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Section 1202 Planning: When Might the Assignment of Income Doctrine Apply to a Gift of QSBS?

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Jan 26, 2022

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Blogs Qualified Small Business Stock (QSBS) Tax Law Defined™ Blog

Scott W. Dolson

Section 1202 allows taxpayers to exclude gain on the sale of QSBS if all eligibility requirements are met.  Section 1202 also places a cap on the amount of gain that a stockholder is entitled to exclude with respect to a single issuer’s stock. [i]   A taxpayer has at least a $10 million per-issuer gain exclusion, but some taxpayer’s expected gain exceeds that cap.  In our article Maximizing the Section 1202 Gain Exclusion Amount , we discussed planning techniques for increasing, and in some cases multiplying, the $10 million gain exclusion cap through gifting QSBS to other taxpayers. [ii]  Increased awareness of this planning technique has contributed to a flurry of stockholders seeking last-minute tax planning help.  This article looks at whether you can “multiply” Section 1202’s gain exclusion by gifting qualified small business stock (QSBS) when a sale transaction is imminent.

This is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045.  During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice.  Much of this interest can be attributed to the reduction in the corporate rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion.  Recently proposed tax legislation sought to curb Section 1202’s benefits, but that legislation, along with the balance of President Biden’s Build Back Better bill, is currently stalled in Congress.

The Benefits of Gifting QSBS

Section 1202(h)(1) provides that if a stockholder gifts QSBS, the recipient of the gift is treated as “(A) having acquired such stock in the same manner as the transferor, and (B) having held such stock during any continuous period immediately preceding the transfer during which it was held (or treated as held under this subsection by the transferor.”  This statute literally allows a holder of $100 million of QSBS to gift $10 million worth to each of nine friends, with the result that the holder and his nine friends each having the right to claim a separate $10 million gain exclusion.  Under Section 1202, a taxpayer with $20 million in expected gain upon the sale of founder QSBS can increase the overall tax savings from approximately $2.4 million (based on no Federal income tax on $10 million of QSBS gain) to $4.8 million (based on no Federal income tax on $20 million of QSBS gain) by gifting $10 million worth of QSBS to friends and family. [iii]

A reasonable question to ask is whether it is ever too late to make a gift of QSBS for wealth transfer or Section 1202 gain exclusion cap planning?  What about when a sale process is looming but hasn’t yet commenced?  Is it too late to make a gift when a nonbinding letter of intent to sell the company has been signed?   What about the situation where a binding agreement has been signed but there are various closing conditions remaining to be satisfied, perhaps including shareholder approval?  Finally, is it too late to make a gift when a definitive agreement has been signed and all material conditions to closing have been satisfied?

Although neither Section 1202 nor any other tax authorities interpreting Section 1202 address whether there are any exceptions to Section 1202’s favorable treatment of gifts based on the timing of the gift, the IRS is not without potential weapons in its arsenal.

Application of the Assignment of Income Doctrine

If QSBS is gifted in close proximity to a sale, the IRS might claim that the donor stockholder was making an anticipatory assignment of income. [iv]

As first enunciated by the Supreme Court in 1930, the anticipatory assignment of income doctrine holds that income is taxable to the person who earns it, and that such taxes cannot be avoided through “arrangement[s] by which the fruits are attributed to a different tree from that on which they grew.” [v]   Many assignment of income cases involve stock gifted to charities immediately before a prearranged stock sale, coupled with the donor claiming a charitable deduction for full fair market value of the gifted stock.

In Revenue Ruling 78-197, the IRS concluded in the context of a charitable contribution coupled with a prearranged redemption that the assignment of income doctrine would apply only if the donee is legally bound, or can be compelled by the corporation, to surrender shares for redemption. [vi]  In the aftermath of this ruling, the Tax Court has refused to adopt a bright line test but has generally followed the ruling’s reasoning.  For example, in Estate of Applestein v. Commissioner , the taxpayer gifted to custodial accounts for his children stock in a corporation that had entered into a merger agreement with another corporation. Prior to the gift, the merger agreement was approved by the stockholders of both corporations.  Although the gift occurred before the closing of the merger transaction, the Tax Court held that the “right to the merger proceeds had virtually ripened prior to the transfer and that the transfer of the stock constituted a transfer of the merger proceeds rather than an interest in a viable corporation.” [vii]   In contrast, in Rauenhorst v. Commissioner , the Tax Court concluded that a nonbinding letter of intent would not support the IRS’ assignment of income argument because the stockholder at the time of making the gift was not legally bound nor compelled to sell his equity. [viii]

In Ferguson v. Commissioner , the Tax Court focused on whether the percentage of shares tendered pursuant to a tender offer was the functional equivalent of stockholder approval of a merger transaction, which the court viewed as converting an interest in a viable corporation to the right to receive cash before the gifting of stock to charities. [ix]   The Tax Court concluded that there was an anticipatory assignment of income in spite of the fact that there remained certain contingencies before the sale would be finalized.  The Tax Court rejected the taxpayer’s argument that the application of the assignment of income doctrine should be conditioned on the occurrence of a formal stockholder vote, noting that the reality and substance of the particular events under consideration should determine tax consequences.

Guidelines for Last-Minute Gifts

Based on the guidelines established by Revenue Ruling 78-197 and the cases discussed above, the IRS should be unsuccessful if it asserts an assignment of income argument in a situation where the gift of QSBS is made prior to the signing of a definitive sale agreement, even if the company has entered into a nonbinding letter of intent.  The IRS’ position should further weakened with the passage of time between the making of a gift and the entering into of a definitive sale agreement.  In contrast, the IRS should have a stronger argument if the gift is made after the company enters into a binding sale agreement.  And the IRS’ position should be stronger still if the gift of QSBS is made after satisfaction of most or all material closing conditions, and in particular after stockholder approval.  Stockholders should be mindful of Tax Court’s comment that the reality and substance of events determines tax consequences, and that it will often be a nuanced set of facts that ultimately determines whether the IRS would be successful arguing for application of the assignment of income doctrine.

Transfers of QSBS Incident to Divorce

The general guidelines discussed above may not apply to transfers of QSBS between former spouses “incident to divorce” that are governed by Section 1041.  Section 1041(b)(1) confirms that a transfer incident to divorce will be treated as a gift for Section 1202 purposes.  Private Letter Ruling 9046004 addressed the situation where stock was transferred incident to a divorce and the corporation immediately redeemed the stock.  In that ruling, the IRS commented that “under section 1041, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of the asset.  The spouses are thus free to negotiate between themselves whether the ‘owner’ spouse will first sell the asset, recognize the gain or loss, and then transfer to the transferee spouse the proceeds from the sale, or whether the owner spouse will first transfer the asset to the transferee spouse who will then recognize gain or loss upon its subsequent sale.”  Thus, while there are some tax cases where the assignment of income doctrine has been successfully asserted by the IRS in connection with transfers between spouses incident to divorce, Section 1041 and tax authorities interpreting its application do provide divorcing taxpayers an additional argument against application of the doctrine, perhaps even where the end result might be a multiplication of Section 1202’s gain exclusion.

More Resources 

In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning. Venture capitalists, founders and investors who want to learn more about QSBS planning opportunities are directed to several articles on the Frost Brown Todd website:

  • Planning for the Potential Reduction in Section 1202’s Gain Exclusion
  • Section 1202 Qualification Checklist and Planning Pointers
  • A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
  • Maximizing the Section 1202 Gain Exclusion Amount
  • Advanced Section 1045 Planning
  • Recapitalizations Involving Qualified Small Business Stock
  • Section 1202 and S Corporations
  • The 21% Corporate Rate Breathes New Life into IRC § 1202
  • View all QSBS Resources

Contact  Scott Dolson  or  Melanie McCoy  (QSBS estate and trust planning) if you want to discuss any QSBS issues by telephone or video conference.

[i] References to “Section” are to sections of the Internal Revenue Code.

[ii] The planning technique of gifting QSBS recently came under heavy criticism in an article written by two investigative reporters.  See Jesse Drucker and Maureen Farrell, The Peanut Butter Secret: A Lavish Tax Dodge for the Ultrawealthy.  New York Times , December 28, 2021.

[iii] But in our opinion, in order to avoid a definite grey area in Section 1202 law, the donee should not be the stockholder’s spouse.  The universe of donees includes nongrantor trusts, including Delaware and Nevada asset protection trusts.

[iv] This article assumes that the holder of the stock doesn’t have sufficient tax basis in the QSBS to take advantage of the 10X gain exclusion cap – for example, the stock might be founder shares with a basis of .0001 per share.

[v]   Lucas v. Earl , 281 U.S. 111 (1930).  The US Supreme Court later summarized the assignment of income doctrine as follows:  “A person cannot escape taxation by anticipatory assignments, however skillfully devised, where the right to receive income has vested.”  Harrison v. Schaffner , 312 U.S. 579, 582 (1941).

[vi] Revenue Ruling 78-197, 1978-1 CB 83.

[vii] Estate of Applestein v. Commissioner , 80 T.C. 331, 346 (1983).

[viii] Gerald A. Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[ix] Ferguson v. Commissioner , 108 T.C. 244 (1997).

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Hoensheid: assignment of income and gift substantiation.

It is fairly common to make charitable gifts of property prior to a sale transaction. Often, those gifts are of real property or closely-held business interests. This is for good reason. Structured properly, not only do donors generally receive a charitable income tax deduction equal to the fair market value of the donated property, they also avoid any capital gains on the sale of that property. [1] The double benefit of both avoiding capital gain and receiving a full fair market value deduction can be quite powerful. [2]

As stated above, however, the gift must be structured properly in order to obtain these benefits. Two of the important areas in this regard are: (1) avoidance of an assignment of income; and (2) proper gift substantiation. We have previously written about cases where these issues have arisen. [3]   A recent Tax Court opinion once again addresses these issues, [4] this time possibly contradicting IRS guidance [5] and a previous binding opinion of the full Tax Court. [6]

Commercial Steel Treating Corp. (“CTSC”) was owned by three brothers. After one of the brothers announced his plans to retire in the Fall of 2014, the three brothers decided to solicit bids for a sale of the company. In so doing, they engaged a financial advisory firm which began the process in early 2015.

Once that process started, the following sequence of events unfolded:

  • April 1, 2015: HCI Equity Partners (“HCI”) submitted a draft Letter of Intent (“LOI”) to acquire CTSC.
  • Mid April 2015: Mr. Hoensheid, one of the owner/brothers and the taxpayer in this case, begins discussing the possibility of establishing a donor advised fund (“DAF”) to make a charitable contribution of CTSC stock prior to the anticipated sale to take advantage of the type of planning described above (i.e. double benefit of fair market value charitable deduction and avoidance of capital gains on the donated shares).
  • April 16, 2015: Mr. Hoensheid’s attorney emailed that “the transfer would have to take place before there is a definitive agreement in place.” [7]
  • April 23, 2015: LOI between HCI and CTSC was executed.
  • May 22, 2015: CTSC executed an Affidavit of Acquired Person for the Federal Trade Commission representing that CTSC had “a good faith intention of completing the transaction.”
  • Valuation date of CTSC submitted in substantiation of charitable deduction.
  • Hoensheid emailed his attorney that “I do not want to transfer the stock until we are 99% sure we are closing.”
  • Shareholders and Directors meetings ratifying sale of all stock of CTSC to HCI.
  • CTSC submitted to the Michigan Department of Licensing and Regulatory Affairs an amendment to its Articles of Incorporation per request from HCI.
  • Stock Purchase Agreement submitted by Mr. Hoensheid’s attorney to Fidelity Charitable for execution (dated effective June 15, 2015).
  • Shareholders approve Mr. Hoensheid’s transfer of an unspecified number of CTSC shares to Fidelity.
  • June 12, 2015: HCI’s investment committee and managing partners approved acquisition of CTSC.
  • HCI formed a new Delaware corporation to serve as the acquirer of CTSC.
  • Hoensheid sends an email that he is “not totally sure of the shares being transferred to the charitable fund yet.”
  • July 7: CTSC determined to distribute payments to employees pursuant to a Change of Control Bonus Plan and almost all remaining cash to its shareholders.
  • Email from Mr. Hoensheid’s financial advisor that “it looks like Scott has arrived at 1380 shares.”
  • Hoensheid delivered the stock certificate transferring shares in CTSC to his attorney.
  • Revised draft Stock Purchase Agreement circulated with missing date upon which Mr. Hoensheid transferred shares to Fidelity Charitable.
  • CTSC paid bonuses to employees under Change of Control Bonus plan.
  • Redline draft of Stock Purchase Agreement circulated indicating acceptance of all substantive changes.
  • Printout list of CTSC shareholders indicating gift to Fidelity Charitable from Mr. Hoensheid on July 10, 2015.
  • PDF stock certificate submitted by email to Fidelity Charitable showing the stock transfer from Mr. Hoensheid to Fidelity Charitable.
  • July 14: CTSC distributed almost all remaining cash to its shareholders.
  • July 15, 2015: Transaction closing and funding.

There was some dispute between the taxpayers and the IRS about the date of the charitable gift. The taxpayers argued the stock was gifted on July 10, 2015, the date upon which Mr. Hoensheid decided to transfer 1380 shares of CTSC to Fidelity Charitable, executed a stock certificate to that effect, and delivered the stock certificate to his attorney. However, the IRS argued, and the Tax Court agreed, that the transfer did not occur until July 13, 2015. The reason was that, citing to Michigan law [8] , there was no deliver of the gift to the charity until the PDF stock certificate was sent [9] and no acceptance of the gift until Fidelity Charitable’s email on July 13, 2015, acknowledging same. [10] As a result, for purposes of the tax dispute, July 13, 2015, was the date of the charitable donation.

Assignment of Income

The assignment of income doctrine recognizes income as taxed “to those who earn or otherwise create the right to receive it.” [11] Particularly in the charitable donation context, a donor will be deemed “to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income.” [12] This analysis looks “to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities.” [13] The form of a charitable donation will not be respected if the donor does not: (1) give the appreciated property away absolutely and divest of title (2) before the property gives rise to income by way of a sale. [14]

Before analyzing Mr. Hoensheid’s donation through the relevant tests for assignment of income, the Tax Court addressed arguments raised by Mr. Hoensheid regarding existing guidance. In addition to other sources, this is particularly important in citing to Rev. Rul. 78-197 and Rauenhorst [15] . In Rev. Rul. 78-197 the IRS acquiesced in the Palmer [16] decision where a donor transferred shares in a closely-held corporation he controlled to a private foundation he also controlled, followed by a redemption of those shares by the corporation. The IRS argued the substance of the transaction was a redemption followed by a cash contribution since the taxpayer had a “prearranged plan” of redeeming the shares at the time of the contribution. After the Tax Court ruled in favor of the taxpayer, the IRS issued Rev. Rul. 78-197 stating that “the Service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation to surrender the shares for redemption ” (emphasis added). Certainly, regardless of any other facts, there was nothing to legally compel a closing of the sale of CTSC stock to HCI, or otherwise compel such closing, at the date of Mr. Hoensheid’s charitable gift.

In Palmer , the Tax Court held that certain charitable gifts made after a redemption of stock was “imminent” did not constitute an assignment of income. In Rauenhorst , the Tax Court noted that the IRS attempted to “devise a ‘bright-line’ test which focuses on the donee’s control over the disposition of the appreciated property” by adopting Rev. Rul. 78-197. Although Revenue Rulings do not bind the Tax Court, they do bind the IRS. When there was an LOI, but no binding obligation to sell, therefore, the IRS was precluded in Rauenhorst from arguing there as an assignment of income when the facts in the case were not distinguishable from those in Rev. Rul. 78-197. The facts in Rauenhorst bear similarities to those in Hoensheid . In Rauenhorst , there was a signed LOI, a resolution authorizing executing an agreement of sale, and a valuation report indicating there was little chance the transaction would not close.

However, in Rauenhorst , and cited in Hoensheid , the Tax Court noted “we have indicated our reluctance to elevate the question of donee control to a talisman for resolving anticipatory assignment of income” and that the donee’s power to reverse the transaction is “only one factor to be considered in ascertaining the ‘realities and substance’ of the transaction.” In Rauenhorst and Hoensheid , the Tax Court stated that “the ultimate question is whether the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in property at the time of the transfer.” [17] As such, notwithstanding that the Tax Court in Rauenhorst held the IRS to its position in Rev. Rul. 78-197, the court stated that “in the appropriate case we could disregard a ruling or rulings as inconsistent with our interpretation of the law.” As such, while Hoensheid could be seen as inconsistent with Rauenhorst , it also could be seen as consistent insofar as the Tax Court kept the door open for the Hoensheid result in the opinion it issued in Rauenhorst . [18]

In making that determination the Tax Court in Hoensheid looked at factors including: (1) “any legal obligation to sell by the donee”, (2) “the actions already taken by the parties to effect the transaction”, (3) “the remaining unresolved transactional contingencies”, and (4) “the status of the corporate formalities required to finalize the transaction.”

