Federal Income Tax Update
By I. Conservation Easement Charitable Deduction Limited to Taxpayer’s Basis in Ordinary Income Property; Oconee Landing Property vs. Commissioner, TC Memo 2024-25.
Oconee Landing Property, LLC claimed a charitable contribution deduction of almost $21 million for its donation of a conservation easement on property it owned in Georgia. The IRS disallowed the entire deduction. The Tax Court held the charitable contribution failed in its entirety for two reasons. First, the appraisers were not qualified appraisers, which meant Oconee failed to attach a qualified appraisal to its tax return. Second, because the property on which the easement was granted was ordinary income property, the amount of the charitable contribution was limited to Oconee’s basis in the donated property. Because Oconee could not prove its tax basis in the property exceeded zero, its charitable contribution was zero.
In 2015, Oconee donated a conservation easement over land it owned in Georgia (the “Easement Tract”). Oconee acquired the Easement Tract through a capital contribution from one of its partners, Carey Station, LLC. The principals of Carey Station were members of the Reynolds family and were real estate developers. The Reynolds family held the Easement Tract as part of a much larger tract acquired by them in 2003 (the “Carey Tract”). The Reynolds family hoped to develop the Carey Tract. It made extensive efforts to develop the tract. When they eventually ran out of cash, they attempted unsuccessfully to find a joint venture partner to provide capital to develop a master infrastructure for the tract, including roads and sewer facilities. In 2014, the Reynolds family formed Carey Station, LLC and contributed to it 980 acres of the Carey Tract. They unsuccessfully attempted to sell the Carey Station property at prices between $6.7 million and $7.9 million.
After the Reynolds family failed to find a joint venture partner or sell the Carey Tract, they formed a syndicated conservation easement joint venture called Oconee Landing Property, LLC. The plan was for the Reynolds family to sell units in the joint venture that would provide the buyers with a $4.35 charitable contribution deduction for every $1.00 paid by the buyers. Although the Reynolds family had been unsuccessful in finding buyers to pay more than $7 million for the entire tract, Oconee obtained a valuation of the tract of almost $60 million.
The Reynolds family caused Carey Station to contribute 355 acres to Oconee. The appraisers valued the contributed property at about $60,000 per acre. After contributing the 355 acres to Oconee, Carey Station received 95% of the Oconee units. It sold them to investors for $3.7 million, far less than $60,000 per acre. Oconee then granted a conservation easement over its property, valued at almost $21 million for charitable contribution purposes.
The Tax Court struck down the charitable contribution deduction on numerous grounds. First, the court held the Easement Tract had been inventory in the hands of Carey Station, LLC. That caused Oconee’s charitable deduction to be limited to Oconee’s tax basis in the Easement Tract. The history of the Reynolds family’s and Carey Station’s efforts to develop the Easement Tract showed the Reynolds held the tract for sale to customers in the ordinary course of their real estate business. When the Reynolds family sold portions of the tract, they reported their gains as ordinary income. Similarly, when the contributing partner (Carey Station) sold portions of the Carey Tract it retained, it reported its gain as ordinary income. When Carey Station conveyed the Easement Tract to Oconee, the nature and character of the property carried forward as inventory pursuant to Section 724. The Easement Tract retained its character as ordinary income property after the conservation easement.
Further, the court ruled the charitable deduction was reduced to zero because Oconee failed to establish its basis in the Easement Tract. The only evidence presented at trial was information from an earlier tax return of Carey Station, LLC. Carey Station’s 2014 return showed a cost basis of $9 million for the Easement Tract. However, as the court stated, “an entry on a tax return simply states the taxpayer’s position as to an item; it does not constitute evidence.” Without anything more to substantiate the basis in the Easement Tract, the charitable contribution deduction was reduced to zero.
