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Monday July 22, 2024

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Phishing, Spear Phishing and Whaling

The Internal Revenue Service (IRS) is conducting Nationwide Tax Forums sponsored by the Security Summit in five different cities this summer. The four remaining forums are July 30 in Orlando, August 13 in Baltimore, August 20 in Dallas and September 10 in San Diego.

The registration forms and deadlines are available on IRS.gov. The IRS notes that taxpayers and professional advisors are welcome to attend the forums, but it is expected that they will sell out.

The forums are designed to highlight the latest strategies of fraudsters. There is a a specific focus on protecting tax preparers and their clients. The latest and most successful scams will be covered. Some of the scams to be aware of include:

  1. Phishing/Smishing — Phishing emails or SMS/texts (known as "smishing") are common strategies for a fraudster. One method to increase the probability of success is to send phishing emails to several professionals who are all in the same firm. This increases the likelihood that at least one individual will click on a link and download malware.
  2. Spear Phishing — This is an email strategy known as a "lure." These scams are more difficult to identify. They single out an individual and attempt to craft an email that is especially likely to succeed. The scammer often claims to be a potential client. He or she may engage in a series of emails that appear to be a normal part of business. However, there eventually will be an email with a link to documents that supposedly have been requested by the tax professional. This link will download the malware.
  3. Clone Phishing — The latest phishing scam involves hacking an email message from a client to the tax professional. Since a regular email is not encrypted or protected, a hacker may be able to intercept an email from a client to the tax professional. The scammer then re-sends the email and pretends to be the actual client. This makes the tax professional think the email is from a known client increasing the likelihood that they click on a link and download malware. The malware enables the fraudster to use client data, file false returns and claim improper tax refunds.
  4. Whaling — A whaling attack is similar to spear phishing. However, these attacks are focused on leaders of organizations or executives who have access to important business information. Whaling attacks will frequently target individuals who are in a finance or human relations office. The whaling email may claim to be from an officer or director of the organization and asks the finance or HR staff person for critical information.

The IRS warns professionals to be on the lookout for red flags or warning signs. If you receive an unexpected email or text that claims to come from a colleague, a bank, a credit card company or your tax software provider, check out the source before clicking on links or responding. A scammer may also decide to send a duplicate email that is very similar to the email you have just received from a trusted individual. The duplicate will contain an attachment or link that downloads the malware.

Another effective strategy for scammers is to claim urgency. They may indicate your password to an important website has expired and must be renewed immediately. Finally, be careful if there is an email address that includes misspellings. Some scammers have been quite successful with email addresses that are identical, except there is a "0" that replaces the "o" in the email address.

IRS Commissioner Danny Werfel notes, "There are major red flags that can be easily overlooked, so tax professionals and taxpayers should be extra careful and look closely when they receive an email from an official looking source."

Tax preparers are reminded they are required by the Federal Trade Commission to use multi-factor authentication for access to client personally identifiable information (PII). Professionals should develop a Written Information Security Plan (WISP). This plan will help protect your clients and yourself from fraudsters and scammers.

Easement Charitable Deduction Fails "Smell Test"

In Kenneth M. Brooks et al. v. Commissioner; No. 23-1314 (4th Cir. 2024), the Court denied a $5.1 million deduction on property that had been purchased a year earlier for $652,000. The opinion noted this deduction "simply does not pass any reasonable smell test, much less the tax law’s requirements."

Kenneth Brooks and Anita Wolke Brooks, both physicians living and working in Virginia, purchased 85 acres of land in Liberty County, Georgia for $1.35 million in 2006. They divided it into two parcels, one for 44 acres and the other for 41 acres. They then deeded a conservation easement to Liberty County on the 41-acre parcel. They claimed a $5.1 million charitable deduction. The IRS audited them in 2015 and denied the carryforward deductions for the years 2010, 2011 and 2012. The statute of limitations had run on the prior deductions. The IRS also imposed a 40% penalty for a Section 6662(h) gross valuation misstatement.

The property was next to a Planned Unit Development (PUD) named the Hampton Island Preserve. However, only two homes had been built on the 4,000-acre PUD and allowed no access to the Brookses’ parcels. The easement deed included 16 paragraphs that reserved rights to allow the Brookses to construct horse paddocks, a barn, fencing, lighting and other facilities for recreational use activities. The Brookses claimed a $5.1 million charitable deduction and reported their cost basis as $1.35 million on the 41-acre tract. They did not obtain a contemporaneous written acknowledgment from Liberty County. The IRS audited and assessed approximately $1 million in taxes, penalties and interest.

