How a $3.4M gift to the University of Michigan ended up in tax court

On his way to becoming the University of Michigan's largest donor, Stephen M. Ross and a group of business partners donated a collective gift to his alma mater.

In return, the partnership claimed a giant charitable tax deduction: $33 million.

The Internal Revenue Service didn't buy it.

IRS lawyers flagged Ross and his partners as engaging in a "tax avoidance scheme lacking in economic substance … to the benefit of Mr. Ross and his associates at Related Companies.”

It would take nearly a decade of legal wrangling before U.S. Tax Judge James S. Halpern sided with the IRS last month and disallowed the entire $33-million write-off that the judge valued at a more paltry $3.4 million. The judge also imposed maximum civil penalties for a "gross valuation misstatement" that could now cost Ross and his partners millions more.

“I think this transaction was grossly abusive, and the court decided that in imposing the highest non-criminal penalty that can be imposed on a taxpayer,” said Brian Galle, law professor at Georgetown University Law Center.

Tax law experts expressed shock at the large difference between how much Ross and his partners paid for the gift and the inflated value claimed in the return by Ross and his partnership only months later.

"It's very, very rare that something is going to grow tenfold in less than a year," said Miranda Perry Fleischer, professor of law at the University of San Diego and expert in tax policy and charitable giving. "They were trying to play games" with valuing the gift.

The gift in question is a small fraction of giving by Ross, who stands among the nation's most generous supporters of higher education. With a total of $328 million pledged to the University of Michigan, he remains the largest alumni benefactor in the institution's history. His name stretches across the Ann Arbor campus, from its business school to its athletic facilities.

U-M also received the money Ross promised 15 years agoat the heart of the tax case. The gift came from Ross, who also owns the Miami Dolphins professional football team, and his partners. It helped pay for the Stephen M. Ross Academic Center for student-athletes.

But in the tax case, the IRS and federal tax judge found that Ross and his partners failed to back up their claimed deduction based on the U-M gift with credible information about its fair market value.

“I don’t understand why someone is not going to jail,” University of Florida professor Steven J. Willis, who has authored books on charities and tax law, said of those involved with the tax filing.

Two key figures in structuring his gift and its resale by U-M were Ross' former accountant and an outside lawyer brought in to complete the deal.

In an unrelated criminal case, federal prosecutors later charged Ronald Katz, Ross’ former tax accountant, and Harold Levine, a lawyer who helped engineer the U-M donation, with fraud for a series of deals not connected to Ross. In June of this year, both men pleaded guilty to felony obstruction and tax evasion.

Ross "was surprised and extremely disappointed by the actions of the two individuals, who have pled guilty, and has severed all dealings with them," Ross' spokeswoman said in a statement.

As for the tax case, Ross is likely to appeal the judge's ruling, Ross spokeswoman Joanna Rose said.

The outcome of the case has not affected Ross' pledges, she said. "Mr. Ross is pleased to have fulfilled on all of his obligations" to the University of Michigan, Rose added in a statement.

In his ruling last month, the tax judge didn't directly address the role of U-M officials. But according to the IRS, the University of Michigan also failed to follow some of its own policies and procedures in accepting and reselling the non-cash gift in Ross’ name.

Critics say those were warning signs that the deal was problematic, and U-M officials may have succumbed to pressure from a wealthy donor.

In response to questions from the Detroit Free Press, U-M officials said the acceptance of the Ross gift and its resale by the university was thoroughly reviewed by lawyers and tax experts.

"The university does, on occasion, accept gifts of tangible property, real estate and, in this case, non-marketable financial interests," university spokesman Rick Fitzgerald said in a statement. “When such gifts are accepted, the university works to liquidate those assets as soon as appropriate.”

The U.S. Tax Court did not find fault with the university's handling of the Ross donation, Fitzgerald added.

Others, however, see evidence of a broader problem.

“This is one of a few instances we’ve seen recently where major universities are seemingly willing to look the other way when a major donor is clearly playing a little fast and loose with the charitable tax deduction,” said Galle, who had served as a tax enforcement attorney at the U.S. Department of Justice.

Most alumni gifts to U-M are cash. But this gift from Ross was a piece of southern California real estate that housed a data center. The property stake was donated to the university and resold for nearly $2 million for cash to help Ross fulfill his pledge, which eventually grew to $5 million — and enable him to take a tax deduction.

