Importance of Substantiating Value for Charitable Contribution, Estate Tax, and Gift Tax Positions

In July 2012, we published an article stressing the importance of properly substantiating a charitable contribution with a qualified appraisal prepared by a qualified appraiser.

As detailed in that article, the tax law is complex and when the taxpayers in the highlighted cases argued that their compliance was sufficient, IRS and the Tax Court (the “Court”) disagreed and consequently, disallowed the deductions. As such, the Court continues to challenge taxpayers for their charitable contribution, estate tax, and gift tax positions. 

For charitable contribution purposes, a qualified appraisal must include the following: certain information about the contributed property; the terms of any agreement or understanding that relates to the use, sale, or disposition of the property; the date of the contribution; certain information and declarations related to the appraiser; a statement indicating the appraisal was prepared for income tax purposes; and the method and basis used for the valuation. The report must be made effective no more than 60 days before the contribution date and must also be prepared by a qualified appraiser, whose qualifications should be included in the qualified appraisal report.

The following highlights two recent cases that reiterate the importance of obtaining a qualified appraisal.

Ben Alli & Shaki Alli v. Commissioner
In 2008, BSA Corp., a Michigan Subchapter S corporation owned by two Alli siblings, contributed a 34-unit apartment building to a qualified Section 501(c)(3) organization and claimed a $499,000 charitable deduction. The Court disallowed the charitable deduction, stating that it did not comply with the qualified appraisal and qualified appraiser requirements of Internal Revenue Code (“IRC”) Section 170.

In support of their deduction, the Allis submitted two appraisals. The first appraisal was completed more than ten years prior to the date of the donation, and only presented a conclusion as to the income-generating potential of the property rather than determining a fair market value. The Court noted that the first appraisal failed to include a number of the requirements, including the “date or expected date” of the contribution. 

The second appraisal, also not compliant, was completed five months prior to the date of donation. That report concluded as to the hypothetical value of the property after renovation and remodeling and did not appraise the property in its current condition, nor did it provide a description of the current condition of the property. Further, the report excluded several other key requirements of a qualified appraisal including the fact that the standard used by the appraiser was not “fair market value.”

Neither appraiser included his qualifications, tax identification number, the date or expected date of the contribution, the income tax purpose for the appraisal, or provided an appraisal with a valuation date within 60 days prior to the contribution date. In the end, the Court denied the deduction.

Estate of Helen P. Richmond, et al. v. Commissioner
Ms. Richmond held a 23.44% interest in a 76-year-old family-owned investment holding C corporation at the time of her death. The securities held by the entity were worth $52,159,430, with Ms. Richmond’s indirect interest worth $12,226,170. Assuming a sale at the date of death, the securities would be subject to a built-in gain (“BIG”) tax of $18,113,083. The entity’s investment philosophy had been to hold the investments for future gains.

The Estate engaged an accounting firm to perform the valuation. The expert utilized a single approach, the capitalized dividend approach, in arriving at a value of $3,149,767. Although this expert was not a certified valuation expert and provided the Estate with an unsigned draft report documenting his conclusions, the Estate used the draft report’s value conclusion for its estate tax filing.

At trial, the Estate employed a different expert who also primarily relied upon the capitalized dividend approach and arrived at a higher value of $5,046,500. As a reasonableness check, the trial expert utilized a net asset value (“NAV”) approach, and applied an 8% discount for lack of control and a 35.6% discount for lack of marketability. The Estate’s trial expert incorporated a dollar-for-dollar reduction for the unrealized BIG tax in the NAV approach. 

The IRS expert utilized an NAV approach, incorporating a 6% discount for lack of control and a 36% discount for lack of marketability (comprised of a 15% BIG tax liability discount and a 21% discount for lack of marketability). The expert arrived at a value of $7,330,000. 

The Court had several theoretical issues with the appraisals:

  • The Court rejected the use of the capitalized dividend approach and relied solely on the NAV approach. The Court stated that the method ignores the most concrete and reliable data available – the actual market prices of the publicly traded securities that constituted the entity’s portfolio.
  • The Court rejected the use of the dollar-for-dollar reduction in value for the unrealized BIG tax liability (despite prior Court decisions to the contrary), as well as the IRS expert’s 15% discount. The Court compared the BIG tax liability to a zero-interest note whose payment could be deferred indefinitely, to a note where the full payment was due tomorrow, stating, “It stands to reason that a potential buyer would be willing to pay more for a company with a contingent liability of $18.1 million than he would pay for a company otherwise equivalent but that had an unconditional liability of $18.1 million payable now.”  
  • The Court also took issue with the Estate expert’s approach in quantifying the discount for lack of marketability as it did not constitute an independent analysis and merely selected the high end of the range of restricted stock and pre-IPO study discounts. 

Finally, in considering an accuracy penalty, the Court considered whether the taxpayer acted reasonably and in good faith. Factors to be considered include: (1) the methodology and assumptions underlying the appraisal, (2) the appraised value, (3) the circumstances under which the appraisal was obtained, and (4) the appraiser's relationship to the taxpayer or to the activity in which the property is used. Additionally, as part of the process, the Court noted that the appraiser did not demonstrate that he was qualified as a valuation expert. As a result, the Commissioner's imposition of a 20% accuracy-related penalty under IRC Section 6662 was sustained.

As evidenced by these recent cases, it is now more critical than ever to obtain a qualified appraisal from a qualified appraiser to properly support tax filings.