Charitable Giving Update
According to a recent report on charitable giving, the number of donors at every level of giving dropped during the first three quarters of 2022.[i] The number of new donors was down by over 19 percent and the number of “newly retained” donors was down by almost 25 percent. The number of individual donors was down 7 percent.
That said, the amount donated was up 4.7 percent. According to the report, however, “the amount of goods and services that money could purchase was down,” citing the rate of inflation.
The report also stated that some organizations may be trying to capitalize on large donors now, “fearing they’ll be less generous if a recession hits,” but noted “it’s important to also focus on building the small donor base for future support.” In fact, the report added that research shows organizations with a broad base of support that includes smaller donors are more resilient during economic downturns. So relying on big donors to provide most of the gifts could be problematic, especially with worries that a recession is looming.
Of course, there are always some donors, regardless of the state of the economy, who are not willing to make a significant charitable contribution until they are about to experience a large liquidity event, such as the sale of their closely held business.
However, in their exuberance over a successful sale, some business owners often stumble onto the application of a basic tax doctrine, as a result of which they fail to capture a major benefit otherwise arising from their contribution of appreciated property to a charity; specifically, not having to recognize the gain inherent in such property.
The U.S. Tax Court recently considered one such case in which a shareholder’s contribution of shares of stock in a family business was made – for reasons that most business owners would appreciate – near contemporaneously with the sale of the issuing corporation to a third party.[ii]
Pre-Sale Activity
Corp was owned equally by three brothers: Bro-1, Taxpayer, and Bro-2. The same individuals comprised Corp’s board of directors.
Toward the end of Year One, Bro-1 informed Taxpayer and Bro-2 that he was retiring from Corp and wanted to be bought out in accordance with the terms of their Buy-Sell Agreement, which restricted their ability to dispose of their shares of Corp stock.
Taxpayer and Bro-2 did not want Corp to incur any indebtedness to finance Corp’s redemption of Bro-1’s one-third interest, so they instead decided to pursue a potential sale of Corp to a third party.[iii]
With that, the dominos began to fall.
As of December 12 of Year One, Corp had established a Change in Control Bonus Plan, which granted certain employees a potential right to bonus compensation in the event of a change in control of Corp, such as a transfer of more than 80 percent of Corp’s stock to third parties.[iv]
Corp engaged an investment banker (IB) as its financial adviser in connection with a potential sale. Both Taxpayer and IB considered $80 million to be a fair target price for Corp.
Early in Year Two, IB began soliciting bids for Corp and received several letters of intent to purchase the company from interested private equity firms, including PE. In early April of Year Two, PE submitted a letter of intent to acquire Corp for total consideration of $92 million.
Meanwhile, in mid-April, Taxpayer began discussing the prospect of making a pre-sale charitable contribution of some of his Corp stock with his wealth adviser (Adviser) and with his tax/estate planning attorney (Planner).
Pre-Sale Donation (or Forewarned is Forearmed)
Planner informed the corporate team at her law firm that was going to handle the sale of Corp to PE that Taxpayer was considering donating some of his Corp stock to a charity “to avoid some capital gains” and noted that “the transfer would have to take place before there is a definitive agreement in place.”[v]
Shortly after discussions with representatives of 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[vi] – Adviser contacted Taxpayer and Planner to inform them that Charity had brought up a “concept called the ‘anticipatory assignment of income’ which makes the timing of the gift very important.” Adviser added that the gift must be completed “before any purchase agreement is executed or else the IRS can come back and try and impose the capital gains tax on the gift.”
Charity provided Adviser with a Letter of Understanding to be executed in advance of the gift. Planner immediately contacted Adviser and Taxpayer, stating that “the deadline to assign the stock to a [charity] is prior to execution of the definitive purchase agreement” and suggesting that they “gather the forms and documents from [Charity] so we’re ready to go and the paperwork is done well before the signing of the definitive purchase agreement.”
Taxpayer’s Concern
Taxpayer responded that he had decided upon the value of the charitable gift he wanted to make, though he also added: “but I would rather wait as long as possible to pull the trigger. If we do it and the sale does not go through, I guess my brothers could own more stock than I and I am not sure if it can be reversed.”[vii]
LOI, Due Diligence, Draft SPA
On April 23, PE, Corp, Taxpayer, and his brothers executed a nonbinding letter of intent, establishing their mutual interest in PE’s acquisition of Corp for total consideration of $107 million.[viii]
After the execution of the letter of intent, PE began the process of conducting due diligence into Corp’s business and financial operations.
In mid-May of Year Two, counsel for PE and Corp began negotiating a contribution[ix] and stock purchase agreement based on the terms of the letter of intent. Planner was not involved in the drafting process but was provided with copies of each draft and was kept up to date on the progress of the negotiations.