As part of their probe, IRS officials also found that the University of Michigan:

  • Agreed to accept Ross' gift of a stake in the California property without first obtaining an appraisal of its value, contrary to university practice.
  • Acceded to Ross' request for an unusual two-year hold on reselling the gift, even though university policy calls for disposing of non-cash gifts promptly.
  • Accepted an offer for reselling the property stake from a mysterious buyer — who it turned out was the same lawyer and accountantwho represented Ross and his partners in the original donation.
  • Resold the property stake for less than one-third the appraised value, contrary to university policy calling for sales of public property to be for fair market value.
  • Public institutions have an obligation to try to sell their non-cash gifts for a fair market value and refrain from giving “insiders” any economic advantage, according to legal experts.

Galle said U-M officials may have improperly allowed a suspicious donation to the university's athletic department and served as a kind of pass-through to raise funds needed for a construction project.

“Michigan walked away with  $1.94 million ... for allowing someone else” to try to take millions out of the U.S. Treasury,” he said. “Well-run charities shouldn’t do that.”

NETTING A ‘BIG FISH’

There are few graduates better-known by top U-M officials than 77-year-old Stephen M. Ross.

The Detroit native graduated with a business degree in 1962 and practiced tax law early in his career. Then in 1972, Ross founded Related, the real estate empire behind New York City’s Time Warner Center and the under-construction Hudson Yards, billed as the largest private real estate development in the history of the U.S.

“After all, Steve Ross gave the university another hundred million dollars for the business school, so he was a big fish,” former U-M athletic director Bill Martin said in a deposition for the tax case.

In 2013, Ross walked into his namesake business school to announce a $200-million donation as the university marching band played “Hail to the Victors,” Michigan’s fight song. A throng of students inside wore maize and blue T-shirts proclaiming “WELCOME HOME.”

"This is a great day for the University of Michigan," then U-M President Mary Sue Coleman said at the campus rally. "We are celebrating a historic $200-million gift from a remarkable leader and alumnus, Stephen Ross."

His total gifts also made Ross the second-largest donor as an individual to any college or university in the country at the time, only behind former New York City Mayor Michael Bloomberg.

According to Forbes’ latest list of the world’s wealthiest people, Ross is now worth $7.4 billion. In 2013, Ross signed on to the Giving Pledge, a public commitment created by Microsoft founder Bill Gates and famed investor Warren Buffett for the nation's richest people willing to give more than half of their wealth away.

Most people, Ross told the Free Press in an interview last fall, “want to leave the world a better place. ... I think there is a social responsibility in giving back.”

HUNTING FOR TAX BREAK

In the early 2000s, Katz, Ross’ accountant, first told him about a new partnership called RERI, according to trial testimony.

RERI was a limited liability company only in existence from 2002-04. It would have no assets other than property stakes known as remainder interests, including the Hawthorne, Calif., industrial property leased to AT&T.

Ross said he and Katz did work together for at least three decades.

“He would bring me deals from time to time and ask me if I would be interested in them,” he testified at the June 2015 tax trial.

Seeking a deal with tax advantages wasn’t unusual for Ross.

“In real estate, there’s a lot of tax benefits so that the tax benefits that the real estate throws oftentimes are lucrative,” he said.

Court documents filed by the IRS describe Ross as “RERI’s largest member.” Despite that, Ross said in his trial testimony he didn’t concern himself with the technical details of the deal, which he described as outside his normal business of developing real estate projects.

“Once I agreed to do the deal, he showed me and described the transaction, he followed through and handled all the arrangements,” Ross said of Katz.

Other Related executives said they joined RERI knowing about the potential tax benefits.

Two of them said in a separate civil lawsuit that Katz described the deal as a complex transaction that involved forming a limited liability corporation that would buy “remainder interest” in properties and then donate it to a nonprofit. Each investor would be allowed to take a tax write-off substantially higher than the donation, according to the lawsuit.

Experts say that a remainder interest can be relatively common for wealthy donors who want to gift their home to a charity, but allow a surviving spouse to remain in the house until they die. The charity's stake in the property is known as a remainder interest.

“It was brought to my attention it would be a good time to give a gift based on the fact that there would be a sizable deduction and that it would be (to) the University of Michigan,” Ross said at the tax trial.

Federal court records show Ross and his partners, through RERI, paid $2.95 million in 2002 for the so-called remainder interest in the Hawthorne property outside Los Angeles.

Witnesses at trial said  RERI’s donation of this kind of remainder interest was unusual, if not unprecedented.

