projections and the pricing of developed lots. It is typically
completed using a Discounted Cash Flow (DCF) analysis. The Appraisal of Real
Estate, 13th Edition, The Appraisal Institute, Chicago, Ill, 2008, page 375
states: “The application of the DCF analysis is useful as a method for checking
the reasonableness of value indications derived from other methods applied to
the estimate the value of vacant land with development potential.”•

The Uniform Appraisal Standards for Federal Land
Acquisitions (UASFLA) (which is commonly referred to as Yellow Book), was
developed by Interagency Land Acquisition Conference as a guide for appraisers
performing appraisals for federal land acquisition. The use of the subdivision
development method is discussed on page 45 of the Yellow Book stating, “When
comparable sales are available with which to accurately estimate the property’s
market value, the development approach should not be relied upon as the primary
indicator of value, as it is considerably more prone to error.”• UASFLA goes on
to state the approach can be used as a test of both the HBU conclusion and to
support a value indicated by the sales comparison approach. Thus if this
approach appears in an appraisal, one should carefully research all of the
assumptions that were put forth within the analysis for reasonableness.

Although the Tax Courts have not specifically addressed the
issue of utilizing the Subdivision Development Method, there are several
decisions in the Federal Courts, which provide some insight. The Supreme Court
stated in Olson v. United States, 292 U.S. 246, 257 (1934) that “Elements
affecting value that depend upon events or combinations of occurrences which,
while within the realm of possibility, are not fairly shown to be reasonably
probable, should be excluded from consideration.”• This position was also
brought forth in United States v. 320.0 Acres of Land, 605 F.2d 762, 814-820
(5th Cir. 1979). In United States v. 47.3096 Acres of Land, 583 F.2d 270, 272
(6th Cir. 1978) the court stated “that the property was “˜needed or likely to
needed in the reasonably near future’ for residential subdivision.”•

Since there are many variables involved in this type of
analysis, there is a greater chance of errors, which could result in an
incorrect valuation. Some common errors include:

 Failure to account for time to obtain necessary project
approval.

 Failure to recognize time to put infrastructure in place.

 Failure to include the cost of the infrastructure.

 Lack of recognition of the time necessary to sell the
units (absorption) or lack of support for the absorption estimate.

 Failure to include developer’s profit.

 Lack of recognition of existing competing properties as
well as properties that are still in the planning stage.

 Inadequate assessment of the risk associated with the
development.

Transferable Development Rights (TDRs)

A transferable development right (TDR) is a development
right held by the landowner that can be transferred by the landowner to another
location. A number of states, counties and cities have established TDR
programs. These programs are used to manage land development through the exchange
of zoning privileges allowing property owners to separate development rights
from the underlying property and sell them to purchasers who want to increase
the density of development in higher density areas.

For example, in New York City, an owner of a building with
TDRs may be able to transfer or sell unused development rights to other
building sites subject to the program restrictions.

A transfer of development rights by the owner of the
property is not a transfer of the owner’s entire interest in the property and
may not qualify for a charitable contribution per IRC § 170(f)(3). Examiners
and IRS appraisers should consult with Counsel if the conservation easement
case involves TDRs.

Chapter 10: Preplanning the Examination Chapter 10:
Preplanning the Examination Chapter 10: Preplanning the Examination Chapter 10:
Preplanning the Examination Chapter 10: Preplanning the Examination Chapter 10:
Preplanning the Examination Chapter 10: Preplanning the Examination Chapter 10:
Preplanning the Examination Chapter 10: Preplanning the Examination Chapter 10:
Preplanning the Examination

Overview

IRM 4.10, Pre-contact Responsibilities, requires Examiners
to perform a pre-contact analysis, including a review of the income tax return,
any attachments to the return, and internal and external sources of
information.

Review of Return

A taxpayer must itemize to claim a deduction for a
conservation easement. A conservation easement deduction is reported on
Schedule A, Itemized Deductions (PDF), Line 17, “Other than by cash or check.”•
Any carryover of charitable contributions originating from earlier tax years
appears on the “Carryover from Prior Year,”• Line 18.

Audit Tip: Examiners should determine at the beginning of
the examination the tax year of the contribution. If the amount claimed on the
return is a carryover from an earlier tax year, the original return including
all attachments must be secured. This is important 1) to verify compliance with
substantiation requirements, and 2) to ensure that all tax years are included
in the examination to the extent the statute of limitations is open.

Form 8283

Form 8283, Noncash Charitable Contributions (PDF), referred to
in the Deficit Reduction Act and Treas. Reg. 1.170A-13(c)(4) as the “appraisal
summary,”• is the starting point to gather information about the conservation
easement deduction.

This form must be completed and attached to the return for
all noncash charitable contribution deductions greater than $500. IRC §
170(f)(11)(A) and Treas. Reg. § 1.170A-13(b)(3). For

noncash charitable contribution deductions in excess of
$5,000, the taxpayer must complete Section B, of the Form 8283. IRC §
170(f)(11)(B) and Treas. Reg. § 1.170A-13(c).

If the donation originates from a flow-through entity (such
as S-corporation or partnership), the partner or shareholder must include a
copy of the entity’s Form 8283 with the return. Treas. Reg. §
1.170A-13(c)(4)(iv)(G).

Close inspection of Form 8283 may reveal preliminary
indications of an improper deduction or overvalued conservation easement such
as:

 Incomplete or missing information such as an inadequate
description of the property, lack of acquisition date, or basis in the property.

 Missing appraiser or donee acknowledgments.

 Inconsistent dates when compared to the appraisal or other
attached documents.

 A short time period between the acquisition of the
property and the donation date.

 High valuation of the easement as compared to the basis of
the underlying property, in light of holding period and the market conditions
for the relevant market.

 High valuation of the easement in light of the total
acreage of the underlying land.

 Use of an appraiser who does not generally perform
appraisals where the easement is located.

Audit Tip: Completion of the appraisal summary (Form 8283)
does not satisfy the contemporaneous written acknowledgment requirement
outlined in IRC § 170(f)(8). Failure to comply with the contemporaneous written
acknowledgment requirement will result in disallowance of the charitable
contribution deduction.

Signature Requirements

Part II, of Section B, Taxpayer (Donor) Statement is not
relevant unless the appraised value is $500 or less.

Part III of Section B, Declaration of Appraiser, must be
signed and dated by the qualified appraiser for donations in excess of $5,000.
The signature date does not need to be the same date as the date of the
contribution.

Part IV of Section B, Donee Acknowledgment, must be signed
by an official authorized to sign the tax returns of the donee organization or
a person specifically designated to sign Form 8283. Examiners should look for
incomplete or improperly completed donee acknowledgments and determine if there
are any date discrepancies with other available information.

Audit Tip: If either the appraiser or donee signature is
missing, Examiners should solicit the signature on a copy of the Form 8283 (to
be submitted within 90 days of the IRS request) and determine whether such
failure was due to reasonable cause under IRC § 170(f)(11)(A)(ii)(II) or a good
faith omission under Treas. Reg. § 1.170A-13(c)(4)(iv)(H). If not due to
reasonable cause or good faith omission, the lack of signatures on the original
Form 8283 is a basis for disallowance of the charitable contribution.

Return Attachments

A qualified appraisal is required to be attached to the
return if the deduction claimed (1) exceeds $500,000, or (2) regardless of the
dollar amount claimed, if the deduction relates to a contribution of a façade
easement in tax years after August 17, 2006, on a building or structure in a
registered historic district.

Note: The special rule for façade easements in tax years
after August 17, 2006 does not apply to properties listed on the National
Register.

See Chapter 7 for guidance on qualified appraisals.

If a qualified appraisal was not attached to the original
return claiming the conservation easement, the charitable contribution may be
disallowed for failing to meet the IRC 170(f)(11) requirements. See IRC §
170(f)(11)(A)(ii)(II) and Treas. Reg. § 1.170A-13(c)(4)(iv)(H) for limited
exceptions to this rule.

If the Examiner does not have the original return or has
been assigned a carryover tax year, the original return must be ordered from
the Service Center using SC 45 to verify compliance with the requirement to
attach the appraisal.

If a return is filed electronically, any attachments
including the appraisal must be filed with the Form 8453, U.S. Individual
Income Tax Transmittal (PDF) for an IRS e-file Return. The Examiner will need
to request the original Form 8453 with attachments to determine if the taxpayer
has met the substantiation requirements.

IDRS command code TRDBV will show whether the Form 8453 was
filed and the related Document Locator Number (DLN). The Form 8283 can be
secured using command code ESTAB with the identified DLN. If the TRDBV does not
show the filing of a Form 8453, the IDRS print should be included in the
examiner’s work papers to demonstrate that there is no record of filing the
required return attachments.

In some cases, taxpayers attach baseline studies,
correspondence or other documents related to the easement donation. This
information should be reviewed for unusual items or inconsistencies and
ultimately compared to actual source documents.

Other Tax Issues

The Examiner is responsible for determining the scope of the
audit and should be alert to other potential tax issues on the tax return,
which may or may not be related to the conservation easement deduction.

Some examples of potential issues related to the
conservation easement donation are income generated from the sale of state tax
credits and recapture of rehabilitation tax credits.

IRM 4.10.4.3, Minimum Requirements for Examination of
Income, requires Examiners to consider gross income during the examination of
all income tax returns regardless of the type of return filed by the taxpayer.
All deviations from minimum probes need to be documented and approved by the
group manager.

TEFRA Considerations

An individual’s income tax return may be selected for examination
based on a large noncash contribution or carryover. Examiners must determine as
quickly as possible whether the donation originated from a partnership or
limited liability company (LLC) electing tax treatment as a partnership. This
information may not be readily available by inspection of the return
particularly for carryovers into subsequent tax years.

The determination of the tax treatment of partnership items
is made at the partnership level. If the easement donation was made by a
partnership or LLC treated as a partnership, the charitable contribution is a
partnership item. An adjustment to the conservation charitable contribution
cannot be proposed without conducting an examination of the originating donor
entity (i.e., Form 1065 entity). If the entity is a TEFRA entity, the unified
audit procedures for partnership proceedings must be followed. These procedures
may present additional administrative complexities due to statute concerns,
involvement of multiple tiers of ownership, and the location of the key case
entity and other partnership investors.

In some instances, the originating partnership or LLC return
may have a statute that is less than the 12-month minimum that is required to
initiate an examination without securing SB/SE Area Director or the LB & I
Director of Field Operations (DFO) approval (IRM 4.31.2.2.1).

It is also possible that the minimum assessment period for
partnership items per IRC § 6229 may have expired. While the government can
best protect its interest by extending the IRC § 6229 period of assessment
before it expires and conducting the partnership proceeding that includes all
the partners, the government is not precluded from conducting a partnership
proceeding if the IRC § 6501 assessment period for any of the partners is still
open.

Examiners should consult with their local TEFRA Coordinator
for guidance on TEFRA examinations. A list of current coordinators can be found
on MySB/SE, Issues and Procedures, TEFRA.

Internal Sources of Information

Information available from internal sources may be useful in
preplanning for the examination, including the Conservation Easement issue Web
page on MySB/SE, IDRS and contacts with program analysts and the Office of
Professional Responsibility.

IRS Intranet

Training materials, job aids, recent court decisions and
other reference materials on conservation easements can be found on MySB/SE,
Issues and Procedures, under “Conservation Easements.”• Examiners should refer
to the Web page for updated information.

Program Analysts

Examiners are encouraged to contact program analysts (PAs)
assigned to this issue to discuss case development as early as possible in the
examination. A list of PAs assigned to conservation easements is available on
the conservation easement web page on MySB/SE under “Contacts.”• PAs can help
with understanding of the statutory requirements, analysis of the documents,
review of legal documents, and report writing.

Integrated Data Retrieval System – IDRS

Examiners should review all available IDRS information to
identify any additional donations and carryovers. A review of the taxpayer’s
filing history over several years can provide insight into the taxpayer’s
contribution history.

Reviewing the taxpayer’s Information Returns Processing
(IRP) documents and securing a link analysis (Yk1) may reveal related
flow-through entities associated with the easement transaction.

Façade Filing Fee Verification

For certain contributions of façade easements on or after
February 13, 2007, donors must pay a $500 filing fee to the U.S. Treasury. This
fee is required for donations of easements on buildings in registered historic
districts if a deduction of more than $10,000 is claimed. IRC § 170(f)(13). The
fee is to be used to enforce the provisions of IRC § 170(h).

No deduction is allowed unless the taxpayer includes the fee
with the return. IRC § 170(f)(13)(A). Payment is transmitted to the IRS using
Form 8283V, Payment Voucher for Filing Fee under Section 170(f)(13) (PDF).

IDRS reports IMFOLT (individual returns) and BMFOLT
(corporate/partnership returns) will show a TC (Transaction Code) 971 with AC
(Action Code) 670 to identify the payment of the filing fee. Examiners can also
contact a program analyst for confirmation of fee payment.

Publication 78

Publication 78, Cumulative List of Organizations described
in Section 170(c) of the Internal Revenue Code of 1986, should be consulted to
verify whether the organization has tax-exempt status. An online searchable
version can be found IRS.gov. Click on “Charities and Nonprofits,”• then “Search
for Charities”• to search for qualified organizations by name and city.
Examiners should also be aware that a listing in Publication 78 is not
definitive of an organization’s qualification for exempt status.

Churches and Federal, State, and local governments generally
are eligible to receive tax-deductible contributions even though they are not
listed in Publication 78. In addition, a local organization that is exempt
under a group ruling may not be listed, as it may be a local arm or subsidiary
of a national conservation organization.

Inclusion in Publication 78 alone is not conclusive that the
organization is an organization eligible to receive a conservation easement
contribution. The donee organization must have the commitment to protect the
conservation purpose and have the resources to enforce the conservation
restrictions.

See Chapter 4 for detailed discussion on qualified
organization requirements.

Office of Professional Responsibility

Examiners can search the Office of Professional
Responsibility intranet Web page for any previous disciplinary actions against
the appraiser or the return preparer. The presence of prior sanctions suggests
a need for extra scrutiny by the examiner.

External Sources of Information

Examination of a charitable contribution deduction for a
conservation easement is fact intensive requiring examiners to gather and
analyze information to determine whether the charitable contribution deduction
is allowable. Review of documents from external sources such as the Internet,
public records, and the National Park Service in advance of taxpayer contact
can help streamline the examination process.

Internet Research

The Internet (using Google or other similar search engine) can
be an excellent source of background information relevant to the taxpayer,
donee organization and appraiser.

Taxpayer

Examiners should search the Internet for information on the
taxpayer’s business, personal history, reputation in the community, and involvement
with conservation issues and organizations.

A particular easement donation may have received local
newspaper coverage at the time of the donation. News articles may provide
evidence to support charitable intent, quid pro quo, transactions between
related parties, or the donor’s basis (e.g., if the property constitutes
inventory in the hands of the taxpayer).

Donee Organization

Guidestar.org provides tax returns of charitable
organizations and other important information relating to the organizations.
Examiners will need to register online to access the information.

Returns provided on Guidestar, however, generally do not
include schedules of contributors. The Economic Research Institute also can be
used to research charitable organizations.

An Internet search of the donee organization may provide
relevant information on the organization. Most organizations have their own Web
sites, which provide a wealth of information, especially regarding their
charitable purpose and goals.

This research may reveal relationships between the donor and
donee organization. Transactions between related parties by either position or
business activity must be scrutinized closely.

Audit Tip: Taxpayers have been known to create a
“self-serving” donee organization solely for the purpose of accepting
their own easement. These organizations may lack charitable purpose or be
engaged in self-dealing. If there is a question or concern as to the operations
of the organization, examiners should submit a referral to Tax Exempt and Governmental
Entities (TEGE).

Appraiser

Examiners can obtain information about the appraiser and
appraisal firm such as their professional credentials, expertise with respect
to conservation easements, and past business dealings with the donor or donee
organization. This information is helpful in determining if the appraiser is a
“qualified appraiser” and may provide some insight into any business
history with the taxpayer or donee organization.

License information regarding jurisdictions, history and
disciplinary actions can be found on The Appraisal Foundation Web page. You can
search for information on a specific appraiser by selecting the “find an
appraiser”• button or utilize this link: Find an Appraiser Web page. Some
states also provide appraisal licensing information online. Examiners or IRS
appraisers can contact the various state boards by telephone to determine if
there are any past or pending disciplinary actions against the appraiser.

 

Audit Tip: If the appraisal is attached to the return, the
appraiser’s professional qualifications should be included as part of the
appraisal. Information found on the Internet should be compared to the
information provided with the return.

Public Records

Examiners must secure directly from the appropriate
recordation office the conservation easement deed, any subordination
agreements, and other pertinent documents that are recorded under State law. If
online research is not available, the Examiner or the IRS appraiser will need
to travel to the recorder’s office to obtain this information. Use of research
services such as Accurint alone will not be sufficient in these examinations.

Audit Tip: Until the easement is recorded, the easement is
not enforceable in perpetuity. Treas. Reg. § 1.170A-14(g)(1). In some cases, taxpayers
claim the donation in the wrong tax year.

Examiners should determine if there were any preexisting
restrictions on the property imposed by local or state ordinances, zoning or
the rules of the historic districts. There may be no loss in value as a result
of the granting of the easement if the easement does not impose new or expanded
restrictions on the property. IRS appraisers have significant experience with
this type of research and will generally address this aspect as part of their
fieldwork.

In addition to obtaining copies of the recorded instruments,
examiners should research the property’s ownership, sales and mortgage history.
Be alert to recent sales or mortgages on the property that may provide insight
into the easement value.

How title is held to the property may affect the amount that
can be claimed as a charitable contribution by a taxpayer. In addition, the IRS
appraiser will need to know the property owner of the eased property, any
contiguous properties and any other properties owned by the taxpayer in order
to properly apply the contiguous/enhancement rules in valuing the property.
Examiners should verify through interviews and review of public records in the
county the property is located to verify ownership on the date of the contribution.

Many conservation easements originate from flow-through
entities (i.e., S-corporations and partnerships). The allocation of the
contributions to the shareholders or partners is reported on Form K-1.
Examiners should verify the percentage of ownership and determine if the
contribution amount was properly allocated.

National Park Service

For donations of easements on certified historic structures,
examiners must verify that the property is a certified historic structure and
that the status was obtained by the due date of the return including
extensions. IRC § 170(h)(4)(C) and Treas. Reg. § 1.170A-14(d)(5)(iii). The
taxpayer will generally provide this information in response to the initial
information document request (IDR).

If a building is individually listed on The National
Register of Historic Places, no certification is required from the National
Park Service Historic Preservation Division.

Audit Tip: To obtain certification from the National Park
Service, the taxpayer would have submitted Form 10-168 (PDF) to the Historic
Preservation Division for certification that the building contributes to the
district. Examiners should obtain a copy of the certification and any related
documents from the taxpayer or the National Park Service.

Interviews

As in all income tax examinations, the interview is an
important component of a quality examination. The interview is the first step
in securing the necessary background information to evaluate the claimed
deduction.

The best time for interviewing the taxpayer is usually after
reviewing the easement documents and assignment of an IRS appraiser to the
case. If possible, the Examiner and IRS appraiser should jointly interview the
taxpayer.

Unless the representative has first-hand knowledge of the
conservation easement transaction, Examiners will need to interview the
taxpayer. Do not provide written questions to the representative to ask the
taxpayer. In some instances, it may be necessary to summons the taxpayer.

Information Document Requests

A sample Information Document Request (IDR can be found on
the conservation easement MySB/SE web page under the “Job Aids”• tab and on
RGS. The IDR should be modified to meet the specific needs of the examination
requesting only relevant information. Documents from the taxpayer are necessary
not only to verify the easement donation, but also to collect initial
documentation of the fair market value (FMV) of the easement.

Securing documents is only the beginning of the examination
of a conservation easement deduction. A final determination cannot be made
without careful review of the documents and background information,
coordination with LB & I Engineering on the valuation, and in many cases
third party contacts.

Valuation Expert Involvement

Valuation of the conservation easement is an important part
of a conservation easement deduction examination. A referral to LB & I
Engineering for an IRS appraiser or an outside expert will generally be
required. Examiners and the IRS appraiser need to work together to avoid duplication
of effort, share information, and rely on each person’s specific job skills to
fully develop the case.

Note: The Examiner has primary responsibility for the
non-valuation aspects of the issue and must not suspend or delay work on the
income tax case pending receipt of a valuation report.

Referral to LB & I Engineering

A referral is made through the Specialist Referral System
(SRS). Referrals to LB & I Engineering should be considered in all
conservation easement cases, even if the case falls outside of the mandatory
referral specifications. See the SRS web page for current referral criteria.

The referral must be made early in the examination process
to allow sufficient time for LB & I Engineering input. The Examiner should
inform the taxpayer and their Representative of an IRS appraiser’s
participation and expected examination timeframes.

Examiners should promptly provide the IRS appraiser with:

 A copy of the return or pertinent part of the return

 Form 8283, including attachments

 Copy of the appraisal (if attached or once received)

 Other pertinent information attached to the return

 A recorded copy of easement deed including any attachments
and correspondence

 Baseline study of the property (if attached or once
received)

Referral Outcomes

LB & I Engineering may accept or decline in response to
the referral depending on the dollar amount of the easement, available staffing
resources and other factors. Another option is a consultation, where the IRS
appraiser will provide informal feedback to the Examiner as to the
reasonableness and adequacy of the taxpayer’s appraisal.

If the referral is accepted, a meeting should be scheduled
with the assigned IRS appraiser to discuss duties and timeframes for
completion. This meeting should be documented in memo form. An action plan
template is available on the conservation easement web page on MySB/SE under
“Job Aids, Engineering Coordination”• to help with allocation of
responsibilities. The IRS appraiser and Examiner should coordinate their
actions throughout the examination.

Generally, the scope of the IRS appraiser’s work should be
limited to valuation and qualified appraisal issues, and the Examiner will
handle the legal issues under IRC § 170. However, there is some overlap of
responsibilities. For example, the inspection of the property and interview of
the taxpayer are important for both the IRS appraiser and the Examiner and
should (to the extent possible) be conducted jointly.

If funds are available, LB & I Engineering may hire an
outside fee appraiser.

Examiners can seek assistance from program analysts to
discuss alternatives and assistance in resolution of any issues with LB & I
Engineering.

LB & I Engineering Products

The IRS appraiser will generally prepare an “appraisal
review with an opinion of value, which is a detailed review of the taxpayer’s
appraisal and includes an estimation of the fair market value of the
conservation easement.

In some cases, the IRS appraiser may provide only an
“appraisal review,”• which is simply a critique of completeness and reliability
of the taxpayer’s appraisal without determining the fair market value of the
conservation easement. In other cases, the IRS appraiser may elect to complete
an appraisal in lieu of completing a review with an opinion of value report.

Outside Experts

The IRS utilizes outside valuation experts if funds are
available. Requests for use of an outside expert are made using the SRS
referral process.

An outside fee appraiser must be approved through the IRS
procurement process. LB & I Engineering is responsible for working with the
Contracting Officer Technical Representative (COTR) to identify experts,
solicit bids, arranging for background investigations and execute the contract.

The outside expert reports are limited to valuation of the
conservation easement so Examiners will need to address the legal issues under
IRC § 170.

Consultation with Counsel

Because examination of a conservation easement deduction
involves review of a number of legal documents, Examiners will need to consult
with Counsel. A list of Counsel assigned to conservation easements is available
on MySB/SE under “Contacts.”•

Counsel should be engaged early in the examination to assist
with review of the legal documents for areas of noncompliance, particularly for
issues such as conservation purpose, inconsistent use of the property,
perpetuity, subordination and allocation of proceeds.

Examiners will need to be alert to court decisions that
could affect their examination. Recently decided cases relevant to the
conservation easement issue can be found on MySB/SE.

Coordination with TEGE

The Examiner should determine whether the donee organization
is or has been under examination by TEGE. If so, the Examiner should contact
the Exempt Organization (EO) Examiner assigned to the case to obtain pertinent
information and to coordinate examination activities, as appropriate.

The EO Examiner can assist in securing records from the
donee organization and provide detailed information on the organization.
Coordination with TEGE avoids duplication of effort and unnecessary contacts
with the donee organization.

During the examination, the Examiner may need to consider a
referral to TEGE for examination of the donee organization. Some factors that
may warrant a referral include:

 False or misleading statements by the donee organization
regarding the tax requirements or valuation of contributions of conservation
easements.

 Evidence of undue influence on the taxpayer’s appraiser by
the donee organization.

 Presence of related party transactions between donor and
the donee organization.

 Lack of any charitable activity by the donee organization,
or activities contrary to its stated charitable purpose.

 Use of a related “for-profit” business to
process easement donations.

 Information indicating that the donor’s conservation
contribution lacked a “conservation purpose”• for purposes of section 170(h)
could also have a bearing on the donee

organization’s exempt status, particularly if it is accepted
other similar conservation contributions that lack a conservation purpose.

Examiners can make referrals to TEGE using the SRS referral
process.

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Overview

Conservation easement examinations are very challenging
cases requiring substantial factual development and review of legal documents.
A team approach (working with LB & I Engineering, Counsel and program
analysts) is the most effective way to conduct these examinations.

Examiners will need to look beyond information provided on
the tax return and analyze the substance of the transaction rather than the
mere form. Examiners must employ investigative skills to identify any omissions
or discrepancies of material facts.

During an examination, the examiner will obtain
documentation, conduct interviews of the taxpayer and third parties and inspect
the property encumbered by the easement. The examiner must evaluate all of this
information to determine if the taxpayer meets the:

 General statutory requirements for charitable
contributions per IRC § 170(a).

 Specific statutory requirements for qualified conservation
contributions per IRC § 170(h) and Treas. Reg. § 1.170A-14, including
compliance with one or more of the conservation purposes listed in IRC §
170(h)(4)(A).

 Contemporaneous written acknowledgment requirement under
IRC § 170(f)(8).

 Substantiation requirements and, specifically, the
qualified appraisal and appraiser requirements in IRC § 170(f)(11), Notice
2006-96, and Treas. Reg. § 1.170A-13.

Interviews

As with all examinations, interviewing the taxpayer who
donated the conservation easement is an important first step in the development
of facts. The interview provides important information regarding the
taxpayer’s:

 Intent in making the easement donation

 Understanding of the transaction

 Efforts to comply with the statutory requirements

 Due diligence in obtaining a correct appraisal

If possible, the examiner and IRS appraiser should conduct a
joint interview. Review of the conservation easement deed, baseline study and
the taxpayer’s appraisal, prior to the interview,

will help the Examiner and IRS appraiser carry out a focused
interview. In some cases, more than one interview may be required to gather all
relevant facts.

Sample interview questions are found on the “Job Aids”• tab
on the conservation easement MySB/SE Web page. The list of questions is not
all-inclusive and should be modified to address the specific facts of the case.
These questions are not intended to be utilized as a check sheet but rather as
a basis to assemble a case-specific interview.

Audit Tip: Some representatives may request that questions
be submitted in writing prior to the interview or in lieu of an interview.
Written questions and answers are not an appropriate substitute for an
in-person interview of the taxpayer. If the taxpayer or representative will not
consent to an interview, then the examiner should either issue a summons for
interview or develop the case based on third party contacts.

Depending on the case, interviews of third parties such as
representatives of the donee organization, the appraiser, the baseline study
author or other conservation experts may be needed. See discussion below on
third party contacts.

Property Inspection

The examiner’s inspection of the property provides valuable
information to assist in determining whether the conservation easement meets
one of the IRC 170(h)(4) conservation purposes.

If possible, the examiner should inspect the entire
property. Site visitation should be coordinated with the IRS appraiser,
whenever possible. If the examiner does not inspect the property, they should
contact the IRS appraiser to discuss their observations and review pictures
obtained during their site inspection. Examiners can also research property on
Google Maps or Zillow.

If it is not practical to inspect the entire property, the
examiner should view areas that are relevant to the taxpayer’s claimed
conservation purpose and document their observations.

Both the interior and exterior of historic properties should
be inspected. The IRS appraiser generally will need to inspect the interior for
purposes of valuing the property.

Audit Tip: Depending on the location of the property and
time of year, casual attire and boots may be necessary.

During the inspection, the examiner should take note:

 The location of the significant or protected habitat or
species

 Physical and visual access by the public to the easement
property

 The nature of the surrounding properties and intensity of
development in the area

 The location of buildings and other structures

 Any post-easement building or land improvements impacting
the stated conservation purposes

 Any inconsistent use of the property

The IRS appraiser will be interested in factors affecting
the highest and best use of the property before and after the granting of the
conservation easement, such as zoning or other restrictions on the property,
topography or floodplains.

Ask the taxpayer or representative to point out the outdoor
recreation areas, animals, plants, scenic views, or historic land and
structures that contribute to the conservation purpose. If the examiner
observes an absence of conservation attributes, lack of access, de minimus
public benefit or use inconsistent with the conservation purpose, the examiner
should discuss with the taxpayer or representative to clarify and solicit
additional documentation as warranted.

Example: A Wisconsin taxpayer donates a conservation
easement with a claimed conservation purpose of protecting habitat for
pheasants, a federally protected species. Pheasants thrive in a habitat of hay
fields, cropland and grassland. The examiner observes none of this habitat on
the property during the site inspection.

Audit Tip: “A picture speaks a thousand words.”• Consider
taking photographs or video of the property, the surrounding areas, and the
protected habitat or species, from various public access points. The IRS
appraiser will generally take pictures of the property.

Review of Documents

The examiner and IRS appraiser will be required to review
documents such as the deed of conservation easement, subordination agreements,
baseline study, appraisals, information provided by the qualified organization
and documents submitted to the National Park Service. The documents lay the
foundation for determining the deductibility of the charitable contribution.

Deed of Conservation Easement

Conservation easement deeds vary considerably in complexity
and length. It is imperative that the examiner read the deed carefully and have
a clear understanding of each of the deed’s provisions in order to properly
assess the taxpayer’s compliance with the statute and regulations. Program
analysts and Counsel should be consulted for help.

Be sure to review a complete and executed copy of the
recorded deed including attachments. Taxpayers and representatives sometimes
provide drafts or unexecuted copies. If there are multiple versions, inquire as
to the changes made and reasons for the revisions.

Audit Tip: A copy of the easement deed is generally included
as part of the appraisal report, which may not be the final easement document.
Compare it to the recorded deed to see if they are the same. If not, discuss
with the IRS appraiser since the valuation of the conservation easement could
be impacted.

In reading the conservation easement deed, the examiner
should ascertain:

 What property is being encumbered?

 What is the stated conservation purpose?

 Does the deed protect the property in perpetuity?

 What type of public access is allowed to the property?

 What are the reserved rights?

 What are the provisions for subordination and allocation
of proceeds?

Perpetuity

Most conservation easement deeds will state that the
easement is in perpetuity, but be alert to any provisions contradicting or
negating that statement. Conservation easements are not in perpetuity if they
can be abandoned or terminated.

Examiners need to pay close attention to any language in the
document regarding reserved rights that are inconsistent with the perpetuity
requirement.

See Chapter 3 for guidance on the perpetuity requirements.

