Charitable gifts of publicly traded securities are the most efficient income tax and transfer tax assets to give to publicly supported charities. Gifts of privately held securities are also viable assets though they require special care. These securities not only must be valued and documented in an Internal Revenue Code-compliant way, but also their transfer must not trigger the operation of the assignment of income rules.
Chrem v. Commissioner,1 T.C. Memo. 2018-64 (Sept. 26, 2018), presented two compliance issues that the Tax Court concluded raised questions of fact to be decided at trial.
Charitable Deduction Denied
The taxpayers (along with eight other individuals or couples) owned 100 percent of the stock of Comtrad Trading, Ltd. (Comtrad), a closely held Hong Kong corporation. A related company, SDI, proposed to purchase 100 percent of Comtrad’s stock for $4,500 per share. After Comtrad’s shareholders agreed to tender about 87 percent of their shares, the petitioners donated the balance of them to a charitable organization, the Jewish Communal Fund (JCF). The acquiring company (SDI) then completed the acquisition, purchasing the donated stock for $4,500 per share. Because an employee stock ownership plan (ESOP) held the shares of SDI, an S corporation, a fairness opinion was needed to determine a valuation for the Comtrad shares. The taxpayers made charitable gifts totaling $4.05 million. Some made gifts totaling $500,000 and higher; others donated less. On auditing of the returns, the Internal Revenue Service denied the charitable deduction for lack of proper documentation; specifically, the omission of the appraisal from the income tax returns and its disagreement with the methodology of the stock valuation. The IRS found the assignment of income rules applied to impute income to the donating shareholders.
Assignment of Income
A business owner selling his business in a stock transfer often makes a charitable contribution of closely held stock to reduce some of the taxes owed. The question arises if the donor should realize capital gains income as part of a prearranged redemption triggering the assignment of income back to the donor. The assignment of income doctrine taxes the taxpayer who’s earned or otherwise created a right to receive income that’s almost certain to occur. For years, the IRS argued (albeit unsuccessfully) that the donor should be taxed on the appreciation because the donee is under some stated or implied obligation to redeem the stock. Palmer v. Comm’r2 created the rule of examining whether the donee is under a binding obligation to sell. The mere fact that a sale is contemplated or raised in early discussions doesn’t mean the taxpayer will be imputed with income. Rauenhorst v. Comm’r3 showed that a taxpayer transferring absolute title and interest in the gift property will avoid a deemed sale.
The IRS argued that the corporate reorganization was essentially a done deal because of the overlapping shareholder and director ownership of SDI and Comtrad. SDI proposed to acquire all of Comtrad’s stock in two steps. SDI would first purchase 6,100 shares of Comtrad from the petitioners and other shareholders. The per share price of $4,500 meant this tranche of stock was worth $27.45 million. Nearly all of the purchase price ($27 million) would be paid by a 15-year promissory note; $450,000 would be paid in cash. Then, the remaining 900 shares of Comtrad’s stock would be gifted to the JCF, an IRC Section 501(c)(3) organization. SDI would purchase from JCF the gifted shares for $4,500 in cash for each share. Additionally the taxpayers agreed “to use all reasonable efforts”4 to effectuate JCF’s tender of all 900 shares to SDI. If JCF didn’t tender the shares within 60 days, SDI would obtain 100 percent control through “a squeeze out merger, a reverse stock split, or any other such action…”5
The IRS in its motion for summary judgment argued that the transaction was “virtually certain to occur”6 because of common management, aligned business interests and mutual interest in completing the deal. The IRS additionally argued JCF agreed in advance to tender its shares received from the taxpayers to SDI. The Tax Court ruled there were genuine issues of fact as to whether JCF was under an obligation to tender the shares to SDI. The Tax Court noted the record lacked evidence of the taxpayer’s ability to sway JCF’s tendering of the shares to SDI.
The Tax Court also found there was a question of fact about the implications of JCF’s fiduciary duty as a custodian of the stock. If JCF tendered the shares, they would receive $4.05 million in cash. If JCF didn’t tender the shares, they would own a closely held business interest that may not be readily liquid. The Tax Court ruled that a trial was needed to determine what was the donors’ ability to sway JCF to tender all gifted shares.
