Part III. Administrative, Procedural, and Miscellaneous

Charitable Contributions and Conservation Easements

Notice 2004–41

The Internal Revenue Service is aware that taxpayers who (1) transfer an easement on real property to a charitable organization, or (2) make payments to a charitable organization in connection with a purchase of real property from the charitable organization, may be improperly claiming charitable contribution deductions under § 170 of the Internal Revenue Code. The purpose of this notice is to advise participants in these transactions that, in appropriate cases, the Service intends to disallow such deductions and may impose penalties and excise taxes. Furthermore, the Service may, in appropriate cases, challenge the tax-exempt status of a charitable organization that participates in these transactions. In addition, this notice advises promoters and appraisers that the Service intends to review promotions of transactions involving these improper deductions, and that the promoters and appraisers may be subject to penalties.

Contributions of Conservation Easements

Section 170(a)(1) allows as a deduction, subject to certain limitations and restrictions, any charitable contribution (as defined in § 170(c)) that is made within the taxable year. Generally, to be deductible as a charitable contribution under § 170, a transfer to a charitable organization must be a gift of money or property without receipt or expectation of receipt of adequate consideration, made with charitable intent. See U.S. v. American Bar Endowment, 477 U.S. 105, 117–18 (1986); Hernandez v. Commissioner, 490 U.S. 680, 690 (1989); see also § 1.170A–1(h)(1) and (2) of the Income Tax Regulations.

Section 170(f)(3) provides generally that no charitable contribution deduction is allowed for a transfer to a charitable organization of less than the taxpayer’s entire interest in property. Section 170(f)(3)(B)(iii) provides an exception to this rule in the case of a qualified conservation contribution.

A qualified conservation contribution is a contribution of a qualified real prop

erty interest to a qualified organization exclusively for certain conservation purposes. Section 170(h)(1), (2), (3), and (4); § 1.170A–14(a). A qualified real property interest includes a restriction (granted in perpetuity) on the use that may be made of the real property. Section 170(h)(2)(C); see also § 1.170A–14(b)(2). For purposes of this notice, qualified real property interests described in § 170(h)(2)(C) are referred to as conservation easements.

One of the permitted conservation purposes listed in § 170(h)(4) is the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem. Section 170(h)(4)(A)(ii); see also § 1.170A–14(d)(1)(ii) and (3). Another of the permitted conservation purposes is the preservation of open space (“open space easement”), including farmland and forest land, for the scenic enjoyment of the general public or pursuant to a clearly delineated governmental conservation policy. However, if the public benefit of an open space easement is not significant, the charitable contribution deduction will be disallowed. See § 170(h)(4)(A)(iii); see also § 1.170A–14(d)(1)(iii) and (4)(iv), (v), and (vi). Section 170(h) and § 1.170A–14 contain many other requirements that must be satisfied for a contribution of a conservation easement to be allowed as a deduction.

A charitable contribution is allowed as a deduction only if substantiated in accordance with regulations prescribed by the Secretary. Section 170(a)(1) and (f)(8). Under § 170(f)(8), a taxpayer must substantiate its contributions of $250 or more by obtaining from the charitable organization a statement that includes (1) a description of any return benefit provided by the charitable organization, and (2) a good faith estimate of the benefit’s fair market value. See § 1.170A–13 for additional substantiation requirements. In appropriate cases, the Service will disallow deductions for conservation easement transfers if the taxpayer fails to comply with the substantiation requirements. The Service is considering changes to forms to facilitate compliance with and enforcement of the substantiation requirements.

If all requirements of § 170 are satisfied and a deduction is allowed, the amount of

the deduction may not exceed the fair market value of the contributed property (in this case, the contributed easement) on the date of the contribution (reduced by the fair market value of any consideration received by the taxpayer). See § 1.170A–1(c)(1), (h)(1) and (2). Fair market value is the price at which the contributed property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and each having reasonable knowledge of relevant facts. Section 1.170A–1(c)(2). See § 1.170A–14(h)(3) and (4) for a discussion of valuation.

If the donor (or a related person) reasonably can expect to receive financial or economic benefits greater than those that will inure to the general public as a result of the donation of a conservation easement, no deduction is allowable. Section 1.170A–14(h)(3)(i). If the donation of a conservation easement has no material effect on the value of real property, or enhances rather than reduces the value of real property, no deduction is allowable. Section 1.170A–14(h)(3)(ii).

