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Report from the Trenches: What's New with in-Kind Charitable Gifts?

portrait of a manAs an attorney primarily representing large nonprofit organizations, I am often approached by individuals and advisors wishing to donate various kinds of property to charity.  Not infrequently, these are interests in active businesses that have the potential to be sold soon.  For the donors, the sale of a company that they may have been building for decades is often one of the most significant liquidity events they will experience in their lives, one that often triggers the desire to make charitable donations to meet religious tithing obligations or other charitable goals.  Donors understandably hope to increase tax efficiency by making a gift pre-sale, so that they can claim a deduction for the fair market value of the donation and also avoid what could be substantial gains on the sale of the portion of the company transferred to charity. 

At the same time, business owners in the midst of a major sale transaction are often stretched thin between the demands of operating the business, preparing it for sale, responding to due diligence queries, and negotiating with prospective buyers.  Little wonder, then, that despite the significant tax advantages available for a properly structured gift, business owners can easily leave the mechanics of a donation to the last minute, potentially overlooking the numerous technical requirements imposed on such gifts.  Advisors can play a critical role in determining what property is a good candidate for in-kind donation, and making sure that even amid a hectic selling process, all prerequisites for a successful donation are met.  In this article, I hope to highlight a number of issues, some old but some new, that advisors should consider as they work with would-be donors with a likely liquidation event ahead. 

I. When the Normal Tax Treatment Might Not Apply

The following are some of the cases we see regularly where some or all of the tax savings associated with a pre-tax gift may not apply:

The foregoing are by no means the only tax complications that can arise with an in-kind gift.  But they are several of the perennially occurring ones. 

II. “Assignment of Income” Issues

A. General Background

Under general income tax principles, a donor will normally be taxed on income to which the donor has a right even if the donor makes an anticipatory assignment of that income to another person.  In the charitable giving context, this can happen if the donor keeps the income-producing property and transfers only certain associated rights to income (transferring only the “fruit” of the tree rather than the whole tree).  It can also occur if appreciated assets are donated when the sale process is so far advanced that “the shareholder’s corresponding right to income had already crystallized at the time of the gift.” Keefer v. United States, Civ. No. 3:20-CV-0836-B, 2022 WL 2473369 at *8 (N.D. Tex. Jul. 6, 2022). 

Two different standards have arisen for determining whether a potential sale of property is far enough along to create problems.  The first, known as the “bright-line” test, holds that the donor will not be taxed on the income so long as the donee is not legally bound and cannot be compelled to sell the shares.  In Palmer v. Commissioner, 62 T.C. 684, 694-95 (1974), the Tax Court respected a gift of 80% of the stock in a company to a charitable foundation.  Even though it was expected that the foundation would choose to redeem its shares, and even though the company and the foundation were both controlled by the donor, the Foundation was not obligated to sell its shares.  Thereafter, the IRS acquiesced in Palmer’s holding, indicating that even if a redemption was prearranged, the Service would “treat the proceeds as income to the donor under facts similar to those in the Palmer decision only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption.” Rev. Rul. 78-197, 1978-1 C.B. 83. 

This ruling and the Palmer case are typically taken as authority for allowing a donor not to realize gain even if the property is donated only shortly before the sale, so long as no definitive sale agreement has been entered before the donation is complete.  But other cases suggest that this is not always the rule.  For instance, in Blake v. Commissioner, 697 F.2d 473 (2nd Cir. 1982), a donor gave appreciated stock to a charity, apparently on the understanding that the charity sell the stock and use the stock proceeds to purchase his boat.  Even though there was no binding obligation, the courts recharacterized this as a sale by the donor of the stock, and a contribution of the boat.  And in Ferguson v. Commissioner, 108 T.C. 244 (1997), aff’d, 174 F.3d 997 (9th Cir. 1999), the donor gave stock that was subject to a merger tender offer, whereby the merger would not occur unless 85% of shareholders tendered their shares.  At the time of the gift, a majority short of 85% had tendered their shares, so the formal conditions for the merger to proceed had not all been met.  However, the Ninth Circuit upheld the Tax Court’s conclusion that the “assignment of income” doctrine applied, because given the favorable terms of the tender offer, the merger was “practically certain” to proceed. 

