Using A Fancy Trust Without An Advisor

 

I am a fan of charitable remainder trusts. These are (sometimes) also referred to as split interest trusts.

What is an interest in a trust and how can you split it?

In a generic situation, an interest in a trust is straightforward:

(1) Someone may have a right to or is otherwise permitted to receive an income distribution from a trust. This is what it sounds like: if the trust has income, then someone might receive all, some or none of it – depending on what the trust is designed to do. This person is referred to as an “income” beneficiary.

(2) When there are no more income beneficiaries, the trust will likely terminate. Any assets remaining in the trust will go to the remaining beneficiaries. This person(s) is referred to as a “remainder” beneficiary.

Sounds complicated, but it does not have to be. Let me give you an example.

(1)  I set up a trust.

(2)  My wife has exclusive rights to the income for the rest of her life. My wife is the income beneficiary.

(3)  Upon my wife’s death, the assets remaining in the trust go to our kids. Our kids are the remainder beneficiaries.

(4)  BTW the above set-up is referred to as a “family trust” in the literature.

Back to it: what is a split interest trust?

Easy. Make one of those interests a 501(c)(3) charity.

If the charity is the income beneficiary, we are likely talking a charitable lead trust.

If the charity is the remainder beneficiary, then we are likely talking a charitable remainder trust.

Let’s focus solely on a charity as a remainder interest.

You want to donate to your alma mater – Michigan, let’s say. You are not made of money, so you want to donate when you pass away, just in case you need the money in life. One way is to include the University of Michigan in your will.

Another way would be to form a split interest trust, with Michigan as the charity. You retain all the income for life, and whatever is left over goes to Michigan when you pass away. In truth, I would bet a box of donuts that Michigan would even help you with setting up the trust, as they have a personal stake in the matter.

That’s it. You have a CRT.

Oh, one more thing.

You also have a charitable donation.

Of course, you say. You have a donation when you die, as that is when the remaining trust assets go to Michigan.

No, no. You have a donation when the trust is formed, even though Michigan will not see the money (hopefully) for (many) years.

Why? Because that is the way the tax law is written. Mind you, there is crazy math involved in calculating the charitable deduction.

Let’s look at the Furrer case.

The Furrers were farmers. They formed two CRATs, one in 2015 and another in 2016.

COMMENT: A CRAT is a flavor of CRT. Let’s leave it alone for this discussion.

In 2015 they transferred 100,000 bushels of corn and 10,000 bushels of soybeans to the CRAT. The CRAT bought an annuity from a life insurance company, the distributions from which were in turn used to pay the Fullers their annuity from the CRT.

They did the same thing with the 2016 CRT, but we’ll look only at the 2015 CRT. The tax issue is the same in both trusts.

The CRT is an oddball trust, as it delays - but does not eliminate – taxable income and paying taxes. Instead, the income beneficiary pays taxes as distributions are received.

EXAMPLE: Say the trust is funded with stock, which it then sells at a $500,000 gain. The annual distribution to the income beneficiary is $100,000. The taxes on the $500,000 gain will be spread over 5 years, as the income beneficiary receives $100,000 annually.

Think of a CRT as an installment sale and you get the idea.

OK, we know that the Furrers had income coming their way.

Next question: what was the amount of the charitable contribution?

Look at this tangle of words:

§ 170 Charitable, etc., contributions and gifts.

           (e)  Certain contributions of ordinary income and capital gain property.

(1)  General rule.

The amount of any charitable contribution of property otherwise taken into account under this section shall be reduced by the sum of-

(A)  the amount of gain which would not have been long-term capital gain (determined without regard to section 1221(b)(3)) if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution),

This incoherence is sometimes referred to as the “reduce to basis” rule.

The Code will generally allow a charitable contribution for the fair market value of donated property. Say you bought Apple stock in 1997. Your cost (that is, your “basis”) in the stock is minimal, whereas the stock is now worth a fortune. Will the Code allow you to deduct what Apple stock is worth, even though your actual cost in the stock is (maybe) a dime on the dollar?

Yep, with some exceptions.

Exceptions like what?

Like the above “amount of gain which would not have been long-term capital gain.”

