Many of our clients (and perhaps some of us) hold appreciated alternative investments, such as hedge funds, real estate or private equity funds. They may be limited partnership interests or limited liability company units, but for income tax purposes, they’re overwhelmingly partnerships. The general rule of thumb is that appreciated capital gain property makes the most tax-effective donation. Naturally, clients look to donate their successful partnership investments to their private foundations (PFs) or their chosen public charities. What could go wrong?
Bargain Sale
With any partnership donation, the first potential issue is the possibility of a bargain sale arising from debt inside the partnership (more common with hedge funds and real estate partnerships than private equity).1 When a donor gives away property subject to a debt, the amount of the debt is considered to be sale proceeds: The charitable income tax deduction is measured by the difference between the partner’s share of the value of the partnership’s property less the sales proceeds.2
An example may help: Assume a partnership interest has a net value of $100, with an adjusted basis of $60. The partner’s share of partnership debt is $50, so the gross value of our donor’s share of the partnership property is $150. The Tax Code doesn’t just see a donation here: It sees a sale for $50/$150 and a donation of $100/$150. The $60 basis is allocated between the deemed sale and the donated value based on the ratio of sale to gross value. So, one-third of the basis ($20) is allocated to the deemed sale for a taxable gain of $30. The $100 deduction (which isn’t reduced by the basis allocated to it) will more than offset that gain in this particular case, but the partial gain recognition is almost always a surprise to donors because they didn’t incur the loan individually and may have received no direct benefit from its proceeds. If the ratio of debt-to-value is relatively high, it’s quite possible for the taxable gain to exceed the donation deduction. There’s nothing wrong with this type of transaction (donation/bargain sale) with a public charity, as long as the donor understands the tax impact in advance.
On the other hand, if the intended charitable donee of a partnership interest with inside debt is a PF, the donor should proceed with extreme caution. A bargain sale is still a sale between the donor and the PF. In some cases, that would be an act of self-dealing3 subject to a non-waiveable penalty—and the transaction must be corrected (unwound). Depending on when the debt was incurred and what percentage of the partnership the donor owns, such a donation to a PF may be prohibited.
Deduction for PF Donation
Speaking of PFs, because alternative investments aren’t publicly traded stock, the charitable income tax deduction for a donation to a PF is limited to the lesser of basis or fair market value.4 For some donors, that’s still acceptable because the avoided taxable income on any future gains and the ability to fund their PFs are more important than the charitable income tax deduction. Even though the deduction is limited, a qualified appraisal is still required to support the deduction (apparently to prove that the value is at least as much as the basis).5
Obtaining a qualified appraisal may also be a challenge if the appraiser won’t be granted access to the books of the partnership. Although funds produce periodic statements for their investors, and they certainly have detailed internal valuations (for fee calculations, if nothing else), such reports generally don’t provide the level of detail required to produce an appraisal in accordance with the required standards.6 This issue should be considered in advance, or the deduction may be lost due to the inability to obtain a qualified appraisal.
Transfers to Charity Precluded
Of course, the above issues may be moot if the partnership investment agreement contains a provision that precludes transfers to charity. Even so, it never hurts to ask if that provision can be changed or waived. The charity may need to represent that it meets the qualifications to own the particular fund before the transfer can be completed.
These aren’t simple donations, and a number of other problems can arise in the process. But, given the tax benefits of donating appreciated property, it’s usually worth seeing if the obstacles can be overcome.
Endnotes
1. Treasury Regulations Section 1.1001-2(a)(2); see also Goodman v. United States, 1999 U.S. Dist. LEXIS 20650 (S.D. Fla. 1999).
2. Treas. Regs. Section 1.1001-2(c), Ex. 4.
3. Internal Revenue Code Section 4941(d)(1)(A), Treas. Regs. Section 53.4941(d)-2(a)(1).
4. IRC Section 170(e)(1)(B)(ii).
5. Treas. Regs. Section 1.170A-13(c).
6. Treas. Regs. Section 1.170A-13(c)(3)(ii).
—This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates and related entities, shall not be responsible for any loss sustained by any person who relies on this publication.