Conservation Purpose

The conservation easement deed should include a specific
description of the conservation purpose of the particular easement, including,
for example, the species, scenic views or building being protected. The deed
alone is not evidence of conservation purpose and must be substantiated by
other available information.

Audit Tip: In some cases, the conservation purpose as
described in the deed merely repeats the conservation purpose definition in IRC
§ 170(h)(4)(A). The taxpayer must clearly describe and provide documentation to
show how the easement meets the conservation purpose.

Except for protection of a relatively natural habitat or
ecosystem, conservation easements generally must offer either physical or
visual access by the public. Physical access is only required if the
conservation purpose is for recreation by or education of the general public
under IRC § 170(h)(4)(A)(i). When evaluating access the examiner needs to
determine:

 What access is allowed, by whom, and with what frequency?

 What portion of the conservation easement can be seen from
the highway or other public space (if an open space easement for scenic
enjoyment)?

 What impact any reserved rights have on public access?

Effective for donations of conservation easements on
buildings in registered historic districts after July 25, 2006 that are not
listed in the National Register, the entire exterior (including the front,
sides, rear, and height of the building) must be restricted. If the
conservation easement deed does not clearly protect all sides of the property,
the charitable contribution is not deductible.

Audit Tip: The term “height”• was specifically used in the
statute to encompass the donation of space above the historic building. A deed,
which describes the restriction as the “roof,”• would

not satisfy the statute absent any additional narrative
limiting the “height”• of the building. A roof can be raised and additional
floors added if the easement merely uses the term “roof.”•

See Chapter 5 for guidance on conservation purpose
requirements.

Reserved Rights

Taxpayers sometimes reserve property rights that can destroy
a conservation purpose.

Example: The easement calls for the protection of the
Virginia running buffalo clover, an endangered plant. However, the deed allows
use of all terrain vehicles over the protected land in the area of the clover,
which would destroy the natural habitat. This is an inconsistent use of the
property, which would result in disallowance of the deduction.

Taxpayers are permitted to reserve some development rights
on a portion of the property, such as construction of additional homes or
structures, installation of utilities, and building of fences or roads,
provided the conservation purposes are protected. However, the examiner must
determine whether such construction would destroy the claimed conservation
purpose. Depending on the facts and circumstances, retention of these reserved
rights may result in disallowance.

Example: A taxpayer claims a charitable contribution
deduction for an open space easement but reserves the right to build three
additional residences on the property. The deed does not state the specific
location or limit the size of the residences. The deed allows the taxpayer to
construct residences that, whereby as a result of size or placement on the
property, would block the public’s scenic view, thus undermining the stated
conservation purpose.

See Chapter 3 and Chapter 5 for guidance on perpetuity and
conservation purpose requirements.

Lender Agreements

If the property was encumbered by a mortgage or other lien
at the time of the easement recordation, the taxpayer must obtain a
subordination agreement from the lender(s) prior to the granting of the
conservation easement in order for the conservation easement to be deductible.
The lender must also agree that the donee organization has a claim on any
proceeds in the event of the easement’s extinguishment.

See Chapter 3 for additional guidance on lender agreements.

Subordination Agreements

If there is a preexisting mortgage or other lien on the
property (including home equity loans or other lines of credit) prior to the
granting of the conservation easement, the taxpayer must obtain a subordination
agreement from the lender. Subordination agreements must be recorded in the
public record.

The best way to determine if there are existing mortgages
including home equity loans or lines of credit by researching public records
and interviewing the taxpayer. The subordination agreement is generally part of
the lender agreement attached to the conservation easement deed.

Audit Tip: Examiners must confirm that timely subordination
agreements for all liens were recorded in the public record prior to the
easement donation. If the taxpayer did not obtain a subordination agreement
before the time of the contribution, the charitable contribution should be
disallowed for lack of perpetuity.

Substantial compliance does not apply to failure to properly
subordinate.

Allocation of Proceeds

In order for a charitable contribution deduction to be
allowed, the taxpayer, at the time of the gift, the donation of the perpetual
conservation restriction gives rise to a property right vested in the donee
organization. This means that the donee organization must share in the proceeds
in the event of extinguishment (e.g., condemnation, casualty, hazard or
accident) of the easement. If the lender retains a prior claim on any proceeds
on extinguishment, the charitable contribution is not deductible.

Most lenders are willing to execute a subordination
agreement but some will not agree to the allocation of proceeds in the event of
extinguishment. Language in the lender agreement that requires payment to the
mortgage or other lien holder before the donee organization receives proceeds
violates the allocation of proceeds requirement.

Audit Tip: Counsel should always be consulted to determine
whether the lender agreement meets the allocation of proceeds requirement since
variances in the language of the subordination agreement or deed could affect
the ultimate legal conclusion.

Baseline Study

A baseline study is required if the taxpayer has reserved
any right which may impair the conservation purpose. If there are no reserved
rights, a baseline study is not required. Nevertheless, the taxpayer must still
be able to provide sufficient documentation to establish that the donation
meets one of the conservation purposes defined in IRC § 170(h)(4)(A).

The baseline study is a record of a property’s condition at
the time of the donation and is required to substantiate the conservation
purpose if the donor retains certain rights in the property. It serves two
purposes: 1) to satisfy the Treasury Regulations and 2) to assist the donee
organization and others in monitoring and enforcing the easement.

The baseline study does not have to be attached to the
return or the deed of conservation easement but the donor must provide the
study to the donee prior to the time the donation is made. In most cases, a
copy must be obtained from the taxpayer or donee organization.

The statement required by the Form 8283 is not the baseline
study.

The quality of a baseline study can vary a great deal. Some
are detailed expert reports, describing the property condition, conservation
value, impact of reserved rights, and environmental hazards. Some are the
taxpayer’s self-assessment of the property or the work of a volunteer with
little or no professional credentials.

A properly documented baseline study is invaluable in
helping the examiner determine if the donation satisfies one of the
conservation purposes. A comprehensive baseline study would generally include:

 A description of the encumbrance

 A description and map of the conservation characteristics
and areas (i.e., listing of identified plants or wildlife)

 A map or series of maps depicting roads, fences, existing
structures, trails, water bodies, wetlands, and any other property features

 Identification of any reserved building sites

 Surveys or plat maps

 Description of any management plans, such as a timber plan

 On-site photographs including aerial photographs

 The study author’s name and professional credentials

The first step in reviewing the baseline report is
determining whether the taxpayer was required to secure one.

If the taxpayer is required to have a baseline study, the
next step is to ascertain whether the baseline study is sufficient to satisfy
the baseline requirements as outlined in Treas. Reg. § 1.170A-14(g)(5),
including the signed statement by the donor and representative of the donee
organization. This statement is an affirmation that the baseline study is an
accurate representation of the protected property at the time of transfer. The
statement may be incorporated in the baseline study or be a separate document.

The examiner will also need to assess the credibility of the
baseline study. A baseline study prepared by an independent qualified expert
such as a conservationist, biologist, forester or botanist would generally be
given greater evidentiary weight than one prepared by a less qualified person
or the taxpayer’s self-assessment.

Examiners will need to confirm that the baseline study is
based on accurate information. In some cases, outside experts may be hired
depending on availability of funds. Generally, Examiners will need to conduct
their own research contacting federal, state or local conservation agencies or
historic preservation groups as appropriate. Internet research will reveal many
useful internet Web sites such as natureserve.org that can help the Examiner in
determining whether the baseline study supports the claimed conservation
purpose(s).

Audit Tip: Some baseline studies are not property-specific
but rather, they include narrative about the general area or State without any
specific reference to the donated property. These baseline studies do not meet
the requirements of Treas. Reg. § 1.170A-14(g)(5).

See Chapter 5 for guidance on the baseline study
requirements.

Taxpayer’s Appraisal

The IRS appraiser has primary responsibility for review of
the taxpayer’s appraisal to determine if it is a qualified appraisal prepared
by a qualified appraiser and that the conservation easement was properly
valued.

The examiner should read the appraisal to obtain background
information on the property and have a general understanding of the appraisal
content and methodology. In consultation with the IRS appraiser, the examiner
should determine if the appraisal was timely filed and if it meets the
requirements of IRC § 170(f)(11), Notice 2006-96, and Treas. Reg. §
1.170A-13(c).

See Chapter 7 for guidance on qualified appraisal
requirements.

Donee Organization

During the preplanning of the examination, the examiner will
generally be able to determine whether the donee is an organization eligible to
receive tax-deductible contributions. The examiner must also consider whether
the donor made any cash payments to the donee, and review the contemporaneous written
acknowledgment.

Examiner may need assistance from TEGE to determine whether
the donee has the commitment to protect the conservation purposes of the
donation and has resources to enforce the restrictions of the conservation
easement.

Indication of failure by the donee organization in these
areas may suggest the need for a referral to TEGE.

See Chapter 4 for guidance on qualified organizations.

Commitment and Resources

The taxpayer must transfer the conservation easement to an
eligible donee to qualify for a contribution deduction. In order to be an
eligible donee, the organization must be a qualified organization, must have a
commitment to protect the conservation purpose of the donation and must have
the resources to enforce the restrictions in the conservation easements.

Some of the information used to evaluate this factor
includes:

 The donee organization’s Web site

 The donee organization’s tax returns (Forms 990), obtained
from Guidestar.org or the Economic Research Institute

 Interviews of the taxpayer and representatives of the
donee organization

 Observations during the property inspection

 Property monitoring reports

 Written agreements between the organization and the
taxpayer (required for contributions of easements of registered historic
districts made after July 25, 2006)

If the organization did not meet the commitment and
resources tests at the time of contribution, no deduction is allowed. A
conservation group organized or operated primarily or substantially for one of
the conservation purposes specified in IRC § 170(h) is considered to have the
requisite commitment. Treas. Reg. § 1.170A-14(c)(1).

Audit Tip: Monitoring reports are a good source to verify
whether the taxpayer is in compliance with, and the donee organization is
enforcing, the terms of the easement. In some cases, donee organizations have
allowed changes after the donations that were in violation of the terms of the
easement. Examiners should consult Counsel for assistance if the easement was
terminated or not being enforced. In addition, a referral to TEGE should be
considered.

Cash Payments

A voluntary transfer of money or property to a qualified
organization is generally deductible as a charitable contribution.

If a taxpayer received goods or services from the
organization in exchange for making the cash contribution, the deduction is
limited to the excess of the cash over the FMV of the goods and services. Goods
and services include cash, property, services, benefits or privileges.

Any cash payment made in conjunction with the conservation
easement must be addressed as part of the examination. Examination steps should
include an interview of the taxpayer and a review of documents provided by the
taxpayer and the donee organization.

Factors that may indicate that the cash payment was in
exchange for goods or services include:

 Negotiations between the donor and donee as to the amount
of the payment and timing of the payment, and discounts generally found only in
commercial transactions.

 Offering of substantial services to facilitate the
donation process.

 Refusal of the donee organization to sign the Form 8283
until full payment of the cash.

 Use of cash payment amounts tied to the value of the
conservation easement.

 Conditional or refundable donations dependent on some
event such as an IRS examination.

Each case must be decided on the facts and circumstances.

Audit Tip: The Examiner may need to issue a summons to the
donee organization for relevant documents (including the application,
correspondence, donation agreements, processing documents, and other documents
relevant to the cash and easement donations).

Contemporaneous Written Acknowledgment

IRC § 170(f)(8) requires that all cash and noncash
contributions of $250 or more must be substantiated with a contemporaneous
written acknowledgment (CWA) and lists the requirements for a CWA. It must be
secured by the earlier of the date the taxpayer filed their return or the due
date (including extensions) for the return. The Form 8283, Noncash Charitable
Contributions (PDF), is not a substitute for a CWA.

A CWA is required for both the cash payment and the
conservation easement. Examiners must verify that it was a timely
acknowledgment and fully complies with the statutory requirements. Failure to
secure a timely or proper CWA is a basis for disallowance of the contribution.

Note: A CWA is not sufficient if it does not include either
a statement that no goods or services were provided (if this was the case) or
if it does not state the value of any goods or services provided.

Audit Tip: Some taxpayers may argue all that is required is
substantial compliance with the CWA requirement. However, the CWA is a
statutorily mandated provision and substantial compliance does not apply.

See Chapter 6 for guidance on CWA requirements.

National Park Service-Form 10-168

Congress provided two incentives for historic preservation:
(1) the charitable contribution deduction for historic preservation of a
historically important land area or a certified historic structure under IRC §
170(h) and (2) the rehabilitation credit under § 47.

The taxpayer would have submitted Form 10-168 (PDF) to the
National Park Service (NPS) for certification that the building contributes to
the district. Examiners should obtain a copy of the certification and any
related documents from the taxpayer or the NPS.

Even if the property is certified by the Secretary of
Interior, it does not mean the charitable contribution deduction is allowable.
36 CFR 67.1 provides that the IRS is responsible for all legal determinations
concerning the tax consequences.

Part I of the Form 10-168 is used for certification of the
building for historic status details the condition of the building at the time
of the application. Part II is a notice of proposed work and generally includes
information such as:

 Date of application

 Description of the condition of the building and any
proposed work.

 The expected start and completion dates

 Estimated costs

 Architectural drawings

Part II is required for any rehabilitation project whether
the property is individually listed on the National Register of Historic Places
or in a registered historic district.

Audit Tip: While the owner is under no legal obligation to
complete the proposed rehabilitation of the building, prior to submitting the
application, the owner has to undertake preliminary steps such as obtaining
market studies, architectural drawings, cost estimates, financing applications,
investment prospectus, legal opinions, lease agreements, partnership
agreements, and other documents that may be legally binding.

In some cases, taxpayers have improperly claimed a
charitable contribution deduction for the contribution of development rights
that were retained.

Section 48(g) permits the rehabilitation tax credit to be
claimed only by owners and, in some instances, lessees. If the taxpayer does
not own all of the interests in real property to which the rehabilitation
relates (and is not a lessee), the taxpayer is not entitled to the entire
rehabilitation tax credit. Generally, no tax credit is permitted for property
that the taxpayer does not own. See Villa v. Commissioner, T.C.M. 1980-305;
Davenport v. Commissioner, T.C.M. 1977-34); Schaevitz v. Commissioner, T.C.M.1971-197
and Bailey v. Commissioner, 88 T.C. 1293 (1987).

Audit Tip: If the easement is contributed prior to the start
of rehabilitation, the deed of easement will generally reserve the right to
rehabilitate the property. Accordingly, a portion of the rehabilitation
benefits is attributable to a real property interest that the taxpayer no
longer owns. In that case, a ratable portion of the dollars spent on the
rehabilitation would not be eligible for the rehabilitation tax credit.

If it is determined that a deduction for the easement is
allowable, the examiner or IRS appraiser must take into account the reserved
rehabilitation rights in determining the fair market value of the conservation
contribution under Treas. Reg. 1.170A-14(h)(3)(ii). Consideration must also be
given to the impact of local zoning, conservation and historic preservation
laws.

Being listed on the National Register of Historic Places or
located in a registered district imposes no restrictions on the property. Only
local law can impose restrictions. A local historic district may not have the
same boundaries as the National Register District by the same name. Thus, a
building may be certified for purposes of a charitable contribution deduction
by the NPS but the only restrictions prior to the easement might be local
zoning.

Audit Tip: Be sure to determine whether there are
restrictions under local preservation law. A building added to the National
Register of Historic Places may or may not be subject to local restrictions.

Partnership Documents

In some instances, partnerships are formed to transfer the
charitable contribution deduction. Some partnerships offer guarantees that if
the IRS disallows the deductions, the investor will be paid the amount of the
deduction disallowed times the highest tax rate.

A similar partnership arrangement was used to transfer state
rehabilitation tax credits in the Virginia Historic Tax Credit Fund 2001LP v.
Commissioner, 693 F.3d 129(4th Cir. 2011) case.

The Fourth Circuit Court of Appeals held in this case that
the transfer of the state tax credit was a disguised sale.

Audit Tip: Examiners should review partnership agreements
and other documents specifically inquiring about any guarantees. Counsel
guidance should be solicited in evaluating these transactions.

Third-Party Contacts

Development of a conservation easement case frequently
requires third-party contacts for additional facts or confirmation of
information obtained during the course of the examination. Examples of possible
third party contacts include:

 Donee organization(s)

 Mortgage lenders

 Appraisers

 Local government officials

 Real estate agents

 State and Federal conservation agencies

 Prior or subsequent property owners

Examiners must adhere to procedures for making third-party
contacts as outlined in IRM, Section 4.11.57, Third Party Contacts. Advance
notification of potential third party contacts during an examination is
accomplished by the providing the taxpayer with a Publication 1, Your Rights as
a Taxpayer (PDF), at the onset of the examination, generally with the initial
appointment letter.

Not all contacts are third party contacts. See IRM Section
4.11.57.3 for additional guidance.

Form 12180, Third Party Contact Authorization Form, or
Letter 1995, Third Party Contact Letter to Request Information, is used to
solicit records. Some cases may require use of an administrative summons (Form
2039).

Audit Tip: While advance notification (using Publication 1,
Your Rights as a Taxpayer (PDF)) and reporting of any third party contacts to
the third-party coordinator is required, there is no requirement to obtain the
taxpayer’s permission prior to making a third party contact.

Donee Organizations

Third-party contacts may be warranted with key
representatives of the donee organization. Individuals involved in drafting of
the easement deed or who were points of contact may have important information
on the transactions. Consider separate interviews of all third parties.
Typically, these interviews can be done by telephone.

Audit Tip: Examiners should request the organization’s
entire file for this donation and any other donation by the taxpayer.

Donee organizations may want a summons before consenting to
release of records. A standard document request, approved by Counsel, which can
be attached to the summons, is found on the conservation easement Web page on
MySB/SE under “Job Aids.”•

Mortgage Lenders

Mortgage lender files are a valuable source of information
about the subordination, allocation of proceeds, and valuation of the
conservation easement.

If the bank agreed to the subordination, the lender’s file
may include correspondence or other information from the taxpayer or the donee
organization describing the impact of the conservation easement on the value
and or use of the property. Examiners should obtain explanations for any
inconsistent statements made to third parties.

Example: Correspondence from the donee organization to the
lender soliciting a subordination agreement included statements that the
conservation easement has no impact on the value of the property.

If the taxpayer secured a mortgage or refinanced around the
time of the easement donation, an appraisal may have been obtained by the
lender. The appraisal coupled with information on the loan application may be
helpful in evaluating the reasonableness of the claimed value of the easement.

Example: The taxpayer granted a conservation easement on
December 29, 2010, claiming a loss in value on the property of $23 million. The
before value of the property was determined to be $25 million with an after
value of $2 million. The taxpayer obtained a mortgage loan on January 27, 2011.
The bank’s appraisal reports a value of $20 million after considering the
impact of the conservation easement on the property value. This suggests that
the easement may have been overvalued.

The loan application and related appraisals can also be
useful in determining whether the taxpayer made a good faith investigation of
the value of the easement. This is relevant to imposition of penalties.

Example: Using the example above, suppose the taxpayer
showed the value of the property on his loan application as $24 million. If the
taxpayer believed his property lost $23 million in value due to the donation of
the easement, why was the “alleged”• $2 million after value not reported on the
loan application?

A summons will generally be required to obtain the loan file
information. A standard document request, approved by Counsel, which can be
attached to the summons, is found on the conservation easement web page on
MySB/SE under “Job Aids.”•

Appraiser

In some instances, it may be necessary to interview the
taxpayer’s appraiser. The IRS appraiser would generally conduct this interview;
however, the Examiner may also participate.

It may also be necessary to obtain the appraiser’s work
file. Most licensed appraisers are required to maintain a work file in
accordance with State licensing requirements. The appraiser’s work file may
include communications between the taxpayer or donee organization or may reveal
the existence of multiple versions of the appraisal.

The examiner or the IRS appraiser should inquire to
determine the changes made and the reasons for the revisions.

A standard document request, approved by Counsel, which can
be attached to the summons, is found on the conservation easement web page on
MySB/SE under “Job Aids.”•

Federal, and State Conservation Agencies

To help ascertain the physical characteristics of the
subject property as well as evaluate the conservation purposes, examiners may
want to contact various federal and state conservation agencies, including but
not limited to:

 National Park Service

 U.S. Fish and Wildlife Service

 U.S. Environmental Protection Agency

 U.S. Department of Agriculture

 U.S. Army Corps of Engineers

 State Departments of Natural Resources

These agencies may have information on the specific property
or on the area in general.

Local Government Officials

Local officials responsible for zoning and building permits
and preservation boards are good sources of information. If possible, secure
copies of pertinent records and speak directly to the knowledgeable officials.
Evidence of quid pro quo may be found by talking to local officials and
reviewing records including minutes of meetings.

Audit Tip: If the conservation easement is part of
subdivision development, request assistance from the IRS appraiser in reviewing
documents such as plats, maps, etc.

Real Estate Agents

Local real estate agents can be valuable third party
contacts, having knowledge of property values, sales and local market
conditions, including properties encumbered by easements.

Audit Tip: If the property was purchased or sold shortly
before or after the date of the contribution, the real estate agent may be able
to provide useful information as to the value of the property or impact of the
conservation easement.

Property Owners

Prior or subsequent owners of the subject property can
provide information useful in determining the value of the property such as
physical condition, preexisting restrictions or encumbrances and other specific
attributes.

Audit Tip: If the property was sold subsequent to the
granting of the easement, consider contacting the buyer to determine the impact
(if any) on the purchase price paid. Buyers are sometimes not aware of the
easement or may indicate the easement had no impact on the purchase price.

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Overview

The examiner must determine whether the taxpayer meets all
of the requirements to claim a charitable contribution for the conservation
easement. While the process of issue identification begins in the preplanning
stages of the examination, a conclusion as to the deductibility of the
conservation easement can only be made after considering all of the information
obtained during the examination.

In addition to legal issues, examiners, generally with the
assistance of a valuation expert, will determine if the conservation easement
has been properly valued.

Preparation of a quality examination report is a critical
component of the examination process. The examiner will need to include a
comprehensive explanation of the facts, law and conclusions incorporating the
IRS appraiser’s work product and attaching relevant exhibits. If the
examination results in a proposed adjustment, the examiner must consider
whether penalties are applicable and who is liable for the penalties.

During the closing conference, the examiner should explain
the bases for any proposed adjustments to the charitable contribution deduction
and proposed penalties. In unagreed cases, the examiner will need to verify
that the taxpayer’s protest complies with the requirements as outlined in
Publication 5, Your Appeal Rights and How to Prepare a Protest If You Don’t
Agree (PDF) and prepare a rebuttal to the protest as warranted.

Issue Identification

The examiner and IRS appraiser must have a comprehensive
understanding of all of the legal requirements and evaluate the value of the
conservation easement in order to make a decision on the deductibility of the
easement.

The Internal Revenue Code, Treasury Regulations,
publications and this ATG are tools to help in the identification of potential
issues. Program analysts and Counsel can also be consulted for assistance.

An Issue Identification Worksheet has been developed as a
job aid to help examiners with issue analysis. The worksheet is not
all-inclusive but is a summary of key issues. See Exhibit 12-1.

Besides assessing all aspects of the issue, examiners must
also examine whether other costs associated with the conservation easement
contribution were properly reported.

Audit Tip: Appraisal fees are deductible only as
miscellaneous deductions subject to adjusted gross income limitation. Taxpayers
will sometimes improperly claim the appraisal fees and other costs as cash contributions.

Substantial Compliance

The burden is on taxpayers to establish they have complied
with all statutory requirements to substantiate the charitable contribution
claimed under IRC § 170. Moreover, a charitable contribution is allowed as a
deduction only if verified under the Treasury Regulations. IRC § 170(a)(1);
Smith v. Commissioner, T.C. Memo 2007-368; Hewitt v. Commissioner, 109 T.C.
258, 261 (1997), aff’d without published opinion, 166 F.3d 332 (4th Cir. 1998).

In cases where the disallowance is based in whole or in part
on noncompliance with the substantiation rules, taxpayers and their
representatives may argue that they have substantially complied, based on a
judicial doctrine called “substantial compliance.”•

Under prior law, some courts have allowed a deduction for a
taxpayer who has substantially, but not strictly, complied with “directory”•
regulations governing tax elections and deductions. See Bond v. Commissioner,
100 T.C. 32, 41 (1993). However, see Scheidelman v. Commissioner, T.C. Memo.
2010-151 (July 14, 2010), stating that “the lack of a methodology or specific
basis for the calculated after-donation value is too significant for us to
ignore under the guise of substantial compliance”• and “[w]hen a qualified
appraisal has not been submitted, we have not applied the doctrine of
substantial compliance to excuse a taxpayer’s failure to meet the qualified
appraisal requirement.”•

It is important to note that Bond and Simmons v.
Commissioner, T.C. Memo. 2009-208 (Sept. 15, 2009), were based on law in effect
prior to the enactment of the American Jobs Creation Act (2004) and the Pension
Protection Act (2006), both of which imposed new mandatory statutory
requirements for qualified appraisals.

Report Writing

The examiner’s report is the principal means of
communicating to the taxpayer, Appeals, and Counsel the reasons for proposed
adjustments to the conservation easements. Typically, conservation easement
issue reports take a significant amount of time to prepare. Unagreed reports
should be prepared in accordance with IRM section 4.10.8.11, Unagreed Case
Procedures: Preliminary (30-Day) Letters.

The explanation of items, whether presented in a lead sheet
format or on Form 886A, Explanation of Items, will be fact intensive,
describing all details of the transaction, the tax law and the bases for any
proposed adjustment. There may be a number of exhibits including an appraisal,
an appraisal review, the conservation easement deed, lender agreement, the
contemporaneous written acknowledgment and other pertinent documents.

If the lead sheet work papers are used for the unagreed
report, extraneous information (e.g., work paper cross-referencing, audit
steps, etc.) that would be of no use to the taxpayer or Representative should
be removed prior to the issuance of the report.

 

In many cases in which an adjustment is proposed, there will
be more than one legal reason for the proposed adjustment (in addition to
valuation). The legal issues are generally the primary position, and valuation
serves as an alternative position.

Audit Tip: It is very important that the report clearly
articulate and address all issues and include relevant exhibits. Appeals will
generally not consider other bases for the adjustment if not specifically
mentioned in the unagreed report.

Job Aids

Report writing job aids are available on the conservation
easement Web page on MySB/SE under “Job Aids.”• These aids, while intended to
help streamline the report writing process, must be customized to address the
facts and circumstances of each case.

The job aids provide a sample presentation format including
facts, applicable tax law, analysis and conclusions. The content in the
analysis and conclusions section is organized to match the content of the Issue
Identification Worksheet discussed above. The examiner will need to check the
most current edition of the IRC to be sure that there have not been any
statutory changes since the date of the job aid.

The Facts section of the job aid serves as an example of the
extent and type of information, which should be included in the report.

The Law section contains a summary of conservation easement
tax law. It was prepared in consultation with Counsel and generally is used
verbatim in all reports but examiners should update for any statutory changes
subsequent to the date of this report writing job aid.

The Analysis and Conclusion section will also be case
specific, but this material may be used to assist with drafting of the
examiner’s conclusions. A discussion of substantial compliance included in this
section should be incorporated into all unagreed reports.

Valuation Expert Reports

The IRS appraiser or outside appraiser’s report or review
must be attached as an addendum to the examiner’s unagreed report.

In some cases, the IRS appraiser will also provide a Form
886A, Explanation of Items, in addition to an appraisal or appraisal review.
While this information will be very useful in drafting the unagreed report,
these documents generally should not be used as a substitute for the examiner’s
report narrative.

IRS appraisers sometimes include legal positions in their
Form 886A write-ups. The Examiner must review this information for factual and
technical accuracy particularly for tax law interpretations to 1) identify any
inconsistent facts or conclusions, 2) verify correct application of tax law,
and 3) ensure that correct positions are incorporated into the examiner’s
report as a basis for any proposed adjustment.

Audit Tip: Notate on the Examiner Case Activity Record (Form
9984) and in the Report Transmittal (Form 4665) that a complete copy of IRS
appraiser report was provided to the taxpayer so there will be no question that
the taxpayer received a copy. It is also a good idea to mention in the report
narrative.

Penalties

The application of penalties is based on the facts and
circumstances of each case. There is no statutory authority to waive penalties
unless the taxpayer can establish that the reasonable cause exception applies.

A separate lead sheet or Form 886A will be needed for
proposed penalties (if any). Throughout the examination, the examiner should be
developing relevant facts to determine what penalties may apply and whether
waiver of the penalty may be appropriate (based on reasonable cause).

Audit Tip: Do not wait until the end of the audit to think
about penalties. Consideration of penalties and gathering of information should
be done throughout the examination, beginning with the preplan. Interviews of
the taxpayer and third parties may be required to obtain all necessary facts.

The penalty report for a conservation easement case would
generally include a tiering of proposed penalties with multiple alternative
positions, starting with valuation misstatements, then substantial
understatement, and finally negligence.

A discussion of reasonable cause must be incorporated into
the penalty write-up. There are special rules with respect to overvaluation of
charitable contributions. Note: For gross valuation overstatements for
donations after August 17, 2006, there is no reasonable cause exception for
gross overvaluation. Reasonable cause may apply for substantial overvaluation
or negligence.

Audit Tip: Examiners should be alert to any indication of
fraud and should consult the Fraud Technical Advisor program analyst if badges
of fraud are identified during the examination.

See Chapter 13 for detailed discussion of penalties and
reasonable cause.

Technical Assistance

Program analysts and Counsel assigned to this issue are
available to provide assistance and feedback with respect to unagreed reports.
A list of contacts is found on the conservation easement web page on MySB/SE
under “Contacts.”•

Closing Conference

A closing conference is normally held with the taxpayer or
representative. The purpose of the conference is to explain the bases for any
proposed adjustments to the charitable contribution deduction and proposed
penalties, confirm the accuracy of the facts, gather new information, and
obtain a preliminary response from (or on behalf of ) the taxpayer.

The examiner may want to provide a draft report in advance
of the meeting or at the conference. Since valuation is a significant issue in
most conservation easement cases, it is recommended that the IRS appraiser
participate in the conference.

Taxpayer Protests

Taxpayers will generally need to file a formal written
protest in order to exercise appeal rights. If the total amount of tax for any
tax period is less than $25,000, a small case request can be submitted instead
of a formal written protest.

Publication 5, Your Appeal Rights and How to Prepare a
Protest If You Don’t Agree (PDF), outlines the specific information that must
be included in a formal protest. The taxpayer or representative must provide a
list of changes they do not agree with, the facts supporting their position,
and the authority they are relying upon.

A protest is not adequate if it does not comply with the
requirements as described in Publication 5. A taxpayer’s general statements
without a clear explanation and without citing any legal basis for disagreement
is generally not sufficient.

Letter 3615, Letter Advising of Incomplete Protest, is
mailed to the taxpayer if the protest is determined to be inadequate. Unless
the group manager agrees to an extension, if the taxpayer fails to provide a
complete protest within 10 days, the case would be closed for Statutory Notice of
Deficiency.

Rebuttals to Taxpayer Protest

If there is new or contradictory information in the protest,
the examiner may need to request additional information from the taxpayer or
prepare a rebuttal to supplement the unagreed report.