Next, the court ruled the two appraisers failed to meet the qualified appraiser requirement. Therefore, the final appraisal report, which was attached to the Oconee’s tax return, was not a qualified appraisal as required by Section 170(f)(11)(E)(i). Even if appraisers generally have the qualifications to be qualified appraisers, they may lose that qualification by virtue of the exception in Regulation §1.170A-13(c)(5)(ii). That exception provides an individual is not a qualified appraiser as to a particular donation if the appraiser and the donor had an understanding as to the amount at which the property will be valued and “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.” The appraisers who appraised the Carey Tract at almost $21 million knew that was the number the Reynolds family needed to make the syndicated conservation transaction meet the family’s economic requirements. Thus, there was already an understanding between the appraiser and the taxpayer of the value that would ultimately be placed on the Easement Tract. The Reynolds family knew the tract was worth less than $10 million. Therefore, they “had knowledge of the facts that would cause a reasonable person to expect the appraiser falsely to overstate the value of the donated property.” Regulation §1.170A-13(c)(5)(ii).
II. S Corporation Shareholder Must Pay Tax on Income He Never Received; Maggard vs. Commissioner, TC Memo 2024-77.
Mr. Maggard established an S corporation to operate his engineering firm. The company’s articles of incorporation provided the company was authorized to issue 10,000 common shares. The company’s bylaws did not mention the firm’s having more than one class of stock. There was no provision allowing disproportionate distributions to shareholders.
Soon after forming the new company, Mr. Maggard brought in two new partners, Mr. L and Mr. J. Mr. L was the firm’s CEO and CFO. Mr. J was its secretary. Mr. Maggard, Mr. L, and Mr. J were members of the board of directors. Mr. Maggard owned a 40% interest in the company. Mr. L and Mr. J owned 40% and 20% of the shares. The three men never changed the firm’s articles of organization or its bylaws to allow for disproportionate distributions.
Almost immediately, Mr. L began misappropriating funds. Also, Mr. L and Mr. J began making disproportionate distributions to themselves at the expense of Mr. Maggard. As soon as he became CFO, Mr. L stopped filing S corporation tax returns and stopped sending Schedules K-1 to the shareholders. Litigation ensued after Mr. Maggard discovered the disproportionate distributions. Mr. Maggard accused Mr. L and Mr. J of embezzling more than $1 million from the firm. Mr. L and Mr. J then froze Mr. Maggard out of all business operations and prevented him from seeing the books and records of the company.
After litigation, Mr. L agreed to purchase Mr. Maggard’s shares for $1.2 million. The parties signed a settlement agreement in October 2018 that included a covenant that the company would not make any changes to its Forms K-1 for 2012 through 2017 that it finally issued to Mr. Maggard in late 2018.
Mr. Maggard’s attorney contacted Mr. L to secure profit and loss information so Mr. Maggard could file his personal tax returns. Mr. L provided a single number “$300,000” written on a napkin. Mr. L represented that was Mr. Maggard’s pro rata portion of the firm’s losses for 2014. Mr. Maggard filed his 2014 return and claimed those losses on his return. For 2015, Mr. L again provided a single number to Mr. Maggard, a $50,000 loss, which Mr. Maggard claimed on his tax return. For 2016, Mr. Maggard reported no income or loss from the S corporation. In November 2018, the company issued Schedules K-1 to the shareholders and the IRS for 2011 through 2016. The K-1s showed Mr. Maggard had a proportionate share of the firm’s profits and no losses.
Mr. Maggard argued he should not have to pay tax on S corporation profits taken by his two partners. He also contended the firm’s S election terminated when it began making disproportionate distributions to Mr. L and Mr. J at the expense of Mr. Maggard well before the 2014 through 2016 years at issue.
The Tax Court ruled the S election remained effective notwithstanding the bad acts of Mr. L and Mr. J. The regulations provide in determining whether an S corporation has violated the one class of stock rules, one looks at the corporation’s governing documents and not what the shareholders actually do. Regulation §1.1361-1(l)(2) provides non-pro rata distributions do not mean the corporation has more than one class of stock where the underlying governing documents (such as articles of incorporation and bylaws) do not authorize unequal distributions to its shareholders. Rev. Proc. 2022-19.
