In a recent Tax Court decision handed down in a Memorandum opinion, the Internal Revenue Service (“IRS”) showed that it will continue to be aggressive in denying charitable deductions for transactions they might view as taking abuse of the charitable deduction available under Internal Revenue Code (“IRC”) §170. In Chrem v. Comm’r, TC Memo 2018-164, the Tax Court denied the taxpayer’s motion for summary judgment where the IRS sought to include income on the taxpayer’s return through the assignment of income doctrine. Additionally, the Tax Court denied cross-motions for summary judgment on whether taxpayer was entitled to the charitable deduction under IRC §170.
Marc and Esther Chrem (along with 10 other taxpayers involved in the same transaction whose cases were consolidated) (the “Taxpayer”) donated stock in a closely held corporation located in Hong Kong, Comtrad Trading, Ltd. (“Comtrad”), to the Jewish Communal Fund (“JCF”), a qualified charitable organization. The date of the actual donation was disputed, which the Taxpayer claiming it happened on December 5, 2012, and the IRS claiming it happened on December 10, 2012. Around the same time, the Taxpayer also sold its remaining shares not donated to JCF to a related corporation, SDI technologies, Inc. (“SDI”), for a price of $4,500 per share. SDI was owned by an employee stock ownership program (“ESOP”) of which the Taxpayer and other employees of Comtrad were beneficiaries.
As part of the transaction, the ESOP obtained a fairness opinion relating to the Comtrad stock to ensure that the purchase by the ESOP was fair to the beneficiaries of the ESOP. The ESOP trustee hired Empire Consultants, LLC (“Empire”) to provide a fairness opinion supported by a valuation report. Empire issued its fairness opinion, dated December 10, 2012, which concluded that the value of 100% of the outstanding shares of Comtrad was between $29.5 and $32.4 million, or $4,214 to $4,626 per share. The opinion concluded that the purchase of Comtrad stock for $4,500 was fair to the beneficiaries of the ESOP. As part of its opinion, Empire issued a “restricted use appraisal report” dated December 8, 2012. Empire emphasized that the “sole use [of the report]…[was for the ESOP trustee] in its fiduciary capacity” and could “not be used for any other purpose or by any other user without the express consent of Empire.”
Based on the report, the ESOP consented to the deal and purchased 6,100 shares, approximately 87.1%, of Comtrad stock from the shareholders, including the Taxpayer. The remaining shares, 900 total, were donated to JCF and were subsequently purchased from JCF. Both sales transactions were for $4,500 per share and were closed on December 12, 2012.
The Taxpayer filed its 2012 income tax return on which it claimed a charitable contribution deduction of $202,500 for the 45 shares of Comtrad it contributed to the JCF. The other taxpayers whose cases were consolidated took similar deduction, with 4 of them being for $562,500, above the $500,000 threshold discussed below. The IRS audited the returns of the Taxpayer and the other 10 taxpayers who took deductions for the contribution of Comtrad stock to the JCF. The IRS first requested a copy of an appraisal report to support the values claimed by the Taxpayer, in response to which the Taxpayer provided the IRS with the Empire report. On review, the IRS came down hard on the Taxpayer with its notice of deficiency making the following determinations: 1) the Taxpayer was liable of tax on the shares sold by JCF under the anticipatory assignment of income doctrine; 2) the Taxpayer was not allowed to take any deduction for the shares contributed to JCF; and 3) the Taxpayer was liable for the 20% accuracy related penalty under IRC §6662(a), or, in the alternative, the 40% gross valuation misstatement penalty under IRC §6662(h).
Upon receipt of the notice of deficiency, the Taxpayer timely filed its petition to the Tax Court and the Tax Court consolidated the 11 cases. The IRS subsequently filed a motion for partial summary judgment on the whether the Taxpayer was entitled to a deduction for the contribution of the stock to the JCF. In response, the Taxpayer filed its cross-motion seeking summary judgment on both issues, the assignment of income allegation and the denial of the charitable deduction.
Making the Most of a Charitable Contribution
As part of this transaction, the Taxpayer engaged in a widely used technique of contributing built-in-gain property to charity and taking a charitable contribution deduction for the fair market value of such property contributed without being subject to any shave-down under IRC §170(e). Ordinarily, this technique is a win-win for the contributing taxpayer. First, the contributing taxpayer does not recognize gain on the contribution, thereby avoiding the payment of tax on the spread between the contributing taxpayer’s basis in the property and its fair market value. Second, the contributing taxpayer is entitled to a charitable contribution deduction for the fair market value of its property (as long as the contribution is to a public charity), assuming certain conditions are met. When the charity later sells the property, the gain is exempt from income. However, the IRS does have weapons to combat against this technique as seen in this case. The IRS alleged that the assignment of income doctrine (discussed below) applied to deny the Taxpayer the first benefit, and sought to fully deny the charitable contribution deduction thereby denying the Taxpayer the second benefit.
