Charitable Planning with Appreciated Property
By Brent A. Andrewsen
It’s that time of year when people are thinking about gift giving (and some even get focused on gift receiving). Whether we dream of Red Ryder BB guns or the latest technological advancements, we all hope there will be something under the Christmas tree for us. In the world of charitable giving, donors wish for tax deductions and tax avoidance, while charities hope for funds they can use to advance their charitable mission. When it comes to simplicity, cash is king, but donors usually derive better tax benefits by gifting appreciated assets. If a charity is willing and able to accept such gifts and, under the right circumstances, both the donor’s and the charity’s interests align, the donor achieves significant tax benefits and the charity ends up with the funds it wants and needs.
The Church maintains policies and procedures that allow it (and its affiliates) to receive what are sometimes referred to as “complex assets.” Such assets include real estate, artwork and historical artifacts, public securities and closely held business interests, insurance policies, and other types of assets. The primary reason donors donate such assets has to do with the tax treatment associated with such donations.
Using appreciated stock as an example, generally the donor gets a fair market value deduction for the contribution of the stock, and the charity can then sell the stock and pay no capital gains. This creates a double benefit to the donor—the deduction and the tax avoidance.
Because the donor gets a fair market value deduction, the donor wants the value to be the highest possible value at the time of his or her gift. Therefore, these gifts usually occur fairly close in time to the date of a sale. In the case of publicly traded stock, the charity usually liquidates the stock within a day or two of the donation. In the case of privately held stock, the donor usually negotiates a sale of the stock or the assets of the company prior to the donation. As will be discussed below, it is important that the donor make a donation before there is a signed agreement for the sale of the stock or a definitive agreement between the company and the buyer, in the case of an asset purchase transaction.
It may be helpful to provide an example of how these donations work. Assume that a donor owns $2 million of stock in his business that is taxed as a C corporation. The donor’s basis in his stock is $0. If the donor were to sell the stock, he would recognize $2 million of gain. This gain would be taxed for federal income tax purposes at a rate of approximately 23.8 percent (20 percent rate plus the Obamacare tax of 3.8 percent). Therefore, without considering any charitable giving, the donor would face a federal tax bill of approximately $476,000.
However, if the donor is charitably inclined and wants to gift half of what he has to charity, he could gift the stock or make a cash donation. If the donor gives $1 million of stock to a public charity prior to a liquidation event, by following procedures set forth below, the donor will get a tax deduction for $1 million and the charity will not have any capital gain when it sells its shares. This will reduce the tax from $476,000 to $166,600, and the charity will have the full $1 million.
This is explained as follows: The donor would recognize $1 million of long-term capital gain. The federal tax would be approximately $238,000. However, because of the donation, the donor can deduct the value of the gift, up to 30 percent of his adjusted gross income. If the $1 million is all of the income the donor has, that means the donor can deduct $300,000 from the $1 million of gain (30 percent of his adjusted gross income). (Note: The donor can carry forward the $700,000 he could not deduct this year for five years to offset future income.) Therefore, the donor will instead owe $166,600, a tax savings of $71,400. Further, the donor will have avoided all of the tax on the $1 million he donated, for an additional tax savings of $238,000.
If the donor were to donate $1 million cash, the tax results would be as follows: The donor could deduct $600,000 from the $2 million of gain. (Note: In this case, the donor can carry forward the $400,000 he could not deduct this year for five years to offset future income.) Then the tax on the $1.4 million would be $333,200. Thus, the donor will pay twice the amount of tax than what would have been owed if the donor had donated the stock, and he will be left with significantly less in net proceeds.
Issues to Consider in Gifting Appreciated Property
The Type of Charity Matters
In order to take a deduction under Section 170 of the Internal Revenue Code of 1986, as amended (the “Code”), generally the donor is required to give to an organization exempt from tax under Code Section 501(c)(3). However, not all 501(c)(3) entities are the same. The “best” charities for donors are public charities. These include operating charities like universities, churches, and donor advised fund (“DAF”) sponsors. Other types of 501(c)(3) charities have other rules that are implicated in the donation context. For instance, a donor may be limited on what may be deducted for donations to a private foundation. In the case of a gift to a “split-interest” trust, such as a charitable remainder trust, the facts and circumstances at the time of the gift, including the terms of the trust, also limit what the donor can deduct.
