Tax Matters

Conservation Easements
Do you have a client who’s interested in protecting the environment as well as getting a tax break? Recently, the Tax Court considered the deductibility of a conservation easement to a charity.

In 1988 Mr. and Mrs. Charles Glass purchased property on the shore of Lake Michigan. In the 1990s bald eagles returned to this area, and one roosted on their land. The property also was a suitable habitat for a couple of endangered plants.

In 1990 the couple gave a conservation easement on part of the property to a qualified charity. In 1992 and 1993 they gave two additional easements to LTV, a Michigan nonprofit organization, for the purpose of ensuring the scenic and natural resource value of the property would be retained forever by preventing development of the listed parts of the property. The easements did not restrict development of other parts of the property, which the Glasses used as a vacation home until 1994, when they converted it to their principal residence. They claimed a charitable contribution for both easements. The IRS objected to the deduction.

Result. For the taxpayers. IRC section 170(f)(3) normally denies a charitable contribution for donations of less than a taxpayer’s entire interest in a property, but there is an exception for a “qualified conservation contribution.” To be eligible, the property must be a qualified real property interest, the contributee must be a qualified organization and the contribution must be exclusively for conservation purposes. The IRS said the contributions met the first two requirements but not the third.

Under section 170(h)(4) and (5), a contribution is made exclusively for conservation purposes if it is made in perpetuity and designed to

Preserve land for the general public’s outdoor recreation or education.
Protect the relatively natural habitats of fish, wildlife or plants.
Preserve open space for the public’s scenic enjoyment.
Preserve a historically important land area or structure.

The regulations expand the requirement to ensure the charity is able to enforce the restriction.

The legislative history makes clear that widespread use of this special contribution provision was not intended. The contribution should apply only to “the preservation of unique or otherwise significant land areas or structures.” The taxpayers’ case was aided by testimony from the director of the charity that the property was indeed a roosting spot for bald eagles and a proper place for threatened plants to grow. The Tax Court concluded the contribution met all the requirements.

Taxpayers desiring a charitable contribution for a conservation easement should carefully review the requirements, guarantee the documents contain the necessary provisions and restrictions and provide a qualified appraisal for the amount of the deduction.

Charles F. Glass v. Commissioner, 124 TC no. 16.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

What Makes It Alimony?
When do family support payments constitute alimony? CPAs advising clients about their tax status in a divorce need to know the rules.

Alimony payments are deductible for tax purposes for a payor spouse but represent gross income to the payee. Under a divorce or separation agreement, payments are considered alimony if they are made in cash to an ex-spouse not living in the same household as the payor and not designated as either child support or a property settlement. Also the payor can’t be liable to make payments after the death of the spouse (a continuing payment liability) or in place of postdeath payments (substitute payment liability).

Michael Berry was divorced from his wife in 1997. The divorce judgment required him to pay approximately $4,000 a month in support to his ex-wife and their two minor children. Under California law, a family support agreement combines spousal and child support without stating the specific amount of each component. Berry deducted the family support payments as alimony on his 1999 tax return; however that deduction was disallowed by the IRS. The taxpayer petitioned the Tax Court for relief.

Result. For the taxpayer. Family support payments would not be deductible as alimony if they created either a continuing payment liability or a substitute payment liability. The court first determined whether Berry had any obligation to make those payments after the death of his ex-wife. Since the divorce agreement did not address the issue, the court examined California and related case law. Neither dealt directly with the issue. In the court’s judgment Berry would not have had to continue making those payments to her estate since it was unlikely a state court would recognize her estate as having an enforceable interest in the payments. Thus there was no continuing payment liability.

The court then examined whether Berry had an obligation to make payments in lieu of the child support component after his ex-wife’s death. The IRS argued that all parents are required to support their children until the age of emancipation; therefore the taxpayer would be required to make child support payments if his ex-wife died, thus creating a substitute payment liability. This argument is based on a “worst case scenario approach” previously advanced by the Tax Court in which it is assumed that a third party is awarded custody of the minor children after the death of an ex-spouse and state law requires the taxpayer to make child support payments to that third party (Wells v. Commissioner, TC Memo (1998-2)). Under that theory, family support payments represent substitute payments since they include an undesignated child support component for which the taxpayer’s obligation continues after the death of his ex-wife.