Not a problem with Apple stock, as that thing is capital gain all day long.

How about crops to a farmer?

Not so much. Crops to a farmer are like yoga pants to Lululemon. That is inventory - ordinary income in nerdspeak - as what a farmer ordinarily does is raise and sell crops. No capital gain there.

Meaning?

The Furrers must reduce their charitable deduction by the amount of income that would not be capital gain.

Well, we just said that none of the crop income would be capital gain.

I see income minus (the same) income = zero.

There is no charitable deduction.

Worst … case … scenario.

I found myself wondering how the tax planning blew up.

In July 2015, after seeing an advertisement in a farming magazine, petitioners formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), of which their son was named trustee. The trust instrument designated petitioners as life beneficiaries and three eligible section 501(c)(3) charities as remaindermen.”

The Furrers should have used a tax advisor. A pro may not be necessary for routine circumstances: a couple of W-2s, a little interest income, interest expense and taxes on a mortgage, for example.

This was not that. This was a charitable remainder trust, something that many accountants might not see throughout a career.

Yep, don’t do this.

Our case this time is Furrer v Commissioner, T.C. Memo 2022-100.

Donating Cryptocurrency

 

I was reading something recently, and it reminded me how muddled our tax Code is.

Let’s talk about cryptocurrency. I know that there is bad odor to this topic after Sam Bankman-Fried and FTX, but cryptocurrencies and their exchanges are likely a permanent fixture in the financial landscape.

I admit that I think of cryptos – at least the main ones such as Bitcoin, Ethereum or Binance Coin – as akin to publicly traded stock. You go to www.finance.yahoo.com , enter the ticker symbol and see Bitcoin’s trading price. If you want to buy Bitcoin, you will need around $23 grand as I write this.

Sounds a lot like buying stock to me.   

The IRS reinforced that perspective in 2014 when it explained that virtual currency is to be treated as property for federal income tax purposes. The key here is that crypto is NOT considered a currency. If you buy something at Lululemon, you do not have gain or loss from the transaction. Both parties are transacting in American dollars, and there is no gain or loss from exchanging the same currency.

COMMENT: Mind you, this is different from a business transaction involving different currencies. Say that my business buys from a Norwegian supplier, and the terms require payment in krone within 20 days. Next say that the dollar appreciates against the krone (meaning that it takes fewer dollars to purchase the same amount of krone). I bought something costing XX dollars. Had I paid for it then and there, the conversation is done. But I did not. I am paying 20 days later, and I pay XX minus Y dollars. That “Y” is a currency gain, and it is taxable.

So, what happens if crypto is considered property rather than currency?

It would be like selling Proctor and Gamble stock (or a piece of P&G stock) when I pay my Norwegian supplier. I would have gain or loss. The tax Code is not concerned with the use of cash from the sale.

Let’s substitute Bitcoin for P&G. You have a Bitcoin-denominated wallet. On your way to work you pick-up and pay for dry cleaning, a cup of coffee and donuts for the office. What have you done? You just racked up more taxable trades before 9 a.m. than most people will all day, that is what you have done.

Got it. We can analogize using crypto to trading stock.

Let’s set up a tax trap involving crypto.

I donate Bitcoin.

The tax Code requires a qualified appraisal when donating property worth over $5,000.

I go to www.marketwatch.com.

I enter BTC-USD.

I see that it closed at $22,987 on January 27, 2023. I print out the screen shot and attach it to my tax return as substantiation for my donation.

Where is the trap?

The IRS has previously said crypto is property, not cash.

A donation of property worth over $5 grand generally requires an appraisal. Not all property, though. Publicly-traded securities do not require an appraisal.

So is Bitcoin a publicly-traded security?

Let’s see. It trades. There is an organized market. We can look up daily prices and volumes.

Sounds publicly-traded.

Let’s look at Section 165(g)(2), however:

    (2)  Security defined.

For purposes of this subsection, the term "security" means-

(A)  a share of stock in a corporation;

(B)  a right to subscribe for, or to receive, a share of stock in a corporation; or

(C)  a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.

The IRS Office of Chief Counsel looked at this and concluded that it could not see crypto fitting the above categories.

Crypto could therefore not be considered a security.