Taken by themselves, Blake and Ferguson would not cast too much doubt on the validity of the bright-line Palmer test.  After all, in Ferguson, whether the merger would convert the recipient church’s stock into cash was dependent on other shareholders’ decision to tender their shares, and was completely out of the church’s control.  And in Blake, the donor and the charity colluded to flow the proceeds from selling the donated stock back to the donor in return for a boat, understandably triggering step transaction concerns.  Furthermore, in 2002, the Tax Court decided Rauenhorst v. Commissioner, 119 T.C. 157 (2002), rejecting the IRS’s attempt to apply cases like Blake and Ferguson to replace the “legally bound” standard with a “practically certain to proceed” standard, and holding that the IRS was required to follow the “legally bound” standard even in the case of a multi-party stock sale to a third party buyer quite different than the original facts in Palmer.   Although the Tax Court did note that it had not itself adopted this bright-line test, as a practical matter the bright-line rule seemed ascendant, at least so long as Revenue Ruling 78-197 remained on the books. 

B. Recent Cases

A few recent cases, most involving donor advised funds, demonstrate that the IRS is once again challenging the bright-line approach, with mixed results.  First, in Chrem v. Commissioner, T.C. Memo 2018-164, the Tax Court refused to grant summary judgment on an assignment of income claim when stock was contributed to the Jewish Communal Foundation shortly before being purchased by a related entity.  Among other things, it determined that a trial was needed to determine whether the Jewish Communal Foundation had agreed in advance to sell the stock being donated, or alternatively, whether the Foundation’s charitable duties would make it imperative to sell the stock to avoid being stuck as a minority owner of a Hong Kong privately held business. 

Two years later, in Dickinson v. Commissioner, T.C. Memo 2020-128, the Tax Court granted summary judgment to the taxpayer in another “assignment of income” case.  The donor was the CFO of a company that regularly allowed donations to Fidelity donor advised funds, under an understanding that Fidelity’s policy was to redeem the donated shares immediately.  Although the IRS argued that Fidelity’s policies created a pre-existing understanding that the shares would be sold, the Tax Court found that to be irrelevant, because there was no legal obligation for Fidelity to redeem its shares and there was no sale “practically certain” to occur that would have happened if the donor had not donated his shares.  Thus, the donor never had a fixed right to income from the shares that was being transferred to charity. 

Last year, in Keefer v. United States, Civ. No. 3:20-CV-0836-B, 2022 WL 2473369 (N.D. Tex. Jul. 6, 2022), the IRS again argued for an assignment of income in the case of a transfer to a donor advised fund of a 4% interest in a limited partnership in the process of selling a hotel.  The gift to the DAF was dated June 18, after a nonbinding letter of intent was signed but before the definitive agreement regarding the hotel’s sale was executed in early July.  The District Court also noted that even after the definitive agreement was signed, the buyer would still have no obligation to go through with the purchase until the end of a 30-day due diligence period.  Thus, the court declined to extend Ferguson’s “practically certain to proceed” standard to the facts at issue, given that the donor was far from having any right to sale proceeds at the time of the gift. 

However, the court ultimately found that there was an assignment of income, because the donor had not parted with his entire 4% interest but only his rights to income from the sale of a hotel.   The problem was that the partnership distributed certain cash previously held as capital reserves in proportion to the pre-gift partnership interests, excluding the charitable donee from sharing in that portion of the partnership distributions.  As a result, the court was not able to conclude that all of the rights pertaining to the 4% interest had been transferred to charity.  Accordingly, the donor was held to be taxable on the portion of the gain attributable to the donated interest. 