Ross said he called his friend Bill Martin, a successful real estate company owner who ran the university's athletics department, shortly after RERI bought the property stake in 2002 to see whether U-M would accept the gift of a remainder interest.

“He indicated he would. I told that to Katz. And they then took it from there, and that was about the end of my involvement,” Ross said at trial.

QUESTIONING TAX WRITE-OFF

The federal government relies on voluntary information submitted by taxpayers to account for the real value of their donations when assessing their bill to Uncle Sam. Legal loopholes and tax shelters can substantially lower a rich person's tax bill.

Still, Ross said he initially had concerns about the size of the tax benefits he sought.

“They were quite large," he said in trial testimony, recalling his discussions with Katz. "And I wanted to know, you know, if it was really something that was real. And he brought in Harold Levine who explained to me the transaction and satisfied me."

Ross said he had no role in the university’s resale of the property stake more than two years later, in December 2005.

“I was hoping it would be held longer and it would satisfy the agreement — the pledge,” Ross said of his commitment to pay for half of U-M's Stephen M. Ross Academic Center. (Ross boosted his pledge for the center to $5 million from $4 million in September 2004 after the university changed its plans for the building, which opened in 2006.)

Believing it could claim a substantial tax deduction, the 30-member RERI partnership donated the entire stake in 2003 to help fulfill Ross’ $5-million pledge for the academic center. The university later sold the stake for $1.94 million and credited Ross' pledge, records show.

Ross' personal tax write-off for his $500,000 investment in RERI was $5.4 million. (His company’s president at the time, U-M alumnus and donor Jeff Blau, testified he received a $3.8-million deduction for his $350,000 investment in RERI).

IRS lawyers wanted to know whether Ross ever questioned the disparity between the investment and the value under the deduction.

“When I gave the gift knowing that the deduction would be such, I asked, you know, you know, how that was possible because I wanted to make sure that what I was doing was proper and legal,” Ross responded. “And I was told by Mr. Levine who showed me that the regulations provided for this and had a table that set forth the valuation of remainder interest.”

During the court fight, the IRS argued that RERI’s charitable contribution was "a sham for tax purposes or lacks economic substance, and therefore the transaction should be disregarded for federal tax purposes and the deduction disallowed in its entirety."

Katz and Levine invoked their constitutional right against self-incrimination, declining to testify at the 2015 trial.

Still, in court papers, RERI countered that its members took the write-off because they properly valued the asset and used a government tax table for the remainder interest in the property.

The RERI donation wasn’t the only time Ross fulfilled part of his pledge to U-M using a stake in real estate.

He also donated holdings in several Rite Aid pharmacies and a movie theater, which were later resold by U-M. A spokeswoman declined to say how much Ross may have saved on his taxes from these deals.

VALUING GIFT

How to sell Ross’ unusual gift through RERI was a challenge for university officials. And in the end, U-M only received less than one-third the appraised value in reselling the gift, according to the sales price and the university's own appraisal.

Early on, some university officials thought the gift might be worth more. Ross described the donated property interest as “worth, best of my recollection, three or three-and-a-half million dollars,” Michael Hilliard, now U-M’s assistant vice president for leadership giving, said in a deposition.

But when RERI sent the university a form on noncash charitable contributions, the partnership left blank the part asking for a fair market value. So the university logged the gift with a nominal value of only $1.

As part of the agreement with RERI, university officials also agreed not to sell the stake for at least two years. That meant U-M didn't need to file a government form that would have alerted the IRS to how much RERI originally paid, according to legal experts.

“Is it a common practice of the university to allow donors of non-cash assets to decide the timing of sale?” asked IRS lawyer Travis Vance III.

“It’s uncommon,” Gordon Beeman, then U-M associate general counsel in charge of vetting charitable gifts, answered at his deposition.

(On its own, RERI obtained an appraisal for the stake in September 2003 of $32,935,000, more than 10 times what it paid for the stake the prior year. Then RERI claimed a charitable deduction of nearly the same amount on its tax return.)

In early 2005, university officials began discussions on selling the stake. Beeman said in his deposition that Martin took a “lead role” in the sale and “he would be consulting with Stephen Ross” in mid-2005.

There was concern among some at the university that the value of the RERI property had significantly diminished since the date of the gift and the property stake might not be readily convertible into cash.

That’s when Levine approached U-M about buying the stake for another client.

