This talk is based on Internal Revenue Code §170(f)(8), Charitable Contributions. A recent case in the US Tax Court is presented to show what needs to be done in order to ensure the IRS will accept deductions for Charitable Contributions on tax returns.
July 10, 2017 Ohde v. Commissioner
(Commissioner = IRS)
In this case, Mr. and Mrs. Ohde filed their prior year tax return with a Schedule A.
Schedule A is the form that is used by taxpayers to report itemized deductions, which can help reduce an individual’s federal tax liability. One of the items on the form is gifts to charity. As long as the donation is given to a registered charity, the donation can be “written off” and “credited” to your tax return to reduce your overall tax burden.
However, there are certain requirements that must be met before the deduction can be definitively allowed according to the IRS regulations. What’s more, if the charitable deductions are denied, the taxpayers can face an accuracy penalty. Our goal is to show what went wrong in this particular Tax Court case so that our readers can properly substantiate significant charitable contributions and avoid any disallowance in the event of an IRS audit.
The Ohde Case
Mr. and Mrs. Ohde resided in West Virginia, and claimed a contribution deduction of $145,250 for gifts to Goodwill “other than by cash or check.” They reduced their taxable income by that amount on their individual tax return (1040).
The IRS later audited their tax return and challenged the deductions. They disallowed the charitable contributions and assessed an accuracy-related penalty. The Ohdes went to Tax Court in July of 2017, and did not prevail. The Court found a problem with the way they “substantiated” their charitable deductions, which opened the door to the penalties.
Goodwill is a charitable organization tax exempt under section 501(c)(3). Petitioners [the Ohdes] allegedly made dozens of separate trips from their home in Shepherdstown, West Virginia, to deliver these items to Goodwill. In terms of claimed dollar value, roughly half of petitioners’ alleged gifts consisted of clothing and accessories. In this category petitioners during 2011 allegedly gave Goodwill (among other things) 1,040 items of boys’ clothing, 811 items of girls’ clothing, 658 items of men’s clothing, and 945 items of women’s clothing. In the furniture category petitioners allegedly gave Goodwill (among other things) 115 chairs, 36 lamps, 22 bookshelves, 20 desks, 20 chests of drawers, 16 bedframes, and 14 filing cabinets. And they allegedly gave Goodwill 3,153 books. We did not find petitioners’ testimony on any of these points credible."
What went wrong?
According to the Internal Revenue Code, Deductions are a matter of legislative grace; taxpayers must demonstrate their entitlement to deductions allowed by the Code and substantiate the amounts of claimed deductions.
§170 allows as a deduction any contribution made within the taxable year to a charitable organization. Such deductions are allowable “only if verified under regulations prescribed by the Secretary.” [Note:’Secretary’ and ‘Commissioner’ mean ‘The IRS.’]
In other words, the reason that the Ohdes lost their case wasn’t because the Court found the deductions to be excessive or unlikely just by looking at the numbers. In Tax Court, the burden of proof is generally on the petitioner to prove his claim (unless it is a criminal or fraud case). The problem here is that they were not able to prove the contributions because they didn’t properly substantiate them.
In order to protect yourself from losing charitable contribution claims during an IRS audit, you must substantiate well. Let’s go further into the case and §170 to learn more:
Reliable Written Records
According to §170
For all contributions of property, the taxpayer must maintain reliable written records with respect to each item donated. These records must include:
- the name of the donee
- the date and location of the contribution
- a description of the property in detail reasonable under the circumstances (including the value of the property)
The taxpayer must also maintain records to establish:
- the fair market value of the property at the time the contribution was made
- the method utilized in determining the fair market value
For all contributions valued at $250 or more, the taxpayer must obtain a “contemporaneous written acknowledgment” (CWA) from the donee. The CWA must include (among other things) “a description (but not value) of any property other than cash contributed.” In the absence of a CWA meeting the statute’s requirements, “no deduction shall be allowed.”
Additional substantiation requirements are imposed for contributions of property with a claimed value exceeding $500.
Still more rigorous substantiation requirements are imposed for contributions of property with a claimed value exceeding $5,000. “Similar items of property” must be aggregated in determining whether gifts exceed the $500 and $5,000 thresholds. For purposes of determining thresholds, property and all similar items of property donated to 1 or more donees shall be treated as 1 property.
For contributions of property valued in excess of $500, the taxpayer must include with his return “a description of such property and such other information as the Secretary may require.” The Secretary has prescribed regulations requiring that the taxpayer maintain records establishing “the manner of acquisition” of the property (e.g., by purchase, gift, or inheritance), the approximate date of the property’s acquisition, and the cost or adjusted basis of the property.
For contributions of property (other than publicly traded securities) or similar items of property valued in excess of $5,000, the taxpayer must “obtain a qualified appraisal of such property.” He must also attach to his return a fully completed “appraisal summary.” The IRS has prescribed Form 8283 to be used as an “appraisal summary.”
Main points in plain English:
Donated property worth $250 or more – a contemporaneous written acknowledgement with a description of donated property is required (ie. a receipt with full details)
Donated property worth $500 or more – records must contain a description of how the property was acquired, the date of the acquisition, and cost or adjusted basis of the property
Donated property worth $5,000 or more – a qualified appraisal must be attached to the tax return using form 8283 as an appraisal summary
Total charitable deduction claim over $5,000 – similar items of property are lumped together to determine if the value is over the $500 or $5,000 threshold, requiring the detailed records or appraisal, even if they are donated to more than one donee.
Again, What went wrong?