Reminder
On May 21, Planner noted to Adviser and Taxpayer: “We now have a draft purchase and sale agreement; do you have the information from [Charity] for my review?”
Taxpayer responded that he had not yet signed the Letter of Understanding provided by Charity, to which Planner replied that she “want[ed] to make sure that nothing slips and all of your advisors are on the same page so that there are no issues with the charitable deduction.”[x]
Charity’s Letter of Understanding
On June 1 of Year Two, Adviser sent Charity a Letter of Understanding signed by Taxpayer, which described the planned donation as being of shares of Corp stock but without specifying the number of shares.
The terms and conditions of that Letter of Understanding stated that (1) “As holder of the Asset, [Charity] is not and will not be under any obligation to redeem, sell, or otherwise transfer the asset”[xi] and (2) “No contribution is complete until formally accepted by [Charity].”
Taxpayer’s Concern, Again
On the same day, Taxpayer requested that Planner prepare a shareholder consent agreement allowing him to transfer a portion of his stock to Charity. However, Taxpayer also reiterated to Planner that “I do not want to transfer the stock until we are 99% sure we are closing.”[xii]
Corporate Formalities
On June 11,[xiii] Corp held its annual shareholders meeting, at which Taxpayer and his two brothers unanimously approved Taxpayer’s request for “ratification of the sale of all outstanding stock of [Corp] to [PE].”
Bro-1 and Bro-2 also approved Taxpayer’s request to transfer a portion of his stock to Charity and executed a Consent to Assignment agreement to that effect.[xiv] The Consent to Assignment agreement had a blank space for the parties to specify the number of shares and stated that the consent governed “only the number of shares identified above.” However, that field was left blank when the parties signed the agreement on June 11 and when Taxpayer emailed a copy of the signed agreement to Planner on June 15.[xv]
At some point after the June 11 shareholders and board meetings, Taxpayer had a stock certificate partially prepared for the eventual transfer to Charity. Taxpayer kept the incomplete stock certificate on his office desk until July 9 or 10 of Year Two, when he dropped it off at Planner’s office.
On June 12, PE’s investment committee and managing partners unanimously approved the acquisition of Corp, subject to completion of their financial and business due diligence. On June 30, consultants hired by PE completed and delivered a due diligence report addressing certain issues relating to Taxpayer’s assets.
Gathering Steam
On July 1 of Year Two, PE’s counsel prepared a revised draft of the Contribution and Stock Purchase Agreement. This draft, dated July 1, included a new, partially blank recital stating in relevant part: “On June 2015, [Taxpayer] transferred … shares of Common Stock to ….”
Furthermore, on July 1, PE prepared and circulated the initial draft of the Minority Stock Purchase Agreement for a purchase of shares from Charity. Counsel for Corp forwarded the draft to Taxpayer with this message: “Attached is the initial draft of the purchase agreement for the shares you have/intend to gift.”
On July 6, PE caused the organization of a new corporation, Holdings, for the purpose of acquiring the shares of Corp.
That same day, Taxpayer provided a copy of the draft Minority Stock Purchase Agreement to Adviser and Planner, stating: “We are not totally sure of the shares being transferred to [Charity] yet” and “[h]opefully, and based on the closing documents, we will have a much better handle on this” later this week. Taxpayer added: “Once we know the share values, I am confident [Planner] will execute the stock assignment as required.”
The next day, July 7, Taxpayer notified Adviser that Corp would “sweep the cash from the company prior to closing and distribute it to the brothers.”
Also on July 7, Taxpayer executed an amendment to Corp’s Change in Control Bonus Plan, specifying that the impending sale to PE would constitute a change in control and thus trigger bonus payments to key employees pursuant to such Plan.
On July 9, Corp prepared a revised draft of the Contribution and Stock Purchase Agreement, in which counsel for Corp had partially filled in the recital relating to the gift transfer to read in relevant part: “On July … 2015, [Taxpayer] transferred 1,380 shares of Common Stock to [Charity].”[xvi] Furthermore, the revised draft added that one of the conditions precedent to Holding’s obligations was that Charity “shall have executed and delivered to [PE] and [Holding] the Minority Stock Purchase Agreement.”
Adviser informed Charity that “it looks like [Taxpayer] has arrived at 1380 shares—which will come out to about $3,000,000” and that Adviser would “have the stock certificate shortly.” Taxpayer informed Adviser noted that “[Planner] is completing the Stock transfer of 1380 shares to [Charity].”
Additionally, on July 10, PE prepared a revised draft of the Contribution and Stock Purchase Agreement. Nevertheless, the share contribution provision was still missing the specific date on which Taxpayer transferred the shares to Charity.
The Clincher
Three significant actions were taken on July 10.
First, Corp paid out employee bonuses totaling $6 million pursuant to the Change in Control Bonus Plan.
Second, Corp filed an amendment to its Articles of Incorporation that was requested by PE.
