Double Taxation: A Take On All Things Taxes

Back in early June, we discussed the latest in a string of cases in which the IRS successfully attacked a taxpayer’s charitable deduction for failing to properly substantiate the contribution. From our earlier write-up:

During 2004, Steve and Rory Rothman executed a conservation deed of easement to the National Architectural trust, a donee that likely doomed the taxpayers from the start. The Rothmans engaged Mitchell, Maxwell & Jackson, Inc. (MMJ) to perform the qualified appraisal supporting the contribution. (For more on the qualified appraisal rules, see here).

This is where the problem started.

In determining the value of the conservation easement, MMJ set out to perform a “before and after valuation,” a commonly accepted methodology. This required MMJ to first determine the value of the Brooklyn home without the easement, then the value of the home after the easement, with the reduction in value representing the value of the conservation easement.

In attempting to value the home with the easement, MMJ looked to a series of previous court cases that generally valued the loss in value caused by a conservation easement at 10-15% of the total value. MMJ then “backed in” to the loss in value of the Brooklyn property, multiplying the $2.6M “before” value by 11.5% to determine a value for the conservation easement of $290,000.

The IRS denied the charitable contribution deduction, and the Tax Court upheld the deduction. Relying heavily on its 2010 decision in a case with similar facts called Scheidelman – in which MMJ was also the appraiser — the Tax Court held that MMJ merely estimated the value of the conservation easement by applying a set percentage to the property’s “before” value. In both cases, this percentage was not determined through a detailed analysis of the easement’s terms and covenants relative to the specific contribution, but rather on a review of previously approved relative values of conservation easements to gross values. This, the court determined, did not constitute a valuation method approved under I.R.C. § 170 for determining the property’s “after” value, and thus the Tax Court agreed with the IRS that the appraisal failed to contain the required method of valuation.

Similarly, the court sided with the IRS that the appraisal did not include the specific basis for the valuation. While MMJ ‘s appraisal generally cited elements that may affect the value of eased properties, it never expounded upon how, if at all, the factors affected the fair market value of the encumbered Brooklyn property. Thus, the appraisal did not specifically mention what restrictions supported the proffered 11.15% reduction in value.

Four days after the Tax Court published Rothman, the Court of Appeals for the Second Circuit ruled on the taxpayers appeal in Scheidelman, holding that MMJ’s appraisal in that case did indeed satisfy the “method and basis for valuation” requirements of Section 170 [see a great write-up on the appeals court decision here.] The taxpayers in Rothman immediately filed with the Tax Court to vacate its previous decision, since Rothman would also be appealable to the Second Circuit.

In response, the Tax Court agreed to vacate the portion of Rothman concluding that the appraisal was not qualified because it lacked a valuation method and a specific basis for the underlying value. a victory for the taxpayer.

It wasn’t all good news for the Rothman taxpayers, however. Unlike the taxpayer in Scheidelman, there were initial defects in the Rothman appraisal that prevented it from meeting the definition of a qualified appraisal. From our initial post:

Citing numerous other missed appraisal requirements — for example, the appraisal was performed more than 60 days prior to the contribution – the court concluded that the appraisal was not a “qualified appraisal,” and denied the full deduction.

In reconsidering its initial decision in Rothman, the Tax Court remained steadfast in its belief that these deficiencies continue to doom the appraisal:

The cumulative effect of the defects discussed in Rothman… deprives the Internal Revenue Service of sufficient information to evaluate the deductions claimed. The appraisal describes (and values) a property right different from the one petitioners contributed, and in doing so, fails to describe the easement accurately or in sufficient detail for a person unfamiliar with the property to ascertain whether the appraised property and the contributed property were one and the same…Moreover, the appraisal values a property interest greater than the one petitioners contributed, and it applies the wrong measure of value. Against this backdrop, even when we view the appraisal in the light of the Court of Appeals’ decision in Scheidelman, we decline to conclude the appraisal is qualified…[the court originally ruled that] the appraisal failed to satisfy 10 of 15 regulatory requirements, and following reconsideration, we conclude that the appraisal still fails to satisfy 8 of 15 requirements.

So what happens now? The Rothman’s failure to meet the appraisal requirements is not deadly, because the charitable contribution deduction can still be allowed if the failure was due to reasonable cause and not to willful neglect, an issue the Tax Court must now reconsider in a future trial.

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On a busy Wednesday on the floor of Congress, the Senate Democrats and House Republicans engaged in a good ol’ fashion political pissing match, with only the 2013 tax bill of every American taxpayer at stake.

Firing the opening salvo in what is sure to be a long, fruitless battle to determine the fate of the Bush tax cuts, Senate Democrats passed legislation  (Senate bill 3412) that would extend the Bush tax cuts for those earning less than $250,000. Adding salt to the Republican wound, the Senate also voted against a Republican amendment to the plan that would have extended the Bush tax cuts for all taxpayers into 2013.

