The Tax Court in Brief – September 26th – September 30th, 2022

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Tax Litigation: The Week of September 26th, 2022, through September 30th, 2022

Furrer v. Comm'r, T.C. Memo. 2022-100| September 28, 2022 | Lauber, Judge | Dkt. No. 7633-19

Summary: This opinion (long in facts and law) regards charitable remainder annuity trusts (CRATs). Petitioners made in-kind transfers of agricultural crops to the CRATs in 2015 and 2016. The CRATs sold the crops (like milo, cotton, and corn, but, here, just corn and soybeans) and used the proceeds to purchase annuity plans. During 2015–2017 the annuity plans made cash distributions to petitioners. The trust instrument designated petitioners as life beneficiaries and three eligible section 501(c)(3) charities as remainder beneficiaries.

When forming CRAT I petitioners transferred to it 100,000 bushels of corn and 10,000 bushels of soybeans grown on their farm. In August 2015 CRAT I sold the crops for $469,003. The sales were effected by Co-Alliance LLP, a grain marketing and storage facility where petitioners stored the crops. CRAT I distributed $47,000 of the proceeds to the charitable remainder beneficiaries and used most of the balance to purchase a Single Premium Immediate Annuity (SPIA) from Symetra Life Insurance Co. (Symetra). The SPIA made annual annuity payments of $84,368 to petitioners in 2015–2017. For each year Symetra issued to the trustee a Form 1099–R. These forms listed the annuity payments as "gross distributions" and showed a small amount of interest as the "taxable amount." Petitioners created the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2016 (CRAT II).

Following the previous pattern, petitioners designated themselves as life beneficiaries, with the remainder going to seven eligible section 501(c)(3) charities. Petitioners funded CRAT II by transferring to it bushels of corn and bushels of soybeans grown on their farm. CRAT II sold the crops for $691,827. The sales were again effected by Co-Alliance LLP, the grain marketing and storage facility. CRAT II distributed $69,294 of the proceeds to the charitable remainder beneficiaries and used the balance to purchase another SPIA from Symetra. This SPIA made annual annuity payments of $124,921 to petitioners in 2016 and 2017. Symetra again issued a Form 1099–R to the trustee, listing the annuity payments as "gross distributions" and showing a small amount of interest as the "taxable amount."

Petitioners timely filed joint Federal income tax returns for 2015– 2017. They attached to each return a Schedule F, Profit or Loss From Farming, reporting farming income and expenses. On their 2015 and 2016 returns petitioners claimed charitable contribution deductions for cash gifts but claimed no deductions for their in-kind crop transfers to the CRATs. On each return they reported interest income from the SPIA as shown on the Form 1099–R issued to the trustee. But they did not report the balance of the annuity distributions, taking the position that these payments constituted a nontaxable return of corpus under section 664(b)(4). For 2015 and 2016 petitioner husband filed Forms 709, United States Gift (and Generation-Skipping Transfer) Tax Return.

On the 2015 return he reported that petitioners had contributed to CRAT I corn and soybeans with a fair market value (FMV) of $469,003 and a cost basis of zero. On the 2016 return he reported that petitioners had contributed to CRAT II corn and soybeans with an FMV of $666,975 and a cost basis of zero. For each year the trustee filed for each CRAT a Form 5227, Split-Interest Trust Information Return. The trustee attached to each of the 2015 and 2016 information returns a Form 4797, Sales of Business Property, reporting sale of the crops contributed by petitioners.

For 2015 he reported that CRAT I had received proceeds of $469,003 from sale of crops with a basis of $471,000, for a loss of $1,997. For 2016 he reported that CRAT II had received proceeds of $691,827 from sale of crops with a basis of $666,975, for a gain of $24,852.

The IRS selected petitioners' 2015–2017 income tax returns for examination. It determined that their characterization of the SPIA distributions as nontaxable returns of corpus under section 664(b)(4) was improper. Rather, the examining agent concluded that these distributions represented proceeds from the sale of petitioners' corn and soybeans and as such were taxable to them as ordinary income. The IRS accordingly increased their Schedule F farm income by $83,440 in 2015 and by $206,967 in 2016 and 2017. During the examination petitioners contended that they had neglected to claim on their 2015 and 2016 returns, but should be allowed, noncash charitable contribution deductions for portions of their donations to the CRATs. In petitioners' view, the allowable deduction for each year was equal to the proportion of the FMV of the donated crops that was destined to the charitable remaindermen. Petitioners had not secured an appraisal for either donation or attached a Form 8283, Noncash Charitable Contributions, to their 2015 or 2016 income tax return.

