The Sum Of The Parts Is Less Than The Whole

 

I am looking at a case involving valuations.

The concept starts easily enough:

·      Let’s say that your family owns a business.  

·      You personally own 20% of the business.

·      The business has shown average profits of $1 million per year for years.

·      Altria is paying dividends of over 7%, which is generous in today’s market. You round that off to 8%, considering that rate fair to both you and me.

·      The multiple would therefore be 100% divided by 8% = 12.5.   

·      You propose a sales price of $1,000,000 times 12.5 times 20% = $2.5 million.  

Would I pay you that?

Doubt it.

Why?

Let’s consider a few things.

·      It depends whether 8 percent is a fair discount rate.  Considering that I could buy Altria and still collect over 7%, I might decide that a skinny extra 1% just isn’t worth the potential headache.

·      I can sell Altria at any time. I cannot sell your stock at any time, as it is not publicly-traded. I may as well buy a timeshare.

·      I am reasonably confident that Altria will pay me quarterly dividends, because they have done so for decades. Has your company ever paid dividends? If so, has it paid dividends reliably? If so, how will the family feel about continuing that dividend policy when a non-family member shows up at the meetings? If the family members work there, they might decide to increase their salaries, stop the dividends (as their bumped-up salaries would replace the lost dividends) and just starve me out.

·      Let’s say that the family in fact wants me gone. What recourse do I – as a 20% owner – have? Not much, truthfully. Own 20% of Apple and you rule the world. Own 20% of a closely-held that wants you gone and you might wish you had never become involved.

This is the thought process that goes into valuations.

What are valuations used for?

A ton of stuff:

·      To buy or sell a company

·      To determine the taxable consequence of nonqualified deferred compensation

·      To determine the amount of certain gifts

·      To value certain assets in an estate

What creates the tension in valuation work is determining what owning a piece of something is worth – especially if that piece does not represent control and cannot be easily sold. Word: reasonable people can reasonably disagree on this number.

Let’s look at the Estate of Miriam M. Warne.

Ms Warne (and hence the estate) owned 100% of Royal Gardens, a mobile home park. Royal Gardens was valued – get this - at $25.6 million on the estate tax return.

Let’s take a moment:

Q: Would our discussion of discounts (that is, the sum of the parts is less than the whole) apply here?

A: No, as the estate owned 100% - that is, it owned the whole.

The estate in turn made two charitable donations of Royal Gardens.

The estate took a charitable deduction of $25.6 million for the two donations.

The IRS said: nay, nay.

Why?

The sum of the parts is less than the whole.

One donation was 75% of Royal Gardens.  

You might say: 50% is enough to control. What is the discount for?

Here’s one reason: how easy would it be to sell less-than-100% of a mobile home park?

The other donation was 25%.

Yea, that one has it all: lack of control, lack of marketability and so on.

The attorneys messed up.

They brought an asset into the estate at $25.6 million.

The estate then gave it away.

But it got a deduction of only $21.4 million.

Seems to me the attorneys stranded $4.2 million in the estate.

Our case this time was the Estate of Miriam M. Warne, T.C. Memo 2021-17.

Qualifying As A Real Estate Professional

 

The first thing I thought when I read the opinion was: this must have been a pro se case.

“Pro se”” has a specific meaning in Tax Court: it means that a taxpayer is not represented by a professional. Technically, this is not accurate, as I could accompany someone to Tax Court and they be considered pro se, but the definition works well enough for our discussion.

There is a couple (the Sezonovs) who lived in Ohio. The husband (Christian) owned an HVAC company and ran it as a one-man gang for the tax years under discussion.

In April 2013 they bought rental property in Florida. In November 2013 they bought a second. They were busy managing the properties:

·      They advertised and communicated with prospective renters.

·      They would clean between renters or arrange for someone to do so.

·      They hired contractors for repairs to the second property.

·      They filed a lawsuit against the second condo association over a boat slip that should have been transferred with the property.

