Despite the weak economy and turbulence of the capital markets during these past several years, charitable giving remains a significant part of many wealthy individuals' financial and estate planning. Since 2000, Americans have donated more than $200 billion a year to charities. Clearly, they believe philanthropy is important.1
The primary motives for charitable giving always have been humanitarian and moral concerns. Still, there are practical, personal considerations that go into giving. As the total dollar amount of charitable contributions increases, the tax benefits of philanthropy assume increasing importance.
Certain financial instruments could enhance charitable planning and giving. Yet very little has been written about the potential use of derivatives and other financial instruments within the charitable world. These strategies, including certain short selling techniques, if used properly and judiciously, should allow donors to not only generate attractive profits, but also achieve better tax results.
LIMITS ON DEDUCTIONS
Sometimes, donors cannot fully deduct lifetime gifts made to charities. Often, investors are surprised to find themselves unable to fully take a charitable contribution deduction.
Charitable gifts are usually deductible to between 20 percent and 50 percent of the donor's adjusted gross income (AGI).2 The exact percentage depends on whether the donor is an individual or corporation, whether the donee is a public charity or private foundation, the donation's nature (cash or other property) and the form of the gift (whether it's “to” the charity or “for the use of” the charity).
If a donor makes charitable contributions in any tax year in excess of the applicable percentage of AGI limitation, he may carry forward the excess unused portion to each of the five succeeding tax years until it is utilized. If it's not used within five years, it will expire.
For example, suppose that a wealthy family established a private foundation and, in 1999, contributed $10 million of highly appreciated Microsoft shares to it. Because the contribution consists of qualified appreciated stock,3 the donor should be entitled to a deduction equal to the fair market value of the property contributed,4 up to 20 percent of his AGI.5 Contributions in excess of the limit may be carried over for deduction to the five succeeding tax years subject, each year, to the 20 percent cap.6
The problem is this formula can result in a donor's forfeiting potential tax benefits if his AGI is too low in all five years and he continues to make charitable contributions. Assume, for example, that he was able to deduct only $5 million in the first four years. That still leaves him with a potential $5 million deduction, but only if his AGI is at least $25 million. If his AGI is lower, he stands to lose a potential tax benefit. For instance, if his AGI is only $5 million, he can deduct only about $1 million (20 percent of his $5 million AGI) of his remaining $5 million carryforward. Put more bluntly, a potential tax benefit for a donor worth about $1.4 million ($4 million times 35 percent) will be forfeited.
What can the investor and his advisors do? One response is to attempt to increase AGI. How? Property sales are an obvious possibility and can be effective. But it's not an ideal fix, because it can take a long time to sell certain property, such as real estate. Even if the property is very liquid, such as publicly traded-stocks, the donor might want to continue holding the property because he thinks it's a good investment.
Selling property also will increase taxable income. For example, to fully utilize the $4 million carryforward, our donor would need to generate a gain of $20 million ($20 million × 20 percent AGI limitation = $4 million). Assuming that the donor held the property for at least one year before selling and that it was a capital asset, this formula would result in a $3 million tax ($20 million gain × 15 percent long-term capital gain rate), while the tax benefit of utilizing the $4 million carryforward would be $1.4 million.
If an outright sale of property is not palatable and there is no other obvious method (such as exercising stock options) to increase AGI during the final year of the carryforward period, are there any other tactics that a donor might consider?
Certain investment strategies provide an ideal solution to the dilemma. The net gain or loss on these transactions will be reflected in taxable income. But the income generated should increase AGI, while expenses should be treated as itemized deductions — which are subtracted from AGI when determining taxable income. Therefore, if a transaction is structured properly, the investor should be able to deduct the charitable contribution due to the increase in AGI. What are these strategies and how do they work? They involve various short selling techniques.
One such investment strategy to raise AGI is to short sell flat bonds just before the record date for a coupon payment. Such a tactic, if structured correctly, should raise AGI and generate an itemized deduction.
A flat bond is a bond for which the quoted price reflects both principal and accrued interest. As the record date for a coupon payment approaches, the bond's price increases to reflect the coupon payment that will soon be made. In the United States, some bonds trade flat; in some other countries, such as Australia, trading flat is conventional. Investors can trade flat bonds to hopefully generate significant profits, while creating capital gain and investment interest expense for federal income tax purposes.
