Assignment of Income And Charitable Contributions of Closely Held Stock
October 08, 2018
But I Don’t Want to Pay Any Taxes!
I was recently speaking to an older client who told me that he was contemplating the sale of a commercial rental property that he has owned for many years. The property was not used in his business, was unencumbered and, for all intents and purposes, his adjusted basis – i.e., his unrecovered investment – for the property was zero. The client was concerned about the amount of gain he would recognize on the sale, and the resulting income tax liability.
The gain would be treated as long-term capital gain, I told him, and neither he nor the property was located in a high-tax state. That didn’t alleviate his concern.
I then suggested that he consider a like-kind exchange, but he wasn’t interested in simply deferring the gain; in any case, he didn’t want another property to manage.
I asked if there was a pressing business reason for disposing of the property. When he asked why that was relevant, I replied that he may want to hold on to the property until he died, leaving the property to the beneficiaries of his estate. The property may be valued more “aggressively” than a liquid asset, I explained, and his beneficiaries would take the property with a basis step-up. “Death solves many problems,” I told him, jokingly. That didn’t go over too well.
Finally, I recalled that the client had a somewhat charitable bent, so I mentioned that he may want to consider a contribution to a public charity or to a charitable remainder trust. That seemed to pique his interest, so I explained the basics.
Then I asked him when he planned to list the property. “I already have a buyer,” he responded. Yes, I thought to myself, death solves many problems. After composing myself, I asked “What do you mean, you have a buyer? Have you agreed to a price? Do you have a contract? Are there any contingencies? . . . ”
“Stop with all the questions” – he interrupted me – “why does any of that matter?”
“Let me tell you about the ‘assignment of income doctrine’,” I replied.
Shortly after the above discussion with the client, I came across the decision described below; I forwarded a copy to the client, his accountant, and his real estate lawyer.
Sale of a Business
Target was a closely held foreign corporation in which Taxpayer and others owned stock. Buyer (an S corp.) was Target’s principal customer. Virtually all of Buyer’s stock was owned by an employee stock ownership plan (ESOP). Taxpayer and other Target shareholders were among the beneficiaries of the ESOP. Target and Buyer were also related through common management, with a majority of each corporation’s board of directors serving as directors for both corporations.
Buyer offered to acquire all of Target’s stock for bona fide business reasons. It was proposed that the stock acquisition would proceed in two steps.
Buyer would first purchase 6,100 Target shares (87% of the outstanding shares) from Taxpayer and the other Target shareholders. The proposed purchase price was $4,500 per share. The consideration to be paid by Buyer for this tranche would consist of cash and interest-bearing promissory notes.
The second step involved the remaining 900 shares (13%) of Target’s outstanding stock.
In connection with Buyer’s acquisition of the 6,100 Target shares, Taxpayer agreed to donate 900 Target shares to Charity, an organization that was exempt from Federal income tax under Sec. 501(c)(3) of the Code, and that was treated as a public charity under Sec. 509(a) of the Code.[i] Buyer agreed to purchase each share tendered by Charity for $4,500 in cash.
Taxpayer agreed, after donating their shares to Charity, “to use all reasonable efforts” to cause Charity to tender the 900 shares to Buyer. If Taxpayer failed to persuade Charity to do this, it was expected that Buyer would use a “squeeze-out merger, a reverse stock split or such other action that will result in [Buyer] owning 100% of * * * [Target].” If Buyer failed to secure ownership of Charity’s shares within 60 days of acquiring the 6,100 shares, the entire acquisition would be unwound, and Buyer would return the 6,100 shares to the tendering Target shareholders.
Because Buyer and Target were related parties, the ESOP – a tax-exempt qualified plan – believed that it was required to secure a fairness opinion to ensure that Buyer paid no more than “adequate consideration” for the Target stock. The ESOP trustee hired Appraiser to provide a fairness opinion supported by a valuation report.
In describing the proposed transaction, Appraiser expressed its understanding that Buyer would acquire 100% of Target’s stock “in two stages.” According to Appraiser, “The first stage” involved “the acquisition of 6,100 shares, or approximately 87.1%, of [Target’s] outstanding ordinary shares,” for cash and promissory notes. “Simultaneously with [Buyer’s] acquisition of the 6,100 shares,” Appraiser stated, “certain of [Target’s] shareholders will transfer 900 shares” to Charity. “The second stage of the [transaction] involves the acquisition of the Charity shares for $4,500 per share.”
