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.

The $64 Million Question

Let’s talk about hard rules in the tax Code.

Let’s say that you donate $500 to your church or synagogue. You come to see me to prepare your taxes. I ask you whether you have received a letter concerning that $500 donation.

You think that I am a loon. You after all have the cancelled check. What more does the government want?

That’s the problem.

Here’s the rule:

A single contribution of $250 or more – whether by cash, check or credit card – must be supported by a receipt that meets the following requirements:

a.    It must identify the amount.

b.    It must state that no goods or services were given in exchange (alternatively, it must subtract said goods and benefits from the donation if such were given); and

c.     The taxpayer must have such receipt before filing his/her tax return.

To restate this: you can give the IRS a cancelled check and it will not be enough to save your contribution deduction - if that deduction is over $250.

The tax Code is spring-loaded with traps like this. Congress and the IRS say this is necessary for effective tax administration. Nonsense. What they are interested in is taking your money.

There is a super-sized type of charitable deduction known as an “easement.” Think real property, like land or a building. The concept is that real estate is a combination of legal rights: the right to ownership, to development, to habitation, to just leave it alone and look at it.

Let’s say that you own a historical building in name-a-town USA. Chances are that restrictions are in place disallowing your ability to upsize, downsize, renovate the place or whatever. You decide to donate a “façade” easement, meaning that you will not mess with the exterior of the building. Well, messing with the exterior of the building is one of those legal rights that together amalgamate to form real estate, and you just gave one such right away. Assuming that a value can be placed on it, you may have a charitable donation.   

There are a couple of questions that come to mind immediately:

(1) Depending upon the severity of town restrictions, you may not have had a lot of room to alter the exterior anyway. You may not have given away much, in truth.

(2) Even hurdling (1), how do you value the donation?

Sure enough, there are people who value such things.

That is one thing about the tax Code: Congress is always employing somebody to do something whenever it changes the rules, and it is forever changing the rules. Virtually all tax bills are jobs bills. We can question whether those jobs are useful to society, but that is a different issue.

You will not be surprised that a super deduction brings with it super rules:

(1) One must attached a specific tax form (8283)

(2) One must attach a qualified appraisal

(3) One must attach a photograph of the building exterior

(4) One must attach a description of all restrictions on the building

There is an LLC in New York that claimed a 2007 easement deduction of $64.5 million.

Folks, you know this is going to be looked at.  

Let’s set the trap:

The LLC received a letter from the charity acknowledging the easement. Assuming the return had been extended, this would have been a timely letter.

However, the letter did not contain all the “magic words” necessary to perform the required tax incantation. More specifically, it did not say whether the charity had provided any benefits to the LLC in return.

Guess who gets pulled for audit in 2011? Yeah, a $64 million-plus easement donation will do that.

While preparing for audit, the tax advisors realized that they did not have all the magic words. They contacted the charity, which in turn amended its 2007 Form 990 to upgrade the information provided about the donation.

Strikes you as odd?

Here is what the LLC was after:

IRC Section 170(f)(8):

(A) General rule

No deduction shall be allowed under subsection (a) for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization that meets the requirements of subparagraph (B).

(D) Substantiation not required for contributions reported by the donee organization

Subparagraph (A) shall not apply to a contribution if the donee organization files a return, on such form and in accordance with such regulations as the Secretary may prescribe, which includes the information described in subparagraph (B) with respect to the contribution.

The LLC was after that “(A) shall not apply if the donee organization files a return” language. The charity amended its return, after all, to beef-up its disclosure of the easement donation.

Nix, said the IRS. All that hullabaloo was predicated on “regulations as the Secretary may prescribe.” And guess what: the Secretary did not prescribe Regulations.

Do you remember about a year ago when we talked about charitable organizations issuing 1099-like statements to their donors? We here at CTG did not care for that idea very much, especially in an era of increasing identity theft. Many charities are small and simply do not have the systems and resources to secure this information.

Well, that was also the IRS trying to prescribe under Section 170(f)(8)(D). You may remember the IRS took a tremendous amount of criticism, after which it withdrew its 1099-like proposal.

The LLC argued that Congress told the IRS to issue rules under Section 170(f)(8)(D) but the IRS did not. It was unfair to penalize the LLC when the IRS did not do its job.

The IRS took a very different tack. It argued that Section 170(f)(8)(D) gave it discretionary and not mandatory authority. The IRS could issue regulations but did not have to. In the jargon, that section was not “self-executing.”

The Tax Court had to decide a $64 million question.

And the Tax Court said the IRS was right.

At which point the LLC had to meet the requirements discussed earlier, including:

The taxpayer must have such receipt before filing his/her tax return.