Applying these factors, while conceding that there was no obligation of Fidelity Charitable to sell shares at the time of contribution, the Tax Court found there to be an assignment of income. The court cited to the number of acts which had taken place at the time of the donation which rendered the transaction a “foregone conclusion.” Relevant facts included that, on the date of the charitable donation, corporate formalities of approving the transaction had occurred, bonuses payable to employees resulting from the transaction had been paid, dividends had been paid to such an extent that CTSC no longer remained a viable going concern, and all substantive terms of the transaction had been fully negotiated. Ultimately, the court stated that, by July 13, 2015, “the transaction had simply ‘proceeded too far down the road to enable petitioners to escape taxation on the gain attributable to the donated shares.’”

Substantiation

Although the scope of this writing is to address the concept of anticipatory assignment of income and the Hoensheid opinion, particularly as it relates to prior authorities and guidance, it is important to note the substantiation issues which ultimately cost the taxpayers any charitable deduction. Even finding an assignment of income, the taxpayers would be entitled to charitable donation equal to the fair market value of the shares gifted. They merely would be forced to recognized their share of gain from the sale transaction. However, having failed to satisfy the charitable donation substantiation requirements, the taxpayers lost the deduction in full.

Relevant in Hoensheid , gifts of property of more than $500,000 require taxpayers to obtain a qualified appraisal from a qualified appraiser to attach to the taxpayer’s income tax return for the year of the gift. [19] Although the scope of what constitutes a “qualified appraisal” from a “qualified appraiser” is beyond the scope of this writing, in Hoensheid , the taxpayer failed primarily as a result of obtaining an appraisal from someone unqualified to render valuations for purposes of substantiating charitable gifts.

The Tax Court notes that the requirement for the appraiser to be qualified is “the most important requirement” of the regulations. [20] The appraiser in Hoensheid only infrequently performed valuations, did not hold himself out as an appraiser, and held no certifications from any professional appraiser organization. Based on these and other factors, it was clear that the appraiser in Hoensheid was not a “qualified appraiser” as contemplated by the applicable statute and regulations. By all accounts, he was used because he charged no fee for the valuation, instead offering to perform the valuation under the fees paid to the financial advisory firm handling the sale transaction which is where he was employed. In addition to the appraiser lacking the proper qualifications, the valuation report contained a number of deficiencies which rendered it not to constitute a “qualified appraisal” either. One of such problems was using a June 1, 2015, valuation date when intervening events between that date and the date of the gift, including the substantial bonus and dividend distributions, should have caused the value of CSTC to materially change.

Although “substantial compliance” can be sufficient in satisfying regulatory substantiation requirements [21] , the Tax Court found that Mr. Hoensheid failed to substantially comply due to his failure to engage a qualified professional to complete the valuation along with the numerous errors could not be concluded to satisfy the requirements of substantial compliance. However, as a silver lining, in avoiding a 20% underpayment penalty [22] , Mr. Hoensheid was held to have reasonably relied on his attorney’s advice that the deadline for the charitable donation was the date a definitive agreement is executed.

Here, Mr. Hoensheid made a couple of fatal choices. First, he chose to wait until the transaction was 99% sure to close before making the charitable gift. Second, he cut corners by using a free and unqualified appraiser rather than simply paying for a qualified valuation professional. Sure, Mr. Hoensheid’s professional advisors led him to believe he may have had until the closing (the date the purchase agreement would be signed) in order to make the gift. Further, his attorney may have been justified in believing that to constitute the law given Rauenhorst and Rev. Rul. 78-197. However, his own attorney said “any tax lawyer worth [her] fees would not have recommended that a donor make a gift of appreciated stock” so close to the closing.

It is understandable that taxpayers desire to wait until they are confident a sale will close before donating equity interests. We encounter that frequently. There is no clear, bright-line date on which the tests as discussed in Hoensheid may apply (as opposed to Rauenhorst and Rev. Rul. 78-197). As such, taxpayers and their planners should look to the timeline in this case and the Tax Court’s discussion in determining when to make charitable gifts in anticipation of a sale. In many cases, closing and purchase agreement execution occur simultaneously as opposed to transactions where a purchase agreement is signed with a number of contingencies and before much of the due diligence or other pre-closing details have been finalized. Extra care is likely needed when there is a contemporaneous execution and closing, as in  Hoensheid . While no legally binding document may have been executed, the deal may be a “foregone conclusion” at some point along the spectrum.

Of course, beyond the assignment of income issues, we continue to see taxpayers trip up on charitable gift substantiation. [23] Sometimes it is a mere mistake; other times taxpayers try to cut corners and/or save money by not engaging the proper professionals. When large gifts are being made, real value is being donated. The donor will never get those funds back and the costs of complying with the substantiation requirements is typically much less than the value of the deduction, especially when gifts are made in advance of a liquidity event.

[1] This presumes a donation of long-term capital gain property to a public charity, generally subject to a limitation on the deduction of 30% of the donor’s adjusted gross income. IRC § 170(b)(1)(C).

[2] As an example, a top bracket taxpayer (37% ordinary income tax bracket and 20% capital gains bracket) who donates a $1 million asset with a $200,000 cost basis stands to obtain both an $1M income tax deduction for a benefit of $370,000 and also avoid $800,000 of capital gains for a benefit of $160,000, yielding a combined tax benefit of $530,000. This means the true cost of the $1 million charitable gift was only $470,000. The savings may be more to the extent the net investment income tax and/or state income tax applies.

[3] Allen, Charles J., “IRS Continues Aggressive Stance on Charitable Contributions,” Oct. 23, 2018, https://esapllc.com/chrem-case/ ; and Sage, Joshua W., “Gifting Appreciated Stock Before Redemption – Dickinson,” Oct. 6, 2020, https://www.esapllc.com/dickinson-redemption2020/ .

[4] Estate of Scott Hoensheid, et ux. v. Commissioner , T.C. Memo 2023-34.

[5] Rev. Rul. 78-197.

[6] Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[7] These statements were repeated in an email from the taxpayer’s financial advisor on April 20, 2015, and the taxpayer’s attorney on April 21, 2015.

[8] Michigan law requires a showing of: (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee , 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

[9] Although the stock ledger showing an earlier transfer date could have possibly substantiated delivery, that printout was dated July 13, 2015, meaning the Tax Court could not determine an earlier date upon which CTSC acknowledged the transfer.

[10] Again, here, there were communications with Fidelity Charitable showing a July 11, 2015, transfer date but the documentary proof provided to the Tax Court by the taxpayers bore a July 15, 2015, date rather than a production of the earlier original. As such, absent proper proof, the Tax Court could not conclude a July 11, 2015, acceptance date occurred.

[11] Helvering v. Horst , 311 U.C. 112, 119 (1940).

[12] Cold Metal Process Co. v. Commissioner , 247 F.2d 864, 872-73 (6th Cir. 1957).

[13] Jones v. U.S. , 531 F.2d 1343, 1345 (6th Cir. 1976); and Allen v. Commissioner , 66 T.C. 340, 346 (1976).

[14] Humacid Co. v. Commissioner , 42 T.C. 894, 913 (1964).

[15] See supra Note 6.

[16] Palmer v. Commissioner , 62 T.C. 684 (1974),

[17] Citing Ferguson v. Commissioner , 108 T.C. 244 (1997).

[18] Note also the Ninth Circuit’s opinion in Ferguson v. Commissioner , 174 F.3d 997 (9th Cir. 1999), whereby assignment of income was found where a threshold of a tender of 85% of corporate shares was required prior to any binding obligations to sell when only more than 50% had been transferred at the time of the gift, the court finding there was enough “momentum” to the transaction to make the merger “most unlikely” to fail. This extension of the assignment of income doctrine was specifically refused to be followed by the U.S. District Court in Keefer v. U.S. , 2022 WL 2473369, particularly given that the case was appealable to the Fifth Circuit Court of Appeals.

[19] IRC §170(f)(11)(D) and (E), and Treas. Reg. § 1.170A-13.

[20] Citing Mohamed v. Commissioner , T.C. Memo 2012-152.

[21] We have discussed substantial compliance in other writings including, Gray Edmondson, “RERI Revisited on Appeal, $33M Deduction Denial Upheld,” June 5, 2019, https://esapllc.com/reri-appeal/ ; and Devin Mills, “Private Jet Deduction Fails for Lack of Substantiation,” July 26, 2022, https://esapllc.com/izen-jet-2022/ .

[22] IRC § 6662 based on any underpayment of tax required to be shown on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax.

[23] For a recent article discussing charitable gift substantiation, including substantial compliance, see Sholk, Steven H., “A Guide to the Substantiation Rules for Deductible Charitable Contributions,” 137 J. Tax’n 03 (Dec. 2022).

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  • TAX MATTERS

Appreciated stock donation not treated as a taxable redemption

The tax court holds that taxpayers made an absolute gift..

  • Individual Income Taxation

The Tax Court granted summary judgment to a married couple, ruling that the IRS improperly recharacterized their charitable donations of stock as taxable redemptions. The court held the couple made an absolute gift in each tax year at issue, and although the charity soon after redeemed the stock, the court respected the form of the transaction.

Facts:  Jon and Helen Dickinson claimed a charitable contribution deduction on their joint federal income tax returns for 2013 through 2015, due to a contribution each year by Jon Dickinson of appreciated stock in his employer, Geosyntec Consultants Inc. (GCI), a privately held company, to Fidelity Investments Charitable Gift Fund, a Sec. 501(c)(3) tax-exempt organization. Dickinson was GCI’s CFO.

GCI’s board of directors authorized shareholders to donate GCI shares to Fidelity in written consent actions in 2013 and 2014, stating that Fidelity’s donor-advised fund program required Fidelity “to immediately liquidate the donated stock” and that the charity “promptly tenders the donated stock to the issuer for cash.” The board also authorized donations in 2015.

GCI confirmed in letters to Fidelity the recording of Fidelity’s new ownership of the shares. Dickinson signed a letter of understanding to Fidelity regarding each stock donation, stating that the stock was “exclusively owned and controlled by Fidelity.” Fidelity sent confirmation letters stating that it had “exclusive legal control over the contributed asset.” Fidelity redeemed the GCI shares for cash shortly after each donation.

The IRS issued a notice of deficiency, asserting that the Dickinsons were liable for tax on the redemption of the donated GCI shares and a penalty under Sec. 6662(a) for each year. The Service contended the donations should be treated in substance as taxable redemptions of the shares for cash by Dickinson, followed by donations of the cash to Fidelity.

The Dickinsons petitioned the Tax Court for a redetermination of the deficiencies and penalties and moved for summary judgment.

Issue:  Generally, pursuant to Sec. 170 and Regs. Sec. 1.170A-1(c)(1), a taxpayer may deduct the fair market value of appreciated property donated to a qualified charity without recognizing the gain in the property.

In  Humacid Co. , 42 T.C. 894, 913 (1964), the Tax Court stated: “The law with respect to gifts of appreciated property is well established. A gift of appreciated property does not result in income to the donor so long as [1] he gives the property away absolutely and parts with title thereto [2] before the property gives rise to income by way of a sale.” 

The issue before the court was whether the form of Dickinson’s donations of GCI stock should be respected as meeting the requirements in  Humacid Co. , or recharacterized as taxable redemptions resulting in income to the Dickinsons.

Holding:  The Tax Court held that the form of the stock donations should be respected, as both prongs of  Humacid Co.  were satisfied, and granted the taxpayers summary judgment.

Regarding the first prong, the court held that Dickinson transferred all his rights in the shares to Fidelity, based on GCI’s letters to Fidelity confirming the transfer of ownership in the shares, Fidelity’s letters to the Dickinsons stating it had “exclusive legal control” over the donated stock, and the letters of understanding. Thus, Dickinson made an absolute gift.

The Tax Court analyzed the second prong under the assignment-of-income doctrine. This provides that a taxpayer cannot avoid taxation by assigning a right to income to another. The court stated: “Where a donee redeems shares shortly after a donation, the assignment of income doctrine applies only if the redemption was practically certain to occur at the time of the gift, and would have occurred whether the shareholder made the gift or not.”

The Tax Court noted that in  Palmer , 62 T.C. 684 (1974), it held there was no assignment of income where there was not yet a vote for a redemption at the time of a stock donation, even though the vote was anticipated. Similarly, the court reasoned that “the redemption in this case was not a fait accompli at the time of the gift” and held Dickinson did not avoid income due to the redemption by donating the GCI shares. Thus, the court respected the form of the transaction.

The Tax Court did not apply Rev. Rul. 78-197, in which the IRS ruled that it “will 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 [issuing] corporation, to surrender the shares for redemption.” The court noted that it has not adopted the revenue ruling, and furthermore, the IRS did not allege that Dickinson had a fixed right to redemption income at the time of the donation.

  • Dickinson , T.C. Memo. 2020-128

—  By Mark Aquilio, CPA, J.D., LL.M. , professor of accounting and taxation, St. John’s University, Queens, N.Y.

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Tax Alert | Tax Court Guidance on Charitable Contributions and Assignment of Income

Tax Court Guidance on Charitable Contributions and Assignment of Income - Tax Alert - February 2024 - Brach Eichler

February 26, 2024

Tax Court Guidance on Charitable Contributions and Assignment of Income

Today is the first of two alerts dealing with the Estate of Hoensheid v. Commissioner of Internal Revenue, T.C. Memo 2023-34 (2023). In this, the first, the standard for determining whether a taxpayer has made an anticipatory assignment of income is discussed. The judicially created  anticipatory assignment of income doctrine recognizes that income is taxed to those who earn or otherwise create the right to receive it and that it cannot be assigned or gifted away.

Hoensheid involves a common fact pattern. The taxpayer was one of three owners of a closely held business, wishing to both sell and to contribute part or all of the proceeds to a tax exempt charity or donor advised fund, the assignee. If properly structured, the owner receives a charitable deduction equal to the fair market value of the contributed property and the built in gain on the investment is taxed to the charity. In order to do so, the owner must contribute the ownership interest (in this case 1380 shares of stock) to the charity, but when?  Like most owners, the taxpayer in Hoensheid wanted to wait as long as possible before making the actual contribution. During the course of the negotiations concerning the sale, the taxpayer was advised that the contribution had to be completed before any purchase agreement was executed. This is referred to the binding agreement test and has its origin in Rev. Rul. 78-197. If you contribute before the purchase agreement is signed, no anticipatory assignment. If you contribute after the purchase agreement is signed, anticipatory assignment. It provides a bright line for taxpayers. But is it that simple? The Tax Court first analyzed the requirements under state law to determine when the gift was completed. It concluded the gift took place on July 13, 2015 two days before the signing of the SPA on July 15, 2015 seemingly within the bright line test of Rev. Rul. 78-197. The Tax Court agreed that the gift occurred before the sale and that the charity was not obligated to sell at the time of the gift, but that although the donee’s legal obligation to sell is significant to the assignment of income analysis, it was only one factor.

In short, there is no bright line but there are multiple factors in an assignment of income analysis of a fact pattern. Instead, the ultimate question is whether  the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in the property at the time of transfer. If the sale was virtually certain to occur, the anticipatory assignment of income doctrine is satisfied and the taxpayer, not the charity, is taxed on the sales proceeds from the charities sale.

In this case, the relevant factors in determining whether the sale of shares were virtually certain to occur include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transactions.

With regard to the first factor, the Tax Court held that there was no proof of any obligation of the charity to sell the shares either formal or informal. This was a favorable factor for the taxpayer.

With regard to the second factor, the Tax Court found that their were bonus and shareholder distributions made before the SPA was executed. This factor indicates that the income was earned at an earlier point in time.

With regard to the third factor, the Tax Court found that there were major transactional contingencies (environmental obligations) but that they had been resolved before the SPA was executed. This factor indicates that the income was earned at an earlier point in time.

With regard to the fourth factor, the Tax Court found that after the SPA was executed there were only ministerial actions remaining. This factor indicates that the income was earned at an earlier point in time.

The tax court, based on the various factors mentioned above that the income or gain from the sale was earned at an earlier point in time, resulting in the taxpayer being treated as the seller of the shares of stock purportedly gifted to the charity.

In summary, as the Tax Court found, to avoid an anticipatory assignment of income on the contribution of appreciated shares of stock followed by a sale of the donee, a donor must bear at least some risk at the time of contribution that the sale will not close. The bright line of Rev. Rul. 78-187 was a factor but compliance with that alone did not provide a safe harbor. Other factors needed to be considered to determine if the gain was earned before the sale and taxable to the donor.

If you are the owner of a closely held business and are contemplating a charitable gift of a portion of your ownership interest do not hesitate to contact either David Ritter, Stuart Gladstone, Bob Kosicki or Cheryl Ritter for guidance in dealing with the multiple factors set forth in the anticipatory assignment of income doctrine.

For more information or assistance, please contact: 

David J. Ritter, Esq. , Member and Chair, Tax Practice , at  [email protected] or 973-403-3117

Stuart M. Gladstone, Esq. , Member,  Tax Practice , at  [email protected]  or 973-403-3109

Robert A. Kosicki, Esq. , Counsel, Tax Practice , at  [email protected] or 973-403-3122

Cheryl L. Ritter, Esq. , Counsel, Tax Practice , at  [email protected] or 973-364-8307

About Brach Eichler LLC

Brach Eichler LLC, is a full-service law firm based in Roseland, NJ. With over 80 attorneys, the firm is focused in the following practice areas: Healthcare Law; Real Estate; Litigation; Trusts and Estates; Corporate Transactions & Financial Services; Personal Injury; Criminal Defense and Government Investigations; Labor and Employment; Environmental and Land Use; Family Law Services; Patent, Intellectual Property & Information Technology; Real Estate Tax Appeals; Tax; and Cannabis Law. Brach Eichler attorneys have been recognized by clients and peers alike in The Best Lawyers in America©, Chambers USA, and New Jersey Super Lawyers. For more information, visit www.bracheichler.com .