Purchases of Real Property from Charitable Organizations

Some taxpayers are claiming inappropriate charitable contribution deductions under § 170 for cash payments or easement transfers to charitable organizations in connection with the taxpayers’ purchases of real property.

In some of these questionable cases, the charitable organization purchases the property and places a conservation easement on the property. Then, the charitable organization sells the property subject to the easement to a buyer for a price that is substantially less than the price paid by the charitable organization for the property. As part of the sale, the buyer makes a second payment, designated as a “charitable contribution,” to the charitable organization. The total of the payments from the buyer to the charitable organization fully reimburses the charitable organization for the cost of the property.

In appropriate cases, the Service will treat these transactions in accordance with their substance, rather than their form. Thus, the Service may treat the total of the

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similar organizations), and other interested parties.

In addition, from those that perform basis studies that are intended to comply with the requirements of Rev. Proc. 81–70, the following information is specifically requested: (i) descriptions of the sources of information, both historic and recent, available for use in performing basis studies; and (ii) descriptions of the methodologies utilized to determine the basis of stock held by persons that do not respond to requests for basis information.

From record keepers, the following information is specifically requested: (i) descriptions of the kinds of information that are maintained that may be used to perform basis studies and of the sources of this information; (ii) statements describing the length of time that this information is generally maintained and available for use; and (iii) descriptions of confidentiality concerns, if any, that may impair or delay a response to a basis inquiry.

Please submit all comments by September 30, 2004. Written comments should be sent to:

Internal Revenue Service Attn: CC:PA:LPD:PR

(Notice 2004–44) Room 5203 P. O. Box 7604 Ben Franklin Station Washington, DC 20044

Or hand delivered between the hours of 8 a.m. and 4 p.m. to:

Courier’s Desk Internal Revenue Service Attn: CC:PA:LPD:PR

(Notice 2004–44) 1111 Constitution Avenue, N.W. Washington, D.C. 20224

Alternatively, comments may be submitted electronically via e-mail to the following address: Notice.Comments@irscounsel.treas.gov. Please include “Notice 2004–44” in the subject line. All comments will be available for public inspection and copying in their entirety.

FOR FURTHER INFORMATION

For information regarding estimates and sampling techniques, please con

buyer’s payments to the charitable organization as the purchase price paid by the buyer for the property.

Penalties, Excise Taxes, and Tax-Exempt Status

Taxpayers are advised that the Service intends to disallow all or part of any improper deductions and may impose penalties under § 6662.

The Service intends to assess excise taxes under § 4958 against any disqualified person who receives an excess benefit from a conservation easement transaction, and against any organization manager who knowingly participates in the transaction. In appropriate cases, the Service may challenge the tax-exempt status of the organization, based on the organization’s operation for a substantial nonexempt purpose or impermissible private benefit.

In addition, the Service intends to review promotions of transactions involving improper deductions for conservation easements. Promoters, appraisers, and other persons involved in these transactions may be subject to penalties under §§ 6700, 6701, and 6694.

DRAFTING INFORMATION

The principal author of this notice is Patricia M. Zweibel of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this notice, contact Ms. Zweibel at (202) 622–5020 (not a toll-free call).

Request For Comments Regarding Rev. Proc. 81–70, 1981–2 C.B. 729

Notice 2004–44

Section 368(a)(1)(B) of the Internal Revenue Code defines as a reorganization the acquisition by one corporation, in exchange solely for all or part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition) (a B reorganization).

Section 362(b) generally provides that the basis of property acquired by a corporation in connection with a reorganization shall be the same as it would be in the hands of the transferor. Therefore, the acquiring corporation’s basis in the stock acquired in a B reorganization is determined by reference to the basis of the former shareholders in such stock.

In Rev. Proc. 81–70, 1981–2 C.B. 729, the Internal Revenue Service set forth guidelines for estimating the basis of stock acquired by an acquiring corporation in a B reorganization. That revenue procedure permits the acquiring corporation in a B reorganization to apply certain statistical sampling techniques to determine its basis in the acquired stock. The guidelines reflect the recognition that the information needed by the acquiring corporation to establish the basis of the acquired corporation’s stock is in the possession of the former shareholders of the acquired corporation, who may not respond to basis inquiries. They also reflect the recognition that, in certain cases, it may be time consuming, burdensome and costly for the acquiring corporation to contact each former shareholder of the acquired corporation.