Third, Planner forwarded to Adviser the updated draft of the Minority Stock Purchase Agreement dated July 15 and asked Adviser to forward it to Charity for signature. The draft Minority Stock Purchase Agreement was dated July 13 and included a warranty that Charity “is the record and beneficial owner of and has good and valid title to the Shares.”
Enough Already[xvii]
On July 13, the Contribution and Stock Purchase Agreement underwent a redline comparison against the prior revised updated draft on behalf of PE in which the share contribution provision still did not specify the date on which Taxpayer transferred the shares to Charity.
Later that day, Adviser once more asked Charity for its signature on the Minority Stock Purchase Agreement, as the parties were “hoping to close … the next day.”
Charity responded: “It is important that we receive the stock certificate before we reach a conclusion on the sale/redemption. Did the stock certificate go out yet?”
Adviser alerted Planner to the problem, informing her that Charity “will not sign off on anything until they see the stock certificate. As far as they know, they don’t have any shares to sell.”
At Adviser’s request, Planner sent him a PDF stock certificate, which Adviser then forwarded to Charity. The stock certificate was signed by Taxpayer but undated, and stated that 1,380 shares of Corp common stock were owned by Charity.
On the afternoon of July 13, counsel for PE contacted counsel for Corp, noting that “I know [Corp] will be issuing a certificate to [Charity] and asking whether the transfer had occurred yet. Counsel for Corp responded that “[y]es, the transfer to [Charity] has occurred” and provided a spreadsheet that purported to list Corp’s shareholders, numbers of shares held, and dates of issuance. The printout displayed an issuance entry for a certificate stating that 1,380 shares had been issued to Charity.
Charity delivered to Adviser the signature page for the Minority Stock Purchase Agreement executed on behalf of Charity. Counsel for Corp forwarded signature pages for a number of transaction-related documents to Taxpayer and his brothers requesting their signatures.
Early on July 14, Adviser forwarded the signature pages from Charity to Planner, who forwarded them to Corp’s counsel. Later that day, counsel for Corp circulated a revised draft of the Contribution and Stock Purchase Agreement, which filled in the share contribution provision to specify that Taxpayer had transferred the shares on July 10. Additionally, on July 14, Corp made a pro rata distribution, characterized as a dividend, of $4.8 million – nearly all of the remaining cash within Corp – to Taxpayer and his two brothers; Charity did not participate in the distribution.
The Sale
On July 15, PE, Holdings, Taxpayer, and his two brothers executed signatures on a final Contribution and Stock Purchase Agreement, which was approved by Corp’s shareholders and board that same day. The final agreement included the share contribution provision, which specified that Taxpayer had transferred 1,380 shares to Charity on “July 10, 2015.”
The final agreement provided for Taxpayer and his brothers to exchange shares in Corp for shares in Holdings, in an amount sufficient to constitute 51 percent ownership of Holdings. PE agreed to contribute cash to Holdings in exchange for shares in a number sufficient to constitute 49 percent ownership of the common stock of Holdings. Holdings then agreed to purchase the remainder of the outstanding shares of Corp owned by Taxpayer and his two brothers, as well as the 1,380 shares owned by Charity.
On July 15, a representative from Planner’s firm signed an “Irrevocable Stock Power” on behalf of Charity. The document represented that Charity “does hereby sell, assign and transfer” the 1,380 shares to Holdings. The document also stated that Charity “does hereby irrevocably constitute and appoint (blank space) as attorney to transfer the said stock on the books of the Corporation with full power of substitution in the premises.” Charity received $2.9 million in cash proceeds from the sale.[xviii]
Confirmation Letter
On November 18 of Year Two, Charity sent Taxpayer a confirmation letter acknowledging a charitable contribution of 1,380 shares of Corp stock. The letter indicated Charity received the shares of Corp stock on June 11, and stated that “[Charity] has exclusive legal control over the contributed asset, and this contribution is irrevocable and cannot be refunded.”
Tax Return
Planner supervised the preparation of Taxpayer’s Year Two federal income tax return. The return was timely filed with the IRS on April 14 of Year Three. Taxpayer did not report any capital gain associated with the sale of the 1,380 shares of Corp stock donated to and sold by Charity, and claimed a noncash charitable contribution deduction of $3.3 million.
Taxpayer attached to his return a Form 8283, Noncash Charitable Contributions, reporting the charitable contribution of the 1,380 shares of Corp stock and a June 11 contribution date. The donee acknowledgment section was signed by a representative of Charity.
A Form 8282 was also prepared for Taxpayer.[xix] It was signed by a representative of Charity and reported the receipt of Taxpayer’s entire interest in 1,380 shares of Corp stock on June 11 of Year Two and the subsequent sale of such stock to PE on July 15.
