Spotting A Contribution

Do you think you could spot a tax-deductible donation?

Let’s begin by acknowledging that the qualifier “tax-deductible” kicks it up a notch. Give $300 to the church on Christmas Eve service and you have made a donation. Fail to get a letter from the church acknowledging that you donated $300, receiving in return only intangible benefits, and you probably forfeited the tax deductibility.

Let’s set it up:

(1)  There was a related group of companies developing a master-planned community in Lehi, Utah.

(2)  There were issues with density. The company had rights to develop if it could receive approval from the city council.

(3)  The city council said sure – but you have to reduce the density.

a.     Rather than reduce the number of units, the developer decided to donate land to the city – 746.789 acres, to be exact.

I see couple of ways to account for this additional land. One way is to add its cost to the other costs of the development. With this accounting you have to wait until you sell the units to get a deduction, as a slice of the land cost is allocated to each unit.

That wasn’t good enough for our taxpayer, who decided to account for the additional land by …

(4) … taking a charitable donation of $11,040,000.

What do you think? Does this transaction rise to the level of a deductible contribution and why or why not?

In general, a contribution implies at least a minimal amount of altruism. If one receives value equivalent to the “donation,” it is hard to argue that there is any altruism or benevolence involved. That sounds more like a sale than a donation. Then there is the gray zone: you donate $250 and in turn receive concert tickets worth $60. In that case, one is supposed to show the contribution as $190 ($250 - $60).

Sure enough, the IRS fired back with the following:

(1)  The transfer was part of a quid pro quo arrangement to receive development approvals.

That seems a formidable argument, but this is the IRS. We still have to bayonet the mortally wounded and the dead.

(2)  The transfer was not valid because [taxpayer] did own the development credits (i.e., someone else in the related-party group did).

(3)  The contemporaneous written acknowledgement was not valid.

(4)  The appraisal was not a qualified appraisal.

(5)  The value was overstated.

Yep, that is the IRS we know. Moderation is for amateurs.

A quid pro quo reduces a charitable deduction. Quid too far and you can doom a charitable deduction. Judicial precedence in this area has the Court reviewing the form and objective features of the transaction. One can argue noble heart and best intentions, but the Court was not going to spend a lot of time with the subjectivity of the deal.

The taxpayer was loaded for bear: the written agreement with the city did not mention that taxpayer received anything in return. To be doubly careful, it also stated that – if there was something in return – it was so inconsequential as to be immeasurable.

Mike drop.

The IRS pointed out that – while the above was true – there was more to the story. The taxpayer wanted more than anything to have the development plan approved so they could improve the quality of life make a lot of money. The city council wanted a new plan before approving anything, and that plan required the taxpayer to increase green space and reduce density.

Taxpayer donated the land. City council approved the project.

Nothing to see here, argued the taxpayer.

The Court refused to be blinkered by looking at only the written agreement. When it looked around, the Court decided the deal looked, waddled and quacked like a quid pro quo.

The taxpayer had a back-up argument:

If there was a quid pro quo, the quid was so infinitesimal, so inconsequential, so Ant-Man small as to not offset the donation, or at least the lion’s share of the donation.

I get it. I would make exactly the same argument if I were representing the taxpayer.

The taxpayer trotted out the McGrady decision. The facts are a bit peculiar, as someone owned a residence, a developer owned adjoining land and a township was resolute in preserving the greenspace. To get the deal to work, that someone donated both an easement and land and then bought back an odd-shaped parcel of land to surround and shield their residence. The Court respected the donation.

Not the same, thundered the Tax Court. McGrady had no influence over his/her deal, whereas taxpayer had a ton of influence over this one. In addition, just about every conservation easement has some incidental benefit, even if the benefit is only not having a crush of people on top of you.

The quid quo pro was not incidental. It was the key to obtaining the city council’s approval. It could not have been more consequential.

And it was enough to blow up a $11,040,000 donation.

Whereas not in the decision, I can anticipate what the tax advisors will do next: capitalize the land into the development costs and then deduct the same parcel-by-parcel. Does this put the taxpayer back where it would have been anyway?

