Originally published on Forbes.com.
Billionaire Stephen Ross, owner of the Miami Dolphins, who thanks to a $200 million donation (largest in the history of the school) was described as Leader, Visionary, Philanthropist, Wolverine by the University of Michigan is inherently more interesting than filling out Form 8283 properly, so I will lead with his part of the story in the Tax Court’s recent decision RERI Holdings I, LLC. Don’t forget about the form, though because we have here another illustration of Reilly’s Fourth Law of Tax Planning -Execution isn’t everything, but it’s a lot.
About Stephen Ross
Stephen Ross with a net worth of $7.4 billion is number 58 in the Forbes 400 and number 186 in the list of the world’s billionaires. He is a big-time New York real estate developer. His current project, Hudson Yards, does not sound like that big a deal when you consider that it is 28 acres, but given that that 28 acres will be more or less an expansion of midtown Manhattan, it is really something. Location, location, location. Quite interesting to me is that Mr. Ross got his start in real estate based on his knowledge of federal tax garnered as a tax attorney for Coopers and Lybrand. His first deals were affordable housing deals. That business was very tax-driven. What is really extraordinary is a tax attorney becoming a developer and succeeding. Usually, when people in the ancillary trades dive into development, they go broke. I have to wonder whether the name of his flagship Related Companies is a tax geek joke.
What Was Donated
As noted, Mr. Ross is a big supporter of the University of Michigan. And it is a donation to UM that is the subject of the decision. You have to dip into a prior decision in the same case to see Mr. Ross. What was being donated was a Successor Member Interest (SMI) in an entity that owns land and building in Hawthorne, CA leased to AT&T as a data center. When the building was acquired by Red Sea Tech I it created H.W. Hawthorne Holdings, LLC. The building’s purchase price of $42,350,000 was 100% financed by Branch Banking & Trust Co. The final balloon payment on the mortgage of $11.8 million corresponded with the end of the initial term of the AT&T net lease in May 2016. AT&T had three renewal option of 5 years each.
Of course, that is not complicated enough. There were two interests in Holdings. One was for a term of years and the other was the Successor Member Interest that kicked in in 2021 around when AT&T would have its second renewal option if it exercised its first one. RERI bought the SMI for $2,950,000 in March of 2002. One of the appraisals that was used in the case is available online. It gives more detail on the transactions involved. The cash flow net of expenses was roughly equal to the debt service. There was also an insurance policy to guarantee the payment of the balloon. In the event the insurance company paid the balloon, it got the building.
The SMI was something of a bet in 2002 on what circumstances would be in 2016. If AT&T did not renew the lease and the specialized building, which went up in 1963, did not have an alternative use that justified a value over $12 million, the SMI would be worthless. We here in 2017, of course, have the benefit of hindsight and can see that it worked out pretty well. Red Sea Group sold the data center for $79.5 million to Carter Validus Mission Critical REIT in 2016. That didn’t do the Wolverines any good, as we will see.
Given that the Holdings had, in principle, zero equity in the building at that point in time nearly $3 million seems like a pretty nice sum. That’s why we have capital markets, I guess.
The Gift
Mr. Ross had pledged $4 million (later raised to $5 million) for a University of Michigan athletic center. RERI’s donation of the SMI was done under an agreement that provided that there would be a $1 nominal credit to the pledge, that the University would hold the interest for two years and then sell it crediting Mr. Ross’s pledge with whatever was received for the interest. The appraised value of the SMI used for charitable donation purposes was $32,935,000.
Wash Rinse Repeat
After the two years went by UM sold the interest as contemplated. Despite an appraisal of $6.5 million, UM received only $1.94 million from HRK Real Estate Holdings, LLC, which was owned indirectly “by petitioner and one of his associates” (This is ambiguous. I don’t know if they mean RERI, Mr. Ross, or Howard Levine the Tax Matters Partner). HRK had presold the interest to another individual for $3 million. That individual donated the property and took a charitable contribution of nearly $30 million.
So now using round numbers, the partners in RERI (mainly Mr. Ross apparently) bought something for $3 million and gave it to UM. People they knew bought the item from UM a couple of years later for $2 million and sold it to somebody else for $3 million. That puts the related crew out of pocket $2 million which is what went to UM. For that somebody, probably mostly Mr. Ross, gets a charitable deduction of $32,935,000.