The Service is concerned that changes in the marketplace since Rev. Proc. 81–70 was issued may have rendered compliance with its requirements for statistical sampling unduly burdensome or impossible and that, therefore, taxpayers are not complying with those requirements. For example, the Service understands that the way stock is held today may prevent or hinder access to the information necessary to determine the shareholder’s basis in such stock.

A number of commentators have suggested that the Service revise Rev. Proc. 81–70. The Service requests comments regarding problems taxpayers are encountering in their effort to comply with the requirements of Rev. Proc. 81–70 and whether it should be modified.

The Service particularly seeks comments from those who perform basis studies that are intended to comply with the requirements of Rev. Proc. 81–70, those engaged in providing services and information to the investment community (including those who maintain custodial information that may be used in such studies, such as broker/dealers, banks, and

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Employer. V.I.LLP typically treats these payments for tax accounting purposes either as guaranteed payments for services or as distributions of Taxpayer’s allocable share of partnership income. Under this arrangement, the promoter may be a general partner in V.I.LLP and may retain a percentage of the fees received from Employer.

V.I.LLP either has or secures a reduction, up to 90 percent, in USVI income tax liability under the Economic Development Program (EDP) of the USVI. Taxpayer takes the position that the EDP benefits granted to V.I.LLP provide a corresponding reduction in the income tax liability that Taxpayer reports on his or her USVI income tax return with respect to guaranteed payments from the partnership or distributive shares of the partnership’s net income, or both. Taxpayer pays tax to the USVI in an amount approximately equal to 10% of the U.S. income tax liability that otherwise would be imposed on Taxpayer’s income from performing the services. Taxpayer claims that, for purposes of computing his or her U.S. income tax liability, gross income does not include guaranteed payments received from V.I.LLP or Taxpayer’s distributive share, if any, of the partnership’s net income, or both.

Positions Promoted

In situations such as those described above, as well as in other situations, the following highly questionable positions are being promoted:

—“You can continue to live and work in the United States and, nev- ertheless, be a bona fide resident of the USVI.” The concept of a “ bona fide resident of the Virgin Islands” was an integral part of the predecessor to § 934(b), and as such, its meaning has been well established. See § 934(c) as enacted by P.L. 86–779, §4(a) (1960). When Congress enacted the current versions of §§ 932 and 934(b), it retained this concept, but noted that Treasury has the authority to modify its meaning when necessary to prevent abuse. See H.R. Rep. No. 99–426 (1985) and General Explanation of the Tax Reform Act of 1986, JCS–10–87 (1987) (“Similarly, where appropriate, the Secretary may treat an individual as not

tact Edward Cohen at (212) 719–6693 (not a toll-free call). For further information regarding this notice generally, please contact George Johnson or Reginald Mombrun at (202) 622–7930 (not a toll-free call).

Meritless Filing Position Based on Sections 932(c) and 934(b)

Notice 2004–45

The Internal Revenue Service is aware that certain promoters are advising taxpayers to take highly questionable, and in most cases meritless, positions described below in order to avoid U.S. taxation and claim a tax benefit under the laws of the United States Virgin Islands (USVI). Promoters may also be advising taxpayers to take similar positions with respect to other U.S. possessions. This notice alerts taxpayers that the Service intends to challenge these positions in appropriate cases. The Service may impose civil penalties on taxpayers or persons who participated in the promotion or reporting of these positions. In addition to being subject to other penalties, any person who willfully attempts to evade or defeat tax by means of an arrangement such as the one described in this notice, or who willfully counsels or advises such evasion or defeat, may be guilty of a criminal offense under federal law.

Background

Section 934, which was enacted in 1960, provides that the USVI may reduce its territorial income tax only in certain limited cases. The USVI may not, however, reduce the tax liability of U.S. citizens or residents who are not bona fide residents of the USVI. In the case of U.S. citizens or residents who are bona fide residents of the USVI, it may reduce their tax liability only with respect to income from sources in the USVI or income effectively connected with the conduct of a trade or business within the USVI.