This alert is intended for informational and discussion purposes only. The information contained in this alert is not intended to provide, and does not constitute legal advice or establish the attorney/client relationship by way of any information contained herein. Brach Eichler LLC does not guarantee the accuracy, completeness, usefulness or adequacy of any information contained herein. Readers are advised to consult with a qualified attorney concerning the specifics of a particular situation.

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Related Attorney:   Cheryl L. Ritter , David J. Ritter , Stuart M. Gladstone , Robert A. Kosicki

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assignment of income and gifts

A recent taxpayer victory in the Tax Court in the case of Jon Dickinson, et ux. v. Commissioner, TC Memo 2020‑128 (Sept. 3, 2020), is an important reminder to donors and potential charitable donees to be well informed of the law when donating, or soliciting donations of, appreciated closely held business interests.

Benefits of Donating Appreciated Interests Ahead of Sales

Wise taxpayers, frequently on the advice of their knowledgeable tax advisors, know that when making a charitable gift, it is typically most beneficial to make a donation to a public charity of an appreciated asset in order to obtain a charitable deduction, rather than donating cash, or even worse, the after-tax proceeds of the sale of the appreciated asset. The benefits, of course, are that the taxpayer will both receive a tax deduction equal to the fair market value of the asset and will not incur tax (i.e., capital gains) on the transaction. This benefit is illustrated in the below example:

 Donating appreciated business interests in situations where the business may be sold, or the business owner may otherwise be preparing to divest herself or himself of part of their ownership interest, may be particularly appealing to a philanthropic business owner. As the example illustrates, pre-transaction planning can maximize the amount ultimately available for philanthropic endeavors at the lowest cost to the donor. Savvy gift officers and charities will often suggest this strategy to donors as a way for both the donor and the charity to “win.”

Assignment of Income Doctrine

Donors should be cautious about making a gift of an interest in anticipation of a sale or other liquidation event for a variety of reasons. For example, if the expected transaction does not occur, it may not be advisable for the charity to own an interest in the company (and the company may not be too happy about it either). Under those circumstances a charity is not permitted to “re-gift” the interest back to the donor. In even the best of situations, reversing such a transaction would be become complex, and in fact, in most cases it is usually not possible.

Because of the risk associated with a deal not closing, donors often seek to wait until there is some certainty that a transaction will in fact close. However, the longer a donor waits, the greater the risk that the intended result – a donation of property subject to an unrealized gain (i.e., untaxed) – will not be achieved because of the assignment of income doctrine. 

The assignment of income doctrine is one of a handful of judicial doctrines developed by United States courts to try to limit tax evasion. A key principal is that a donor cannot avoid taxation on property by merely making a gift of the property. If the substance of the transaction is to avoid income that is otherwise already subject to taxation, such gift may be disregarded. 1 This boils down to a facts-and-circumstances timing question.

Generally, the assignment of income doctrine provides that gain is realized by the owner of property when all events have occurred such that the final resulting transaction is all but assured. In reality, the interest has “ripened” into a fixed right to receive income. 2 Said yet another way, the question is often whether subsequent to the gift there are independent event(s) of significance to conclude that all substantive events related to the transaction have not yet occurred. The charity receiving the donation cannot simply function as a conduit for a transaction that has progressed to the point where it is almost certainly taking place. Whether a particular transaction or series of transactions have, when considering the reality and substance of the circumstances, proceeded to such a point is a fact-specific determination.

The Tax Court Emphasizes Form of Gift of Appreciated Stock

In the Dickinson case decided earlier this month, Mr. Dickinson had acquired shares over time in a large privately held engineering and consulting firm. He, along with other shareholders, were authorized by the company’s Board of Directors to donate shares to Fidelity Investments Charitable Gift Fund, the donor advised fund, in the years 2013 and 2014. Fidelity Charitable’s policy, known to the firm and its shareholders, was to immediately liquidate donated stock and it did so with Mr. Dickinson’s donated shares by selling them back to the company.

On audit, the IRS determined that Mr. Dickinson did not donate appreciated stock, rather he donated cash because, in substance, the company first redeemed the shares and he then donated the cash to fund a donor advised fund account at Fidelity Charitable. The Tax Court rejected that characterization, however, choosing instead to focus on the form of the transaction, namely that (1) Mr. Dickinson fully transferred his rights to and legal control of the shares to Fidelity Charitable, and (2) he did so before the shares gave rise to income by way of a sale or redemption. Preexisting knowledge of Fidelity Charitable’s policy to immediately dispose of donated stock did not, in and of itself, convert the donation of stock into a pre-donation redemption; Fidelity Charitable received the stock and it had the right to do with it what it pleased. At the time of the donation, it could not have been definitively said that a redemption of the shares, regardless of who the owner was, would have occurred.

While the IRS attempted to base its conclusion on the theory that there was a pre-arranged plan for the redemption of the stock, the Tax Court rejected that argument. The Court found that even if that was the case, that does not mean that had the donor retained the stock it would similarly have been redeemed. Citing its 1974 Palmer decision, the Tax Court stated, “[t]he ultimate question, as noted in Palmer, is whether the redemption and the shareholder’s corresponding right to income had already crystallized at the time of the gift.” 3

Planning Pointers for Donors and Charities

The Dickinson case is a good reminder that the IRS will seek to challenge gifts of appreciated business interests. With such an emphasis by the Tax Court on the proper form of such gifts, donors should be mindful to make the donation sufficiently before the time when the “all events” test has been met, especially in the case of a proposed or impending transaction, or before “the shareholder’s corresponding right to income…[has] already crystallized.” While the taxpayer succeeded in the Dickinson case, the facts-and-circumstances nature of the assignment of income doctrine can make decision-making tricky when donors hope to make donations of appreciated interests in advance of transactions. Taxpayers should seek legal counsel in such cases.

Charities should also take heed. While many charities have wisely begun to focus on soliciting non-cash charitable gifts, such as appreciated stock, charities should become familiar with the legal principles, such as the assignment of income doctrine, which can impact these gifts. Charities should consider their policies and practices with respect to soliciting and accepting such gifts, both in form and in practice. Not all donors will be fully aware of these principles and may be sorely surprised after making a gift if audited. It may behoove a charity to help educate donors so that a gift is successfully completed. Unhappy donors are not typically repeat donors.

1 See Palmer v. Commissioner, 62 T.C. 684, 692 (1974), affd. on other grounds 523 F.2d 1308 [36 AFTR 2d 75-5942] (8th Cir. 1975), acq. 1978-1 CB 2.

2 See Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999).

3 See Palmer v. Commissioner, 62 T.C. at 694-695

Christina Cahill, Nicole Riberio & Erica Seaborne also contributed to this article. 

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Charitable Gifts of Stock: Timing and Documentation Continue to be Critical When Selling a Business

Donating Stock

A recent Tax Court case affirms the importance of timing and documentation when planning a charitable stock donation before a business sale.

Prior to selling a business, small business owners often consider donating their company stock to charity. If executed correctly, donating stock prior to a business sale may reduce capital gains while allowing owners a charitable contribution deduction.

In Estate of Hoensheid et al. v. Commissioner , (No. 18606-19; T.C. Memo. 2023-34) the Court determined the timeline of events associated with the transfer of stock and subsequent sale of the business resulted in the petitioner significantly underreporting capital gains.

The Court held that by delaying the gift until the transaction was essentially finalized, the petitioner avoided recognition of realized income under the anticipatory assignment of income doctrine. The Court’s decision also highlighted the petitioner’s failure to secure a qualified appraisal given that the stock gift exceeded $500,000.

The Timeline of the Case

In 2014, the petitioner (now deceased) and his two brothers equally owned all the outstanding shares of Commercial Steel Treating Corporation (CSTC). The brothers were grandchildren of the founder. In the fall of 2014, the brothers began to explore a potential sale of CSTC and established a target sale price. On April 1, 2015, a private equity firm submitted a letter of intent to acquire CSTC for a price more than the original target price. On April 23, the brothers signed a nonbinding letter of intent with the buyer. The next month, on May 22, the brothers signed an affidavit indicating their intent to complete the transaction and sell CSTC.

During negotiations, in mid-April, the petitioner expressed to his financial advisors his intent to donate a portion of his CSTC stock to Fidelity Charitable Gift Fund, a tax-exempt, charitable organization with a donor-advised fund program. On June 1, after the terms of the CSTC sale were negotiated and agreed upon, an advisor to the petitioner emailed Fidelity Charitable a letter of understanding describing the planned stock donation. The petitioner sent a donation letter to Fidelity Charitable, which the tax-exempt entity confirmed on June 11. However, the petitioner did not send Fidelity Charitable the CSTC stock certificate at this time.

Over the next month, the terms of the sale were finalized, and the petitioner delivered the CSTC stock certificate to Fidelity Charitable on July 13. The sale of CSTC closed on July 15, 2015.

On his 2015 return, the petitioner reduced the amount of his recognized gain to reflect the stock transfer and took a charitable contribution deduction. The return included a completed Form 8283, Noncash Charitable Contributions, with an attachment titled “CSTC Fidelity Gift Fund Valuation.” The form reported the donation date as June 11, 2015.

Anticipatory Assignment of Income

The anticipatory assignment of income doctrine prevents taxpayers from transferring, or assigning, realized income to another taxpayer before actual receipt to avoid income recognition. The Court determined the petitioner effectively realized income from the CSTC sale before the July 15 closing date because of evidence (including a fixed sales price) supporting that the CSTC sale transaction was virtually certain.

Based on Michigan state law, the petitioner’s resident state, determining the validity of a gift requires three steps:

  • donor intent to make the gift
  • actual or constructive delivery of the subject matter of the gift
  • donee acceptance

The Court concluded that although a valid gift was executed on July 13, 2015, the terms of the CSTC sale were fixed before the stock delivery resulting in an unreported gain on sale of CSTC.

Qualified Appraisal

The Court acknowledged the validity of the gift on July 13, 2015, but denied the charitable contribution deduction. Among other requirements, contributions of property exceeding $500,000 require a qualified appraisal to substantiate the deduction. The petitioner’s gift of CSTC shares was valued at over $3 million dollars in June 2015.

An appraiser signed the completed Form 8283; however, the Court determined the appraisal did not meet the requirements of Internal Revenue Code Section 170(f)(11)(D). Specifically, the Court cited the following: the valuation was not completed for federal income tax purposes; the appraisal included an incorrect date of transfer; the appraisal date was considered premature; the appraisal did not sufficiently describe the method for the valuation; it was not signed by the appraiser; it did not include the appraiser’s qualifications; the appraisal did not describe the property in sufficient detail; and the appraisal did not include an explanation of the specific basis for the valuation.

Important Reminders

This case provides two important reminders. First, the importance of completing charitable gifts of stock prior to selling a business. In this case, the Court determined that the stock transfer (two days before the business sale closing) was made after the sale transaction was agreed upon, essentially eliminating all the petitioner’s risk.

No bright-line rule exists, but donations must occur before finalizing the terms of the business sale, including, for example, signing a letter of intent or other sales contract.

Second, make sure the appraisal conforms to the applicable rules. A review of the rules compared to the components of the appraisal prior to filing the return can save a valuation deduction. There are other important rules to follow as well, including the necessary components of the Form 8283.

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Anticipatory assignment of income, charitable contribution deduction, and qualified appraisals.

Anticipatory Assignment Of Income, Charitable Contribution Deduction, And Qualified Appraisals

Estate of Hoenshied v. Comm’r, T.C. Memo. 2023-34 | March 15, 2023 | Nega, J. | Dkt. No. 18606-19

Summary: In this 49-page opinion the Tax Court addresses a deficiency arising from the charitable contribution of appreciated shares of stock in a closely held corporation to a charitable organization that administers donor-advised funds for tax-exempt purposes under section 501(c)(3). The contribution in issue was made near contemporaneously with the selling of those shares to a third party. The timeline (truncated heavily for this blog) is as follows:

On June 11, 2015, the shareholders of the corporation in issue unanimously ratified the sale of all outstanding stock of the corporation. Immediately following the shareholder meeting, the corporation’s board of directors unanimously approved Petitioner’s request to be able to transfer a portion of his shares to Fidelity Charitable Gift Fund, a tax-exempt charitable organization under section 501(c)(3). Thereafter, the corporation and the purchaser of shares continued drafting and revising the Contribution and Stock Purchase Agreement.

On July 13, 2015, Fidelity Charitable first received a stock certificate from Petitioner.

On July 14, 2015, the Contribution and Stock Purchase Agreement was revised to specify that Petitioner contributed shares to Fidelity Charitable on July 10, 2015, and on July 15, 2015, the Contribution and Stock Purchase Agreement was signed and the transaction was funded.

Fidelity Charitable, having provided an Irrevocable Stock Power as part of the transaction, received $2,941,966 in cash proceeds from the sale, which was deposited in Petitioner’s donor-advised fund giving account.

On November 18, 2015, Fidelity Charitable sent Petitioner a contribution confirmation letter acknowledging a charitable contribution of the corporate shares and indicating that Fidelity Charitable received the shares on June 11, 2015.

In its 2015 tax return, Petitioner did not report any capital gains on the shares contributed to Fidelity Charitable but claimed a noncash charitable contribution deduction of $3,282,511. In support of the claimed deduction, a Form 8283 was attached to the return.

Petitioner’s 2015 tax return was selected for examination. The IRS issued to Petitioners a notice of deficiency, determining a deficiency of $647,489, resulting from the disallowance of the claimed charitable contribution deduction, and a penalty of $129,498 under section 6662(a).

Key Issues:

Whether and when Petitioners made a valid contribution of the shares of stock? Whether Petitioners had unreported capital gain income due to their right to proceeds from the sale of those shares becoming fixed before the gift? Whether Petitioners are entitled to a charitable contribution deduction? Whether Petitioners are liable for an accuracy-related penalty under section 6662(a) with respect to an underpayment of tax?

Primary Holdings:

(1) Petitioners failed to establish that any of the elements of a valid gift was present on June 11, 2015. No evidence was presented to credibly identify a specific action taken on June 11 that placed the shares within Fidelity Charitable’s dominion and control. Instead, the valid gift of shares was made by effecting delivery of a PDF of the certificate to Fidelity Charitable on July 13.

(2) Yes. None of the unresolved contingencies remaining on July 13, 2015 were substantial enough to have posed even a small risk of the overall transaction’s failing to close. Thus, Petitioners, through the doctrine of anticipatory assignment of income, had capital gains on the sale of the 1,380 appreciated shares of stock, even though Fidelity Charitable received the proceeds from that sale.

(3) No, Petitioners failed to show that the charitable contribution met the qualified appraisal requirements of section 170. The appraiser was not shown to be qualified, per regulations, at trial or in the appraisal itself, and the appraisal did not substantially comply with the regulatory requirements. “The failure to include a description of such experience in the appraisal was a substantive defect. . . . Petitioners’ failure to satisfy multiple substantive requirements of the regulations, paired with the appraisal’s other more minor defects, precludes them from establishing substantial compliance.” In addition, Petitioners failed to establish reasonable cause for failing to comply with the appraisal requirements “because petitioner knew or should have known that the date of contribution (and thus the date of valuation) was incorrect.” Thus, the IRS’s determination to disallow the charitable contribution deduction is sustained.

(4) No. While Petitioners did not have reasonable cause for their failure to comply with the qualified appraisal requirement, their liability for an accuracy-related penalty was a separate analysis, and the IRS did not carry the burden of proof. Petitioners did not follow their professional’s advice to have the paperwork for the contribution ready to go “well before the signing of the definitive purchase agreement.” But, Petitioners adhered to the literal thrust of the advice given: that “execution of the definitive purchase agreement” was the firm deadline to contribute the shares and avoid capital gains (even if that proved to be incorrect advice under the circumstances).

Key Points of Law:

Gross Income. Gross income means “all income from whatever source derived,” including “[g]ains derived from dealings in property.” 26 U.S.C. § 61(a)(3). In general, a taxpayer must realize and recognize gains on a sale or other disposition of appreciated property. See id. at § 1001(a)–(c). However, a taxpayer typically does not recognize gain when disposing of appreciated property via gift or charitable contribution. See Taft v. Bowers, 278 U.S. 470, 482 (1929); see also 26 U.S.C. § 1015(a) (providing for carryover basis of gifts). A taxpayer may also generally deduct the fair market value of property contributed to a qualified charitable organization. See 26 U.S.C. § 170(a)(1); Treas. Reg. 16 § 1.170A-1(c)(1). Contributions of appreciated property are thus tax advantaged compared to cash contributions; when a contribution of property is structured properly, a taxpayer can both avoid paying tax on the unrealized appreciation in the property and deduct the property’s fair market value. See, e.g., Dickinson v. Commissioner, T.C. Memo. 2020-128, at *5.