In response, House Republicans quickly put an end to any Senate celebration by refusing to consider the Senate bill, opting instead to proceed with plans to pass a bill next week  (H.R. 8, which we discussed earlier this week here) that would extend the Bush tax cuts for all taxpayers into 2013, while also keeping the estate tax at its current parameters and increasing the AMT exemption for 2012 and 2013. Of course, if President Obama is re-elected in November — and assuming he doesn’t drastically shift his long-held refusal to extend the Bush tax cuts for America’s wealthiest taxpayers — he will surely veto any bill that comes out of the House.

Call me a cynic, but I’ve got to believe that being in Congress must be a lot like running in deep water: you’re spending a lot of energy, but you’re not actually getting anywhere.

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In a move that surprised absolutely no one, House Republicans formally introduced legislation today to counter bill S.3412 — introduced by Senate Democrats to extend the Bush tax cuts only for those earning less than $250,000 — with their own plan for the soon-to-expire cuts.

In H.R. 8, Republicans would extend the  Bush tax cuts — and the 10/15/25/28/33/35% rates that came with them —  for all taxpayers for one year, through December 31, 2013. In addition, the bill contains the following proposals:

• The overall limitation on itemized deductions and phase-out of personal exemptions, both slated to return in 2013, would be deferred one year, this time until January 1, 2014.
• The child tax credit would remain at $1,000 for 2013 (it was set to drop to $500) and will be permitted to offset AMT in 2013.
• All marriage penalty relief provisions (a standard deduction double the individual deduction, doubling of the 15% rate bracket) would be extended through 2013.
• The maximum rate on qualified dividends and long-term capital gain — slated to return to ordinary rates and 20%, respectively — will remain at 15% for 2013. The bill would seem to attempt to remove the proposed 3.8% Obamacare surtax from the dividend and LTCG rates, though the text does not make this abundantly clear.
• The current 35%/$5,120,000 estate tax rate/exemption would be extended through 2013.  
• The Section 179 deduction will remain at $100,000 for 2013.
• A one year AMT patch with an increased exemption of $78,750 for MFJ and $50,600 for single taxpayers for 2012, and $79,850 and $51,150 for 2013.

If you’re curious about a price tag for this one-year reprieve, the Joint Committee of Taxation puts it at $228 billion for 2013 alone, with $64 billion of the cost attributable to the extended Bush-era tax rates.

H.R. 8 is nearly identical in effect to a Senate bill sponsored by Orrin Hatch, though that bill would make an overhaul of the Code mandatory in 2013. The overhaul would be required to achieve the following results:

• Reduce rates,
• Eliminate preferences and deductions,
• Permanently repeal the AMT,
• Bring the top corporate rate down to 25%,
• Be revenue neutral,
• Retain a progressive tax code,
• Reunite the cast of tv’s “The Facts of Life,” including long-time hold-out Tootie, and
• Move to a territorial international tax regime, 

Now that you’ve read and digested this, feel free to print it out and promptly light it on fire, since there’s absolutely zero chance the Democratic controlled Senate will support either bill.

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While having to identify the most complex area of the Internal Revenue Code is akin to being asked to choose the most annoying member of the Miami Heat, in my opinion, there’s no more complicated jumble of rules than those governing partnership taxation. Subchapter K, which spans from Sections 701 through 777, is rife with cumbersome language, exceptions to exceptions, and seemingly endless cross-references, with the “substantial economic effect” rules of the Section 704 regulations enough to send even the most brazen of tax advisors running for the relative simplicity of subchapter S.

Sadly, I’ve spent the better part of the past decade trying to understand the finer points of the partnership rules, and it seems that whenever I think I’m finally comfortable with a specific provision, something comes along and throws me for a loop.

Consider the Tax Court’s decision yesterday in Brennan v. Commissioner, T.C. Memo 2012-158. Brennan dealt with Section 736, which governs partner retirements, a provision that could — and certainly should — read much simpler than currently constructed.  

One might logically conclude that when a partner in a partnership retires, they cease to be treated as a partner on the retirement date, and should receive no further allocation of income, gain, loss or deduction from that point forward. Stephen Brennan certainly believed so.

Brennan was a partner in Cutler & Company (Cutler), an LLC taxed as a partnership. In 2002, Brennan apparently “retired” from Cutler just as Cutler was preparing to sell a large portion of its assets pursuant to a restructuring agreement. As part of the restructuring agreement, Cutler was to distribute 44% of the sales proceeds — after paying off any Cutler liabilities — to Brennan in liquidation of his interest. This relationship was described by the Tax Court as an “economic interest” held by Brennan in Cutler, one that conferred upon Brennan a continuing right to share in the income or loss of Cutler while also securing Cutler’s obligation to make liquidating payments to Brennan.