The legislative history of § 934 indicates that the statute was enacted in part because of concerns that certain local income tax programs, which were intended to provide incentives to corporations and USVI residents that made new investments in the USVI, were having the effect of

reducing the tax liability attributable not only to income from sources within the USVI but also to income from sources within the United States. While recognizing the goal of encouraging economic development in the USVI through appropriate income tax reductions, the legislative history to § 934 indicates that

in no case should this [goal] be attained by granting windfall gains to taxpayers with respect to income derived from investments in corporations in the continental United States, or with respect to income in any other manner derived from sources outside of the Virgin Islands. S. Rep. No. 1767, 86 ^th Cong., 2nd Sess. 4 (1960).

Typical Promotion

The highly questionable positions described in this notice may be promoted to taxpayers in a variety of forms. The Service is aware, however, that they have frequently been promoted in the following manner:

Promoters typically approach a taxpayer (Taxpayer) living and working in the United States and advise Taxpayer to (i) purport to become a USVI resident by establishing certain contacts with the USVI, (ii) purport to terminate his or her existing employment relationship with his or her employer (Employer) and (iii) purport to become a partner of a Virgin Islands limited liability partnership (“V.I.LLP”) that is treated as a partnership for U.S. tax purposes. V.I.LLP then purports to enter into a contract with Employer to provide Employer with substantially the same services that were provided by Taxpayer prior to the creation of this arrangement. Typically, after entering into the arrangement, Taxpayer continues to provide substantially the same services for Employer that he or she provided before entering into the arrangement, but Taxpayer is nominally a partner of V.I.LLP instead of an employee of Employer.

Under this arrangement, Employer makes payments to V.I.LLP for Taxpayer’s services and no longer treats the payments as wages paid to Taxpayer subject to the withholding and payment of employment taxes and reporting on Taxpayer’s Form W–2. V.I.LLP, in turn, makes payments to Taxpayer for his or her services to

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grants limited authority to the USVI to reduce the USVI tax liability with respect to income from USVI sources or income effectively connected with a trade or business within the USVI. The use of the term “effectively connected with the conduct of a trade or business” in § 934 indicates that Congress generally intended for the rules under § 934 to follow the well-established rules that apply for purposes of determining the taxation of nonresidents, such as the definition of effectively connected income under § 864(c). Section 934(b)(4), however, provides Treasury with the authority to issue regulations providing an alternative definition of the term. The legislative history of § 934 makes clear that this grant of regulatory authority was for the purpose of preventing abuse, and that Congress anticipated that it would be used to provide further limitations on the type of income that would be treated as from USVI sources or as effectively connected with the conduct of a trade or business within the USVI. S. Rep. No. 99–313, at 484, 1986–3 C.B. (vol. 3) 484. Taxpayers have no legal basis for claiming that the scope of the term “income effectively connected with the conduct of a trade or business” is broader under § 934 than it is under § 864. In particular, taxpayers have no legal basis for disregarding the rules of § 864(c)(4), which generally limit the amount of foreign source income that is treated as effectively connected with a U.S. trade or business to certain, very narrow categories of income. Accordingly, with the exception of those narrow categories, and in the absence of regulations to the contrary, income, gain, or loss from sources without the USVI cannot be treated as effectively connected with the conduct of a trade or business within the USVI for purposes of § 934. For example, income from the performance of personal services without the USVI cannot under any circumstances be treated as effectively connected with the conduct of a trade or business within the USVI. Promoters typically interpret the phrase “effectively connected to the conduct of a trade or business within the USVI” broadly, and inconsistently with § 864(c)(4), in order to claim a

a bona fide resident of the Virgin Islands.”) The determination of whether an individual is a bona fide resident of the USVI turns on the facts and circumstances and, specifically, on an individual’s intentions with respect to the length and nature of his or her stay in the USVI. See § 1.934–1(c)(2) (generally applying the principles of §§ 1.871–2 through –5). Promoters typically represent that a taxpayer need not make major lifestyle changes in order to become a bona fide resident of the USVI, and may represent that the taxpayer need only spend a few weeks or less out of the year in the USVI to become a resident for income tax purposes. These representations, however, have no basis in the well-established meaning of the term “ bona fide resident of the Virgin Islands.” Accordingly, a claim of USVI residency for income tax purposes may be considered without merit or fraudulent when the taxpayer continues to live and work in the United States.