In the case of donations to a public charity, a donor usually may deduct an amount equal to the fair market value of the stock as of the date of the gift, but the deduction in any given year is limited to an amount equal to 30 percent of the donor’s adjusted gross income. Because DAF sponsors are public charities, this same rule applies to gifts to DAFs. In the case of donations of appreciated property that is not publicly traded securities, a donor may only deduct his or her basis in the property when the donor gives to a private foundation. Therefore, private foundations are not a great gifting tool for such assets, unless the donor does not care about the charitable deduction and just wants to avoid tax on the gain of the sale. In the case of publicly traded stock, the donor may deduct the fair market value of the stock on the date of the gift, but the deduction is limited to an amount equal to 20 percent of the donor’s adjusted gross income.
The Timing of the Gift Matters
A common question asked when a donor is considering a donation of appreciated property is how soon before a sale a donor must give the appreciated property. We are often contacted by potential donors or their advisors when they are in the middle of negotiating the sale of the property. Sometimes they have signed a nonbinding letter of intent. Other times they have nearly fully negotiated a purchase agreement but have not signed it. Must the donor give 90 days before a sale, as I heard a panelist say at a continuing education presentation? A week before? The day before? Is there a bright-line test? Below is a discussion of the law in this area.
As a general rule, taxpayers are not required to recognize any gain upon the donation of appreciated property to a charity. That is, the donation of appreciated property generally does not constitute a “realization event” for tax purposes. In the typical donation scenario, a realization event does not occur until the charity sells the donated property, at which time the charity, rather than the donor, realizes the property’s built-in gain (which gain, as noted previously, typically does not constitute taxable income for the charity, given its tax-exempt status).
However, if the Internal Revenue Service (“IRS”) determines that a realization event has occurred prior to a donation, then, under the anticipatory assignment of income doctrine (the “Doctrine”), the IRS will require the donor to realize any built-in gain that existed at the time of a realization event. In essence, the Doctrine deems the donor to have sold the appreciated property to a third party, thereby causing the donor to realize all of the built-in gain and then to donate the proceeds of the sale to the charity. The IRS seeks to apply the Doctrine in those circumstances in which it believes that, prior to the time a donation is made, something has happened to the donated property that has caused it to “ripen” into a fixed right to receive cash. A realization event is deemed to have occurred once the right to receive cash is sufficiently “ripe.” Thus, the Doctrine generally applies in those circumstances in which, rather than donating property to a charity that the charity can decide to either retain or sell, the donor is basically designating the charity as the party to receive a cash payment that the donor otherwise would be entitled to receive.
The courts have agreed with the IRS that, under certain circumstances, a taxpayer’s right to convert a property interest into cash has become sufficiently “ripe” prior to a donation in which a realization event occurred while the property was still held by the taxpayer. However, the courts have struggled to define precisely when a right to convert property into cash has become sufficiently “ripe” for the Doctrine to apply, given the extremely fact-intensive nature of the “ripeness” determination. Nonetheless, several general themes can be derived from cases and rulings involving the Doctrine.
In Kinsey v. Commissioner,477 F.2d 1058 (2nd Circuit 1973), and Hudspeth v. United States, 471 F. 2d 275 (8th Circuit 1972), stockholders made gifts of appreciated stock to charities after affirmative votes to liquidate the corporations already had occurred. In Kinsey, the final resolution by the board of directors to liquidate the corporation was not passed until after the donation to the charity, but the charity nevertheless was unable to change the course of events and avoid the liquidation. Similarly, in Hudspeth, the charitable gift was made before the filing of articles of dissolution with the proper state authority, but the charity’s limited interest was not sufficient to stop the planned liquidation.