As property not a security, any donation over $5 grand would require a qualified appraisal.

There was no qualified appraisal in our example. All I did was take a screen shot and include it with the return.

That means no charitable deduction.

I have not done a historical dive on Section 165(g)(2), but I know top-of-mind that it has been in the Code since at least 1986.

Do you know what did not exist in 1986?

The obvious.

Time to update the law, me thinks.

This time we were discussing CCA 202302012.

IRAs and Nonqualified Compensation Plans

Can an erroneous Form 1099 save you from tax and penalties?

It’s an oddball question, methinks. I anticipate the other side of that see-saw is whether one knew, or should have known, better.

Let’s look at the Clair Couturier case.

Clair is a man, by the way. His wife’s is named Vicki.

Clair used to be the president of Noll Manufacturing (Noll).

Clair and Noll had varieties of deferred compensation going on: 

(1)   He owned shares in the company employee stock ownership program (ESOP).

(2)   He had a deferred compensation arrangement (his “Compensation Continuation Agreement”) wherein he would receive monthly payments of $30 grand when he retired.

(3)   He participated in an incentive stock option plan.

(4)   He also participated in another that sounds like a phantom stock arrangement or its cousin. The plan flavor doesn’t matter; no matter what flavor you select Clair is being served nonqualified deferred compensation in a cone.

Sounds to me like Noll was taking care of Clair.

There was a corporate reorganization in 2004.

Someone wanted Clair out.

COMMENT: Let’s talk about an ESOP briefly, as it is germane to what happened here. AN ESOP is a retirement plan. Think of it as 401(k), except that you own stock in the company sponsoring the ESOP and not mutual funds at Fidelity or Vanguard. In this case, Noll sponsored the ESOP, so the ESOP would own Noll stock. How much Noll stock would it own? It can vary. It doesn’t have to be 100%, but it might be. Let’s say that it was 100% for this conversation. In that case, Clair would not own any Noll stock directly, but he would own a ton of stock indirectly through the ESOP.

If someone wanted him out, they would have to buy him out through the ESOP.

Somebody bought out Clair for $26 million.

COMMENT: I wish.

The ESOP sent Clair a Form 1099 reporting a distribution of $26 million. The 1099 indicated that he rolled-over this amount to an IRA.

Clair reported the roll-over on his 2004 tax return. It was just reporting; there is no tax on a roll-over unless someone blows it.

QUESTION: Did someone blow it?

Let’s go back. Clair had four pieces to his deferred compensation, of which the ESOP was but one. What happened to the other three?

Well, I suppose the deal might have been altered. Maybe Clair forfeited the other three. If you pay me enough, I will go away.

Problem:

         § 409 Qualifications for tax credit employee stock ownership plans

So?

        (p)  Prohibited allocations of securities in an S corporation

                      (4)  Disqualified person

Clair was a disqualified person to the ESOP. He couldn’t just make-up whatever deal he wanted. Well, technically he could, but the government reserved the right to drop the hammer.

The government dropped the hammer.

The Department of Labor got involved. The DOL referred the case to the IRS Employee Plan Division. The IRS was looking for prohibited transactions.

Found something close enough.

Clair was paid $26 million for his stock.

The IRS determined that the stock was worth less than a million.

QUESTION: What about that 1099 for the rollover?

ANSWER: You mean the 1099 that apparently was never sent to the IRS?

What was the remaining $25 million about?

It was about those three nonqualified compensation plans.

Oh, oh.

This is going to cost.

Why?

Because only funds in a qualified plan can be rolled to an IRA.

Funds in a nonqualified plan cannot.

Clair rolled $26 million. He should have rolled less than a million.

Wait. In what year did the IRS drop the hammer?

In 2016.

Wasn’t that outside the three-year window for auditing Clair’s return?

Yep.

So Clair was scot-free?

Nope.

The IRS could not adjust Clair’s income tax for 2004. It could however tag him with a penalty for overfunding his IRA by $25 million.

Potato, poetawtoe. Both would clock out under the statute of limitations, right?

Nope.

There is an excise tax (normal folk call it a “penalty”) in the Code for overfunding an IRA. The tax is 6 percent. That doesn’t sound so bad, until you realize that the tax is 6 percent per year until you take the excess contribution out of the IRA.