The examiner should provide a copy of the protest to the IRS
appraiser so they can provide a written rebuttal for issues within the scope of
their responsibilities (such as qualified appraisal or appraiser and
valuation). The IRS appraiser’s rebuttal may be incorporated into a single
rebuttal or as an addendum to the examiner’s rebuttal.

A copy of the rebuttal, including the IRS appraiser’s
rebuttal, should be provided to the taxpayer.

Exhibit 12-1 Conservation Easement Issue Identification
Worksheet

NOTE: This worksheet is an all-inclusive list of potential
issues for donations of conservation easements. Users should review IRC section
170, DEFRA section 155, the corresponding Treasury Regulations, Notice 2006-96
and case law.

General Rule Issues

Code/Regs

Lack of charitable intent (including quid pro quo)

170(a); 1.170A-1(h)

Conditional gift

1.170A-1(e); 1.170A-7(a)(3)

Contemporaneous written acknowledgment (CWA)

170(f)(8); 1.170A-13(f)

Qualified Appraisal Issues

Code/Regs

(Note: The Deficit Reduction Act of 1984 (DEFRA) and section
170(f)(11) outline the statutory appraisal requirements.)

170(f)(11) (donations after 6/3/04) DEFRA
155(a)(1)(A),(a)(4) 1.170A-13(c)(3)(i) Notice 2006-96 §3.02(1)

Appraisal not attached to return (FMV >$500K)

170(f)(11)(D) (donations after 6/3/04)

Appraisal not prepared in accordance with generally accepted
appraisal standards

170(f)(11)(E)(i)(II) (returns filed after 8/17/06); Notice
2006-96 §3.02(2)

Appraisal not timely

1.170A-13(c)(3)(i)(A)

Not a qualified appraiser

170(f)(11)(E)(ii) (returns filed after 8/17/06) DEFRA
155(a)(5) 1.170A-13(c)(3)(i)(B); Notice 2006-96, §3.03

Doesn’t meet IRC, DEFRA, or Treas. Reg.

170(f)(11)(E)(i)(I) (returns filed after 8/17/06)

Qualified Appraisal Issues

Code/Regs

requirements

DEFRA 155(a)(1) through (6) 1.170A-13(c)((3)(ii)
1.170A-13(c)(3)(i)(C); Notice 2006-96

Appraisal fee based on percentage of value

1.170A-13(c)(3)(i)(B); 1.170A-13(c)(6)

Form 8283 (appraisal summary) missing or incomplete

1.170A-13(c)(4) DEFRA 155(a)(1)(B); DEFRA 155(a)(3)

Qualified Real Property Interest Issues

Code/Regs

Qualified real property interest

170(h)(2); 1.170A-14(a), (b)

Lack of perpetuity

170(h)(2)(C); 170(h)(5)

Lack of perpetuity – Failure to properly subordinate

1.170A-14(g)(2)

Lack of perpetuity – Extinguishment-allocation of proceeds

1.170A-14(g)(6)(ii)

Not a qualified organization or eligible donee

170(h)(3); 1.170A-14(c)(1)

Conservation Purpose Issues

Code/Regs

Conservation purpose

170(h)(4)(A); 1.170A-14(d)(1)

Outdoor recreation or education of public

170(h)(4)(A)(i); 1.170A-14(d)(2)

Outdoor recreation or education of public – Lack of access

1.170A-14(d)(2)(ii)

Protection of environmental system (natural habitat)

170(h)(4)(A)(ii); 1.170A-14(d)(3)

Protection of environmental system -Significant habitat or
ecosystem

1.170A-14(d)(3)(ii)

Preservation of open space

170(h)(4)(A)(iii); 1.170A-14(d)(4)

Preservation of open space -Scenic enjoyment

170(h)(4)(A)(iii)(I); 1.170A-14(d)(4)(ii)

Preservation of open space -Scenic enjoyment-Lack of visual
access

1.170A-14(d)(4)(ii)(B)

Preservation of open space -Governmental conservation policy

170(h)(4)(A)(iii)(II): 1.170A-14(d)(4)(iii)

Preservation of open space -Governmental conservation policy
Physical or visual access

1.170A-14(d)(4)(iii)((C)

Conservation Purpose Issues

Code/Regs

required if conservation purpose is frustrated without
access

Preservation of historic land or certified historic
structure

170((h)(4)(A)(iv)

Preservation of historic land or certified historic
structure – Historic land

1.170A-14(d)(5)

Preservation of historic land or certified historic
structure – Certified historic structure

1.170A-14(d)(5)(ii)

Preservation of historic land or certified historic
structure – Certified historic structure (1) Individually listed or (2) in
historic district and NPS certifies

170(h)(4)(C) (donations made after 8/17/06);
1.170A-14((d)(5)(iii)

Preservation of historic land or certified historic
structure – Lack of visual access

1.170A-14(d)(5)(iv)(A)

Failure to comply w/ PPA for buildings not individually
listed. (façade only)

170(h)(4)(B) (donations after 7/25/06)

Failure to comply w/ PPA for buildings not individually
listed – No restriction for entire exterior.

170(h)(4)(B)(i) (donations after 7/25/06)

Failure to comply w/ PPA for buildings not individually
listed – Lack of written agreement between donor/donee.

170(h)(4)(B)(ii) (donations after 7/25/06)

Failure to comply w/ PPA for buildings not individually
listed – Failure to attach appraisal, with photos and description of
restrictions.

170(h)(4)(B)(iii) (tax years beg. after 8/17/06)

Failure to comply w/ PPA for buildings not individually
listed – Failure to pay $500 filing fee (façade only)

170(f)(13) (contributions on or after 2/13/07

Not exclusively for conservation purpose

170(h)(5); 1.170A-14(e)

Not exclusively for conservation purpose – Inconsistent Use

1.170A-14(e)((2) and (3)

Insufficient or lack of documentation for conservation
purpose (baseline study)

1.170A-14(g)(5)(i); 1.170A-13(c)(4)(ii)(M)

Valuation Issues

Code/Regs

Valuation Issues

Code/Regs

Overvaluation

170(a); 1.170A-14(h)(3)

Deduction not based on FMV

170(a); 1.170A-1(c); 1.170A-14(h)(3)

Deduction limited to basis

170(e)(1)(A)

Contiguous parcel/noncontiguous parcel

1.170A-14(h)(3)(i)

Miscellaneous Issues

Code/Regs

Percentage limitations not computed properly

170(b)

Rehabilitation credit-reduction of deduction (façade only)

170(f)(14)

Rehabilitation credit-recapture (façade only)

50(a); Rev. Rul. 89-90

Penalty Issues

Code/Regs

Taxpayer penalties

6662(a), (e), (h); 6664(c)(1) – (3)

Appraiser penalty (Returns filed after 7/25/06 if facade
easement on a building in a registered historic district; returns filed after
8/17/06 for all other easements.)

6695A

Chapter 13: Penalties Chapter 13: Penalties Chapter 13:
Penalties Chapter 13: Penalties Chapter 13: Penalties

Overview

Penalties exist to encourage voluntary compliance by
supporting the standards of behavior required by the IRC. Examiners are
required to consider penalties and document their determination in all taxpayer
examinations.

All facts and circumstances must be developed during the
examination to determine what penalties, (if any) are appropriate. Penalties
may be warranted on the taxpayer, return preparer, appraisers and/or other tax
advisors.

See the IRM 20.1, Penalty Handbook, for additional guidance
on penalties.

Accuracy-Related Penalties

IRC § 6662 imposes accuracy-related penalties on
underpayments. The maximum accuracy-related penalty imposed on any portion of
an underpayment is 20% (40% in the case of a gross

valuation misstatement), even if that portion of the
underpayment is attributable to more than one type of misconduct.

Penalties must be determined on a case-by-case basis taking
into account all the pertinent facts and circumstances. In order to determine
what penalties, if any, should be applied examiners must ascertain the
taxpayer’s experience, knowledge, education, the extent of their review or
inquiry in assessing the correctness of the conservation easement donation, and
whether they relied on any appraisers, return preparers or other professionals.

IRC § 6662(c) Negligence or Disregard of Rules or
Regulations

A 20% accuracy-related penalty can be asserted pursuant to
IRC § 6662(c) if the underpayment of tax is attributable to negligence or a
careless, reckless, or intentional disregard of rules or regulations.

Negligence includes any failure to make a reasonable attempt
to comply with the provisions of the Internal Revenue Code or to exercise ordinary
and reasonable care in the preparation of a tax return. IRC § 6662(c) and
Treas. Reg. § 1.6662-3(b).

In Turner v. Commissioner (126 T.C. 299 (2006)), the tax
court held the taxpayer was liable for a 20% negligence penalty under IRC §
6662. The appraiser’s report was not considered sufficient for the reasonable
cause exception (IRC § 6664(c)) to apply because the report was based on
erroneous assumptions.

The term “disregard”• includes any careless, reckless, or
intentional disregard of rules or regulations. A disregard is careless if the
taxpayer does not exercise reasonable diligence to determine the correctness of
a return position that is contrary to a rule or regulation. A disregard is
reckless where the taxpayer makes little or no effort to determine whether a
rule or regulation exists, under circumstances which are a substantial
deviation from the standard of conduct observed by a reasonable person.
Additionally, a disregard is intentional where the taxpayer has knowledge of
the rule or regulation that the taxpayer disregards. Treas. Reg. §
1.6662-3(b)(2).

“Rules or regulations”• under this section includes the
provisions of the Internal Revenue Code, temporary or final Treasury
regulations, and revenue rulings or notices (other than notices of proposed
rulemaking) issued by the Internal Revenue Service and published in the
Internal Revenue Bulletin. IRC § 1.6662-3(b)(2). Therefore, if the facts
indicate that a taxpayer took a return position contrary to any published
notice or revenue ruling, the taxpayer may be subject to the accuracy-related
penalty for an underpayment attributable to disregard or rules or regulations,
if the return position was taken subsequent to the issuance of the notice or
revenue ruling.

See IRM 20.1.5.7, Negligence or Disregard of Rules or
Regulations for additional guidance.

IRC § 6662(d) Substantial Understatement of Income Tax

A 20% accuracy-related penalty can be asserted pursuant to
IRC § 6662(d) if the underpayment of tax is attributable to a substantial
understatement of income tax.

A substantial understatement of income tax exists for a
taxable year of an individual if the amount of understatement exceeds the
greater of 10% of the tax required to be shown on the return or $5,000. IRC §
6662(d)(1).

For taxable years beginning on or after October 23, 2004,
the substantial understatement of a corporation must exceed the lesser of (i)
10% of the tax required to be shown on the return (or, if greater, $10,000), or
(ii) $10,000,000.

The amount of the understatement generally is reduced by the
portion of the understatement attributable to any item if:

 The treatment is, or was, supported by substantial
authority, or

 Facts relevant to the tax treatment were adequately
disclosed on the return or on a statement attached to the return and there is a
reasonable basis for the tax treatment.

There is no reduction, however, if any item is attributable
to a tax shelter, which means a partnership or other entity, any investment
plan or arrangement, or any other plan or arrangement with a significant
purposes of avoidance or evasion of Federal income tax. IRC § 6662(d)(2)(C).

See IRM 20.1.5.8, Substantial Understatement, for additional
guidance.

IRC § 6662(e) Valuation Misstatements

A 20% accuracy-related penalty can be asserted pursuant to
IRC § 6662(e) if the underpayment of tax is attributable to a substantial
valuation misstatement. IRC § 6662(e)(1).

A 40% accuracy-related penalty can be asserted pursuant to
IRC § 6662(h) if the underpayment of income tax is attributable to a gross
valuation misstatement.

For returns filed after August 17, 2006, a substantial
valuation misstatement exists when the claimed value of any property is 150% or
more of the amount determined to be the correct value. A gross valuation
misstatement occurs when the claimed value of any property is 200% or more of
the amount determined to be the correct value. Note: In the case of an
appraisal with respect to a donation under IRC §170(h)(4)(C)(ii) (a facade easement
on a building which is located in a registered historic district), these rules
apply to returns filed after July 25, 2006.

Note: For returns filed prior to August 17, 2006, a
substantial valuation misstatement penalty applies if a value claimed on the
return is at least twice (200% or more) the amount determined to be the correct
value. A gross valuation misstatement penalty applies if a value claimed on the
return is at least four times (400% or more) the amount determined to be the
correct value. The reasonable cause exception (IRC § 6664(c)) applied to both
substantial and gross valuation misstatements.

No penalty is imposed unless the portion of the underpayment
attributable to the valuation misstatement exceeds $5,000 ($10,000 in the case
of a corporation other than an S corporation or a personal holding company).

See IRM 20.1.5.9, Substantial Valuation Misstatement, for
additional guidance.

IRC § 6663 Civil Fraud Penalties

IRC § 6663 states that if any portion of the underpayment of
tax is due to fraud, a penalty of 75% may be asserted on the portion of
underpayment attributable to fraud.

Examiners should be alert to any indications of fraud, such
as altered or backdated documents, false testimony or evidence of collusion
between the taxpayer, the donee organization, return preparer, and the
appraiser.

If badges of fraud are noted the examiner is required to
discuss with their group manager and involve the local fraud technical advisors
as early as possible.

See IRM 20.1.5.12, Civil Fraud Penalty, for additional
guidance.

IRC § 6664 Reasonable Cause Exception

In general, no penalty will be proposed under IRC §§ 6662 or
6663 if the taxpayer establishes there was reasonable cause for the
underpayment and they acted in good faith. IRC § 6664(c)(1). See IRM 20.1.5.6,
Reasonable Cause, for additional guidance.

Special Rule for Overvaluation of Charitable Contributions

For substantial valuation misstatements of charitable
contribution property, reasonable cause only applies if:

 The claimed value of the property was based on a qualified
appraisal made by a qualified appraiser, and

 The taxpayer made a good faith investigation of the value
of the contributed property.

Improper valuation of conservation easements and a lack of
qualified appraisal are common bases for full or partial disallowance of the
charitable contribution. Accordingly, if the claimed value is substantially
overvalued (150% or more), the substantial valuation misstatement penalty must
be applied unless the appraisal was a qualified appraisal by a qualified
appraiser and the taxpayer made a good faith investigation of the value.

The reasonable cause exception is not available for gross
valuation misstatements on returns filed after August 17, 2006. IRC §
6664(c)(3). In the case of an appraisal of a facade easement on a building
located in a registered historic district), the reasonable cause exception is
not available for gross valuation misstatements on returns filed after July 25,
2006.

Reliance on Professionals

Reliance on a return preparer or other professional such as
an attorney or appraiser does not automatically constitute reasonable cause and
good faith under Treas. Reg. § 1.6664-4(b).

Reliance constitutes reasonable cause and good faith if,
under all the circumstances, such reliance was reasonable and the taxpayer
acted in good faith.

The taxpayer must prove:

 They did not know, nor should have known, that the advisor
suffered from a conflict of interest or a lack of expertise,

 Complete, accurate and all necessary information was provided
to the advisor by the taxpayer, and

 The taxpayer actually relied in good faith on the
advisor’s judgment.

In Scheidelman vs. Commissioner, T.C. Memo. 2010-151, the
court concluded that the taxpayer had reasonable cause and acted in good faith.
A tax deficiency was proposed for the disallowance of a charitable contribution
of a façade easement and for an accuracy-related penalty for substantial
understatement of income tax or in the alternative negligence. The taxpayer had
no tax experience or real estate training and had relied on her long-time
return preparer, a competent tax professional and the appraiser.

If the taxpayer claims reliance on professionals, the
Examiner must identify specifically who advised the taxpayer, when and what
services or advice was provided and determine whether the taxpayer fully
disclosed the necessary information for the advisor to make a proper
determination.

This will generally require an interview of the taxpayer and
of the professional(s) to confirm the taxpayer’s information and evaluate
whether nonassertion of the penalty is appropriate due to reasonable cause.
Copies of any professional opinion letters, correspondence, analysis, billing
records or other documentation should be solicited from the taxpayer or
professional to substantiate reliance on professionals.

Examiners should review IRM 20.1.5.6.4, Reliance on Advice,
for additional guidance.

Return Preparers-IRC § 6694

Examiners are responsible for determining whether IRC §
6694, Understatement of Taxpayer’s Liability by Tax Return Preparer, penalties
should be asserted on the return preparer for improper tax return preparation.
Preparer penalties should be asserted only after deliberation of all facts and
circumstances and not based solely on the determination of deficiencies in
related tax return examinations.

Examiners may consider asserting penalties under IRC § 6694
on appraisers for inflated or incorrect appraisals in lieu of IRC § 6695A if
the appraiser meets the definition of a nonsigning return preparer (Treas. Reg.
§ 301.7701-15(b)(2)).

IRM 20.1.6.3, Preparer Conduct Penalties, provides
additional guidance on the return preparer penalties. Examiners also may
contact their local Return Preparer Coordinator for help with preparer penalty
cases.

Promoters-IRC §§ 6700 and 6701

Appraisers may be subject to IRC § 6700 for direct or
indirect participation in the sale of a tax plan or arrangement that results in
a material gross overvaluation misstatement. IRC § 6701 may also be applicable
for the preparation of the appraisal if the appraiser knows or had reason to
believe that the appraisal was to be used in connection with a material tax
matter and knows that use of the document would result in an understatement of
tax.

The examiner should consider a referral to the SB/SE Lead
Development Center (LDC) for return preparers, appraisers, promoters, authors
of legal opinions, donee organizations, or anyone else who was directly or
indirectly involved with a scheme or promotion advocating improper or
overvalued conservation easement donations.

While examiners may secure information on the role and level
of involvement of each person in conjunction with the determination of the
appropriateness of taxpayer penalties, examiners cannot commence an IRC § 6700,
Promoting Abusive Tax Shelters, Etc., or IRC § 6701, Aiding and Abetting
Understatement of Tax Liability, penalty investigation without specific
authorization from the SB/SE LDC. A referral form can be found on the LDC Web
page.

Contact a SB/SE LDC program analyst for assistance on the
application of IRC § 6700 or 6701 penalties, determination of whether a
referral is warranted, or coordination of participant examinations.

See IRM 20.1.6.1, Overview of the Return Preparer, Promoter,
and Material Advisor Penalties, and IRM 4.32 for additional guidance.

Appraisers-IRC § 6695A Substantial and Gross Valuation
Misstatements Attributable to Incorrect Appraisals

IRC § 6695A was added by the Pension Protection Act of 2006.
It provides a civil penalty on any person who prepares an appraisal that the
appraiser knows (or reasonably should have known) is to be used to support a
tax position, and such appraisal results in a substantial or gross valuation
misstatement (as defined in IRC § 6662(e) and (h) respectively).

The amount of the IRC § 6695A penalty is the lesser of:

 The greater of 10% of the amount of the underpayment
attributable to the misstatement or $1,000, or

 125% of the gross income received from the preparation of
the appraisal

Under the provision, the penalty does not apply if the
appraiser establishes that it was “more likely than not” that the
value established in the appraisal was correct.

This penalty applies to returns filed after August 17, 2006,
with respect to easements based on one of the first three conservation purposes
outlined in IRC § 170(h)(4)(A). However, if the

appraisal relates to a façade easement donation in a
registered historic district, the penalty applies to returns filed after July
25, 2006.

There are no preassessment appeal rights extended to the
appraiser at the time of the penalty case closure by the examiner. The
appraiser may request an appeals conference upon notice of the service’s intent
to assess the penalty.

CAUTION: The statute of limitations for the appraiser
penalty case is three years from the later of the due date of the related
return or the date the return was filed. Securing an extension on the return
being examined does not extend the appraiser penalty statute. Form 872-AP,

Consent to Extend the Time on Assessment of IRC Section 6695A Penalty, is used
to extend the appraiser penalty case statute.

See IRM 20.1.12, Penalties Applicable to Incorrect
Appraisals, and the Servicewide Penalty Web page for additional guidance on the
assessment of this penalty.

Office of Professional Responsibility Sanctions

Prior to the changes instituted by the Pension Protection
Act of 2006 (PPA), an IRC § 6701 penalty for aiding and abetting was required
to be assessed before the Office of Professional Responsibility (OPR) could
seek disciplinary action against an appraiser.

The PPA eliminated the penalty assessment requirement.
Disciplinary action may include, but is not limited to, suspending or barring
an appraiser from:

 Preparing or presenting appraisals on the value of
property or other assets to the Treasury Department or the IRS.

 Appearing before the Treasury Department or the IRS for
the purpose of offering opinion evidence on the value of property or assets.

Chapter 14: State Tax Credits

Overview

An increasing number of states offer tax incentives in the
form of income tax deductions or credits for the donation of conservation
easements. Some programs allow for the transfer and sale of unused state tax
credits. Qualifying for a state tax benefit does not automatically qualify a
taxpayer for a federal tax benefit.

State Tax Credit Programs

Generally, state conservation credit programs are designed
to encourage landowners to voluntarily preserve their land. State tax
incentives have become increasingly popular.

In 1983, North Carolina was the first state to enact a
conservation tax credit program with eleven more states (California, Colorado,
Connecticut, Delaware, Georgia, Maryland, Mississippi, New Mexico, New York,
South Carolina, and Virginia) passing similar tax credit legislation.

Most state tax credit programs closely follow the federal
requirements for conservation easements. There is no uniform model but nearly
all state programs determine the amount of the credit based on a percentage of
the fair market value of the donated easement. Generally, the programs provide
for carry forward of unused tax credits over a number of years. Some states,
including Colorado, South Carolina, Virginia and New Mexico, have transferable
tax credits.

Transferability allows taxpayers to sell tax credits to
third parties. Credit brokers or facilitators assist taxpayers in negotiating
the sales price and are generally reimbursed for their services from the
proceeds of the sale. The third party purchaser then uses the credits to reduce
their own state tax liabilities.

In 2007, The Conservation Resource Center, a nonprofit
conservation organization, published a report analyzing the impact of state
conservation tax credits. According to the report, taxpayers receive as much as
70 to 82 percent of the face value of their state tax credits, depending on
market rates at the time of the sale.

Sale of State Tax Credits

The issuance of the state tax credit or its use to reduce
state tax liability, does not result in federal gross income to a taxpayer who
qualifies for the credit or reduce the amount of the taxpayer’s federal
charitable contribution deduction, but a sale of a transferable state tax
credit is a taxable transaction.

Section 1001(a) provides that the gain from the sale or
other disposition of property is the excess of the amount realized over the
adjusted basis of the property.

The amount realized from the sale of the credit is the sum
of any money received plus the fair market value of any property received (IRC
§ 1001(b)). The taxpayer to whom the state issued tax credits does not have any
basis in the credits because nothing was paid to receive the credits and the
issuance of the tax credits was not a taxable event requiring inclusion in
gross income. Thus, the gain from the sale of tax credits by a taxpayer who
obtained them from the state would usually be equal to the entire amount
realized.

The Tax Court in Tempel v. Commissioner, 136 T.C. 15 (2011)
and McNeil v Commissioner T.C. Memo 2011-109, reached a conclusion stating that
the state tax credits are capital assets. The Court did affirm that the
taxpayer did not have any basis in the state tax credits and the holding period
begins when the credits are granted

U.S. v. KHANU, Cite as 108 AFTR 2d 2011-XXXX, 10/07/2011

 

——————————————————————————–

UNITED STATES OF AMERICA, Appellee v. Abdul Karim Khanu,
Appellant.

Case Information:

 

 

 

Code Sec(s):

 

 

 

 

 

 

Court Name:

 

United States Court of Appeals FOR THE DISTRICT OF COLUMBIA
CIRCUIT,

 

 

 

Docket No.:

 

No. 10-3039,

 

 

 

Date Argued:

 

04/04/2011

 

 

 

Date Decided:

 

10/07/2011.

 

 

 

Disposition:

 

 

 

HEADNOTE

 

.

 

Reference(s):

 

OPINION

 

John W. Nields Jr., argued the cause for appellant. With him
on the briefs were William R. Martin and Kerry Brainard Verdi.

 

Katherine M. Kelly, Assistant U.S. Attorney, argued the
cause for appellee. With her on the brief were Ronald C. Machen Jr., U.S. Attorney,
andElizabeth Trosman and Suzanne G. Curt, Assistant U.S. Attorneys. Roy W.
McLeese III, Assistant U.S. Attorney, entered an appearance.

 

United States Court of Appeals FOR THE DISTRICT OF COLUMBIA
CIRCUIT,

 

Appeal from the United States District Court for the
District of Columbia (No. 1:09-cr-00087)

 

Before: Sentelle, Chief Judge, Ginsburg and Brown, Circuit
Judges.

 

Opinion for the Court filed Per Curiam.

 

Opinion concurring in part and dissenting in part filed by
Chief Judge Sentelle.

 

Judge: Per Curiam:

 

Appellant Abdul Karim Khanu appeals his conviction and
sentence on two counts of attempted tax evasion. He argues the Government
failed to prove the element of tax loss because it relied upon a flawed
calculation under the “cash method of proof” and attributed to Khanu $1.9
million of alleged gain when those funds, as a matter of law, belonged to his
two corporations. Khanu challenges his sentence to the extent it rests upon the
allegedly incorrect calculation of tax loss. We affirm the convictions and the
sentence.

 

Background

 

This appeal arises from an indictment returned in March of
2009, charging appellant Khanu with twenty-two counts generally related to his
alleged evasion of personal income taxes and corporate taxes arising from his
operation of two nightclubs in Washington, DC. According to the evidence
adduced at trial, appellant owned or co-owned corporations which operated the
two nightclubs from 1999 until 2003. In preparation for establishment of the
first nightclub, appellant leased a property in northwest Washington from a
landlord who required the submission of a personal balance sheet. The balance
sheet, which became critical evidence for reasons which will be set forth more
fully below, indicated that appellant personally had $700,000 in cash on hand
and in bank accounts as of April 12, 1999. The operation of the nightclubs
generated substantial amounts of cash from such items as cover charges at the
door and sales from the bars. Khanu was responsible for large cash deposits in
the corporate bank accounts.

 

In October of 2003, Internal Revenue Service agents executed
a search warrant on Khanu’s home and seized approximately $1.9 million in cash
from a safe in a dead-boltlocked pantry. Khanu later swore an affidavit attesting
that the $1.9 million “is the property” of the corporations, which, pursuant to
a closing agreement with the IRS, then used the money to satisfy outstanding
tax liabilities of their own.

 

In March of 2009, the grand jury returned the twenty-two
count indictment charging: (1) conspiracy (18 U.S.C. § 371) (Count 1); (2)
three counts of attempted tax evasion related to the filing of his individual
income tax returns from 2001 through 2003 (26 U.S.C. § 7201) (Counts 2–4); (3)
four counts of aiding and assisting in the preparation and filing of false tax
returns related to the annual corporate tax returns for two corporations of
which he was an owner for the fiscal years ending September 30, 2002 and 2003
(26 U.S.C. § 7206(2)) (Counts 5–8); and (4) fourteen counts of aiding and
assisting in the preparation and filing of false tax returns related to the
quarterly tax returns for those corporations during the same time period (26
U.S.C. § 7206(2)) (Counts 9–22).

 

Before trial, the defense moved to exclude evidence of the
$1.9 million, arguing that Khanu had disclaimed any ownership of the funds in
the affidavit, and that the funds could not be included in his net worth at the
end of 2003 because the Government had seized them before the end of that tax
year. The district court denied Khanu’s motion because, notwithstanding the
putative “repayment” of the $1.9 million to the corporations, a jury could find
Khanu had exercised sufficient control over the money for it to be taxable as
personal income to him.

 

After a three-week trial, the jury found Khanu guilty of two
counts of attempted tax evasion related to the filing of his individual tax
returns for 2002 and 2003 but acquitted him of all other charges. The district
court sentenced Khanu to concurrent thirty-eight month terms of incarceration
on the two counts of conviction followed by concurrent three-year terms of
supervised release, and ordered restitution of $951,520.00. In an amended
judgment, the court reduced the amount of restitution to $302,832.64.

 

The Trial

 

As pertinent to this appeal, critical evidence offered by
the government in the trial included an income and tax computation presented by
an expert witness and evidence of the $1.9 million seized under the search
warrant of October 2003. The government presented the computation evidence
through IRS Agent Freddie Lewis. The theory of the government’s case as to both
years, outlined by Lewis, was based on the “cash method of proof.” This method
computes cash on hand held by the taxpayer, cash expenditures by the taxpayer,
and compares that cash total against cash from all known sources for the years
in question. The net excess of cash expenditures over the cash from all sources
is treated as unreported income. As the government’s expert testified at trial,
the cash method of proof requires a starting point with respect to the cash on
hand. Lewis began his analysis with a starting figure for cash on hand derived
from the balance sheets Khanu submitted to his landlord preparatory to the
lease of nightclub space in April of 1999. After making adjustments for Khanu’s
accounts at the time of the filing of the balance sheet, Lewis calculated that
the appellant had cash on hand of $698,886.20 on the date of the balance sheet.

 

Using the cash method, the cash on hand remaining at the end
of 1999 ($559,554.29) was carried forward to the beginning of 2000, the
remaining cash on hand at the end of 2000 ($371,652.77) was carried forward to
2001, and the remaining cash on hand at the end of 2001 ($65,507.67) was carried
forward to 2002.

 

Lewis then continued his calculation by determining all
identifiable sources and uses of cash by Khanu during the years under
examination. These calculations, as presented in evidence before the jury,
included the $1.9 million of cash seized from appellant’s home in October 2003.
In this final calculation, Lewis determined that in 2002 appellant had total
cash expenditures of $609,498.90 against $156,403.85 in total sources of cash.
By subtracting the cash from known sources from the total cash expenditures,
Lewis concluded and the government contended that appellant had $453,095.05 in
unreported income for the tax year 2002. For the tax year 2003, Lewis
calculated that appellant’s total cash expenditures exceeded his total sources of
cash by $2,227,690.07. The government contended that Khanu had underreported
his income by that amount in 2003. Particularly, the calculation for 2003
included the $1.9 million seized from Khanu’s home. Therefore, exclusive of the
$1.9 million, Khanu’s unreported income, as evidenced by the cash method
calculation, approximated $300,000 for that year.

 

Analysis

 

Appellant argues that the judgment of the district court
rests on reversible errors both as to the convictions and the sentences.
Appellant offers two principal arguments going to the validity of the
convictions, one as to the sentencing. One of the alleged substantive errors
affects both counts of conviction, the other only tax year 2003. We begin with
the error asserted as to both years.

