Substantial Compliance versus Strict Compliance
There are a number of cases where taxpayers have had to pay more tax than they should due to technical foot faults. These cases often come up when the IRS employees believe that their job is to look for strict compliance (100%) rather than substantial compliance (something more akin to 80%). This brings us to the Cave Buttes, LLC v. Commissioner, 147 T.C. 10 (2016) case. It is an example of a case where the IRS argued for strict compliance.
The facts and procedural history are as follows:
- The taxpayer was a partnership that owned undeveloped land in Phoenix, Arizona.
- The land was situated next to a dam owned by the Maricopa County Flood Control District (“District”).
- The land proved to be difficult to develop given the zoning and access due to the proximity to the dam.
- Given these difficulties, the partnership decided to sell the property to the District.
- The District’s appraiser determined that the value was $735,000; however, he made several errors in valuing the property.
- To rectify this, the District and the taxpayer agreed that the property would be sold for $735,000 and the remaining value would be treated as a charitable contribution to the District.
- The value of the charitable contribution was to be determined by another appraiser.
- The taxpayer engaged two appraisers who valued the property at $1.5 and $2 million.
- The taxpayer reported the $1.5 million valuation on a Form 8283, Noncash
- Charitable Contributions, filed with its partnership tax return.
- It also included both appraisals with its tax return.
- The IRS concluded that the charitable contribution was not allowable because of several defects in the appraisals submitted with the tax return.
The issue for the court was whether the taxpayers substantially complied with the rules and, as such, were entitled to the charitable contribution deduction. The court addressed each defect raised by the IRS, which argued that the appraisal:
- Was not prepared by a qualified appraiser and does not include the qualification of the appraiser who prepared the report;
- Did not include a sufficiently detailed or accurate description of the property because it described the property as three separate lots, when it wasn’t officially three separate lots for a few more months;
- Did not include a statement that the appraisal was prepared for income-tax purposes as it only said it was to be submitted to the IRS;
- Did not have the correct date of value, as the date was not the date of the purported contribution; and
- Did not use the correct definition of fair market value as it was not the same definition as in Treas. Reg. § 1.170A-1(c)(2), even though the IRS’s expert also used this non-regulation definition.
The court found each issue in the taxpayer’s favor. It did so by noting that the taxpayer substantially complied with the regulations.
The IRS also argued that this was the type of transaction that Congress intended to prevent with strict substantiation requirements. The IRS argued that the taxpayer orchestrated a voluntary, open-market sale transaction to appear as if it was a bargain sale to enable its partners to entirely offset their significant capital gain with a charitable-contribution deduction.
The court did not agree with the IRS’s argument. The court concluded that “the taxpayers here obtained good appraisals, and we see no reason why we should not accept Cave Buttes’ appraisal report in its entirety as the best reflection of fair market value and determine that it was entitled to the full amount of the deduction.”
This type of strict substantiation issue frequently comes up on audit and in collection matters. It is one that results in taxpayers with identical tax issues obtaining different results from the IRS. At the heart of it, this happens because the IRS does not do a good job explaining which standard its employees should enforce. The IRS is silent on the issue. So IRS employees have to make up their own minds on this issue. Do they protect the government fisc (at all costs) or do they adopt a view that they should only pursue substantial tax adjustments in cases where taxpayers failed to take substantial steps to comply with our laws? If you were an IRS employee, which standard would you apply?