The petitioners had used Turbo Tax to self-file their 2011 tax returns. The software produced a spreadsheet listing the types of items delivered to Goodwill on each trip, and the quantity and quality of each item. The problem with this spreadsheet is that it was not CONTEMPORANEOUS according to the regulations, and that is what rendered them NOT credible. ‘Contemporaneous’ means that a log or journal is being kept and entries are made as they happen. This Turbo Tax spreadsheet is generated when the tax return is being created and filed, based on information that the user inputs into the software during the preparation of that return. It is not a valid way of recording actions [contributions] as they are actually happening.
That spreadsheet did not show an individual value for any of the items donated by the Ohdes — only an aggregate figure for the thousands of items allegedly delivered to Goodwill on a particular trip. The Court cited that many of those aggregate dollar figures are “suspect on their face” — for example, on four occasions the Ohdes allegedly delivered to Goodwill items with an aggregate value of exactly $5,000.
The Goodwill receipts themselves do not describe the specific items contributed or indicate the number of items of any particular type. Rather, they simply state that the items
delivered (allegedly numbering in the thousands) fell into one or more of five general categories: clothing, shoes, media, furniture, or household items. This is not an adequate description of any property contributed. They didn’t list the individual value of each item and it was impossible to make the calculation required to aggregate any one category to arrive at a specific dollar amount.
The contemporaneous issue is so important because although one can note the unlikelihood of 20,000 items being donated in one year, the fact that the records were not contemporaneous is the fact that supported the contention that the claim was far fetched, [statistically] unlikely, and false.
Accuracy – Related Penalty
As we see, the charitable claim didn’t meet the contemporaneous requirement, so it wasn’t allowed. The problem doesn’t stop there, however. According to §6662, The IRS can impose a 20% penalty upon the portion of any underpayment attributable to (among other things) negligence or disregard of rules or regulations. The Ohdes claimed a $145,250 charitable deduction. ($145,250 X 20%) = a penalty assessment of $29,050.
The Ohdes were assessed an accuracy penalty assessment of ($145,250 X 20%) = $29,050
§6662 further explains that the term “negligence” includes any failure to make a reasonable attempt to comply with the tax laws, and “disregard” includes any careless, reckless, or intentional disregard. Negligence also includes any failure to keep adequate books and records or to substantiate items properly.
Burden of Proof
Earlier we mentioned that the burden of proof generally lies on the taxpayer (petitioner) in Tax Court, unless the case involves fraud or a financial crime. This is also true with regards to penalties. In cases where the IRS assesses a penalty against an individual, §7491(c) places on the Commissioner the burden of production, thereby requiring the IRS to come forward with sufficient evidence indicating that imposition of a penalty is appropriate. Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). Once the Commissioner meets his burden of production, the taxpayer bears the burden of proving that the IRS’ determination is incorrect.
In the Ohde case, the Court found that the IRS satisfied the burden of production requirement by showing that petitioners failed to keep adequate records. They could not then prove the accuracy of the deductions, which weighed against their favor.
§6664 provides an exception to the imposition of the accuracy related penalty if the taxpayer establishes that there was reasonable cause for, and that he acted in good faith with respect to, the underpayment. The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Circumstances that may signal reasonable cause and good faith “include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.”
Had the Ohdes used a reputable tax professional instead of a self-preparing software like Turbo Tax, they could have relied on him or her and had the opportunity for protection from the penalty through reasonable cause. Self-preparing your own tax return does not make reasonable cause feasible or likely.
Hiring a reputable tax professional to prepare and file your tax return helps avoid accuracy related penalties.
The Tax Court found the following with regards to the Ohde Case:
The assertion that they donated more than 20,000 items to Goodwill in a single year is implausible on its face and was unsupported by any credible testimony or other reliable evidence.
They kept no contemporaneous records establishing the number of items actually donated or the values of such items.
They do not contend that they relied on the advice of a competent tax professional in claiming a charitable contribution deduction of $145,250.
They were negligent in preparing their 2011 return
No portion of their 2011 underpayment met the “reasonable cause” exception.
When claiming charitable deductions on your tax return, be very careful to keep adequate records. Be sure that you keep all your receipts, and record them contemporaneously as you make each donation throughout the year. This could be done in a simple notebook or in software designed for keeping records. Don’t rely on do-it-yourself tax software to record the reciepts as you prepare the return for e-filing, because that is not considered reliable records according to the Internal Revenue Code standards. Be certain that you include a description of all the properties you donate, what you paid for them, how they were acquired by you, what the basis is and how it was calculated. Keep all of this information for each item donated, regardless of how much it is worth. You may need to aggregate items at the end of the year and it is best to be thorough so that there is no question later so you can prove that you are diligently and honestly keeping contemporaneous records.
Using a self-preparing tax software can be useful to e-file taxes quickly at home, but it does not protect you in the event of an audit for the purposes of a reasonable cause exception. Saying “I didn’t know” will not work because you would have had to rely on a professional’s advice to qualify for relief.
For record keeping software, we highly recommend xero. It is powerful, easy to use, and our favorite accounting software, but you can use any electronic record keeping system that can accomplish these objectives. Just make sure you do it!
It goes without saying that we advise you to hire a tax professional if you have any charitable contributions or anything outside the simplicity of a 1040 form with no added schedules. We would like to be that professional! We can help you with all types of taxes, and get you a discount on xero software, and show you how to use it.
For more information, give us a call at (866) 675-1040, or use the contact form to send us a message.
Happy Charitable giving!