With a short sale entered into before the record date and held open on the record date, the seller will be required to make an “in lieu of” payment equal to the coupon payment to the lender of the bond. The price of the bond should drop by a corresponding amount (plus or minus any movement in market price), creating a capital gain. The capital gain will increase the investor's AGI.
Internal Revenue Code Section 263(h) requires the capitalization of in lieu of dividend payments made in connection with short sales of stock that have not been held open for more than 45 days. But because the in lieu of payment for flat bond trades represents interest, not dividends, Section 263(h) should not apply.
Therefore, the in lieu of payment should be treated as a currently deductible investment interest expense, which is an itemized deduction for an individual investor. This deduction would be subject to the limitations of Section 163(d). Therefore, the in lieu of payment should be deductible against the individual's net investment income, including short-term capital gains. This deduction doesn't reduce AGI. Rather, it is subtracted from AGI to compute taxable income.
Unlike stocks, there is no requirement that a short position in bonds be held open for at least 46 days for the deduction to be allowed (a holding period of as little as one day could suffice).
The gain that is generated on closing out the short position should be treated as a short-term capital gain under Sections 1233(a) and (b).
A trade designed to satisfy the needs of our investor might be as follows: ABC Company's bonds are trading flat at $800 per bond. The bond has a 14 percent coupon, and a semi-annual interest payment of $70 per bond will be made to holders of the bonds on the record date. The investor will want to sell the bond short based on his view that the price will continue to decline after adjusting to reflect the $70 interest payment.
If the investor is correct and the price falls by, say, $5 more than the coupon payment, the ABC bond will decline to $725, thereby creating the potential to buy the bond in order to close the short position and generate a short-term capital gain of $75 per bond. The investor will have to make an in lieu of payment to the lender of the bond equal to $70 per bond, which should be an interest expense. Importantly, because the bond declined by more than $70, the investor would have earned a profit on the transaction. It is critical that the investor trade a bond with sufficient volatility so that the investor has a reasonable chance of earning a significant profit on the speculation. In addition, investors should examine the borrowability and liquidity of the bond.
Let's suppose our investor, on or before the record date, borrows and sells short 285,714 ABC bonds at a price of $800 per bond, for an aggregate short position of $228,571,200. Further assume that our investor buys back the bonds to settle the day after the record date and that there has been a drop in the market price of the ABC bonds by $5 per bond, in addition to the $70 drop due to the passage of the record date. The investor would buy 285,714 ABC bonds at a price of $725 per bond for an aggregate cover price of $207,142,650, generating a $21,428,550 million gain. The investor would also need to make a $20 million in lieu of payment to the lender of the bonds.
For federal tax purposes, the investor should have generated a short-term capital gain of $21,428,550 million and a $20 million investment interest expense deduction. Taxable income has increased by the economic gain in the transaction of approximately $1.4 million. Of course, the bond could have decreased by less than the coupon payment, in which case the investor would have suffered a loss.
In any case, the investor should now be able to fully utilize the $4 million charitable contribution carryover that otherwise would have expired worthless ($21.4 million increase in AGI × 20 percent AGI limitation = $4.28 million).
In the United States, very few bonds trade flat and the investor would have to post a cash margin of between 30 percent and 50 percent of the value of the bonds, or securities of sufficient collateral value to use as margin for the short sale. The amount of margin required would depend on the liquidity and credit rating of the bonds.
In Australia, where the convention is for bonds to trade flat, there are numerous bond issues with characteristics that might make them appropriate candidates with which to implement this speculation. In addition, there aren't any formal margin requirements in Australia and sophisticated investors are able to negotiate much lower margin requirements than in the United States.
In any case, by speculating on the short-term price movement of a flat bond, our investor was able to potentially generate significant trading profits while creating sufficient AGI to utilize its charitable contribution carryovers that would have otherwise expired worthless.
Short-selling U.S. Treasury bonds trading at a premium involves a different economic bet than a flat bond trade. The short sale of premium Treasury bonds gives investors the opportunity to profit from movements in short-term interest rates. Like the flat bond, it should create short-term capital gains and offsetting investment interest expense for federal tax purposes. The transaction requires a relatively small commitment of capital (typically about 1 percent of the face amount of the bonds shorted). Once again, the capital gain will increase AGI while the interest expense is subtracted from AGI to compute taxable income.
