IRS Reaction to Charitable Deduction Ruling Raises Warning to Taxpayers

Although it seemingly scored a significant victory last summer when the U.S. Tax Court denied a taxpayer’s charitable donation deduction for a house donated to a local fire department, the Internal Revenue Service was not completely satisfied with the decision, and recently nonacquiesced to the court’s refusal to impose a penalty against the taxpayer. The IRS’s action raises a clear sign of caution to taxpayers regarding their obligation to investigate gray areas of the law.

U.G. and Avanti Patel purchased a property in Vienna, Virginia in 2006. The property had a house on it, but the Patels wished to demolish it and construct a new house on the land. The Patels’ realtor suggested they donate the old house to the local fire and rescue department, who would burn it down as part of training exercises it would conduct using the house.

The Patels did so, and took a $339,500 charitable deduction on their 2006 taxes for the house. The IRS rejected the deduction, and assessed the couple for a $32,600 deficiency and a $6,500 accuracy-related penalty. The couple sued for reinstatement of the deduction, but the Tax Court upheld the disallowance in 2012. The court concluded that the Patels merely gave the fire department a license to conduct activities that would have otherwise been illegal, but did not transfer an ownership interest in the property to the fire department. Several others homeowners, including well-known television football analyst Kirk Herbstreit, lost cases with similar facts in 2009 and 2010.

The IRS, however, fared less well in its effort to recover a penalty against the Patels. The court concluded that, in light of the “uncertain state of the law,” the taxpayers “acted with reasonable cause and in good faith,” and, therefore, owed no penalty. Last month, the IRS responded by nonacquiescing to the Patel decision. Nonacquiescence means that the IRS disagrees with the decision, and will follow that decision only as it relates to that particular taxpayer. In other words, if the IRS would encounter another taxpayer like the Patels, that taxpayer likely would receive the penalty.

The court did not go far enough in its analysis regarding the penalty, the IRS concluded. An uncertain state of the law, alone, should not save a taxpayer from the penalty. The IRS’s concern appears to regard taxpayers who “luck” into an uncertain area of law, with no effort to investigate, and then use that uncertainty to evade the penalty. The IRS stated that the court should have analyzed, and made findings, regarding the level reasonable diligence the taxpayers undertook to investigate the state of the law, before absolving them of the penalty. The “taxpayer’s reasonable cause and good faith must be evaluated in the context of the taxpayer’s knowledge, efforts and actions. A taxpayer cannot act in good faith and have reasonable cause … if the taxpayer was unaware of the state of the law and did not make reasonable attempts to become aware,” the IRS wrote.

Charitable deductions, especially deductions that are extremely high in comparison to income, are one item that may increase your tax return’s risk of heightened scrutiny by the IRS. To ensure that your deductions are permissible, and properly claimed, consult the tax attorneys at Samuel C. Berger, P.C. and the CPAs at S.C. Berger, P.C., who help people throughout New York and northern New Jersey ensure that their deductions are handled correctly. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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