Donor-Advised Fund. The use of a donor-advised fund further optimizes a contribution by allowing a donor “to get an immediate tax deduction but defer the actual donation of the funds to individual charities until later.” Fairbairn v. Fid. Invs. Charitable Gift Fund, No. 18-cv-04881, 2021 WL 754534, at *2 (N.D. Cal. Feb. 26, 2021).

Two-Part Test to Determine Charitable Contribution of Appreciated Property Followed by Sale by Donee. The donor must (1) give the appreciated property away absolutely and divest of title (2) “before the property gives rise to income by way of a sale.” Humacid Co. v. Commissioner, 42 T.C. 894, 913 (1964). Valid Gift of Shares of Stock. “Ordinarily, a contribution is made at the time delivery is effected.” Treas. Reg. § 1.170A-1(b). “If a taxpayer unconditionally delivers or mails a properly endorsed stock certificate to a charitable donee or the donee’s agent, the gift is completed on the date of delivery.” Id. However, the regulations do not define what constitutes delivery, and the Tax Court evaluates applicable state law for the threshold determination of whether donors have divested themselves of their property rights via gift. See, e.g., United States v. Nat’l Bank of Com., 472 U.S. 713, 722 (1985). In determining the validity of a gift, Michigan law, for example (and as applied in Estate of Hoensheid), requires a showing of (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee, 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

Present Intent. The determination of a party’s subjective intent is necessarily a highly fact-bound issue. When deciding such an issue, the Tax Court must determine “whether a witness’s testimony is credible based on objective facts, the reasonableness of the testimony, the consistency of statements made by the witness, and the demeanor of the witness.” Ebert v. Commissioner, T.C. Memo. 2015-5, at *5–6. If contradicted by the objective facts in the record, the Tax Court will not “accept the self-serving testimony of [the taxpayer] . . . as gospel.” Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Delivery. Under Michigan law, the delivery requirement generally contemplates an “open and visible change of possession” of the donated property. Shepard v. Shepard, 129 N.W. 201, 208 (Mich. 1910). Manually providing tangible property to the donee is the classic form of delivery. Manually providing to the donee a stock certificate that represents intangible shares of stock is traditionally sufficient delivery. The determination of what constitutes delivery is context-specific and depends upon the “nature of the subject-matter of the gift” and the “situation and circumstances of the parties.” Shepard, 129 N.W. at 208. Constructive delivery may be effected where property is delivered into the possession of another on behalf of the donee. See, e.g., In re Van Wormer’s Estate, 238 N.W. 210, 212 (Mich. 1931). Whether constructive or actual, delivery “must be unconditional and must place the property within the dominion and control of the donee” and “beyond the power of recall by the donor.” In re Casey Estate, 856 N.W.2d 556, 563 (Mich. Ct. App. 2014). If constructive or actual delivery of the gift property occurs, its later retention by the donor is not sufficient to defeat the gift. See Estate of Morris v. Morris, No. 336304, 2018 WL 2024582, at *5 (Mich. Ct. App. May 1, 2018).

Delivery of Shares. Retention of stock certificates by donor’s attorney may preclude a valid gift. Also, a determination of no valid gift may occur where the taxpayer instructs a custodian of corporate books to prepare stock certificates but remained undecided about ultimate gift. In some jurisdictions, transfer of shares on the books of the corporation can, in certain circumstances, constitute delivery of an inter vivos gift of shares. See, e.g., Wilmington Tr. Co. v. Gen. Motors Corp., 51 A.2d 584, 594 (Del. Ch. 1947); Chi. Title & Tr. Co. v. Ward, 163 N.E. 319, 322 (Ill. 1928); Brewster v. Brewster, 114 A.2d 53, 57 (Md. 1955). The U.S. Court of Appeals for the Sixth Circuit has stated that transfer on the books of a corporation constitutes delivery of shares of stock, apparently as a matter of federal common law. See Lawton v. Commissioner, 164 F.2d 380, 384 (6th Cir. 1947), rev’g 6 T.C. 1093 (1946); Bardach v. Commissioner, 90 F.2d 323, 326 (6th Cir. 1937), rev’g 32 B.T.A. 517 (1935); Marshall v. Commissioner, 57 F.2d 633, 634 (6th Cir. 1932), aff’g in part, rev’g in part 19 B.T.A. 1260 (1930). The transfers on the books of the corporation were bolstered by other objective actions that evidenced a change in possession and thus a gift. See Jolly’s Motor Livery Co. v. Commissioner, T.C. Memo. 1957-231, 16 T.C.M. (CCH) 1048, 1073.

Acceptance. Donee acceptance of a gift is generally “presumed if the gift is beneficial to the donee.” Davidson, 575 N.W.2d at 576.

Anticipatory Assignment of Income. The anticipatory assignment of income doctrine is a longstanding “first principle of income taxation.” Commissioner v. Banks, 543 U.S. 426, 434 (2005). The doctrine recognizes that income is taxed “to those who earn or otherwise create the right to receive it,” Helvering v. Horst, 311 U.S. 112, 119 (1940), and that tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised,” Lucas v. Earl, 281 U.S. 111, 115 (1930). A person with a fixed right to receive income from property thus cannot avoid taxation by arranging for another to gratuitously take title before the income is received. See Helvering, 311 U.S. at 115–17; Ferguson, 108 T.C. at 259. This principle is applicable, for instance, where a taxpayer gratuitously assigns wage income that the taxpayer has earned but not yet received, or gratuitously transfers a debt instrument carrying accrued but unpaid interest. A donor will be deemed to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income. See Cold Metal Process Co. v. Commissioner, 247 F.2d 864, 872–73 (6th Cir. 1957), rev’g 25 T.C. 1333 (1956). The same principle is often applicable where a taxpayer gratuitously transfers shares of stock that are subject to a pending, prenegotiated transaction and thus carry a fixed right to proceeds of the transaction. See Rollins v. United States, 302 F. Supp. 812, 817–18 (W.D. Tex. 1969).

Determining Anticipatory Assignment of Income. In determining whether an anticipatory assignment of income has occurred with respect to a gift of shares of stock, the Tax Court looks to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities. See Jones v. United States, 531 F.2d 1343, 1345 (6th Cir. 1976) (en banc); Allen v. Commissioner, 66 T.C. 340, 346 (1976). In general, a donor’s right to income from shares of stock is fixed if a transaction involving those shares has become “practically certain to occur” by the time of the gift, “despite the remote and hypothetical possibility of abandonment.” Jones, 531 F.2d at 1346. The mere anticipation or expectation of income at the time of the gift does not establish that a donor’s right to income is fixed. The Tax Court looks to several other factors that bear upon whether the sale of shares was virtually certain to occur at the time of a purported gift as part of the same transaction. Relevant factors may include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transaction.

Corporate Formalities. Also relevant is the status of the corporate formalities necessary for effecting the transaction. See Estate of Applestein, 80 T.C. at 345–46 (finding that taxpayer’s right to sale proceeds from shares had “virtually ripened” upon shareholders’ approval of proposed merger agreement). Under Michigan law, a proposed plan to exchange shares must generally be approved by a majority of the corporation’s shareholders. Formal shareholder approval of a transaction has often proven to be sufficient to demonstrate that a right to income from shares was fixed before a subsequent transfer. However, such approval is not necessary for a right to income to be fixed, when other actions taken establish that a transaction was virtually certain to occur. See Ferguson, 104 T.C. at 262–63. Charitable Contribution Deduction. Section 170(a)(1) allows as a deduction any charitable contribution (as defined) payment of which is made within the taxable year. “A charitable contribution is a gift of property to a charitable organization made with charitable intent and without the receipt or expectation of receipt of adequate consideration.” Palmolive Bldg. Invs., LLC v. Commissioner, 149 T.C. 380, 389 (2017). Section 170(f)(8)(A) provides that “[n]o deduction shall be allowed . . . for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the contribution by the donee organization that meets the requirements of subparagraph (B).” For contributions of property in excess of $500,000, the taxpayer must also attach to the return a “qualified appraisal” prepared in accordance with generally accepted appraisal standards. 26 U.S.C. § 170(f)(11)(D) and (E). Contemporaneous Written Acknowledgement (“CWA”). A CWA must include, among other things, the amount of cash and a description of any property contributed. 26 U.S.C. § 170(f)(8)(B). A CWA is contemporaneous if obtained by the taxpayer before the earlier of either (1) the date the relevant tax return was filed or (2) the due date of the relevant tax return. Id. at § 170(f)(8)(C). For donor-advised funds, the CWA must include a statement that the donee “has exclusive legal control over the assets contributed.” 26 U.S.C. § 170(f)(18)(B). These requirements are construed strictly and do not apply the doctrine of substantial compliance to excuse defects in a CWA.

Qualified Appraisal for Certain Charitable Contributions. Section 170(f)(11)(A)(i) provides that “no deduction shall be allowed . . . for any contribution of property for which a deduction of more than $500 is claimed unless such person meets the requirements of subparagraphs (B), (C), and (D), as the case may be.” Subparagraph (D) requires that, for contributions for which a deduction in excess of $500,000 is claimed, the taxpayer attach a qualified appraisal to the return. Section 170(f)(11)(E)(i) provides that a qualified appraisal means, with respect to any property, an appraisal of such property which—(I) is treated for purposes of this paragraph as a qualified appraisal under regulations or other guidance prescribed by the Secretary, and (II) is conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed under subclause (I). The regulations provide that a qualified appraisal is an appraisal document that, inter alia, (1) “[r]elates to an appraisal that is made” no earlier than 60 days before the date of contribution and (2) is “prepared, signed, and dated by a qualified appraiser.” Treas. Reg. § 1.170A-13(c)(3)(i).

Qualified Appraisal Must Include: Treasury Regulation § 1.170A-13(c)(3)(ii) requires that a qualified appraisal itself include, inter alia:

(1) “[a] description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was (or will be) contributed;”

(2) “[t]he date (or expected date) of contribution to the donee;”

(3) “[t]he name, address, and . . . identifying number of the qualified appraiser;”

(4) “[t]he qualifications of the qualified appraiser;”

(5) “a statement that the appraisal was prepared for income tax purposes;”

(6) “[t]he date (or dates) on which the property was appraised;”

(7) “[t]he appraised fair market value . . . of the property on the date (or expected date) of contribution;” and

(8) the method of and specific basis for the valuation.

Qualified Appraiser. Section 170(f)(11)(E)(ii) provides that a “qualified appraiser” is an individual who (I) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations, (II) regularly performs appraisals for which the individual receives compensation, and (III) meets such other requirements as may be prescribed . . . in regulations or other guidance. An appraiser must also demonstrate “verifiable education and experience in valuing the type of property subject to the appraisal.” The regulations add that the appraiser must include in the appraisal summary a declaration that he or she (1) “either holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis;” (2) is “qualified to make appraisals of the type of property being valued;” (3) is not an excluded person specified in paragraph (c)(5)(iv) of the regulation; and (4) understands the consequences of a “false or fraudulent overstatement” of the property’s value. Treas. Reg. § 1.170A-13(c)(5)(i). The regulations prohibit a fee arrangement for a qualified appraisal “based, in effect, on a percentage . . . of the appraised value of the property.” Id. at subpara. (6)(i).

Substantial Compliance with Qualified Appraisal Requirements . The qualified appraisal requirements are directory, rather than mandatory, as the requirements “do not relate to the substance or essence of whether or not a charitable contribution was actually made.” See Bond v. Commissioner, 100 T.C. 32, 41 (1993). Thus, the doctrine of substantial compliance may excuse a failure to strictly comply with the qualified appraisal requirements. If the appraisal discloses sufficient information for the IRS to evaluate the reliability and accuracy of a valuation, the Tax Court may deem the requirements satisfied. Bond, 100 T.C. at 41–42. Substantial compliance allows for minor or technical defects but does not excuse taxpayers from the requirement to disclose information that goes to the “essential requirements of the governing statute.” Estate of Evenchik v. Commissioner, T.C. Memo. 2013-34, at *12. The Tax Court generally declines to apply substantial compliance where a taxpayer’s appraisal either (1) fails to meet substantive requirements in the regulations or (2) omits entire categories of required information.

Reasonable Cause to Avoid Denial of Charitable Contribution Deduction. Taxpayers who fail to comply with the qualified appraisal requirements may still be entitled to charitable contribution deductions if they show that their noncompliance is “due to reasonable cause and not to willful neglect.” 26 U.S.C. § 170(f)(11)(A)(ii)(II). This defense is construed similarly to the defense applicable to numerous other Code provisions that prescribe penalties and additions to tax. See id. at § 6664(c)(1). To show reasonable cause due to reliance on a professional adviser, the Tax Court generally requires that a taxpayer show (1) that their adviser was a competent professional with sufficient expertise to justify reliance; (2) that the taxpayer provided the adviser necessary and accurate information; and (3) that the taxpayer actually relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). “Unconditional reliance on a tax return preparer or C.P.A. does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise ‘[d]iligence and prudence’.” See Stough v. Commissioner, 144 T.C. 306, 323 (2015) (quoting Estate of Stiel v. Commissioner, T.C. Memo. 2009-278, 2009 WL 4877742, at *2)).

Section 6662(a) Penalty. Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any underpayment of tax required to be show on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax. Negligence includes “any failure to make a reasonable attempt to comply” with the Code, 26 U.S.C. § 6662(c), or a failure “to keep adequate books and records or to substantiate items properly,” Treas. Reg. § 1.6662-3(b)(1). An understatement of income tax is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 26 U.S.C. § 6662(d)(1)(A). Generally, the IRS bears the initial burden of production of establishing via sufficient evidence that a taxpayer is liable for penalties and additions to tax; once this burden is met, the taxpayer must carry the burden of proof with regard to defenses such as reasonable cause. Id. at § 7491(c); see Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001). The IRS bears the burden of proof with respect to a new penalty or increase in the amount of a penalty asserted in his answer. See Rader v. Commissioner, 143 T.C. 376, 389 (2014); Rule 142(a), aff’d in part, appeal dismissed in part, 616 F. App’x 391 (10th Cir. 2015); see also RERI Holdings I, LLC v. Commissioner, 149 T.C. 1, 38–39 (2017), aff’d sub nom. Blau v. Commissioner, 924 F.3d 1261 (D.C. Cir. 2019). As part of the burden of production, the IRS must satisfy section 6751(b) by producing evidence of written approval of the penalty by an immediate supervisor, made before formal communication of the penalty to the taxpayer.

Reasonable Cause Defense to Section 6662(a) Penalty. A section 6662 penalty will not be imposed for any portion of an underpayment if the taxpayers show that (1) they had reasonable cause and (2) acted in good faith with respect to that underpayment. 26 U.S.C. § 6664(c)(1). A taxpayer’s mere reliance “on an information return or on the advice of a professional tax adviser or an appraiser does not necessarily demonstrate reasonable cause and good faith.” Treas. Reg. § 1.6664-4(b)(1). That reliance must be reasonable, and the taxpayer must act in good faith. In evaluating whether reliance is reasonable, a taxpayer’s “education, sophistication and business experience will be relevant.” Id. para. (c)(1).

Insights: Going forward, this opinion of Estate of Hoenshied v. Commissioner will likely be a go-to source for any practitioner involved in a taxpayer’s proposed transfer of corporate shares (or other property) to a donor-advised fund or other charitable organization as part of a buy-sell transaction that is anywhere close in time to the proposed donation.

Have a question? Contact Jason Freeman , Managing Member Legal Team.

assignment of income and gifts

Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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Professional Notes

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Many donors hold a significant part of their wealth in illiquid securities, such as interests in closely held businesses and restricted stock of corporations, or alternative investments, such as hedge funds and private equity funds. Closely held businesses and alternate investments may be organized as corporations, or they may be limited partnerships or limited liability companies (LLCs) that are taxed as pass-through entities, with each partner or member taxed on his or her share of net income or gain. The entity’s form affects the tax consequences of a charitable gift of an equity interest. This edition of  Professional Notes  provides a broad overview of the issues involved when a donor wants to fund a charitable gift with interests in closely held businesses and other illiquid investments. In the section on hedge funds and private equity partnerships, we highlight a unique charitable giving opportunity available in 2017 for hedge fund managers who have deferred some of their compensation through the use of offshore vehicles.

General Considerations

A donor’s income tax treatment for a charitable gift of illiquid securities depends on three things: the type of security contributed, the donor’s holding period for the security, and the type of charity to which it is contributed. Generally, the income tax charitable deduction for a contribution of securities is the fair market value of the securities reduced by the amount of gain that would not have been long-term capital gain if the securities had been sold at fair market value. As a result, when a donor contributes securities held for more than one year (i.e., long-term capital gain property) to a public charity, he or she can claim an income tax charitable deduction for the contribution based on its fair market value—and avoid the taxable capital gain from the appreciation.

For a contribution of an interest in a partnership with no liabilities, the fair market value deduction will be reduced to the extent the partnership owns ordinary income assets. The portion of the gift attributable to the partnership’s ordinary income assets will be deductible only to the extent of the partnership’s basis in those assets. The IRS has ruled that when a taxpayer transfers a partnership interest, the taxpayer’s share of partnership liabilities constitutes an “amount realized” by the donor, causing the donor to be treated as engaging in a “bargain sale.”