Clair never took anything out of his IRA.

This thing has been compounding at 6 percent per year for … how many years?

The IRS wanted around $8.5 million.

The Tax Court agreed.

Clair owed.

Big.

Our case this time was Couturier v Commissioner, T.C. Memo 2022-69.

Overcontributing To Your 401(k)

 

One of the accountants had a question for me:

A:               I added up the W-2s, but the wages per the software does not agree to my number.

CTG:          Is your number lower?

A:               Yes.

Let’s talk about 401(k)s. More specifically, let’s talk about 401(k)s when one changes jobs during the year. It can be an issue if one is making decent bank.

You are under age 50. How much can you defer in a 401(k)?

For 2021 you can defer $19,500. The limit increased to $20,500 for 2022.

You change jobs during 2021. Say you contributed $14,000 at your first job. The second job doesn’t know how much you contributed at first job. You contribute $12,000 at your second job.

Is there a tax problem?

First, congrats. You are making good money or are a serious saver. It could be both, I suppose.

But, yes, there is a tax problem.

The universe of retirement plans is divided into two broad categories:

·      Defined benefit

·      Defined contribution

Defined benefit are also known as pension plans. Realistically, these plans are becoming extinct outside of a union setting, with the government counting as union.

Defined contribution plans are more commonly represented by 401(k)s, 403(b)s, SIMPLES and so forth. Their common feature is that some – maybe most – of the dollars involved are the employee’s own dollars.

Being tax creatures, you know that both categories have limits. The defined benefit will have a benefit limit (the math can be crazy). The defined contribution will have a contribution limit.

And that contribution limit is $19,500 in 2021 for someone under age 50.

COMMENT: If you google “defined contribution 2021” and come back with $58,000, you may wonder about the difference between the two numbers. The $58,000 includes the employer contribution. Our $19,500 is just the employee contribution. This difference is one of the reasons that solo 401(k)s work as well as they do: they max-out the employer contribution – assuming that the income is there to power the thing, of course.  

Let’s go back to our example. You deferred $26,000 for 2021.

Are you over the limit?

Yep.

If you add your two W-2s together, is the sum your correct taxable wages for 2021?

Nope.

Why not?

Because a 401(k) contribution lowers your (income) taxable wages. You went $6,500 over the limit. Your taxable wages are $6,500 lower than they should be.

 What do you do?

There are two general courses of action:

(1)  Contact one of the employers (probably the second one) explain the issue and request that the W-2 be amended by the deadline date for filing your return – that is, April 15. Rest assured, you have just drawn the wrath of someone in the accounting or payroll department, but you have only so many options. 

BTW the earnings on the excess contributions are also taxable to you. Say that you earned 1% on the excess. That $65 will be taxable to you, but it will be taxable the following year. 

In summary,

§  Your 2021 W-2 income goes up by $6,500

§  You will report the $65 earnings on the excess contribution in 2022.

    It is a mess, but the second option is worse.

(2)  You do not contact one of the employers, or you contact them too late for them to react by April 15.

Your 2021 W-2s show excessive 401(k) deferral.

Your tax preparer will probably catch this and increase your taxable W-2 totals by $6,500. This is what created the accountant’s question at the beginning of this post.

Oh well, you say. You are back to the same place as option one. No harm, no foul – right?

Not quite. 

First, your employer may not be too happy if the issue is later discovered. This is an operational plan issue, and there can be penalties for operational plan issues. 

Second, once you go past the time allowed for correction, the money is stuck in the plan until you are allowed take a distribution (or until the employer learns of the issue and corrects the plan on its own power). 

Say you never tell them. Let’s not burn this bridge, right? 

Problem. Take a look at this bad boy: 

                 Section 402(g)(6)  Coordination with section 72 .

For purposes of applying section 72 , any amount includible in gross income for any taxable year under this subsection but which is not distributed from the plan during such taxable year shall not be treated as investment in the contract.

What does this assemblage of mostly unintelligible words mean?    

It means that you will be taxed again when the 401(k) finally distributes the excess contribution to you. 