Levine’s client was a company called HRK Real Estate Holdings. Katz and Levine owned HRK themselves or through family members but university officials said they did not know that, according to court records.

Some university officials said at that time they felt pressured by Ross to sell. Beeman called it a “new risk."

“If we didn’t accept the offer we received in December of 2005, which was, I think $1,940,000 for the Hawthorne property, that (Ross) would deem himself relieved of his pledge by that amount,” Beeman said, although he added that he didn’t become aware of that risk until later.

Tim Slottow, then the university’s chief financial officer, argued in pre-trial depositions that he didn’t feel pressure from Ross since the university viewed the $5-million gift agreement as binding no matter the sales price of the RERI remainder interest.

But in a 2005 e-mail just before the sale closed, Slottow acknowledged the influence of a prominent donor on the sale of his gift. 

“I am not a (real estate) expert but continue to be comfortable relying on Bill’s (Martin) and Steve’s (Ross) collective advice for timing and price — they now agree and want to sell fast,” Slottow wrote in an e-mail to other university administrators.

Beeman said in his deposition that “we had an interest in maximizing the price. It was university property. We had a fiduciary duty, too, considering all the risks and all the attendant factors in getting the best deal. That would mean getting the cash sooner, not later.”

By the end of the year, U-M agreed to sell for $1.94 million, the original offer price, to HRK. That was two-thirds less than the appraised value of around $6.5 million, obtained by the university that year before the sale.

During one deposition, an IRS attorney asked whether university officials were concerned “that the general public was going to find out that you got a $6-million appraisal and you sold the property for $1.94 million.”

“That was one of the concerns, yes,” Beeman responded. “Remember, the university of Michigan is a public body.

LOSING IN COURT

University of Michigan officials declined to answer specific questions about the tax court case decided last month against RERI. Instead, its spokesman provided a statement.

"The university plays no role in establishing or even agreeing to what may be the fair market value claimed by the donor as a charitable contribution on their individual tax return. Rather, that is a decision made by the donor and his or her tax counsel and advisers,” U-M's Fitzgerald said in a statement.

Seton Hall University’s Sarah Waldeck, a law school professor who specializes in charitable giving, sees the university's role as thoughtful despite unusual circumstances.

“In my experience, nonprofits work really hard to stay away from the question of what donors are actually claiming on their taxes," Waldeck said. "I think that the decision not to become tangled up in or involved in what donors’ tax returns looks like a legitimate, practical move by a nonprofit.”

But others remain critical of the university's actions.

"The fact that the donor left the donor's valuation blank on the form they gave Michigan was a red flag that should have gotten more attention," Galle said, adding that "the pressure from the donor is not a proper reason for the university to get a bad deal on what is, legally, fully its own property at that point."

In the unrelated criminal case, Katz and Levine are scheduled for sentencing in October and face recommended prison time. Their attorneys did not return e-mails and phone calls seeking comment.

The criminal investigation connected to Katz and Levine is ongoing, according to a person familiar with the matter. The IRS declined to comment.

In addition, another civil case  looms.

In June 2014, the federal government sued Levine, alleging he had participated in “at least” 90 different schemes “designed to cheat the government out of hundreds of millions of dollars in tax liability,” according to the complaint. The government accused Levine of making more than $5 million in fees from improper transactions.

The suit is currently on hold because of criminal proceedings against Levine, court records show. None of the transactions described in the suit appear to be related to RERI.

In his July tax case ruling, Judge Halpern cut RERI’s allowable deduction completely: from $33 million sought in the partnership's 2003 tax return down to zero.

He also ruled the partnership was liable for an additional penalty: Forty percent of the overvaluation. The exact amount to be paid will likely depend on the tax bracket and other financial circumstances of the individual partners, legal experts said.

Ross' spokeswoman attributed the adverse ruling to a technical error. RERI failed to fill out a tax form completely by leaving blank the value of the property stake, she said.

“The value of a charitable gift of a remainder interest is governed by" U.S. tax code, Rose wrote. “In this decision, the charitable deduction was disallowed due to a failure to include an entry on the form, which we continue to believe was done in error.”

But West Virginia University tax law professor Elaine Wilson said Ross and his partners mayhave received a harsh ruling from the tax judge because the partnership tried to use a wildly inflated appraisal to justify the $33-million deduction.

"There's a saying that tax lawyers use, which is: 'Pigs get fed and hogs get slaughtered,'" Wilson said. "They went for too much."

© 2017, Detroit Free Press


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