This transaction involves short selling a high-coupon, short-term Treasury bond that is currently trading at a premium and then buying it back just before its maturity date. To facilitate the short sale, the investor sells bonds he has borrowed from a third party.
The bond lender is entitled to receive from the investor an in lieu of payment in an amount equal to all coupon payments due on the bonds while the transaction is open.
The short sale proceeds and the cash collateral posted by the investor, which collateralizes his obligation to return identical bonds to the lender, are invested in a reverse-repurchase agreement, enabling the investor to earn interest on this collateral. The rate of interest will typically float with the 30-day London Interbank Offered Rate (LIBOR).
The transaction will generate a pre-tax profit to the extent that the money coming in (the premium on the bonds and the interest earned on the collateral) exceeds the money going out (the in lieu of payments).
The analysis of the trade from a tax perspective is similar to that of the flat bond trade. Section 263(h) only applies to short sales of stock and not to short sales of debt securities, so it shouldn't apply to this transaction. Therefore, the in lieu of payments should be treated as a currently deductible investment interest expense, which should be an itemized deduction for an individual investor. The deduction should be subject to the limitations of Section 163(d). Therefore, the in lieu of payments should be deductible against the investor's net investment income, including short-term capital gains. The gain that is generated on closing out the short position should be treated as short-term capital gain under Sections 1233(a) and (b).
A trade designed to satisfy our investor's needs might be something like this: Suppose that a U.S. Treasury bond with a coupon of 11 percent and one year remaining until maturity is currently trading at $1,100 per bond (a 1 percent yield). The investor borrows the $200,000,000 face amount of these bonds from his broker and sells the bonds at $1,100 each for an aggregate short sale price of $220,000,000. The investor posts the short sale proceeds plus an additional $2 million cash margin as collateral for its obligation to return identical bonds. The dealer agrees to pay the investor a rate of return on the collateral that floats with the 30-day LIBOR. During the term of the trade, the investor has to pay the lender of the bond in lieu of payments equal to the coupon payments on the bonds, which in this case total $22 million ($200 million face amount × 11 percent). The day before the bond matures the investor buys the bonds back at par for $200 million, generating a gain of $20,000,000. Let's suppose that the cash collateral earned $2.3 million.
From an economic perspective, our investor earned a $300,000 profit. That is, the cash coming in (the $20 million gain on closing out the short and the $2.3 million of interest earned on its collateral) is greater than the cash going out (the $22 million in lieu of payments) by $300,000. Of course, the investor could have been wrong, in which case he would have suffered a loss on the transaction.
For federal tax purposes, the investor should have generated a short-term capital gain of $20 million, interest income of $2.3 million (both of which are included in AGI) and a $22 million investment interest expense deduction. Note that the investor is now able to fully utilize the $4 million charitable contribution carryover that otherwise would have expired worthless ($22.3 million increase in AGI × 20 percent AGI limitation = $4.46 million).
Therefore, if structured properly, both the flat bond and short premium bond trades should allow donors to utilize charitable contribution carryovers that would otherwise expire.
These short selling techniques have other potential applications in the area of charitable planning/giving. For instance, they can increase the amount of charitable giving an investor might make. Consider, for instance, a “cascading” foundation.7
Assume our investor contributes an art collection to an operating foundation. The current fair market value of the art is $30 million. Therefore, the contribution should generate a federal tax savings of $10.5 million. The donor contributes this $10.5 million tax savings to the foundation, which is sufficient to buy a building to house and exhibit the art. This contribution should generate a further federal tax benefit of about $3.675 million, which the donor also contributes to the foundation. With this money, the foundation can hire an executive director and staff and perhaps buy more art.
Because the cascading occurs in a single tax year, the donor needs a large AGI for this plan to work. Donors could use either a short sale of flat bonds or premium treasury bonds in order to facilitate the implementation of a cascading foundation by increasing AGI.