Tax Court Pleadings
After examining Taxpayer’s return for Year Two, the IRS proposed to disallow in full Taxpayer’s charitable contribution deduction.[xx]
The IRS then issued a notice of deficiency to Taxpayer,[xxi] determining a deficiency in income tax resulting from the disallowance of the claimed charitable contribution deduction,[xxii] plus an accuracy-related penalty.[xxiii]
Taxpayer timely filed a petition with the U.S. Tax Court.[xxiv]
After fling an Answer[xxv] to Taxpayer’s petition, the IRS filed an amended Answer,[xxvi] asserting an increased deficiency and penalty, due to application of the anticipatory assignment of income doctrine, pursuant to which the gain realized by Charity on its sale of the 1,380 shares of Corp stock received from Taxpayer should have been included in Taxpayer’s gross income.[xxvii]
Burden of Proof
The Tax Court explained that the IRS bears the burden of proof with respect to new matters or increases in deficiency pleaded in its answer.[xxviii]
In its amended Answer, the IRS first asserted an increase in deficiency on the grounds that Taxpayer made an anticipatory assignment of income of his proceeds from the sale of Corp shares to PE.
Consequently, the IRS had the burden with respect to whether Taxpayer realized and recognized gain from the sale of Charity’s 1,380 shares pursuant to the anticipatory assignment of income doctrine.[xxix]
Charitable Contribution
In general, a taxpayer must realize and recognize gain on a sale or other disposition of appreciated property.[xxx] However, a taxpayer typically does not recognize gain when disposing of appreciated property by way of a charitable contribution. Moreover, the taxpayer may still be able to claim a deduction for income tax purposes equal to the fair market value of the contributed property.[xxxi]
Framework for Analysis
The Court applied a two-part test to determine whether to respect the form of Taxpayer’s transaction as a charitable contribution of appreciated property to Charity followed by a sale of such property by Charity.
According to this test, (1) the Court had to first determine whether Taxpayer made a valid gift of the Corp shares to Charity and, if so, when, and (2) then the Court must determine whether such gift occurred “before the property gives rise to income by way of a sale.”
The first prong of the test, the Court stated, incorporates the requirement that the taxpayer make a valid gift of property, while the second prong incorporates the anticipatory assignment of income doctrine.
Valid Gift of Shares of Stock
IRS regulations provide that, “[o]rdinarily, a contribution is made at the time delivery is effected.”[xxxii] The regulations further provide that “[i]f 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.” However, the regulations do not define what constitutes delivery.
The Court looked to State law for the threshold determination of whether Taxpayer divested himself of his property rights via gift.[xxxiii] In determining the validity of a gift, State law required 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.
Taxpayer and the IRS each advanced different dates for when Taxpayer made a gift to Charity of the Corp shares. Taxpayer argued that a gift was made on June 11 of Year Two, and pointed to his testimony and Charity’s contribution confirmation letter, which both claimed June 11 as the date of the gift. The IRS argued that a valid gift was not made until at least July 13 of Year Two – two days before the sale to PE – when Charity first received a stock certificate from Taxpayer’s representatives.[xxxiv]
Present Intent?
“The determination of a party’s subjective intent at some historical point,” the Court stated, “is necessarily a fact-bound issue.”
The Court started with Taxpayer’s contemporaneous statements and the contemporaneous transactional documents, which the Court considered to be especially probative evidence with respect to his intent. On June 1 of Year Two, Taxpayer first expressed that he wanted to wait to make the gift of the shares to Charity until the last possible moment, when he was “99% sure” that the sale to PE would close. Taxpayer’s subsequent actions and communications were consistent with that intent.
On June 11, Taxpayer and his brothers executed the Consent to Assignment agreement, an act that demonstrated Taxpayer’s generalized future intent to make a gift. However, the Consent to Assignment did establish that, as of June 11, such an intent was sufficiently present and specific. On its face, the Consent to Assignment agreement failed to specify the number of shares to be contributed, suggesting that Taxpayer had not yet decided that key detail. Similarly, the original stock certificate, which was prepared on or sometime after June 11, failed to specify an effective date, again suggesting that a date would be decided upon later.[xxxv] On July 6, Taxpayer stated that he was still “not totally sure of the shares being transferred to [Charity] yet.” This confirmed that, as of July 6, the details of the contribution were still in flux. Indeed, three days later, on July 9, Adviser informed Charity that “it looks like [Taxpayer] has arrived at 1380 shares.”
The record did not support a finding of present intent to make a gift until July 9 when Taxpayer settled on a number of 1,380 shares. From that point on, Taxpayer took a number of actions that confirmed his then present intent to transfer. On July 9 or 10 of Year Two, Taxpayer delivered the physical stock certificate to Planner’s office. Taken together, these actions provided sufficient evidence of Taxpayer’s intent.
Thus, the Court concluded that, as of July 9, Taxpayer had the present intent to make a gift to Charity.
