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.