No, it does not. Why? Because the contribution would have been at the land's fair market value. Development accounting keeps the land at its cost. To the extent the land had appreciated, the contribution would have been more valuable than development accounting.

Our case for the home gamers was Triumph Mixed Use Investments II LLC, Fox Ridge Investments, LLC, Tax Matters Partner v Commissioner, T.C. Memo 2018-65.

Using a 401(k) to Supercharge a Roth

Let’s talk this time about a tax trick that may be available to you if you participate in a 401(k). The reason for the “may” is that – while the tax Code permits it – your individual plan may not. You have to inquire.

Let’s set it up.

How much money can you put into your 401(k) for 2015?

The answer is $18,000. If you are age 50 or over you can contribute an additional $6,000, meaning that you can put away up to $24,000.

Most 401(k)’s are tax-deductible. There are also Roth 401(k)’s. You do not get a tax break like you would with a regular 401(k), but you are putting away considerably more than you could with just a Roth IRA contribution.

Did you know that you might be able to put away more than $18,000 into your 401(k)?

How?

It has to do with tax arcana. A 401(k) is a type of “defined contribution” (DC) plan under the tax Code. One is allowed to contribute up to $53,000 to a DC plan for 2015. 

What happens to the difference between the $18,000 and the $53,000?

It depends. While the IRS says that one can go up to $53,000, your particular plan may not allow it. Your plan may cut you off at $18,000.

But there are many plans that will allow.  

Now we have something - if you can free-up the money.

Let’s say you max-out your 401(k). Your company also contributes $3,000. Combine the two and you have $21,000 ($18,000 plus $3,000) going to your 401(k) account. Subtract $21,000 from $53,000, leaving $32,000 that can you put in as a “post-tax” contribution. 

Did you notice that I said “post-tax” and not “Roth?” The reason is that a Roth 401(k) is limited to $18,000 just like a regular 401(k). While the money is after-tax, it is not yet “Roth.”

How do you make it Roth?

Prior to 2015, there had been much debate on how to do this and whether it could even be done. The issue was the interaction of the standard pro-rata rules for plan distributions with the unique ordering rule of Code Section 402(c)(2).

In general, the pro-rata rule requires you to calculate a pre- and post-tax percentage and then multiply that percentage times any distribution from a plan.

EXAMPLE: You have $100,000 in your 401(k). $80,000 is from deductible contributions, and $20,000 is from nondeductible. You want to roll $20,000 into a Roth account. You request the plan trustee to write you a $20,000 check, which you promptly deposit in a newly-opened Roth IRA account. 

           Will this work?

Through 2014 there was considerable doubt. It appeared that you were to calculate the following percentage: $20,000/$100,000 = 20%. This meant that only 20% of the $20,000 was sourced to nondeductible contributions. The remaining $16,000 was from deductible contributions, meaning that you had $16,000 of taxable income when you transferred the $20,000 to the Roth IRA. 

I admit, this is an esoteric tax trap.

But a trap it was. 

There were advisors who argued that there were ways to avoid this result. The problem was that no one was sure, and the IRS appeared to disagree with these advisors in Notice 2009-68. Most tax planners like to keep their tires on the pavement (so as not to get sued), so there was a big chill on what to do.

The IRS then issued Notice 2014-54 last September.

The IRS has clarified that the 401(k) can make two trustee-to-trustee disbursements: one for $80,000 (for the deductible part) and another of $20,000 (for the nondeductible). No more of that pro-rata percentage stuff.

There is one caveat: you have to zero-out the account if you want this result.

Starting in 2015, tax planners now have an answer.

Let’s loop back to where we started this discussion.

Let’s say that you make pretty good money. You are age 55. You sock away $59,000 in your 401(k) for five years. Wait, how did we get from $53,000 to $59,000? You are over age 50, so your DC limit is $59,000 (that is, $53,000 plus the $6,000 catch-up). Your first $24,000 is garden-variety deductible, as you do not have a Roth option. The remaining $35,000 is nondeductible. After 5 years you have $175,000 (that is, $35,000 times 5) you can potentially move to a Roth IRA. You may have to leave the company to do it, but that is another discussion.

Not a bad tax trick, though.