Delivery
At bottom, Court continued, the delivery requirement generally contemplates an “open and visible change of possession” of the donated property.[xxxvi] The Court explained that the determination of what constitutes delivery is inherently context-specific and depends upon the “nature of the subject-matter of the gift” and the “situation and circumstances of the parties.”
Delivery need not necessarily be actual, the Court stated. Constructive delivery, it explained, may be effected where property is delivered into the possession of another on behalf of the donee. 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.”
With respect to delivery, neither Taxpayer nor Planner was able to credibly identify a specific action taken on June 11 that placed the shares within Charity’s dominion and control. Instead, their testimony suggested that the physical, partially completed stock certificate remained on Taxpayer’s desk until July 9 or 10 of Year Two, at which point it was dropped off at Planner’s office. Consequently, delivery to Charity could not have taken place before July 9 or 10, because Taxpayer retained dominion and control of the physical shares before then.
The same principle was applicable to the three or four days when the physical certificate was in Planner’s office, before the forwarding of the share certificate to Charity. The Minority Stock Purchase Agreement named Planner’s law firm as Charity’s seller representative. That designation raised the question of whether Planner’s possession of the certificate constituted delivery to Charity. The Court, however, countered that providing the certificate to Planner did not remove the shares from Taxpayer’s power of recall. Taxpayer did not provide any evidence to indicate that Planner could have disregarded an instruction from Taxpayer – her client – to return or discard the stock certificate before July 13 of Year Two.
Thus, the Court concluded that the stock certificate, while in Planner’s possession, was subject to recall by Taxpayer at any time and was not within the dominion and control of Charity, which precluded delivery.
Finally, the Court looked to Adviser’s July 13 delivery of the PDF stock certificate to Charity. According to the Court, that act provided the strongest documentary evidence of the shares’ leaving Taxpayer’s dominion and control. Providing Charity with a copy of a stock certificate issued in its name was an objective act evidencing an “open and visible change of possession.” Further, the Court found that this act placed the Corp shares in Charity’s dominion and control, by providing Charity with an instrument it could present to Corp and exercise its rights as shareholder. On the basis of the foregoing, the Court concluded that delivery of the Corp shares did not occur before July 13 of Year Two.
Acceptance
Donee acceptance of a gift is generally “presumed if the gift is beneficial to the donee.”[xxxvii]
The Court pointed to Charity’s July 13 statement that it would need the stock certificate before it could take action with respect to the sale of Corp shares to PE. Indeed, later on July 13, after receiving the stock certificate, Charity executed the Minority Stock Purchase Agreement under warranty of good title. That act was sufficient to establish acceptance by Charity. Thus, the acceptance occurred on July 13 of Year Two.
With that, the Court found that Taxpayer made a valid gift of Corp shares by effecting delivery to Charity on July 13.
Having established this fact, the Court next considered where the tax liability from the sale of the contributed shares should reside.
Anticipatory Assignment of Income
The Court explained that the anticipatory assignment of income doctrine recognizes that income is taxed “to those who earn or otherwise create the right to receive it,” and that tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised.” For example, a person with a fixed right to receive income from property cannot avoid taxation by arranging for another to gratuitously take title to the property before the income is received.[xxxviii]
According to the Court, 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. The same principle, the Court continued, is often applicable where a taxpayer gratuitously transfers shares of stock that are subject to a pending, pre-negotiated transaction, such as a sale, and thus carry a fixed right to proceeds of the transaction.[xxxix]
In determining whether an anticipatory assignment of income has occurred with respect to a gift of shares of stock, the Court stated that “one must look to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities.”
In general, a donor’s right to income from shares of stock is fixed, the Court explained, 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.”
In contrast, “[t]he mere anticipation or expectation of income” at the time of the gift does not establish that a donor’s right to income is fixed.[xl]
After reviewing the IRS’s published rulings in which the doctrine was applied,[xli]
the Court considered the significance of a donee’s legal obligation to sell the donated property, and concluded that it was “only one factor to be considered in ascertaining the ‘realities and substance’ of the transaction.” 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.”
Thus, the Court looked to several other factors that bear upon whether the sale of shares was virtually certain to occur at the time of Taxpayer’s gift. According to the Court, the relevant factors included (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, if any, and (4) the status of the corporate formalities required to finalize the transaction.
Charity’s Obligation to Sell
The Court turned first to whether Charity had an obligation to sell the Corp shares.
The Court concluded that the IRS had not established that Charity had any legal obligation to sell the shares. As Taxpayer pointed out, the terms and conditions of Charity’s Letter of Understanding expressly disclaimed any such obligation. In addition, the IRS did not sufficiently establish the existence of any informal, prearranged understanding between Taxpayer and Charity that might otherwise constitute an obligation.
This factor weighed against an anticipatory assignment of income but was not dispositive.
