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Sunday May 1, 2016

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No Significant Change In Tax Gap

The IRS reports that there is “no significant change” in the tax gap. The tax gap is the shortfall in tax collections. It is measured each year to determine the level of taxpayer compliance.

For years 2008, 2009 and 2010, the tax gap averaged $458 billion per year. With an estimated $52 billion per year still to be collected through tax audits, the net tax gap for these years is projected to be $406 billion.

The IRS reports that taxpayer compliance level is 83.7%. This compliance level for people who pay timely the correct amount of tax has been generally in the low eighties range for several years.

IRS Commissioner John Koskinen observed that the tax gap reflects a generally honest population of taxpayers. He noted, “The IRS continues to look for other ways to keep the voluntary compliance rate high. These include such things as our educational efforts aimed at preparers and taxpayers; ongoing efforts to improve compliance in the international area; and working with businesses on employment tax issues. The IRS also continues to work with Congress on providing new tools to help address compliance issues, such as the legislation enacted last year to provide W-2s to us earlier in the filing season.”

Sen. Ron Wyden (D-OR) is the ranking minority member on the Senate Finance Committee. Wyden observed, “It is absolutely unacceptable that the country has lost more than $400 billion . . . over the past ten years from corporations dodging their tax payments. This is money that could be put to good use shoring up critical programs such as Medicare. It is time the IRS put an effective tracking and auditing system in place to locate this lost money.”

There are four major components to the tax gap. The shortfall in individual tax payments is $319 billion. Employment taxes are short by $91 billion. Corporations failed to pay $44 billion in tax and the loss in excise and estate taxes is an estimated $4 billion.

Editor’s Note: Each year the Senate Finance Committee and the House Ways and Means Committee hold hearings to track IRS efforts to reduce the tax gap. The IRS claims that it would have a higher compliance level if it had more funding for auditors. Congress recognizes that the United States generally has one of the higher tax compliance rates in the industrial world. Most Americans are indeed making payments of the appropriate amounts of tax. Some taxpayers might think that use of the word “voluntary” by IRS Commissioner Koskinen is a modest stretch.

Extinguishment Ratio Precludes Tax Deduction


In Douglas G. Carroll III et ux. v. Commissioner; 146 T.C. No. 13; No. 5445-13 (26 Apr 2016), the Tax Court denied a deduction for a conservation easement. The owner of the property drafted the agreement and it did not fulfill the “granted in perpetuity” requirement of Sec. 170(h).

Dr. Douglas Carroll III was owner of 25.8533 acres of land in Lutherville, MD. On November 22, 2005, he deeded the property as tenants in common to himself, his wife and their three children under the Maryland Uniform Transfers to Minors Act. The deed did not specify the ownership percentages.

On December 15, 2005, Dr. Carroll, his wife and the three minor children, through their trust agreements, deeded a conservation easement to the Maryland Environmental Trust (MET) and the Land Preservation Trust, Inc. (LPT).

MET held multiple conservation easements in the area. The two charities were qualified under Sec. 170(h)(3) to receive conservation easements.

Most conservation easements have a provision to determine the division of proceeds if the easement becomes impossible to maintain or is extinguished. Under Reg. 1.170A-14(g)(6)(ii) the ratio that must be used to value extinguishment of a conservation easement is the fair market value of the easement divided by the total fair market value on the date of the grant. The ratio is calculated as of the date of the deed and may not vary in later years.

However, the numerator in the fixed ratio under the document drafted by Dr. Carroll stated that the ratio would be “the deduction for federal income tax purposes allowable by reason of this grant, pursuant to Sec. 170(h) of the code” divided by the fair market value on the date of the gift.

Dr. Carroll secured a qualified appraisal and the value of the charitable deduction was determined to be $1.2 million. Even though the deed had included the three children, Dr. and Mrs. Carroll claimed the full value of the $1.2 million charitable deduction in years 2005, 2006, and 2007.

The IRS audited and determined that the deduction did not qualify. It also assessed Sec. 6662(a) penalties.

The Tax Court noted that the charities were qualified to receive and enforce the conservation easement. However, the extinguishment provision did not comply with Reg. 1.170A-14(g)(6)(ii). The charitable deduction could be denied by the IRS and valued at $0. If this were the case, and the conservation easement was extinguished, there would be no distribution to the charitable organizations under the agreement.

The taxpayer noted that Maryland law required fair value to be paid for an extinguishment. However, the court observed that Maryland law applied to MET, but not to LPT. The taxpayer also maintained that the probability of extinguishment was virtually nil. However, the court noted that probability was not an applicable factor under the statute.

Because the deduction could be $0, producing a zero ratio for extinguishment, and the language did not qualify under the regulations, there was no charitable deduction. In addition, because the doctor drafted the conservation easement himself without counsel of a tax attorney or other qualified advisor, the reasonable defense to the penalties did not apply. The penalties are applicable.

Conservation Easement Deduction Denied Due to Mortgages


In RP Golf LLC et al. v. Commissioner; T.C. Memo. 2016-80; No. 27873-08 (28 Apr 2016), the Tax Court denied a $16.4 million conservation easement deduction because mortgages were not subordinated when the deed was signed.

Partnership RP Golf, LLC (RP Golf) developed two golf courses in Platt County, MO. The realty was subject to loans from Hillcrest Bank and Great Southern Bank.

On December 29, 2003, RP Golf deeded a conservation easement to Platt County Land Trust (PCLT). The deed created a perpetual conservation easement to maintain and preserve open space.

On April 15, 2004, RP Golf obtained consents from Hillcrest Bank and Great Southern Bank to subordinate their two loans. The consents stated, “effective as of December 31, 2003.” However, the deed for the conservation easement was recorded on December 30, 2003.

A qualified appraisal was obtained on April 13, 2004. The conservation easement on 277.86 acres was valued before the easement at $17.4 million and after the easement at $1 million, with a net charitable deduction of $16.4 million.

The IRS audited the partnership and issued a Final Partnership Administrative Adjustment (FPAA). It claimed that the deduction was not valid under Sec. 170, that the value was less than the claimed $16.4 million and that the partnership had failed to reduce its depreciable basis.

The Tax Court noted that under Sec. 170(h)(1) a deductible conservation easement must involve a qualified interest transferred to a qualified charity in perpetuity for an appropriate conservation purpose.

Reg. 1.170A-14(g)(ii) notes that if there is a mortgage, it must be subordinated on the date of deed.

The taxpayer claimed there was an oral agreement in December of 2003 to subordinate the mortgages, but the Tax Court noted this oral agreement had not been approved at trial. Because there was not a valid subordination on the date of the deed, there is no charitable deduction.

Editor’s Note: The Tax Court has been very strict in interpreting the requirements for a conservation easement deduction. This case shows the huge penalties that may result from failure to comply with the letter of the law.

Applicable Federal Rate of 1.8% for May -- Rev. Rul. 2016-11; 2016-19 IRB 1 (18 Apr 2016)


The IRS has announced the Applicable Federal Rate (AFR) for May of 2016. The AFR under Section 7520 for the month of May will be 1.8%. The rates for April of 1.8% or March of 1.8% 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 2016, pooled income funds in existence less than three tax years must use a 1.2% deemed rate of return. Federal rates are available by clicking here.

Published April 29, 2016

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