Yep, you will be taxed twice on the same income. 

That $6,500 got expensive. 

Upon reflection, there really is no option 2. You have to tell your employer and have them correct the W-2.      

Deducting “Tax Insurance” Premiums

 There is an insurance type that I have never worked with professionally: tax liability insurance.

It is what it sounds like: you are purchasing an insurance policy for unwanted tax liabilities.

It makes sense in the area of Fortune 500 mergers and acquisitions. Those deals are enormous, involving earth-shaking money and a potentially disastrous tax riptide if something goes awry. What if one the parties is undergoing a substantial and potentially expensive tax examination? What if the IRS refuses to provide advance guidance on the transaction? There is a key feature to this type of insurance: one is generally insuring a specific transaction or limited number of transactions. It is less common to insure an entire tax return.  

My practice, on the other hand, has involved entrepreneurial wealth – not institutional money - for almost my entire career. On occasion we have seen an entrepreneur take his/her company public, but that has been the exception. Tax liability insurance is not a common arrow in my quiver. For my clients, representation and warranty insurance can be sufficient for any mergers and acquisitions, especially if combined with an escrow.

Treasury has been concerned about these tax liability policies, and at one time thought of requiring their mandatory disclosure as “reportable” transactions. Treasury was understandably concerned about their use with tax shelter activities. The problem is that many routine and legitimate business transactions are also insured, and requiring mandatory disclosure could have a chilling effect on the pricing of the policies, if not their very existence. For those reasons Treasury never imposed mandatory disclosure.

I am looking at an IRS Chief Counsel Memorandum involving tax liability insurance.

What is a Memorandum?

Think of them as legal position papers for internal IRS use. They explain high-level IRS thinking on selected issues.

The IRS was looking at the deductibility by a partnership of tax insurance premiums. The partnership was insuring a charitable contribution.

I immediately considered this odd. Who insures a charitable contribution?

Except …

We have talked about a type of contribution that has gathered recent IRS attention: the conservation easement.

The conservation easement started-off with good intentions. Think of someone owning land on the outskirts of an ever-expanding city. Perhaps that person would like to see that land preserved – for their grandkids, great-grandkids and so on – and not bulldozed, paved and developed for the next interchangeable strip of gourmet hamburger or burrito restaurants. That person might donate development rights to a charitable organization which will outlive him and never permit such development. That right is referred to as an easement, and the transfer of the easement (if properly structured) generates a charitable tax deduction.

There are folks out there who have taken this idea and stretched it beyond recognition. Someone buys land in Tennessee for $10 million, donates a development and scenic easement and deducts $40 million as a charitable deduction. Promoters then ratcheted this strategy by forming partnerships, having the partners contribute $10 million to purchase land, and then allocating $40 million among them as a charitable deduction. The partners probably never even saw the land. Their sole interest was getting a four-for-one tax deduction.

The IRS considers many of these deals to be tax shelters.

I agree with the IRS.

Back to the Memorandum.

The IRS began its analysis with Section 162, which is the Code section for the vast majority of business deductions on a tax return. Section 162 allows a deduction for ordinary and necessary expenses directly connected with or pertaining to a taxpayer’s trade or business.

Lots of buzz words in there to trip one up.

You my recall that a partnership does not pay federal tax. Instead, its numbers are chopped up and allocated to the partners who pay tax on their personal returns.

To a tax nerd, that beggars the question of whether the Section 162 buzz words apply at the partnership level (as it does not pay federal tax) or the partner level (who do pay federal tax).

There is a tax case on this point (Brannen). The test is at the partnership level.

The IRS reasoned:

·      The tax insurance premiums must be related to the trade or business, tested at the partnership level.

·      The insurance reimburses for federal income tax.

·      Federal income tax itself is not deductible.

·      Deducting a premium for insurance on something which itself is not deductible does not make sense.

There was also an alternate (but related argument) which we will not go into here.

I follow the reasoning, but I am unpersuaded by it.

·      I see a partnership transaction: a contribution.

·      The partnership purchased a policy for possible consequences from that transaction.

·      That – to me - is the tie-in to the partnership’s trade or business.

·      The premium would be deductible under Section 162.

