Members of both Parties joined the debate this week on income taxes. Without action by Congress, all of the tax reductions in the 2001/2003 tax acts will be phased out on January 1, 2011.

The White House has steadfastly maintained that the reductions for lower and middle-income brackets should be retained, while the reductions for the top brackets must be phased out. Under the White House proposal, individuals with incomes over $200,000 ($250,000 for married couples) would pay higher taxes. The top two brackets will increase to 36% and 39.6%. In addition, the White House proposes that the capital gains tax rate returns to 20%.

Senator Ben Nelson (D-NE) has expressed concern about the increase in taxes on upper income individuals. He is joined by Sen. Charles Grassley (R-IA), who has consistently supported extending all of the 2001/2003 tax brackets. Sen. Grassley suggested that it would be important to continue the tax reductions in order to encourage small business owners to hire new employees and reduce unemployment.

A long-term deficit hawk on the Democratic side is Senate Budget Committee Chair Kent Conrad (D-ND). He stated for the first time this week that he may be open to a temporary extension of the top brackets at the current 33% and 35% rate. Senator Conrad indicated that at some future time it will be necessary to "pivot" and move aggressively toward deficit reduction. However, he questioned whether the economy is strong enough to start the process of tax increases this year.

House Speaker Nancy Pelosi (D-CA) joined the debate with a strong affirmation of the White House position. She stated, "Our position has been that we support middle-income tax cuts. The tax cuts at the high end have increased the deficit enormously and they have not created jobs in the eight years."

Editor's Note: With Congress soon turning to the fall election, it is highly probable that action on income taxes will be deferred until after the election. With bipartisan concern about unemployment and the economy, it is quite likely that the tax reductions at the lower and middle brackets will be extended. The result for upper-income individuals is still uncertain.


Senate Refuses to Repeal Estate Tax

On July 21, 2010, Sen. Jim DeMint (R-SC) offered an amendment to the unemployment bill that would repeal the estate tax. Sen. DeMint noted that the White House is creating a difficult environment for "small businesses that are already facing higher income taxes and higher investment taxes."

The proposed amendment was defeated on a vote of 39-59. Democratic Senators Blanche Lincoln (D-AR) and Ben Nelson (D-NE) supported the abolition of the estate tax. Republican Senators Olympia Snowe (R-ME), Susan Collins (R-ME) and George Voinovich (R-OH) opposed the abolition of estate tax.

Sen. Lincoln and Sen. Jon Kyl (R-AZ) continue to advocate an estate tax compromise. Under the compromise, the $3.5 million exemption from 2009 would be increased over 10 years to $5 million and the top 45% estate tax rate would be reduced to 35% over that same time frame.

Editor's Note: The political pressure on the Senate continues to rise. Following the March death of Houston oilman Dan Duncan with a $9 billion estate, the news media noted that the government had lost $2 to $3 billion on that estate alone. When New York Yankees owner George Steinbrenner passed away with an estimated $1.1 billion estate, news media suggested that he hit a "home run" by dying in 2010 with no estate tax. While action is not likely before the election, there now seem to be two general patterns to a potential Senate compromise. First, the estate tax exemption will start at $3.5 million and increase to a higher number over ten years. Second, the estate tax rate will begin at 45% and decrease again over that same decade. The House majority has held strongly to a $3.5 million exemption and 45% top tax rate, so the final compromise would also need to reflect their preferences.


Donor Couple "Burned" by Denial of Deduction

In James Hendrix et al. v. United States; No. 2:09 cv.00132 (20 Jul 2010), a District Court denied a charitable deduction for a home given to a fire department that was destroyed as part of the fire training process.

In 2000, taxpayers James and Lori Hendrix bought a property at 2580 Sherwin Road in Upper Arlington, Ohio. In 2004, the couple decided to demolish the home and rebuild a new home on the lot. The estimated cost of demolition was $10,000.

Mr. and Mrs. Hendrix then had a creative idea. Rather than tear down the house, they would give the home to the local fire department for training and allow them to burn the house down. Following the destruction of the house, they would then rebuild a new home and would save the cost of demolition.