It had no such receipt before filing its return.

It now had no $64.5 million deduction. 

The taxpayer was 15 West 17th Street, and they ran into an unforgiving tax rule. I am not a fan of all-or-nothing-magic-tax-incantations, as the result appears ... unfair, inequitable, almost cruel ... and as if tax compliance is a cat-and-mouse game.

Does The IRS Want 1099s For Your Contributions?

I have been thinking about a recent IRS notice of proposed rulemaking. The IRS is proposing rules under its own power, arguing that it has the authority to do so under existing law.

This one has to do with charitable contributions.

You already know that one should retain records to back up a tax return, especially for deductions. For most of us that translates into keeping receipts and related cancelled checks.

Contributions are different, however.

In 1993 Congress passed Code section 170(f)(8) requiring you to obtain a letter (termed “contemporaneous written acknowledgement”) from the charity to document any donation over $250.  If you do not have a letter the IRS will disallow your deduction upon examination.

Congress felt that charitable contributions were being abused. How? Here is an example: you make a $5,000 donation to the University of Kentucky and in turn receive season tickets – probably to football, as the basketball tickets are near impossible to get. People were deducting $5,000, when the correct deduction would have been $5,000 less the value of those season tickets. Being unhappy to not receive 100 percent of your income, Congress blamed the “tax gap” and instituted yet more rules and requirements.

So begins our climb on the ladder to inanity.

Soon enough taxpayers were losing their charitable deductions because they failed to obtain a letter or failed to receive one timely. There were even cases where all parties knew that donations had been made, but the charity failed to include the “magic words” required by the tax Code.

Let’s climb on.

In October, 2015 the IRS floated a proposal to allow charities to issue Forms 1099s in lieu of those letters. Mind you, I said “allow.” Charities can continue sending letters and disregard this proposal.

If the charity does issue, then it must also forward a copy of the 1099s to the IRS. This has the benefit of sidestepping the donor’s need to get a timely letter from the charity containing the magic words.

Continue climbing: for the time-being charities have to disregard the proposal, as the IRS has not designed a Form 1099 even if the charity were interested.  Let’s be fair: it is only a proposal. The IRS wanted feedback from the real world before it went down this path.

Next rung: why would you give your social security number to a charity – for any reason? The Office of Personnel Management could not safeguard more than 20 million records from a data hack, but the IRS wants us to believe that the local High School Boosters Club will?

Almost there: the proposal is limited to deductible contributions, meaning that its application is restricted to Section 501(c)(3) organizations. Only (c)(3)s can receive deductible contributions.

But there is another Section 501 organization that has been in the news for several years – the 501(c)(4). This is the one that introduced us to Lois Lerner, the resignation of an IRS Commissioner, the lost e-mails and so on. A significant difference between a (c)(3) and a (c)(4) is the list of donors. A (c)(3) requires disclosure of donors who meet a threshold. A (c)(4) requires no disclosure of donors.    

You can guess how much credibility the IRS has when it says that it has no intention of making the 1099 proposal mandatory for (c)(3)s - or eventually extending it to also include (c)(4)s.

We finally reached the top of the ladder. What started as a way to deal with a problem (one cannot deduct those UK season tickets) morphed into bad tax law (no magic beans means no deduction) and is now well on its way to becoming another government-facilitated opportunity for identity theft.

The IRS Notice concludes with the following:

Given the effectiveness and minimal burden of the CWA process, it is expected that donee reporting will be used in an extremely low percentage of cases.”

Seems a safe bet.

UPDATE: After the writing of this post, the IRS announced that it was withdrawing these proposed Regulations. The agency noted that it had received approximately 38,000 comments, the majority of which strongly opposed the rules. Hey, sometimes the system works.

My Hypothetical Family Foundation

I deeply doubt that I will ever fund a private foundation. However, all things are possible until they are not, so it may yet happen.

And private foundations have been in the news recently, as you know.

What are these things, and how are they used?

Let us start with what a private foundation is.

First, the terms “private foundation” and “family foundation” are often interchanged.  If it is private enough, the only donors to the foundation are one family.

Second, it is a type of tax-exempt. It can accept tax-deductible donations, but the overall limit on the deduction is lower than for donations to a 501(c)(3).  It is not completely tax-exempt, however, as it does have to pay a 2% tax annually. I suspect however most of us would leap at an opportunity to pay a 2% tax.  Depending on what the foundation does, it may be possible to reduce that tax further to just 1%.

Third, what is the word “private” doing in there?

That “private” is the big difference from a (c)(3).