One thing they did not do was to keep a contemporaneous log of what they did and when they did it. Mind you, tax law does not require you to write it down immediately, but it does want you to make a record within a reasonable period. The Court tends to be cynical when someone creates the log years after the fact.

The case involves the Sezonovs trying to deduct rental losses. There are two general ways you can coax a deductible real estate rental loss onto your return:

(1) Your income is between a certain range, and you actively participate in the property. The band is between $1 and $150,000 for marrieds, and the Code will allow one to deduct up to $25 grand. The $25 grand evaporates as income climbs from $100 grand to $150 grand.

(2)  One is a real estate professional.

Now, one does not need to be a full-time broker or agent to qualify as a real estate professional for tax purposes. In fact, one can have another job and get there, but it probably won’t be easy.

Here is what the Code wants:

·      More than one-half of a person’s working hours for the year occur in real estate trades or businesses; and

·      That person must rack-up at least 750 hours of work in all real estate trades or businesses.

Generally speaking, much of the litigation in this area has to do with the first requirement. It is difficult (but not impossible) to get to more-than-half if one is working outside the real estate industry itself. It would be near impossible for me to get there as a practicing tax CPA, for example.

One more thing: one person in the marriage must meet both of the above tests. There is no sharing.

The Sezonovs were litigating their 2013 and 2014 tax years.

First order of business: the logs.

Which Francine created in 2019 and 2020.

Here is what Francine produced:

                                     Christian              Francine

2013 hours                        405                      476                

2014 hours                         26                        80                 

Wow.

They never should have gone to Court.

They could not meet one of the first two rules: at least 750 hours.

From everything they did, however, it appears to me that they would have been actively participating in the Florida activities. This is a step down from “materially participating” as a real estate pro, but it is something. Active participation would have qualified them for that $25-grand-but-phases-out tax break if their income was less than $150 grand. The fact that they went to Court tells me that their income was higher than that.

So, they tried to qualify through the second door: as a real estate professional.

They could not do it.

And I have an opinion derived from over three decades in the profession: the Court would not have allowed real estate pro status even if the Sezonovs had cleared the 750-hour requirement.

Why?

Because the Court would have been cynical about a contemporaneous log for 2013 and 2014 created in 2019 and 2020. The Court did not pursue the point because the Sezonovs never got past the first hurdle.

Our case this time was Sezonov v Commissioner. T.C. Memo 2022-40.

A Model Home As A Business

 

What does a tax CPA do a few days after the filing deadline?

This one is reviewing a 17-page Tax Court case.

Yes, I would rather be watching the new Batman movie. There isn’t much time for such things during busy season. Maybe tomorrow.

Back to the case.

There is a mom and dad and daughter. Mom and dad (the Walters) lived in Georgia. They had launched three successful business in Michigan during the 70s and 80s. They thereafter moved to Georgia to continue their winning streak by developing and owning La-Z-Boy stores.

During the 90s dad invested in and subsequently joined the board of an environmentally oriented Florida company. He followed the environmental field and its technology, obtained certifications and even guest lectured at Western Carolina University.

Daughter received an undergraduate degree in environmental science and then a law degree at a school offering a focus on environmental law.

After finishing law school, daughter informed her parents that she was not interested in the furniture business. Mom and dad sold the La-Z-Boy businesses but kept the real estate in an entity called D&J Properties. They were now landlords to La-Z-Boy stores.

The family decided to pivot D&J by entering the green real estate market.

Through the daughter’s connections, mom and dad became aware of a low-density housing development in North Carolina, emphasizing land conservation and the incorporation of geothermal and solar technologies.

You know this caught dad and daughter’s attention.

They bought a lot. They built a house (Balsam Home). They stuck it in D&J Properties. The house received awards. Life was good.

They received an invitation to participate in a “Fall Festival of Color.” Current and potential property owners would tour Balsam Home, meet with members of the team and attend a panel discussion. Word went out to the media, including the Atlanta Journal-Constitution.