However, they also thought that they might receive a charitable deduction for the value of the destroyed structure. On June 11, 2004, they obtained an appraisal of the home and lot from appraiser Ann Ciardelli. She valued the home at $520,000. They transferred the home on June 29, 2004 to the local fire department. After the home was burned down by the fire department, it was returned to them on October 29, 2004. They then constructed the new home on the existing foundation.

Taxpayers claimed a charitable deduction in 2004 of $287,400. The IRS denied the deduction and assessed a deficiency of $100,590.

The court noted that under Sec. 170(f)(11)(C), the deduction needed to be supported by a qualified appraisal that is conducted by a qualified appraiser. The Ciardelli appraisal did not indicate the anticipated date of contribution, failed to disclose the terms between taxpayers and the fire department, failed to include the required qualifications of the appraiser and did not include the required statement that the appraisal was prepared for income tax purposes.

Taxpayers acknowledged the failings of the appraisal but claimed substantial compliance. The court indicated that the appraisal "wholly lacks even a modicum of content in critical areas to say that it substantially complies." While the court was not even willing to state that substantial compliance was a permissible ground for a deduction, it noted that the appraisal failed completely to meet the standard of substantial compliance.

Second, a deduction for a gift over $250 requires a contemporaneous written acknowledgement. Because there was no contemporaneous written acknowledgement under Sec. 170(f)(8)(A), the deduction was denied.

Editor's Note: The court did not reach the Sec. 170(f) partial interest issue. Even if the appraisal and contemporaneous written acknowledgement were appropriate, the gift of the home for fire training would fail to produce a deduction. A qualified deduction for a transfer of a home is permitted for an undivided interest to a charitable remainder unitrust, charitable remainder annuity trust or a gift of remainder interest. The gift of the home for fire department training is a nondeductible partial interest. As a result of the appraisal failure, the Hendrix' charitable deduction went up in flames.


Charitable Deduction Permitted But No Court Costs

In Consolidated Investors Group et al.v. Commissioner; T.C. Memo. 2010-158; No. 23703-06 (21 Jul 2010), the Tax Court refused to allow a partnership that had been awarded a charitable deduction for the litigation costs of that effort.

Consolidated Investors Group owned a property that was sought by the Ohio Transportation Commission (OTC) in an eminent domain proceeding. After negotiation between the parties, they settled for a payment of $950,000 from OTC to the partnership. However, the partnership valued the property through an appraisal at $1,591,000 and therefore claimed a $641,000 charitable contribution deduction.

The IRS and taxpayers contested the issue and the Tax Court determined that the deduction did qualify. Taxpayer now sues under Sec. 7430 to recover litigation costs.

The court noted that IRS appraiser Mr. Richard G. Racek valued the property at $953,671. While the court determined that the appraisal value was highly subjective and had accepted the taxpayers' higher appraisal, the IRS was reasonably entitled to rely on the Racek appraisal.

The partnership did present sufficient evidence to show an intention to create a part-charitable deduction and part-sale transaction. The partnership appraisal failed in several respects. It was not prepared within this 60-day period, did not show the date of the contribution, did not indicate the fair market value of the property on that date and did not contain a statement that it was prepared for income tax purposes. The court determined, under a substantial compliance theory, that the appraisal would be accepted.

However, with the reasonableness of the Racek appraised value and the obvious failures of the partnership to comply with appraisal formalities, the IRS position was justified. No litigation costs were awarded to the partnership.


Applicable Federal Rate of 2.6% for August – Rev. Rul. 2010-19; 2010-31 IRB 1 (18 July 2010)

The IRS has announced the Applicable Federal Rate (AFR) for August of 2010. The AFR under Sec. 7520 for the month of August will be 2.6%. The rates for July of 2.8% or June of 3.2% 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 2010, pooled income funds in existence less than three tax years must use a 4.6% deemed rate of return. Federal rates are available by clicking here.