By contrast, only a gift of securities that meet the definition of “qualified appreciated stock” qualifies for a fair market value deduction when contributed to a private non-operating foundation. Qualified appreciated stock is defined as stock in a corporation for which market quotations are readily available on an established securities market and that is a long-term capital asset. This rule for private foundations has limited and comparatively rare exceptions (e.g., a gift to a “pass-through” foundation that distributes the gift within a specified time).

Even if the stock is qualified appreciated stock, if the total amount of stock contributed, including all past contributions, exceeds 10 percent of the value of all outstanding stock of the corporation, the donated stock in excess of this threshold will not be considered qualified appreciated stock. Therefore, a donor’s deduction for giving restricted or closely held stock, or interests in most partnerships and LLCs, to a private, non-operating foundation ordinarily will be limited to the donor’s basis.

The Internal Revenue Code (Code) generally permits a charitable deduction of up to to 30 percent of an individual donor’s adjusted gross income for gifts of long-term capital gain property contributed to a public charity or private operating foundation. But a gift of such stock to a private non-operating foundation is ordinarily deductible only up to 20 percent of adjusted gross income. Any unused deductions may be carried forward for up to five more tax years.

Interests in a Closely Held Business

A charitable gift of an interest in a closely held business requires careful planning. A key concern for the owners of the business may be the impact of adding an outsider as an owner. In addition, charitable organizations typically do not want to hold illiquid investment assets, particularly interests in an operating business (as distinct from, say, a private equity fund or a hedge fund). To address these concerns, a redemption of the charity’s interest at fair market value soon after the gift is completed may be appealing to both the charity and other owners of the business.

To avoid triggering the inherent capital gain, however, the contribution and subsequent redemption must occur without prearrangement between the donor and the charity. That is, there must be no pre-existing obligation that the charity will tender its donated interest or that the business will redeem the charity’s interest. Under the “assignment of income doctrine,” a gift that is linked to a prearranged redemption could be reclassified for tax purposes as a sale by the donor (with corresponding realization of the gain), followed by a gift to charity of the proceeds.

If the charitable recipient is a private foundation or a donor-advised fund, the application of the excess business holdings rules must also be considered. These rules are not triggered so long as a private foundation or donor-advised fund owns 2 percent or less of the donated business (both as a percentage of vote and a percentage of value), but the excess business holdings rules become an important consideration once the charity’s stake exceeds either of those levels.

Generally speaking, there will be excess business holdings (and hefty excise taxes may apply) if the combined holdings of the private foundation or donor-advised fund and its “disqualified persons” (e.g., the donor, his or her spouse, and their children or trusts for their benefit) is more than 20 percent of the voting or non-voting stock of a corporation or more than 20 percent of the profits or capital interest in an LLC or partnership. However, the permissible threshold increases to 35 percent if the foundation or donor-advised fund can demonstrate that the business is effectively controlled by third parties who are not disqualified persons. Any interest in a sole proprietorship will be excess business holdings for a private foundation or a donor-advised fund.

In the case of gifts and bequests, there is a five-year “grace period” to bring holdings within permitted levels, and, in special cases, the IRS may exercise its discretion to grant one or more extensions. It will be important to identify this issue before the gift is made, so there can be a plan in place (e.g., the possibility of redemptions or sales to unrelated third parties) to bring holdings within permitted levels.

Newman’s Own Foundation—established by actor Paul Newman, who died in 2008—is seeking repeal of these rules so the Foundation can continue to own 100 percent of the well-known food company that Newman bequeathed to the Foundation. Right now, the Foundation is nearing the end of its second five-year holding period.

Note that the excess business holdings rules apply only if the business is a “business enterprise.”  Therefore, interests in a “functionally related business” (i.e., related to the tax-exempt purpose of the charity) or one that derives at least 95 percent of its gross income from passive sources are not subject to the excess business holdings rules.

S Corporation Stock

Some closely held businesses are structured as Subchapter S corporations. They generally operate as corporations, but are treated similarly to partnerships for tax purposes (i.e., with flow-through treatment of their income and no tax at the entity level). By definition, Subchapter S corporations may not have more than 100 shareholders.

In evaluating a potential gift of Subchapter S stock to charity, a donor should be aware of the types of assets held by the corporation, especially appreciated inventory or unrealized receivables. A fair market value charitable deduction for the gift of appreciated stock must be reduced by the amount of “ordinary income” the donor would have recognized if he or she had sold the property. Code Section 170(e)(1) provides that “rules similar to the rules of [Code] section 751 shall apply in determining whether gain on [S corporation] stock would have been long-term capital gain if such stock were sold by the taxpayer.” Consequently, the donor’s deduction for a contribution of Subchapter S stock, in most instances, will not be the full fair market value of the stock, but will be reduced to the extent of the donor’s share of the corporation’s appreciated inventory and unrealized receivables, including depreciation recapture.

Charities usually are reluctant to accept gifts of Subchapter S stock because all items of income and gain allocable to the charity during the period it holds the stock (including the gain on disposition of the shares) will constitute unrelated business taxable income (UBTI) and will be taxable in its hands. These rules generally are less favorable than the rules for gifts of partnership interest, discussed below.  A donor of Subchapter S stock should expect the charitable donee to want assurances there will be adequate distributions from the corporation to cover the charity’s potential tax liability.

One alternative may be for the Subchapter S corporation itself to donate assets to charity. The gift is treated as if made on a pro rata basis by the shareholders and is subject to their individual contribution limits. Generally, the shareholder’s basis in his or her shares is reduced pro rata by the shareholder’s share of the corporation’s basis in the property contributed to charity, and the charitable deduction available to the shareholder for gifts by the corporation is limited to the basis in his or her shares.

Restricted Stock

Stock—whether or not closely held—may be subject to restrictions on sale imposed by law, by agreement with an underwriter, or by a shareholders’ or other agreement. Restricted securities generally trade at a discount relative to freely traded shares.

The contribution of restricted stock to charity raises issues about the amount a donor may claim as an income tax charitable deduction. Long-term capital gain assets, including securities, may be deducted at fair market value when donated to public charities (and private operating foundations), even if the shares are not considered readily marketable. This includes gifts to a public charity for a donor-advised fund.

However, as previously noted, it is usually the case that only “qualified appreciated stock” contributions to private non-operating foundations are deductible at fair market value. The IRS has ruled privately that stock subject to Rule 144 (i.e, restricted stock of a type that is publicly traded, but is not readily marketable under SEC rules) is not “qualified appreciated stock.” Moreover, the IRS noted that the value of the stock was discounted from the value of the unrestricted shares listed on the established securities market because of the resale restrictions.

In a Private Letter Ruling involving a contribution to a private non-operating foundation of stock subject to Rule 144 volume restrictions, where the donor agreed to restrict his own sales so the volume restriction would not prevent the foundation from selling the shares, the IRS held that the stock was qualified appreciated stock, deductible at fair market value, because the shares the foundation received would be freely transferable upon receipt.

Pass-Through Entities

Gifts of interests in pass-through entities, such as partnerships and LLCs, present novel tax issues for the charity and the donor, and require careful consideration.

As a general rule, a donor who contributes a partnership interest or units of an LLC with no liabilities to a public charity or private operating foundation receives a tax deduction equal to the fair market value of the property, provided the donor has held it for more than a year. However, there is an important limitation to the extent the partnership owns ordinary income assets, such as unrealized receivables or inventory. Those assets—sometimes called Code Section 751 assets, or “hot assets”—may be included in the donor’s deduction only to the extent of the donor’s basis in the partnership, as if the donor had given a pro rata share of his or her interest in the partnership’s underlying assets.

The New York Community Trust, like most charities, will not accept a general partnership interest; the for-profit activity generally is inconsistent with our charitable mission and places charitable assets at risk for the liabilities of the partnership. Even if the donated asset is a limited partnership interest or an interest in an LLC, most charities will want assurance they will not be subject to capital calls under the governing documents.

A charity may be reluctant to accept gifts of partnership interests because income and gain will be allocable to the charity during the time it holds the interest. It will need to understand the underlying business of the partnership, and whether the partnership uses debt, to determine whether all or part of its allocable income and gain from the partnership may constitute unrelated business taxable income.

A charity is unlikely to accept an interest in a partnership that will produce UBTI unless it can be certain the distributions will cover its potential tax liability, and even then, it may have reservations about the receipt of UBTI (e.g., the burden and possibly enhanced audit risk associated with starting to file IRS Form 990-T).

Before accepting a gift of a partnership interest, particularly an interest in a partnership structure with multiple layers, a charity likely will want to be sure the partnership is properly reporting all “reportable transactions” (transactions that must be specifically disclosed to the IRS). Failure to include information about a reportable transaction can result in significant tax penalties. Indeed, the charity may want representations from the partnership that it is not engaged in any reportable transactions or listed tax shelter transactions. As discussed above in connection with Subchapter S corporations, a partnership can donate assets to charity directly, passing through the deduction to its partners subject to certain limitations.

No partial interests.  Under the partial interest rules generally applicable to gifts of property, the donor of a partnership interest must give charity his or her entire interest or an undivided portion of that entire interest. Otherwise, no deduction will be allowed. An undivided portion of a donor’s partnership interest must be expressed as a fraction or percentage, so it includes a pro rata share of each and every attribute of the interest, such as capital, allocation of income and expense, and distributions.

Gift subject to liabilities.  As with any charitable gift of property, a gift of a partnership interest subject to liabilities may be treated as a bargain sale, resulting in the donor’s recognition of taxable gain. The donor will be deemed to have sold his or her partnership interest to the extent of his or her allocable share of liabilities; his or her basis in the partnership will be allocated pro rata between the amount treated as sold and the amount treated as a charitable contribution. Passive activity losses.  Losses that arise from activities in which a partner did not materially participate (including most limited partner interests) may be claimed as losses by a partner only to the extent of income or gain from those activities or upon a qualifying disposition of the passive activity. A charitable contribution of a partnership interest is not a qualifying disposition for these purposes, and a donor will not be able to take a deduction for suspended passive activity losses.

An individual with suspended passive activity losses from a partnership should consider whether he or she would be better off selling the partnership interest, deducting the losses, and donating the net proceeds to charity.

Hedge Funds and Private Equity Partnerships.  A partner with a carried interest in a partnership may want to consider contributing all or an undivided portion of the interest to charity. A carried interest is an interest in the partnership, typically without any capital contribution.  Under current law, the carried interest is treated as a capital asset and, as such, is subject to favorable capital gains tax rates upon sale or other disposition; a charitable contribution of such an interest would be subject to the rules generally applicable to partnership interests.

Because hedge funds often raise money through borrowing, they are likely to produce UBTI as a result of the application of the debt-financed income rules. To enable charities to invest in alternate investments such as hedge funds without incurring significant tax liabilities, U.S. hedge funds commonly create foreign feeder funds called “blocker corporations”. The dividends charities receive from foreign blocker corporations are not considered debt-financed income and therefore are not UBTI.

Unfortunately, if a donor contributed his or her interest in the U.S. feeder fund to a non-U.S. blocker corporation, the donor could recognize gain under Code Section 367. If, instead, the donor gave the interest to charity and charity then contributed the interest to a non-U.S. blocker corporation, charity likely would be treated as recognizing the gain—which would be taxable to charity as UBTI (i.e., debt-financed income).

Hedge fund managers may have greater motivation to make charitable gifts in 2017 if, prior to 2009, they structured management compensation using deferred arrangements, investing that deferred compensation in offshore funds. Under Code Section 457A, this deferred compensation must be recognized in 2017; charitable gifts may offer an opportunity to offset some of the resulting taxes.

Valuation and Appraisal Requirements

The fair market value of a contributed asset is determined as of the date of gift, usually by reference to recent arm’s length sales. Unfortunately, this information is rarely available for closely held or restricted stock or for other non-publicly traded business interests, such as LLC and partnership interests.

Except for contributions of publicly traded securities, the IRS generally requires an appraisal by a qualified appraiser of contributed property valued at more than $5,000. However, for non-publicly traded stock, an appraisal is not required unless the stock is valued at more than $10,000. Failure to obtain an appraisal when it is required will result in the disallowance of any deduction for the gift. If the deduction is more than $500,000, the qualified appraisal must be filed by the donor with the IRS.

Among other requirements, a qualified appraiser is someone who has met certain minimum education and experience requirements and who regularly prepares appraisals for pay. No part of the fee arrangement can be based on a percentage of the appraised value of the property. By definition, the donor and the recipient charity are not qualified appraisers.

An appraisal is not a qualified appraisal if it was made more than 60 days before the date of contribution or after the due date (with extensions) of the return on which the deduction must be claimed.

Illiquid securities, such as interests in closely held businesses and restricted stock of corporations, or alternative investments, such as hedge funds and private equity funds, can be smart choices for charitable gifts. However, donors and charities must consider a number of issues when making and accepting such gifts. Among the concerns are the timing and valuation of the gift, potential tax liabilities, and the ability of charity to subsequently dispose of the contributed asset. The New York Community Trust is experienced in handling these gifts. If your client is considering contributing such interests, The Trust can provide opportunities for integrating long-term philanthropic goals into a donor’s business planning, while generating a significant tax deduction.

For further information, see

  • IRC §170(b)(1)(A): General rule for percentage limitations for individuals
  • IRC §170(e)(5): Qualified appreciated stock
  • IRC §170(f)(3)(A): Denial of deduction for certain contributions of partial interests in property
  • IRC §170(f)(11): Qualified appraisals
  • IRC §457A: Nonqualified deferred compensation
  • IRC §469: Passive activity losses
  • IRC §§512 – 514: UBIT rules
  • IRC §751:  Partnership unrealized receivables and inventory
  • IRC §752: Treatment of certain partnership liabilities
  • IRC §6111: Disclosure of reportable transactions
  • IRS Form 8283 (Noncash Charitable Contributions)
  • Treas. Reg. §170A-13(c)(3): Qualified appraisals
  • Rev. Rul. 75-194, 1975-1 CB 80 (charitable contribution of partnership interest subject to liabilities treated as deemed sale to the extent liabilities exceed the donor’s basis)
  • Rev. Rul. 96-11 (partnership charitable contribution of property)
  • PLR 9247018: Rule 144 stock ruled not “qualified appreciated stock”
  • PLR 9734034: Rule 144 stock “qualified appreciated stock” where volume restrictions would not apply due to donor agreement not to sell shares
  • Paul Newman’s Foundation Fights Looming 200 Percent Tax, The Daily Tax Report (August 17, 2016)

Written by Jane L. Wilton, General Counsel of The New York Community Trust, with special thanks to Patterson Belknap Webb & Tyler LLP for its assistance.

The material is published for informational purposes only. The publisher is not rendering legal, nycommunitytrust.org accounting, or other professional advice.

Peter Panapento [email protected] (202) 531-3886

Courtney Biggs [email protected] (212) 889-3963

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Privacy Overview

assignment of income and gifts

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Timing Is Critical for Gift of Appreciated Stock to Avoid Capital Gain From Sale of Company

Business owners contemplating selling their companies often look to their tax advisers for options to reduce the potential tax impact upon sale. One option routinely considered is having the owner contribute a portion of the appreciated stock to a charitable organization before the transaction closes to avoid income taxes on the donated shares. This leads to a critical question: How far in advance of the closing must the charitable contribution occur?

On March 15, 2023, the Tax Court issued an opinion concluding that donating stock two days before closing on a third-party sale transaction was clearly too late to avoid tax. The Tax Court declined to specify a “bright line” deadline for making a donation and instead focused on the substance of the underlying transactions. All in all, these taxpayers paid income taxes on the recognized gain on the shares they no longer owned and didn’t get the charitable tax deduction for failure to meet the strict substantiation rules.

In the Estate of Scott M. Hoensheid, et al. v. Commissioner (T.C. Memo 2023-34), the taxpayers were clear at the outset that they wanted to “wait as long as possible to pull the trigger” on donating shares valued at more than $3 million to charity because they wanted to make sure the sale of the company was going to occur. They were also clear that the purpose for donating was to avoid paying income taxes on any gain associated with the donated shares. To reach these stated goals, the taxpayers worked closely with their tax/estate planning attorney and a financial adviser to structure the stock sale transaction hoping for an $80 million target price and to find a charity that was willing to accept the stock and then participate in the third-party sale transaction without much hassle.

In early 2015, the taxpayers’ financial adviser started soliciting bids for the company and received significant interest from private equity firms. In mid-April 2015, the taxpayers’ tax attorney advised them that “the transfer [to the charity] would have to take place before there is a definitive agreement in place.” Concurrently, the taxpayers began working with Fidelity Investments Charitable Gift Fund, a large tax-exempt organization that serves as a sponsoring organization with regard to establishing donor-advised funds, to accept the donation of company stock. Fidelity Charitable provided a similar warning to the taxpayers that the gift must take place before any purchase agreement is executed to avoid the Internal Revenue Service raising the anticipatory assignment of income doctrine.