The court rejected this argument stating that it implied the only amount required to be designated as child support in a divorce agreement is an amount in excess of that required under state law, since state law automatically would cause part of unallocated support payments to be considered child support. The court further stated it clearly was not the intent of Congress to have state law determine what portion of unallocated support payments represented child support when the divorce agreement did not. In addition, if state law automatically fixes a portion of unallocated payments as child support, IRC section 71(c)(1)—which disqualifies as alimony any amount specifically designated as child support in the divorce agreement—would not be necessary.

This case resolves the issue of whether parents’ general obligation to support their minor children after the death of an ex-spouse automatically causes the creation of a substitute payment liability when undesignated family support payments are present, and rejects the application of the “worst case scenario approach” to that situation.

Michael K. Berry v. Commissioner, TC Memo, 2005-91.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

No Marketability Discount for Lottery Winnings
The Massachusetts District Court held in Estate of Donovan v. United States that, for estate tax purposes, the value of a stream of lottery payments due to a decedent must be based on the annuity valuation tables in IRC section 7520 without a discount for lack of marketability.

The decedent, John R. Donovan, won the Massachusetts lottery in January 1999. He received the first of 20 annual payments of $100,000 on the day he won, but died in July. Under Massachusetts law the decedent was prohibited from assigning the lottery payments. Based on this restriction, an appraiser determined the value of the 19 remaining payments was $367,482. The estate used that amount on its return; however, the IRS determined, based on the annuity valuation tables, that the value of the remaining payments was $1,091,553.

The decedent’s estate paid the resulting deficiency and subsequently sought a refund in the Massachusetts District Court. The IRS and the estate executor agreed the lottery payments should be included in the decedent’s gross estate but disagreed as to their valuation. The first issue was whether the lottery payments constituted an annuity. The second was whether the section 7520 annuity valuation tables should be applied or a discount for lack of marketability allowed.

Result. For the IRS. The district court held the payments were an annuity and should be valued in accordance with the section 7520 tables. The provisions of that section define an annuity as “the right to receive a fixed dollar amount at the end of each year during one or more measuring lives or for some other defined period.”

The estate argued that, due to the restrictions on assignment of the lottery winnings, the “restricted beneficial interest” exception applied. The exception provides that valuation according to annuity tables is not required where an interest is restricted by a contingency, power or other limitations. However, the court noted the exception applies to restrictions that limit the decedent’s receipt of payments, not to restrictions that affect his ability to dispose of payments. Accordingly, the exception did not apply and the lottery winnings were held to be an annuity.
The court next turned to valuation of the lottery annuity. Generally, the section 7520 tables must be used to value annuities unless their use would have an unreasonable result. The district court noted a split among the few circuit courts that have ruled in such cases. The Second Circuit Court of Appeals and the Ninth Circuit have held that the right to transfer property is a fundamental right of ownership and that any restriction on that right affects the value of the property. Therefore, those circuit courts have upheld a marketability discount for lottery payments. The Fifth Circuit, however, has held that such discounts are improper because there is an underlying assumption of nonmarketability in the annuity tables.

The decedent’s estate had sought valuation of the lottery annuity based on the willing buyer/willing seller standard, whereby what a willing buyer would pay for property is attributed to the willing seller. Since the estate tax values assets in the hands of the decedent, not a third party, it is inappropriate to use this method of valuation.

What was at issue in this case was essentially an income interest unaffected by market forces. The fact that the interest could not be assigned did not affect its value for estate tax purposes. Accordingly, for the time being CPAs should use the section 7520 annuity tables to value a client’s right to an annual stream of lottery winnings. However, Donovan has been appealed to the First Circuit, which has not yet ruled on the case. Given the split that already exists, it is possible this issue ultimately may be heard by the U.S. Supreme Court.

Estate of John R. Donovan, Jr. v. United States, 2005 US Dist., Lexis 7232; 95 AFTR2d 2005-2131 (April 26, 2005).

Prepared by Laura Lee Mannino, CPA, LLM, assistant professor of accounting and taxation, St. John’s University, New York.