Assignment of Income Doctrine
The assignment of income doctrine is a longstanding doctrine developed by case law whereby the IRS seeks to prevent someone who earns income from shifting that income to another taxpayer who may be in a lower tax bracket (or exempt from tax as is the case here). See 1 In Basye, the Supreme Court held that a “he who earns income may not avoid taxation through anticipatory arrangements no matter how clever or subtle” and person expecting income “cannot avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person.”2
In its analysis, the Tax Court notes that the assignment of income as it relates to charitable contributions is not new to the Tax Court. In determining whether the doctrine applies, the Tax Court will look to the charity and determine whether the acquisition of the contributed property from the charity is a “mere expectation” or a “virtual certainty.” 3
A second relevant question again looks to the charity and asks whether the charity “is obligated, or can be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer.”4 The donee’s control is an important factor in the analysis.5 The existence of an understanding among the parties, or the fact that the transactions occur simultaneously or according to prearranged steps, is relevant but does not seem to be dispositive. 6
While this opinion was not dispositive on the issue but only denying summary judgment to the Taxpayer on the assignment of income issue, the Tax Court did analyze some of the facts which may lead the Tax Court to later rule one way or the other in the future.
First, Comtrad and SDI were related by common management, common interests, and both companies wanted the transaction to close. These facts suggest that the acquisition of the Comtrad stock from JCF was a virtual certainty. There were also emails brought up by the IRS which seemed to suggest that JCF had agreed in advance to tender its shares to SDI.7
A second issue discussed was the date of the contribution of the Comtrad stock to JCF. The Taxpayer alleged it occurred on December 5, 2012, and the IRS alleged it occurred on December 10, 2012, allegedly after JCF had unconditionally agreed to sell the shares to SDI. Along these same lines, Empire’s report described the proposed transaction as a “transfer [of] 900 shares to JCF simultaneously with SDI’s acquisition of the 6,100 shares”, lending credence to the IRS’ stance that the shares were contributed on December 10th rather than December 5th.8
Third, the Tax Court briefly discussed whether JCF was obligated to tender the share to SDI upon receipt.9 Empire’s report stated that the Taxpayer would use “all reasonable efforts to cause JCF to agree to sell its shares to SDI.” The IRS asserted that the JCF did not have any meaningful negotiations but was only informed through the Taxpayer that the 900 shares would be sold to SDI at once. While the Tax Court did not have much evidence at the time of its opinion denying summary judgment, one issue discussed was JCF’s fiduciary duties as a custodian of charitable assets. If JCF chose to sell the shares, it would have $4,050,000 in cash. If the JCF refused, it would hold a 13% minority interest in a closely held Hong Kong corporation, the market value of which would be questionable.
Assignment of Income Take-Away
While not ruling on the issue other than denying summary judgment and concluding an issue of material fact which warranted a trial did in fact exist, taxpayers and their advisors can still glean some useful bits from this opinion. One thing the IRS has jumped on in this case is the timing of the transaction. Taxpayers contemplating a similar transaction to what was done in this case would be wise to have some time between the contribution to charity and later sale by the charity. Second, there should be no prearranged plan that the charity will sell or any documentation or discoverable correspondence which implies a previous agreement that the charity will sell. Third, to the extent possible, the charity should engage in its own negotiations with the purchaser and should acquire its own valuation analysis to support its decision to sell. Anytime the IRS is making an argument which relies on the facts and circumstances rather than a bright-line rule, as is the case with the assignment of income doctrine, taxpayers will serve themselves well by stacking as many of the good facts in their corner as possible.
Charitable Contribution Deduction
The second issue discussed by the Tax Court was the denial of the Taxpayer’s charitable contribution deduction under IRC §170. As is the case with many charitable contributions, failure to strictly adhere to the requirements of IRC §170 and the related Treasury Regulations may result in a complete denial of the charitable deduction. As the Tax Court notes, IRC 170(a)(1) states on its face that “a charitable contribution deduction shall be allowable as a deduction only if verified under the regulations prescribed by the Secretary.” The Secretary has prescribed extensive regulations governing such verifications and the technical requirements that must be met for the deduction to be allowable.