Appraiser concluded that the fair market value of Target, “valued on a going concern basis,” was between $4,214 and $4,626 per share. Appraiser submitted its findings to the ESOP trustee in an appraisal report and a fairness opinion. Given the range of value it determined for Target, Appraiser opined that the proposed transaction was fair to the beneficiaries of Buyer’s ESOP.
The Sale and the Donation
Two days after Appraiser’s fairness opinion was issued, Buyer purchased 6,100 shares of Target stock from Taxpayer and the other Target shareholders.
It was unclear when Taxpayer donated their 900 shares to Charity; Taxpayer asserted that the donation occurred almost a week before the fairness opinion, whereas the IRS contended that it occurred no earlier than the day of the fairness opinion, allegedly after Charity had unconditionally agreed to sell the 900 shares to Buyer.
Both parties agreed that Charity formally tendered its 900 shares to Buyer on the same day on which the other Target shareholders tendered their shares. And the parties also agreed that Charity received the same per-share price that the other Target shareholders received, but that Charity was paid entirely in cash.
Off to Court
Taxpayer filed Form 1040, U.S. Individual Income Tax Return, for the year of the sale, and claimed a noncash charitable contribution deduction for the stock donated to Charity.
The IRS examined Taxpayer’s return and subsequently issued a notice of deficiency to Taxpayer determining that they were liable for tax under the “anticipatory assignment of income doctrine” on their transfer of shares to Charity; in other words, Taxpayer should have reported the gain from the sale of the 900 shares to Buyer and should be treated as having contributed to Charity the cash received in exchange for such shares.
Taxpayer timely petitioned the U.S. Tax Court for redetermination, and asked for summary judgement on the IRS’s application of the assignment of income doctrine to their donation of Target stock to Charity.
Assignment of Income
A longstanding principle of tax law is that income is taxed to the person who earns it. A taxpayer who is anticipating the receipt of income “cannot avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person.”
The Court noted that it had previously considered the assignment of income doctrine as it applied to charitable contributions. In the typical scenario, the Court explained, the taxpayer donates to a public charity stock that is about to be acquired by the issuing corporation through a redemption, or by another corporation through a merger or other form of acquisition.
In doing so, the taxpayer seeks to obtain a charitable deduction in an amount equal to the fair market value of the stock contributed, while avoiding recognition of the gain, and liability for the tax, resulting from the subsequent sale of the stock. The tax-exempt charity ends up with the proceeds from the sale, undiminished by taxes.
In determining whether the donating taxpayer has assigned income in these circumstances, one relevant question is whether the prospective sale of the donated stock is a mere expectation or a virtual certainty. “More than expectation or anticipation of income is required before the assignment of income doctrine applies,” the Court stated.
Another relevant question, the Court continued, is whether the charity is obligated, or can be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer.
Thus, the existence of an “understanding” among the parties, or the fact that the contribution and sale transactions occur simultaneously or according to prearranged steps, may be relevant in answering that question.
For example, a court will likely find there has been an assignment of income where stock was donated after a tender offer has effectively been completed and it is “most unlikely” that the offer would be rejected, or where stock is donated after the other shareholders have voted and taken steps to liquidate a corporation.
In contrast, there is probably no assignment of income where stock is transferred to a charity before the issuing corporation’s board has voted to redeem it.[ii]
No Summary Judgement
Based on the facts presented, the Court concluded that there existed genuine disputes of material fact that prevented the Court from summarily resolving the assignment of income issue.
Target and Buyer were related by common management, the interests of both companies seemed to have been aligned, and both apparently desired that the stock acquisition be completed. If so, these facts supported the conclusion that the acquisition was virtually certain to occur. In turn, this evidence would support the IRS’s contention that Charity agreed in advance to tender its shares to Buyer and that all the steps of the transaction were prearranged.