Cutler apparently sold its assets on the installment method, receiving large chunks of cash and recognizing the related capital gains in 2003 and 2004. No cash was ever distributed to Brennan before Cutler went bankrupt in late 2004.  While Cutler properly reported the capital gains resulting from the asset sale on its 2003 and 2004 Forms 1065, Brennan did not recognize his share of any of the gains, operating under the theory that since he had retired as a partner at the end of 2002 and did not receive any of the sale proceeds, he was not required to recognize his share of the gain.

And this is where the confusion sets in. In general, Section 736 — like much of subchapter K — contains a trap for the unwary. Treas. Reg. §1.736-1(a)(1)(ii) provides that while a partner “retires” when he ceases to be a partner under local law, for the purposes of subchapter K, a retired partner will be treated as a partner until his interest in the partnership has been completely liquidated. This regulation is further clarified by Treas. Reg. §1.761-1(d), which provides that a partner is not completely liquidated until they have received the final distribution owed to them.

Now, until yesterday, I had always believed that these regulations only served the administrative purpose of continuing to require the partnership to issue a K-1 to the retired partners until they were fully redeemed, but importantly, the retired partner would not be allocated any additional income, gain, loss or deduction during the period of time spanning from his retirement date until the day he receives his final liquidating distribution. In other words, while the retired partner would continue to receive K-1s until he was fully redeemed, they would be blank K-1s.

The McKee, Nelson & Whitmore treatise on the subject only confirmed my belief:

For tax purposes, a retired partner is treated as a continuing partner until the § 736 liquidation process is complete.Accordingly, the taxable year of a partnership does not terminate prematurely with respect to a retired partner until such time as all § 736 payments have been received.Furthermore, even though a retired partner is entitled to receive only fixed liquidating distributions and is not entitled to any distributive share of partnership income, the fact that the retiree is still treated as a partner means that certain provisions, such as § 704 and § 751, continue to apply to him.

Yesterday, however, the Tax Court forced me to revisit this approach, as it concluded that Brennan had to recognize his share of Cutler’s capital gain recognized during 2003 and 2004, even though he “retired” at the end of 2002,  because he had not yet received his final liquidating payment from Cutler and was thus still a partner. Here’s the court’s explanation:

Here, Mr. Brennan was entitled to receive 44.985% of the net IA sale proceeds in complete liquidation of his partnership interest  in Cutler after the IA sale. Cutler received proceeds from the IA sale in 2003 and 2004, yet never distributed any amount of the net IA sale proceeds to Mr. Brennan. Nor did Cutler make any other distribution of cash or property in complete liquidation of Mr. Brennan’s partnership interest in Cutler before the end of 2004. Accordingly, Mr. Brennan remained a Cutler partner for tax purposes for 2003 and 2004. Consequently, Mr. Brennan must take into account his distributive shares of the capital gains income from the IA sale for 2003 and 2004 as set forth in the restructuring agreement, along with various other partnership items as required under section 702(a).

The decision is largely bereft of facts analysis, leaving readers wanting for clarification. For example, the opinion does not stipulate Brennan’s state-law retirement date, but rather casually mentions that “the Brennans argue that Mr. Brennan’s status as a partner of Cutler for tax purposes terminated in 2002…” and  “Mr. Brennan was to hold an economic interest in Cutler rather than a membership interest upon the [asset sale]“.

Further complicating matters,  in reaching its conclusion, the court does not reference back to the specifics of Brennan’s “withdrawal,” but instead only addresses the general rules under Section 736 stating that a retired partner is still considered a partner for tax purposes until completely liquidated.

This ambiguity leaves several unanswered questions as to why the court concluded Brennan was required to recognize his share of Cutler’s income in 2003 and 2004,  all of which I’d like an answer to: 

• Does the lack of mention of a specific retirement date indicate that perhaps there was no state-law retirement date, meaning Brennan was unquestionably a partner through 2004? If so, why wasn’t this referenced in the opinion section?
• Could it be that because Brennan’s liquidating distributions were so inextricably tied  to the asset sale, he was required to recognize the gain resulting from those sales, regardless of the fact that they occurred after his retirement date?
• Is this really just a matter of the “economic interest” Brennan held in Cutler after his retirement? If readers had access to the full restructuring agreement, would the language make clear that Brennan was to continue receiving allocations of income and loss until he received the final liquidating distribution even though he no longer owned a “membership interest” in the partnership?
• Or could I just have misunderstood Section 736 all along, and in all tax years beginning with the state-law retirement date and through the final liquidation payment, the retired partner is required to receive full allocations of income, gain, loss and deduction on Schedule K-1? I doubt that this is the case for a multitude of reasons, but this decision has certainly left me doubting my understanding of I.R.C. § 736.

I’ve got a call in with the IRS attorney assigned to Section 736, because I find the Brennan decision to be lacking in relevant details, and reaching a confusing conclusion, even by subchapter K standards.  In the meantime, if you’ve got a grasp of Section 736 and an abundance of free time, please chime in. Updates forthcoming.

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