The examining agent nevertheless agreed with their position and allowed additional charitable contribution deductions of $67,788 for 2015 and $106,413 for 2016.4 The IRS issued petitioners a timely notice of deficiency determining deficiencies of $55,040, $56,904, and $95,907 for 2015–2017, respectively, plus accuracy-related penalties. The Tax Court granted the IRS's Motion for Leave to Amend Answer to disallow the noncash charitable contribution deductions that the examining agent had allowed for 2015 and 2016. On January 28, 2022, respondent filed a Motion for Partial Summary Judgment, to which petitioners timely replied.

Key Issues:

(1) Whether petitioners are entitled under section 1701 to noncash charitable contribution deductions for 2015 and 2016 for portions of the crops transferred to the CRATs.

(2) Whether the annuity distributions were taxable to petitioners as ordinary income for 2015–2017.

Primary Holdings: No and yes.

Key Points of Law:

Summary Judgment Standard. The purpose of summary judgment is to expedite litigation and avoid costly, unnecessary, and time-consuming trials. See FPL Grp., Inc. & Subs. v. Commissioner, 116 T.C. 73, 74 (2001).

Charitable Contribution Deductions and Substantiation. Income tax deductions are a "matter of legislative grace." INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Charitable contribution deductions may be allowable for transfers to a CRAT, corresponding to the value of the charitable remainder interest. See 26 U.S.C. § 170(f)(2)(A); Treas. Reg. § 1.170A-6(b). However, charitable contribution deductions are permitted "only if verified under regulations prescribed by the Secretary." 26 U.S.C. § 170(a)(1). The Code imposes strict substantiation requirements for noncash gifts, especially where the claimed value of the contribution exceeds $5,000.

Charitable Gifts of Property. For gifts of property (other than publicly traded securities) valued in excess of $5,000, the taxpayer generally must (1) obtain a qualified appraisal of the property and (2) attach to the return on which the deduction is claimed a fully completed appraisal summary on Form 8283. See 26 U.S.C. § 170(f)(11)(C); Oakhill Woods, LLC v. Commissioner, T.C. Memo. 2020-24, 119 T.C.M. (CCH) 1144, 1147. A "qualified appraisal" must be prepared by a "qualified appraiser" no later than the due date of the return, including extensions. See 26 U.S.C. § 170(f)(11)(E); Treas. Reg. § 1.170A-13(c)(3). The taxpayer must also maintain records substantiating the deduction. See Treas. Reg. § 1.170A-13(b)(2)(ii)(D) (mandating written records demonstrating the FMV of the property, the methodology used to determine the FMV, and a copy of the signed report of an appraiser where applicable).

Charitable Deductions. Deductions are allowable for charitable gifts "only if verified under regulations prescribed by the Secretary." 26 U.S.C. § 170(a)(1). "[N]o deduction shall be allowed" for gifts of property described in section 170(f)(11) unless its strict substantiation requirements are met. See id. at § 170(f)(11)(A)(i). Section 170(f)(11) may not operate to deny a deduction "if it is shown that the failure to meet [its] requirements is due to reasonable cause and not to willful neglect."

Inventory Held for Sale. Inventory held primarily for sale to customers in the regular course of a trade or business is ordinary income property. No portion of the gain from the sale of such property could be long-term capital gain. 26 U.S.C. § 1221(a)(1). The deduction for a contribution of ordinary income property is typically limited to the donor's cost basis in the property. See Jones v. Commissioner, 560 F.3d 1196, 1199 (10th Cir. 2009), aff'g 129 T.C. 146 (2007); Strasburg v. Commissioner, T.C. Memo. 2000-94, 79 T.C.M. (CCH) 1697, 1704. If a taxpayer has zero basis in ordinary income property, section 170(e)(1)(A) "require[s] that the deduction for donating that property be reduced by the property's entire value—leaving the taxpayer with no deduction at all." Jones v. Commissioner, 560 F.3d at 1199; see Lary v. United States, 787 F.2d 1538, 1540–41 (11th Cir. 1986); Conner v. Commissioner, T.C. Memo. 2018-6, 115 T.C.M. (CCH) 1013, 1023, aff'd, 770 F. App'x 1016 (11th Cir. 2019).

