Side Agreement Made Charitable Gift Conditional and Nondeductible
Graev , 140 TC No 17, Tax Ct Rep (CCH) 59573, Tax Ct Rep Dec (RIA) 140.17, 2013 WL 3184618.
The Tax Court in Graev1 ruled that a taxpayer was not entitled to charitable deductions for his contributions of a façade easement and cash to a charitable organization. A side letter issued to the taxpayer by the charitable organization, which provided for the refund of the cash and removal of the easement if the deductions were disallowed by the IRS, rendered the gifts conditional in violation of the requirements for deductibility contained in Section 170.
Mr. Graev was the owner of New York City real estate that was located in a historic preservation district and was listed on the National Register of Historic Places. In 2004, a representative of National Architectural Trust (NAT) contacted Mr. Graev. NAT is a charitable organization whose mission is to preserve historic architecture in metropolitan areas across the U.S. NAT solicits contributions of façade conservation easements by owners of property with historic significance as determined by the National Park Service. Generally, the donors to NAT contribute a façade easement and make a corresponding cash gift equal to 10% of the appraised value of the façade easement in order for NAT to pay current operating costs and to fund its long-term monitoring and administrative needs.
During discussions with NAT, Mr. Graev became aware that he had a neighbor who had contributed a façade easement to NAT and who received from NAT a side letter that promised to remove the façade easement from the property's title if the charitable deduction was disallowed in its entirety. That agreement also promised to return a portion of the cash contribution if the IRS challenged the appraised value of the façade easement and disallowed a portion of the charitable contribution. Mr. Graev expressed an interest in making an easement contribution and, like his neighbor, wanted to receive a similar side letter from NAT.
In 2004, the IRS issued Notice 2004-412 which addressed charitable contributions of conservation easements. The Notice stated that the IRS was aware that taxpayers may be improperly claiming charitable contribution deductions for transfers of easements to charitable organizations and that in appropriate cases, the IRS will disallow such deductions. In the Notice, the IRS provided an example of a transaction that it considered questionable in which a charitable organization acquired real estate, put an easement on it, and then sold it for a reduced price plus a tax-deductible contribution of cash.
Shortly thereafter, Mr. Graev sent an email to NAT stating that his accountants had made him aware of Notice 2004-41 and asked NAT for their opinion regarding the Notice and the side letter. NAT responded to the email by stating that the types of transactions that the IRS was concerned with were the types of real estate transactions between charitable organizations and donors that were set forth in the example in the Notice. NAT stated that the types of activities in which it engaged were distinguishable from those described in the Notice.
NAT also indicated that it had been in contact with the IRS since the Notice was issued and, based on those conversations, had no reason to believe that any of their donations would be audited. In addition, NAT stated that it did not believe that the side letter compromised the tax-deductibility of the cash contribution in the current tax year.
Mr. Graev was evidently reassured because he executed a conservation deed, made a cash contribution of $99,000, and received the side letter from NAT. The deed did not refer to the side letter. An appraiser valued the façade easement at $990,000. Several months after the contribution and in the following tax year, NAT wrote to Mr. Graev stating that its attorney recently brought to its attention the fact that the offers of a refund contained in the side letters being issued by NAT may adversely affect the deductibility of the cash contribution as a charitable gift.
The letter from NAT urged Mr. Graev to contact his professional tax advisor to determine the actual impact of the refund offer. The letter also stated that NAT would be willing to withdraw the refund offer if Mr. Graev so desired. The letter stated that NAT believed that the withdrawal of the refund offer would restore the deductibility of the cash contribution. Mr. Graev did not ask NAT to withdraw the refund offer.
Following an audit, the IRS issued a notice of deficiency disallowing Mr. Graev's charitable deduction for both the façade easement and the cash contribution. Mr. Graev filed a petition in Tax Court.
The question before the court was whether the deductions for the contribution of the façade easement and the cash contribution to NAT should be disallowed because they were conditional gifts based on the promises made by NAT in the side letter. The answer to that question depended on whether the chance that the condition would occur was so remote as to be negligible.
Reg. 1.170A-1(e) provides in part:
If an interest in property passes to, or is vested in, a charity on the date of the gift and the interest would be defeated by the subsequent performance of some act or the happening of some event, the possibility of occurrence of which appears on the date of the gift is so remote as to be negligible, the deduction is allowed.