However, the parties also disputed the dates on which relevant events occurred. Taxpayer asserted that they transferred their shares to Charity one week before the sale and almost one week before the fairness opinion, and there appeared to have been documentary evidence arguably supporting that assertion. The IRS contended that Charity did not acquire ownership of its 900 shares until (at the earliest) the date of the fairness opinion, allegedly after Charity had unconditionally agreed to sell the 900 shares to Buyer. That contention derived some support from other documentary evidence, as well as from Appraiser’s description of the proposed transaction, which recited that Taxpayer would transfer 900 shares to Charity simultaneously with Buyer’s acquisition of the 6,100 shares.
There were also genuine disputes of material fact concerning the extent to which Charity, having received the 900 shares, was obligated to tender them to Buyer. Appraiser stated in its report that Taxpayer would use “all reasonable efforts to cause * * * [Charity] to agree to sell the shares to [Buyer].” The record included little evidence concerning Taxpayer’s ability to influence Charity’s actions or Charity’s negotiations with Buyer. The IRS contended that Charity had no meaningful discussions with Buyer, but was “simply informed by” Taxpayer that the 900 shares should be tendered at once. The Court pointed out that a trial would be necessary to determine whose version of the facts was correct.
One fact potentially relevant to this question, the Court noted, concerned Buyer’s fiduciary duties as a custodian of charitable assets. If Charity tendered its Target shares, it would immediately receive a significant amount of cash. If it refused to tender its shares and the entire transaction were scuttled, Charity would apparently be left holding a 13% minority interest in a closely held corporation.
In sum, viewing the facts and the inferences that might be drawn therefrom in the light most favorable to the IRS as the nonmoving party, the Court found that there existed genuine disputes of material fact that prevented summary judgement on the assignment of income issue.
Thus, the Court denied Taxpayer’s motion.
Insofar as charitable giving is concerned, there are generally three kinds of taxpayer-donors: (i) those who genuinely believe in the mission of a particular charity and seek to support it, (ii) those who support the charity, or charitable works generally, but who want to use their charitable gift to generate some private economic benefit,[iii] and (iii) those who are not necessarily charitably inclined but who do not want to see their wealth pass to the government.[iv]
Most donors fall into the first category. This is fortunate, in part because the tax benefit that the donation generates for the donor-taxpayer will not compensate the taxpayer for the “lost” economic value represented by the property donated – the gift is being made for the right reason.
That is not say that such donors do not engage in any tax planning with respect to their charitable giving; for example, a donor would generally be better off donating a low basis asset rather than an identical asset with a high basis.
In the case of the closely held business, the donor’s tax planning almost always implicates the assignment of income doctrine. After all, would an owner’s fellow shareholders willingly accept a charity into their fold as an owner? Would the charity accept equity in a closely held business in which it will hold a minority interest, where the interest cannot readily be sold, and which cannot compel cash distributions from the business? Each of these questions has to be answered in the negative.
It is a fact that most charities prefer donations of liquid assets. Under what circumstances, then, may a donation of an interest in a close business ever find its way into the hands of a charity?
In last week’s post[v], we saw how the “excess business holdings” and other rules operate to prevent a private foundation from holding equity in a closely held business. These rules do not apply to public charities, but that does not give such charities carte blanche, nor does it change their preference for gifts of cash or cash equivalents.
A charity will be most open to accepting a gift of an interest in a closely held business where the charity is “assured” that the interest will be redeemed by the business or sold to a third party for cash shortly thereafter.
Unfortunately for the donor-taxpayer, these are also the circumstances in which the IRS will raise the assignment of income doctrine in order to tax the donor-taxpayer on the gain recognized in the redemption or sale of the interest donated to the charity.
As illustrated by the decision discussed above, the application of the doctrine will often be a close call, especially for a business owner who is unaware of its existence.
[i] See last week’s post, for a brief discussion of the distinction between private foundations and public charities.
[ii] Toujours les “facts and circumstances.” Apologies to Napoleon and Patton.
[iii] For example, contributing property to a charitable remainder – split-interest – trust, generating an immediate tax deduction, having the trust sell the property without tax liability, then investing the entire proceeds to generate the cash flow necessary for paying out the annuity or unitrust amount.
[iv] The latter typically name a charity, any charity, as the beneficiary of last resort in the so-called “Armageddon clauses” of their wills and revocable trusts.
[v] But do you remember NYU Law School’s pasta business? Mueller’s anyone?