I would continue the reasoning further.

·      What if the partnership collected on the policy? Would the insurance proceeds be taxable or nontaxable?

o  I would say that if the premiums were deductible on the way out then the proceeds would be taxable on the way in.

o  The effect – if one collected – would be income far in excess of the deductible premium. There would be no further offset, as the federal tax paid with the insurance proceeds is not deductible.

o  Considering that premiums normally run 10 to 20 cents-on-the-dollar for this insurance, I anticipate that the net tax effect of actually collecting on a policy would have a discouraging impact on purchasing a policy in the first place.

The IRS however went in a different direction.

Which is why I am thinking that – albeit uncommented on in the Memorandum – the IRS was reviewing a conservation easement that had reached too far. The IRS was hammering because it has lost patience with these transactions.

No Shareholder, No S Corporation Election

 Our case this time takes us to Louisville.

There is a nonprofit called the Waterfront Development Corporation (WDC). It has existed since 1986, and its mission is to development, redevelop and revitalize certain industrial areas around the Ohio river downtown. I would probably shy away from getting involved - anticipating unceasing headaches from the city, Jefferson county and the Commonwealth of Kentucky - but I am glad that there are people who will lift that load.

One of those individuals was Clinton Deckard, who wanted to assist WDC financially, and to that effect he formed Waterfront Fashion Week Inc. (WFWI) in 2012. WFWI was going to organize and promote Waterfront Fashion Week – essentially a fundraiser for WDC.

Seems laudable.

Mr Deckard had been advised to form a nonprofit, on the presumption that a nonprofit would encourage people and businesses to contribute. He saw an attorney who organized WFWI as a nonprofit corporation under Kentucky statute.

Unfortunately, Waterfront Fashion Week failed to raise funds; in fact, it lost money. Mr Deckard wound up putting in more than $275,000 of his own money into WFWI to shore up the leaks. There was nothing to contribute to WDC.  What remained was a financial crater-in-the-ground of approximately $300 grand. Whereas WFWI had been organized as a nonprofit for state law purposes, it had not obtained tax-exempt status from the IRS. If it had, Mr Deckard could have gotten a tax-deductible donation for his generosity.

COMMENT: While we use the terms “nonprofit” and “tax-exempt” interchangeably at times, in this instance the technical difference is critical. WFWI was a nonprofit because it was a nonprofit corporation under state law. If it wanted to be tax-exempt, it had to keep going and obtain exempt status from the IRS.  One has to be organized under as a nonprofit for the IRS to consider tax-exempt status, but there also many more requirements.

No doubt Mr Deckard would have just written a check for $275 grand to WDC had he foreseen how this was going to turn out. WDC was tax-exempt, so he could have gotten a tax-deductible donation. As it was, he had ….

…. an idea. He tried something. WFWI had never applied for tax-exempt status with the IRS.

WFWI filed instead for S corporation status. Granted, it filed late, but there are procedures that a knowledgeable tax advisor can use. Mr Deckard signed the election as president of WFWI. An S election requires S corporation tax returns, which it filed. Mind you, the returns were late – the tax advisor would have to face off against near-certain IRS penalties - but it was better than nothing.

Why do this?

An S corporation generally does not pay tax. Rather it passes its income (or deductions) on to its shareholders who then include the income or deductions with their other income and deductions and then pay tax personally on the amalgamation

It was a clever move.

Except ….

Remember that the attorney organized WFWI as a nonprofit corporation under Kentucky statute.

So?

Under Kentucky law, a nonprofit corporation does not have shareholders.

And what does the tax Code require before electing S corporation status?

Mr Deckard has to be a shareholder in the S corporation.

He tried, he really did. He presented a number of arguments that he was the beneficial owner of WFWI, and that beneficial status was sufficient to allow  an S corporation election.

But a shareholder by definition would get to share in the profits or losses of the S corporation. Under Kentucky statute, Mr Deckard could NEVER participate in those profits or losses. Since he could never participate, he could never be a shareholder as intended by the tax Code. There was no shareholder, no S corporation election, no S corporation – none of that.

He struck out.

The sad thing is that it is doubtful whether WFWI needed to have organized as a nonprofit in the first place.

