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.

Grantor Retained Annuity Trusts In 2020

I was glancing over selected IRS interest rates and one caught my attention.

The Section 7520 rate for June, 2020 is 0.6%.

There are certain tax tools that work well in times of low interest rates. One is a grantor retained annuity trust, commonly referred to as a “GRAT.” One associates them with the fancy-pants rich, but I am thinking they can have broader appeal when the triggering interest rate is 0.6%.

Let’s talk about it. We will keep the discussion general as otherwise we would be going into a math class. Our purpose today is to understand what makes this tax tool work and why 2020 – with low interest rates and declining stock prices – are a perfect setup for a GRAT.

First, a GRAT is an irrevocable trust. Irrevocable means no take-backs.

A trust generally has three main players:

(a)  The settlor; that is, the moneybags who funds the trust. Let’s say that is me (CTG)

(b)  The trustee. That will be you.

(c)  The beneficiaries., There are two types:

a.    Income. For now, that will be me (CTG) as I receive the annuity.

b.    Remainder. That will be my grandkids (mini-CTGs), because they receive what is left over.

This trust will be taxed to me personally rather than pay taxes on its own. The nerd term for this is “grantor’ trust.

I fund the trust. Say that I put in $50 grand.

The trust will then pay me a certain amount of money for a period of time. Let’s say the amount is $10,000, and the trust will pay me for two years. I am retaining an annuity from the trust.

COMMENT: Truthfully, I think it would take at least 2 years to even qualify as an “annuity.” One payment does not an annuity make.

When the trust runs its course (two years in our example), whatever is left in the trust goes to the mini-CTGs.

If you sweep aside the details, you can see that I am making a gift to my grandkids. The GRAT is just a vehicle to get there.

Why bother?

Say that I just give $50 grand to my grandkids or to a trust on their behalf.

I made a gift.

Granted, I am not worried about gift tax on $50 grand given the current lifetime gift tax exemption of $11.5 million, but if someone moves enough money there can be gift tax.

Let’s say you can move enough money.

Congrats, by the way.

Is there a way for you to gift and also minimize the amount of gift tax?

Yep. One way is the GRAT.

Here is how the magic happens:

(1)  The tax Code backs into the amount of the gift. It does this by placing a value on the annuity. It then subtracts that value from the amount transferred into the trust ($50 grand in our example). The difference is the gift.

(2)  How can I maximize the value of the annuity?

a.    I want $10 grand. If I could get 5% interest, I would need $200,000 grand to generate that $10 grand.

b.    But I cannot get 5% in today’s economy. I might get lucky and get 1.5%. To get $10 grand, I would have to put in $666,667, which is a whole lot more than $200,000.

c.    This example is far from perfect, as I what I am describing is closer to an endowment than to an annuity. The takeaway however is valid: I have to put more money into an annuity as interest rates go down if I want to keep the payment steady.  

(3)  How does this affect the gift?

a.    Had I created the GRAT in June, 2018, I would have used a Section 7520 rate of 3.4%.

b.    It would require less money in 2018 to fund a $10,000 payment, as the money would be earning 3.4% rather than 0.6%.

c.    Flipping (b), it would require more money in 2020 to fund a $10,000 payment at 0.6% rather than 3.4%.

d.    As the value of the annuity goes up, the value of the gift goes down.

Let’s express this as a formula:

Gift = initial funding – value of annuity

e.    As the value of the annuity increased in 2020, the gift correspondingly decreased.

f.     That is how low interest rates power the GRAT as a gifting technique.

How do declining stock prices play into this?

Let’s look at Boeing stock.

Around March 1^st Boeing was trading at approximately $275.

As I write this Boeing trades around $120.

Now, I do not want to get into Boeing’s story, other than this: let’s say you believe that Boeing will bounce back and bounce much sooner than eternity. If you believe that, you could fund the GRAT with Boeing stock. The mathematics will be driven-off that $120 stock price and Section 7520 rate of 0.6%.

What happens if you are right and the stock returns to $275?

Your annuity is unchanged, your gift is unchanged, but the value of Boeing stock just skyrocketed. Your beneficiaries will do very well, and there was ZERO added gift tax to you.

Another way to say this is that you want to fund that GRAT with assets appreciating at more than 0.6%.

Folks, that is a low bar.

There however be dragons in this area.

You could fund the trust and the assets could go down in value. It happens.

Or you could die when the trust is still in existence. That would pull the trust back into your estate.

Or the trust becomes illiquid and you start pulling back assets rather than cash. That is a problem, as the assets appreciating is part of what powers this thing.