Thus, in both cases the liquidations were a fait accompli at the time of the donations, as the charities had no option but to exchange the stock they had received for liquidation proceeds from the corporations. The primary factor in the courts’ decisions to apply the Doctrine was the fact that the charities were powerless to prevent the forced disposition of the stock they received. The courts essentially found that the realization event relating to the conversion of the stock into liquidation proceeds occurred when the right to receive liquidation proceeds arose, rather than when the liquidation proceeds were actually received.
In Palmer v. Commissioner, 62 T.C. 684 (1974), the taxpayer sold and donated approximately 80 percent of the shares of a closely held corporation that he controlled to a charity that he also controlled. The next day, as a member of the corporation’s board of directors, the taxpayer voted to cause the corporation to redeem the charity’s shares. That same afternoon, just hours after the corporation’s board vote, the taxpayer also sat on the charity’s board and approved the redemption by which all of the charity’s stock would be transferred to the corporation in exchange for some of its assets. Notwithstanding the taxpayer’s individual participation in the decision-making of both entities, the court ruled that the charity was not obligated, at the time of the donation, to have its stock redeemed, and therefore it could not have been forced to dispose of its stock without its consent. The court held that where the donee is not legally bound and cannot be compelled to surrender its shares at the time of the donation, the right to receive redemption proceeds is not yet “ripe,” such that no realization event is deemed to have occurred until the donee decides to sell its shares. Therefore, the gain realized upon such a sale is taxable to the donee and not the donor.
In Rev. Rul. 78-197, the IRS acquiesced to the court’s ruling in Palmer (i.e.,agreed to follow the Palmer decision), and stated that a donor making a gift of stock followed by a prearranged (but not legally required) redemption will not be deemed to have received the redemption proceeds until he or she is “legally bound or can be compelled by the corporation to surrender the shares.” Revenue rulings are binding on the IRS and thus can provide meaningful guidance on how the IRS will view substantially similar factual situations. Thus, at least in the redemption context, a donor should not be subject to the Doctrine unless the donee has no opportunity to refuse to redeem its shares, even though, as a practical matter, a charitable donee generally will be anxious to have the opportunity to realize cash in exchange for donated shares.
In Caruth Corp. v. United States, 865 F.2d 644 (5th Circuit 1989), the taxpayer owned stock in a corporation that declared a dividend on May 8 to shareholders of record as of May 15. On May 9, the taxpayer donated stock in the corporation to a charity, which then received a dividend of $1.5 million. Approximately two months later, the taxpayer purchased the stock back from the charity for $100,000. The taxpayer claimed a charitable contribution deduction of $1.6 million, the claimed fair market value of the stock at the time it was donated to the charity. While the IRS argued that the dividend had been earned by the taxpayer before the donation because the taxpayer owned the stock when the dividend was declared, the court held that no prior agreement existed requiring the taxpayer to repurchase the stock, and the absence of such an agreement was consistent with the fact that the donation included the taxpayer’s entire interest in the stock, not just the right to the dividend. Because the taxpayer had not merely assigned to the charity its right to the dividend (the Doctrine would have applied to such an assignment) but instead had transferred a complete property interest that consisted of more than the mere right to receive a dividend, the court found that the Doctrine did not apply.
Caruth is a good reminder that, in structuring a donation of business interests, the donor must transfer and the donee must receive all of the rights of ownership, not just the right to receive income attributable to such ownership interest. Caruth also emphasizes that the Doctrine does not seek to prohibit the assignment of income in all its forms, such as income that might flow from the ongoing ownership of a capital asset, but rather only income that might flow from disposition of the capital asset itself.
