Washington News

Each year the IRS conducts a survey to determine the amount of unpaid taxes. The "tax gap" is defined as the amount of taxes that are owed by taxpayers but not paid on time.

For the year 2006, revised figures released this week showed that the tax gap increased. The previous estimate of the 2006 tax gap was $345 billion but it increased to $450 billion.

The "net tax gap" is a smaller number that reflects the ability of the IRS to collect some of the unpaid taxes. When the additional $65 billion in taxes collected later is subtracted from the $450 billion, the net tax gap is $385 billion. The net tax gap number increased from $290 billion in 2001 to the larger number by 2006.

The compliance level for taxpayers remains 83.7%. This indicates that the majority of Americans are continuing to calculate and pay their taxes correctly.

Sen. Max Baucus (D-MT) is Chairman of the Senate Finance Committee. He responded to the IRS survey by noting, "This report shows that closing the tax gap needs to be a major focus of tax reform. An improved tax code that's simple and fair to all Americans will help close the tax gap, boost our economy and create jobs."

Editor's Note: Both Sen. Baucus and House Ways and Means Committee Chair Dave Camp (R-MI) have been conducting hearings that will lead to major tax reform in 2013. For the vast majority of Americans who pay their fair share of taxes, it is beneficial if Baucus and Camp are able to simplify the tax system and reduce the tax gap. More effective collection of revenue decreases the need to raise taxes on those who are currently paying their fair share.

Bargain Sale Deduction Denied

In Marshall Cohan et ux. et al. v. Commissioner; T.C. Memo. 2012-8; Nos. 19849-05, 19854-05, 19857-05 (9 Jan 2012), the Tax Court denied charitable deductions claimed as a result of a bargain sale.

Benjamin and Hildergarde Cohan, parents of Marshal Cohan and related taxpayers, acquired a farm on Martha's Vineyard. The 220-acre property was adjacent to Edgartown, Massachusetts.

After negotiations in 1969, the Cohans sold most of the property to the Wallace family. Their two children and one grandson retained adjacent residential properties. Both the Wallaces and the Cohan family members granted reciprocal rights of refusal with a termination date of January 1, 2010. If any individual desired to sell his or her property, the other parties would have a right of refusal to buy the property at a quite reasonable price. The effect of the mutual rights of refusal was to preclude development without agreement of all of the various parties.

On January 4, 1996, Marshall and Judith Cohan, John and Janet Aldeborgh and Robert and Susan Hughes created HCAC Limited Liability Corporation ("HCAC"). The purpose of HCAC was to hold title to their rights of first refusal and oppose the Wallace family's efforts to develop the property into a residential subdivision.

Following various negotiations with different prospective developers, in 2001 the Wallace family and HCAC initiated discussions with The Nature Conservancy (TNC). TNC was interested in acquiring the farm because of its unique location in maritime sand plains. In order to acquire the property, TNC needed to purchase the property from the Wallace family and also to acquire the rights of refusal from HCAC.

On October 10, 2000, there was an initial agreement for sale. TNC agreed to provide HCAC with 12 different types of payments or benefits. The agreement was finalized on June 29, 2001. Appraiser Robert LaPorte, Jr. completed an appraisal of portions of the property and valued them at $8.34 million.

Following negotiations between HCAC and TNC, on December 21, 2001, TNC provided a bargain sale letter. Based on the appraised value of $14 million for the rights of refusal and consideration provided by TNC of $11,931,755, there was a bargain sale element and charitable deduction of $2,068,245. TNC provided HCAC with a gift letter that indicated there were "no goods or services provided" other than the specified consideration.

The IRS audited HCAC and denied the charitable deduction. It also claimed that the gain on the bargain sale portion was ordinary income rather than capital gain.

The court initially considered the claim for the charitable contribution as a result of the bargain element. It observed that the TNC letter omitted several substantial items of consideration. According to the provisions of Sec. 170(f)(8), a charity must disclose the items transferred to the taxpayer and is required to make a "good-faith estimate of the value of the benefit it gave to the taxpayer." The Court stated, "In fact, the record strongly suggests that representatives of TNC and HCAC made a conscious decision to exclude items of consideration received in the 2001 transaction in calculating the amount of the bargain sale gift and to play the audit lottery with the hope of minimizing the tax indemnification amount."

HCAC then claimed that it should have a right of "reasonable reliance" on the TNC gift letter. The Court stated that because the HCAC attorneys and principals understood the omission of consideration in the letter, there could be no reasonable reliance. Finally, taxpayers claimed that they had substantially complied with requirements. The Court noted that the record did not show substantial compliance. Therefore, because of the failure to disclose substantial consideration elements in the TNC gift letter, the bargain sale charitable deduction was denied.

The Court also considered a valuation of various items within the transaction and the capital gain versus ordinary income issue. Because the property had been held since 1969, the Court deemed it a capital asset.

Finally, the IRS had assessed Sec. 6662(a) penalties in the deficiency. With respect to the charitable gifts, the court noted that the taxpayers had not "introduced any credible evidence indicating that they sought professional advice regarding the substantiation of the charitable contribution deductions." Therefore, the penalties apply.

Editor's Note: As is true with many real estate transactions involving family of the original owners, the fact situation is quite complex. However, the essence of a bargain sale is that the fair market value is reduced by the consideration, leaving the charitable element. In this case, the consideration received was not fully disclosed or valued and therefore there was no charitable deduction. For a bargain sale, advisors should insist that all in-kind consideration from the charity be listed and appropriately valued.

Executor Charitable Gifts Not Deductible In Estate

In Estate of Dwight T. Fujishima et al. v. Commissioner; T.C. Memo. 2012-6; No. 3930-10 (9 Jan 2012), the Tax Court determined that gifts during the administration of an estate by an executor were not qualified estate tax deductions.

Decedent Dwight T. Fujishima suffered a major injury in 1992 and lived with his mother Evelyn Fujishima until his death on January 23, 2005. After his death, she was appointed personal administrator of the estate.

Ms. Fujishima filed IRS Form 706 on April 6, 2007. She included insurance policies from Allianz and Amerus, but did not include a third policy from West Coast. She also claimed charitable contribution deductions of $142,000 (reduced at trial to a claim for $130,000).

The IRS audited the estate tax return and accessed a deficiency of $1,956,202.

The Court first considered the inclusion of the insurance policies. Ms. Fujishima claimed that she had paid premiums on the West Coast Life Insurance Co. policy and therefore, should have ownership. However, the records demonstrated that the decedent was the named owner for all three policies. The court determined that the evidence of ownership required estate inclusion of the three insurance policies.

Miss Fujishima also claimed $130,000 of charitable contribution deductions as a Sec. 2055 charitable estate deduction. However, she did not have adequate records to substantiate the deductions. Furthermore, the decedent did not have a will and therefore passed away intestate. As a result, there was no obligation to make charitable transfers on the date of his death. Because the actions of a personal representative cannot create charitable deductions in the estate, the $130,000 in claimed charitable deductions were denied.

Applicable Federal Rate of 1.4% for January – Rev. Rul. 2012-2; 2012-3 IRB 1 (19 Dec. 2011)

The IRS has announced the Applicable Federal Rate (AFR) for January of 2012. The AFR under Sec. 7520 for the month of January will be 1.4%. The rates for December of 1.6% or November of 1.4% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2012, pooled income funds in existence less than three tax years must use a 1.8% deemed rate of return. Federal rates are available by clicking here.