 

A. The Method of Proof

 

To establish a violation of 26 U.S.C. § 7201, the
prosecution must establish three elements beyond a reasonable doubt: “(1)
willfulness, (2) the existence of a tax deficiency, and (3) an affirmative act
constituting an evasion.” United States v. Smith, 267 F.3d 1154, 1165 (D.C.
Cir. 2001). Appellant asserts that the prosecution in the present case did not
present sufficient evidence to establish the second element beyond a reasonable
doubt. Therefore, the defense argues, the district court erred in denying his
motion for judgment of acquittal. As noted above, the government’s evidence on
the element of tax deficiency rested on a “cash method” of proof. Under this
indirect method of proof, the prosecution’s evidence “focuses on the taxpayer’s
sources and uses of income,” United States v. Hogan, 886 F.2d 1497, 1509 (7th
Cir. 1989). In using this method, the government is required to present
evidence relating to the taxpayer’s cash expenditures. See United States v.
Toushin, 899 F.2d 617, 619 [65 AFTR 2d 90-786] (7th Cir. 1990). As Agent Lewis
presented in this case, taxable and nontaxable cash sources are added together,
including any cash accumulated and on hand at the beginning of the tax period.
To the extent that cash expenditures exceed cash sources during the taxable
period, as was evidenced in this case, the government’s theory is that the excess
may be inferred to be unreported income. See id. at 620. The government argues
that the accounting evidence, supported by documentary and other evidence
underlying the accounting, is sufficient to survive defense motions for
judgment of acquittal, and support the jury’s determination that the evidence
established a tax deficiency beyond a reasonable doubt.

 

Appellant argues that the prosecution’s evidence is not
sufficient to establish a deficiency under the cash method. This argument rests
on the proposition that under this method, “the government must establish the
defendant’s cash on hand at the beginning of each of the disputed years with
reasonable certainty, while negating all other sources of nontaxable income
during the same period.” United States v. Conaway, 11 F.3d 40, 44 [73 AFTR 2d
94-722] (5th Cir. 1993) (emphasis added). Appellant argues that the
government’s figure of $698,886.20 was not established with reasonable
certainty, nor all other sources of nontaxable income negated. Appellant contends
that he might well have understated his cash on hand for business reasons at
the time of the preparation of the balance sheet relied upon by the
government’s accountant. He further contends generally that there might have
been other sources of nontaxable income that the government did not negate. We
find neither of these arguments convincing.

 

While it is true that appellant might have understated his
cash on hand in his business transactions, this goes to the weight of the
evidence, not its legal sufficiency. Likewise, it is also true that despite the
government’s evidence that it could locate no sources of nontaxable income,
there may have been some. The difficulty with appellant’s arguments is not that
they are without reason, but that they prove far too much. It is always the
case that the government’s accounting figures in a cash method tax computation
might be refuted, either as to the beginning amount or to the possibility of
nontaxable sources. If the government had to establish with absolute certainty
a beginning number and an impervious bar to nontaxable sources, indirect
methods of proof of income could never be used. No matter how the government
proved the beginning number, the defendant could always argue after judgment
that the government had not negated the possibility that he had some other
money hidden somewhere or that some other source existed. It is not improperly
shifting the burden of proof to the defendant to say that unrebutted evidence
of the government is sufficient to survive a motion under Rule 29 and to
sustain a conviction. To adopt the appellant’s argument would be to hold that
indirect methods of proof can never be used to establish deficiencies in income
tax prosecutions—a proposition long ago rejected. For example, in United States
v. Johnson, 319 U.S. 503 [30 AFTR 1295] (1943), the Supreme Court upheld the
tax evasion convictions of a defendant engaged in an illicit gambling business,
observing that “[i]t is not to be expected that the actual financial
transactions of such a vast illicit business would appear by direct proof.” Id.
at 517. InJohnson , as in the case before us, the government proved the
existence of a deficiency by an indirect method—in this case by the “cash
method,” inJohnson by the similar “cash expenditures method.”

 

In short, we find no error in the district court’s denial of
the defendant’s motions for judgment of acquittal.

 

B. The $1.9 Million

 

Khanu has, from the outset, argued the $1.9 million seized
from his safe should have been “excluded” from the Government’s evidence of tax
loss. In his pretrial “Motion to Exclude the $1.9 Million,” Khanu said the
money was not income to him because it was the “property” of the corporations,
for which he acted only as a custodian. Khanu renewed this argument after
trial, pointing to evidence the nightclubs brought in nearly $1 million in cash
from a party just two weeks before the raid. The district court rejected
Khanu’s argument because, it held, the money would still count as income to
Khanu if he exercised sufficient control over it and intended to put it to his
personal use; whether he did so was for the jury to determine.

 

On appeal, however, Khanu does not press the point about
control and ownership of the funds while they were in his custody; rather, he contends
his “return” of the funds, regardless of his prior actions or intent, nullifies
any liability on his part for the income tax on those funds. Citing cases about
the tax consequences of embezzlement, he says he had no obligation to report
the $1.9 million on his 2003 tax return because he “lost control of the funds”
to the IRS or at least “disclaimed any ownership interest” in the money when he
signed the affidavit. See James v. United States, 366 U.S. 213, 220 [7 AFTR 2d
1361] (1961) (dictum) (“if, when, and to the extent that the victim recovers
back the misappropriated funds, there is of course a reduction in the
embezzler’s income’”); Gilbert v. Comm’r, 552 F.2d 478, 481 [39 AFTR 2d
77-1225] (2d Cir. 1977) (“if [an embezzler] repays the money during the same
taxable year, he will not be taxed”);Han v. Comm’r , 83 T.C.M. 1824 [TC Memo
2002-148], 2002 WL 1298745, at 23 (2002) (“Funds over which a taxpayer has
obtained dominion and control, lawfully or unlawfully, are not taxable to him
to the extent they are repaid before year end”); Mais v. Comm’r, 51 T.C. 494
(1968) (funds seized from embezzler by police not taxable to him in the year
repaid).

 

If we are to consider this late-raised but intriguing
argument, then we must first determine the appropriate standard of review,
which in turn depends upon the nature of the error Khanu has assigned. In his
opening brief Khanu argued “it was error to permit the government to include
the $1.9 million in its [c]hart,” which went to the jury. Br. of Appellant at 40.
To this the Government understandably responded that the district court
“properly admitted” evidence of the $1.9 million. Br. of Appellee at 17.
Although the dispute thus seemed to have been neatly framed in terms of
admissibility, Khanu in his reply brief (at page 5) then informed us that,
contrary to the Government’s understanding (and ours), “[his opening] brief on
appeal makes no argument about admissibility of evidence in connection the $1.9
million at all.”

 

Khanu’s emphatic reply does not clarify matters; quite the
opposite. Accusing the Government of “mischaracterizing” his argument does not
thereby entitle Khanu to review of the claim on his terms, to wit, as a bare
question of law we may resolve without considering how, when, or whether he presented
the claim to the district court. If there is a distinction between Khanu’s
argument against “permitting the inclusion” of evidence and a conventional
argument against “admission” of the same, then it eludes us. According to
Khanu, however, the difference lies in the standard of review: Whereas
questions of admissibility are reviewed only for abuse of discretion,see United
States v. Warren , 42 F.3d 647, 655 (D.C. Cir. 1994), his claim, which raises
the purportedly different, legal question of “includability,” should be
reviewed de novo.

 

Khanu is confused as well as confusing. In order to pursue
an objection based upon “erroneous evidence,” Br. of Appellant at 39, he must
identify an erroneous evidentiary ruling, whether the underlying error is one of
law, fact, or judgment. Khanu, however, waived any objection to the admission
of evidence, as we explained above, and has identified no other evidentiary
ruling as the subject of his argument. *

 

Assuming Khanu’s argument is aimed at something, we think it
is the sufficiency of the evidence that he willfully attempted to evade taxes;
to wit, he says, “there is no criminal tax evasion with respect to the $1.9
million,” because under the dictum in James “there was no tax due and owing on
those funds.” Br. of Appellant at 35. When we address the sufficiency of the
evidence underlying a conviction, we view the evidence in the light most
favorable to the Government and ask whether “any rational trier of fact” could,
based upon the evidence at trial, find the element of tax loss beyond a
reasonable doubt. Jackson v. Virginia, 443 U.S. 307, 319 (1979).

 

Khanu concedes the Government’s chart, which he identified
as the target, if not the underlying subject, of this argument, showed
unreported income of $300,000 in addition to the $1.9 million in dispute. One
would think that an end to the matter. Khanu nevertheless contends the verdict
cannot be assumed to rest upon the tax owing on the $300,000 because the
inclusion of the $1.9 million on the chart “severely prejudiced” the jury’s
deliberations. The objective standard prescribed inJackson , however, requires
us to consider whether “any rational trier of fact” could convict Khanu, not
whether the jury that actually convicted him might have voted differently under
other circumstances. Because a rational trier of fact could find beyond a
reasonable doubt a tax was due and owing on $300,000 of income, we leave for
another day how best to interpret the dictum in James.

 

The Sentencing

 

Appellant also contends, unsurprisingly, that the district
court erred in considering the tax due on the $1.9 million in determining his
sentence. We affirm the sentence because the district court made sufficient
factual findings at sentencing to support the inclusion of the $1.9 million in
the calculation of tax loss. See U.S.S.G. § 2T1.1(c)(5) (“the tax loss is the
total amount of loss that was the object of the offense”). ***

 

In sum, the judgment of the district court is in all
respects

 

Affirmed.

 

Judge: Sentelle,
Chief Judge, concurring in part and dissenting in part: While I am pleased to
join in my colleagues’ affirmance of the judgment of conviction on Count 3, I
find myself unable to join the opinion or the result as to Count 4. I accept
the majority’s statement of the underlying facts respecting the $1.9 million.
Briefly, government agents discovered the $1.9 million in cash in Khanu’s
possession during the relevant tax year. Khanu identified the money as that of
his corporation, disavowed ownership, paid the money over to the IRS in
settlement of corporate tax obligations, and did not possess it at the end of
the tax year. Unlike the majority, I cannot, however, conclude that those facts
support the inclusion of the $1.9 million in the computation of the deficiency
element of tax evasion. Unlike the majority, I find appellant’s argument on
this point neither confusing nor confused, nor do I find the distinction
between ““permitting the inclusion” of evidence and a conventional argument
against “admission” of the same,” elusive. Maj. Op. at 10. To me, the
distinction is plain. Appellant does not contend that the evidence was not
admissible for some purpose, only that the $1.9 million amount could not be
included in the expert witness’s computation upon which the deficiency element
of tax evasion was based. It would seem reasonable, indeed commonplace, to
assume that use of a cash method or other circumstantial evidence method of
establishing deficiency would always involve accounting which would include
cash flow and cash amounts that would pass through the expert witness’s
computations but not be included in the final deficiency at the conclusion of
those computations. Any nontaxable source of cash to the taxpayer would
certainly enter the expert witness’s computation, but such amount would not be
included at the end. For example, it would not be error for the court to admit
evidence of a taxpayer’s bank account swelling by $100,000 due to a nontaxable
gift, and yet it would be error for the same court to permit the expert witness
to testify to the jury that that $100,000 was included in the shortage upon
which the expert witness bases his conclusion of reported income deficiency.
Just so here. Unlike the majority, I share appellant’s understanding of the
appropriate standard of review. Certainly, admissibility of evidence is
generally reviewed for abuse of discretion,see United States v. Warren , 42
F.3d 647, 655 (D.C. Cir. 1994). However, the tax consequences of a particular
transaction would seem to be a rather pure question of law which we would
review de novo for legal error. Finally, I do not accept the majority’s description
of this argument as “late raised.” Khanu filed his “motion to exclude $1.9
million from government’s calculations …” on August 3, 2009. The district
court entered its denial of that motion on October 14, 2009. Both of these
occurred before the commencement of the trial. In this court, the first point
argued by appellant in his opening brief is that “the $1.9 million was, as a
matter of law, not taxable income to Mr. Khanu.” I see no sense in which the
argument is late raised. Therefore, concluding that the standard of review is
for legal error, the remaining question is whether it was in fact error. It
was. 1 In the court below, and before us, appellant has consistently contended
that the $1.9 million could not be included in the computation of his cash
expenditures, as it was held by him only in safekeeping for the corporations.
The government argued at trial, and argues on appeal, that it was a factual
issue for the jury to resolve as to whether he was in fact holding the cash for
the corporations, or had taken it for his personal use. If the $1.9 million was
properly included in the accountant’s computation, the government contends,
then it was for the jury to decide whether it was cash he held and expended
upon its seizure, or cash he held for the corporation which was not includable.
The difficulty with the government’s case is that it should not have been
included in his unreported income under either circumstance. Appellant argues,
and I agree, that under the principle of taxation announced by the Supreme
Court in James v. United States, 366 U.S. 213 [7 AFTR 2d 1361] (1961), even if
Khanu took the money from the corporations for his personal use—whether that is
called embezzling or skimming—it could not under the facts of this case be
included in his taxable income. InJames , the Court accepted with approval the
government’s proposition that ““if, when, and to the extent that the victim
recovers back the misappropriated funds, there is of course a reduction in the
embezzler’s income.””Id. at 220 (quoting the brief of the United States). While
the opinion in James is a plurality opinion, neither of the separate opinions
questioned the judgment of the plurality on this point. While neither the
Supreme Court nor this court has clearly spoken to the question sinceJames ,
other lower courts have reiterated the Supreme Court’s point. In Gilbert v.
Commissioner of Internal Revenue, 552 F.2d 478 [39 AFTR 2d 77-1225] (2d Cir.
1977), the Second Circuit held that “if [an embezzler] repays the money during
the same taxable year, he will not be taxed.”Id. at 481 (citing James).
Likewise, the Tax Court has followed James. In Han v. Commissioner, 83 T.C.M.
1824 (2002), that court declared, “[f]unds over which a taxpayer has obtained
dominion and control, lawfully or unlawfully, are not taxable to him to the
extent they are repaid before year end.”Id. at 23 (emphasis added). Very
directly on point to the issue before us, inMais v. Commissioner , 51 T.C. 494
(1968), the Tax Court held that embezzled money turned over “to the New York
Police Department for restitution to” the victim would not be “treat[ed] as
income” to the embezzler in the year of the embezzlement. Id. at 497. Language
ofMais applies perfectly to the case before us. The United States on appeal is
unable to dispute the correctness of defendant’s interpretation that money
gained by embezzlement but repaid during the tax year does not generate tax
liability for the embezzler. Citing Mais, the government argues that Khanu
should have reported the $1.9 million then deducted it. I am at a loss as to
how this would fill in the necessary element of deficiency. The zero income
shown by not reporting the $1.9 million is precisely the same as the zero that
would be shown by reporting then deducting it. In any event, nothing inJames
compels the “report then deduct” procedure the government would impose, nor do
I see any way in which willful criminal conduct could be found on the part of
the defendant for not complying with such an apparently frivolous accounting
procedure. Finally, the government contends, and the majority argues, that if
the inclusion of the $1.9 million in the tax accounting was error, it was
harmless. Its argument is that because there was other accounting evidence of
over $300,000 of unreported income in 2003, on which an additional $75,000 was
due in owing, the inclusion of the $1.9 million did not prejudice the
defendant. This argument fails for two reasons. First, the potential prejudice
from a properly evidenced $300,000 understatement enhanced by a $1.9 million
improper inclusion would seem evident. The government went to the trouble of
including the $1.9 million in its accounting, defended it against motions to
exclude at trial, and argued the $2.2 million figure to the jury. I do not
believe we can hold with confidence that this change in the magnitude of
evidence by the improper inclusion did not prejudice the minds of the jury.
Perhaps equally importantly, if not more so, we cannot know that the jury did
not entirely base its guilt verdict on the $1.9 million while disbelieving or
being unconvinced as to the smaller figure in the accounting. Nonetheless, the
government is correct that the $300,000 was properly in evidence. Therefore, we
should not reverse the district court’s denial of defendant’s motion for
judgment of acquittal, but rather should vacate the judgment and remand this
count for retrial. I note again that I would not hold, nor did appellant
contend, that the seizure of the $1.9 million could not come into evidence—only
that it could not be included as part of the unreported income. It may be that
the evidence would go to the intent of the defendant or to his method of
operation. It is likely that the $1.9 million could, indeed perhaps should, be
part of the accountant’s computation as a source of cash, then offset by an
expenditure at the time of the seizure and the return to the corporation. For
the reasons set forth above, I dissent from the court’s affirmance of the
conviction and sentence on Count 4.

 

——————————————————————————–

*

Khanu first cited
the dictum in James v. United States, 336 U.S. 213 (1961), and the decisions of
the tax court described in the dissenting opinion, at the sentencing phase of
this case. We think Khanu’s objection under James rests upon a theory of
embezzlement that he did not present in his pretrial motion, in which he argued
he was merely the custodian of the $1.9 million, and that he effectively
repudiated when he moved for a judgment of acquittal; in that motion he
maintained he had “freely and transparently” borrowed cash from the
corporations and “there was not one shred of evidence” of skimming. Therefore,
were we to review the district court’s ruling on a “pure question of law”
arising underJames , we would do so only for plain error, and under that
standard we would hold the district court did not commit reversible error.

——————————————————————————–

1

The majority’s
footnote at page 10 does 1 nothing to change this fact. The most the majority
can assert is not that Khanu did not raise the objection in the district court,
but that he did not cite the appropriate case. I know of no precedent or other
rule of law requiring a litigant to cite a particular case in order to preserve
an error.

Hearing Statement of Senator Max Baucus (D-Mont.)

 

Regarding Tax Reform and Incentives for Innovation

As prepared for delivery

 

Apple co-founder Steve Jobs once said, ‘’Innovation distinguishes between a leader and a

follower.”

 

 

Thirty years ago, on the heels of the 1982 recession, a divided Congress passed the first federal

research and development tax credit to help stimulate economic growth.

The United States became the world’s leader in funding research.  This ushered in years of

innovation and investment in groundbreaking research.  Since then, U.S. companies have

changed the world with revolutionary inventions.  These include the microprocessor, the

mobile phone, solar panels, office software, personal computers and social networking.

The U.S. still leads the world in international patent filings, but we risk losing that title.  While

our international patent applications fell slightly from 2006 to 2010, China’s tripled.  We aren’t

doing enough to support our research and development sectors, and this puts our country’s

competitiveness at risk.

Today, out of the 21 OECD nations, the U.S. ranks 17th in tax incentives for research and

development.  American companies have little certainty that the main tax incentive for

research and development – the R&D credit – will continue.  Since 1981, we have relied on 14

short-term extensions to renew the credit.  This undermines the potential of the tax credit to

provide the certainty businesses need to generate meaningful growth.

Today, again in the wake of a recession, Congress must do its part to support American

ingenuity.  Development and innovation here at home will boost our economy, and they will

help create jobs.

Economists, such as Gregory Tassey of the National Institute of Standards and Technology,

argue that technology is the single most important determinant of long-term growth.

Technology creates new market opportunities.  This increases productivity and quality.  This

helps businesses create good-paying jobs and profits.

FOR IMMEDIATE RELEASE Contact: Communications Office

September 20, 2011 (202) 224-4515Today we discuss how we can most effectively encourage R&D to help create jobs here at

home.

Clearly, the world is a much different place than it was 30 years ago, when we first created the

R&D tax credit.  We are not the only country thinking along these lines.  Competition is now

fierce as other nations try to lure scientists and investors to their shores.  Now more than ever,

it is crucial that we remain the leader in research and development.

To understand this issue and help businesses create jobs, we at the Finance Committee must

think like inventors.  In doing so, we also must structure any tax incentives to get the most bang

for our buck, given our enormous fiscal challenges.

Clearly, tax credits are not the entire solution, but we can look to improve the incentives for

innovation through tax reform.

Yesterday, we took a major step forward.  Senator Hatch and I introduced a permanent R&D tax

credit – the Grow Research Opportunities with Tax Help Act, or the GROWTH Act.

This bill would make the research and development tax credit a permanent part of the tax code.

Making this tax credit permanent will provide certainty, and it will help spur economic growth

for generations to come.

The bill also simplifies and enhances the tax credit, making America more competitive in the

global race for jobs and investment.

I suspect we’ll hear from some of our witnesses today on other ways to improve the R&D tax

credit, and I want to hear those ideas.

So let us think like inventors.  Let us be creative in our solutions.  Let us understand what drives

businesses to innovate.  Let us support that innovation.  And most importantly, let us lead, not

follow.

###

 

Reasonable cause defense of   section 6664(c)(1). Pursuant to that section, an accuracy- related penalty under   section 6662(a) may not be imposed with respect to any portion of an underpayment of tax if it is established that the taxpayer  had reasonable cause and acted in good faith. Whether a taxpayer acted with reasonable cause and in good faith is a factual determination, in which the taxpayer’s effort to assess the proper level of tax is of utmost importance. See   sec. 1.6664- 4(b)(1), Income Tax Regs.

 

A taxpayer’s reliance on the advice of a professional, such as an attorney, may constitute reasonable cause and good faith where the taxpayer proves by a preponderance of the evidence that: (1) The taxpayer reasonably believed that the professional upon whom the reliance is placed is a competent tax adviser with sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Associates, P.A. v. Commissioner,   115 T.C. 43, 98-99 (2000), affd.   299 F.3d 221 [90 AFTR 2d 2002-5442] (3d Cir. 2002); see also   sec. 1.6664-4(c)(1), Income Tax Regs.

 

Rovakat, LLC, A Partnership, et al. v. Commissioner, TC Memo 2011-225 , Code Sec(s) 61; 162; 451; 988; 1012; 1221; 1402; 6229; 6501; 6662; 6664.

 

ROVAKAT, LLC, A PARTNERSHIP, SHANT S. HOVNANIAN, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .

Case Information:

 

Code Sec(s):       61; 162; 451; 988; 1012; 1221; 1402; 6229; 6501; 6662; 6664

Docket:                Docket No. 3251-09.

Date Issued:       09/20/2011

Judge:   Opinion by LARO

HEADNOTE

 

XX.

 

Reference(s): Code Sec. 61 ; Code Sec. 162 ; Code Sec. 451 ; Code Sec. 988 ; Code Sec. 1012 ; Code Sec. 1221 ; Code Sec. 1402 ; Code Sec. 6229 ; Code Sec. 6501 ; Code Sec. 6662 ; Code Sec. 6664

 

Syllabus

 

Official Tax Court Syllabus

 

Counsel

 

William R. Rankin, for petitioner.

Laurie A. Nasky and Justin D. Scheid, for respondent.

 

Opinion by LARO

 

MEMORANDUM FINDINGS OF FACT AND OPINION

 

This case is a partnership-level proceeding subject to the unified audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248,   sec. 402, 96 Stat. 648. Shant S. Hovnanian (Mr. Hovnanian), as the tax matters partner of Rovakat, LLC (Rovakat), petitioned the Court to readjust partnership items that respondent adjusted for See   sec. 6226(a). 1 Rovakat’s 2002 through 2004 taxable years. Respondent’s principal adjustment was to disallow Rovakat’s claim to   section 988 ordinary losses of $130,766 for 2002, $890,485 for 2003, and $2,479,991 for 2004. These losses stem from Rovakat’s receipt of $34,185 in Swiss francs (francs) that, Mr. Hovnanian claimed, carried with them a $5,805,000 tax basis. Respondent determined that the claimed losses are not allowed because Mr. Hovnanian failed to establish Rovakat’s basis in the francs. Respondent determined alternatively that the claimed losses are not allowed because the transaction underlying Rovakat’s receipt of the francs (francs transaction) lacked economic substance. We agree with respondent on both points. 2

 

We also decide the following secondary issues: (1) Whether Rovakat omitted income of $650,000 and $90,443 for 2002 and 2003, respectively. We hold it omitted income of $593,125 for 2002;

 

(2) whether the period of limitations for assessment has expired as to Rovakat’s 2002 taxable year. We hold it has not;

 

(3) whether $593,125 and $943,192 of Rovakat’s income for 2002 and 2003, respectively, is self-employment income. We hold it is; (4) whether Rovakat may deduct “other expenses” of $63,964 and $352,663 for 2003 and 2004, respectively. We hold it may not; (5) whether the 40-percent accuracy-related penalty under  section 6662(a) and   (h) for gross valuation misstatement applies to any underpayment of tax attributable to the reporting of the losses of $130,766 for 2002, $890,485 for 2003, and $2,479,991 for 2004. We hold it does; and (6) whether a 20-percent accuracy-related penalty under   section 6662(a) and   (b)(1), (2), or (3) for negligence or disregard of rules or regulations, substantial understatement of income tax, or substantial valuation misstatement, respectively, applies to any underpayment of tax attributable to the omitted income for 2002 and the disallowed deductions for 2003 and 2004. We hold it does.

 

FINDINGS OF FACT

 

I. Preliminaries The parties filed with the Court numerous stipulations of fact and accompanying exhibits. The Court also deemed some facts and accompanying exhibits stipulated pursuant to Rule 91(f). 3 The stipulated facts, including those deemed established, and the accompanying exhibits are incorporated herein by this reference. We find the stipulated facts accordingly.

 

II. Mr. Valdez

 

A. Background

 

Lance O. Valdez (Mr. Valdez) is a tax attorney who practiced law through his wholly owned professional corporation, Lance O. Valdez & Associates, P.C. (LOVA). He also is a financial adviser who provided investment advisory services primarily through two other entities that he controlled, LVCM, Ltd. (Limited), and Lance Valdez Tax Management.

 

As part of his investment advisory services, Mr. Valdez structured and marketed tax-shelter transactions which generated for U.S. taxpayers superficial Federal income tax losses greatly disproportionate to economic outlay in the activities underlying those losses. For the most part, Mr. Valdez designed and implemented these transactions, and he created the transaction documents effecting their implementation. The documents were generally the same as to each transaction, except for the names of the parties to the transaction and the amounts involved.

 

B. Transactions Promoted

 

Mr. Valdez promoted his transactions as “investments”. While the transactions varied according to the entities, taxpayers, and assets involved, the transactions generally involved foreign property with significant built-in losses incurred by a foreign person not subject to U.S. tax, and used the same three steps.

 

As the first step in the transaction, a foreign entity, pursuant to an agreement with Mr. Valdez in which he agreed to pay the foreign entity a fee, transferred the built-in loss property with its purportedly high basis and a low fair market value (distressed assets) to a domestic partnership in exchange for an interest in the partnership. Second, the foreign entity sold a significant portion of its interest in the partnership to a U.S. taxpayer who was one of Mr. Valdez’s “investors”. Third, the partnership disposed of the distressed assets to formally trigger the built-in losses claimed to continue to inhere in the distressed assets, with those “losses” allocated to the U.S. taxpayer to offset the taxpayer’s unrelated income otherwise subject to Federal income tax.

 

In total, Mr. Valdez’s transactions caused over $147 million in “losses” to be allocated among his “investors” who did not actually realize economic losses of anywhere near the amounts allocated and who had minimal economic outlays in relation to the allocated “losses”.

 

C. IRS Investigates Mr. Valdez The Internal Revenue Service (IRS) investigated Mr. Valdez, LOVA, and Lance Valdez Tax Management as organizers, sellers, or promoters of potentially abusive tax shelters. That investigation led the IRS to examine Rovakat’s 2002 through 2004 Forms 1065, U.S. Return of Partnership Income (2002 return, 2003 return, and 2004 return, respectively).

 

III. Rovakat

 

A. Formation of Rovakat

 

International Capital Partners, LP (ICP), and International Strategic Partners, LLC (ISP), formed Rovakat on June 6, 2002, as a Delaware limited liability company. 4 Rovakat uses the cash receipts and disbursements method of accounting for Federal tax purposes, and Rovakat reports its income and expenses on the basis of the calendar year. Rovakat’s mailing address and registered office were in the third judicial circuit of the United States when the petition was filed. B. ICP

 

1. Overview

 

Mosafa, Ltd. (Mosafa), and Credicom N.V. (CNV) formed ICP as a Cayman Islands limited partnership on May 7, 2001. ICP conducted its activities and maintained its books and records in U.S. dollars. Mr. Valdez controlled ICP at all relevant times.

 

2. Mosafa

 

Mosafa is a Cayman Islands company. As part of ICP’s formation, Mosafa transferred $1,000 to ICP in exchange for a 2- percent general partnership interest.

 

3. CNV

 

CNV is a Belgian company that is a subsidiary of Immobiliere Hoteliere, S.A. (Immobiliere), a French real estate and hotel conglomerate. CNV conducted its activities and maintained its books and records on the basis of the Belgian franc (Belgian franc). CNV’s managing director was Henri Van Zeveren (Mr. Van Zeveren), a Belgian citizen and resident. As part of ICP’s formation, CNV contributed $49,000 to ICP in exchange for a 98-percent limited partnership interest.

 

4. Investment Advisory Agreement

 

LVCM, LLC (LVCM), is a Delaware limited liability company whose managing member was Mr. Valdez. LVCM and ICP entered into an investment advisory agreement under which LVCM agreed to provide investment advisory and management services to ICP from May 10, 2001, through December 31, 2015, in exchange for a management fee and an allocation of ICP’s profits. The agreement appointed LVCM as ICP’s manager, agent, and attorney-in-fact, and the agreement authorized LVCM to bind ICP with respect to, among other things, asset transfers, bank accounts, and transactions. C. ISP

 

Limited formed ISP on January 23, 2001, as a Delaware limited liability company. During March 2002, Mr. Hovnanian purchased a 93.9-percent interest in ISP; he did not conduct any due diligence regarding that purchase. ISP’s remaining 6.1- percent interest was owned by ICP and by Mr. Valdez’s wholly owned corporation Horizon Capital Holdings Corp. Mr. Valdez controlled ISP at all relevant times.

 

IV. Mr. Hovnanian and Related Entities

 

A. Mr. Hovnanian Mr. Hovnanian is the managing member of Rovakat and its tax matters partner. He earned a bachelor of science degree in economics from the University of Pennsylvania, and he has over 20 years of experience in the computer, software, and wireless telecommunications industries. He has invested in real estate, startup companies, and financial instruments such as foreign currency contracts, hedging contracts, and the buying and selling of stock (including short selling). He is a wealthy individual, and he is a high-income taxpayer. B. VSHG

 

Mr. Hovnanian was the executive vice president of V.S. Hovnanian Group (VSHG) from June 1980 until January 1991. VSHG was a holding company, and its subsidiaries engaged in construction, development, and utilities. At all relevant times, Mr. Hovnanian owned 25 percent of VSHG, and three members of his family equally owned the remaining 75 percent.

 

Hovbilt, Inc. (Hovbilt), a C corporation, was one of VSHG’s subsidiaries. VSHG owned 99 percent of Hovbilt, and Mr. Hovnanian owned the other 1 percent.

 

C. Speedus

 

Speedus Corp. (Speedus) is a publicly traded company that specializes in information technology and medical devices. 5 Since 1991, Mr. Hovnanian has been its president, chief executive officer, and chairman of its board of directors. Mr. Hovnanian also was an employee of Speedus at all relevant times.

 

V. Jacques Vabre Transactions Immobiliere and its subsidiaries (collectively, Immobiliere group) owned various assets which had lost much of their value by February 2001. Mr. Valdez and the Immobiliere group discussed Immobiliere’s transferring of these distressed assets to entities controlled by Mr. Valdez. Mr. Valdez and the Immobiliere group referred to these transactions as Jacques Vabre transactions, with an understanding that “Jacques Vabre” was Mr. Valdez’s nickname.

 

The Immobiliere group participated in four Jacques Vabre transactions. Each transaction involved the equity interests of a single entity; namely, Credicom Asia, Limited (Credicom Asia), Kislev Partners, L.P. (Kislev Partners), Silvecom S.A., or Todor, S.A. The Immobiliere group earned between $7 million and $10 million in fees by participating in these transactions. The fee for each transaction was set at a percent (ranging from 2 to 2.5 percent of 90 percent) of the distressed assets’ Federal income tax basis that was claimed to be obtained from the Immobiliere group as part of the transaction.