Balsam Home became a model home for the development. Awards and certificates were hung on the walls, pamphlets about green technology were placed on coffee tables. A broker showed Balsam Home when mom and dad were back at their regular residence.

Sometimes the line blurred between model home and “home” home. Mom and dad registered cars at the Balsam Home address, for example, and dad availed himself of a golf membership. On the flip side, the green technology required one to be attentive and hands-on, and mom and dad did most of that work themselves.

Where is the tax issue here?

Balsam Home never showed a profit.

The La-Z-Boy stores did.

The IRS challenged D&J Properties, arguing that Balsam Home was not a business activity conducted for profit and therefore its losses could not offset the rental income from the furniture stores.

This “not engaged in for profit” challenge is more common than you may think. I am thinking of the following from my own recent-enough experience:

·      A mom supporting her musically inclined twin sons

·      A young golfer hoping to go pro

·      A model certain to be discovered

·      A dancer determined she would join a professional company

·      A dressage rider meeting “all the right people” for later success

The common thread is that some activity does not make money, seems likely to never make money but is nonetheless pursued and continued, normally by someone having (or subsidized by someone having) enough other income or wealth to do so. It can be, in other words, a tax write-off.

But then again, someone will be the next Bruno Mars, Scottie Scheffler or Stevie Nicks. Is it a long shot? Sure, but there will be someone.

Not surprisingly, there is a grid of questions that the IRS and courts go through to weigh the decision. It is not quite as easy as having more “yes” than “no” answers, but you get the idea.

Here is a (very) quick recap of the grid:

·      Manner in which taxpayer carried on the activity

·      Taxpayer’s expertise

·      Taxpayer’s advisors’ expertise

·      Time and effort expended by the taxpayer

·      Expectation that activity assets will appreciate in value

·      Success of the taxpayer on carrying on similar activities

·      History of activity income and loss

·      Financial status of the taxpayer

·      Elements of personal pleasure or recreation

Let’s review a few.

·      Seems to me that mom, dad and daughter had a fairly strong background in green technology. The IRS disagreed, arguing “yes this but not that.”  The Court disagreed with the IRS.

·      Turns out that mom and dad put a lot of time into Balsam House, and much of that time was as prosaic as fertilizing, weeding and landscaping. The Court gave them this one.

·      Being real estate, it was assumed that the asset involved would appreciate in value.

o  BTW this argument is often used in long-shot race-horse challenges. Win a Kentucky Derby, for example, and all those losses pale in comparison to the future income.

·      I expected financial status to be a strong challenge by the IRS. Mom and dad owned those La-Z-Boy stores, for example. The Court took pains to point out that they had sold the stores but kept the real estate, so the ongoing income was not comparable. The Court called a push on this factor, which I considered quite generous.

The Court decided that the activity was conducted for profit and that losses could be used to offset income from the furniture stores.

A win for the taxpayers.

Could it have gone differently?

You bet. Court decisions in this area can be … quixotic.  

Our case this time was Walters v Commissioner, T.C. Memo 2022-17.

Taxing Foreign Investment In U.S. Real Estate

One of the Ps buzzed me about a dividend item on a year-end brokers’ statement.

P:      “What is a Section 897 gain?”

CTG: It has to do with the sale of real estate. It is extremely unlikely to affect any of our clients.

P:      Why haven’t I ever seen this before?

CTG: Because this is new tax reporting.

We are talking about something called the Foreign Investment in Real Property Tax Act, abbreviated FIRPTA and pronounced FERP-TUH. This thing has been around for decades, and it has nothing to do with most of us. The reporting, however, is new. To power it, you need a nonresident alien – that is, someone who is not a U.S. citizen or resident alien (think green card) – and who owns U.S. real estate. FIRPTA rears its head when that person sells said real estate.

This is specialized stuff.