Valuation of Minority Interest
While the IRS didn’t question the credentials of the appraiser Empire Consultants, LLC (Empire), it did question the applicability of its appraisal for valuing a charitable gift. The taxpayers didn’t request from Empire an appraisal for income tax purposes.7 The appraisal was prepared as required under the Employee Retirement Income Security Act (ERISA) because an ESOP owned the purchaser SDI. The IRS in effect argued that the wrong asset was being valued. Empire explicitly noted the report was for “the sole use of …[the ESOP trustee] in its fiduciary capacity” “not [to] be used for any other purpose.”8 Empire further noted its appraisal didn’t take into consideration any tax consequences related to the selling shareholder.9
The IRS additionally argued there should be a discount for the gifted stock to charity because it wasn’t a controlling interest. Instead, the taxpayers relied on the per share value determined under the ERISA-required appraisal valuing the entire business. That appraisal contemplates the transaction as a done deal. The taxpayers’ argument the transaction wasn’t a done deal could well be undermined by their using such appraisal in any subsequent trial.
Qualified Appraisal Requirement
Gifts over $500,000 require the actual appraisal to be attached to the return.10 The donors argued substantial compliance with that requirement notwithstanding the omission. Substantiating the deduction with the required appraisal is treacherous terrain to navigate, and the court ruled that a trial was required to determine whether substantial compliance had occurred. The donors argued they’d met the substantial compliance standard of Hewitt v. Comm’r,11 which requires a showing that the failure to comply “is due to reasonable cause and not to wilfull neglect.” The Tax Court remanded for a determination of the fact of whether there was substantial compliance. The record was silent on whether the parties were relying on “a competent and independent advisor unburdened with a conflict of interest.”12
Lessons Learned
Practitioners should advise their clients to:
1. Make the charitable transfer before tender offers to gifting shareholders. Had the steps of the transaction been reversed, I think the donors would have a stronger argument that the gifts weren’t part of a prearranged deal. There would have been no need in the tender offer to require the Comtrad shareholders to use all reasonable efforts to persuade JCF to tender its shares to SDI.
2. Explore the use of a donor-advised fund (DAF). Had the petitioners initially donated the shares to a DAF before the agreement had been executed, they would have been able to argue they didn’t control what the JCF would do regarding the tender offer. They could only make a recommendation to the DAF that the JCF receive the shares. Once the shares were gifted to DAF, the donors’ ability to control JCF’s tendering of the shares would be nonexistent. The JCF as the donee could then independently determine whether to accept any tender offers from SDI.
3. Comply literally with valuation and documentation rules. The fundamental rules of valuation and documentation apply; anything less than literal compliance invites litigation with uncertain prospects for success. Prepare appraisals for the taxpayer and attach them to the tax returns. Failing to do either is leaping into the unknown world of “substantial compliance” as a way of preserving the income tax deduction. The taxpayers would have been better served asking Empire or any other qualified appraiser to value the stock at date of gifting and to reflect some minority discount. Relying on the appraisal prepared for the ESOP opened the door to an IRS attack on the charitable deduction.
Endnotes
1. Chrem v. Commissioner, T.C. Memo. 2018-64 (Sept. 26, 2018).
2. Palmer v. Comm’r, 62 T.C. 684 (1974).
3. Rauenhorst v. Comm’r, 119 T.C. 157 (2002).
4. Supra note 1, at p. 5.
5. Ibid., at pp. 5-6.
6. Ibid., at p. 14.
7. Ibid., at p. 7.
8. Ibid., at p. 8.
9. Ibid.
10. See Internal Revenue Code Section 170(f)(11)(D). Gifts over $5,000 but less than $500,000 require an appraisal summary to be attached to the return. See Treasury Regulations Section 1.170A-13(c)(2)(i)(A), 1.170A-13(c)(2)(i)(B).
11. Hewitt v. Comm’r, 109 T.C. 258, 265 (1997), held the substantial compliance requirement is satisfied when the taxpayer has “provided most of the information required” or made omissions solely through inadvertence. See supra note 1, at p. 19.
12. Supra note 1, at p. 19.