 

VI. Transaction Involving Credicom Asia

 

A. Overview

 

The Jacques Vabre transaction at issue was essentially a four-step transaction involving Credicom Asia. First, Credicom Asia redeemed its worthless class A common stock (class A stock) from CNV for 1,718,116 francs and $303,375. Second, CNV transferred the francs to ICP in exchange for an increased interest in ICP. Third, ICP transferred to Rovakat 50,000 of the francs with an aggregate fair market value of $34,185. Fourth, ICP sold 90 percent of its interest in Rovakat to Mr. Hovnanian. One day after the fourth step, Rovakat sold its 50,000 francs to a third party at their fair market value of $35,268.

 

B. History of Credicom Asia

 

Credicom Asia is a subsidiary of CNV and a member of the Immobiliere group. Credicom Asia was formed as a British Virgin Islands company on June 18, 1992, under the name Pacific Eagle Corporation Limited, and subsequently changed its name to Credicom Asia. On or about September 13, 1996, Credicom Asia was registered to do business in the Cayman Islands. Credicom Asia primarily conducted its activities and maintained its books and records in U.S. dollars.

 

Credicom Asia had two classes of common stock outstanding as of December 2, 1996. The first class, class A stock, was initially owned entirely by CNV and represented 70 percent of the equity interests in Credicom Asia. The second class, class B common stock (class B stock), was initially owned entirely by Colony Credicom, L.P., and Colorado Credicom, LLC (collectively, C&C), and represented the remaining 30 percent equity interests in Credicom Asia.

 

C. Liquidation Preference of Credicom Asia

 

In a Restated Memorandum of Association dated September 13, 1996, Credicom Asia provided that holders of its common stock were entitled to apportion any assets that remained after the preference rights of the preferred shareholders were satisfied as follows:

 

First, to the holders of the *** [class B stock], an amount that would cause [them] to receive an 18% per annum (compounded annually and computed from the date of the issuance thereof) internal rate of return on [their] original principal investment after taking into account *** all dividends and distributions from [Credicom Asia] in respect of the *** [class B stock] *** ; *** Second, to the holders of the *** [class A stock], an amount that would cause [them] to receive an 18% per annum (compounded annually and computed from the date of issuance) internal rate of return on [their] original principal investment after taking into account *** all dividends and distributions from *** [Credicom Asia] in respect of the *** [class A stock] *** ; *** Third, to the holders of the *** [class B stock], an amount equal to the product of (A) that percentage which the *** [class B stock] represents of all the outstanding common stock, times (B) the ratio of 25/35 times (C) the remaining amount of proceeds to be distributed in respect of a liquidation; and *** *** [Fourth,] *** the remaining amount to the holders of the *** [class A stock] *** . C&C paid $55 million for the class B stock and as of December 2, 1996, was entitled upon the liquidation of Credicom Asia to a priority distribution of $55 million plus an 18-percent cumulative annual return before any distributions were made to CNV. CNV, the holder of the class A stock, was entitled to receive a portion of the liquidated assets after payment of the priority distribution. 6

 

D. Credicom Asia’s Holdings

 

1. Overview As of January 1, 1997, Credicom Asia’s assets consisted of: (1) 100 percent of the stock of Golf de Ramatuelle, S.A. (Golf de Ramatuelle), a French societe anonyme; (2) 100 percent of the stock of Lahotel Corporation (Lahotel), a British Virgin Islands company; (3) 91.3 percent of the stock of Argent Holdings, Ltd. (Argent), a British Virgin Islands company; and (4) an unspecified interest in Kislev Partners, a Cayman Islands partnership.

 

2. Golf de Ramatuelle

 

As of January 1, 1997, Golf de Ramatuelle was engaged in the attempted development of land (Golf property) in the Commune of Ramatuelle in the Canton of Saint-Tropez, France. Golf de Ramatuelle’s principal assets were direct and indirect ownership interests in the Golf property. Golf de Ramatuelle’s liabilities totaled $10,524,301 as of December 2, 1996, and approximately $7 million on June 7, 2001.

 

The Golf property consists of approximately 321 acres of land. The land is principally forest land, with a portion that may be used for agriculture, and is in an area subject to a high risk of fire. The land lacks adequate water, sewer, and power supply to support extensive development. The Golf property was not zoned for commercial development, and Golf de Ramatuelle’s attempts to develop the property for nonagricultural uses were unsuccessful throughout the years.

 

3. Lahotel

 

As of January 1, 1997, Lahotel owned L’Ermitage Hotel (L’Ermitage), a luxury hotel in Beverly Hills, California. Built in 1976, L’Ermitage was closed for renovations from September 1993 until June 1998. L’Ermitage’s liabilities were $9,347,765 as of December 31, 1996. In 1998, L’Ermitage was assessed at $13,185,232 for property tax purposes.

 

4. Argent

 

As of January 1, 1997, Argent owned an interest in the Amanresorts hotel chain, through a 60.97-percent interest in Silverlink Holdings, Ltd. (Silverlink). Amanresorts and the nine Aman operating assets, partially or wholly owned by Silverlink, are widely viewed as an innovative upscale hotel group. Aman was recapitalized in 1993 with Immobiliere, through Argent, acquiring control of the company. Silverlink’s current liabilities exceeded its current assets on December 31, 1995 and 1996.

 

5. Kislev Partners

 

As of January 1, 1997, Kislev Partners, through a wholly owned subsidiary, owned approximately 60 percent of Financiere Saresco (Saresco). Saresco was founded in 1976 by Air France Group and Aeroports de Paris to operate duty-free stores in Paris airports. Saresco, through its various subsidiaries, operated duty-free retail stores which sold perfumes, cosmetics, spirits, tobacco, and fashion accessories. Substantially all of these retail stores sold goods free of duty and of tax. Over 80 percent of the sales in the duty-free division were from Saresco’s stores in two terminals in Paris Charles de Gaulle Airport at Roissy.

 

E. Buyout of the Class B Stock By 1998, C&C had become increasingly unhappy with their investment in the class B stock. On February 15, 1999, C&C petitioned the High Court of Justice, British Virgin Islands, to order the winding up of Credicom Asia. At that time, Credicom Asia was unable to pay its debts, and C&C owned 36.62 percent of Credicom Asia through ownership of the class B stock and a partial interest in Kislev Partners. Credicom Asia also owed C&C approximately $22 million.

 

During August 2000, Immobiliere disposed of substantially all of Saresco’s assets in exchange for the cancellation of debt. Shortly thereafter, on September 1, 2000, Credicom Asia, CNV, and C&C entered into a settlement agreement in lieu of the winding up of Credicom Asia. Under that agreement, C&C granted CNV an option to pay $118 million to acquire the following assets (optioned assets): (1) 45,834 shares of class B stock owned by C&C; (2) the Kislev partnership interest owned by C&C; (3) debts which Credicom Asia owed to C&C; and (4) a mortgage on Lahotel’s assets. In return, C&C agreed to dismiss the winding up petition upon CNV’s exercise of the option. Mr. Valdez received a copy of this settlement agreement.

 

CNV exercised its option and purchased the optioned assets on September 18, 2000. By October 5, 2000, Credicom Asia’s remaining assets were its interests in Golf de Ramatuelle and in Saresco.

 

Credidev, Ltd. (Credidev), a British Virgin Islands entity, was formed as a wholly owned subsidiary of CNV to receive C&C’s class B stock. The class B stock was transferred to Credidev on October 5, 2000. CNV retained its interest in the class A stock.

 

F. March 14, 2001, Meeting of the Board of Directors CNV had no source of revenue other than fees generated from the Jacques Vabre transactions. During a meeting of CNV’s board of directors on March 14, 2001, the board of directors “ordered” that CNV reduce its interest in Credicom Asia.

 

Mr. Van Zeveren, in his capacity as CNV’s managing director, worried that CNV’s directors could be faulted for failing to call for the cessation of CNV’s activities. Specifically, he was concerned that CNV’s directors might be reproached because CNV had consistently generated losses since 1991 and all of its fixed assets, with the exception of Golf de Ramatuelle and shares in shell companies, were sold. Mr. Van Zeveren reasoned that CNV’s interests in the shell companies had “residual value” in that the companies could generate fees from Mr. Valdez by participating in his transactions. Immobiliere, in its capacity as CNV’s majority shareholder, contemplated using any such fees to pay CNV’s arrears, to cover its operating expenses for 1 to 2 years, and if necessary, to pay for an amicable liquidation of CNV.

 

G. ICM’s Purchase of Class A Stock International Capital Management, LLC (ICM), is a Delaware limited liability company that Mr. Valdez controlled as its managing member. On March 26, 2001, ICM purchased (1) 1,586.5 shares of class A stock from CNV for $26,503; and (2) 2,291.7 shares of class B stock from Credidev for $38,913. The purchased class A stock represented a 2-percent interest in Credicom Asia, and the purchased class B stock represented a 5-percent interest in Credicom Asia.

 

H. Redemption of Class A Stock

 

Mr. Valdez was named Credicom Asia’s president sometime before June 7, 2001. On April 25 and May 8, 2001, Mr. Valdez transferred a total of $1,325,126 to a UBS AG (UBS) bank account held by Credicom Asia. On May 14, 2001, Credicom Asia purchased 1,718,116 francs through its UBS bank account for $1,021,751. These francs were transferred to a UBS bank account held by CNV.

 

On June 7, 2001, Credicom Asia redeemed from CNV all of its class A stock for 1,718,116 francs and $303,375. The redemption was entered into by Mr. Van Zeveren in his capacity as CNV’s managing director and by Mr. Valdez in his capacity as Credicom Asia’s president. Also on June 7, 2001, CNV transferred the 1,718,116 francs to ICP in return for an increased limited partnership interest in ICP.

 

Mr. Valdez wired the $303,375 to CNV from Credicom Asia’s UBS bank account. CNV then wired the $303,375 to ICP’s UBS bank account. No further activity in Credicom Asia’s UBS account occurred until August 24, 2005, when Mr. Valdez closed both the Credicom Asia and ICP UBS bank accounts.

 

I. Participation Fees CNV’s claimed basis in the class A stock was approximately $184 million, and CNV expected to receive approximately $4,140,000 from Mr. Valdez in exchange for its participation in the Credicom Asia transaction. These fees were payable in two tranches. The first tranche related to $100 million of CNV’s claimed basis in the class A stock and generated $2.2 million in fees for CNV. 7 The second tranche related to $84 million of CNV’s claimed basis in the class A stock and generated $1,940,000 in fees for CNV. CNV used the fees from the first tranche to purchase bonds issued by Immobiliere in 2001. CNV (or Immobiliere) intended to use the fees generated from the second tranche to pay its arrears, to continue its operations long enough to allow for the sale of CNV’s remaining assets, and “to pick the bones clean”.

 

VII. Francs Transaction During November 2002, ICP transferred to Rovakat 50,000 francs with a fair market value of $34,185. Immediately thereafter, Rovakat’s owners were ISP (approximately 75-percent owner) and ICP (approximately 25-percent owner). On December 26, 2002, Mr. Hovnanian purchased 90 percent of ICP’s interest in Rovakat for $30,776. Immediately after, Rovakat’s owners (with their approximate ownership interests) were ISP (approximately 75-percent owner), ICP (approximately 2-percent owner), and Mr. Hovnanian (approximately 23-percent owner).

 

On December 27, 2002, Rovakat sold the 50,000 francs to a third party for $35,468. Rovakat reported on its 2002 return that its tax basis in the francs was $5,805,000 and that it realized a $5,769,532 loss on the sale ($35,468 – $5,805,000). Rovakat lacked sufficient income to apply all of the reported loss to 2002, and it reported that it was suspending the unused portion of the reported loss.

 

VIII.      Payment of Fees to Mr. Valdez

A.   Overview

From 2002 through 2004, Rovakat directly or indirectly paid fees of at least $147,318 to Mr. Valdez. Rovakat paid these fees through an intermediary entity, Wireless Audience Survey, Inc. (WASI). Manuel Asensio, a close personal friend and business acquaintance of Mr. Hovnanian, controlled WASI and authorized the fee payments. WASI, in turn, paid the fees to Mr. Valdez through Limited. Additional fees of $234,835 were paid to another entity controlled by Mr. Valdez.

 

B. 2002 Payments Limited issued WASI an October 30, 2002, invoice in the amount of $650,000 for “advisory services in connection with software licensing and code development”. Limited received $650,000 from WASI on November 22, 2002.

 

Rovakat issued Limited a December 26, 2002, invoice in the amount of $593,125 for “consulting” services. One day later, Rovakat issued Limited an invoice in the amount of $593,125 as a “refundable prepaid deposit” for “consulting” services. Limited transferred $593,125 to Rovakat on December 31, 2002.

 

Rovakat did not report on its 2002 return that any portion of either the $650,000 or the $593,125 was includable in income.

 

C. 2003 Payments Limited issued WASI a February 27, 2003, invoice for $1,033,635 of “advisory services in connection with software licensing and code development rendered in 2002”. Limited received $1,033,635 from WASI on March 24, 2003.

 

Rovakat issued Limited a March 25, 2003, invoice for $943,192 of “consulting” services. On March 25, 2003, Limited transferred $943,192 to Rovakat.

 

Rovakat did not report on its 2003 return that any portion of either the $1,033,635 or the $943,192 was includable in income. IX. WIC Lawsuit and Mr. Hovnanian’s Bonus

 

A. Overview

 

Speedus filed a lawsuit (WIC lawsuit) against Western International Communications (WIC) on or before April 25, 2002. Speedus agreed in an employment agreement with Mr. Hovnanian to pay him a bonus (bonus) of 20 percent of any net proceeds received by Speedus from the WIC lawsuit. When that agreement was executed, Mr. Hovnanian was Speedus’ chief executive officer, and he was paid in that capacity an annual salary of at least $250,000. He also was entitled to receive reimbursement for “reasonable business related expenses” incurred as Speedus’ chief executive officer.

 

B. Mr. Hovnanian Assigns Bonus to Rovakat On July 10, 2002, Mr. Hovnanian assigned his rights to the bonus to Rovakat. Mr. Hovnanian did so without receiving a membership interest in Rovakat commensurate with the value of the rights. The assignment agreement stated that Mr. Hovnanian assigned his rights to the bonus to Rovakat because Rovakat “has members who can confidentially assist and advise the pursuit of the interest in the [WIC lawsuit].” Under the assignment agreement, Mr. Hovnanian permitted Rovakat to assign the bonus to subsidiaries or partnerships in which Rovakat held a majority interest.

 

C. Settlement of WIC Lawsuit

 

In late 2003 or early 2004, Speedus and WIC settled the WIC lawsuit for $15 million. Of that amount, Speedus was entitled to receive $14,232,280 in net proceeds. Speedus was amenable to paying the $2,846,456 bonus (20 percent x $14,232,280) to Mr. Hovnanian as he directed.

 

D. Sunshower

 

Mr. Hovnanian, on behalf of Rovakat, formed Sunshower LLC

 

(Sunshower) as a Delaware limited liability company on February 4, 2004. Sunshower is a disregarded entity for Federal income tax purposes. On February 20, 2004, Speedus transferred $2,846,456 to Sunshower’s bank account. In correspondence with Rovakat’s accountant, Mr. Hovnanian designated these proceeds as “consulting income”.

 

On February 27, 2004, Mr. Hovnanian caused $234,835 to be transferred from Sunshower to Sterling Capital Management, Ltd. (Sterling), an entity controlled by Mr. Valdez. Mr. Hovnanian noted that this payment represented “fees paid to *** [Mr. Valdez's] entity”. Speedus did not reimburse Mr. Hovnanian for the $234,835 paid to Mr. Valdez. X. Similar Transactions in Which Mr. Hovnanian Participated Mr. Hovnanian participated in two additional transactions involving purportedly high-basis francs and the reporting of ordinary losses. The first transaction involved the transfer of francs with a fair market value of approximately $60,000 and a purported basis of $11,698,313. Hovbilt used the resulting claimed loss to offset income that VSHG earned. The second transaction involved the transfer of francs with a fair market value of approximately $59,920 and a purported basis of $11,847,499. ISP used the resulting claimed loss to offset income that Mr. Hovnanian earned from unrelated sources. XI. Rovakat’s Federal Partnership Tax Returns

 

A. Preparer of the Returns

 

Harvey Weinreb (Mr. Weinreb) prepared Rovakat’s 2002, 2003, and 2004 returns. Mr. Hovnanian retained Mr. Weinreb for that purpose at the suggestion of Mr. Valdez.

 

B. 2002 Return Rovakat filed its 2002 return on October 23, 2003. The 2002 return reported no gross receipts and no income. Rovakat reported that it was entitled to recognize $130,766 as a loss on the francs transaction and that another $5,638,765 from the transaction was a “suspended loss”.

 

C. 2003 Return Rovakat filed its 2003 return on April 7, 2005. The 2003 return reported no gross receipts, no ordinary business income or loss, and “other fees income” of $943,192. Rovakat recognized $890,485 of the suspended loss and reported that $4,335,154 remained “suspended”. 8 Rovakat also reported a charitable contribution deduction of $6,224.

 

D. 2004 Return Rovakat filed the 2004 return on February 13, 2006. The 2004 return reported total income of $2,846,456, which apparently was the bonus from Speedus. Rovakat recognized $2,479,991 of the suspended loss as a “prior year suspended loss” and reported that $1,855,163 remained “suspended”. Rovakat also reported a charitable contribution deduction of $60,350.

 

E. Expenses Reported on 2003 and 2004 Returns Rovakat reported the following expenses as deductions on its 2003 and 2004 returns:

 

Expense                        2003           2004

Bank fee                            $332            -0-

Consulting                        22,000        $56,154

Filing fees                          546          2,418

Finance charge                        58            -0-

Office                               861            -0-

Postage and delivery                  14            -0-

<8>

The amount of the remaining “suspended loss” appears to

have been reported incorrectly ($5,769,532 claimed loss -

$130,766 loss reported on the 2002 return – $890,485 loss

reported on the 2003 return = $4,748,281).

Professional fees                   13,000         -0-

Legal and accounting fees              -0-     250,410

Miscellaneous                          -0-          65

Auto                                 7,659       1,408

Computer                               198         -0-

42,208

Meal and entertainment              19,296

Total                             63,964     352,663

XII.     Tax Advice and Opinions

A.   KPMG Facsimile

On March 1, 2001, KPMG sent to Mr. Van Zeveren a one-page facsimile which stated that the “evolution of the purchase value” of the class A stock as recorded in CNV’s books was $184,955,349. KPMG apparently did not attach the source documents for this conclusion to its facsimile, and the memorandum does not define “purchase value”.

 

B. Sidley Austin Opinion

 

Before July 31, 2001, Mr. Valdez hired Sidley, Austin, Brown, and Wood LLP (Sidley Austin) to render an opinion (Sidley Austin opinion) for Federal tax purposes on the bases of various assets transferred in connection with Credicom Asia’s redemption of its class A stock. In rendering its opinion, Sidley Austin reportedly “relied on audited financial statements, accounting records, third party appraisals, and certain other factual, financial, and numerical information that *** [it] deemed relevant.” In addition, the Sidley Austin opinion noted that Sidley Austin relied on at least 25 assumptions and 13 factual representations.

 

The Sidley Austin opinion concluded that (1) the basis of CNV’s interest in the class A stock as of June 7, 2001, was $207,093,834; (2) CNV’s basis in the 1,718,116 francs and the $303,375 received from the redemption of the class A stock totaled $207,093,834; (3) the basis of CNV’s interest in ICP as of June 8, 2001, was $207,093,834; and (4) ICP’s basis in the 1,718,116 francs which ICP received from CNV was $206,790,459. Mr. Hovnanian first received a copy of the Sidley Austin opinion in 2008.

 

C. De Castro Opinions

 

Mr. Hovnanian, at the suggestion of Mr. Valdez, hired the law firm of De Castro, West, Chodorow, Glickfield & Nass, Inc. (De Castro), to render a tax opinion regarding the tax consequences of the francs transactions (Rovakat opinion). The cost of the Rovakat opinion was $13,000. Mr. Hovnanian relied on Mr. Valdez to serve as an intermediary between Mr. Hovnanian and De Castro. The Rovakat opinion concluded that “there is a greater than 50% likelihood that the tax treatment of the *** [francs transaction] would be upheld if challenged by the IRS.” In rendering that opinion, De Castro “assumed *** the accuracy of the factual matters” represented in the Sidley Austin opinion, including ICP’s basis in the francs, and did not review “any transactional documents”.

 

Mr. Hovnanian also procured an opinion from De Castro on the tax consequences associated with ISP’s investment in francs (ISP opinion). The Rovakat and ISP opinions are identical in most material regards.

 

In total, De Castro wrote nine opinions for Mr. Valdez and for individuals who invested in his transactions. De Castro made thousands of dollars on referrals from Mr. Valdez and at least $2 million from writing opinions on other similar transactions. Menasche Nass, a partner of De Castro, invested in a “distressed debt transaction”.

 

XIII.        FPAAs

On November 13, 2008, respondent issued to Rovakat a separate notice of final partnership administrative adjustment (FPAA) for each of Rovakat’s 2002, 2003, and 2004 taxable years. The FPAAs determined that Rovakat had not established its basis in the francs. The FPAAs determined alternatively that the francs transaction lacked economic substance. XIV. Trial of This Case

 

A. Overview

 

A trial was held in New York, New York, from December 14 through December 17, 2010. The evidence consists of the uncontested pleadings, the trial testimony of 7 lay and 3 expert witnesses, over 700 stipulated facts, and over 600 exhibits.

 

B. Expert Witnesses

 

1. Dr. LaRue Respondent offered, and the Court recognized, David W. LaRue, Ph.D. (Dr. LaRue), as an expert in financial and tax accounting, finance, and economics. Dr. LaRue is a professor emeritus at the University of Virginia, and he holds a Ph.D. in accounting, taxation, and economics and a master’s degree in accounting and taxation. From 2000 through 2005 he was the director of the graduate accounting program at the University of Virginia. He has over 30 years of teaching experience in the fields of taxation, accounting, and finance. He has testified before this and other Courts on many previous occasions as an expert in financial and tax accounting, finance, and/or economics.

 

2. Dr. Friedman Respondent offered, and the Court recognized, Jack P. Friedman, Ph.D. (Dr. Friedman), as an expert on fair market value as it relates to real estate and business valuation. Dr. Friedman holds a Ph.D. in business administration with a focus in real estate and urban affairs, a master’s degree in business administration, and a bachelor’s degree in business administration. Dr. Friedman is published and holds the following professional certifications: Certified public accountant (C.P.A.), member of the Appraisal Institute, senior real estate analyst, senior member of the American Society of Appraisers, and fellow of the Royal Institute of Chartered Surveyors. Dr. Friedman has taught real estate appraisal courses for 19 years, and he has developed courses for various professional associations.

 

3. Mr. Bernatowicz Mr. Hovnanian called Frank A. Bernatowicz (Mr. Bernatowicz) as his expert, and the Court recognized Mr. Bernatowicz as an expert in financial accounting. Mr. Bernatowicz is a C.P.A. and a member of the American Institute of C.P.A.s, the Illinois C.P.A. Society, and the National Society of Professional Engineers. He holds a bachelor of science degree in electrical engineering and a master’s degree in business administration in finance. He was a partner with Ernst and Whinney (now Ernst and Young), and he directed the firm’s Midwest Region Litigation Services and Real Estate Advisory Services practices. He was a managing principal of Alix & Associate’s Chicago office, a managing partner of the Midwest Region Intellectual Property Practice of PricewaterhouseCoopers LLP, and a managing partner of BDO Seidman’s Specialized Services practice.

 

C. Special Procedure as to Expert Testimony With the agreement of the parties, we directed the experts to testify concurrently. To implement the concurrent testimony, the Court sat at a large table in the middle of the courtroom with all three experts, each of whom was under oath. The parties’ counsel sat a few feet away. The Court then engaged the experts in a three-way conversation about ultimate issues of fact. Counsel could, but did not, object to any of the experts’ testimony. When necessary, the Court directed the discussion and focused on matters that the Court considered important to resolve. By engaging in this conversational testimony, the experts were able and allowed to speak to each other, to ask questions, and to probe weaknesses in any other expert’s testimony. The discussion that followed was highly focused, highly structured, and directed by the Court. 9

 

OPINION

 

I. Burden of Proof Taxpayers generally bear the burden of proof in a partnership-level proceeding such as this, see Rule 142(a), and Mr. Hovnanian concedes that this general rule applies with respect to the adjustments in the FPAAs. Respondent bears the burden of proving the allegation in his amendment to answer that Rovakat earned unreported income of $650,000 in 2002. See id.

 

II. Rovakat’s Claimed Loss

 

A. Overview

 

We first decide whether Rovakat may recognize its claimed losses of $130,766 for 2002, $890,485 for 2003, and $2,479,991 for 2004. Mr. Hovnanian contends that these losses are allowed on account of Rovakat’s sale of the francs. As Mr. Hovnanian sees it, CNV was a partnership that had a $182,068,631 basis in its class A stock (which Mr. Hovnanian considers to be a partnership interest), and that basis was transferred to the 1,781,116 francs that CNV received upon the redemption of the class A stock. Then, Mr. Hovnanian reasons, ICP received that basis upon its receipt of the francs, and Rovakat received a pro rata share of the basis upon Rovakat’s receipt of 50,000 of the francs. Mr. Hovnanian concludes that Rovakat’s sale of the 50,000 francs on December 27, 2002, triggered the basis, which in turn resulted in an approximately $5 million loss allocable to its partners (principally, Mr. Hovnanian).

 

Respondent argues that Rovakat may not recognize its claimed losses because Mr. Hovnanian has failed to establish Rovakat’s basis in the francs. In addition, respondent argues, Rovakat may not recognize its claimed losses because the transfers of the francs lacked economic substance in that the francs transaction was effected solely to generate an artificial loss.

 

We agree with respondent that Rovakat may not recognize its claimed losses. As we find, Mr. Valdez orchestrated a series of transactions through which CNV, a corporation, sold its built-in loss in its class A stock to either Mr. Valdez or to ICP, and the transactions resulting in that sale were intended solely to disguise the sale as a tax loss that could ultimately shelter Mr. Hovnanian’s ordinary income from U.S. taxes.

 

B. Basis in the Francs

 

Mr. Hovnanian bears the burden of establishing Rovakat’s basis in the francs, and that burden includes establishing ICP’s basis in the francs upon their transfer. Mr. Hovnanian strives to meet this burden by focusing on the general rules of partnership taxation. Under those rules, which apply even where the contributor is a foreign entity, see Gutwirth v. Commissioner,   40 T.C. 666, 678-679 (1963), a partner’s contribution of property to a partnership in exchange for a partnership interest is generally a tax-free transaction, see   sec. 721(a). In addition, the partner’s basis in the partnership interest received generally equals the partner’s adjusted basis in the contributed property plus, where applicable, the amount of any money the partner also contributed.   Sec. 722. In addition, the partnership’s basis in the contributed property generally is a substitute basis that equals the partner’s adjusted basis in that property at the time of contribution.   Sec. 723.

 

These general rules do not apply, however, where, as here, the facts establish that one or more of the relevant transactions is not in substance a contribution to a partnership as it purports to be. The substance of the transactions at hand, as we find on the basis of the credible evidence in the record, is that Mr. Valdez, in his individual capacity or on behalf of ICP, bought the class A stock from CNV, a corporation, at an amount drastically in excess of the stock’s fair market value, and he did so with an understanding that CNV would cooperate in structuring the sale to appear to be a nontaxable transfer. For obvious reasons, the parties to the agreement could not memorialize in the transaction documents the true terms of the transaction as a sale because a sale would negate any claims of a substitute basis in the francs under the partnership rules applicable to contributions of property. When viewed in total, however, the record leads us to conclude that either Mr. Valdez engaged in an actual purchase of the class A stock or ICP engaged in a disguised purchase of the class A stock, which in either case sets the basis in the francs at their cost. See   sec. 1012; see also   sec. 1.707-3(a)(2), Income Tax Regs.

 

To be sure, Mr. Valdez structured the transactions using entities he controlled, aiming to manipulate the rules applicable to partnership taxation so that he could sell to his U.S. “investors” foreign built-in losses that they could personally apply as ordinary losses. He provided the money for the class A stock to be “redeemed”. He converted the stock to francs so he could use a currency which was CNV’s nonfunctional currency. He caused CNV to transfer the francs to ICP, an entity he controlled and which he claimed was a partnership, so he could claim a substitute basis in the francs. The fact that Mr. Valdez wanted directly or indirectly to purchase the class A stock with its built-in loss retained for use by Mr. Hovnanian cannot reasonably be denied.

 

Nor has Mr. Hovnanian established (as he asserts) that ICP was a partnership entitled to a substitute basis in the francs. A partnership exists for Federal income tax purposes only when “persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses.” Commissioner v. Tower,   327 U.S. 280, 286 [34 AFTR 799] (1946). Facts relevant to this determination include the conduct of the parties, particularly their due diligence (or lack thereof) and negotiations (or lack thereof), the relationship of the parties, and the control of income and the purposes for which it is used. See Commissioner v. Culbertson,   337 U.S. 733, 742 [37 AFTR 1391] (1949). The absence of a nontax business purpose is fatal to the validity of a partnership. See ASA Investerings Pship. v. Commissioner,   201 F.3d 505, 512-513 [85 AFTR 2d 2000-675] (D.C. Cir. 2000), affg.   T.C. Memo. 1998-305 [1998 RIA TC Memo ¶98,305].

 

 

The record does not suggest, and we do not find, that ICP’s listed partners intended to join together to carry on a trade or business. The record does not establish the intent of each of ICP’s “partners”, but we find as to Mr. Valdez and CNV, ICP’s primary “partners”, that they had their own agendas. CNV was in financial trouble, and it and Immobiliere desired to obtain liquidity primarily by selling alleged tax basis in what was otherwise a worthless shell entity, Credicom Asia. CNV’s and Immobiliere’s due diligence was focused on how many Jacques Vabre transactions could be put together with Mr. Valdez and how fast payment could be made. CNV and Immobiliere expected to be paid approximately $4 million for their part, far in excess of the approximately $1.3 million actually exchanged for the redemption of the class A stock. Because Mr. Hovnanian has failed to prove that ICP was a partnership for Federal income tax purposes (and the record establishes that it was not), ICP had a cost basis in the francs, see   sec. 1012, rather than the substitute basis that Rovakat reported. 10

 

C. Economic Substance

 

1. Guiding Legal Principles Mr. Hovnanian stated at trial that an appeal in this case would lie in the Court of Appeals for the Third Circuit, and In ACM Pship. v. Commissioner,   157 F.3d 231 [82 AFTR 2d 98-6682], respondent agreed. 247-248 (3d Cir. 1998), affg. in part and revg. in part on an issue not relevant here  T.C. Memo. 1997-115 [1997 RIA TC Memo ¶97,115], the Court of Appeals for the Third Circuit articulated a two-factor inquiry to decide whether a transaction or series of transactions had sufficient economic substance to be respected for Federal tax purposes. 11 The first factor requires an objective inquiry as to whether the transaction had practical economic effect apart from tax savings. The second factor requires a subjective inquiry into whether the taxpayer participated in the transaction for a valid nontax business purpose. See id. These factors are interrelated and are not simply “discrete prongs of a `rigid two-step analysis.” Id. at 247 (quoting Casebeer v. Commissioner,   909 F.2d 1360, 1363 [66 AFTR 2d 90-5361] (9th Cir. 1990), affg. Sturm v. Commissioner,   T.C. Memo. 1987- 625 [¶87,625 PH Memo TC]). In applying these factors, all stages of the transaction must be scrutinized to determine whether the taxpayer’s beneficial interest was affected in a meaningful nontax way. Knetsch v. United States,   364 U.S. 361, 366 [6 AFTR 2d 5851] (1960).