Why do I say that?

If you or I make a donation, we need a tax-exempt organization on the other side. The only way we can get some tax pop is as a donation.

A business has another option.

The payment could just be a trade or business expense.

Say that you have a restaurant downtown (obviously pre-COVID days). You send a check to a charitable event that will fill-up downtown for a good portion of the weekend. Is it a donation? Could be. It could also be just a promotion expense – there are going to be crowds downtown, you are downtown, people have to eat, and you happen to be conveniently located to the crowds. Is that payment more-than-50% promotion or more-than-50-% donation?

I think of generosity when I think of a donation. I think of return-on-investment when I think of promotion or business expenses.

What difference does it make? The more-than-50% promotion or business deduction does not require a tax-exempt on the other side. It is a business expense on its own power; it does not need an assist.

I cannot help but suspect that WFWI was primarily recruiting money from Louisville businesses. I also suspect that many if not most would have had a keen interest in downtown development and revitalization. Are we closer to our promotion example or our donation example?

Perhaps Mr Deckard never needed a nonprofit corporation.

The Tax Doctrine Of The Fruit And The Tree

 

I am uncertain what the IRS saw in the case. The facts were very much in the taxpayer’s favor.

The IRS was throwing a penalty flag and asking the Court to call an assignment of income foul.

Let’s talk about it.

The tax concept for assignment-of-income is that a transaction has progressed so far that one has – for all real and practical purposes – realized income. One is just waiting for the check to arrive in the mail.

But what if one gives away the transaction – all, part or whatever – to someone else? Why? Well, one reason is to move the tax to someone else.

A classic case in this area is Helvering v Horst. Horst goes back to old days of coupon bonds, which actually had perforated coupons. One would tear-off a coupon and redeem it to receive an interest check. In this case the father owned the bonds. He tore off the coupons and gave them to his son, who in turn redeemed them and reported the income. Helvering v Horst gave tax practitioners the now-famous analogy of a tree and its fruit. The tree was the bond, and the fruit was the coupon. The Court observed:

… The fruit is not to be attributed to a different tree from that on which it grew.”

The Court decided that the father had income. If he wanted to move the income (the fruit) then he would have to move the bond (the tree).

Jon Dickinson (JD) was the chief financial officer and a shareholder of a Florida engineering firm. Several shareholders – including JD – had requested permission to transfer some of their shares to the Fidelity Charitable Gift Fund (Fidelity). Why did they seek permission? There can be several reasons, but one appears key: it is Fidelity’s policy to immediately liquidate the donated stock. Being a private company, Fidelity could not just sell the shares in the stock market. No, the company would have to buy-back the stock. I presume that JD and the others shareholders wanted some assurance that the company would do so.

JD buttoned-down the donation:

·      The Board approved the transfers to Fidelity.

·      The company confirmed to Fidelity that its books and records reflected Fidelity as the new owner of the shares.

·      JD also sent a letter to Fidelity with each donation indicating that the transferred stock was “exclusively owned and controlled by Fidelity” and that Fidelity “is not and will not be under any obligation to redeem, sell or otherwise transfer” the stock.

·      Fidelity sent a letter to JD after each donation explaining that it had received and thereafter exercised “exclusive legal control over the contributed asset.”

So what did the IRS see here?

The IRS saw Fidelity’s standing policy to liquidate donated stock. As far as the IRS was concerned, the stock had been approved for redemption while JD still owned it. This would trigger Horst – that is, the transaction had progressed so far that JD was an inextricable part. Under the IRS scenario, JD would have a stock redemption – the company would have bought-back the stock from him and not Fidelity – and he would have taxable gain. Granted, JD would also have a donation (because he would have donated the cash from the stock sale to Fidelity), but the tax rules on charitable deductions would increase his income (for the gain) more than the decrease in his income (for the contribution). JD would owe tax.

The Court looked at two key issues:

(1)  Did JD part with the property absolutely and completely?

This one was a quick “yes.” The paperwork was buttoned-up as tight as could be.

(2)  Did JD donate the property before there was a fixed and determinable right to sale?