Bonuses & Shareholder Distributions
Next, the Court looked to what acts Corp and PE took to effect the transaction before Taxpayer’s gift to Charity.
As of the date of the gift, a number of acts had already taken place that suggested the transaction was a virtual certainty. One week before the gift, PE had caused the incorporation of a new holding company subsidiary to acquire the Corp shares. Three days before the gift, Corp had amended its Articles of Incorporation as requested by PE. Most significantly, however, the “cash sweeping” actions taken by Corp strongly suggested that the transaction with PE was a virtual certainty before the gift on July 13 of Year Two.
On July 7 of Year Two, Taxpayer amended Corp’s Change in Control Bonus Plan to specify that Corp desired “that the consummation of the Investment Transaction result in payments to eligible Grantees under the Plan.” That same day, Taxpayer stated that Corp would “sweep the cash from the company prior to closing and distribute it to the brothers.”
Thus, as of July 7, Corp and Taxpayer considered the transaction with PE so certain to occur that they took action to trigger the bonus payouts, consistent with the plan to sweep Corp’s cash before closing. On July 10, Corp paid out approximately $6.1 million in employee bonuses and, a few days later, on July 14, distributed approximately $4.8 million to Taxpayer and his two brothers as shareholders. While the July 14 distribution took place the day after the gift, Taxpayer’s earlier statement evidenced that the decision to make the distribution had already been made as of that date, if not well formally authorized by Corp.
The Court thus found that, before the date of the gift, Corp and Taxpayer had distributed and/or determined to distribute over $10 million out of the corporation.
According to the Court, it was highly improbable that Taxpayer and his brothers would have emptied Corp of its working capital if the transaction had even a small risk of not consummating. Absent its working capital, the Court added, Corp was no longer a going concern until the transaction was finalized. The bonus payouts and distributions were not contingent on the final execution of the purchase agreement. Thus, the Court concluded that, once made, the bonus payouts and distributions could not be clawed back and had tax consequences upon receipt for the participating employees and shareholders, including Taxpayer.[xlii]
Unresolved Sale Contingencies
Next, the Court looked to what unresolved sale contingencies remained between the parties as of the date of the gift.
Taxpayer argued that the transaction with PE was still being negotiated up until the closing on July 15 of Year Two.
However, the Court found that the record did not bear out the substance of Taxpayer’s characterization. In fact, the issues identified by Taxpayer appeared to have been resolved in drafts of the agreement prepared before July 13. Given that the written drafts memorialized the negotiations between the parties, the Court found that the parties had resolved their issues before the contribution to Charity.
Thus, none of the unresolved contingencies remaining on July 13 were substantial enough to have posed even a small risk of the overall transaction’s failing to close.
The Court found that Taxpayer, consistent with his “99% sure” statement, waited until all material details had been agreed to with PE before he transferred the shares to Charity. The absence of significant unresolved contingencies weighed in favor of the sale of shares to PE being a virtual certainty.
Corporate Formalities
Finally, the Court looked to the status of the corporate formalities necessary for effecting the transaction. Under State law, it explained, a proposed plan to exchange shares must generally have been approved by a majority of the corporation’s shareholders. Formal shareholder approval of a transaction, the Court observed, has often proven to be sufficient to demonstrate that a right to income from shares was fixed before a subsequent transfer. The Court added, however, that such approval was not necessary for a right to income to be fixed, when other actions taken established that a transaction was virtually certain to occur.
On June 11, of Year Two, Taxpayer and his two brothers (the sole shareholders of Corp) unanimously approved pursuing a sale of all outstanding stock of Corp to PE. On July 15, they provided written consent to the final Contribution and Stock Purchase Agreement with PE.
However, “viewed in the light of the reality of the transaction,” the record showed that final written consent was a foregone conclusion. As a practical matter, finalizing the transaction with PE presented Taxpayer and his two brothers with the opportunity to partially cash out of Corp at a significant premium over their initial target price of $80 million.[xliii] All three brothers, and particularly Taxpayer, were involved in negotiating the transaction, making their approval all but assured as of July 13, the date of the gift.
The Court concluded that formal shareholder approval was purely ministerial, as any decision by the brothers not to approve the sale was, as of July 13, “remote and hypothetical.” This factor was neutral as to whether Taxpayer’s right to income was fixed.
The Holding
According to the Court, to avoid an anticipatory assignment of income on the contribution of appreciated shares of stock followed by a sale by the donee, a donor must bear at least some risk at the time of contribution that the sale will not close.
The Court determined, on the record before it, that Taxpayer’s delay in transferring the Corp shares until two days before closing eliminated any such risk and made the sale a virtual certainty. Taxpayer’s right to income from the sale of Corp shares was thus fixed as of the gift on July 13.
With that, the Court held that Taxpayer was required to recognize the gain from the sale of the 1,380 shares of Corp stock he had donated to Charity.