Finally, last week in Estate of Hoensheid v. Commissioner, T.C. Memo 2023-34, the Tax Court considered another donation made to a donor advised fund (once again, at Fidelity) of a portion of the donor’s interest in a family-owned company being sold to an outside buyer.  Although the donor’s attorney kept pushing for the donor to complete the donation documents well before the sale was final, some of her advice indicated that the final deadline for completing the gift was just before the definitive sale agreement was signed.  The donor indicated in one email that he wanted to put off the donation until it was “99% certain” that the deal would close, lest he donate stock and then the deal fall through.  The donor started talking about making a donation in April, before a nonbinding letter of intent was even signed, and the other shareholders signed a document approving the transfer of the donor’s shares in a document dated June 11.  However, the DAF account was not opened and the actual number of shares to be transferred was not filled in until much later. 

The final sale agreement was signed on July 15, and shares were transferred on the records of the corporation at earliest on July 10, with an actual share certificate issued to Fidelity only on July 13 (which the Tax Court found to be the relevant date of transfer under local law).  At that point, revisions of transaction documents going back and forth showed that the owners and the buyer had largely worked out all substantive disagreements in the draft.  Furthermore, the company being sold had already made significant distributions of working capital and paid out substantial employee bonuses in preparation for the final sale.  Given these factors, the Tax Court concluded that the donor should be taxed on the gain, notwithstanding the fact that final shareholder approvals for the final deal were consummated after the gift.  According to the Tax Court, the circumstances were different enough from those of Revenue Ruling 78-197 that its bright-line test was not binding on the IRS (as it was held to be in Rauenhorst).  Thus, the fact that Fidelity was not legally bound to participate in the sale, which the Tax Court acknowledged, did not save the gift from being considered an anticipatory assignment of income. 

III. Documentation Issues

Large donations of in-kind property are subject to various documentation requirements.  Like all donations of more than $250, they require a contemporaneous written acknowledgment (or “CWA”).  I.R.C. § 170(f)(8).  In addition, the donation must be valued by a qualified appraisal issued by a qualified appraiser.  For donations over $5,000, a Form 8283 must be signed by the appraiser and the donee; for larger donations, either a summary of the appraisal or the entire appraisal must be attached to the donor’s return.  Cf. I.R.C. § 170(f)(11).  Although a full discussion of these requirements is beyond the scope of this article, it is worth noting that Treasury Regulation §§ 1.170A-16 and  -17 contain new regulations effective July 30, 2018 and January 1, 2019, respectively regarding documentation requirements and qualified appraisal and qualified appraiser requirements.  These rules impose more specific requirements for the education and experience of the appraiser, as well as numerous specific directives as to what must be included in the appraisal itself. 

The contemporaneous written acknowledgment must generally describe the property given, state whether any goods or services were provided in return, and if so, provide a description of what was provided in return and estimate its value.  It must also state whether any intangible religious benefits were received in return for the donation.  I.R.C. § 170(f)(8); Treas. Reg. § 1.170A-13(f)(2).  For donor-advised funds, the sponsoring organization must also provide a written acknowledgment that it has “exclusive legal control over the assets contributed.”  I.R.C. § 170(f)(18).  These requirements must be met before the earlier of the date the donor’s income tax return is filed or the due date (taking into account duly obtained extensions) of the return.

The IRS has enforced these requirements quite aggressively.  In three of the four recent cases cited above, the IRS claimed that documentation flaws precluded any charitable deduction for these gifts.  In Chrem v. Commissioner, T.C. Memo 2018-164, the donors apparently used as their appraisal an ERISA appraisal of the entire company obtained for the ESOP trustee buying the stock.  The appraisal thus did not indicate that it was being used for income tax purposes and did not reference the particular gifts made or their dates (in some cases, the small size of these gifts may have warranted substantial minority discounts); certain donors had also failed to include a copy of the appraisal with their return, as required given the size of their donation.  With these requirements not satisfied, the Tax Court withheld summary judgment so that at trial the donors could present evidence that the donors had reasonable cause for their failures (e.g., due to reliance on advice of counsel) or that they had substantially complied with these rules.