In Ferguson v. Commissioner, 174 F.3d 997 (9th Circuit 1999), the taxpayer gifted shares of stock to a charity after more than 50 percent of the corporation’s stock had been tendered to a potential buyer. Although the other shareholders were not legally required to tender their shares and the buyer could have backed out, the buyer held enough shares to approve the acquisition of the entire company and thereby convert the remaining shares to a fixed right to merger proceeds. The Tax Court had followed its holding in Palmer and the general reasoning of Rev. Rul. 78-197 regarding the charity’s obligations and rights in the stock to determine that the Doctrine did not apply, but the Ninth Circuit Court of Appeals reversed and held that the practical certainty of the merger was enough to apply the Doctrine. According to the Ninth Circuit, at the time of the donation there was a sufficiently high degree of likelihood that the stock would be sold that the stock had ripened “from an interest in a viable corporation into a fixed right to receive cash.”
Ferguson thus altered the required analysis under the Doctrine, changing the question from whether, at the time of donation, the donee was under a legally binding obligation to sell to a question of the degree of likelihood that the donated property would, in fact, be sold. Given the possibility of unforeseen changes in circumstance that might render a transaction less probable, and given the absence of any legal obligation to proceed with a particular transaction (no matter how likely it then may appear), the standard adopted by the Ninth Circuit may require more prescience than most courts are capable of.
In Rauenhorst v. Commissioner, 119 T.C. 157 (2002), two partners in an entity caused that entity to donate to several charities certain warrants it held to purchase stock in another entity, NMG Inc. A third party sought to purchase all of the stock in NMG Inc. and entered into an agreement with the charities to purchase their warrants. The Tax Court relied heavily on Rev. Rul. 78-197 and held that because the charitable donees had the legal power at the time of the gift to decide whether to sell the warrants, the Doctrine did not apply.
Finally, the IRS determined in Private Letter Ruling 201012050 that the mere fact that the transferred interest in the hands of the transferee may be callable at some future date is not a basis for applying the Doctrine if, at the time of transfer, the transferee is not legally bound, or cannot be compelled, to transfer the interest pursuant to the call right. The taxpayer was a member of a limited liability company (the “LLC”). Another member of the LLC acted as its managing member (the “Managing Member”). The Managing Member was granted the right to “call” certain of the taxpayer’s units upon 30 days prior notice, and the taxpayer likewise had the right to “put” the same number of units back to the Managing Member. The taxpayer proposed to donate a portion of his units to a charity along with the right (so long as the taxpayer continued to hold units sufficient to fulfill a call by the Managing Member) to decide whether the call right, if exercised, should apply to the charity’s units or the taxpayer’s units. The charity also would be able to exercise the taxpayer’s put right with respect to the units donated to the charity. At the time of the donation, no call or put right would be pending. Finally, the charity was to receive full ownership of the units, including voting rights.
Citing Rev. Rul. 78-197, the IRS affirmed that it would apply the Doctrine “only if, at the time of the transfer, the charitable donee is legally bound, or can be compelled, to sell the contributed property.” The IRS went on to explain that “[t]he mere fact that [the charity’s] LLC units may be callable at some future date following the transfer is not a basis for applying the anticipatory assignment of income doctrine, if at the time of transfer [the charity is] not legally bound, or cannot be compelled, to transfer the LLC units to the [other member]” (emphasis added). Notably, the IRS did not reference Ferguson. In its analysis, the IRS focused on the call right, since that right, if operative on the date of transfer, would constitute a legally binding obligation upon the donee to sell. The corresponding put right apparently was immaterial; at least it did not merit any mention in the IRS’ analysis. The IRS observed that the call right in fact was not operative on the date of transfer. The IRS also noted that the charity had the right to require the taxpayer’s units, rather than its own, to be subject to the call right first, thus giving the charity a meaningful opportunity to hold the donated property for the indefinite future.
As a technical matter, a private letter ruling (“PLR”) cannot be cited as precedent and is only binding on the IRS with respect to the taxpayer who requested the PLR. Nonetheless, a PLR indicates the IRS’s position with respect to the matters it addresses and therefore can provide valuable guidance in structuring substantially similar transactions.