You can see where the IRS was swinging. All parties knew that Fidelity would redeem the stock; it was Fidelity’s policy. By approving the transfer of shares, the company had – in effect – “locked-in” the redemption while JD still owned the stock. This would trigger assignment-of-income, argued the IRS.

Except that there is a list of cases that look at formalities in situations like this. Fidelity had the right to request redemption – but the redemption had not been approved at the time of donation. While a seemingly gossamer distinction, it is a distinction with tremendous tax weight. Make a sizeable donation but fail to get the magic tax letter from the charity; you will quickly find out how serious the IRS is about formalities. Same thing here. JD and the company had checked all the boxes.

The Court did not see a tree and fruit scenario. There was no assignment of income. JD got his stock donation.

Our case this time was Dickinson v Commissioner, TC Memo 2020-128.

This Is Why We Cannot Have Nice Things

I am looking at a case involving a conservation easement.

We have talked about easements before. There is nothing innately sinister about them, but unfortunately they have caught the eye of people who have … stretched them beyond recognition.

I’ll give you an example of an easement:

·      You own land in a bucolic setting.

·      It is your intention to never part with the land.

·      It is liturgy to the beauty and awe of nature. You will never develop it or allow it to be developed.

If you feel that strongly, you might donate an easement to a charitable organization who can see to it that the land is never developed. It can protect and defend long after you are gone.

Question: have you made a donation?

I think you have. You kept the land, but you have donated one of your land-related legal rights – the right to develop the land.

What is this right worth?

That is the issue driving this area of tax controversy.

What if the land is on the flight path for eventual population growth and development? There was a time when Houston’s Galleria district, for example, was undeveloped land. Say you had owned the land back when. What would that easement have been worth?

You donated a potential fortune.

Let’s look at a recent case.

Plateau Holdings LLC (Plateau) owned two parcels of land in Tennessee. In fact, those parcels were the only things it owned. The land had been sold and resold, mined, and it took a while to reunite the surface and mineral rights to obtain full title to the land. It had lakes, overlooks, waterfalls and sounded postcard-worthy; it was also a whole lot out-of-the-way between Nashville and Chattanooga. Just to get utilities to the property would probably require the utility company to issue bonds to cover the cost.

Enter the investor.

He bought the two parcels (actually 98.99%, which is close enough) for approximately $5.8 million.

He worked out an arrangement with a tax-exempt organization named Foothills Land Conservancy. The easement would restrict much of the land, with the remainder available for development, commercial timber, hunting, fishing and other recreational use.

Routine stuff, methinks.

The investor donated the easement to Foothills eight days after purchasing the land.

Next is valuing the easement

Bring in the valuation specialist. Well, not actually him, as he had died before the trial started, but others who would explain his work. He had valued the easement at slightly over $25 million.

Needless to say, the IRS jumped all over this.

The case goes on for 40 pages.

The taxpayer argument was relatively straightforward. The value of the easement is equal to the reduction in the best and highest use value of the land before and after the granting of the easement.

And how do you value an undeveloped “low density mountain resort residential development”? The specialist was looking at properties in North Carolina, Georgia, and elsewhere in Tennessee. He had to assume government zoning, that financing would be available, that utilities and roads would be built, that consumer demand would exist.

There is a flight of fancy to this “best and highest” line of reasoning.

For example, I would have considered my best and highest professional “use” to be a long and successful career in the NFL. I probably would have been a strong safety, a moniker no longer used in today’s NFL (think tackling). Rather than playing on Sundays, I have instead been a tax practitioner for more than three decades.

According to this before-and-after reasoning, I should be able to deduct the difference between my earning power as a successful NFL Hall of Famer and my actual career as a tax CPA. I intend to donate that difference to the CTG Foundation for Impoverished Accountants.

Yeah, that is snark.

What do I see here?

·      Someone donated less than 100% of something.

·      That something cost about $6 million.

·      Someone waited a week and gave some of that something away.

·      That some of something was valued at more than four times the cost of the entire something. 

Nah, not buying it.

Neither did the Court.

Here is one of the biggest slams I have read in tax case in a while:

           We give no weight to the opinion of petitioner’s experts.”

The taxpayer pushed it too far.

Our case this time for the home gamers was Plateau Holdings LLC v Commissioner.