Charitable Contributions
The Fifth Circuit affirmed the Tax Court's determination of the value of a façade easement, finding that the Tax Court had properly followed its instructions on remand.
Background
Whitehouse Hotel LLP (Whitehouse) was formed in 1995 to purchase the Maison Blanche building in New Orleans, renovate it, and reopen it as a Ritz-Carlton hotel and condominium complex with retail space. Built between 1907 and 1909, the building was listed on the National Register of Historic Places in 1966 and designated a City of New Orleans landmark in 1980. Whitehouse's development plan included combining the Maison Blanche with the contiguous Kress building.
In 1997, Whitehouse conveyed a conservation easement to a Louisiana nonprofit corporation dedicated to historical preservation. The easement burdens the Maison Blanche with a number of restrictions and affirmative obligations, all revolving around maintaining the appearance of the ornate terracotta façade. On its 1997 tax return, Whitehouse claimed a $7.445 million charitable contribution deduction for the easement. On audit, the IRS determined that Whitehouse was entitled to a deduction of only $1.15 million for the easement and assessed a gross-undervaluation penalty of 40% for the underpayment related to the overstated deduction.
Whitehouse challenged the easement valuation and the penalty in the Tax Court. The 2006 trial focused on the pre- and post-easement valuation of the Maison Blanche building. The difference in value represented the value of the conservation easement and therefore the amount of the permissible deduction in the year of conveyance. Whitehouse and the IRS each presented the testimony and report of a qualified appraisal expert on the value of the easement. Whitehouse's expert considered the replacement-cost, income, and comparable-sales methods in determining the easement's value. The IRS's expert considered only the comparable-sales method. The experts also disagreed about whether the relevant property was the Maison Blanche building and the Kress building or just the Maison Blanche building and whether the easement had an effect on the Kress building. The Tax Court for the most part agreed with the IRS's expert, finding that the replacement-cost and income methods were not suitable for valuing the easement and that the easement did not affect the Kress building. Ultimately, it determined the easement was worth approximately $1.79 million and approved the imposition of the gross-undervaluation penalty. Whitehouse appealed the decision to the Fifth Circuit.
On appeal, the Fifth Circuit took issue with the way the Tax Court determined the easement's value. It found that the relevant property was the Maison Blanche and Kress buildings, so the Tax Court should have considered how the easement affected the Kress building. It was also concerned that in determining the pre- and post-easement values of the buildings, the Tax Court did not make an explicit determination of their highest and best use. It remanded the case to the Tax Court for reconsideration, with instructions to: (1) reconsider all valuation methods, not just the comparable-sales method; (2) determine the buildings' "highest and best use" for purposes of its valuation; and (3) consider the effect of the easement on the Kress building. Because it vacated the Tax Court's valuation of the easement, the Fifth Circuit also vacated the Tax Court's decision regarding the gross-undervaluation penalty.
In its opinion on remand, the Tax Court made it clear that it did not agree with the Fifth Circuit regarding whether the easement affected the Kress building, explaining at length why it continued to believe that, under Louisiana law, it did not have an effect on the building. However, it followed the circuit court's instruction to consider the effect of the easement on the Kress building. With respect to the highest and best use of property, the Tax Court found that it was unnecessary to follow either expert's opinion and determined that the ultimate highest and best use of the property did not affect the value of the property because, at the time the easement was granted, the property was only a shell building that could be converted into a hotel.
As it had previously, the Tax Court rejected the use of the replacement-cost and income methods for valuing the property. Using the comparable-sales method, the Tax Court came up with a slightly higher value for the easement ($1.857 million) than it did in its first decision because it took the Kress building into account in its valuation. Finally, the court found on remand that Whitehouse did not qualify for the good-faith exception to the gross-undervaluation penalty because Whitehouse had not presented evidence that it made a good-faith investigation that the easement value it used on its returns was correct. Whitehouse once again appealed the Tax Court's decision to the Fifth Circuit.
The Fifth Circuit's Decision
Whitehouse's second trip to the Fifth Circuit yielded mixed results. The Fifth Circuit upheld the Tax Court's valuation of the façade easement, but it overturned its decision to impose the gross-undervaluation penalty.
Valuation of the easement: Whitehouse first argued that the Tax Court had failed to follow the Fifth Circuit's instruction regarding the easement's effect on the Kress building. The Fifth Circuit found that although the Tax Court had gratuitously expressed in great detail why it disagreed with the Fifth Circuit's finding on this point, it had followed the instructions on remand and included the Kress building in its valuation. The Fifth Circuit observed that it did not matter that the Tax Court had been unenthusiastic about the instructions given to it, only that it had followed the instructions.
On the highest-and-best-use issue, the Tax Court, as it had in its original opinion, took the position that the highest and best use for the buildings was either as a luxury or nonluxury hotel, so the highest and best use did not affect the valuation. Whitehouse argued that the Fifth Circuit's original opinion foreclosed the Tax Court from finding that the highest and best use for the property was as a nonluxury hotel. The Fifth Circuit stated that Whitehouse had misinterpreted its prior opinion and that it had left the highest-and-best-use determination open on remand.
With respect to the valuation method, Whitehouse, as it did in its first appeal, raised several substantive issues with respect to the Tax Court's choice of valuation method. However, the Fifth Circuit did not find the Tax Court erred when it rejected the replacement-cost and income methods and chose to use the comparable-sales method. Whitehouse also objected to the Tax Court's failure to use nonlocal comparables in its analysis, but the Fifth Circuit stated that while it had questioned the Tax Court's dismissal of nonlocal comparables in its previous opinion, it had not precluded a finding that their use was unnecessary.
Gross-undervaluation penalty: The Fifth Circuit, however, rejected the Tax Court's imposition of the gross-undervaluation penalty. Under Sec. 6664(c), there is a reasonable-cause and good-faith exception to the penalty. To qualify for the exception, the taxpayer must obtain an appraisal for the property in question and, in addition, make a good-faith investigation of the value of the property. The IRS conceded that Whitehouse met the first requirement but contended that it did not meet the second good-faith investigation requirement. Whitehouse argued that its reliance on its tax professionals was enough to meet the requirement. The Tax Court, finding that the record was bare of any evidence that Whitehouse had conducted an investigation of the value it claimed for the easement, held that it did not meet the requirement and therefore the penalty applied.
The Fifth Circuit concluded that the Tax Court had imposed an excessively high standard of proof and its decision was clearly erroneous. The court noted that valuation of assets is a difficult task in general and was particularly so in this case, where even the IRS, its expert, and the Tax Court all determined different values for the easement. Whitehouse had conducted two appraisals for the easement and had its returns prepared by professional accountants. Because valuing the easement was "such a complex task that involves so many uncertainties," the Fifth Circuit found that Whitehouse's actions met the good-faith investigation requirement. Thus, it determined that Whitehouse was not liable for the gross-undervaluation penalty.
Reflections
As this case once again demonstrates, although almost everyone can agree a façade easement has some value, reasonable minds can differ on what the value is and how it should be determined. While it was the Fifth Circuit's job to determine from a legal standpoint how the valuation should be conducted, it was the Tax Court's job to decide the value based on the facts and evidence. Having satisfied itself that the Tax Court performed the valuation as it had instructed, the Fifth Circuit properly left its results untouched. Contrast this with the penalty issue, where the Fifth Circuit reversed the Tax Court because it determined that the Tax Court incorrectly applied the legal standard for imposing the penalty.
Whitehouse Hotel LP , No. 13-60131 (5th Cir. 6/11/14)