Taxability of CRAT Distributions. A CRAT is a type of charitable remainder trust (CRT). In general, a CRT provides for annual distributions to the grantor (or other noncharitable life beneficiaries) and an irrevocable remainder interest designated for one or more qualified charities. See 26 U.S.C. § 664; Treas. Reg. § 1.664-1(a). A trust is a CRT only if it is a CRAT or a charitable unitrust. See Treas. Reg. § 1.664-1(a)(2). As a rule, no gain is recognized by the donor upon transfer of appreciated property to a CRT. See Buehner v. Commissioner, 65 T.C. 723, 740 (1976) ("A gift of appreciated property [to a CRT] does not result in income to the donor . . . ." (quoting Humacid Co. v. Commissioner, 42 T.C. 894, 913 (1964))). Because CRTs are exempt from income tax, appreciated property can be sold by the trust tax free. See 26 U.S.C. § 664(c)(1); Treas. Reg. § 1.664-1(a)(1)(i). Notwithstanding a CRT's tax-exempt status, the income earned by the trust is taxable to its income beneficiaries upon distribution. See Alpha I, L.P. v. United States, 682 F.3d 1009, 1015 (Fed. Cir. 2012).

CRATs. Distributions from a CRAT to income beneficiaries are deemed to have the following character, and to be distributed in the following order: first, as ordinary income, to the extent of the trust's current and previously undistributed ordinary income; second, as capital gain, to the extent of the trust's current and previously undistributed capital gain; third, as other income, to the extent of the trust's current and previously undistributed other income; and fourth, as a nontaxable distribution of trust corpus. 26 U.S.C. § 664(b)(1)?(4). 6 The ordering rules specified in section 664(b) supersede the general rules set forth in subchapter J, sections 652 and 662, for income taxation of estates, trusts, and beneficiaries. A distribution from a CRAT is deemed to consist first of income that is subject to the highest Federal tax rate (ordinary income), and then, upon exhaustion of that class, of income subject to progressively lower tax rates. Only after all taxable income has been distributed is a beneficiary deemed to receive a nontaxable return of corpus. See id. at 88–89.

CRATs and Strict Reporting. CRATs are subject to strict reporting requirements to ensure compliance with the statutory ordering rules. See 26 U.S.C. § 4947(a)(2); Treas. Reg. § 1.664-1(a)(1)(ii). A CRAT must file an annual information return on Form 5227 reflecting its income, deductions, accumulations, and distributions for the year. See 26 U.S.C. § 6011; Treas. Reg. § 53.6011-1(d). It must issue to each income beneficiary a Schedule K–1, Beneficiary's Share of Income, Deductions, Credits, etc., properly describing the tax character of all distributions. See 26 U.S.C. § 6034(a); Treas. Reg. § 1.6012-3(a)(6). And it must maintain a record of the basis of all property contributed to it. See 26 U.S.C. § 1015(a).

Insights: Distributions from a CRAT to income beneficiaries are deemed to have the following character, and to be distributed in the following order: first, as ordinary income, to the extent of the trust's current and previously undistributed ordinary income; second, as capital gain, to the extent of the trust's current and previously undistributed capital gain; third, as other income, to the extent of the trust's current and previously undistributed other income; and fourth, as a nontaxable distribution of trust corpus. And, Petitioners did not satisfy the charitable contribution substantiation requirements. At no time did they secure an appraisal—"qualified" or otherwise—of the crops they transferred to the CRATs. They did not attach to their 2015 or 2016 return a completed Form 8283 substantiating the gifts. And they did not maintain the written records required by the regulations. Because petitioners failed to satisfy these requirements, they are not entitled to any noncash charitable contribution deductions.

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