At trial, the Brookses presented a new appraiser, Duane Miller, who claimed the easement was valued at $3.63 million. The IRS appraiser disputed the value and claimed that the actual value of the conservation easement was $470,000. The IRS denied the deduction because the taxpayers had not provided a "contemporaneous written acknowledgment." They also had not provided a baseline report sufficient to demonstrate the condition of the property and they misrepresented their basis on the return. The Tax Court concluded the Duane Miller appraisal had significant errors and there was a gross misstatement of the value. The taxpayers claimed they had substantially complied and therefore the deduction should be permitted.

Section 170(f)(8) states a contribution of $250 or more requires substantiation through a contemporaneous written acknowledgment (CWA). While there was no CWA, the taxpayer claimed the deed itself satisfied the requirements. However, the deed did not note whether or not Liberty County offered "other good and valuable consideration" for the gift. The taxpayer said that this language was boilerplate and should be disregarded. However, the Tax Court noted that many contracts include boilerplate terms that are relevant to the interpretation of the contract. Therefore, the deduction is denied for lack of a CWA.

A second ground for denial is the requirement under Reg 1.170A-14(g)(5) that a Baseline Report be sufficient to enable the nonprofit to enforce the easement. The Brooks’ Baseline Report did not provide specifics about timber, open fields, special plant life and habitats. Therefore, it did not provide sufficient information to enable the nonprofit to enforce the claimed easement. While the Baseline Report may have been accurate, it was not adequate for that purpose. The Tax Court determined it was "woefully inadequate" and therefore did not qualify.

Third, the Brookses misstated their basis. They claimed the $1.35 million basis for the 85 acres was the correct basis for the 41 acres. Reg 1.170A-13(e)(4)(ii)(B) states the appraisal summary is required to report the cost basis. The actual cost basis for the 41 acres was $652,000 and therefore the IRS Form 8283 did not meet the requirement.

Because there was a substantial valuation misstatement, the 40% penalty applies to the underpayment of tax from the excess valuation.

Taxpayer expert Duane Miller claimed the highest and best use of the property would be for a subdivision development and based his valuation on an income approach. However, IRS expert George Petkovich valued the property based upon comparable sales. The Tax Court determined the appraisal of Miller was "incredible as a practical matter." Therefore, it determined that the correct value of $470,000 for the easement was set by the IRS appraiser Petkovich. Because the $5.1 million deduction was more than 200% of the $470,000 value, the 40% penalty was applicable.

The Fourth Circuit stated, "The issues before us are influenced by a gentle tension between a defined public policy of favoring, for the public good, perpetual conservation easements and the strict requirements imposed on taxpayers when claiming charitable deductions for granting such easements." The deduction was denied in part because documentation was “sloppy and inadequate”, but the primary problem was that there was no evidence to support the claim that property purchased for $652,000 could produce a $5.1 million deduction a year later.

Wildly Inflated Conservation Easement Deduction Denied

In Corning Place Ohio LLC et al. v. Commissioner; No. 12428-20; T.C. Memo. 2024-72, a partnership acquired a historic office building in Cleveland, Ohio and renovated it into luxury apartments. The partnership received approximately $9 million in state and federal credits as part of the renovation plan. Corning Place Ohio, LLC (Corning Place) granted a conservation easement on that property, claiming that it had "lost development rights" because it no longer could build a 34-story vertical addition on top of the historic building. The Tax Court held the 34-story tower "was a chimerical concept ginned up solely to support a wildly inflated appraisal." It sustained the disallowance of the charitable deduction and imposed a 40% penalty under Section 6662(h) for a gross valuation misstatement.

The Garfield Building is an 11-story building in Cleveland, Ohio and is on the National Register of Historic Places. A developer determined it could be rehabilitated into luxury residences and would qualify for approximately $9 million of state and federal preservation credits. Under the credit requirements the plan must meet the standard that "all new rooftop construction will be invisible from the ground."

The building was acquired by Corning Place in 2015 for $6 million. It sold approximately $6.6 million of tax credits to the Bank of America and used those funds to complete the renovations. The taxpayer also determined that it should be able to obtain a charitable tax deduction for a gift of a conservation easement. Appraiser Claud Clark III was hired to determine the value of the "lost development rights."

The Sandvick Architects firm was handling the construction and also prepared plans for a 34-story apartment tower placed on top of the Garfield Building. Mr. Clark appraised the lost development rights in the amount of $22,128,045.