Generally speaking, a private foundation does not even pretend that it is broadly supported. To contrast, a (c)(3) has to show on its Form 990 that it is publicly-supported, meaning that it receives donations from a large number of people. Calling it a private – or family - foundation clues you that it is disproportionately funded by one family. When I hit the lottery there will be a Hamilton Family Foundation, funded by one family – mine.

There are two key reasons that someone would establish a private foundation:

(1)  one has accumulated wealth and wants to give back through philanthropy; and

(2)  to provide income for someone.

The first reason is quite common, and the private foundation has a lot to commend it. Let’s say that I sign an NFL contract and receive a $25 million signing bonus. That is an excellent year to fund the Hamilton Family Foundation, as (i) I have the cash and (ii) I could use the tax deduction. An additional attractive feature is that I could fund the foundation in one year but spread the charitable distributions over many years. The tax Code requires a foundation to distribute a minimum amount annually, generally defined as 5% of assets. Assuming no rate of return on investments, I could keep the Hamilton Family Foundation functioning for 20 years off that one-time infusion.

I have had clients that use a foundation as a focal point for family giving. It allows multiple generations to come together and decide on causes and charities, and it helps to instill a spirit of giving among the younger family members.

The second reason is to provide an income stream to someone, such as an unemployable family member or friends and associates that one wants to reward.  An easy enough way to do so is to put them on the Board – and then pay trustee fees. This is more the province of the larger foundations, as it is unlikely that a foundation with $2 million or $3 million in investments could sustain such payouts. I myself would not be interested in providing an income stream, but I might be interested in a foundation that provided college grants to students who are residents of Kentucky, attend the University of Tennessee and have the last name "Hamilton."

The ongoing issue with private foundations is the outsized influence of one family on a tax-favored entity. Congress has tried over the years to tighten the rules, resulting in a bewildering thicket of rules:

(1) There is a tax if the foundation owns 20% or more of a business. Congress does not want foundations running a business.

(2) The foundation managers have to exercise common sense and business prudence when selecting investments.  Stray too far and there is a penalty on investments which “jeopardize” the charitable purpose.

Note the reference to the charitable purpose. Let’s say the Romanov Foundation’s purpose is to promote small business in economically disadvantaged areas. Let’s say it made a high-risk loan to business-people interested in opening a shopping center in such an area. Most likely, that loan would not jeopardize its exempt purpose, whereas the same loan by the Hamilton Family Foundation would. 

(3) Generally speaking, foundations that make grants to individuals must seek advance approval from the IRS and agree to maintain detailed records including recipient names, addresses, manner of selection, relationship with foundation insiders and so forth. As a consequence, it is common for foundations to not make contributions to a payee who is not itself a 501(c)(3). Apparently Congress realized that - if it did not impose this restriction - someone would claim a charitable deduction for sending his/her kids through college. 

(4) Certain transactions between the foundation and disqualified persons are prohibited. Prohibited transactions include the sale or leasing of property, the loaning of money, the use of foundation property (if unrelated to carrying out the exempt purpose of the foundation), paying excessive compensation or reimbursing unreasonable or unnecessary expenses.

Who are disqualified persons? The group would include officers, directors, foundation managers (a term of art in this area), substantial contributors and their families. I would be a disqualified person to the Hamilton Family Foundation, for example, as I would be a substantial contributor. 

Would prohibited transactions include the travel and entourage expenses of an ex-President and politico spouse receiving speaking and appearance fees not otherwise payable to their foundation?  Tax law is ... elastic on this point. I am thinking of including a tax education purpose for the Hamilton Family Foundation so I can, you know, travel the world researching blog topics and have my expenses paid directly or otherwise reimbursed to me.

For many years the IRS enforced compliance by wielding the threat of terminating the tax-favored status. It did not work well, frankly, as the IRS was hesitant to sign a death sentence unless the foundation had pushed the matter beyond all recognizable limits.

Congress then expanded the panoply of tax penalties applicable to tax-exempts, including both (c)(3)’s and private foundations. These penalties have come to be known as the “intermediate” sanctions, as they stop short of the death sentence. Penalties can be assessed against both the foundation and its officers or managers. There can even be a second round of penalties if the foundation does not correct the error within a reasonable period of time. Some of these penalties can reach 200% and are not to be taken lightly.

There is wide variation in the size of private foundations, by the way. Our hypothetical Hamilton Family Foundation would be funded with a few million dollars. Contrast that with the Bill and Melinda Gates Foundation, with net assets over $40 billion. It is an aircraft carrier in the marina of foundations, yet it is considered "private" because of its disproportionate funding by one or a limited number of families.