Anticipatory Assignment of Income Doctrine

The anticipatory assignment of income doctrine has been around since at least the 1930s. See Lucas v. Earl , 281 U.S. 111 (1930). Under this doctrine, income is taxed “to those who earn or otherwise create the right to receive it.” See Helvering v. Horst , 311 U.S. 112, 119 (1940). The courts have been clear that taxpayers cannot avoid tax by entering into anticipatory arrangements and contracts where a person with a fixed right to receive income from property arranges for another person to gratuitously take title before the income is actually received.

The person who gratuitously takes title usually has a lower effective income tax rate or does not pay tax at all on recognized gains (i.e., many charitable organizations). If the doctrine is triggered, the donor is deemed to have effectively realized the income and then assigned that income to another. This results in the donor paying tax on the income that he or she did not actually receive. For charitable donations, the donor likely is unable to force the charity to rescind the transaction, causing the taxpayer to use personal funds to pay the taxes on the income received by the charity.

Unfortunately, the Tax Court’s ruling in Estate of Hoensheid did not specify a bright line deadline for making a donation to give donors assurance that the anticipatory assignment of income doctrine would not apply. Instead, to determine who has a fixed right to the income, the Tax Court stated that it looks at the realities and substance of the underlying transactions rather than formalities or hypothetical possibilities. Factors considered include (i) the donee’s obligation to sell the shares, (ii) the acts of the parties to effect the sale transactions, (iii) unresolved sale contingencies as of the date of the donation and (iv) corporate formalities necessary to effect the transaction.

In reviewing the substance of the underlying transactions in the Estate of Hoensheid case, the Tax Court found that Fidelity Charitable did not have any obligation to sell the shares, which was a factor in favor of the taxpayers. However, the court was not persuaded by the taxpayers’ arguments that the donation occurred over a month before the transaction closed. Importantly, nine days before the transaction closed, the taxpayers’ attorney indicated that the amount of shares being transferred was unclear and that the stock assignment had not been executed.

In the end, the court concluded that Fidelity Charitable accepted the gift only two days before the stock sale transaction closed when one of the taxpayers’ advisers emailed a copy of the company stock certificate issued in the name of Fidelity Charitable.

As of the date of contribution, the Tax Court opined that there were no unresolved sale contingencies and noted that the shareholders had emptied the company’s working capital by distributing cash to the owners (not including Fidelity Charitable).

Finally, the Tax Court looked at the corporate formalities. While the taxpayers argued that negotiations were ongoing all the way through the closing date of July 15, 2015, the Tax Court said the signing of the definitive purchase agreement on that date was purely ministerial and any decision not to sell as of the date of donation was remote and hypothetical. These facts led to the conclusion that the transaction was “too far down the road to enable [the taxpayers] to escape taxation on the gain attributable to the donated shares.”

When considering the enumerated factors, donors should be very careful to avoid creating an informal, prearranged understanding with the charity that would constitute an obligation for the charity to agree to sell. Additionally, the donor must bear some risk at the time of the contribution that the sale will not close. In the Estate of Hoensheid , the taxpayers sought to eliminate any risk that the sale would not go through, and as a result, the Tax Court agreed with the Internal Revenue Service imposing the anticipatory assignment of income doctrine to force the taxpayers to recognize gain on the contributed shares as a result of the later sale to the private equity firm.

The key takeaways from this case are: (i) waiting until shortly before a purchase agreement is executed significantly increases the risk that the Internal Revenue Service will assert the anticipatory assignment of income doctrine; and (ii) the Internal Revenue Service and the courts will look closely at the transaction documents, intent of the donor, correspondence between the donor and his or her advisers, and the records of the charity to determine the date of the gift and the application of this doctrine.  This does not mean that donors must make such gifts before a transaction is contemplated, or even before a nonbinding letter of intent is executed. This case is simply a cautionary tale to remind taxpayers that the Internal Revenue Service will closely scrutinize donations of stock in advance of a stock sale transaction. Maybe one day the Internal Revenue Service or the courts will provide a “bright line,” but for now caution is key.

Loss of Charitable Deduction

After reaching its conclusion related to the anticipatory assignment of income doctrine, the Tax Court turned to the Internal Revenue Service’s argument that the taxpayers should not be permitted a charitable deduction for the donated shares for failing to comply with the rigid substantiation requirements. For a more complete discussion of these requirements, see McGuireWoods’ Nov. 10, 2022, alert .   As a reminder, when the Internal Revenue Service challenges a charitable deduction on procedural grounds, it is not disputing the fact that a charitable contribution was made.  In fact, the Internal Revenue Service admits that the contribution was made but nonetheless challenges the taxpayers’ ability to claim a tax deduction. 

Here, the Internal Revenue Service argued that the taxpayers failed to engage a qualified appraiser and the appraisal did not satisfy the basic requirements for a qualified appraisal.

A qualified appraiser is someone who has obtained an appraisal designation from a recognized professional organization or otherwise has sufficient education and experience, and who regularly performs appraisals for compensation. The qualified appraisal must include all of the following:

  • A description of the contributed property in sufficient detail, including the physical condition of any real or tangible property.
  • The valuation effective date. For qualified appraisals prepared before the date of contribution, the valuation effective date must be no earlier than 60 days before the date of contribution and no later than the actual date of contribution. For qualified appraisals prepared after the contribution, the valuation effective date must be the date of contribution.
  • The fair market value of the contributed property on the valuation effective date.
  • The date or expected date of contribution.
  • The terms of any agreement relating to the use, sale or other disposition of the contributed property. This includes any restrictions on the donee’s ability to dispose of the property, any rights to income from the property or rights to vote any contributed securities.
  • The name, address and taxpayer identification number of the qualified appraiser or the partnership or employer who employs the qualified appraiser.
  • The qualifications of the appraiser, including education and experience.
  • A statement that the appraisal was prepared for income tax purposes.
  • The method of valuation used (e.g., income approach, market-data approach, replacement-cost-less-depreciation approach) and the specific basis for the valuation (e.g., specific comparable sales, statistical sampling).
  • A description of the fee arrangement between the donor and qualified appraiser.
  • This declaration: “I understand that my appraisal will be used in connection with a return or claim for refund. I also understand that, if there is a substantial or gross valuation misstatement of the value of the property claimed on the return or claim for refund that is based on my appraisal, I may be subject to a penalty under Section 6695A of the Internal Revenue Code, as well as other applicable penalties. I affirm that I have not been at any time in the three-year period ending on the date of the appraisal barred from presenting evidence or testimony before the Department of Treasury of the Internal Revenue Service pursuant to 31 U.S.C. 330(c).”
  • The signature of the qualified appraiser and the appraisal report date. The qualified appraisal must be signed and dated no earlier than 60 days before the date of contribution and no later than the due date for the tax return (including extensions) on which the deduction is claimed.

In Estate of Hoensheid , the taxpayers decided to use the services of their financial adviser that worked on the sales transaction to save the costs of having an outside expert prepare the appraisal. This cost-saving move ended up actually costing the taxpayers their entire $3.3 million claim of a charitable deduction for the donated stock. Because the taxpayers’ financial adviser did not have any appraisal certifications, did not hold himself out as an appraiser, and prepares valuations only once or twice a year in order to solicit business for his financial advisory firm, the Tax Court agreed with the Internal Revenue Service that the taxpayer failed to engage a qualified appraiser.

The Tax Court reviewed the Internal Revenue Service’s arguments that the contents of the appraisal attached to the tax return were deficient. The Tax Court agreed and indicated that the appraisal (i) included the incorrect date of contribution, (ii) did not include the statement that it was prepared for federal income tax purposes, (iii) included a premature date of appraisal, (iv) did not sufficiently describe the method for the valuation, (v) was not signed by the appraiser, (vi) did not include the appraiser’s qualifications as an appraiser, (vii) did not describe the donated property in sufficient detail and (viii) did not include an explanation of the specific basis for the valuation.

While the taxpayers did not dispute that the appraisal had defects, they sought to rely on the “substantial compliance” doctrine to excuse these stringent substantiation requirements. The Tax Court analyzed the substantial compliance argument but rejected it, stating that the appraisal failed with regard to multiple substantive requirements of the applicable regulations. As a result, no deduction for the contribution of shares to Fidelity Charitable was allowed.

Again, it is critical for taxpayers and their advisers to closely review the Treasury regulations that set forth the substantiation requirements to minimize the risk that the Internal Revenue Service challenges a charitable deduction on procedural grounds.

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Ensuring that allocations of LLC tax items are respected

  • Partnership & LLC Taxation
  • Allocations & Substantial Economic Effect

Allocations of limited liability company (LLC) tax items (assuming the LLC is classified as a partnership for federal income tax purposes) must be made under one of two allocation methods to be valid under Sec. 704(b) and the related regulations (Regs. Sec. 1. 704 - 1 (b)(1)(i)):

  • The allocations must be in accordance with the members' interests in the LLC (technically called PIP — for partners' interests in the partnership); or
  • The allocations must be made in accordance with the substantial-economic-effect safe-harbor rules.

These two methods of validating allocations are separate alternatives. The tax allocations need not have substantial economic effect; it is only necessary that the tax allocations be in accordance with the PIP. The substantial - economic - effect rules are strictly a safe harbor.

Because the rules for determining members' interests in the LLC are broad and general, the regulations provide an alternative safe harbor — the substantial - economic - effect rules — with which an LLC can comply. These safe - harbor allocation rules contain the capital account bookkeeping rules for recording the economic (not tax) results of LLC operations. Once the economic bookkeeping has been properly done, the allocation of tax results among the members must be made in a manner consistent with the allocation of the corresponding economic results.

For example, assume two equal members own LLC interests all year and have identical book capital accounts. If the operating agreement allocates the overall economic gain and loss between the two members 50/50, it cannot allocate the tax results differently. Likewise, if the members agree to specially allocate one item for economic purposes, they must allocate the associated tax results for that item in the same way.

Following the safe - harbor rules may require a considerable amount of additional recordkeeping and analysis to maintain separate book (economic) capital accounts and make required revaluations of LLC property and member capital accounts.

Certain tax allocations do not have any corresponding economic element. Examples include allocations of tax credits, percentage depletion in excess of cost, and deductions related to nonrecourse liabilities. Safe - harbor allocations of these items must be made in accordance with PIP under special rules set forth in Regs. Sec. 1. 704 - 1 (b)(3).

Sec. 704 is not the exclusive test for determining the validity and consequences of a tax allocation. Other tax principles also must be considered, such as whether the allocation involves an assignment of income, misallocation of income among related parties (see Sec. 482), LLC interests created by gift (including a purchase by a family member) (see Sec. 704(e)), employee compensation (see Secs. 83 and 707(a)), a gift (see Sec. 2501), or a sale (see Secs. 707(a) and 1001). In other words, while an allocation may satisfy the Sec. 704(b) rules, other Code sections and related IRS guidance may still affect the tax treatment of that allocation.

Not only must an LLC member have a profit motive in entering into an LLC arrangement, but the LLC transactions themselves must also have economic substance. Otherwise, the IRS can disregard the LLC for tax purposes. Furthermore, the IRS has the authority to recast a transaction if the LLC violates the anti - abuse regulations.

Anti-abuse regulations

A purported LLC can be disregarded, in whole or in part, if the LLC is formed or availed of in connection with a transaction having a principal purpose of substantially reducing the present value of the members' aggregate federal tax liabilities and the transaction is inconsistent with the intent of Subchapter K (the partnership section of the Internal Revenue Code). The intent of Subchapter K is set forth in five tests, all of which must be met (Regs. Sec. 1. 701 - 2 (a)):

  • The entity must be bona fide;
  • Each transaction must have a bona fide and substantial business purpose;
  • The transaction must be respected under substance-over-form principles;
  • The tax consequences must accurately reflect the members' economic agreement; and
  • The tax consequences must clearly reflect the members' income.

Failure to pass these tests opens the door for the IRS to disregard transactions, disregard one or more members, disregard the LLC, or otherwise ignore or change the transactions to reflect reality.

The regulations also give the IRS the power to treat any LLC as an aggregate of the members, in whole or in part, if necessary to carry out the purpose of a Code provision or regulation (Regs. Sec. 1. 701 - 2 (e)).

In Countryside Limited Partnership , T.C. Memo. 2008 - 3 , however, the Tax Court denied the IRS's attempt to use the economic substance doctrine and the anti - abuse regulations to recharacterize a partnership transaction. The case involved a liquidating distribution that was structured to defer tax by distributing property rather than cash to the partners. The partners conceded that tax avoidance was the sole motivation for the structure of the transaction. However, the court found that the transactions had economic substance and the anti - abuse regulations could not be applied. While the employed means were designed to avoid recognition of gain by the liquidated partners, those means served a genuine, nontax business purpose (i.e., to convert the liquidated partners' investments in Countryside into 10 - year promissory notes, an economically distinct form of investment).

Particular attention should be paid to LLCs involving related parties, since one of the facts and circumstances that the IRS will scrutinize involves related parties. However, the regulations point out that all of the facts and circumstances must be considered in determining the validity of the transaction. No special weight should be given to the presence or absence of any particular factor.

Regs. Sec. 1. 704 - 3 (a)(10) provides that the anti - abuse regulations take into account the tax liabilities of both the members of the LLC and certain direct and indirect owners of those members. Regs. Sec. 1. 704 - 3 (a)(10)(ii) provides that indirect owners include any direct or indirect owner of a partnership, an LLC classified as a partnership or as an S corporation, an S corporation, or a controlled foreign corporation that is a member in the LLC. Also included are a direct or indirect beneficiary of a trust or estate that is a member in the LLC and any consolidated group of which the member in the LLC is a member.

Example. Application of the anti-abuse regulations: K , B , and J , all brothers, form the M LLC to operate a restaurant. The LLC is classified as a partnership. K , B , and J each contribute one - third of the LLC's capital. J has had some serious financial problems and has $500,000 of net operating losses (NOLs) that are about to expire. The LLC's operating agreement provides that all members are to receive a $35,000 guaranteed payment and that J is to then receive 80% of the net income or loss for managing the restaurant, with K and B each receiving 10%. The goal is to make the business profitable, then sell to a national chain. The profits on the sale will be split equally.

These LLC allocations may be challenged by the IRS. First, the allocations are suspect because the parties are related and most of the income is allocated to J , who is effectively exempt from tax by virtue of the large NOL. This substantially reduces the present value of the taxes due from what it would be if the profits were allocated equally. Additionally, the stated goal is to eventually sell the restaurant, at which time all of the parties will share the profit equally.

The IRS, by invoking the anti - abuse regulations, could reallocate the income to the members or treat J as an employee (or independent contractor) rather than a member.

Economic substance doctrine

The economic substance doctrine is a common law doctrine under which tax benefits related to a transaction are disallowed if the transaction does not have economic substance or lacks a business purpose. Although the doctrine originated in case law, Sec. 7701(o) codifies it. Sec. 6662 imposes an accuracy - related penalty on transactions that lack economic substance. The codified rules apply only to transactions to which the economic substance doctrine is "relevant." Sec. 7701(o)(5) provides that the determination of whether the doctrine is relevant to a transaction or series of transactions is made as if the Code section had never been enacted, in other words, under the old rules.

Sec. 7701(o)(1) provides that a transaction is treated as having economic substance only if (1) the transaction changes in a meaningful way the taxpayer's economic position beyond tax benefits (objective test) and (2) the taxpayer has a substantial nontax business purpose for entering into the transaction (subjective test). Changes in the taxpayer's federal and/or state and local taxes (including financial accounting benefits originating from a reduction of income taxes) are not considered meaningful and do not constitute a substantial purpose.

A transaction's potential for profit can be taken into account to determine its economic substance only if the present value of the reasonably expected pretax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. Fees and other transaction expenses must be taken into account to determine pretax profits.

In Sala , 613 F.3d 1249 (10th Cir. 2010), which was decided soon after Sec. 7701(o) was enacted but does not mention that provision, the Tenth Circuit held that "an investment program that included an initial phase designed primarily to generate a tax loss so as to offset over $60 million in income [the taxpayer] earned during the 2000 tax year" lacked economic substance. The loss "was structured from the outset to be a complete fiction" because the transaction was designed to create a tax loss that would almost entirely offset the taxpayer's 2000 income "with little actual economic risk." Furthermore, the taxpayer was aware that the partnership would have to be liquidated by year end to generate a large enough tax loss to offset his income.

Observation : Sala is important because it is an appellate decision and because it addresses many of the issues underlying Sec. 7701(o). While the district court found the long and short options had a profit potential of $550,000 over a one - year period, the expected tax benefit was nearly $24 million, which "dwarf(ed) any potential gain from" the taxpayer's participation in the transaction. Furthermore, any economic benefit from participating in the transaction for a few weeks, and then liquidating the partnership by year end, was negligible in comparison to the $24 million tax benefit.

The economic substance doctrine has been used in several other cases to deny taxpayer losses. For example, in Fidelity International Currency Advisor A Fund LLC , 661 F.3d 667 (1st Cir. 2011), a transaction involving the contribution of offsetting options to a partnership, where the purchased option was treated as an asset and the sold option was not treated as a liability, was deemed to have no economic substance. Similarly, in Nevada Partners Fund, LLC , 720 F.3d 594 (5th Cir. 2013), the "sale" of suspended losses largely resulting from foreign currency transactions was deemed to have no economic substance. The court held that any profits the taxpayer would recognize from the series of transactions were insignificant in relation to the tax benefits generated.