The transfer of the deed of easement to the Historic Gateway Neighborhood Corporation, a qualified nonprofit, was on May 25, 2016. On July 7, 2016, Corning Place transferred a 10% interest and, thus, became a partnership.

The construction of a 34-story residential tower on top of the historic building would require at least 40 holes in each floor with support braces that would extend 130 feet below grade. The taxpayer and Sandvick obtained engineering statements that suggested the 34-story addition could be built.

However, the Tax Court determined the proposal "was nothing but a castle in the air ginned up to support a bogus valuation for a conservation easement." First, the tax credit plan prohibited the construction of any structures on the roof. In addition, there would be enormous damage to the building to build 40 vertical pillars sufficient to support the weight of a 34-story building on the roof of the Garfield Building. The evidence indicated that the owners and Mr. Clark worked together to develop a $22 million charitable deduction for the easement. The deduction was based on an income capitalization approach based on the assumption that all the apartments would be constructed, have a 95% occupancy rate and an above-average rental rate.

The taxpayer provided valuation expert Randall Dawson. At trial, he based his "lost development rights" appraisal on the initial information provided by appraiser Clark. He assumed there was a reasonable potential to build the 34-story building and disregarded the building purchase one year earlier for $6 million.

IRS appraiser Charles Brigden is co-author of a textbook on conservation and historic easements published by the Appraisal Institute. He stated the best valuation method was comparable sales and located five similar transactions. He determined that the conservation easement was valued at $800,000.

The IRS specified 10 specific grounds for denying the charitable deduction. The Tax Court determined that only one ground was necessary to deny the deduction. Corning Place was a single-member LLC until July 7, 2016. At that time, it became a partnership. The deduction claimed by the partnership was for a deed on May 25, 2016, but the partnership did not exist until July 7, 2016. The partnership claimed it filed a second amended return that corrected the error, but the amended tax return was not signed and there was insufficient evidence showing the error was corrected. Therefore, because the partnership was not qualified for a deduction for a deed transferred prior to its existence, the deduction was denied.

While the deduction was denied, valuation was essential to determine whether the 40% gross misstatement penalty applied. The "before" value was determined by the court to be the $6 million price paid 15 months prior to the easement deed. The taxpayer claimed that the $6 million cost was not a fair reflection of the airspace development rights. However, the Tax Court noted that a fee simple interest includes all rights. If the prior owner had thought that the air development rights were worth $22.6 million, it would not have sold the property for $6 million.

Therefore, the comparable sales approach of IRS appraiser Brigden was deemed the best determinant of value. There were five comparable sales, and those transactions suggested the $6 million value was correct. Taxpayer appraiser Dawson stated there was an insufficient number of sales of multifamily apartment complexes in the Cleveland area and therefore the sales comparison was not applicable. The Tax Court indicated this rationale made "no sense whatsoever." The typical comparable sale cost per square foot was approximately $25, while Mr. Dawson claimed the value of the building was $298 per square foot. Therefore, the comparable sale method was deemed the best for determining the value of the highest and best use (HBU).

It was also not even "reasonably probable" that a 34-story building could be constructed on top of the Garfield Building. The taxpayer did not prove that this was possible with the required structural engineering or financial feasibility.

The other assumptions with respect to the 34-story tower for construction cost and occupancy rate were also seriously in error. Given all the data, the Tax Court determined that the value of the conservation easement was $900,000. Because the claimed value of $22.6 million was more than 200% of the actual value, the 40% gross misstatement penalty applied. In addition, the taxpayer claimed $665,500 of easement expenses, but did not document these expenses. Therefore, these expenses were denied.

Editor's Note: This case is a good explanation of appraisal methodology. The Tax Court has handled a "deluge of conservation easement cases" and gathered significant expertise in appraisal methodology. This opinion is an excellent primer on appraisal methods.

Applicable Federal Rate of 5.2% for August: Rev. Rul. 2024-15; 2024-32 IRB 1 (16 July 2024)

The IRS has announced the Applicable Federal Rate (AFR) for August of 2024. The AFR under Sec. 7520 for the month of August is 5.2%. The rates for July of 5.4% or June of 5.6% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2024, pooled income funds in existence less than three tax years must use a 3.8% deemed rate of return. Charitable gift receipts should state, “No goods or services were provided in exchange for this gift and the nonprofit has exclusive legal control over the gift property.”


Published July 19, 2024

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