We had several nonresident alien clients until we decided to exit that area of practice. The rules have reached the point of absurdity – even for a tax practitioner – and the penalties can be brutal. There is an encroaching, if unspoken, presumption in tax law that international assets or activities mean that one is gaming the system. Miss something – a form, a schedule, an extension, an election - and face a $10,000 penalty. The IRS sends this penalty notice automatically; they do not even pretend to have an employee review anything before mailing. The practitioner is the first live person in the chain, He/she now must persuade the IRS of reasonable cause for whatever happened, and that a penalty is not appropriate. The IRS looks at the file - for the first time, mind you - says “No” and demands $10,000.

And that is how a practitioner gets barreled into a time-destroying gyre of appealing the penalty, getting rejected, requesting reconsideration, getting rejected again and likely winding up in Tax Court. Combine that with the bureaucratic rigor mortis of IRSCOVID202020212022, and one can understand withdrawing from that line of work.

Back to Section 897.

The IRS wants its vig at the closing table. The general withholding is 15% of selling price, although there is a way to reduce it to 10% (or even to zero, in special circumstances). You do not want to blow this off, unless you want to assume substitute liability for sending money to the IRS.

The 15% is a deposit. The IRS is hopeful that whoever sold the real estate will file a nonresident U.S. income tax return, report the sale and settle up on taxes. If not, well the IRS keeps the deposit.

You may wonder how this wound up on a year-end brokers’ tax statement. If someone sells real estate, the matter is confined to the seller, buyer and title company, right? Not quite. The real estate might be in a mutual fund, or more likely a REIT. While you are a U.S. citizen, the mutual fund or REIT does not know whether its shareholders are U.S. citizens or resident aliens. It therefore reports tax information using the widest possible net, just in case.

Becoming Personally Liable For An Estate’s Taxes

 

I had lunch with a friend recently. He is executor for an estate and was telling me about some … questionable third-party behavior and document discoveries. I left the conversation underwhelmed with his attorney and recommending a replacement as soon as possible. There are two other beneficiaries to this estate, and he has a fiduciary responsibility as executor.

Granted, all are family and get along. The risk - it seems to me - is minimal.

It is not always that way. I have a client whose family was ripped apart by an inheritance. I shake my head, as there was not enough money there (methinks) to spat over, much less exact lifelong grudges. However, he was executor and so-and-so received such-and-such back when Carter first started making liver pills and he should have offset someone for … oh, who knows.

Being executor can be a thankless job.

It can also get one into trouble.

Let’s take a look at the Lee estate.

Kwang Lee died testate in September, 2001.

         COMMENT: Testate means someone died with a will.

A municipal court judge was named executor.

The judge filed the estate return in May, 2003.

COMMENT: The return was late, but there was some complexity as both spouses died within six months. There was language in the will about a-spouse-is-considered-to-survive-if that created some confusion.

COMMENT: It doesn’t matter. You know the IRS is coming in with penalties.

The IRS audited the return.

 In April 2006 the IRS issued a Notice of Deficiency for over $1,000,000. 

COMMENT: The IRS also wanted a penalty over $255 grand for late filing.

The executor filed with the Tax Court.

 In February, 2007 the executor distributed $640,000 to the beneficiaries.

COMMENT: Pause on what happened here. The IRS wanted additional tax and penalties. The executor was contesting this in Tax Court. The issue was live when the executor distributed the money.

Is there a risk?

You bet.

What if the estate lost its case and did not have enough money left to pay the tax and penalties?

The Tax Court gave the executor a partial win: the estate owed closer to a half million dollars than a million. The Court also waived the penalties.

The estate did not have a half million dollars. It did have $182,941.

The estate submitted an offer in compromise to the IRS for $182,941.

The IRS looked at the offer and said: are you kidding me? What about that $640,000 you distributed before its time?

The IRS pointed out this bad boy:

31 U.S. Code § 3713.Priority of Government claims

(a)

(1) A claim of the United States Government shall be paid first when—

(A) a person indebted to the Government is insolvent and—

(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;

(ii) property of the debtor, if absent, is attached; or

(iii) an act of bankruptcy is committed; or

(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.