 

2. Objective Inquiry a. Overview We first examine whether the francs transaction had practical economic effect other than the creation of a tax loss. We conclude it did not. When viewed according to their objective economic effect, Credicom Asia’s redemption of the class A stock from CNV partially for francs, CNV’s transfer of the francs to ICP, ICP’s transfer of a portion of the francs to Rovakat, CNV’s sale of 90 percent of its interest in Rovakat to Mr. Hovnanian, and Rovakat’s sale of the francs were, economically speaking, negligible events. The francs transaction as a whole, when viewed in the light of its individual steps, had no economic significance other than to serve as a means for Mr. Hovnanian’s attempt to purchase and use CNV’s built-in loss. The following factors further support our conclusion that the objective economic effect of the francs transaction is not consistent with Rovakat’s reporting of that transaction. b. Lack of Pretax Profit Potential In general, a transaction has economic substance and will be respected for Federal tax purposes where the transaction offers a reasonable opportunity for profit independent of tax savings. Gefen v. Commissioner,   87 T.C. 1471, 1490 (1986). A reasonable opportunity for profit will ordinarily be found only if there was a legitimate expectation that the nontax benefits would be at least commensurate with the associated transaction costs. ACM Pship. v. Commissioner,   T.C. Memo. 1997-115 [1997 RIA TC Memo ¶97,115]; see also Salina Pship. L.P. v. Commissioner,   T.C. Memo. 2000-352 [TC Memo 2000-352]. Deliberately incurring expenses in excess of appreciable gain is “the antithesis of profit-motivated behavior”. Yosha v. Commissioner,   861 F.2d 494, 498 [63 AFTR 2d 89-369] (7th Cir. 1988), affg. Glass v. Commissioner,   87 T.C. 1087 (1986).

 

The francs transaction did not present Rovakat with a reasonable opportunity for profit independent of tax savings. Rovakat incurred at least $395,153 in transaction costs related to the francs transaction. These costs included at least $382,153 in fees paid to Mr. Valdez and $13,000 paid to De Castro for the Rovakat opinion. 12 The sole economic gain that Rovakat could realize on the francs transaction was attributable to exchange rate fluctuations between the franc and the U.S. dollar.

 

Dr. LaRue reviewed the franc to U.S. dollar exchange rates from January 1, 1990, to December 30, 2006. During that time, the relationship between the franc and the U.S. dollar was relatively stable, and the buy-side market for francs was highly liquid with minimal transaction costs. Dr. LaRue concluded that the franc to U.S. dollar exchange rates were not sufficient to yield a positive pretax return and that the value of the U.S. dollar against a franc would have had to increase by more than 157 percent before Mr. Hovnanian realized his first nominal dollar of pretax profit. 13 Dr. LaRue concluded that even if the franc became worthless, Mr. Hovnanian would have experienced a positive aftertax return in excess of 9,380 percent, notwithstanding the corresponding loss of his initial investment in francs. When Credicom Asia redeemed its class A stock, the claimed tax basis in the francs ultimately transferred to ICP was over 200 times greater than their fair market value. If the value of the francs doubled during Mr. Hovnanian’s holding period, the potential Federal income tax savings, assuming a tax rate of 39.1 percent, would exceed the pretax economic gain by approximately 80 times.

 

We credit Dr. LaRue’s testimony and conclude that a rational investor would have recognized the nonexistence of a realistic probability that the francs which Rovakat held would have sufficiently appreciated to produce a pretax profit. This lack of pretax profit potential weighs heavily against a finding that the francs transaction was economically significant. 14 Accord Gilman v. Commissioner,   T.C. Memo. 1989-684 [¶89,684 PH Memo TC] (sale-leaseback transaction lacked economic substance where, when the transaction was entered into, a prudent investor would have concluded that there was no chance to earn a nontax profit in excess of transaction costs), affd.   933 F.2d 143 [67 AFTR 2d 91-1016] (2d Cir. 1991). c. Actual Economic Effect Tax losses which fail to “correspond to any actual economic losses, do not constitute the type of bona fide losses that are deductible” for Federal tax purposes. ACM Pship. v. Commissioner, 157 F.3d at 252 (internal citations omitted). The economics of the francs transaction do not support Rovakat’s claim to the losses reported on its 2002 through 2004 returns. Upon the sale of the francs, Rovakat did not realize a $5,769,532 economic loss; it realized a $1,283 economic gain. 15 While realization of an economic gain may suggest that a transaction has economic substance, the prospect of a nominal, incidental pretax profit does not necessarily establish that a transaction Id. at 258; was designed to serve a nontax profit motive. Sheldon v. Commissioner,   94 T.C. 738, 768 (1990). Moreover, as to the francs transaction, any profitability on the transaction was subsumed by the costs of entering into the transaction. 16 d. Francs Paid in Redemption We are similarly not persuaded that Credicom Asia’s partial redemption of its class A stock with francs had practical economic effect apart from tax savings. The functional currency of Credicom Asia was the U.S. dollar, and the functional currency of CNV was the Belgian franc. One might reasonably expect that the redemption would have been effected with the functional currency of one of the parties to the redemption and not the nonfunctional franc. While the form of consideration might, at first blush, appear to be insignificant, the tax benefit to Rovakat’s members by structuring the transaction with francs was potentially tremendous.

 

Gains or losses attributable to a   section 988 transaction are generally treated as ordinary income or ordinary losses.   Sec. 988(a)(1). A disposition of property is usually considered to be a   section 988 transaction where the property is a nonfunctional currency; i.e., a currency other than (1) the U.S. dollar or (2) in certain cases, the currency of the economic environment in which a significant part of an activity is conducted and which is used in the books and records of that activity. See   sec. 1.988-1, Income Tax Regs.; see also   secs. 985(b)(1),   989(a).

 

If, as Mr. Hovnanian asserts, Rovakat acquired the francs as part of an investment activity entered into for the production of income, the francs would be a nonfunctional currency to Rovakat, and Rovakat’s disposition of the francs would result in ordinary income or ordinary loss. See   ,   sec. 988(a)(1), (c)(1). If, however, Credicom Asia had redeemed its class A stock in U.S. dollars and the contributions from CNV to ICP to Rovakat were denominated in U.S. dollars, any gain or loss on Rovakat’s disposition of the U.S. dollars would be taxed as a capital gain See Ark. Best Corp. v. Commissioner, 485 U.S. or a capital loss. 212, 213 (1988); see also   sec. 1221(a). Thus, by using francs in partial satisfaction of the redemption, Mr. Valdez aimed to convert capital losses into ordinary losses that could offset ordinary income such as salaries and wages. For a high-income taxpayer such as Mr. Hovnanian expecting to receive a significant amount of ordinary income for his role in the WIC lawsuit, these tax savings were substantial. Mr. Hovnanian has offered no valid business reason why Credicom Asia would partially redeem its class A stock with francs but for the prospect of converting the character of the purported resulting loss from capital to ordinary. e. Rovakat’s Sale of the Francs Nor do we find that there was a valid business reason for Rovakat’s sale of the francs just 1 day after Mr. Hovnanian purchased 90 percent of ICP’s interest in Rovakat. Mr. Hovnanian asserts that the sale of the francs was necessary for Rovakat to generate working capital. We are not persuaded. As of December 27, 2002, Rovakat had $100,000 in its checking account and had invoiced Limited for $593,125 from “consulting” services. Mr. Hovnanian fails to adequately explain why its proffered need for Rovakat to have working capital was not met by these funds. Rovakat’s decision to exit the francs transaction literally overnight is especially telling because Rovakat’s sale of the francs served as the triggering mechanism by which Mr. Hovnanian would purportedly be able to personally claim his portion of that loss for Federal income tax purposes. See Santa Monica Pictures, LLC v. Commissioner,   T.C. Memo. 2005-104 [TC Memo 2005-104]. f. Fees Paid to the Immobiliere Group Mr. Valdez’s payment of over $4 million in fees to the Immobiliere group in exchange for CNV’s participation in the francs transaction also suggests that the francs transaction lacked economic substance. These fees were not standard financing fees but were based upon the amount of tax basis which ICP expected to receive. Mr. Hovnanian has not explained why a fee due to a foreign company would depend upon the basis of property for Federal tax purposes. The payment of fees contingent upon the tax basis which could be realized for Federal tax purposes suggests that tax-motivated considerations were the principal reason for the francs transaction. See Kerman v. Commissioner,   T.C. Memo. 2011-54 [TC Memo 2011-54]. g. Summary of Objective Economic Effect We conclude that the first factor of the economic substance inquiry weighs heavily against a finding that the francs transaction was “compelled or encouraged by business or regulatory realities, *** imbued with tax-independent considerations, and *** not shaped solely by tax-avoidance features”. Frank Lyon Co. v. United States,   435 U.S. 561, 583 [41 AFTR 2d 78-1142]- 584 (1978). Rovakat effectively spent over $382,000 to produce an economic gain of less than $1,300 and a reportable tax loss in excess of $5 million. Rovakat’s reporting of the losses reflects neither the economic realities of the gain which Rovakat realized, nor that the actual economic loss was borne by CNV. The use of francs to partially redeem Credicom Asia’s shares served the seemingly limited purpose of converting the character of the loss from capital to ordinary. Rovakat joined ICP so as to effect a disposition of the francs and have those losses allocated to Mr. Hovnanian.

 

3. Subjective Business Purpose a. Overview The second factor of the economic substance inquiry requires that we examine the taxpayer’s subjective nontax reasons for entering into a transaction and whether the taxpayer held a legitimate profit motive for doing so. Rice’s Toyota World, Inc. v. Commissioner,   752 F.2d 89, 92 [55 AFTR 2d 85-580] (4th Cir. 1985)), affg. in part and revg. in part   81 T.C. 184 (1983). Whether a transaction is conducted with a subjective business purpose depends on a number of subfactors, including whether: (1) The taxpayer had a valid nontax business purpose for entering into the transaction, see Casebeer v. Commissioner, 909 F.2d at 1363-1364; (2) the transaction was negotiated and entered into at arm’s length, see Helba v. Commissioner,   87 T.C. 983, 1004-1007 (1986), affd. without published opinion 860 F.2d 1075 (3d Cir. 1988); (3) the taxpayer performed due diligence regarding the commercial viability and market risks of the transaction, see Rose v. Commissioner,   868 F.2d 851, 854 [63 AFTR 2d 89-776] (6th Cir. 1989), affg.   88 T.C. 386 (1987); (4) in the case of a partnership, the partners intended to join together for the present conduct of an undertaking or enterprise, see Culbertson v. Commissioner, 337 U.S. at 742; and (5) the transaction was marketed as a tax shelter in which the purported tax benefit significantly exceeded the taxpayer’s actual investment, see Booker v. Commissioner,  T.C. Memo. 1996-261 [1996 RIA TC Memo ¶96,261]. These subfactors are not exclusive, and no one subfactor is dispositive. We analyze the subfactors seriatim. b. Rovakat’s Business Purpose Mr. Hovnanian has failed to establish that the francs transaction served any legitimate business purpose, and we conclude that none existed. He asserts that the contribution of francs to Rovakat and Rovakat’s subsequent sale of the francs were intended to serve as seed money to fund Rovakat’s development of a competitor to the Nielsen television rating service (Nielsen). We are unpersuaded.

 

Early in 2001, Mr. Hovnanian introduced Dish and EchoStar (collectively, EchoStar) to the concept of establishing EchoStar as a competitor to Nielsen. EchoStar committed support of up to $15 million to a project to carry out this concept, though the record is not clear whether Mr. Hovnanian or Rovakat actually received these funds. Mr. Hovnanian testified that he engaged Mr. Valdez to form Rovakat as part of the project because, among other things, Mr. Valdez had access to investors with the capital to fund such a venture. The Nielsen-competitor project ultimately failed.

 

Mr. Hovnanian’s testimony misses the point. We focus on the business purpose of the francs transaction and not any business venture which Mr. Hovnanian may have pursued before Rovakat’s formation. The record does not establish that Rovakat had an ongoing business after the Nielsen-competitor project failed, nor when that project failed. Mr. Hovnanian could have called witnesses from EchoStar to testify on this point, but he declined to do so. 17

 

Mr. Hovnanian also asserts that the francs transaction enabled him to establish and cultivate ties with Mr. Valdez and with the Belgian entities, apart from any possible tax considerations. We are not persuaded. The Credicom Asia redemption, CNV’s contribution of the francs to ICP, and the payment of fees from ICP to Immobiliere occurred between Mr. Valdez and members of the Immobiliere group. Any goodwill which may have been gained from these transactions was to the benefit of Mr. Valdez and not Mr. Hovnanian. c. Lack of Arm’s-Length Dealing In determining whether a transaction possesses objective indicia of economic substance, we examine whether the transaction Helba v. Commissioner, supra at was conducted at arm’s length. 1005. Where a transaction occurs between related parties, the transaction is carefully scrutinized “because the control element suggests the opportunity to contrive a fictional *** [transaction].” Geftman v. Commissioner,   154 F.3d 61, 68 [82 AFTR 2d 98-5617] (3d Cir. 1998) (quoting United States v. Uneco, Inc.,   532 F.2d 1204, 1207 [37 AFTR 2d 76-1119] (8th Cir. 1976)), revg. in part and vacating in part   T.C. Memo. 1996-447 [1996 RIA TC Memo ¶96,447]; see also Schering-Plough Corp. v. United States,   651 F. Supp. 2d 219, 244 [104 AFTR 2d 2009-6157] (D.N.J. 2009), affd. sub nom. Merck & Co. v. United States, __ F.3d __ (3d Cir., June 20, 2011).

 

We find a lack of arm’s-length dealing with respect to the francs transaction. Mr. Valdez controlled each aspect of that transaction up until the sale of ICP’s interest in Rovakat to Mr. Hovnanian. By June 7, 2001, Mr. Valdez was Credicom Asia’s president, and he caused the redemption of the class A shares with francs and with U.S. dollars. He controlled the bank accounts of Credicom Asia and of ICP. He effected the transfer of funds between Credicom Asia, CNV, and ICP. He controlled ICP, and he managed LVCM.

 

In addition, Mr. Valdez continued to influence the outcome of the francs transaction even after ICP sold 90 percent of its interest in Rovakat to Mr. Hovnanian. Mr. Valdez suggested that Mr. Hovnanian engage Mr. Weinreb to prepare Rovakat’s 2002 through 2004 returns. Mr. Valdez recommended that Mr. Hovnanian engage De Castro to provide tax advice regarding the francs transaction. Rovakat’s procurement of tax advice was more reflective of a symbiotic relationship between De Castro and Mr. Valdez rather than of independent counseling on the merits of the francs transaction. d. Lack of Due Diligence Mr. Hovnanian presented no documentary evidence to suggest that he undertook a critical nontax economic analysis of the risks associated with investing in francs. 18 The De Castro opinion focuses only on the tax effect of the francs transaction without regard to the commercial viability or market risk associated with that transaction. Such a lack of due diligence on the part of Mr. Hovnanian suggests that he was not concerned with the economic realities of the francs transaction or with elements of risk. Cf. Salina Pship. L.P. v. Commissioner,   T.C. Memo. 2000-352 [TC Memo 2000-352] (finding indicia of economic substance where a partnership held two meetings with the investment banker who structured a transaction in which the partnership invested and was presented with several analyses of the financial risks and rewards associated with such an investment). Mr. Hovnanian’s lack of concern for the underlying economics of the francs transaction is not consistent with a genuine nontax profit motive. e. Lack of Mutuality of Profit Objective We also examine the surrounding facts and circumstances to determine whether any of the relevant persons, in good faith, intended to join together for the present conduct of an undertaking or enterprise. TFID III-E, Inc. v. United States,   459 F.3d 220, 231-232 [98 AFTR 2d 2006-5616] (2d Cir. 2006); see also Commissioner v. Culbertson, 337 U.S. at 742. We find that the francs transaction lacks mutuality of profit objective.

 

CNV was motivated to enter into the francs transaction to realize whatever fees it could from its failed investment in Credicom Asia. The payment of these fees allowed CNV to pay its arrears and to continue its operations long enough to allow for the sale of CNV’s remaining asset, an interest in Golf de Ramatuelle. While these goals might be valid business reasons for CNV’s redemption of its class A stock, they bear no apparent relation to CNV’s, ICP’s, or Rovakat’s business purpose for entering into the francs transaction. The fees due to CNV were contingent on the tax basis in the francs for Federal tax purposes. Such a framework suggests that ICP was motivated by CNV’s tax attributes and not by an independent economic significance of the francs.

 

Mutuality of profit objective also is lacking between ICP and Rovakat. ICP’s transfer of 50,000 francs and ISP’s transfer of $100,000 served the seemingly limited purpose of enabling ICP to become a temporary partner of Rovakat and to transfer the purportedly high-basis francs to Rovakat to trigger the intended tax loss. Mr. Hovnanian did not desire to invest in francs, and those francs were sold just 1 day after Mr. Hovnanian acquired ICP’s 90-percent interest in Rovakat. The occurrence of these steps within such a short time suggests that the disposition of the francs was predetermined. f. Other Distressed Asset Transactions Mr. Hovnanian, acting in a capacity as other than Rovakat’s tax matters partner, invested in at least two other transactions similar to the francs transaction. The resulting claimed losses from those transactions were used to offset unrelated income of Mr. Hovnanian and an entity that he and his family owned. Mr. Hovnanian’s investment in those similar transactions supports a finding that the francs transaction lacked economic substance. g. Other Considerations Mr. Hovnanian asserts that because Rovakat was not sure it would earn income, any loss from the francs transaction was not certain to be used. We disagree. Mr. Hovnanian purchased ICP’s interest in Rovakat during the last week of 2002, by which time he most likely knew whether some or all of the loss could be used for that year. In addition, we doubt that Mr. Hovnanian would have paid $13,000 to De Castro for its tax opinion if he did not expect that the loss could be used. Further, notwithstanding whether Rovakat realized any income, the loss passed through to Mr. Hovnanian who in turn was entitled to carry forward and to apply any unapplied portion of the loss against his future income (e.g., his salary and any bonus he received as to the WIC lawsuit). 19 h. Summary of Subjective Business Purpose We conclude that Rovakat’s reasons for entering into the francs transaction do not demonstrate a legitimate profit motive. The lack of arm’s-length dealing at almost every stage of the francs transaction, coupled with the lack of mutuality of profit objective by all parties, suggests that a nontax profit was a primary driver for entering into the francs transaction. Mr. Hovnanian’s investment in two similar transactions also suggests that Rovakat was motivated mostly by tax considerations when entering into the francs transaction. On balance, we conclude that the economic reality of the francs transaction is not consistent with a bona fide profit objective.

 

4. Summary of Economic Substance

 

We conclude that the francs transaction lacked economic substance. Because a transaction that lacks economic substance is not recognized for Federal tax purposes, and “cannot be the basis for a deductible loss”, see ACM Pship. v. Commissioner, 157 F.3d at 247 (quoting Lerman v. Commissioner,   939 F.2d 44, 45 [68 AFTR 2d 91-5223] (3d Cir. 1991), affg. Fox v. Commissioner,   T.C. Memo. 1988-570 [¶88,570 PH Memo TC]), we hold that Rovakat is not entitled to the losses claimed on its 2002 through 2004 returns. 20

 

III. Omitted Income

 

A. Overview

 

Respondent determined that Rovakat’s 2003 gross income includes $90,443 which was paid to Limited through WASI on March 24, 2003. In addition, respondent amended his answer to assert that Rovakat omitted $650,000 in income from its 2002 gross income. As to the latter, respondent asserts that Rovakat failed to recognize the (1) $593,125 received from Limited on December 31, 2002, and (2) $56,875 paid to Limited, through WASI, on or about November 22, 2002. We agree with respondent that Rovakat omitted income for 2002 but only to the extent of the $593,125.

 

Gross income includes “all income from whatever source derived, including (but not limited to) *** gross income derived from business”.   Sec. 61(a)(2). Under  section 451(a), items of gross income generally must be included in the gross income of a cash method taxpayer in the taxable year in which the taxpayer actually or constructively received that income. See   sec. 1.451-1(a), Income Tax Regs. Income not actually reduced to a taxpayer’s possession is constructively received by a taxpayer in the year during which the income is credited to an account, set apart, or otherwise made available so that the taxpayer may draw upon it at any time. See   sec. 1.451-2(a), Income Tax Regs. Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or to restrictions. See id.

 

B. Payments From Limited

 

Limited deposited $593,125 in Rovakat’s bank account on December 31, 2002. Mr. Hovnanian concedes that Rovakat was required to recognize the $593,125 as income but maintains that the amount was a “refundable prepaid deposit” includable in Rovakat’s 2003 gross income. The $593,125 is not includable in Rovakat’s 2002 income if it is a deposit. See Commissioner v. Indianapolis Power & Light Co.,   493 U.S. 203, 213 [65 AFTR 2d 90-394] (1990). The $593,125 is includable in Rovakat’s 2002 income if it is an advance. See Schlude v. Commissioner,   372 U.S. 128, 134 [11 AFTR 2d 751] (1963).

 

Respondent seeks to prevail on this issue by relying on the record as a whole, the 2002 return, and the invoices between Rovakat, Limited, and WASI. On the basis of these documents, we are satisfied that respondent has met his burden of proof. Limited deposited the $593,125 payment into Rovakat’s bank account during 2002. Neither of the two invoices submitted by Rovakat to Limited in connection with the $593,125 payment states that the payment was subject to a contingency. Nor does the record contain any document that establishes the existence of a contingency that would negate inclusion of the payment in 2002 under   sections 61 and   451. See Commissioner v. Indianapolis Power & Light Co., supra at 211 (”Whether these payments constitute income when received *** depends upon the parties’ rights and obligations at the time the payments are made.”).

 

Moreover, Rovakat reported as income on its 2003 return a $943,192 payment received from Limited for “consulting” services on March 25, 2003. Rovakat did not report any portion of the $593,125 payment as income on its 2003 return even though Mr. Hovnanian asserts that the income was taxable to Rovakat in that year. Nor did Rovakat file an amended 2003 return to include that payment in its gross income for that year. See   sec. 1.451- 1(a), Income Tax Regs. (”If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due.”). We hold that Rovakat was required to report the $593,125 payment received from Limited in 2002.

 

C. Payments to WASI

 

Respondent also determined that Rovakat was required to report as income (1) $56,875 of the $650,000 which Limited received from WASI on November 22, 2002, and (2) $90,443 of the $1,033,635 which Limited received from WASI on March 24, 2003. According to respondent, these amounts represent “implicit deductions” claimed by Rovakat. We disagree.

 

The definition of gross income encompasses all undeniable accessions to wealth, clearly realized, and over which a taxpayer has complete dominion and control. Commissioner v. Glenshaw Glass Co.,   348 U.S. 426, 431 [47 AFTR 162] (1955). While broad, the definition of gross income does not contemplate income that does not result in a realizable economic benefit to the taxpayer. United States v. Goldberg,   330 F.2d 30, 39 [13 AFTR 2d 938] (1964) (citing Burnet v. Wells,  289 U.S. 670 [12 AFTR 65] (1933), and Corliss v. Bowers,   281 U.S. 376 [8 AFTR 10910] (1930)). Rovakat realized no apparent economic benefit from the fees of $56,875 and $90,443. Respondent’s contention that Mr. Hovnanian seeks an implicit deduction from these fees is without merit because Rovakat did not report these fees as deductions on its 2002, 2003, or 2004 returns. We hold that Rovakat need not recognize as income the fees of $56,875 and $90,443.

 

IV. Effect of Omitted Income on 2002 Period of Limitations Mr. Hovnanian asserts that the period of limitations as to Rovakat’s 2002 taxable year is closed. Respondent counters that the period remains open because Rovakat omitted from its 2002 return an amount in excess of 25 percent of the amount of gross income required to be stated on that return. We agree with respondent.

 

The Commissioner generally must assess tax within 3 years after a return is filed. See   sec. 6501(a).   Section 6501(e)(1) provides an exception, however, where the taxpayer fails to report gross income in excess of 25 percent of the amount of gross income stated on its return.   Section 6229 sets forth special rules to extend the period of limitations described by   section 6501 with respect to partnership items or affected items.   Section 6229(a) generally provides that the period for assessing against a person any income tax attributable to a partnership item or to an affected item shall not expire before the date that is 3 years after the later of the date that the partnership return is filed or the last day for filing the return.   Section 6229(c)(2) provides that if any partnership omits from gross income an amount properly includable therein that is in excess of 25 percent of the amount of gross income stated on its return, the 3-year period described in   section 6229(a) is extended to 6

 

Highwood Partners v. Commissioner,   133 T.C. 1, 10 (2009). years.

 

Mr. Hovnanian filed Rovakat’s 2002 return on October 23, 2003, and the return reported no gross income. The $593,125 omitted from Rovakat’s 2002 return was in excess of 25 percent of the amount of gross income stated on the return. Respondent issued Mr. Hovnanian the FPAA for 2002 on November 13, 2008, within the 6-year period for assessment provided by   sections 6229(c)(2) and   6501(e)(1)(A). Accordingly, respondent timely issued the FPAA for 2002, and the adjustments set forth in that FPAA are not barred by any limitations period.

 

V. Liability for Self-Employment Tax Respondent determined that the $593,125 and $943,192 paid to Rovakat in 2002 and 2003, respectively, were self-employment income. 21   Section 1401 imposes a tax on self-employment income.   Sec. 1401(a) and   (b); Schelble v. Commissioner,   130 F.3d 1388, 1391 [80 AFTR 2d 97-8226] (10th Cir. 1997), affg.   T.C. Memo. 1996-269 [1996 RIA TC Memo ¶96,269]. Self- employment income includes an individual’s distributive share of income from a partnership.   Sec. 1402(a);   ,   sec. 1.1402(a)-2(d), (f), Income Tax Regs.

 

Rovakat received $593,125 and $943,192 in 2002 and 2003, respectively. Limited paid these amounts through WASI as fees. Neither the 2002 nor the 2003 return reported these amounts as self-employment income. They were and should have been reported as such. See   sec. 1402(a).

 

VI. Entitlement to Deductions Respondent determined that Rovakat was not entitled to deduct “other expenses” of $63,964 and $352,663 for 2003 and 2004, respectively. 22 We agree.

 

Deductions are strictly a matter of legislative grace, and a taxpayer bears the burden of producing sufficient evidence to substantiate any deduction that would otherwise be allowed by the   Sec. 6001; Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 Code. U.S. 79, 84 (1992). Rovakat did not present any evidence to substantiate the actual payment of the “other expenses” claimed on its 2003 and 2004 returns or that these payments were ordinary and necessary to Rovakat’s activity. See   secs. 162(a),   212. We conclude that Rovakat may not deduct any portion of those claimed expenses.

 

VII.            Accuracy-Related Penalties

A.       Overview

Section 6662(a) and   (b)(1), (2), and (3) provides that a taxpayer may be liable for a 20-percent accuracy-related penalty on the portion of an underpayment of income tax attributable to, among other things, negligence or disregard of rules or regulations, a substantial understatement of income tax, or a substantial valuation misstatement.   Section 6662(h)(1) increases the 20-percent rate to a 40-percent rate to the extent that the underpayment is attributable to a gross valuation misstatement.   Sec. 6662(h)(1). An accuracy-related penalty under   section 6662 does not apply to any portion of an underpayment of tax for which a taxpayer had reasonable cause and acted in good faith.   Sec. 6664(c)(1).

 

Respondent determined that one or more of the referenced accuracy-related penalties apply with respect to the partnership adjustments for Rovakat’s 2002 through 2004 taxable years. Respondent determined that the 40-percent accuracy-related penalty applies to the portion of any underpayment of tax attributable to the ordinary losses reported for 2002, 2003, and 2004. Respondent determined that a 20-percent accuracy-related penalty applies to any underpayment of tax attributable to the omitted income and to the disallowed deductions. Mr. Hovnanian does not deny that the accuracy-related penalties apply in accordance with their terms. His sole defense against the imposition of the accuracy-related penalties is that Rovakat meets the reasonable cause exception of   section 6664. 23

 

B. Gross Valuation Misstatement Respondent determined that it was appropriate to impose an accuracy-related penalty of 40 percent under   section 6662(h) for a gross valuation misstatement with respect to the basis reported on the francs transaction.   Section 6662(h) provides that a taxpayer may be liable for a 40-percent penalty on that portion of an underpayment of tax that is attributable to one or more gross valuation misstatements. A gross valuation misstatement exists if the value or adjusted basis of any property claimed on a tax return is 400 percent or more of the amount determined to be the correct amount of such value or adjusted basis.   Sec. 6662(h)(2)(A). The value or adjusted basis of any property claimed on a tax return that is determined to have a correct value or adjusted basis of zero is considered to be 400 percent or more of the correct amount.   Sec. 1.6662-5(g), Income Tax Regs. Whether there is a gross valuation misstatement in the partnership context is determined at the partnership level.   Sec. 1.6662-5(h)(1), Income Tax Regs. 23 (…continued) questioned whether   sec. 7491 applies in the partnership context, given that the section applies only to the liability of “any individual”. See, e.g., Palm Canyon X Invs., LLC v. Commissioner,   T.C. Memo. 2009-288 [TC Memo 2009-288]; Santa Monica Pictures, LLC v. Commissioner,   T.C. Memo. 2005-104 [TC Memo 2005-104]. We need not decide that question here because we find that the record establishes that the criteria for the imposition of the   sec. 6662(a) accuracy- related penalties is met without regard to the burden of production.