The court cited its earlier decision in Mowry vs. Commissioner, No. 21407-16 (2018), where the taxpayer argued unauthorized withdrawals from the corporation’s bank account effectively changed the company’s articles of incorporation and bylaws. The court ruled disproportionate distributions do not terminate the company’s S election in the absence of a formal change to the articles of incorporation and bylaws.
Likewise, in Minton vs. Commissioner, T.C. Memo 2007-372, aff’d, 562 F.3d 730 (5th Cir. 2009), the court held, in the absence of a binding agreement, the S corporation shareholders who received unequal distributions do not have enforceable rights to them, even though the majority shareholders had an oral agreement between themselves to make distributions that excluded some shareholders.
Relying on Minton and Mowry, the court concluded the misdeeds of Mr. J and Mr. L never constituted formal corporate action that changed the governing corporate documents.
III. No Deduction for Start-Up Costs for a Company that Never Started Operations; Eason vs. Commissioner, Tax Court Summary Opinion 2024-17.
Mr. Eason and a friend formed an S Corporation to provide advice to real estate owners and investors. Mr. Eason and his friend paid over $40,000 to enroll in educational courses provided by Advanced Real Estate Education (“Advanced”), which offered courses on real estate ownership and investment. Advanced soon went out of business. Mr. Eason and his friend lost their $40,000 investment. The S corporation deducted the $40,000 in fees paid to Advanced as a business expense.
The Tax Court agreed with the IRS that the $40,000 lost investment was not a deductible Section 162(a) business expenses because the expenses were not incurred in connection with carrying on trade or business during 2016. Whatever business activities the S corporation hoped to engage in, it had not done so by the end of 2016. The corporation earned no income in 2016. It did not provide, or even offer to provide, any services to customers during 2016. The court, however, refused to sustain a substantial understatement penalty on the basis that “reasonable minds could differ over the point in time, and/or the specific actions that establish when a business” begins.
IV. Payment of Attorney’s Fees in Wire Fraud Criminal Investigation are Section 162 Business Expenses; Chang vs. Commissioner, TC Summary Opinion 2024-18.
Mr. Chang was involved with several religious organizations, including HOC Associates, Inc. HOCA was a Section 501(c)(3) organization. Mr. Chang was a member of its board of directors. He was also a member of the board of directors of S3 Graphics, Inc. and IA Technologies, Inc. He was a close personal friend of the owner of those two companies. In 2004 Mr. Chang formed HOCA Associates, LLC as a for-profit limited liability company engaged in acquiring and leasing rental property. He was the sole owner of HOCA, LLC.
In 2016 Mr. Chang was indicted on multiple counts of conspiracy to commit wire fraud and money laundering. The criminal charges involved transactions to and from HOCA, Inc., HOCA, LLC, and Mr. Chang’s personal bank accounts. In 2019 a jury convicted Mr. Chang of four counts of wire fraud and three counts of money laundering. During 2016, Mr. Chang incurred over $365,000 of attorney’s fees that he deducted on HOCA, LLC’s return. The IRS argued the legal expenses were nondeductible personal expenses.
The Tax Court agreed with Mr. Chang. Citing US vs. Gilmore, 372 US 39 (1963), the court stated the deductibility of legal fees depends on the origin and character of the claim for which the expenses were incurred and whether the claim bears a sufficient nexus to the taxpayer’s business or income producing activities. Mr. Chang’s criminal charges involved transactions between the HOCA entities and him. The court concluded the origin of Mr. Chang’s legal fees were his business activities as a director of the HOCA entities. Therefore, the legal fees related to his criminal charges could be deducted as a Section 162 ordinary and necessary business expense.
Keith Wood is an attorney with Carruthers & Roth, P.A. in Greensboro, North Carolina.