(2) This subsection does not apply to a case under title 11.

(b) A representative of a person or an estate (except a trustee acting under title 11) paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government. 

The effect of Section 3713 is to make the executor personally liable for a debt to the U.S. when: 

o  The estate was rendered insolvent by a distribution, and

o  The executor had knowledge or notice of the government’s claim at the time of the distribution.

The judge/executor did the only thing he could do: he challenged the charge that he had actual knowledge of a deficiency when he distributed the $640,000.

The executor was hosed. I am not sure what more of a wake-up-call the executor needed than an IRS Notice of Deficiency. For goodness’ sake, he filed a petition with the Tax Court in response.

Maybe he thought that he would win in Tax Court.

He did, by the way, but partially. The tax was cut in half, and the penalties were waived.

Notice that the estate would not have had enough money had it lost the case in full. The tax would have been over a million, with additional penalties of a quarter million. Under the best of circumstances, the estate would have had cash of approximately $822 thousand and unable to pay in full.

In that case I doubt Section 3713 would have applied. The estate would have conserved its cash upon receiving a Notice of Deficiency.

But the estate did not conserve its cash upon receiving a Notice of Deficiency.

The executor became personally liable.

Mind you, this may work out. Perhaps the beneficiaries return the cash; perhaps there is a claim under a performance bond.

Still, why would an executor – especially a skilled attorney and municipal judge – go there?

Our case this time was Estate of Lee v Commissioner, T.C. Memo 2021-92.

Withdrawing A Tax Court Petition

 

We have a case coming up in the Tax Court.

Frankly it should never have gone this far. Much of it was COVID, I suspect. However, some of it was the IRS dropping the ball.

What set this off was someone dying. His employer had a life insurance policy on him. I suspect that this came as a surprise to his employer, who probably thought all along that the employee owned the policy with the employer paying the premiums. This would be a “split dollar” arrangement. The taxation of split dollar plans became trickier in the mid aughts, but these arrangements have been around for a long time. 

The employee died. The company received the proceeds. The company intended for the widow to receive the proceeds. How did the company get the proceeds to the widow?

They botched is what they did.

They tried to correct the botch by amending a Form 1099.

Our client is the widow, and she is being chased by the IRS. I reviewed the history of the transaction, the original and amended 1099, e-mails galore.

I have been trying to contact the IRS on the case. I even reached out to the clerk for Judge Morrison (at the Tax Court) for an assist. She was extremely helpful, but getting a response – or a pulse – from the IRS has been frustrating.

Until this week.

It is amazing how quickly some issues can be resolved if people can just talk.

The IRS understood our argument. They were willing to compromise, except for one thing.

The company never filed the amended 1099 with the IRS.

Explains why the IRS was digging in its heels.

Mind you, we can correct this – now that we know. We could also have corrected this long ago and not involved the Tax Court.

We will never appear before the Court.

Procedure here is important. Both the IRS and we will tell the Court the matter has been settled. The Court will be happy to move on.   

By contrast, what happens if we unilaterally pull out of Tax Court?

Bad things.

The seminal case goes back to 1974.

The IRS came after William Ming. Whatever was going on, the IRS was going after the fraud penalty.

There was back and forth. Mr Ming died. The IRS eventually showed some leeway on the fraud issue.

That caught the estate’s attention.

The estate tried to withdraw its case. They may have wanted a jury, and the Tax Court does not have a jury.

Here is the Court:

It is now settled principle that a taxpayer may not unliterally oust the Tax Court from jurisdiction which, once invoked, remains unimpaired until it decides the controversy.”

There is a Hotel California vibe here: the Tax Court will hold against you should you withdraw. This triggers the legal doctrine of res judicata, and you then cannot relitigate the issue in another court.

You can leave by winning, losing or settling. What you cannot do is walk out.

Our case this time for the at-home tax historians was Estate of Ming 62 T.C. 519.