 

In Merino v. Commissioner,   196 F.3d 147, 158-159 [84 AFTR 2d 99-6790] (3d Cir. 1999), affg.   T.C. Memo. 1997-385 [1997 RIA TC Memo ¶97,385], the Court of Appeals for the Third Circuit held that imposition of a valuation misstatement penalty is generally appropriate where a claimed tax benefit is disallowed because it is an integral part of a transaction determined to lack economic substance. We found that the francs transaction was a sale or, alternatively, that it lacked economic substance. Rovakat’s basis in the francs as reported on its returns exceeds 400 percent of the basis that Rovakat actually had. 24 Consequently, an accuracy-related penalty under   section 6662(a) on account of a gross valuation misstatement under   section 6662(h) applies through its terms to that portion of any underpayment of tax attributable to the reported loss. 25

 

C. Other Accuracy-Related Penalties Determined Respondent determined that Rovakat is liable for the 20- percent accuracy-related penalty under   section 6662(a) as to the portion of any underpayment of tax attributable to the remaining adjustments on account of negligence or disregard of rules or regulations, substantial understatement of income tax, and/or substantial valuation misstatement under   section 6662(b)(1),   (2), and   (3). Only one accuracy-related penalty may be applied with respect to any portion of an underpayment, even if that portion resulted from more than one of the types of misconduct described in  section 6662.   Sec. 1.6662-2, Income Tax Regs. The record establishes (and Mr. Hovnanian does not contest) that the determined accuracy-related penalties apply absent a mitigating reason.

 

D.      Reasonable Cause

Mr. Hovnanian argues that the accuracy-related penalties may not be imposed because Rovakat meets the reasonable cause defense of   section 6664(c)(1). Pursuant to that section, an accuracy- related penalty under   section 6662(a) may not be imposed with respect to any portion of an underpayment of tax for which Mr. Hovnanian establishes that Rovakat, through his actions, had reasonable cause and acted in good faith. 26 Whether a taxpayer acted with reasonable cause and in good faith is a factual determination, in which the taxpayer’s effort to assess the proper level of tax is of utmost importance. See   sec. 1.6664- 4(b)(1), Income Tax Regs.

 

Mr. Hovnanian argues that Rovakat reasonably relied on the Rovakat opinion and on the Sidley Austin opinion when filing Rovakat’s 2002 through 2004 returns. A taxpayer’s reliance on the advice of a professional, such as an attorney, may constitute reasonable cause and good faith where the taxpayer proves by a preponderance of the evidence that: (1) The taxpayer reasonably believed that the professional upon whom the reliance is placed is a competent tax adviser with sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Associates, P.A. v. Commissioner,   115 T.C. 43, 98-99 (2000), affd.   299 F.3d 221 [90 AFTR 2d 2002-5442] (3d Cir. 2002); see also   sec. 1.6664-4(c)(1), Income Tax Regs. On the basis of the record as a whole, we conclude that Mr. Hovnanian has not satisfied all of these requirements.

 

As to the Rovakat opinion, Mr. Hovnanian had no personal contact with the attorneys who rendered that opinion. Instead, he relied solely on the recommendation of Mr. Valdez, the person who promoted the transaction to be opined upon. See Tigers Eye Trading, LLC v. Commissioner,   T.C. Memo. 2009-121 [TC Memo 2009-121] (defining a promoter as “an adviser who participated in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction”). Mr. Hovnanian knew that Mr. Valdez structured and promoted the francs transaction, and we find in the record that the Rovakat opinion was simply a product that Mr. Valdez essentially included as part of his “investments” to attempt to insulate his clients from the imposition of an accuracy-related penalty as to his transactions.

 

Nor did Mr. Hovnanian reasonably rely on the Rovakat opinion in that the opinion contained material misstatements of fact or otherwise did not properly explain the facts. Cf. Long Term Capital Holdings v. United States,   330 F. Supp. 2d 122, 209 [94 AFTR 2d 2004-5666] (D. Conn. 2004), affd.   150 Fed. Appx. 40 [96 AFTR 2d 2005-6344] (2d Cir. 2005). First, the Rovakat opinion stated that Mr. Hovnanian was not affiliated with any member of Rovakat or of ICP; Mr. Hovnanian owned an interest in Rovakat, and he managed ICP. Second, the Rovakat opinion stated that Rovakat’s principal business activity was “trading personal property for the account of owners of interest in the activity”; Mr. Hovnanian admitted during his testimony that Rovakat never intended to invest in francs. Third, the Rovakat opinion stated that the parties to the “transaction” entered into the francs transaction for “business reasons independent of the tax consequences for tax purposes, with a view toward making a profit on the activities contemplated in the Transaction”; the opinion never elaborates on this purported “business purpose”. Fourth, the Rovakat opinion stated that the parties to the “transaction” dealt with each other at arm’s length; the francs transaction was not conducted at arm’s length but orchestrated exclusively by Mr. Valdez. 27

 

Nor do we find that Mr. Hovnanian relied in good faith on the Rovakat opinion’s conclusion that Rovakat realized a $5,769,532 loss as to a transaction that resulted in a $1,283 economic gain. In determining whether a taxpayer relied in good faith on the advice of a professional, we consider (1) the taxpayer’s business sophistication and experience, (2) the reasonableness of the advice solicited, and (3) whether the advice was obtained as part of a tax shelter. See 106, Ltd. v. Commissioner,  136 T.C. 67, 77-78 (2011); see also   sec. 1.6664-4(b)(1), Income Tax Regs. Each factor weighs against a finding that Mr. Hovnanian relied in good faith on the Rovakat opinion. As a business executive with more than 20 years of experience and an economics degree from the University of Pennsylvania, Mr. Hovnanian obviously recognized the incongruity of reporting a loss in excess of $5 million on a transaction that yielded an economic gain. We have stated that where an investment has such obviously suspect tax claims as to put a reasonable taxpayer under a duty of inquiry, a good faith investigation of the underlying viability, financial structure, and economics of the investment is required. Roberson v. Commissioner,   T.C. Memo. 1996-335 [1996 RIA TC Memo ¶96,335] (citing LaVerne v. Commissioner,   94 T.C. 637, 652-653 (1990), affd. without published opinion 956 F.2d 274 (9th Cir. 1992), affd. without published opinion sub nom. Cowles v. Commissioner, 949 F.2d 401 (10th Cir. 1991), and Horn v. Commissioner,   90 T.C. 908, 942 (1988)), affd. without published opinion 142 F.3d 435 (6th Cir. 1998). If Mr. Hovnanian’s business prowess did not allow him to make such a determination, then certainly the fact that the Rovakat and ISP opinions were virtually identical in all material respects should have prompted inquiry from an independent adviser. We conclude that any reliance which Mr. Hovnanian placed on the Rovakat opinion was not reasonable.

 

We similarly reject Mr. Hovnanian’s claimed reliance on the Sidley Austin opinion. Mr. Valdez procured the Sidley Austin opinion for the benefit of ICP and of himself. That opinion makes no specific mention of Rovakat or of Mr. Hovnanian, and it was not given to Mr. Hovnanian until 2008. The Sidley Austin opinion also turned the seemingly simple prospect of purchasing francs and contributing them to a partnership into a 74-page guide on shifting losses from foreign entities to U.S. taxpayers. Any reliance that Mr. Hovnanian claims to have placed on the Sidley Austin opinion is not reasonable or is otherwise not supported by the record.

 

The Supreme Court observed long ago that an expert opinion Winans v. N.Y. & Erie R.R. Co., 62 may be had as to any amount. U.S. 88, 101 (1958). Legal and tax opinions are no different. The mere fact that a taxpayer purchases an “opinion” from a self-professed expert does not necessarily mean that the taxpayer relied on the “expert” in good faith. An individual who blindly relies on a professional opinion to support a facially too good to be true transaction such as we have here does so at his or her Cf. Neonatology Associates, P.A. v. Commissioner, 115 own peril. T.C. at 99. Never has this been more true than in today’s environment where taxpayers seek to reduce their tax liabilities by engineering artificial tax losses in complex and/or foreign transactions which leave little to no paperwork that the Commissioner may access to examine the transaction. We conclude that Rovakat, through Mr. Hovnanian, does not meet the reasonable cause defense of  section 6664(c)(1). It follows that the accuracy-related penalties determined by respondent are applicable to the extent stated herein. VIII. Epilogue We have considered and rejected as without merit all arguments that Mr. Hovnanian made which are not addressed herein. To reflect the foregoing,

 

Decision will be entered under Rule 155.

 

1

Unless otherwise indicated, section references are to the applicable versions of the Internal Revenue Code (Code), and Rule references are to the Tax Court Rules of Practice and Procedure. Some dollar amounts are rounded.

2

Respondent also determined that the losses were not allowed for other reasons. We do not address any of those reasons.

3

We concluded that the deemed facts and documents were relevant to this case, and Mr. Hovnanian failed to show why the matters therein should not be deemed admitted. See Rule 91(f).

4

Rovakat was originally named Radio & Wireless Software Development, LLC (Radio & Wireless). We henceforth refer to Radio & Wireless as Rovakat.

5

Speedus was formerly known as Suite 12 Group, Highcrest Management, and Cellular Vision. We refer to the precursors of Speedus as Speedus.

6

On Mar. 26, 2001, Credicom Asia executed a Restated Memorandum of Association, which sought to eliminate the liquidation preference retroactively.

7

Mr. Valdez initially agreed to pay CNV a $2,250,000 fee related to the first tranche. That fee was reduced, however, following Mr. Valdez’s agreement to accelerate payments due under the first tranche.

8

 

9

The U.S. District Court for the District of Massachusetts has apparently used concurrent witness testimony in a number of nonjury cases in recent years. See Wood, “Experts in the Tub”, 21 Antitrust 95, 97 (2007).

10

Nor does the record establish, as Mr. Hovnanian asserts, that Credicom Asia was a partnership. Credicom Asia had two classes of common stock, and its ownership was represented by “shares” owned by “shareholders”. The record also lacks a partnership agreement entered into between the purported partners of Credicom Asia. While the Sidley Austin opinion states that Credicom Asia amended its articles to reflect the characteristics of a partnership on Dec. 2, 1996, that statement is unsupported by the record. In addition to our discussion set forth above in this footnote, Credicom Asia did not file a Form 1065 until 2001, and we do not find that any of Credicom Asia’s shareholders as of the time of the stated conversion reported the deemed liquidation and distribution that would have occurred on such a conversion. See   sec. 301.7701-3(g)(1)(ii), Proced. & Admin. Regs.; see also   Rev. Rul. 63-107, 1963-1 C.B. 71.

11

Congress codified the economic substance doctrine mostly as articulated by the Court of Appeals for the Third Circuit in ACM Pship. v. Commissioner,   157 F.3d 231, 247-248 [82 AFTR 2d 98-6682] (3d Cir. 1998), affg. in part and revg. in part on an issue not relevant here   T.C. Memo. 1997-115 [1997 RIA TC Memo ¶97,115]. See   sec. 7701(o), as added to the Code by the Health Care and Education Reconciliation Act of 2010, Pub. L. 111-152,   sec. 1409, 124 Stat. 1067; see also H. Rept. 111-443 (I), at 291-299 (2010) (discussing the reasons for codification of the economic substance doctrine). This codified doctrine does not apply to this case pursuant to its effective date.

12

The $382,153 consists of the $56,875 and $90,443 that Rovakat paid in 2002 and 2003, respectively, and the $234,835 that Sunshower paid to Mr. Valdez.

13

A nominal dollar is the value of a dollar in the future that is not discounted to take into account the time-value-of- money, risk, or other similar costs of capital.

14

Mr. Hovnanian presented no expert testimony on the pretax profit potential associated with Rovakat’s investment in the francs transaction. Rather, he contends that the fees which Rovakat paid to Mr. Valdez were “collection fees” unrelated to the structuring of the francs transaction. We find to the contrary. Even if they were collection fees, however, Rovakat still could not have reasonably expected a pretax profit on the francs transaction. The $13,000 fee paid to De Castro for the Rovakat opinion alone consumed any profit to be realized on the francs transaction.

15

Rovakat’s $1,283 economic gain equals $35,468 (amount Rovakat realized when it sold the francs) minus $34,185 (fair market value of francs when Rovakat received them).

16

Equally compelling is our finding that the event giving rise to Rovakat’s claimed high basis in the francs was CNV’s failed investment in Credicom Asia, as opposed to an economic outlay made by Rovakat. Dr. Friedman opined that the class A stock was worthless at and before the time of its redemption. We consider that opinion to be reasonable and reliable, and we accept it.

17

At trial, Mr. Hovnanian attempted to introduce, and the Court declined to admit, an affidavit from an EchoStar executive in lieu of that executive’s direct testimony. We found the affidavit to be inadmissible hearsay not excepted by Fed. R. Evid. 807. See Saavedra v. Commissioner,   T.C. Memo. 1988-587 [¶88,587 PH Memo TC] (declining to admit an affidavit where the taxpayer did not demonstrate “reasonable efforts to obtain the witness’ personal testimony”); see also Rule 143(b).

18

The absence of such evidence creates a presumption that no such documents existed or that they were not favorable to Mr. Hovnanian’s position. See Wichita Terminal Elevator Co. v. Commissioner,   6 T.C. 1158, 1165 (1946), affd.   162 F.2d 513 [35 AFTR 1487] (10th Cir. 1947).

19

Mr. Hovnanian fails to explain why Rovakat did not pass through the entire loss in 2002, the year in which it was reportedly incurred. Instead, Rovakat suspended some of the loss at the partnership level and in later years recognized at the partnership level portions of the suspended loss as needed to offset its partners’ income. Respondent asserts, and we agree, that such a suspension of the loss was improper. We consider Rovakat’s improper reporting of its claimed loss as another attempt to hide the illegitimacy of the francs transaction.

20

We are not unmindful that Rovakat realized an economic gain of $1,283 from the francs transaction. Because respondent does not contend that this gain is taxable to Rovakat or to Mr. Hovnanian, we hold it is not. Cf. Lerman v. Commissioner,   939 F.2d 44, 45 [68 AFTR 2d 91-5223] (3d Cir. 1991) (”If a transaction is devoid of economic substance *** it simply is not recognized for federal taxation purposes, for better or for worse”), affg. Fox v. Commissioner,   T.C. Memo. 1988-570 [¶88,570 PH Memo TC].

21

The FPAA for 2003 determined that Rovakat’s self- employment income was $1,536,317, which apparently is the sum of the $593,125 and $943,192 Rovakat received in 2002 and 2003, respectively. On brief, respondent asserts that Rovakat’s self- employment income was $650,000 and $1,033,635 for 2002 and 2003, respectively. We attribute the increased amounts to respondent’s determination that Rovakat’s gross income includes the $56,875 and the $90,443. We have held supra that those amounts are not includable in Rovakat’s income.

22

We conclude that respondent has conceded his determination that Rovakat may not deduct charitable contributions of $6,224 for 2003 and $60,350 for 2004, by virtue of the fact that respondent did not address that issue at trial or in his posttrial brief. Cf. Harbor Cove Marina Partners Pship. v. Commissioner,   123 T.C. 64, 66 (2004).

23

The Commissioner bears the burden of production on whether an accuracy-related penalty applies “with respect to the liability of any individual”. See   sec. 7491; Higbee v. Commissioner,   116 T.C. 438, 446-447 (2001). We have previously

23

 

24

We conclude from the record that Rovakat’s basis in the francs was $34,185 because the francs transaction was a sale, see   sec. 1012, or, alternatively, that the basis was zero because the francs transaction lacked economic substance.

25

Given that holding, we do not consider the applicability of a 20-percent accuracy-related penalty on that portion of the underpayment of tax attributable to the reported losses.

26

We determine the application of the reasonable cause defense in this partnership-level proceeding because Mr. Hovnanian claims that the defense applies on account of his actions as Rovakat’s managing member and tax matters partner. See Am. Boat Co., LLC v. United States,   583 F.3d 471, 480 [104 AFTR 2d 2009-6666] (7th Cir. 2009); 106 Ltd. v. Commissioner,   136 T.C. 67, 75-77 (2011); Fears v. Commissioner,   129 T.C. 8, 10 (2007).

27

In addition, the Rovakat opinion contained numerous disclaimers that served as notice to Mr. Hovnanian that the legal opinion was tenuous. The opinion states, for example, that “Congress has actively pursued legislation to curb abusive tax shelters and the media has publicized many of the tax transactions of now large bankrupt entities and high profile individuals. *** The legislative and political climate and publicity may influence a court to accept the IRS arguments notwithstanding the merits of our analysis.” The opinion states likewise that “We have *** considered certain judicial doctrines which, if applicable, could affect our view of the facts described and our analysis”.

 

Leonard W. Harbin, et al. v. Commissioner, 137 T.C. No. 7, Code Sec(s) 6015.

 

LEONARD W. HARBIN, Petitioner, AND BERNICE NALLS, Intervenor v. COMMISSIONER OF INTERNAL REVENUE, Respondent .

Case Information:

 

Code Sec(s):       6015

Docket:                Docket No. 9994-07.

Date Issued:       09/26/2011

Judge:   Opinion by KROUPA

HEADNOTE

 

XX.

 

Reference(s): Code Sec. 6015

 

Syllabus

 

Official Tax Court Syllabus

 

P filed a petition seeking relief from joint and several liability under   sec. 6015, I.R.C. R contends that P is barred, under   sec. 6015(g)(2), I.R.C., from seeking relief because P was involved and participated in the prior deficiency proceeding. P contends that he did not participate meaningfully in the prior deficiency proceeding. P’s attorney in the prior deficiency proceeding also represented P’s former spouse in that proceeding. P’s attorney had a conflict of interest while representing P in the prior deficiency proceeding.

 

Held: P did not participate meaningfully in the prior deficiency proceeding. P is therefore not barred under   sec. 6015(g)(2), I.R.C., from claiming relief from joint and several liability.

 

Counsel

 

Andrew R. Roberson and Patty C. Liu, for petitioner.

Bernice Nalls, pro se.

 

Gorica B. Djuraskovic, for respondent.

 

Opinion by KROUPA

 

This case arises from a petition for relief from joint and several liability under   section 6015 1 after respondent issued a Final Notice of Determination Concerning Your Request for Relief From Joint and Several Liability under   section 6015 denying petitioner relief from deficiencies for 1999 and 2000 (years at issue). Petitioner argues that he is entitled to relief under   section 6015 from liability for the portions of the deficiencies for the years at issue that are attributable to his former wife’s (intervenor) gambling activities (deficiencies at issue). We must decide whether petitioner is barred from obtaining any relief from liability under   section 6015(g)(2) and whether petitioner is entitled to relief from liability under   ,   section 6015(b), (c) or (f) for the deficiencies at issue. We hold he is not barred and further hold that he is entitled to relief under   section 6015(b).

 

FINDINGS OF FACT

 

Some of the facts have been stipulated and are so found. We incorporate the stipulation of facts and the accompanying exhibits by this reference.

 

Petitioner and intervenor were married in the 1990s and divorced in 2004. Intervenor gambled at casinos and played the lottery during their marriage. Intervenor maintained calendars and diaries related to her gambling activities for the years at issue. In addition, intervenor retained some of the receipts related to her gambling activities.

 

Petitioner prepared and filed a joint Federal income tax return for petitioner and intervenor for each of the years at issue. He gathered documents for purposes of substantiating intervenor’s gambling winnings and losses that they reported on the returns. They reported all of her $45,540 of gambling winnings for 1999 and $113,445.50 for 2000. They also reported the corresponding gambling losses of $45,540 for 1999 and $108,945.50 for 2000. Petitioner reviewed the gambling records that he understood intervenor kept, and he also discussed with intervenor her gambling winnings and losses when preparing the returns. Petitioner did not know or have reason to know at the time each return was prepared that intervenor’s gambling losses were inaccurately reported.

 

Respondent began in 2001 an examination for the years at issue and focused primarily on whether the claimed deductions for certain rental expenses and intervenor’s gambling losses were allowable. Intervenor stopped cooperating during the examination and provided the examiner with documents different from those she had provided petitioner. Respondent issued a deficiency notice to petitioner and intervenor for the years at issue.

 

The deficiency case was docketed at docket No. 10774-04 (prior deficiency case). Petitioner was over 60 years old and was retired at the time of the prior deficiency case. James E. Caldwell (Mr. Caldwell) represented both petitioner and intervenor in the prior deficiency case. He signed all of the filings with the exception of the petition and the amended petition. Respondent corresponded with, requested documents from and attempted to scheduled meetings with Mr. Caldwell, not petitioner.

 

Petitioner depended on intervenor to contest the deficiencies at issue. It was intervenor who engaged in the gambling activities that gave rise to the deficiencies at issue, and she was the one with personal knowledge about the winnings and losses associated with the gambling activities. It also was intervenor who was responsible for maintaining and providing information regarding the gambling activities.

 

The parties executed a stipulated decision that petitioner and intervenor owed deficiencies and accuracy-related penalties for the years at issue. Neither petitioner nor intervenor requested relief under   section 6015 during the prior deficiency case for either year at issue. No party to the prior deficiency case filed a notice of appeal, and the decision of the Tax Court became final on June 19, 2005. See   secs. 7481(a)(1),   7483.

 

While the prior deficiency case was going forward, Mr. Caldwell also represented petitioner and intervenor in their contentious divorce. Mr. Caldwell represented both petitioner and intervenor in the prior deficiency case and the divorce proceeding until the divorce was finalized shortly before trial in the prior deficiency case. Petitioner’s and intervenor’s financial interests and interests in the allocation of liability for the deficiencies at issue were adverse in the prior deficiency case. Mr. Caldwell’s joint representation of petitioner and intervenor in the prior deficiency case created a conflict of interest.

 

Mr. Caldwell did not explain the advantages and risks of joint representation to petitioner. Mr. Caldwell failed to disclose the conflict of interest to petitioner. He never asked petitioner to waive the conflict of interest, and petitioner never did. Mr. Caldwell proceeded with the joint representation of petitioner and intervenor despite the conflict of interest.

 

Respondent applied an overpayment credit for 2004 to petitioner’s unpaid tax liability for 1999. Petitioner contested respondent’s action. Specifically, petitioner contested that he owed the deficiencies at issue.

 

Petitioner requested relief under   section 6015 from the deficiencies at issue. Petitioner followed numerous formalities, including submitting a Form 8857, Request for Innocent Spouse Relief. Petitioner also submitted a Form 12510, Questionnaire for Requesting Spouse, and an 18-page facsimile from intervenor. Petitioner was 70 years old and retired at the time he sought innocent spouse relief.

 

Respondent sent a preliminary determination letter proposing to deny petitioner’s claim for relief under   ,   section 6015(b), (c) and (f). Petitioner filed a Form 12509, Statement of Disagreement, with an attached statement explaining why he believed he was entitled to relief. He also contacted respondent’s innocent spouse call unit. Approximately 4 months later, he received a letter from respondent sustaining the preliminary determination to deny relief under   ,   section 6015(b), (c) or (f), yet the cover sheet referenced only relief sought under   section 6015(b). Throughout all this correspondence between petitioner and respondent there was no mention of petitioner’s claim’s being barred by   section 6015(g)(2) and res judicata. The deficiency examination began in 2001. Petitioner’s petition under   section 6015 was filed on May 7, 2007.

 

Respondent issued a Final Notice of Determination Concerning Your Request for Relief From Joint and Several Liability denying petitioner’s request for innocent spouse relief under   section 6015 for the years at issue. Petitioner had sought relief under   ,   section 6015(b), (c) and (f), yet the determination letter stated that petitioner was denied relief under   section 6015(b) and did not reference subsection (c) or (f). Respondent denied petitioner relief under   section 6015(b), stating petitioner knew of his wife’s gambling winnings and losses.

 

Mr. Caldwell, petitioner’s counsel at the time, prepared the petition contesting the denial of relief under   section 6015(b) on May 7, 2007. Respondent informed Mr. Caldwell of his conflict of interest resulting from his representation of both petitioner and intervenor in the prior deficiency case. Mr. Caldwell had apparently never encountered such a situation and was unaware of any ethical violations or issues. Mr. Caldwell withdrew from representing petitioner.

 

This Court allowed petitioner leave to amend his petition to request relief under   section 6015(c) and   (f). Respondent had still not asserted that petitioner’s claim was barred by   section 6015(g)(2) and res judicata.

 

Respondent filed a motion for summary judgment asking that petitioner be barred by res judicata under   section 6015(g)(2) because he “participated meaningfully” in the prior deficiency case. The Court denied respondent’s motion.

 

Respondent’s counsel requested additional information about the gambling losses and activities but never raised res judicata as a defense until 2 years after petitioner had requested relief under   section 6015.

 

We held a trial in Chicago, Illinois, in March 2011 to decide whether petitioner is barred from relief.

 

OPINION

 

Petitioner seeks to be relieved from joint liability regarding the deficiencies at issue. Petitioner participated in the prior deficiency case for the years at issue in that he prepared the tax returns for those years and started negotiating with respondent when the audit began. Petitioner hired an attorney who represented him as well as intervenor in the prior deficiency case and in their contentious divorce proceedings at the same time while their interests were adverse.

 

Respondent argues that res judicata bars petitioner’s claim for relief under   section 6015. We disagree.

 

We first explain how res judicata applies in joint and several liability tax cases; then we explain our holding. Res judicata requires that when a court of competent jurisdiction enters a final judgment on the merits of a cause of action, the parties to the action are bound by that decision as to all matters that were or could have been litigated and decided in the Commissioner v. Sunnen,   333 U.S. 591 [36 AFTR 611] (1948). The proceedings. doctrine serves to promote judicial economy by precluding repetitious lawsuits. Gustafson v. Commissioner,   97 T.C. 85, 91 (1991). Federal income taxes are determined annually with each year a separate cause of action. Res judicata is applied to bar subsequent proceedings involving the same tax year. Commissioner v. Sunnen, supra at 597-598.

 

Res judicata would bar a party to a prior proceeding for the same tax year from seeking relief from joint and several liability regardless of whether the claim had been raised in the prior proceeding. Vetrano v. Commissioner,   116 T.C. 272, 280 (2001). The common law doctrine of res judicata, however, is limited by   section 6015(g)(2). Res judicata will bar a taxpayer from requesting relief from joint and several liability only if (1) such relief was an issue in the prior proceeding, or (2) the Court decides that the taxpayer participated meaningfully in the prior proceeding.   Sec. 6015(g)(2); see Deihl v. Commissioner,   134 T.C. 156, 162 (2010); Vetrano v. Commissioner, supra at 278;   sec. 1.6015-1(e), Income Tax Regs. Put more simply, a taxpayer that participated meaningfully in a prior proceeding is barred from requesting relief under   section 6015 for the same taxable year after the decision of the Court has become final. See Vetrano v. Commissioner, supra at 278.

 

Relief from joint and several liability was not an issue in the prior deficiency case. Accordingly, petitioner will be barred under   section 6015(g)(2) from requesting relief under   section 6015 only if he participated meaningfully in the prior deficiency case. We now turn our attention to this issue.

 

The requesting spouse bears the burden of proving that he or she did not participate meaningfully in the prior proceeding. See Diehl v. Commissioner, supra at 162. “Meaningful participation” has not been defined in statutes or by the courts. See id. This Court has looked to the totality of the facts and circumstances to determine whether a taxpayer has participated meaningfully in a prior proceeding. See id. We have previously indicated that exercising exclusive control over the handling of the prior proceeding, having a high level of participation in the prior proceeding (e.g., signing court documents and participating in settlement negotiations), and having the opportunity to raise a claim for relief from joint and several liability in the prior proceeding are all probative of meaningful participation under   section 6015(g)(2). See id.; Thurner v. Commissioner,   121 T.C. 43, 53 (2003); Huynh v. Commissioner,   T.C. Memo. 2006-180 [TC Memo 2006-180], affd.   276 Fed. Appx. 634 [101 AFTR 2d 2008-2073] (9th Cir. 2008).

 

Here, intervenor, not petitioner, effectively exercised exclusive control over the prior deficiency case as it related to the deficiencies at issue. The deficiencies at issue stemmed from intervenor’s gambling activities. Consequently, intervenor was the one with personal knowledge of the winnings and losses from the gambling activities. This knowledge was critical to contesting the deficiencies at issue. It was also intervenor who maintained and provided all of the documentation relating to the gambling activities. Accordingly, petitioner depended on intervenor to contest the deficiencies at issue.

 

Petitioner did not have a high level of participation in the prior deficiency case. Petitioner was over 60 years old and was retired at the time of the prior deficiency case. He participated in the prior deficiency case through Mr. Caldwell’s representation. Mr. Caldwell represented petitioner from the beginning of the prior deficiency case until its conclusion. Mr. Caldwell signed all of the filings with the exception of the petition and the amended petition. Respondent communicated solely with Mr. Caldwell in the development and resolution of the controversy.

 

Petitioner’s opportunity to raise a claim for relief from joint and several liability in the prior deficiency case was obscured and obstructed by Mr. Caldwell’s continued concurrent representation of petitioner and intervenor, whose interests were adverse. Petitioner and intervenor were also involved in a concurrently pending contentious divorce proceeding, and both of them were represented by Mr. Caldwell.

 

Mr. Caldwell’s joint representation of petitioner and intervenor involved an actual conflict of interest. Petitioner had a viable claim for relief from joint and several liability under   section 6015(b) with respect to the deficiencies at issue, discussed infra, during the prior deficiency case. Petitioner’s claim was directly adverse to the interest of intervenor, who was contesting the deficiencies at issue. 2

 

Mr. Caldwell never obtained informed written consent waiving the conflict of interest, as required under this Court’s Rules. See Rule 24(g). Moreover, Mr. Caldwell did not disclose the conflict of interest to petitioner. Instead, he proceeded with the representation despite the conflict of interest. We believe this materially limited Mr. Caldwell’s ability to represent petitioner’s interest in bringing a claim for relief from joint and several liability.

 

Finally, petitioner was not informed of his opportunity to and consequently did not raise a claim for relief from joint and several liability in the prior deficiency case. “erroneous items” of intervenor. See   sec. 6015(b).

 

We find on the totality of the facts and circumstances that petitioner did not participate meaningfully in the prior deficiency case within the meaning of   section 6015(g)(2). We therefore hold that petitioner is not barred from requesting relief from joint and several liability with respect to the deficiencies at issue.

 

We accept petitioner’s and respondent’s stipulation that if petitioner’s claim is not barred by   section 6015(g)(2), then petitioner meets all the requirements under   ,   section 6015(b)(1)(A), (B) and (E) regarding intervenor’s disallowed gambling losses. We further find for purposes of   section 6015(b)(1)(C) that petitioner did not know or have reason to know that there was an understatement of tax attributable to intervenor’s disallowed gambling losses at the time he signed the returns for the years at issue. The record suggests intervenor showed respondent records that she had not shown to petitioner. We find this compelling.

 

We need not analyze all the facts and circumstances for relief under   section 6015(c) and   (f) because of our holding regarding petitioner’s qualification for relief under   section 6015(b). We note, however, that petitioner and respondent agree that petitioner meets all the threshold conditions of   Rev. Proc. 2003-61, sec. 4.03, 2003-2 C.B. 296, 298.

 

We have considered all arguments the parties made in reaching our holdings, and, to the extent not mentioned, we find them to be irrelevant or without merit.

 

To reflect the foregoing, Decision will be entered for petitioner.

 

1

All section references are to the Internal Revenue Code as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.

