The question of what qualifies for the “reasonable cause” exception to the gross valuation misstatement penalty under IRC §6662(h)(1) was the issue before the First Circuit in the case of Kaufman v. Commissioner, Docket No. 14-1863, CA1, affirming TC Memo 2014-52. This was the second time the Kaufmans had appealed an adverse Tax Court decision on this issue to the First Circuit, but the result wasn’t as favorable this time.

The Tax Court, on remand, determined that the value of the facade easement was zero and, given that, went on to decide that the taxpayers were subject to the penalty due to a gross valuation misstatement given the proper value was zero. Finally, and the issue we are interested in at this point, the court found that the taxpayers did not qualify for the relief granted to taxpayers from the penalty under the reasonable cause relief provision for this penalty found at IRC §6664(c).

The First Circuit noted that this provision provides, in relevant part, that:

(1) In general. No penalty shall be imposed . . . with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.

(2) Special rule for certain valuation overstatements. In the case of any underpayment attributable to a substantial or gross valuation overstatement . . . with respect to charitable deduction property, paragraph (1) shall not apply unless --

(A) the claimed value of the property was based on a qualified appraisal made by a qualified appraiser, and

(B) in addition to obtaining such appraisal, the taxpayer made a good faith investigation of the value of the contributed property.

In the case in question the taxpayer had clearly satisfied the first prong of the test—the taxpayers had relied upon a qualified appraisal made by a qualified appraiser. But the Tax Court had found that taxpayers did not meet the second test—they had not made a good faith investigation of the value of the contributed property.

The taxpayers had argued that since they were not expert in easement valuation, they could not have critically evaluated the appraisal in question. Thus, in their view, they had made a good faith attempt to establish the value of the property contributed.

But the Tax Court, with the First Circuit’s concurrence, had found that wasn’t the issue. Rather, as the First Circuit described:

The Tax Court did not suggest that the Kaufmans should have been able to critique the Hanlon appraisal in a vacuum, or that they should have known from the outset that the value of the easement was zero. Rather, the court found that the Kaufmans should have recognized obvious warning signs indicating that the appraisal's validity was subject to serious question, and should have undertaken further analysis in response.

The Kaufmans had sent an email to a representative of the charity to ask if granting a conservation easement would negatively impact the value of his property should he seek to sell the property down the line. The representative told him that he did not expect the granting of the easement to negatively impact the value of his residence at all. As well, the taxpayers signed a statement to their mortgage lender to get the lender to agree to subordinate the mortgage to the charity’s interest in the façade easement that stated the restrictions they were granting were identical to restrictions that already applied to the property.

Both Courts found that one did not need to understand the technicalities of valuing easements to understand that these statements both strongly implied that the easement had no value—that is, the taxpayers had not suffered any economic detriment by having made this “contribution” to the charity. That should have caused the Kaufmans to investigate more closely the validity of the appraisal they were relying upon to claim a charitable contribution deduction. However, the Kaufmans did not do that, but rather claimed a deduction based on that appraisal.

The First Circuit continued by noting that:

The Tax Court did not purport to equate "good faith investigation" with "exhaustive investigation." It merely required that the Kaufmans do some basic inquiry into the validity of an appraisal whose result was squarely contradicted by other available evidence glaringly in front of them. There was no clear error in such reasoning.

The taxpayers sought to argue that they had relied upon the advice of their accountant in accepting the appraisal as appropriately valuing what they had given. The Tax Court noted that the accountant had reviewed it and found it consistent with other real estate appraisals he had seen. But, as the Tax Court noted:

Mr. Cohen, however, testified that he did not express to petitioners any opinion as to whether the valuation was reasonable. Indeed, in response to a question from the Court, he agreed that it was fair to say that he had "no idea whatsoever" as to whether the value reported by petitioners on the basis of the Hanlon appraisal was accurate.

The First Circuit agreed with the Tax Court’s finding that, based on the accountant’s testimony, the taxpayers had not made a good faith investigation of the value of the easement via their use of Mr. Cohen.

To the Kaufman’s general view that obtaining a qualified appraisal performed by a qualified appraiser should automatically constitute a good faith investigation, the Court notes that this would made the second prong of the test unnecessary, since fulfilling the first prong (obtaining the qualified appraisal by a qualified appraiser) would automatically fulfill the second prong. A standard rule of statutory construction is that the Court should avoid a reading that renders a portion of a statute superfluous as opposed to any alternative reasonable reading that does not have that affect.

As well, the First Circuit goes on to note:

Simply obtaining an appraisal is not the same as reasonably relying on that appraisal. The Kaufmans concede as much in their reply brief, acknowledging that "'obtaining' a qualified appraisal alone will not satisfy the good-faith investigation requirement, nor will 'unreasonable' reliance." There may well be situations in which the taxpayer need do little more than read an appraisal and note that there is no other evidence that reasonably casts doubt on the accuracy of the appraisal. Here, however, the Tax Court supportably found that the Kaufmans obtained a qualified appraisal from a qualified appraiser, but that other facts available to the Kaufmans should have alerted them that it was not reasonable to rely on that appraisal.

There are some key issues that an adviser should note here. First, it’s not surprising that the taxpayers attempted to argue they had relied on the accountant who prepared the return in this area. While the Tax Court and the Court of Appeals did not accept that as a position that would show good faith investigation, that’s not to say the taxpayer might not be able to persuade a civil court that the accountant failed in his duty to warn them about the fact that a) he was not an expert in valuation issues and b) simply relying on the appraiser would not be sufficient to escape a penalty if the IRS were able to show the appraisal was in error leading to a gross misstatement of the value for federal tax purposes.

Second, taxpayers must be counseled that they cannot “play ostrich” and ignore information that may suggest a result contrary to what they are claiming on the return. The fact that the taxpayers inquired about the negative impact on property values and received assurance there was none before they went forward with the transaction certainly can lead to the conclusion that the taxpayers believed when they filed the return that they hadn’t really “given” anything. Add to that the statement they gave to the lender, and it certainly appears that they were aware that this deduction looked “too good to be true” regardless of what those promoting the arrangement might have said.

That is, if the taxpayer is faced with a result that sounds “too good to be true” the taxpayer needs to make additional inquiries. Certainly at a minimum they should have made such “bad facts” known to the accountant who, regardless of his expertise in evaluating the value of property, could have recognized the problem in inherent in those facts—or, if he failed to advise the taxpayers of that fact, his lack of a warning would have given the taxpayers an argument that they had reasonably relied on the accountant.