—“USVI source income includes income from services performed in the United States.” The principles that generally apply for determining gross and taxable income from sources within and without the United States (in particular, the rules of §§ 1.861–1 through 1.863–5) also generally apply in determining gross and taxable income from sources within and without a possession of the United States. See § 1.863–6 and Francisco v. Commissioner, 119 T.C. 317 (2002) aff’d, No. 03–1210 (D.C. Cir. June 18, 2004). With certain limited exceptions, compensation for labor or personal services performed in the United States is gross income from sources within the United States. See § 861(a)(3) and § 1.861–4(a)(1). The result does not change if the compensation is received in the form of a guaranteed payment from a partnership rather than in the form of a fee for services under an employment contract. See Miller v. Commissioner, 52 T.C. 752 (1969), acq. 1972–2 C.B. 2. Promoters typically claim that taxpayers are free to argue, under a variety of theories, that income from services performed in the United States constitutes income from USVI sources because “no rules exist under section 934” for determining whether income is from USVI

sources. Based on the foregoing discussion, however, such arguments are without merit.

—“For purposes of determining the source of income, USVI includes the United States.” Section 932 provides coordination rules for filing of returns for U.S. and USVI income taxes by bona fide residents of the USVI and U.S. citizens and residents who have income derived from sources within the USVI or income effectively connected with the conduct of a trade or business within the USVI. To facilitate this coordination, § 932(c)(3) states that the USVI includes the United States for certain tax purposes. Section 932(c)(3) was modeled after § 935(c), which was enacted fourteen years earlier and which provides an equivalent rule with respect to Guam. For an illustration of the types of purposes for which these provisions apply, see § 1.935–1(c)(1)(ii). Notably, these provisions do not apply for purposes of determining the source of income. See H.R. Rep. No. 92–1479, 92d Cong., 2d Sess. 5 (Oct. 2, 1972) (“In determining the source of income for purposes of the special tax system provided in the bill (new code sec. 935), the principles contained in secs. 861–863 are to be applied without reference to sec. 935(c).”) Based on an incorrect reading of § 932(c)(3), promoters may claim that compensation for services performed in the United States is considered for tax purposes to be compensation for services performed in the USVI. This claim is without merit. Section 932 does not apply to determine the source of income on which the USVI tax liability of bona fide residents may be reduced under § 934(b)(1). Thus, § 932(c)(3) does not operate to transform compensation from the performance of personal services in the United States into income from sources in the USVI.

—“Non-USVI source income can be treated as effectively connected with the conduct of a trade or busi- ness within the USVI even if, under equivalent circumstances, such in- come would not be considered effec- tively connected with the conduct of a trade or business within the United States.” As noted above, § 934(b)(1)

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§ 6701. In addition to other penalties, any person who willfully attempts to evade or defeat tax by taking the positions described in this notice, or who willfully counsels or advises such evasion or defeat, may be guilty of a criminal offense under §§ 7201, 7203, 7206, or 7212(a) or other provisions of federal law. Promoters and others who assist taxpayers in taking these positions also may be enjoined from doing so under § 7408.

The principal author of this notice is W. Edward Williams of the Office of Associate Chief Counsel (International). For further information regarding this notice, contact W. Edward Williams at (202) 622–3295 (not a toll-free call).

tax reduction with respect to income from non-USVI sources. As indicated above, however, these interpretations have no merit. The IRS intends to challenge these positions and other similar claims that disregard the statutory and regulatory provisions concerning the limitations on the reduction of USVI income tax. Where taxpayers in order to make these claims enter into arrangements such as the one described in this notice, the Internal Revenue Service may disregard such arrangements on the grounds that they lack economic substance or that they have no purpose other than tax avoidance or evasion. The Service also may assert that the arrangement does not serve to terminate the em

ployment relationship between a taxpayer and Employer for federal employment tax purposes, with the result that Employer remains liable for employment taxes and applicable penalties and interest.

In addition to liability for tax due plus statutory interest, taxpayers that claim to have no requirement to file a federal income tax return or pay federal income tax liability based on the positions described herein may be subject to penalties including, but not limited to, the accuracy-related penalty under § 6662, failure to file or pay penalties under § 6651 and civil fraud penalties under § 6663. Further, persons who participate in the promoting or reporting of these positions may be subject to aiding and abetting penalties under

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