The Third Circuit overturned a Tax Court decision that originally found economic substance in a transaction involving rehabilitation credits ( Historic Boardwalk Hall, LLC ,694 F.3d 425 (3d Cir. 2012)). The Tax Court determined that an LLC formed by New Jersey Sports and Exposition Authority (NJSEA) and an investment corporation allowed the corporate member to invest in the rehabilitation of a historic hall and obtain rehabilitation credits under Sec. 47. The Tax Court found economic substance to the transaction because the corporation did not become a member of the LLC solely for the tax credits but also to invest, with the realistic possibility of earning a profit. The corporate member's investment provided NJSEA with more money than it otherwise would have had; the development fee involved was a legitimate expense; and real risks were involved. The Tax Court also felt that the members had a common rehabilitation goal and would receive a net economic benefit if the project proved successful.

The appeals court, however, found that the overall facts and circumstances showed the intent of the transaction was the sale and purchase of rehabilitation tax credits. The corporation was not in substance a member because it had no downside risk of investment due to the operative agreements and associated tax benefit guaranty in place. Similarly, there was no upside to the corporation's investment. Consequently, in substance, the corporation was not a bona fide member because it had no meaningful stake in either the LLC's success or failure.

Notice 2010 - 62 states that the IRS will continue to rely on relevant case law in applying the two - prong test in Sec. 7701(o)(1) and in determining if the transaction's potential for profit is taken into account in determining economic substance. Notice 2014 - 58 provides additional guidance regarding the definition of "transaction" for applying the economic substance doctrine under Sec. 7701(o).

This case study has been adapted from PPC's Guide to Limited Liability Companies , 26th edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com ).

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assignment of income and gifts

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.

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  • Tax Planning

Form 3520: Reporting Gifts and Inheritances from Foreign Countries

Form 3520 Reporting Gifts and Inheritances from Foreign Countries (1440 x 600 px)

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Written by Susan Yeatts, EA

  • Published May 17, 2024

In this increasingly global world, many of us are finding ourselves caught in the complexities of tax reporting related to income or assets that are held outside of the United States. Taxpayers who receive a gift or bequest (inheritance) from a nonresident alien or foreign estate may be required to file informational Form 3520. This form also reports transactions with and distributions from foreign trusts. However, we will focus on gifts and inheritances received by US individuals.  Since this form is filed separately from your income tax return (and doesn’t result in any tax owed or refund due), it isn’t a supported form within Intuit TurboTax. Many taxpayers will be able to tackle this form on their own if they have gifts and bequests (inheritances).

Note: We do recommend consulting with a tax professional to help ensure you are aware of all of your reporting requirements, as penalties for many informational forms can be quite steep.  

Table of Contents

Who is required to file form 3520 .

US persons (citizens, resident aliens, and residents for tax purposes) must file Form 3520 to report gifts and inheritances received from foreign individuals (also known as nonresident aliens) and foreign estates.  

How do I complete this form?

When reporting only gifts and bequests, taxpayers must complete the top of the form through line 1k (for items that apply). Then, skip to Part IV, question 54 on page 6. In column (a), indicate the date the gift was received.

For inheritances, the laws where the inherited property is located will determine when you are the legal owner or in “constructive receipt” of the property. This governs if you report your inheritance on the date of death or the date of the actual transfer of the property or assets.  

If in doubt, and the two events occur in separate tax years, report at the date of death to avoid the potential for late-filing penalties. You may also file the form again in the year the assets are actually transferred to provide additional details or to update values, though generally, the repetition isn’t necessary.

In column (b) you list a description of what is received. This doesn’t need to be elaborate.  For example, you might list “residential property in City, Province, Country” or “cash/wire transfer,” or “stocks in foreign brokerage account” or any other description that helps you to identify the item. Column (c) is for the Fair Market Value (FMV) of the property received.  In the case of assets that may typically be valued by an appraisal, where an appraisal isn’t available, use your best efforts to determine the value. It’s always better to overestimate the value here when uncertain.  There’s no tax associated with these values. (The value to be used should correspond to the date of the transfer of the asset. This could be the date of death of the decedent or the date of the legal transfer of the asset or some other date as determined by the the law where the asset is located.)

When is Form 3520 due?

Form 3520 is filed in the year that a gift or inheritance is received, and is generally due on the same dates as the filer’s income tax return (April 15, June 15 for US taxpayers living overseas, or October 15 if an extension is granted). 

Where is the form filed? 

Although due at the same time as the individual’s income tax return, Form 3520 is filed separately and can’t be filed electronically.  

If you are a taxpayer who files on June 15 because you live outside of theteh United States or Puerto Rico, attach a statement to your tax return indicating that you are subject to an automatic two-month extension because you are a US citizen (or resident) who resides outside of the United States or Puerto Rico or you are a member of the military stationed outside of the US or PR.  Be sure to sign your attached statement.

The form should be printed, signed, and mailed to:

Internal Revenue Service

P.O. Box 409101

Odgen, UT 84409 

  • I am a dual citizen, and so is my mother. She lived in Italy at the time of her death, and I inherited property that is located there in addition to cash and jewelry. Since she is also a US citizen, do I need to file this form? Yes, you will need to file this form since the estate is located outside the United States. While you are receiving assets from another US citizen, those assets will be distributed outside of a US-governed estate and must be reported to the IRS. 
  • My father passed away two years ago, and I inherited a home. I filed Form 3520 then and have now sold the home. Do I file the form again to report the cash from the sale? No, you don’t report the cash as a separate gift on Form 3520. However, you will likely need to report the gain (or loss) from the sale of the home on your income tax return (Form 1040).
  • I wasn’t aware that I was supposed to file this form last year, and now I’m late. What do I do? Late-filing penalties may be waived in cases where the taxpayer can show “reasonable cause” for the delayed filing. We recommend that you consult with a tax professional in your area familiar with the process for requesting a reasonable cause waiver for this form.
  • My parents pay my tuition in the US and provide money for my support (room, board, transportation, etc.), which exceeds $100,000 USD. Does this form apply to me?  Maybe.  Many students are also considered nonresident aliens, and this form isn’t required for non-US persons living in the US.  Also, payments made directly to universities for tuition aren’t reportable on Form 3520.  However, if you are a US citizen, resident alien, or tax resident (you have qualified based on the substantial presence test) and the funds are transferred directly to you, you may be required to file this form.  If you’re not certain, ‌consult a tax professional in your area for guidance. 
  • I received gifts from multiple sources abroad.  No individual gave me more than $100,000 but the total of my gifts for the year was greater than $100,000.  Do I have to file this form? Yes.  You must aggregate all assets received in a calendar year from foreign individuals and estates.  
  • Do I need to attach copies of statements, appraisals, sales contracts, etc. to my Form 3520?  No, you don’t need to attach statements to your Form 3520 when reporting gifts and bequests.  Keep these with your records, making sure to keep them easily accessible for not less than three years.  
  • I mailed in my Form 3520 and realized that I forgot to include an asset.  What do I do?   You can file an amended version of your form.  Simply re-enter the data on the first page, add the asset in Section IV; write “AMENDED” across the very top of page one, and mail to the same address where you filed the initial form.  

Additional notes: Depending on the assets received, the recipient may also have other filing requirements such as FBAR/FinCEN 114, Form 720, Form 8938, Form 8621, or others. These instructions aren’t applicable to transactions between a US person and a foreign trust and don’t cover all tax situations. Late-filing penalties for failure to timely report foreign gifts and bequests may be applied at the rate of 5% of the unreported value per month, not to exceed 25%.  Taxpayers are encouraged to consult with a tax professional with expertise in this area before filing their tax returns. 

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Assignment Of Income And Charitable Contributions Of Closely Held Stock

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.

Second Step

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.

The Appraisal

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?

[ View source .]

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Income mobility is the American Dream. Most Minnesotans never achieve it.

There is a belief among Americans that with hard work, education and maybe a little luck, anyone can improve their lot in life. That even if you start on the bottom rung of the income ladder, it's possible to climb to the top.

But for most people, that's not true.

Income mobility

  • Income mobility stalls in Minnesota
  • Inequity persists for Black earners
  • Gender pay gap stagnates
  • Great Recession still haunts millennials
  • Native Minnesotans strive for stability
  • Asian Minnesotans stand alone in income mobility

Though Americans as a whole have historically been able to count on doing better economically than their parents, for children born since 1980 out-earning the previous generation has been a coin toss.

New data the Federal Reserve Bank of Minneapolis compiled into the Income Distributions and Dynamics in America report shows income stagnation is widespread , and Minnesotans are among the Americans least likely to move out of their current bracket. Those who start at the bottom here tend to stay at the bottom, and those who start at the top tend to stay at the top.

"It is harder for people who are in the lower-earning percentiles to move up over time, but it is also harder to go the other way, for the most part," said Abigail Wozniak, vice president and director of the Minneapolis Fed's Opportunity & Inclusive Growth Institute. "Certainly, beneficiaries of that have often been white earners, but it also does mean for Black earners and earners of color who start to earn in that highest quartile, they are less likely to fall out of it than other places. There is a two-sides-to-the-coin kind of situation with that mobility piece."

Let's see what this looks like.

This is just one five-year span. Through the course of a working life, the opportunity for mobility declines until it's essentially nonexistent.

Only Washington, D.C., and North Dakota have higher rates of so-called "income persistence." Minnesota takes third place, tied with Maryland and Massachusetts.

There is a regional component at play, Wozniak said, with some other states in the Fed's Ninth District — which includes much of the Upper Midwest — experiencing similar limitations in income mobility. Potential contributing factors include lower rates of in-migration and new business formation, she said.

"Minnesota in particular, we really pride ourselves on having these headquarters and these big companies," Wozniak said. "The earnings of their workers tend to be very, very stable, and so then you don't see that movement as much."

Outward migration in recent decades is also a possible contributor to this phenomenon in Minnesota, said Misty Heggeness, an associate economics and public affairs professor at the University of Kansas. She is an example: After growing up in Fargo, she graduated from the University of Minnesota and then left for a job in Washington, D.C.

"People will get educated, and then they'll move to where the jobs are," she said.

For those who opt to stay, Wozniak said, there are strong local networks that "help preserve the earnings, and in another sphere, even the wealth capacity of families."

High earners who stay in Minnesota are unlikely to see their incomes decline. While that's a positive story for those Minnesotans, it raises questions about the systems that allow income inequality to persist, Heggeness said.

"If you're at the upper level, you're benefiting a lot from a system that is rigid," she said. "Are the supports and systems that we have in place ... just maintaining a status quo?"

Median individual earnings in Minnesota in 2019 were $39,750, with about 16% of all income concentrated among the top 2% of earners, according to the Fed .

The lack of mobility exacerbates persistent racial and gender income gaps that have long plagued Minnesota, despite the state's relatively high level of investment in education, health care and social services. This new data — the most detailed ever made public — confirms the true depth of these inequities.

"It's not the story we tell about ourselves," said Ed Goetz, a professor at the University of Minnesota Humphrey School of Public Affairs. "People have to have opportunities to improve or their investment in the existing social structure really begins to erode."

There are also major inequities between Minnesotans, some of which are likely not reflected in tax records. Though tax data can be more reliable than survey data — which often includes underreporting at the highest levels and overreporting at the lowest, Heggeness said — some earners are missing, such as those who are self-employed or work in informal economies.

Some of the greatest disparities are between racial groups. A Native American worker has just a 1 in 3 chance of moving out of the lowest income quartile within five years. Black and white workers are also more likely than not to stay in the lowest bracket, while Latino workers have a 50% chance of moving up. Asian workers have the greatest chance of leaving the bottom quartile at 57%.

For all workers, the chance of moving up declines at higher income levels. For those who jump one rung to the second quartile, odds are they will either stay there or fall back down again.

Men are also more likely to move up the income ladder than women. Male workers in the second quartile have slightly more than a 1 in 3 chance of moving up, compared to a 1 in 4 chance for female workers at the same level.

In addition, workers can be in the same quartile and have very different incomes. Let's look at the middle of the ladder, or the 50th percentile, what we might call "middle class."

At this level, Black workers are earning $16,000 less, and Native American workers are earning $17,000 less than white workers. Closing that gap would nearly double their incomes.

Female earners at every level earn less than men. Though the gap in Minnesota is narrower than the U.S. average, as women climb the work ladder, they fall further and further behind men.

While U.S. women as a whole have earned about 80 cents on the dollar for the past 30 years, women at the highest income levels earn about 60 cents on the dollar.

Emma Nelson is a reporter and editor at the Star Tribune.

MaryJo Webster is the data editor for the Star Tribune. She teams up with reporters to analyze data for stories across a wide range of topics and beats and also oversees a small team of other data journalists.

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Tax Court in Brief | Estate of Hoenshied v. Commissioner | Anticipatory Assignment of Income, Charitable Contribution Deduction, and Qualified Appraisals

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The Tax Court in Brief – April 3rd – April 7th, 2023

Freeman Law ’s “ The Tax Court in Brief ” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of April 3rd, 2022, through April 7th, 2023

Estate of Hoenshied v. Comm’r, T.C. Memo. 2023-34 | March 15, 2023 | Nega, J. | Dkt. No. 18606-19

Summary: In this 49-page opinion the Tax Court addresses a deficiency arising from the charitable contribution of appreciated shares of stock in a closely held corporation to a charitable organization that administers donor-advised funds for tax-exempt purposes under section 501(c)(3). The contribution in issue was made near contemporaneously with the selling of those shares to a third party. The timeline (truncated heavily for this blog) is as follows:

On June 11, 2015, the shareholders of the corporation in issue unanimously ratified the sale of all outstanding stock of the corporation. Immediately following the shareholder meeting, the corporation’s board of directors unanimously approved Petitioner’s request to be able to transfer a portion of his shares to Fidelity Charitable Gift Fund, a tax-exempt charitable organization under section 501(c)(3). Thereafter, the corporation and the purchaser of shares continued drafting and revising the Contribution and Stock Purchase Agreement.

On July 13, 2015, Fidelity Charitable first received a stock certificate from Petitioner.

On July 14, 2015, the Contribution and Stock Purchase Agreement was revised to specify that Petitioner contributed shares to Fidelity Charitable on July 10, 2015, and on July 15, 2015, the Contribution and Stock Purchase Agreement was signed and the transaction was funded.

Fidelity Charitable, having provided an Irrevocable Stock Power as part of the transaction, received $2,941,966 in cash proceeds from the sale, which was deposited in Petitioner’s donor-advised fund giving account.

On November 18, 2015, Fidelity Charitable sent Petitioner a contribution confirmation letter acknowledging a charitable contribution of the corporate shares and indicating that Fidelity Charitable received the shares on June 11, 2015.

In its 2015 tax return, Petitioner did not report any capital gains on the shares contributed to Fidelity Charitable but claimed a noncash charitable contribution deduction of $3,282,511. In support of the claimed deduction, a Form 8283 was attached to the return.

Petitioner’s 2015 tax return was selected for examination. The IRS issued to Petitioners a notice of deficiency, determining a deficiency of $647,489, resulting from the disallowance of the claimed charitable contribution deduction, and a penalty of $129,498 under section 6662(a).

Key Issues:

  • Whether and when Petitioners made a valid contribution of the shares of stock?
  • Whether Petitioners had unreported capital gain income due to their right to proceeds from the sale of those shares becoming fixed before the gift?
  • Whether Petitioners are entitled to a charitable contribution deduction?
  • Whether Petitioners are liable for an accuracy-related penalty under section 6662(a) with respect to an underpayment of tax?

Primary Holdings:

(1) Petitioners failed to establish that any of the elements of a valid gift was present on June 11, 2015. No evidence was presented to credibly identify a specific action taken on June 11 that placed the shares within Fidelity Charitable’s dominion and control. Instead, the valid gift of shares was made by effecting delivery of a PDF of the certificate to Fidelity Charitable on July 13.

(2) Yes. None of the unresolved contingencies remaining on July 13, 2015 were substantial enough to have posed even a small risk of the overall transaction’s failing to close. Thus, Petitioners, through the doctrine of anticipatory assignment of income, had capital gains on the sale of the 1,380 appreciated shares of stock, even though Fidelity Charitable received the proceeds from that sale.

(3) No, Petitioners failed to show that the charitable contribution met the qualified appraisal requirements of section 170. The appraiser was not shown to be qualified, per regulations, at trial or in the appraisal itself, and the appraisal did not substantially comply with the regulatory requirements. “The failure to include a description of such experience in the appraisal was a substantive defect. . . . Petitioners’ failure to satisfy multiple substantive requirements of the regulations, paired with the appraisal’s other more minor defects, precludes them from establishing substantial compliance.” In addition, Petitioners failed to establish reasonable cause for failing to comply with the appraisal requirements “because petitioner knew or should have known that the date of contribution (and thus the date of valuation) was incorrect.” Thus, the IRS’s determination to disallow the charitable contribution deduction is sustained.