Lesson?
The Court acknowledged that its holding did not provide donors with a temporal bright line they could not cross when structuring charitable contributions of appreciated stock before a sale.
However, it added that by July 13, the transaction with PE had simply “proceeded too far down the road to enable Taxpayer to escape taxation on the gain attributable to the donated shares.”[xliv] In other words, by that time, the Corp stock represented a right to receive the proceeds from its sale rather than an investment to be held by Charity.
But what about the Charity’s Letter of Understanding, which expressly disclaimed any obligation to sell? The Court did not expend much energy on this position, though it recognized it as a factor that militated against application of the doctrine.
That said, query whether a charitable organization may be subject to a fiduciary duty that might impose a legal obligation to sell contributed shares constituting a small minority interest in a closely held corporation. The conversion of such shares into liquid cash that could be used in furtherance of a charitable purpose should be compared to the retention of a minority interest that could lose value and with no ability to compel distributions or a redemption.[xlv]
Assignment of income aside, the most interesting aspect of Taxpayer’s case, at least from my perspective, was the tension between his desire to make a charitable contribution, on the one hand, and his concern over ending up with fewer shares if the sale to PE was not consummated, on the other.
Imagine if the deal had fallen through. Bro-1 would again have insisted on having his shares redeemed. At that point, Taxpayer and Charity would each have been a minority shareholder and Bro-2 would have held the majority interest in Corp.
Taxpayer made it very clear to Planner that he did not want to end up in that position, so he insisted that the contribution to Charity not occur[xlvi] until the sale to PE was a certainty. Of course, that desire for certainty came at a price insofar as the application of the assignment of income doctrine was concerned.
[i] https://www.philanthropy.com/article/giving-was-up-but-the-number-of-donors-was-down-the-first-three-quarters-of-2022?sra=true&cid=gen_sign_in#:~:text=The%20report%20found%20that%20new,down%20by%20only%202%20percent.
[ii] E/o Hoensheid v. Comm’r, T.C. Memo. 2023-34.
Apologies for the length of the post. Lots of relevant facts here.
[iii] It should be noted there were two other siblings who had previously retired from the business. Query how much they received in exchanged for their shares.
[iv] Not an unusual move when the shareholders want to ensure the continued presence and assistance of key employees as the business moves towards a sale.
[v] Planner clearly anticipated the anticipatory assignment of income doctrine. Stay tuned.
[vi] IRC Sec. 509(a).
[vii] Decisions, decisions. Lots of moving parts.
[viii] Quite the premium.
[ix] The selling shareholders rolled over some of their equity in Corp into PE in exchange for equity therein.
[x] Many of us have been in Planner’s position. You work with what you have. You do your best. The client has to cooperate.
[xi] Keep this in mind.
[xii] It is often the case that economic certainty is adverse to a taxpayer’s desired reporting position.
[xiii] Note the date.
[xiv] Immediately following the shareholder meeting, Corp held a board meeting at which the directors unanimously approved Taxpayer’s request to be able to transfer a portion of his shares to Charity. The directors also unanimously approved a resolution to dissolve Corp’s Incentive Compensation Plan for executives and to distribute all remaining balances.
[xv] During the examination of petitioners’ 2015 return, Planner produced a copy of the Consent to Assignment agreement, with a number of “1380” shares hand-written onto the blank line. At trial, Taxpayer confirmed his handwriting inserting the number of shares and testified that he had prepared and signed the agreement on June 11, 2015, before his two brothers signed it.
[xvi] Note the date.
[xvii] This reminds of a skit I performed as a Boy Scout many years ago. An old man and his donkey are trudging through the desert. Periodically, the donkey would ask, “how much further?” The old man would respond, “patience jackass, patience.” This exchange went on for a while until, finally, someone from the audience yelled out, “is this skit ever going to end?” to which the old man responded, “patience jackass.”
[xviii] At closing, Taxpayer received $21.3 million in cash, 50,000 shares of Holdings common stock, and a subordinated promissory note of $5 million. In October 2015 of Year Two, Taxpayer and his two brothers received a post-closing distribution of excess working capital from Corp totaling $1.1 million. Additionally, in August, October, and November 2016 of Year Three, Taxpayer and his two brothers received another distribution relating to Corp’s Year Two tax refunds.
[xix] Donee organizations use Form 8282 to report information to the IRS and donors about dispositions of certain charitable deduction property made within 3 years after the donor contributed the property.
[xx] We won’t be considering the IRS’s or the Court’s decision on this point. Suffice to say that Taxpayer was not happy.
[xxi] In general, the IRS’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that those determinations are erroneous. Tax Court Rule 142(a)(1).
[xxii] deductions are a matter of legislative grace, and taxpayers must demonstrate their entitlement to the deductions claimed.
[xxiii] Under IRC Sec. 6662(a).