As the foregoing summaries demonstrate, it is difficult to distil the Doctrine as it relates to the donation of business interests into bright-line rules given the fact-intensive nature of its application. Nonetheless, we believe that it is fair to state that, as a general rule, the Doctrine does not apply to the donation of appreciated business interests so long as, at the time of the donation, (i) the donated property consists of a complete ownership interest in the business rather than the mere right to receive a predetermined amount of income from the business and (ii) there is a realistic possibility that the charity will hold the donated business interest rather than exchange it for cash. That is, if the charity has no choice but to exchange the appreciated business interest for cash, then the Doctrine likely will apply and cause the donor to realize any gain connected with such exchange.
Unrelated Business Taxable Income
Donors and their advisors often are not aware of the fact that charities are subject to taxation of their “unrelated business taxable income” (“UBTI”). Such tax is often referred to as unrelated business income tax (“UBIT”). UBTI is the income subject to taxation and UBIT is the imposed tax. For charities structured or treated as nonprofit corporations, UBIT is imposed at the corporate tax rates. For charities structured as charitable trusts, the rules applicable to trusts apply to tax such charities UBTI. This topic is fairly complex, and, like many areas of tax, there are rules, exceptions to rules, and exceptions to the exceptions. For the purposes of this article, we want to highlight a couple of issues so that you can better advise your clients.
First, stock in a corporation that is taxed as a C corporation is the “best” type of appreciated business interest to gift to charity. The charity, generally, does not recognize gain on any dividend income earned while holding such stock, and gain on the sale of the stock is not UBTI. S corporation stock is an entirely different matter. Section 512(e) of the Code makes a charity subject to UBIT on its share of all income attributable to an S corporation, including sources that are traditionally tax exempt to charities, such as interest, dividends, rents, and capital gains. Therefore, the Church and its affiliates generally are unwilling to accept donations of stock in a corporation taxed as an S corporation. Such gifts are not very tax efficient, and it is not uncommon to find that there is little difference in the amount of tax that would be imposed if the donor kept the stock, sold it, and donated cash than if the donor made a gift to the Church or its affiliates.
In the case of other entities taxed as partnerships, such as limited liability companies and limited partnerships, because income and gain from the partnership will be allocated to the charity while it is a member, the charity may be reluctant to accept the donation unless the LLC or partnership distributes sufficient funds to cover any UBIT that will be imposed. Upon a sale by the charity of its LLC or partnership interests, the charity may realize additional UBTI on the sale due to the sale including certain ordinary income tax items (“hot assets”) or because the LLC or partnership had depreciation recapture or debt. A common misconception is that a gift of an LLC interest or partnership interest followed by a sale is virtually identical to a gift and sale of C corporation stock. It is not. We often find that a potential gift of LLC interests, followed by a sale of those interests, will generate a substantial amount of UBIT in the hands of the Church or its affiliates. Thus, as in the case of gifts of S corporation stock, at times it is not tax efficient to gift to the Church or its affiliates. Therefore, it is important to provide as much financial information at the front end of the gifting due diligence process so that the parties can explore alternative tax reduction strategies when estimating a large amount of UBIT, particularly where the LLC or partnership carries a substantial amount of debt on its balance sheet.
Documenting and Substantiating the Gift
In order to deduct gifts of appreciated property, such as private stock, a donor must follow certain rules to substantiate the gift and its value. For instance, for gifts valued in excess of $5,000, a donor must obtain a “qualified appraisal” of the asset being gifted. Information relating to the donated asset, including its appraised value, must be included in IRS Form 8283, which must be filed along with the donor’s income tax return. If the value of the gift is over $500,000, the appraisal also must be included with the return. The donor must also obtain from the charity an acknowledgment of the gift. This usually is a letter from the charity saying, “Thank you for your gift of x number of shares of stock in ABC Inc.” The letter should not include any information about value, as the charity does not validate or establish value—the donor is obligated to do so. Note, however, that the charity does have to report any sale of the appreciated asset within three years of the date of the donation. Thus, a charity should not sell the appreciated asset for less than the appraised value. We have at times observed attempts by donors to donate appreciated property at an extraordinarily high appraised value with the intent to buy it back at its “real” value. We have advised donor clients and charity clients not to engage in such transactions.