According to a footnote in one of the decisions, this was not an isolated transaction:
As a result of petitioner’s donation of the SMI to the University and other donations of similar successor member interests in other LLCs arranged by Mr. Ross, the University derived sale proceeds of $4,276,604, which it credited to Mr.Ross’ $5 million pledge. Respondent alleges that, in at least some of those cases, the amounts realized by the University on its sales of the donated successor remainder member interests were far less than the appraisal thereof for which the donor, presumably, claimed a sec. 170 deduction.
One of the things that is disturbing to me is that it seems likely that the University development people must have been aware that these shenanigans were going on. If so, at least these transactions are not philanthropy. They are]a tax scam out of which the University gets a cut.
The Valuations
The fig leaf that was applied to this naked tax grab was Code Section 7520 and the related regulations which give instructions on how to value remainder interests. The Court found that the 7520 rates are meant to value things that are a good bit more certain than the SMI interest was in 2002.
…because of the limitation on remedies available to the holder of the remainder interest for breaches of protective covenants, the agreement that created that interest did not provide adequate protection to its holder, for purposes of sec. 1.7520-3(b)(2)(iii), Income Tax Regs.; the standard actuarial factors provided under sec. 7520 thus do not apply in valuing the remainder interest; instead, the value of that interest is its “actual fair market value”, determined without regard to sec. 7520, on the basis of all of the facts and circumstances. Sec. 1.7520-3(b)(1)(iii), Income Tax Regs.
The discussion of the appraisals in the the final decision is rather mind numbing. Thankfully, Judge James Halpern boils it down for us. (I’m thinking his bachelors from Wharton might be paying off).
Appraiser 2021 Cashflow Growth% Discount% SMI Value
Mr. Myers $8,107,588 3 11.01 $16,550,000
Dr. Cragg 6,663,522 3.29 18.99 2,090,000
Mr. Abraham 6,586,595 2.5 16.44 3,382,000
A future interest such as the SMI is extremely sensitive to the discount rate selected. I would have thought that the price at which the interest was bought and sold within a couple of years was a pretty good indication of its value, but I guess they needed an opportunity to show off their math skills.
But The Value Didn’t Matter Mostly
The valuation discussion was only relevant to determine whether there would be a 20% accuracy penalty or a 40% accuracy penalty. Since $33,019,000 is more than 400% of $3,462,886, the 40% accuracy penalty will apply. How much the penalty actually turns out to be will depend on what kind of a year Mr. Ross and his compatriots had overall in 2003, since the penalty applies to the extent that the transaction created an understatement of tax of greater than 10%.
The reason that the deduction gets entirely disallowed, rather than just reduced by $30 million, is rather mundane. If you study Form 8283, you will note that it asks you when and how your acquired the donated property and what your basis is. That part of the form was not filled out thoroughly.
The Form 8283 appraisal summary that RERI attached to its 2003 return indicates that it acquired the SMI by purchase on March 22, 2002. It shows no amount in the space provided for the “Donor’s cost or other adjusted basis”.
If you are giving away something you inherited from your great grandfather, it is understandable that you might not have a good handle on the basis, but something purchased a little more than a year ago should not be that challenging. Given the large difference between basis and value claimed, the Tax Court was not inclined to give a “substantial compliance” “No harm. No foul.” sort of break to the taxpayer.
Reflections
Although charitable deductions are there to encourage contributions, people are not supposed to come out ahead by making them. They need to be giving something up. In this instance, though, we see a taxpayer looking to score a huge savings, while giving his alma mater something like a good tip for playing along. From a policy viewpoint, the thing to look at might be a limitation or elimination of charitable deductions for unrealized gain. That would also put a break on the abuse in the conservation easement area. The other thing that is troubling is the effort, energy and brainpower that goes into financial engineering that does not appear to create any value for the real economy. The SMI, which was really worth something, was created out of thin air through the interaction of a lease, financing and insurance. That it was used as currency to create $60 million in phony tax deductions just makes it worse.
There are more details related to this story which I hope to share in a future post, but that is enough for now.
Other Coverage
KPMG had a brief summary of the decision, as did CCH. Lew Taishoff had Don’t Give A Sham-Redivivus referring to his previous posts on the previous decisions Don’t Give a Sham and Don’t Give a Sham – Part Deux. Mr. Taishoff is a real aficionado of the Tax Court, rather than a sensationalist tax blogger, but he does not miss much. So in the second of three posts he notes:
And I note in passing that the donor is well-known New York City real estate entrepreneur Steven Ross, head of The Related Companies, builder of the Time-Warner Center, which “has transformed Columbus Circle into one of New York’s premier destinations”. Mr. Ross is also a major donor to the University of Michigan.
Wealth Strategies Journal also had something.
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