February 14, 2011
Charitable Contributions Pushed to the Extreme: The U.S. Tax Court Case of Rolfs v. Commissioner
On November 4, 2010, the United States Tax Court ruled in favor of the IRS in a charitable contribution case in which taxpayers claimed a charitable deduction for the donation of a home.
Taxpayers Mr. Theodore R. Rolfs and Ms. Julia A. Gallagher, a married couple from Wisconsin, donated their house on a 3 acre lakefront property in the Village of Chenequa, Wisconsin in 1998 to the local volunteer fire department. The donation of the house was contingent upon the fire department using the home for training exercises for firefighters and police with the ultimate goal of it being burnt down shortly after the donation in the first part of 1998. The taxpayers obtained all necessary approval from the Wisconsin Department of Natural Resources in October 1997 to donate the home.
The property in question was purchased on November 27, 1996 for $600,000, and it was later appraised by the Village of Chenequa for a total of $460,100 in 1998. In this appraisal, $323,000 was allocated to the land, and $137,100 to the home. Due to the many renovations that the taxpayer’s saw fit for the home, they were undecided whether to remodel or tear down the home. The couple chose to donate the home to the fire department for eventual destruction and five weeks after the destruction of the home they entered into a contract to reconstruct a home on the 3 acre property at a cost of approximately $383,000.
The taxpayers consulted with Mr. Richard S. Larkin, president of Larkin Appraisals, Inc. to determine the value of their lakefront property. Mr. Larkin used what is called the “before and after approach” to determine the fair value of the house. Larkin concluded that the value of the contribution of the home was $76,000 and that the reproduction cost of the home was $235,350.
The taxpayers also estimated that in lieu of donating their home, it would cost $10,000 to $15,000 to demolish the home, remove debris and begin construction on another home in its place. As a result of their research, the taxpayers donated the home and took a deduction of $76,000 on their 1998 tax return as a charitable donation to the fire department. To substantiate the deduction of their home, the taxpayers included the appraisal report from Mr. Larkin with their return and the letter received from the Fire Chief thanking them for their donation.
The IRS examined the 1998 return and disallowed the charitable contribution deduction of $76,000 with respect to the donation of the lake house. The notice of deficiency therefore increased the taxable income by $76,000. The IRS also assessed the taxpayers an underpayment penalty of 40% of the amount due on the return.
In Tax Court, the IRS argued that a charitable contribution does not expect a financial return in exchange for the contribution or gift given and the taxpayers anticipated a substantial benefit in exchange for their contribution. Additionally, the fair market value of contributed property should have taken into account the restrictions or conditions which limited the use of the property – in this case the fact that the fire department could only use the house for training purposes and it was to be destroyed shortly after it was donated. The taxpayers did not donate the land in connection with the home, therefore, the lake house clearly could not be used for residential or any other purposes aside from those outlined.
The taxpayers rebutted that under Internal Revenue Code 7491(a), the burden of proof, which normally lies with the taxpayer, transfers to the IRS since the taxpayer has provided credible evidence in their case and satisfied all requests for information to substantiate their position on the tax return. The fair market value of the home in which they are claiming a charitable deduction was $76,000. Upon further consideration they should have shown $235,350, the value of reproduction of the home. Regardless, the point of their argument was that they only received an incidental benefit in return for their donation and that they did in fact transfer their entire interest in the property since they gave the fire department the right to demolish the home.
The Tax Court ruled in favor of the IRS based on the evidence that the taxpayers did in fact anticipate a substantial benefit in exchange for their donation since the cost of demolition services would have been approximately $10,000 and the fair market value of the home was significantly less. The lake house had relatively little to no value at the time of donation because it could not be used to residential purposes, it had no value if it were to be moved, and it had no salvage value if demolished. In conclusion, the taxpayers were ineligible for a charitable deduction for any amount for the donation of the home to the volunteer fire department and were liable for the taxes assessed on the additional $76,000 of taxable income.
Cases such as this not only are regularly seen in individual tax scenarios, but also in foundations. Often taxpayers have honest charitable intent when they donate to events or charities, but what they often forget is that if receiving a benefit in return, they need to deduct the value of the benefit to arrive at the actual charitable donation. For example, if an individual or foundation donate $500 to a charity event, but receive a meal worth $100 in return, the charitable donation is actually $400 for tax return purposes. The same facts would apply for tickets to an event, gift bags received from a similar event, etc.
In summary, this case displays the prudence taxpayers should take in determining deductibility of their charitable contributions. While not as clean cut as the donation of cash, a donation of property might have unexpected perceived intentions attached to it. It is advisable to keep in mind what a third party would think of the contribution to decide if it is in fact and in appearance a deduction that has a tangible result.