These techniques could also have some potential applications in the area of charitable remainder trusts (CRTs). The non-charitable beneficiaries of a CRT (either a charitable remainder annuity trust or charitable remainder unitrust) are required to treat CRT distributions as income according to IRC Section 664(b) and the regulations prescribed by the secretary pursuant to IRC Section 664(a).8
Distributions are characterized in four categories. First, an individual is deemed to receive ordinary income from the current taxable year of the trust and then any accumulated ordinary income from prior years (Category I). Second, an individual is deemed to receive capital gains for the current taxable year of the trust and then accumulated capital gains from prior years (Category II). Third, an individual is deemed to have received other income, such as tax-exempt bond income (Category III). Finally, an individual is deemed to receive a distribution of corpus (Category IV).
An ordinary loss in Category I reduces undistributed ordinary income for prior years and the excess is carried forward. Capital losses in Category II reduce capital gains and any excess is carried forward.9 Unfortunately, expenses or losses in one category of income cannot be used to effect expenses or losses in another category of income.10 For instance, if a CRT has a capital loss carryforward in Category II, that loss can only be utilized to offset other Category II income, which will be limited to possible future capital gains. The capital loss carryforward is not deductible against Category I income that is taxed at the 35 percent rate.
In this scenario, certain short selling techniques could prove useful by creating both capital gain and interest expense to allow the accelerated use of the capital losses. More specifically, the capital loss carryfoward otherwise trapped in Category II should reduce the capital gain generated by these trades, while the interest expense generated by these trades should be currently deductible against Category I income that otherwise would have been taxed at the 35 percent rate.
Because a CRT is exempt from federal taxation only if it doesn't have unrelated business taxable income (UBTI),11 it's important to determine whether the short sale of a bond might generate UBTI.
The IRS concluded in Revenue Ruling 95-8 that a short sale of publicly traded stock by an exempt organization did not create UBTI. The Service reasoned that income or loss attributable to a short sale is considered derived from debt-financed property only if the seller incurs acquisition indebtedness within the meaning of Section 514 with respect to the property on which he realizes that income. The Service cited a Supreme Court case12 for the proposition that a short sale creates an obligation (to return identical securities at some point in the future), but doesn't create indebtedness. The IRS has maintained this position in several subsequent private letter rulings dealing with almost identical facts.13
Although these rulings deal with the short sale of publicly traded stock, the mechanics and economics of the short sale of a bond are virtually identical. It appears that the short sale of a bond shouldn't create UBTI. Therefore, if a CRT has capital loss carryforwards in Category II and generates ordinary income in Category I, short selling could have the effect of converting a non-deductible Category II loss into a currently deductible Category I loss.
- Donations to charities from American donors increased by 2.8 percent from 2002 to 2003, according to the American Association of Fundraising Counsel's Giving USA.
- IRC Sec. 170(b)(1)(F) defines “contribution base” as adjusted gross income computed without regard to any net operating loss carryback to that year under IRC Sec. 172.
- IRC Sec. 170(e)(5)(B) and (C).
- On our facts, a “shave-down” to cost basis under IRC Sec. 170(e)(1)(B)(ii) should not be required because IRC Sec. 170(e)(5)(A) should apply.
- IRC Sec. 170 (b)(1)(D)(i).
- IRC Sec. 170(b)(1)(D)(ii).
- The concept of a cascading foundation originated with Joseph Toce, Jr., managing director and head of the New York City office of Wealth and Tax Advisory Services, Inc. and lead author of the reference book “Tax Economics of Charitable Giving,” Warren, Gorham & Lamont, Research Institute of America (2003).
- See Reg. Sec. 1.664-1(d).
- Reg. Sec. 1.664-1(d)(1)(i)(b)(2).
- Blattmachr, Jonathan and Michaelson, Arthur, “Income Taxation of Estates and Trusts,” 14th ed., Section 5.4, PLI Pres, June 2002.
- IRC Section 664(c).
- Deputy v. du Pont, 308 U.S. 488 (1940).
- PLRs 9703027 (Oct. 21, 1996), and 9637053 (June 21, 1996). See also PLR 9642051 (July 22, 1996).
Audubon's “Snowy Owl” first appeared in “The Birds of America,” a four-volume set featuring 435 hand-colored plates issued between 1827 and 1838. The first artist to portray birds in life size, Audubon's engraving recently sold for $186,700 by Christie's New York, meeting pre-auction estimates of $150,000 to $200,000.