Next, in Keefer v. United States, Civ. No. 3:20-CV-0836-B, 2022 WL 2473369 (N.D. Tex. Jul. 6, 2022), the district court considered a CWA that did not meet the DAF-specific requirement that it inform the donor that the donee had exclusive legal control over the assets.  Although this had been stated in a packet given to potential donors earlier in the process, this packet could not be considered an “acknowledgment” because it was pre-gift.  Because strict compliance with the CWA requirements is required, the court denied the deduction completely due to this failure. 

Finally, in Estate of Hoensheid v. Commissioner, T.C. Memo 2023-34, Fidelity provided an adequate CWA for the gift to its donor advised fund, but the IRS successfully challenged the donor’s appraisal as not substantially complying with the appraisal rules because (1) the provider, an employee of the company brokering the sale of the underlying company, did not regularly perform this type of appraisal and so was not a qualified appraiser; (2) the appraisal assumed an incorrect donation date of June 11, rather than the actual date of July 13; and (3) the donor should have known better than to rely on their counsel’s judgment as to the correctness of the June 11 date, so there was no reasonable cause.  

IV. Lessons Learned from the Foregoing Cases

On the one hand, the recent string of cases does not mark any large shift in the law governing donations of soon-to-be-sold property.  None of these cases are published opinions having precedential weight, and in Dickinson and Keefer the Tax Court rejected IRS arguments that the gift was virtually certain to occur.  Dickinson even suggested that where there would be no redemption but for the donation, that by itself might keep the assignment of income doctrine from applying, however prearranged the redemption might be.  It also offers helpful confirmation that the mere fact the donee institution has a policy or practice of regularly selling the stock it receives is not sufficient prearrangement for the IRS to prevail on an assignment of income claim.  Similarly, Keefer is helpful in demonstrating that even when the charity will have no unilateral decision whether to sell the donated stock (because the sale of assets is happening within the partnership, at the discretion of those controlling the partnership), a transfer weeks before the signing of a final agreement will not necessarily trigger an assignment of income.  It might even indicate that in appropriate circumstances, a deal could be likely enough to fall through that even after a definitive agreement is signed, there might not be an assignment of income (though given Estate of Hoensheid, certainly I wouldn’t recommend this as a planning opportunity). 

On the other hand, these cases put practitioners on notice that the IRS is bringing new challenges to the tax treatment of pre-sale gifts, even in circumstances where the bright-line “legally bound” standard clearly is not met.  And the Tax Court, at least, does not seem to be stopping the IRS from straying from that standard.  In Chrem, it indicated that it was open to factual contentions that the charity had implicitly agreed to sell its shares, or (more troublingly) that the charity was obligated to sell because it would be imprudent not to sell the donated investment.  If such considerations of prudence are sufficient to create a legally binding obligation, the “bright-line” rule will devolve into a facts-and-circumstances analysis of the merits of holding each investment.  Most strikingly, Estate of Hoensheid directly concluded that the bright-line test should not apply, notwithstanding the Revenue Ruling.    Instead, the Tax Court concluded that “a donor must bear at least some risk at the time of contribution that the sale will not close,” and to determine whether such risk was borne, it considered in detail how “set” the deal terms were and how far advanced the parties’ operational preparations for the sale were. Given these holdings, practitioners may want to consider the following cautions:

V. Conclusion

With 80,000 new IRS agents joining the fray, we are likely to see more IRS challenges to pre-sale charitable gifts.  If the foregoing lessons are taken to heart, such gifts can be an effective way of accomplishing a donor’s charitable goals while substantially reducing taxes. 

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