[xxiv] Tax Court Rule 34.
[xxv] Tax Court Rule 36.
[xxvi] Tax Court Rule 41. A party may amend a pleading once as a matter of course at any time before a responsive pleading is served.
[xxvii] The other issues before the Court were whether Taxpayer was entitled to a charitable contribution deduction, and whether Taxpayer was liable for an accuracy-related penalty under IRC Sec. 6662(a) with respect to an underpayment of tax.
[xxviii] Tax Court Rule 142(a)(1).
[xxix] The burden was on petitioners only with respect to (1) whether they made a valid gift of shares to Charity and (2) whether they are entitled to a charitable contribution deduction.
[xxx] IRC Sec. 1001.
[xxxi] IRC Sec. 170.
[xxxii] Reg. Sec. 1.170A-1(b).
[xxxiii] In doing so, the Court explained it would apply state law in the manner in which the highest court of the state had indicated that it would apply the law. See Comm’r v. Est. of Bosch, 387 U.S. 456, 465 (1967). Where the state’s highest court is silent, the Court continued, the court must discern and apply the state law, giving “proper regard” to the state’s lower courts.
[xxxiv] The IRS raised a separate issue with regard to the dividend paid out by Corp on July 14 to Taxpayer amd his brothers but not paid to Charity, speculating that Taxpayer did not make a valid gift of the shares. The IRS’s contention, the Court stated, appeared to have been foreclosed by state law, which provided that retention of a dividend does not preclude a valid gift of the underlying shares.
[xxxv] The Court noted that copies of the Consent to Assignment agreement and stock certificate that were produced to the IRS during the examination appear to have been modified and backdated to specify, respectively, a number of shares and an effective date that were not originally present at the time of the transaction. The Court found such inconsistencies to be significant in evaluating Taxpayer’s claim that the gift was made on June 11 of Year Two.
[xxxvi] Manually providing tangible property to the donee is the classic form of delivery. Similarly, manually providing to the donee a stock certificate that represents intangible shares of stock is traditionally sufficient delivery.
[xxxvii] In his testimony, Taxpayer implied a belief that the execution of the Consent to Assignment agreement had effected a transfer. The Court responded that execution of the Consent to Assignment agreement did not purport to transfer ownership of any portion of Taxpayer’s shares; instead, it merely allowed him the ability to transfer shares in the future.
[xxxviii] 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.
[xxxix] Stated differently, what was contributed was not the stock, as such, but the right to the proceeds from its sale.
[xl] As a preliminary matter, the Court addressed Taxpayer’s reliance on the Court’s nonprecedential decision in Dickinson, T,C. Memo 2020-128. There, the taxpayer made several contributions to a charity of shares in a closely held corporation of which he was the CFO. On each occasion, the taxpayer’s contributions to the charity were shortly followed by redemptions of those shares by the corporation. The Court looked to whether 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 Court determined to respect the form of the transaction, because the redemption “was not a fait accompli at the time of the gift” and thus the taxpayer “did not avoid receipt of redemption proceeds” by contributing his shares.
In reaching this holding, the Court found it evident from the record that the redemptions would not have occurred but for the taxpayer’s charitable contributions; thus there could be no “practically certain to occur” realization event for the taxpayer to avoid at the time of the gift. This point was the key distinguishing factor between Dickinson and Taxpayer’s case. Here, the record established that Taxpayer’s charitable contribution would not have been made but for the impending sale to PE. Unlike in Dickinson, the timing of the sale and Taxpayer’s gift raised a question as to whether at the time of gift the sale was virtually certain to occur.
[xli] In Rev. Rul. 78-197, 1978-1 C.B. at 83, in the wake of the Tax Court’s decision in Palmer v. Comm’r, 62 T.C. 684 (1974), aff’d on other issue, 523 F.2d 1308 (8th Cir. 1975), the IRS advised that, “under facts similar to those in Palmer,” it would treat a charitable contribution of stock followed by a redemption as an anticipatory assignment of income “only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption.” Palmer involved a taxpayer’s contribution of shares of stock in his controlled corporation to a charitable foundation of which he was a trustee, followed by a redemption of the shares by the corporation.
[xlii] “In the reality of the transaction, the cash sweeps were thus highly significant conditions precedent to consummating the transaction with [PE].” As of July 13, the Corp shares were essentially “hollow receptacles” for conveying proceeds of the transaction with PE, “rather than an interest in a viable corporation.” The cash sweep strongly weighed in favor of the conclusion that the sale was a virtual certainty and thus Taxpayer’s right to income from the shares was fixed as of July 13 of Year Two.
[xliii] Presumably, PE believed it was acquiring Corp at a fair price.
[xliv] The stock was donated too close to the closing date.
[xlv] I know what I would do.
[xlvi] Or at least that the number of shares being contributed not be settled.