This Regulation provides that a charitable deduction is allowable notwithstanding a possibility that the contribution will be defeated by a subsequent event, but only if that possibility is "so remote as to be negligible." The parties agreed that the side letter recited conditions on Mr. Graev's contributions, namely, whether the IRS would successfully challenge the appraised value of the façade easement or whether the IRS would successfully challenge the entire charitable contribution. If the IRS was successful, NAT had promised in the side letter to remove the easement and return all or a portion of the cash. However, the parties disagreed about whether the possibility that the IRS would be successful, and therefore NAT's interests in the easement and cash would be defeated, was so remote as to be negligible.
In prior cases, the Tax Court had interpreted the phrase "so remote as to be negligible" as "a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction."3 Similarly, in another case, the Tax Court had stated that it is "a chance which every dictate of reason would justify an intelligent person in disregarding as so highly improbable and remote as to be lacking in reason and substance."4
The court noted that the enforcement landscape regarding deductions for facade easements donations had changed following the release of Notice 2004-41. Mr. Graev argued that the Notice was not applicable to his contributions because the Notice described a specific transaction that was distinguishable from his transaction with NAT. The court rejected this argument and instead found that the Notice, while it did list one specific transaction, also contained language that was designed to alert taxpayers that the IRS would challenge transfers of conservation easements that the IRS believed were abusive. Therefore, the court believed that Mr. Graev was put on notice that his contribution could be subject to heightened scrutiny. The court concluded that clearly the risk that the IRS might disallow a deduction for the contribution was well above negligible.
In addition, the court found that the fact that Mr. Graev required the side letter is strong evidence that he believed that the risk of disallowance of his contribution of the easement in whole or in part was not so remote as to be negligible. The court believed that the very essence of a comfort letter implies that a non-negligible risk exists, and the comfort letter is used to induce a party to enter into the transaction.
Mr. Graev also argued that, as a matter of law, NAT could not be held to the promises it made in the side letter. Thus, there was, in fact, no possibility that the property would be returned to him. Therefore, he contended, the contributions were not really conditional. The court rejected this argument for several reasons:
- The court stated that the deed to NAT contained a provision that permitted NAT to abandon the easement if it so desired.
- The court did not believe that the doctrine of merger, as Mr. Graev asserted, required that the promises set forth in the side letter were extinguished upon execution of the deed. The court found that the side letter qualified for one of the exceptions to the merger doctrine since the parties clearly intended the promises set forth in the side letter to survive the deed.
- The court rejected the argument of Mr. Graev, based on the case of Procter5 that the side letter should be disregarded for tax purposes because it provides for the potential recovery by Mr. Graev of the property contributed in the event of unwanted tax consequences. The court found that the side letter would not discourage the government's audit function and also that the return to Mr. Graev of the property contributed would have no effect on his tax liability.
- Even if the side letter was not enforceable for any of the reasons advanced by Mr. Graev, the court believed that NAT would have voluntarily removed the easement because if it did not do so, it would get a reputation for failing to keep its promises, which could undermine its ability to obtain future contributions.
The court therefore held that there was a substantial possibility that the IRS would challenge Mr. Graev's easement contribution deductions and that neither state nor federal law would prevent enforcement of the side letter and that apart from any legal enforceability the side letter reflected what NAT was likely to do in the event of IRS disallowance. The court therefore concluded that at the time of Mr. Graev's contributions to NAT, the possibility that the IRS would disallow the Graevs' deductions for the contributions and, as a result, that NAT would promptly refund the entire cash contribution and join with Mr. Graev to immediately remove the façade conservation easement from the property's title was not "so remote as to be negligible." Accordingly, the court disallowed the charitable deduction for the facade easement and the cash contributions.
This case is significant for at least three reasons. First, it is the most recent of a broad array of cases involving an IRS challenge to a façade easement, so any advisor providing advice regarding façade easements should be familiar with the facts and holding of this case. Second, it shows a continuing trend of the Tax Court being tough in disallowing many such deductions. Third, this case has broader implications regarding charitable gifts in general, and advisors should be aware of the significant possibility of disallowance if the return of a charitable gift is made contingent on IRS action or any other future event for that matter.
1140 TC No 17, Tax Ct Rep (CCH) 59573, Tax Ct Rep Dec (RIA) 140.17, 2013 WL 3184618 .
22004-2 CB 31.
3885 Inv. Co., 95 TC 156 (1990) (quoting Dean, 47 AFTR 1341, 224 F2d 26, 55-2 USTC ¶11550 (CA-1, 1955)).
4Briggs, 72 TC 646 (1979).
532 AFTR 750, 142 F2d 824, 44-1 USTC ¶10110, 44-1 USTC ¶10123 (CA-4, 1944).
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more about façade easements, contact Frank at (301) 657-0175 or firstname.lastname@example.org.