Cohan v. Commissioner

Herring Creek Farm (Farm) is a 220-acre property on the southeast shoreline of Martha's Vineyard. The Farm sits in an ecologically significant area known as the Katama maritime sand plains, which is host to many rare, threatened, and endangered species. In 1969, the Wallaces purchased the Farm from the Cohans, who continued to own abutting land. Contemporaneous with this conveyance, the Wallaces, the Cohans, and the Aldeborhgs (other abutters) entered into a reciprocal right of first refusal agreement whereby each party had the right to purchase the others' property at well below fair market value. This agreement encumbered 175 of the Farms' 220 acres, and expired on January 1, 2010. Over the ensuing years, the Wallaces sought to sell the Farm for residential development, and filed an unsuccessful lawsuit to have the 1969 agreement declared unenforceable. In 1996, the Cohans, Aldeborghs, and another neighbor formed Herring Creek Acquisition Co., L.L.C. (HCAC). In 2000, The Nature Conservancy (TNC) entered into negotiations with the Wallaces for purchase of the Farm, and with HCAC for purchase of its rights of first refusal. In June 2001, TNC purchased the Farm from the Wallaces for $64 million. At the same time, TNC and HCAC executed an agreement whereby HCAC sold its rights of first refusal to TNC. HCAC received several different kinds of consideration, including: (1) fee simple interests in house lots on the Farm, (2) two different leaseholds, (3) an option on another lot, (4) various beach access rights, (5) the relocation of road, (6) TNC's payment of land bank transfer fees owed as a result of the transaction, and (7) TNC's release of its reciprocal rights of first refusal on HCAC members' land. Furthermore, TNC agreed to convey a conservation easement on the Farm, but with certain development sites excluded from the easement. HCAC also received payment of its current and past legal fees, and, significantly, TNC's reimbursement of any tax liability owed by HCAC as a result of the transaction and TNC's indemnification of any tax amount owed by HCAC as a result of a federal or state audit. At the prompting of TNC and its attorneys, the agreement acknowledged HCAC's intent to treat the transaction as a bargain sale, thus potentially reducing its tax liability, and, ultimately, the amount TNC would have to reimburse HCAC. HCAC's appraiser determined the fair market value of HCAC's consideration to be $11,931,755. The fair market value of the right of first refusal was valued at $14 million. Thus, HCAC claimed a charitable contribution deduction of $2,068,245. However, this appraisal did not include the leasehold interests, the road relocation, the land bank transfer fees, or the option. TNC provided HCAC with a contemporaneous written acknowledgment that identified the fee simple interests, the release of the reciprocal rights, and beach access rights, and the cash payments to HCAC. Like the appraisal, however, this letter did not reference the leasehold interests, the road relocation, the option, or the land bank transfer fee. Meanwhile, HCAC reported $9,136,593 of long-term capital gain on its tax return, but this gain did not include certain items of consideration. Upon examination, the IRS challenged the transaction on a number of grounds, including the lack of an accurate contemporaneous written acknowledgment, a mischaracterization of the gain as capital gain instead of ordinary income, a failure to include all of the items of consideration in the computation of income, and an undervaluation of the property interests. With the exception of the enhancement effect, discussed below, only the contemporaneous written acknowledgment issue is treated here.

Holding:

(1) Relying on Addis v. Commissioner, 118 T.C. 528 (2002), affd. 374 F.3d 881 (9th Cir. 2004), the Tax Court held that the entire charitable deduction was disallowed because the contemporaneous written acknowledgment failed to include part of the consideration HCAC received. The Tax Court pointed to the lengthy and detailed negotiations between TNC and HCAC over the appraisal and the contemporaneous written acknowledgment, which negotiations included several references to the missing consideration items, in explaining why the failure to include those items was inexcusable.

(2) The Tax Court rejected the taxpayer's substantial compliance argument, distinguishing the instant facts from those in Bond v. Commissioner, 100 T.C. 32 (1993).

(3) In a dicta footnote, the Tax Court suggested that even if the contemporaneous written acknowledgement had been accurate, there would have been no charitable deduction because: (a) the consideration HCAC received exceeded the stipulated $14 million fair market value of the rights of first refusal, and (b) HCAC lacked the requisite intent to make a charitable gift and was simply accommodating TNC's desire to reduce its tax liability reimbursement.

(4) Turning to valuation of the consideration (for the purposes of computing HCAC's income), the Tax Court affirmed the IRS appraiser's 20% enhancement effect for the two lots that were proximate to the conservationveasement-restricted property that was not open to the public. However, the Court found only a 10% enhancement effect for the two lots that were proximate to the conservation-easement-restricted property that would be open to the public.

(5) The Tax Court held that HCAC did not act with reasonable cause and in good faith in failing to include the missing items of consideration in its appraisal and contemporaneous written acknowledgment. Therefore, the accuracy-related penalties were applied with respect to the disallowed charitable deduction.

Analysis and Notes: (Adapted from Leslie Ratley-Beach)

This case is another reminder to land trusts to be very careful not only to timely produce contemporaneous written acknowledgement letters, but also to accurately state all value that the land trust transfers to the donor (quid pro quo). The Cohan court (Judge Marvel) placed the burden on land trusts, other charities and governmental donees to understand what they need to consider when writing a gift acknowledgment letter intended to satisfy the IRC Section 170(f)(8) requirements. If the land trust errs in the gift letter by misstating or underestimating - even unintentionally - the value of goods or services provided in exchange for a donation in excess of $250, the IRS, supported by the tax court under a ""strict compliance"" standard, might use this as leverage to disallow the donation deduction in its entirety.

While it is the donor's obligation to obtain the letter, after Cohan both parties now need to be especially careful that the letter fully reflects the transaction consideration. Karin Gross from the IRS has said in public that land trust preparation of the baseline is not goods and services provided, so while land trusts may want to look again at their practices on what costs they cover for landowners, it appears that baselines do not need to be included as goods or services. Other land trust expenses that benefit the land trust such as a survey, title work, the land trust's attorney or other experts, expenses associated with obtaining grant funds and so forth typically are not included as goods and services. The Alliance is seeking written confirmation from the IRS on these points.

As a practical matter only a few dozen land trusts nationally have transactions as complex as the Cohan. However, it is useful as a lesson for land trusts involved in transactions marketed by others as investments to examine the full transaction carefully and be absolutely certain that the full value the land trust confers on the donors is disclosed in the contemporaneous written acknowledgment letter and on Form 8283. Sometimes land trusts temporarily bridge the transaction costs for landowners. Cohan adds some more complexity to the bridge loan. Land trust counsel recommend possible disclosure in the letter with a statement that the loan is not goods or services, is secured and will be repaid. If there is a default then at that point the loan becomes goods or services. For more details on the complex transactional details of Cohan, see the press coverage and professional articles.