Inheriting A Tax Debt

 I am looking at a decision coming from a New Jersey District Court, and it has to do with personal liability for estate taxes.

Clearly this is an unwanted result. How did it happen?

To set up the story, we are looking at two estates.

The first estate was the Estate of Lorraine Kelly. She died on December 30, 2003. The executors, one of whom was her brother, filed an estate tax return in September, 2004. The estate was worth over $1.7 and owed $214 grand in tax. Her brother was the sole beneficiary.

OK.

The estate got audited. The estate was adjusted to $2.6 million and the tax increased to $662 grand.

COMMENT: It does not necessarily mean anything that an estate was adjusted. Sometimes there are things in an estate that are flat-out hard to value or – more likely – can have a range of values. I will give you an example: what is the likeness of Prince (the musician) worth? Reasonable people can disagree on that number all day long.

The estate owed the IRS an additional $448 grand.

The brother negotiated a payment plan. He made payments to the IRS, but he also transferred estate assets to himself and his daughter, using the money to capitalize a business and acquire properties. He continued doing so until no estate assets were left. The estate however still owed the IRS.

OK, this is not fatal. He had to keep making those payments, though. He might want to google “transferee tax liability” before getting too froggy with the IRS.

He instructed his daughter to continue those payments in case something happened to him. There must have been some forewarning, as he in fact passed away.

His estate was worth over a million dollars. It went to his daughter.

The daughter he talked to about continuing the payments to the IRS.

Guess what she did.

Yep, she stopped making payments to the IRS.

She had run out of money. Where did the money go?

Who knows.

COMMENT: Folks, often tax law is not some abstruse, near-impenetrable fog of tax spew and doctrine descending from Mount Olympus. Sometimes it is about stupid stuff – or stupid behavior.

Now there was some technical stuff in this case, as years had passed and the IRS only has so much time to collect. That said, there are taxpayer actions that add to the time the IRS has to collect. That time is referred to as the statute of limitations, and there are two limitations periods, not one:

·      The IRS generally has three years to look at and adjust a tax return.

·      An adjustment is referred to as an assessment, and the IRS then has 10 years from the date of assessment to collect.

You can see that the collection period can get to 13 years in fairly routine situations.

What is an example of taxpayer behavior that can add time to the period?

Let’s say that you receive a tax due notice for an amount sufficient to pay-off the SEC states’ share of the national debt. You request a Collections hearing. The time required for that hearing will extend the time the IRS has to collect. It is fair, as the IRS is not supposed to hound you while you wait for that hearing.

Back to our story.

Mrs. Kelley died and bequeathed to her brother.

Her brother later died and bequeathed to his daughter

Does that tax liability follow all the way to the daughter?

There is a case out there called U.S. v Tyler, and it has to do with fiduciary liability. A fiduciary is a party acting on behalf of another, putting that other person’s interests ahead of their own interests. An executor is a party acting on behalf of a deceased. An executor’s liability therefore is a fiduciary liability. Tyler says that liability will follow the fiduciary like a bad case of athlete’s foot if:

(1)  The fiduciary distributed assets of the estate;

(2)  The distribution resulted in an insolvent estate; and

(3)  The distribution took place AFTER the fiduciary had actual or constructive knowledge of the unpaid taxes.

There is no question that the brother met the Tyler standard, as he was a co-executor for his sister’s estate and negotiated the payment plan with the IRS.

What about his daughter, though?

More specifically, that third test.

Did the daughter know – and can it be proven that she knew?

Here’s how: she filed an inheritance tax return showing the IRS debt as a liability against her father’s estate.

She knew.

She owed.

Our case this time was U.S. v Estate of Kelley, 126 AFTR 2d 2020-6605, 10/22/2020.

Setting Up A Museum

Have you ever wondered why and how there are so many private art museums in the United States: The Brant Foundation, The Broad, The Warehouse?

Let’s posit the obvious immediately: wealthy people with philanthropic objectives.

This however is a tax blog, meaning there is a tax hook to the discussion.