The arguments made by the IRS in the present case did not allege that JCF was not a qualified charity, or that shares were donated, but rather alleged that the technical requirements of a qualified appraisal were not met. Pursuant to IRC §170(f)(11)(C), taxpayers claiming a deduction of more than $5,000 are required to obtain a qualified appraisal and attach the return such information regarding such property and such appraisal as the Secretary may require, which includes a fully completed appraisal summary on Form 8283. If the contribution is valued at more than $500,000, the taxpayer must also attach a copy of the qualified appraisal to the return in addition to the other requirements.10 For these purposes, a “qualified appraisal” must be performed by a qualified appraiser and must contain (among other things): 1) a detailed description of the property sufficient for a person who is not generally familiar with the property to ascertain that the property appraised is the property that was contributed; 2) a statement that the appraisal was “prepared for income tax purposes”; 3) the date of the contribution; 4) the date of the appraisal; and 5) the appraised fair market value.11
The Tax Court has previously held that the above requirements are helpful, but are also “directory and not mandatory”, thus the requirements may be satisfied by substantial compliance rather than literal compliance when appropriate.12 While substantial compliance may excuse inadvertent omissions or be applicable in cases where the taxpayer has supplied most of the information required, it does not provide relief to taxpayers who have failed to disclose information that goes to the essential requirements of the governing statute.13
Additionally, §170(f)(11)(A)(ii)(II) excuses the failure to comply with the reporting requirements where the failure is due to reasonable cause and not willful neglect. The Tax Court noted that the same standards and analysis for reasonable cause in penalty situations is applicable to reasonable cause here. “Reasonable cause requires that the taxpayer have exercised ordinary business care and prudence as to the challenged item.14 Reasonable cause is determined on a case by case basis based on the facts and circumstances of each particular case. Treas. Reg. §1.6664-4(b)(1). Reasonable cause may be shown by reliance on a tax professional who is a “competent and independent advisor unburdened with a conflict of interest.”15
In the present case, the IRS first asserted that no “qualified appraisal” was ever obtained. The Empire appraisal was not addressed to the Taxpayer, it did not examine any charitable contributions of property, it did not set for the date of the contribution, and it did not state that it was prepared for income tax purposes. On the contrary, the report explicitly stated it was prepared for ERISA purposes and was only to be used by the ESOP trustee. The report did not even value the property contributed, but rather valued the Comtrad stock as a whole, and not the amount of stock contributed by the Taxpayer. A report valuing only the amount contributed might contain minority discounts, a larger lack of marketability discount, and in general, would be written in a whole different way. Based on this, the IRS concluded that the Taxpayer neither strictly nor substantially complied with the valuation requirements under IRC §170 and the related Treasury Regulations.
The Taxpayer responded that the alleged errors were “no harm, no foul” and that the Taxpayer had substantially complied with the requirements. Since SDI was offering to buy 100% of the Comtrad stock, there was no reason for any additional discounting, and further, since JCF was being paid all cash, the shares contributed might even warrant a premium on the valuation. Admittedly, the Empire report did not state it was for income tax purposes, but the Empire professional who signed the appraisal also signed the Form 8283 attached to the Taxpayer’s return. Based on all the facts, the Taxpayer believes there was substantial compliance.
The four taxpayers who contributed Comtrad stock to JCF in excess of $500,000 have a different hurdle, since the statute explicitly requires a qualified appraisal be attached to the return and no such attachment was done by these taxpayers. Instead, they only completed the Form 8283. These taxpayers further argued that the Form 8283 constituted substantial compliance with the requirement that a qualified appraisal be attached. Second, even if not, these taxpayers sought relief under the reasonable cause exception. The Taxpayer had hired a competent CPA to prepare their returns, and they relied on this CPA when filing the returns. The CPA never mentioned or suggested that the appraisal report from Empire be attached.
After weighing the facts presently before the Tax Court, the Tax Court concluded there was an issue of material fact to be decided, and thus denied summary judgment to both parties.
Charitable Contribution Take-Away
While the Tax Court did not rule decisively on the issues, there is plenty to take away from the Tax Court’s opinion denying summary judgment. When it comes to charitable contributions and deductions, strict literal compliance will always benefit the taxpayer and can avoid situations like this. This is true whether the charitable contribution is of appreciated stock, a piece of real property, or a conservation easement. Each has their own nuanced requirements and taxpayers contemplating these transactions should carefully analyze such requirements and be certain to comply with each of them. In the present case, had the Taxpayer obtained his own qualified appraisal in accordance with IRC §170 and the related Treasury Regulations, we would not be writing about this case and the Taxpayer would not be having to argue substantial compliance and/or reasonable cause, both issues that are determined on the facts and circumstances on a case by case basis. Second, if for whatever reason, strict literal compliance is not possible, the taxpayer would serve themselves well to stack as many good facts in their corner as possible.
- U.S. v. Basye, 410 U.S 441 (1973).
- Id. At 449.
- “More than expectation of anticipation of income is required before the assignment of income doctrine applies” Greene v. U.S., 13 F.3d 577, 582 (2d Cir. 1994).
- See Rev. Rul. 78-197, 1978-1 C.B. 83 (1978).
- Rauenhorst v. Commissioner, 119 T.C. 157 (2002).
- See Blake v. Commissioner, 697 F.2d 473 (2d Cir. 1982).
- See Chrem at p. 14
- Id. at p. 13
- See Treas. Reg. §1.170-1(c)(3)(ii).
- Bond v. Commissioner, 100 T.C. 32 (1993). (See also Belair Woods, LLC v. Comm’r., T.C.M. 2018-159, the ESA Law discussion on Belair, and BC Canyon II, L.P. v. Comm’r, 867 F.3d 547 (5th Cir. 2017)
- Estate of Evenchik v. Commissioner, T.C. Memo 2013-34.
- U.S. v. Boyle, 469 U.S. 241 (1985).
- Mortensen v. Commissioner, 440 F.3d 375 (6th Cir. 2006).