2

Petitioner’s claim for relief from joint and several liability under   sec. 6015(b) was adverse to intervenor’s interest in contesting the deficiencies at issue because it required him to prove that the deficiencies at issue were attributable to

 

Architects and Landscape Architects Audit Technique Guide

 

NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date. Audit Guide Rev. August 2011 Chapter One – Introduction and Overview Overview General Architects – Background Landscape Architects – Background General Architects – Training, Other Qualifications and Advancement Landscape Architects – Training, Other Qualifications and Advancement Chapter 2 – Issues Common to Architects and Landscape Architects Personal Service Corporation IRC § 199, Domestic Production Activities Deduction Determining the Proper Method of Accounting Tax Year Chapter 3 – Examination Techniques Pre-audit Analysis Information Document Request Initial Interview Place of Examination Business/Activity Tour Factual Development Income Expenses Penalties Inadequate Books and Records Chapter 4 – Supporting Law Internal Revenue Code Treasury Regulations Revenue Rulings Case Law Appendix Appendix A – Participants in the Construction Industry Appendix B – Industry Terms and Definitions Appendix C – Sample Interview Questions Appendix D – Resources Chapter One – Introduction and Overview Purpose of Guide This audit technique guide (ATG) has been developed to provide guidance to Revenue Agents and Tax Compliance Officers conducting examinations in the architect and landscape architect service industries. The purpose of the ATG is to provide background about the architect and landscape architect service industries, identify frequent and/or unique issues, provide examination techniques, and supply applicable law and court cases. This guide is not designed to be all inclusive nor is it legal precedent and should not be relied upon as such. It is not designed to remove the discretion given to managers and examiners in the application of a variety of audit techniques or procedures appropriate to any given examination. The following appendixes provide additional information that will assist in the examination: Appendix A - Participants in the Construction Industry Appendix B - Industry Terms and Definitions Appendix C - Sample Interview Questions Appendix D - Resources Some of the information contained in Chapter 1, was obtained from the Bureau of Labor Statistics, Occupational Outlook Handbook, 2010-11 Edition. Objectives of Guide Upon completion of this audit technique guide, the examiner will be able to: Have a general understanding of the architect and landscape architect professions, and Identify and develop issues specific to the architect and landscape architect professions. Overview Architects are comprised of two specific areas; general architects and landscape architects. General architectural businesses are described in North American Industry Classification System (NAICS) code 541310 as: establishments primarily engaged in planning and designing residential, institutional, leisure, commercial, and industrial buildings and structures by applying knowledge of design, construction procedures, zoning regulations, building codes, and building materials. Landscape architectural businesses are described in NAICS code 541320 as: establishments primarily engaged in planning and designing the development of land areas for projects, such as parks and other recreational areas; airports; highways; hospitals; schools; land subdivisions; and commercial, industrial, and residential areas, by applying knowledge of land characteristics, location of buildings and structures, use of land areas, and design of landscape projects. General Architects – Background An architectural business may provide a variety of services to their clients. These services generally include consultation, design, and supervision of design of commercial, governmental, and residential structures or buildings. The plans, specifications, and other related documents that are produced in the design phase are called construction documents. People need places in which to live, work, play, learn, worship, meet, govern, shop, and eat. Architects are responsible for designing these places, whether they are private or public; indoors or out; rooms, buildings, or complexes. Architects are licensed professionals trained in the art and science of building design who develop the concepts for structures and turn those concepts into images and plans. Architects create the overall look of buildings and other structures. Buildings also must be functional, safe, and economical and must suit the needs of the people who use them. Architects consider all these factors when they design buildings and other structures. Architects may be involved in all phases of a construction project, from the initial discussion with the client through the final delivery of the completed structure. Their duties require specific skills – designing, engineering, managing, supervising, and communicating with clients and builders. Architects spend a great deal of time explaining their ideas to clients, construction contractors, and others. The architect and client discuss the objectives, requirements, and budget of a project. In some cases, architects provide various predesign services: conducting feasibility and environmental impact studies, selecting a site, preparing cost analysis and land-use studies, or specifying the requirements the design must meet. For example, they may determine space requirements by researching the numbers and types of potential users of a building. The architect then prepares drawings and a report presenting ideas for the client to review. After discussing and agreeing on the initial proposal, architects develop final construction plans that show the building’s appearance and details for its construction. Accompanying these plans are drawings of the structural system; heating, ventilation and air conditioning systems (HVAC); electrical systems; communications systems; plumbing; and, possibly, site and landscape plans. The plans also specify the building materials and, in some cases, the interior furnishings. In developing designs, architects follow building codes, zoning laws, fire regulations, and other ordinances, such as those requiring easy access by people who are disabled. Computer-aided design and drafting (CADD) and building information modeling (BIM) technology has replaced traditional paper and pencil as the most common method for creating design and construction drawings. Continual revision of plans on the basis of client needs and budget constraints is often necessary. Architects may also assist clients in obtaining construction bids, selecting contractors, and negotiating construction contracts. As construction proceeds, they may visit building sites to make sure that contractors follow the design, adhere to the schedule, use the specified materials, and meet work quality standards. The job is not complete until all construction is finished, required tests are conducted, and construction costs are paid and a Certificate of Occupancy has been issued. Sometimes, architects also provide post construction services, such as facilities management. They advise on energy efficiency measures, evaluate how well the building design adapts to the needs of occupants, and make necessary improvements. Often working with engineers, urban planners, interior designers, landscape architects, and other professionals, architects spend a great deal of their time coordinating information from, and the work of, other professionals engaged in the same project. They design a wide variety of buildings, such as office and apartment buildings, schools, churches, factories, hospitals, houses, and airport terminals. They also design complexes such as urban centers, college campuses, industrial parks, and entire communities. Architects sometimes specialize in one phase of work. Some specialize in the design of one type of building—for example, hospitals, schools, or housing. Others focus on planning and predesign services or construction management and do minimal design work. There is an increase in demand for architects with knowledge of ‘green’ design. Green design, also known as sustainable design, emphasizes the efficient use of resources such as energy and water, waste and pollution reduction, conservation, and environmentally friendly design, specifications, and materials. Rising energy costs and increased concern about the environment has led to many new buildings being built ‘green.’ Architects spend most of their time in offices consulting with clients, developing reports and drawings, and working with other architects and engineers. However, they often visit construction sites to review the progress of projects. Architectural firms sometimes outsource the drafting of construction documents and basic design for large-scale commercial and residential projects to architecture firms overseas. Landscape Architects – Background People enjoy attractively designed gardens, public parks and playgrounds, residential areas, college campuses, shopping centers, golf courses, and parkways. Landscape architects design these areas so they are not only functional but also beautiful and harmonious with the natural environment. They plan the location of buildings, roads, and walkways, and the arrangement of flowers, shrubs, and trees. They also design and plan the restoration of natural places disturbed by humans, such as wetlands, stream corridors, mined areas, and forested land. Working with building architects, surveyors, and engineers, landscape architects help determine the best arrangement of roads and buildings. They also collaborate with environmental scientists, foresters, and other professionals to find the best way to conserve or restore natural resources. Once these decisions are made, landscape architects create detailed plans indicating new topography, vegetation, walkways, and other landscaping details, such as fountains and decorative features. In planning a site, landscape architects first consider the purpose of the project and the funds available. They then analyze the natural elements of the site, such as the climate, soil, slope of the land, drainage, and vegetation. They also assess existing buildings, roads, walkways, and utilities to determine what improvements are necessary. At all stages, they evaluate the project’s impact on the local ecosystem. After studying and analyzing the site, landscape architects prepare a preliminary design. To address the needs of the client, as well as the conditions at the site, they frequently make changes before a final design is approved. They also take into account any local, state, or federal regulations, such as those protecting wetlands or historic resources. In preparing designs, computer-aided design (CAD) has become an essential tool for most landscape architects. Many landscape architects also use video simulation to help clients envision the proposed ideas and plans. For larger scale site planning, landscape architects also use geographic information systems (GIS) technology, a computer mapping system. Throughout all phases of planning and design, landscape architects consult with other professionals, such as civil engineers, hydrologists, or building architects, involved in the project. Once the design is complete, they prepare a proposal for the client. They produce detailed plans of the site, including written reports, sketches, models, photographs, land-use studies, and cost estimates and submit them for approval by the client and by regulatory agencies. When the plans are approved, landscape architects prepare working drawings showing all existing and proposed features. They also outline in detail the methods of construction and draw up a list of necessary materials. Landscape architects then monitor the implementation of their design, while general contractors or landscape contractors usually direct the actual construction of the site and installation of plantings. Some landscape architects work on a variety of types of projects. Others specialize in a particular area, such as street and highway beautification, waterfront improvement projects, parks and playgrounds, or shopping centers. Still others work in regional planning and resource management; feasibility, environmental impact, and cost studies; or site construction. Increasingly, landscape architects work in environmental remediation, such as preservation and restoration of wetlands or abatement of storm water run-off in new developments. Historic landscape preservation and restoration is another area where landscape architects increasingly play a role. Landscape architects who work for government agencies do site and landscape design for government buildings, parks, and other public lands, as well as park and recreation planning in national parks and forests. In addition, they may prepare environmental impact statements and studies on environmental issues such as public land-use planning. Landscape architects spend most of their time in offices creating plans and designs, preparing models and cost estimates, doing research, or attending meetings with clients and other professionals involved in a design or planning project. The remainder of their time is spent at the site. During the design and planning stage, landscape architects visit and analyze the site to verify that the design can be incorporated into the landscape. After the plans and specifications are completed, they may spend additional time at the site observing or supervising the construction. Those who work in large national or regional firms can spend considerably more time out of the office traveling to sites General Architects – Training, Other Qualifications and Advancement There are three main steps in becoming an architect: completing a professional degree in architecture; gaining work experience through an internship; and attaining licensure by passing the Architect Registration Exam. In most states, architects must hold a professional degree in architecture from a school of architecture that has a degree program accredited by the National Architectural Accrediting Board (NAAB). Each jurisdiction sets its own requirements for initial registration, examination, and corporate practice. The National Council of Architectural Registration Boards (NCARB) has information on each individual jurisdiction. Most architects earn their professional degree through a five-year Bachelor of Architecture degree program which is intended for students with no previous architectural training. Others earn a master’s degree after completing a bachelor’s degree in another field or after completing a pre-professional architecture program. A master’s degree in architecture can take 1 to 5 years to complete depending on the extent of previous training in architecture. The choice of degree depends on preference and educational background. A five-year Bachelor of Architecture offers the most direct route to the professional degree. A typical program includes courses in architectural history and theory, building design with an emphasis on CADD, structures, technology, construction methods, professional practice, math, physical sciences, and liberal arts. Many schools of architecture also offer post professional degrees for those who already have a bachelor’s or master’s degree in architecture or other areas. Although graduate education beyond the professional degree is not required for practicing architects, it may be useful for research, teaching, and certain specialties. All state architectural registration boards require architecture graduates to complete a training period – usually at least 3 years – before they may sit for the licensing exam. Every state follows the training standards established by the Intern Development Program, a program of the American Institute of Architects (AIA) and the NCARB. These standards stipulate broad training under the supervision of a licensed architect. Most new graduates complete their training period by working as interns at architectural firms. Some states allow a portion of the training to occur in the offices of related professionals, such as engineers or general contractors. Architecture students who complete internships while still in school can count some of that time toward the 3-year training period. Interns in architectural firms may assist in the design of one part of a project, help prepare architectural documents or drawings, build models, or prepare construction drawings on CADD. Interns also may research building codes and materials or write specifications for building materials, installation criteria, the quality of finishes, and other related details. All states and the District of Columbia require individuals to be licensed (registered) before they may call themselves architects and contract to provide architectural services. During the time between graduation and becoming licensed, architecture school graduates generally work in the field under the supervision of a licensed architect who takes legal responsibility for all work. Licensing requirements include a professional degree in architecture, a period of practical training or internship, and a passing score on all divisions of the Architect Registration Examination. The eligibility period for completion of all divisions of the exam varies by state. A roster of all licensed architects may be obtained from the appropriate state licensing authority. Most states also require some form of continuing education to maintain a license. Requirements vary by state but usually involve the completion of a certain number of credits annually or biennially through workshops, formal university classes, conferences, self-study courses, or other sources. Architects must be able to communicate their ideas visually to their clients. Artistic and drawing ability is helpful, but not essential, to such communication. Computer skills are also required for writing specifications, for two-dimensional and three-dimensional drafting using CADD programs, and for financial management. A number of architects voluntarily seek certification by the NCARB. Certification is awarded after independent verification of the candidate’s educational transcripts, employment record, and professional references. Certification can make it easier to become licensed across states. It is the primary requirement for reciprocity of licensing among state boards that are NCARB members. In 2009, approximately one-third of all licensed architects had this certification. In large firms, architects may advance to supervisory or managerial positions. Some architects become partners in established firms, while others set up their own practices. Some graduates with degrees in architecture also enter related fields, such as graphic, interior, or industrial design; urban planning; real estate development; civil engineering; and construction management. Architects held about 141,200 jobs in 2008. Approximately 68 percent of jobs were in the architectural, engineering, and related services industry. A small number worked for residential and nonresidential building construction firms and for government agencies responsible for housing, community planning, or construction of government buildings, such as the U.S. Departments of Defense and Interior and the General Services Administration. About 21 percent of architects are self-employed. Per the Bureau of Labor Statistics 2010-11 Occupational Outlook Handbook, the median annual wages of wage-and-salary architects were $70,320 in May 2008. The middle 50 percent earned between $53,480 and $91,870. The lowest 10 percent earned less than $41,320, and the highest 10 percent earned more than $119,220. Those just starting their internships can expect to earn considerably less. Earnings of partners in established architectural firms may fluctuate because of changing business conditions. Some architects may have difficulty establishing their own practices and may go through a period when their expenses are greater than their income, requiring substantial financial resources. Many firms pay tuition and fees toward advanced degree programs and continuing education requirements for their employees. Landscape Architects – Training, Other Qualifications and Advancement Almost every state requires landscape architects to be licensed. While requirements vary among the states, they usually include a degree in landscape architecture from an accredited school; work experience; and a passing score on the Landscape Architect Registration Examination (LARE). A bachelor’s or master’s degree in landscape architecture is usually necessary for entry into the profession. Sixty-seven colleges and universities offered undergraduate or graduate programs in landscape architecture that were accredited by the Landscape Architecture Accreditation Board of the American Society of Landscape Architects in 2009. There are two undergraduate professional degrees: a Bachelor of Landscape Architecture (BLA) and a Bachelor of Science in Landscape Architecture (BSLA). These programs usually require four or five years of study for completion. Those who hold an undergraduate degree in a field other than landscape architecture can enroll in a Master of Landscape Architecture (MLA) graduate degree program, which typically takes three years of full-time study to complete. Those who hold undergraduate degrees in landscape architecture can earn their MLA in two years. Courses required in these programs usually include subjects such as surveying, landscape design and construction, landscape ecology, site design, grading, drainage, storm water management, and urban and regional planning. Other courses include history of landscape architecture, plant and soil science, geology, professional practice, and general management. Whenever possible, students are assigned real projects, providing them with valuable hands-on experience. Many employers recommend that prospective landscape architects complete a summer internship with a landscape architecture firm during their formal educational studies. As of 2011, all 50 states required landscape architects to be licensed. Licensing is based on the LARE, sponsored by the Council of Landscape Architectural Registration Boards. Applicants wishing to take the exam usually need a degree from an accredited school plus one to four years of work experience under the supervision of a licensed landscape architect, although standards vary by state. For those without an accredited landscape architecture degree, most states provide alternative paths to qualify to take the LARE, usually requiring more work experience. Currently, 13 states require that a state examination be passed in addition to the LARE to satisfy registration requirements. State examinations focus on laws, environmental regulations, plants, soils, climate, and any other characteristics unique to the state. Because requirements for licensure are not uniform, landscape architects may find it difficult to transfer their registration from one state to another. National standards include graduating from an accredited program, serving three years of internship under the supervision of a registered landscape architect, and passing the LARE can satisfy requirements in most states. By meeting national requirements, a landscape architect can also obtain certification from the Council of Landscape Architectural Registration Boards which can be useful in obtaining reciprocal licensure in other states. In states where licensure is required, new hires may be called “apprentices” or “intern landscape architects” until they become licensed. Their duties vary depending on the type and size of the employing firm. They may do project research or prepare working drawings, construction documents, or base maps of the area to be designed. Some are allowed to participate in the actual design of a project. However, interns must perform all work under the supervision of a licensed landscape architect. Additionally, all drawings and specifications must be signed and sealed by the licensed landscape architect, who takes legal responsibility for the work. After gaining experience and becoming licensed, landscape architects usually can carry a design through all stages of development. A majority of states require some form of continuing education to maintain a license. Requirements usually involve the completion of workshops, seminars, formal university classes, conferences, self-study courses, or other classes. Landscape architects must be able to convey their ideas to other professionals and clients and to make presentations before large groups. Landscape architects must also be able to draft and design using CAD software. Knowledge of computer applications of all kinds, including word processing, desktop publishing, and spreadsheets is also important. Landscape architects use these tools to develop presentations, proposals, reports, and land impact studies for clients, colleagues, and superiors. After several years, landscape architects may become project managers, taking on the responsibility for meeting schedules and budgets, in addition to overseeing the project design. Later, they may become associates or partners of a firm, with a proprietary interest in the business. Those with landscape architecture training also qualify for jobs closely related to landscape architecture, and may, after gaining some experience, become construction supervisors, land or environmental planners, or landscape consultants. Per the Bureau of Labor Statistics 2010-11 Occupational Outlook Handbook, the median annual wages for landscape architects were $58,960 in May of 2008. The middle 50 percent earned between $45,840 and $77,610. The lowest 10 percent earned less than $36,520 and the highest 10 percent earned more than $97,370. Architectural, engineering, and related services employed more landscape architects than any other group of industries, and the median annual wages were $59,610 in May 2008. Legal Structure In 2009, more than 72,000 returns with architectural services were filed in the United States. Of those filings, 65 percent were Form 1040 Schedules C; 23 percent were Form1120 S Corporations; 7 percent were Form1120 C Corporations; and 5 percent were Form 1065 Partnerships. An architecture firm is regulated by state law. Some states do not permit an architecture firm to operate as general business corporations. This may be to ensure that only licensed architects own and control architectural firms or to make sure the public is aware of individual architects’ professional liability. Generally, architects are personally liable for their professional acts and may not transfer or otherwise assign the liability to any other party. Some states may allow (or even require) architects to organize their businesses as professional corporations. Professional corporation laws in states may set ownership restrictions to ensure that licensed architects own (or control) the business and require P.C. in the corporate name to distinguish it from a general business corporation. Several states do not allow professional firms to organize as limited liability companies or partnerships. Other states allow the formation of professional limited liability companies (PLLCs) or professional limited liability partnerships (PLLPs) Restrictions vary from state to state and any architectural business conducting business in a state generally must comply with the laws of that state whether or not the business maintains an office in that state. Participants in the Construction Industry There are numerous participants that take part in the construction process. The key participants are listed below and are discussed in depth in Appendix A. Contractors General/Prime Contractors Construction Managers Commercial Contractors Commercial Project Owners Residential Construction Developers Subcontractors Highway Contractors Heavy Construction Contractors General Architects Landscape Architects Engineers Material Suppliers Construction Lenders Surety Companies Each of the above participants can and often do have multiple roles in the construction process. For example, the owner could also be the general contractor (builder/developer). The general contractor in addition to providing supervision may also do specialty work that would typically be subcontracted (for example, concrete work). Construction lenders frequently hold an equity position in a development partnership in order to participate in the management decisions and to share in the profits. Anchor tenants, such as major department store chains participate in the development partnership in exchange for signing long-term leases. Contractors and material suppliers can obtain rights in the project by filing mechanics liens against the property. The Contracting Process When the owner/client determines that the project is feasible and that construction financing is available, the owner will solicit bids from general contractors and/or specialty contractors. Owners will use trade publications and newspapers to invite contractors to bid for the construction contract. The notice will provide the contractors with the procedures to be followed in submitting a bid. The bidding contractor obtains a copy of the plans and specifications prepared by the architect from the owner to prepare for the formal bid. The bidding contractor solicits bids from subcontractors, estimates direct material and labor costs, and evaluates the ultimate profit potential of the contract. The amount of the bid covers the estimated costs and profit for the construction project. The owner evaluates the submitted bids and will award the contract to the successful bidder. The contract document contains the contract amount, project start and completion dates, progress billing procedures, insurance requirements, and other pertinent information. In many cases, the landscape architect will oversee the bidding process on behalf of the project’s owner for landscape site work that does not include extensive roadway or building work. The owner typically will then evaluate the bids after receiving review and recommendations by the landscape architect. A few architectural firms will act as the general contractor. These general contractors make bids on the project (as described above). The architect reviews the bids and recommends one or more of the general contractors to do the job. The owner/client selects and contracts with the general contractor(s) of their choice. There may be more than one general contractor selected for different phases of the project. Chapter 2 – Issues Common to Architects and Landscape Architects This chapter discusses specific issues applicable to the architect and landscape architect industries. In addition to the general examination issues, there are several issues which are frequent or unique to the architectural business. These issues are discussed in more detail below. Personal Service Corporation Many individuals in the business of performing personal services choose to operate as a corporation in order to gain tax advantages not otherwise available to sole proprietors or partners. Some of these advantages include the ability to deduct business expenses that would otherwise be subject to the limitations on miscellaneous itemized deductions, the graduated corporate tax rate, or the use of corporate retirement and fringe benefit plans. Congress, concerned that personal service corporations (PSCs) were being used to shield income from the employee-owners’ higher individual tax rates, made the decision to deny the benefits of the graduated tax rates to a PSC for tax years after 1987. IRC § 11(a) imposes a tax on the taxable income of every corporation. Although for federal income tax purposes corporations generally are taxed at graduated income tax rates under IRC § 11(b)(1), qualified PSCs as defined in IRC §448(d)(2) are taxed at a flat 35-percent income tax rate under IRC § 11(b)(2). It is possible for a C corporation engaged in the architectural business to be a qualified PSC. A qualified PSC is one that meets the function and ownership tests of IRC § 448(d)(2). IRC § 448(a) generally prohibits C corporations, partnerships with C corporations as partners, and tax shelters from using the cash receipts and disbursements method of accounting (cash method) if the corporation’s three prior taxable years average annual gross receipts exceed $5 million. IRC § 448(b) provides an exception to this general rule if a qualified PSC meets the function and ownership tests; in this case the qualified PSC may use the cash method of accounting even if it has average gross receipts in the three prior taxable year exceeding $5 million. A cash basis PSC that fails to meet either the function or ownership test for any taxable year must change its method of accounting for that year from the cash basis to some other basis and is then taxed at a graduated income tax rate. The only exception is where the corporation meets the gross receipts test if the average annual gross receipts for the three taxable years ending prior to the taxable year in question are less than or equal to $5 million (Temp. Treas. Reg. § 1.448-1T(f)). The function test requires that substantially all of the corporation’s activities involve the performance of services in the fields of “health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting” (qualifying field), IRC § 448(d)(2)(A). Section 1.448-1T(e)(4)(i) provides: (4) Function test – (i) In general – A corporation meets the function test if substantially all the corporation’s activities for a taxable year involve the performance of services in one or more of the following fields - Health, Law, Engineering (including surveying and mapping), Architecture, Accounting, Actuarial science, Performing arts, or Consulting Substantially all of the activities of a corporation are involved in the performance of services in any field described in the preceding sentence (a qualifying field), only if 95 percent or more of the time spent by employees of the corporation, serving in their capacity as such, is devoted to the performance of services in a qualifying field. For purposes of determining whether the 95 percent test is satisfied, the performance of any activity incident to the actual performance of services in a qualifying field is considered the performance of services in that field. Activities incident to the performance of services in a qualifying field include the supervision of employees engaged in directly providing service to clients, and the performance of administrative and support services incident to such activities. A corporation meets the ownership test if at all times during the taxable year substantially all of the corporate stock, by value, is held directly or indirectly by any of the following (Treas. Reg. § 1.448-1T(e)(5)): Employees performing services for the corporation in connection with the activities involving the fields of health, engineering, architecture, accounting, actuarial science, performing arts, consulting, or law. Retired employees who had performed the services. An estate of the employees or retirees described above. Any person who acquired the stock of the corporation as a result of the death of an employee or retiree (but only for the two-year period following the date of death). The term “substantially all” means an amount equal to or greater than 95 percent. Stock held indirectly includes: Interests owned by an individual in a partnership, S corporation, or qualified personal service corporation that owns such stock. Stock held by a trust if and to the extent that the individual is treated under grantor trust rules (located in Subchapter J of the Internal Revenue Code) as owner of part of the trust holding such stock. Stock held by any qualified pension, profit-sharing, or stock bonus plan described in IRC § 401(a) that is exempt under IRC § 501(a) (Temp Treas. Reg. §§1.448-1T(e)(5)(iii) and (v)). Audit hint: It is important to verify that a PSC is correctly using the 35 percent tax rate and that when audit adjustments are proposed, Report Generation Software (RGS) correctly computes the 35 percent rate on all adjustments. IRC § 199, Domestic Production Activities Deduction It is possible for an architectural business to claim the IRC § 199, Domestic Production Activities Deduction (DPAD). IRC § 199 allows a deduction equal to 9 percent (3 percent for taxable years beginning in 2005 or 2006, and 6 percent for taxable years beginning in 2007, 2008 or 2009) of the lesser of the qualified production activities Income (QPAI) of the taxpayer for the taxable year or taxable income (or, if the taxpayer is an individual, adjusted gross income) up to 50% of the allocable W-2 wages paid by the taxpayer for the taxable year. A taxpayer’s QPAI is equal to the taxpayer’s domestic production gross receipts (DPGR), reduced by the cost of goods sold (CGS) that is allocable to DPGR, and other deductions, expenses and losses that are properly allocable to DPGR. DPGR include gross receipts derived from: Leases, rentals, licenses, sales, exchanges or other dispositions of Qualifying production property (tangible personal property, computer software and certain sound recordings) manufactured, produced grown, or extracted (MPGE) in whole or in significant part by the taxpayer in whole or significant part within the U.S. Any qualified film produced by the taxpayer within the U.S. Electricity, natural gas, or potable water produced by the taxpayer in the U.S. Construction of real property performed in the U.S. by the taxpayer. Engineering or architectural services performed in the U.S. by the taxpayer with respect to the construction of real property in the U.S. Treas. Reg. § 1.199-3(n)(1) provides that DPGR includes gross receipts derived from engineering and architectural services performed in the United states for a construction project described in Treas. Reg. § 1.199-3(m)(1)(i), if the taxpayer is considered to be engaged in a trade or business that is considered engineering or architectural services, for purposes of NAICS, on a regular and ongoing basis. Such qualifying services also include feasibility studies for a construction project in the U.S., even if the planned construction project is not undertaken or not completed. See Treas. Reg. §1.199-3(n)(1). Post construction services such as annual audits and inspections do not qualify as engineering or architectural services performed for a construction project. See Treas. Reg. § 1.199-3(n)(5). Gross receipts derived from engineering and architectural services related to the development/design of land do not qualify as DPGR because the gross receipts are not derived from engineering or architectural services performed for a construction project described in Treas. Reg. § 1.199-3(m)(1)(i), unless such services relate to “other construction activities” that constitute the erection or substantial renovation of real property in the United States as described in Treas. Reg. § 1.199-3(m)(2)(iii). For example, engineering services provided to a land developer for roads, sewers, sidewalks, and utilities qualify as DPGR because the construction of infrastructure is a qualifying activity. However, any engineering services that are related to land do not qualify unless the services relate to “other construction activities.” See Treas. Reg. § 1.199-3(n)(7). Determining the Proper Method of Accounting Generally, architects and landscape architects are permitted to select the cash or accrual methods of accounting. They are not permitted to use the completed contract method of accounting or the percentage-of-completion method of accounting. IRC § 446(a) provides that taxable income must be computed under the method of accounting on the basis of which the taxpayer regularly computes income in keeping the taxpayer’s books. IRC § 446(c) generally allows a taxpayer to select the method of accounting it will use to compute its taxable income. A taxpayer is entitled to adopt any one of the permissible methods for each separate trade or business, including the cash method or an accrual method subject to certain restrictions. Generally, permissible methods include: IRC § 446(c)(1) – the cash receipts and disbursements method of accounting; IRC § 446(c)(2) – an accrual method; IRC § 446(c)(3) – any other method permitted by this chapter; or IRC § 446(c)(4) – any combination of the foregoing methods permitted under regulations prescribed by the Secretary. IRC § 446(b) provides that the selected method must clearly reflect income. Under Treas. Reg. §1.446-1(c)(2)(ii), the Commissioner has the authority to permit a taxpayer to use a method of accounting that clearly reflects income even though the method is not specifically authorized by the regulations. Cash Receipts and Disbursements Method of Accounting Generally, the “cash method” of accounting is an acceptable method of accounting. However, there are limitations on when this method can be used. The general rule as shown in Treas. Regs. § 1.446-1(c)(1)(i) requires an item to be included in income (whether in the form of cash, property or services) in the taxable year when actually or constructively received and permits a deduction for an expense in the taxable year when paid. However, Treas. Reg. § 1.461-1 provides that if an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of such taxable year, such expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made. Income may be actually or constructively received. If the taxpayer receives a check from a customer in Year 1 but does not deposit or cash it until Year 2, it is included in income in Year 1, when actually received. Constructive receipt occurs when the taxpayer has the unrestricted access to income that has been earned. Treas. Reg. § 1.446-1(c)(2)(i) requires that a taxpayer use an accrual method of accounting with regard to purchases and sales of merchandise whenever § 471 requires the taxpayer to account for inventories, unless otherwise authorized by the Commissioner under Treas. Reg. § 1.446-1(c)(2)(ii). IRC § 448(a) generally prohibits the use of the cash receipts and disbursement method of accounting in the case of C corporations, partnerships which have a C corporation as a partner, and tax shelters in computing taxable income. However, IRC § 448(b) provides exceptions for farming business entities with gross receipts of not more than $5 million, qualified personal service corporations and partnerships in which the C corporation partner is a qualified personal service corporation. Accrual Method of Accounting Treas. Reg. § 1.446-1(c)(2)(i) requires that a taxpayer use an accrual method of accounting with regard to purchases and sales of merchandise whenever IRC § 471 requires the taxpayer to account for inventories, unless otherwise authorized by the Commissioner under Treas. Reg. § 1.446-1(c)(2)(ii). The accrual method requires reporting income in the year earned and expenses in the year incurred. The purpose of an accrual method is to match income and expenses in the correct year. Other Methods of Accounting The ‘any other method’ in IRC § 446(c)(3) refers to special accounting methods. For example, , for construction contracts, the completed contract method and the percentage of completion method are special accounting methods. IRC § 460 was enacted as part of the Tax Reform Act of 1986, which requires the use of percentage of completion method for long-term construction contracts. However, as with many Code sections, there are exceptions to the required use of percentage of completion method. Therefore, you must be aware of the exceptions of IRC § 460 before determining which method of accounting is proper. IRC § 460(f) defines the term “long-term contract” as any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into. The duration of the contract is irrelevant. There are two exceptions for requiring the use of percentage of completion method – the home construction contract and the small contractor’s exception. Architectural contracts do not qualify as long-term contracts within the meaning of IRC § 460 (IRC § 451 for contracts entered into prior to January 11, 2001) and the taxpayers are not entitled to use a long-term contr