As one important item of note, a donor need not have the appreciated property appraised prior to making the gift. In fact, if the donor obtains an appraisal more than 60 days prior to the date of the gift, the appraisal may not be used to establish the value for purposes of taking a deduction. Therefore, we often advise, in the case of private stock, membership interest, or partnership interest, that the donor and the donor’s advisors get an appraisal after the donation and after the property sells.
Gift Acceptance Policies and Due Diligence
Charities generally have specific policies relating to receiving gifts of appreciated property or complex assets. The policies and procedures may vary depending on the type of asset, but the basic elements of such policies and procedures are to ensure that the charity is not receiving an asset that will be problematic and to ensure compliance with relevant legal requirements, including transfer restrictions in shareholder agreements (or operating agreements), securities laws, and applicable tax laws.
Below is a summary of the Church’s rules and policies relating to a handful of types of complex assets. In general, these same rules and policies apply to its affiliates. Generally speaking, in each case of a donation of a complex asset, the donation must be approved by the Church’s gift review committee.
The Church will accept gifts of appreciated real estate, including raw law and commercial or residential improved properties. However, it will not accept such properties until it has a chance to review the title, conduct inspections, and determine the value of the property. (The Church Real Estate Division undertakes its own analysis of the value of the property independent of any claimed value by a donor.) Because of the level of analysis that Church Real Estate Division undertakes, year-end gifts generally are not possible. The Church requests at least 90 days to conduct its due diligence. Therefore, a donor who wants to give on December 1 will have to find an alternative to a direct gift of real estate to the Church or its affiliates. The Church Real Estate Division has a donation packet for donors and their advisors that outlines the information needed to consider a gift of real estate. Such gifts will not be processed without providing the information requested in such packet.
Artwork and Collectibles
A gift of artwork, historical artifacts, or similar collectibles must be compatible with the principles and values as well as the religious, charitable, and educational mission of the Church. The Church and its affiliates will not accept partial interests or arrangements that do not include full transfer of title and control of the asset. Commissioned works must be approved by appropriate committees and Church departments or affiliates. Similarly, such departments (or affiliated entities) must be involved in reviewing a potential donation.
These types of donations appear to present the greatest risk of potential abuse. For instance, a donor may claim to have a historical item worth “millions of dollars,” but an actual qualified appraisal may yield a value of only $10,000. We have seen very poor appraisals of these types of items that fall short of the mark of what constitutes a qualified appraisal. Thus, we advise against proceeding with advising a client to make such a gift without a tax compliant appraisal and discussion with the relevant Church department or affiliate with respect to the value of the item. Taking care of these issues at the beginning of the process will avoid disappointment later.
Closely Held Business Interests
The Church is willing to accept donations of closely held business interests, including stock, membership interests, and limited partnership interests. It will not accept gifts of general partnership interests.
Prior to receiving gifts of closely held business interests, the Church and its affiliates require that donors provide various documents relating to the business prior to accepting the gift. These include the organizational and governing documents for the entity, any agreements controlling the equity (e.g., shareholder agreement), financial records (e.g., tax returns, financials, etc.), and various information about the donor (e.g., name, contact information, basis info, etc.). As in the case of real estate, we have an in-kind gift donation packet that requests the necessary information to consider a gift. The primary issues we seek to address ensure that the Church does not take on any liability or risk, that the donation can be made as intended, and that the extent to which the sale of the gifted asset will create UBTI is known.
Gifts of appreciated property or complex assets present a great opportunity for donors and the charities that will accept such gifts. They are tax efficient and make available more funds to the charity. However, such gifts are “complex” because of the various legal and tax issues related to such gifts. It is important to plan giving with these assets well in advance of any transaction so that the gifting can go as the donor and the charity intend.
Brent A. Andrewsen
Kirton McConkie PC