Another Court of Appeals Agrees: Mortgages Must Be Subordinated to Have Deductible Easement Gift

• Date: 01 October 2015
• Published date: 01 October 2015
• DOI: http://doi.org/10.1002/npc.30125

Bruce R. Hopkins’ NONPROFIT COUNSEL

5

October 2015

THE LAW OF TAX-EXEMPT ORGANIZATIONS MONTHLY

Bruce R. Hopkins’ Nonprofit Counsel DOI:10.1002/npc

Facts

The individual in this case is a chemist, who, from his

home, conducted experiments and research, provided

research services to health supplement companies, and

sold mineral, herbal, and chemical supplements that he

manufactured to these companies. He received payments in

the form of cash or checks for his services. He also directly

administered supplements to individuals from his porch. He

further conducted retreats, for fees, offering exercise, spir-

ituality, holistic meals, and lectures on health and science.

He did not maintain any books or records of his

activities. Earnings from his activities (totaling about

$5.6 million) were, during the years at issue (1995–

2002), deposited in his personal bank accounts, of

which there were at least 14 at nine different banks

under several Social Security numbers. These deposits

were not used to pay his personal expenses. When

audited by the IRS, he explained to the agent that the

funds in these accounts were “donations” and that he

was endeavoring to accumulate $10 million so that he

could establish a foundation. He was sentenced by a

federal court to prison for tax evasion.

He formed a charitable corporation and received

a favorable determination letter in 2003. He initially

claimed that the deposited funds for the years at issue

were those of the charitable organization; he later

abandoned that argument. He also conceded that these

funds were not gifts but were forms of fee-for-service

income. His sole remaining defense against the fraud

penalties was that the eight years of income was pro-

gram revenue of an exempt social welfare organization

(an IRC § 501(c)(4) entity).

This defense was based on the assertion that

although the charitable entity was not incorporated

until 2003, it existed during the years at issue with the

same charitable purpose. Thus, he asserted, while all of

this income from 2003 onward is exempt (by reason of

IRC § 501(c)(3)), the earned income in the prior years

(including the years at issue) was also exempt (albeit by

reason of IRC § 501(c)(4)). He raised two points of law

in this regard (both of which the court did not address):

an organization that qualifies under IRC § 501(c)(3) also

qualifies under IRC § 501(c)(4) (which is generally the

case) and an entity can hold itself out as exempt by rea-

son of IRC § 501(c)(4) without having filed for recogni-

tion of exemption with the IRS (which is true).

Law and Analysis

The court observed that, during the years at issue,

neither this individual nor those assisting him “main-

tained financial records, kept minutes, drafted organizing

documents or bylaws, requested an employer identifica-

tion number, or put in place any structures that would

be expected from a continuing organization.” No state

organizational requirement was met. Federal annual

information returns were either not filed or filed late.

The court also stated that, prior to 2003, “there was

no separation between [this individual] and his activi-

ties.” He was the “sole researcher, analyst, producer,

service provider, and scientist (and was later defined as

the only director and officer).” He had control of all of

the deposited funds (none of which were devoted to

charitable purposes).

The court concluded: “In an effort to avoid taxation

[and penalties], [this individual] is belatedly trying to

make an organization appear where none had existed.”

The court went on to find the commission of fraud,

based on his inconsistent testimony and various “badges

of fraud” recognized by the courts. [4.1(a)] ◆

ANOTHER COURT OF APPEALS

AGREES: MORTGAGES MUST

BE SUBORDINATED TO HAVE

DEDUCTIBLE EASEMENT GIFT

The US Court of Appeals for the Ninth Circuit, on

August 12, joined the Tenth Circuit in holding that for

a donor to validly claim a charitable deduction for the

contribution of a conservation easement, any mortgage

or other financing on the property must be subordinated

to the easement at the time of the gift (Minnick v. Com-

missioner). This is an affirmance of a Tax Court holding

in 2012 (summarized in the February 2013 issue).

The donors in this case gave a conservation ease-

ment to a qualified public charity; this easement is on

property subject to a mortgage. The mortgage was not

subordinated to the easement until four years after the

contribution.

Following the trial in this case, but before a ruling

was issued, the Tax Court decided in another case that

mortgages must be subordinated as of the time of the

charitable gift of an easement to be deductible (Mitchell

v. Commissioner) (summarized in the June 2012 issue).

When the Tax Court ruled for the government in this

latest case, it cited Mitchell, which was based on the

statutory in-perpetuity requirement (IRC § 170(h)(5)(A))

and the tax regulations (Reg. § 1.170A-14(g)(2)). While

this appeal was pending, the Tenth Circuit affirmed in

Mitchell (summarized in the February 2013 issue).

The Ninth Circuit agreed with the Tenth and the

Tax Court that the “plain language” of the regulation

supports the government’s position. As was succinctly

written by the Tenth Circuit, “subordination is a prereq-

uisite to allowing a deduction.” The Ninth Circuit added

that, “[e]ven if ambiguity arguably exists in the language

of the regulation with respect to when subordination is

required, this would not change the outcome.” (The reg-

ulation does not explicitly require subordination as of the