Let’s go through it.

We already know that the tax Code allows a deduction for charitable contributions made to a domestic corporation or trust that is organized and operated exclusively for charitable purposes.  There are additional restrictions: no part of the earnings can inure to the benefit of a private individual, for example.

Got it: charitable and no sneak-arounds on the need to be charitable.

How much is the deduction?

Ah, here is where the magic happens. If you give cash, then the deduction is easy: it is the amount of cash given, less benefits received in return (if any).

What if you give noncash? Like a baseball card collection, for example.

Now we have to look at the type of charity.

How many types of charities are there?

Charities are also known as 501(c)(3)s, but there several types of (c)(3)s:

·      Those that are publicly supported

·      Those that are supported by gifts, dues, and fees

·      The supporting organization

·      The nonoperating private foundation

·      The operating private foundation

What happens is that the certain noncash contributions do not mix will with certain types of (c)(3)s. The combination that we are concerned with is:

 

·      Capital gain property (other than qualified stock), and

·      The nonoperating private foundation

 Let’s talk definitions for a moment.

 

·      What is capital gain property?

 

Property that would have generated a long-term capital gain had it been sold for fair market value. Say that you bought $25,000 of Apple stock in 1997, for example, when it traded at 25 cents per share.

 

By the way, that Apple stock would also be an example of “qualified stock.”

 

·      What is not capital gain property?

The easiest example would be inventory to a business: think Krogers and groceries. A sneaky one would be property that would otherwise be capital gain property except that you have not owned it long enough to qualify for long-term capital gains treatment.

 

·      What is a nonoperating private foundation?

 

The classic is a family foundation. Say that CTG sells this blog for a fortune, and I set up the CTG Family Trust. Every year around Thanksgiving and through Christmas the CTG family reviews and decides how much to contribute to various and sundry charitable causes.  Mind you, we do not operate any programs or activities ourselves. No sir, all we do is write checks to charities that do operate programs and activities.

Why do noncash contributions not mix well with nonoperating foundations?

Because the contribution deduction will be limited (except for qualified stock) to one’s cost (referred to as “basis”) in the noncash property.

So?

Say that I own art. I own a lot of art. The art has appreciated ridiculously since I bought it because the artist has been “discovered.” My cost (or “basis”) in the art is pennies on the dollar.

My kids are not interested in the art. Even if they were interested, let’s say that I am way over the combined estate and gift tax exemption amount. I would owe gift tax (if I transfer while I am alive) or estate tax (if I transfer upon my death). The estate & gift tax rate is 40% and is not to be ignored.

I am instead thinking about donating the art. It would be sweet if I could also keep “some” control over the art once I am gone. 

I talk to my tax advisor. He/she tells me about that unfortunate rule about art and nonoperating foundations.

I ask my tax advisor for an alternate strategy.

Enter the operating foundation.

Take a private foundation. Slap an operating program into it.

Can you guess an example of an operating program?

Yep, an art museum.

I set-up the Galactic Command Family Museum, donate the art and score a major charitable contribution deduction.

What is the museum’s operating program?

You got it: displaying the art.

Let’s be frank: we are talking about an extremely high-end tax technique. Some consider this to be a tax loophole, albeit a loophole with discernable societal benefits.

Can it be abused? Of course.

How? What if the Galactic Command Family Museum’s public hours are between 3:30 and 5 p.m. on the last Wednesday of April in leap years? What if the entrance is behind a fake door on an unnumbered floor in a building without obvious ingress or egress? What if a third of the art collection is hanging on the walls of the CTG family business offices?

That is a bit extreme, but you get the drift.

One last point about the deduction if this technique is done correctly. Let’s use the flowing example:

                  The art is worth             $10,000,000

                  I paid                            $          1,000

We already know that I get a $10,000,000 charitable deduction.

However, what becomes of the appreciation in the art – that is, the $9,999,000 over what I paid for it? Does that get taxed to me, to the museum, to anybody?

Nope.