(4) No. While Petitioners did not have reasonable cause for their failure to comply with the qualified appraisal requirement, their liability for an accuracy-related penalty was a separate analysis, and the IRS did not carry the burden of proof. Petitioners did not follow their professional’s advice to have the paperwork for the contribution ready to go “well before the signing of the definitive purchase agreement.” But, Petitioners adhered to the literal thrust of the advice given: that “execution of the definitive purchase agreement” was the firm deadline to contribute the shares and avoid capital gains (even if that proved to be incorrect advice under the circumstances).

Key Points of Law:

Gross Income. Gross income means “all income from whatever source derived,” including “[g]ains derived from dealings in property.” 26 U.S.C. § 61(a)(3). In general, a taxpayer must realize and recognize gains on a sale or other disposition of appreciated property. See id. at § 1001(a)–(c). However, a taxpayer typically does not recognize gain when disposing of appreciated property via gift or charitable contribution. See Taft v. Bowers , 278 U.S. 470, 482 (1929); see also 26 U.S.C. § 1015(a) (providing for carryover basis of gifts). A taxpayer may also generally deduct the fair market value of property contributed to a qualified charitable organization. See 26 U.S.C. § 170(a)(1); Treas. Reg. 16 § 1.170A-1(c)(1). Contributions of appreciated property are thus tax advantaged compared to cash contributions; when a contribution of property is structured properly, a taxpayer can both avoid paying tax on the unrealized appreciation in the property and deduct the property’s fair market value. See, e.g. , Dickinson v. Commissioner , T.C. Memo. 2020-128, at *5.

Donor-Advised Fund. The use of a donor-advised fund further optimizes a contribution by allowing a donor “to get an immediate tax deduction but defer the actual donation of the funds to individual charities until later.” Fairbairn v. Fid. Invs. Charitable Gift Fund , No. 18-cv-04881, 2021 WL 754534, at *2 (N.D. Cal. Feb. 26, 2021).

Two-Part Test to Determine Charitable Contribution of Appreciated Property Followed by Sale by Donee. The donor must (1) give the appreciated property away absolutely and divest of title (2) “before the property gives rise to income by way of a sale.” Humacid Co. v. Commissioner , 42 T.C. 894, 913 (1964).

Valid Gift of Shares of Stock. “Ordinarily, a contribution is made at the time delivery is effected.” Treas. Reg. § 1.170A-1(b). “If a taxpayer unconditionally delivers or mails a properly endorsed stock certificate to a charitable donee or the donee’s agent, the gift is completed on the date of delivery.” Id. However, the regulations do not define what constitutes delivery, and the Tax Court evaluates applicable state law for the threshold determination of whether donors have divested themselves of their property rights via gift. See, e.g. , United States v. Nat’l Bank of Com. , 472 U.S. 713, 722 (1985). In determining the validity of a gift, Michigan law, for example (and as applied in Estate of Hoensheid ), requires a showing of (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee , 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

Present Intent. The determination of a party’s subjective intent is necessarily a highly fact-bound issue. When deciding such an issue, the Tax Court must determine “whether a witness’s testimony is credible based on objective facts, the reasonableness of the testimony, the consistency of statements made by the witness, and the demeanor of the witness.” Ebert v. Commissioner , T.C. Memo. 2015-5, at *5–6. If contradicted by the objective facts in the record, the Tax Court will not “accept the self-serving testimony of [the taxpayer] . . . as gospel.” Tokarski v. Commissioner , 87 T.C. 74, 77 (1986).

Delivery. Under Michigan law, the delivery requirement generally contemplates an “open and visible change of possession” of the donated property. Shepard v. Shepard , 129 N.W. 201, 208 (Mich. 1910). Manually providing tangible property to the donee is the classic form of delivery. Manually providing to the donee a stock certificate that represents intangible shares of stock is traditionally sufficient delivery. The determination of what constitutes delivery is context-specific and depends upon the “nature of the subject-matter of the gift” and the “situation and circumstances of the parties.” Shepard , 129 N.W. at 208. Constructive delivery may be effected where property is delivered into the possession of another on behalf of the donee. See, e.g. , In re Van Wormer’s Estate , 238 N.W. 210, 212 (Mich. 1931). Whether constructive or actual, delivery “must be unconditional and must place the property within the dominion and control of the donee” and “beyond the power of recall by the donor.” In re Casey Estate , 856 N.W.2d 556, 563 (Mich. Ct. App. 2014). If constructive or actual delivery of the gift property occurs, its later retention by the donor is not sufficient to defeat the gift. See Estate of Morris v. Morris , No. 336304, 2018 WL 2024582, at *5 (Mich. Ct. App. May 1, 2018).

Delivery of Shares. Retention of stock certificates by donor’s attorney may preclude a valid gift. Also, a determination of no valid gift may occur where the taxpayer instructs a custodian of corporate books to prepare stock certificates but remained undecided about ultimate gift. In some jurisdictions, transfer of shares on the books of the corporation can, in certain circumstances, constitute delivery of an inter vivos gift of shares. See, e.g. , Wilmington Tr. Co. v. Gen. Motors Corp. , 51 A.2d 584, 594 (Del. Ch. 1947); Chi. Title & Tr. Co. v. Ward , 163 N.E. 319, 322 (Ill. 1928); Brewster v. Brewster , 114 A.2d 53, 57 (Md. 1955). The U.S. Court of Appeals for the Sixth Circuit has stated that transfer on the books of a corporation constitutes delivery of shares of stock, apparently as a matter of federal common law. See Lawton v. Commissioner , 164 F.2d 380, 384 (6th Cir. 1947), rev’g 6 T.C. 1093 (1946); Bardach v. Commissioner , 90 F.2d 323, 326 (6th Cir. 1937), rev’g 32 B.T.A. 517 (1935); Marshall v. Commissioner , 57 F.2d 633, 634 (6th Cir. 1932), aff’g in part, rev’g in part 19 B.T.A. 1260 (1930). The transfers on the books of the corporation were bolstered by other objective actions that evidenced a change in possession and thus a gift. See Jolly’s Motor Livery Co. v. Commissioner , T.C. Memo. 1957-231, 16 T.C.M. (CCH) 1048, 1073.

Acceptance. Donee acceptance of a gift is generally “presumed if the gift is beneficial to the donee.” Davidson , 575 N.W.2d at 576.

Anticipatory Assignment of Income. The anticipatory assignment of income doctrine is a longstanding “first principle of income taxation.” Commissioner v. Banks , 543 U.S. 426, 434 (2005). The doctrine recognizes that income is taxed “to those who earn or otherwise create the right to receive it,” Helvering v. Horst , 311 U.S. 112, 119 (1940), and that tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised,” Lucas v. Earl , 281 U.S. 111, 115 (1930). A person with a fixed right to receive income from property thus cannot avoid taxation by arranging for another to gratuitously take title before the income is received. See Helvering , 311 U.S. at 115–17; Ferguson , 108 T.C. at 259. This principle is applicable, for instance, where a taxpayer gratuitously assigns wage income that the taxpayer has earned but not yet received, or gratuitously transfers a debt instrument carrying accrued but unpaid interest. A donor will be deemed to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income. See Cold Metal Process Co. v. Commissioner , 247 F.2d 864, 872–73 (6th Cir. 1957), rev’g 25 T.C. 1333 (1956). The same principle is often applicable where a taxpayer gratuitously transfers shares of stock that are subject to a pending, prenegotiated transaction and thus carry a fixed right to proceeds of the transaction. See Rollins v. United States , 302 F. Supp. 812, 817–18 (W.D. Tex. 1969).

Determining Anticipatory Assignment of Income. In determining whether an anticipatory assignment of income has occurred with respect to a gift of shares of stock, the Tax Court looks to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities. See Jones v. United States , 531 F.2d 1343, 1345 (6th Cir. 1976) (en banc); Allen v. Commissioner , 66 T.C. 340, 346 (1976). In general, a donor’s right to income from shares of stock is fixed if a transaction involving those shares has become “practically certain to occur” by the time of the gift, “despite the remote and hypothetical possibility of abandonment.” Jones , 531 F.2d at 1346. The mere anticipation or expectation of income at the time of the gift does not establish that a donor’s right to income is fixed. The Tax Court looks to several other factors that bear upon whether the sale of shares was virtually certain to occur at the time of a purported gift as part of the same transaction. Relevant factors may include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transaction.

Corporate Formalities. Also relevant is the status of the corporate formalities necessary for effecting the transaction. See Estate of Applestein , 80 T.C. at 345–46 (finding that taxpayer’s right to sale proceeds from shares had “virtually ripened” upon shareholders’ approval of proposed merger agreement). Under Michigan law, a proposed plan to exchange shares must generally be approved by a majority of the corporation’s shareholders. Formal shareholder approval of a transaction has often proven to be sufficient to demonstrate that a right to income from shares was fixed before a subsequent transfer. However, such approval is not necessary for a right to income to be fixed, when other actions taken establish that a transaction was virtually certain to occur. See Ferguson , 104 T.C. at 262–63.

Charitable Contribution Deduction. Section 170(a)(1) allows as a deduction any charitable contribution (as defined) payment of which is made within the taxable year. “A charitable contribution is a gift of property to a charitable organization made with charitable intent and without the receipt or expectation of receipt of adequate consideration.” Palmolive Bldg. Invs., LLC v. Commissioner , 149 T.C. 380, 389 (2017). Section 170(f)(8)(A) provides that “[n]o deduction shall be allowed . . . for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the contribution by the donee organization that meets the requirements of subparagraph (B).” For contributions of property in excess of $500,000, the taxpayer must also attach to the return a “qualified appraisal” prepared in accordance with generally accepted appraisal standards. 26 U.S.C. § 170(f)(11)(D) and (E).

Contemporaneous Written Acknowledgement (“CWA”). A CWA must include, among other things, the amount of cash and a description of any property contributed. 26 U.S.C. § 170(f)(8)(B). A CWA is contemporaneous if obtained by the taxpayer before the earlier of either (1) the date the relevant tax return was filed or (2) the due date of the relevant tax return. Id. at § 170(f)(8)(C). For donor-advised funds, the CWA must include a statement that the donee “has exclusive legal control over the assets contributed.” 26 U.S.C. § 170(f)(18)(B). These requirements are construed strictly and do not apply the doctrine of substantial compliance to excuse defects in a CWA.

Qualified Appraisal for Certain Charitable Contributions. Section 170(f)(11)(A)(i) provides that “no deduction shall be allowed . . . for any contribution of property for which a deduction of more than $500 is claimed unless such person meets the requirements of subparagraphs (B), (C), and (D), as the case may be.” Subparagraph (D) requires that, for contributions for which a deduction in excess of $500,000 is claimed, the taxpayer attach a qualified appraisal to the return. Section 170(f)(11)(E)(i) provides that a qualified appraisal means, with respect to any property, an appraisal of such property which—(I) is treated for purposes of this paragraph as a qualified appraisal under regulations or other guidance prescribed by the Secretary, and (II) is conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed under subclause (I). The regulations provide that a qualified appraisal is an appraisal document that, inter alia, (1) “[r]elates to an appraisal that is made” no earlier than 60 days before the date of contribution and (2) is “prepared, signed, and dated by a qualified appraiser.” Treas. Reg. § 1.170A-13(c)(3)(i).

Qualified Appraisal Must Include: Treasury Regulation § 1.170A-13(c)(3)(ii) requires that a qualified appraisal itself include, inter alia:

(1) “[a] description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was (or will be) contributed;”

(2) “[t]he date (or expected date) of contribution to the donee;”

(3) “[t]he name, address, and . . . identifying number of the qualified appraiser;”

(4) “[t]he qualifications of the qualified appraiser;”

(5) “a statement that the appraisal was prepared for income tax purposes;”

(6) “[t]he date (or dates) on which the property was appraised;”

(7) “[t]he appraised fair market value . . . of the property on the date (or expected date) of contribution;” and

(8) the method of and specific basis for the valuation.

Qualified Appraiser. Section 170(f)(11)(E)(ii) provides that a “qualified appraiser” is an individual who (I) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations, (II) regularly performs appraisals for which the individual receives compensation, and (III) meets such other requirements as may be prescribed . . . in regulations or other guidance. An appraiser must also demonstrate “verifiable education and experience in valuing the type of property subject to the appraisal.” The regulations add that the appraiser must include in the appraisal summary a declaration that he or she (1) “either holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis;” (2) is “qualified to make appraisals of the type of property being valued;” (3) is not an excluded person specified in paragraph (c)(5)(iv) of the regulation; and (4) understands the consequences of a “false or fraudulent overstatement” of the property’s value. Treas. Reg. § 1.170A-13(c)(5)(i). The regulations prohibit a fee arrangement for a qualified appraisal “based, in effect, on a percentage . . . of the appraised value of the property.” Id. at subpara. (6)(i).

Substantial Compliance with Qualified Appraisal Requirements. The qualified appraisal requirements are directory, rather than mandatory, as the requirements “do not relate to the substance or essence of whether or not a charitable contribution was actually made.” See Bond v. Commissioner , 100 T.C. 32, 41 (1993). Thus, the doctrine of substantial compliance may excuse a failure to strictly comply with the qualified appraisal requirements. If the appraisal discloses sufficient information for the IRS to evaluate the reliability and accuracy of a valuation, the Tax Court may deem the requirements satisfied. Bond , 100 T.C. at 41–42. Substantial compliance allows for minor or technical defects but does not excuse taxpayers from the requirement to disclose information that goes to the “essential requirements of the governing statute.” Estate of Evenchik v. Commissioner , T.C. Memo. 2013-34, at *12. The Tax Court generally declines to apply substantial compliance where a taxpayer’s appraisal either (1) fails to meet substantive requirements in the regulations or (2) omits entire categories of required information.

Reasonable Cause to Avoid Denial of Charitable Contribution Deduction. Taxpayers who fail to comply with the qualified appraisal requirements may still be entitled to charitable contribution deductions if they show that their noncompliance is “due to reasonable cause and not to willful neglect.” 26 U.S.C. § 170(f)(11)(A)(ii)(II). This defense is construed similarly to the defense applicable to numerous other Code provisions that prescribe penalties and additions to tax. See id. at § 6664(c)(1). To show reasonable cause due to reliance on a professional adviser, the Tax Court generally requires that a taxpayer show (1) that their adviser was a competent professional with sufficient expertise to justify reliance; (2) that the taxpayer provided the adviser necessary and accurate information; and (3) that the taxpayer actually relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner , 115 T.C. 43, 99 (2000), aff’d , 299 F.3d 221 (3d Cir. 2002).  “Unconditional reliance on a tax return preparer or C.P.A. does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise ‘[d]iligence and prudence’.” See Stough v. Commissioner , 144 T.C. 306, 323 (2015) (quoting Estate of Stiel v. Commissioner, T.C. Memo. 2009-278, 2009 WL 4877742, at *2)).

Section 6662(a) Penalty. Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any underpayment of tax required to be show on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax. Negligence includes “any failure to make a reasonable attempt to comply” with the Code, 26 U.S.C. § 6662(c), or a failure “to keep adequate books and records or to substantiate items properly,” Treas. Reg. § 1.6662-3(b)(1). An understatement of income tax is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 26 U.S.C. § 6662(d)(1)(A). Generally, the IRS bears the initial burden of production of establishing via sufficient evidence that a taxpayer is liable for penalties and additions to tax; once this burden is met, the taxpayer must carry the burden of proof with regard to defenses such as reasonable cause. Id. at § 7491(c); see Higbee v. Commissioner , 116 T.C. 438, 446–47 (2001). The IRS bears the burden of proof with respect to a new penalty or increase in the amount of a penalty asserted in his answer. See Rader v. Commissioner , 143 T.C. 376, 389 (2014); Rule 142(a), aff’d in part, appeal dismissed in part , 616 F. App’x 391 (10th Cir. 2015); see also RERI Holdings I, LLC v. Commissioner , 149 T.C. 1, 38–39 (2017), aff’d sub nom. Blau v. Commissioner , 924 F.3d 1261 (D.C. Cir. 2019). As part of the burden of production, the IRS must satisfy section 6751(b) by producing evidence of written approval of the penalty by an immediate supervisor, made before formal communication of the penalty to the taxpayer.

Reasonable Cause Defense to Section 6662(a) Penalty. A section 6662 penalty will not be imposed for any portion of an underpayment if the taxpayers show that (1) they had reasonable cause and (2) acted in good faith with respect to that underpayment. 26 U.S.C. § 6664(c)(1). A taxpayer’s mere reliance “on an information return or on the advice of a professional tax adviser or an appraiser does not necessarily demonstrate reasonable cause and good faith.” Treas. Reg. § 1.6664-4(b)(1). That reliance must be reasonable, and the taxpayer must act in good faith. In evaluating whether reliance is reasonable, a taxpayer’s “education, sophistication and business experience will be relevant.” Id. para. (c)(1).

Insights: Going forward, this opinion of Estate of Hoenshied v. Commissioner will likely be a go-to source for any practitioner involved in a taxpayer’s proposed transfer of corporate shares (or other property) to a donor-advised fund or other charitable organization as part of a buy-sell transaction that is anywhere close in time to the proposed donation.

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COMMENTS

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