Then there are variations on the payment. One could specify a percentage rather than a dollar amount, that way the dollar amount of the annuity would increase as the assets in the trust increase.

There is a technique where one uses the annuity to fund yet another GRAT. It is called a “rolling” GRAT, and it worked when interest rates were much higher.

BTW, there is a twist on a GRAT, and it involves working the math so that the gift comes out to exactly zero. One might want to do this if one has run out of lifetime exemption, for example. The tax nerds refer to it as a “Walton” GRAT, in honor of Audrey Walton, wife of Wal-Mart cofounder Bud Walton. It took a court case to get there, but the technique has thereafter assumed the family name.

You Inherit. Can You Owe Estate Tax?

I came across an estate tax lien case the other day.

It has become unlikely that one will owe estate tax, as the lifetime exclusion has now gone over $11 million. Still, it can and does happen.

The federal estate tax is an odd beast. It is a combination of assets owned or controlled at death, increased by an addback for reportable lifetime gifts. This system is called a “unified” tax, and the intent is to not avoid the estate tax by giving property away to family over the course of a lifetime. In truth, the addback is necessary, as tax planners (including me) would drive an 18-wheeler through the estate tax if the lifetime-gift addback did not exist.

There is a potential trap if the estate tax kicks-in.

Let me give you a scenario, very loosely based on the case.  

Mr Arshem was successful. He created and funded a family limited partnership with real estate, stock and securities. He began a multi-year gifting sequence to his children, each time claiming a generous discount for lack of control and marketability. He had cumulatively gifted away $5 million in this manner.

He passed away early in 2019. He died with an estate of $6 million.

On first pass, $6 million plus $5 million equals $11 million. He is just under the threshold, so he should not have an estate tax issue – right?

Not so fast.

The IRS audits one or more of those gift tax returns. They argue that the discounts were too generous, and the reportable gifts were actually $8 million. The estate disagrees; they go to Court; the estate loses.

Now we have $8 million plus $5 million for $13 million.

There is an estate tax filing requirement.

And estate tax due.

Let’s say that the estate had been probated and closed. There no estate assets remaining.

Who pays the tax?

Look over this little beauty:

§ 6324 Special liens for estate and gift taxes.

(a)  Liens for estate tax.

Except as otherwise provided in subsection (c) -

(1)  Upon gross estate.

Unless the estate tax imposed by chapter 11 is sooner paid in full, or becomes unenforceable by reason of lapse of time, it shall be a lien upon the gross estate of the decedent for 10 years from the date of death, except that such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration, allowed by any court having jurisdiction thereof, shall be divested of such lien.

(2)  Liability of transferees and others.

If the estate tax imposed by chapter 11 is not paid when due, then the spouse, transferee, trustee (except the trustee of an employees' trust which meets the requirements of section 401(a) ), surviving tenant, person in possession of the property by reason of the exercise, nonexercise, or release of a power of appointment, or beneficiary, who receives, or has on the date of the decedent's death, property included in the gross estate under sections 2034 to 2042 , inclusive, to the extent of the value, at the time of the decedent's death, of such property, shall be personally liable for such tax.

It is not the easiest of reading.

What (a)(2) means is that the IRS can after the transferees – the children of Mr Arshem in our example. There is also a sneaky twist. Income tax liens have to be recorded; estate tax liens do not. They are referred to as “silent” liens and can create unexpected – and unpleasant – surprises.  You cannot go to the courthouse and research if one exists.

What if Arshem’s children received his assets and thereafter sold them? What happens to the lien?

The children are “transferees.” They are personally liable for the estate tax.

COMMENT: There are procedures to possibly mitigate this consequence, but we will pass on their discussion in this post.

The case is U.S. v Ringling. The moral of the story is – if the estate is large enough to draw the wrath of the federal estate tax – please consult an experienced professional. Think of it as insurance.

Can You Make Gifts To Your Pastor?

Can you give someone money and not have it considered income?

Of course you can.

One way to do it is to die and leave money as a bequest.

That is a bit extreme for the average person, including me.

Another way is to give someone a gift. Granted, if the gift is large enough, you may have to report it. You do not actually write a check to Uncle Sam until your cumulative lifetime gifting exceeds $11,180,000, but you do have to file paperwork.

Can you make a gift to an employee?

Much harder.

The Code does allow some de minimis things, such as holiday hams – but even that has to be under $75. 

Oh, and it cannot be in cash, whether less than $75 or not. Cash taints the deal.

There is a narrow exemption for length of service or safety awards, but let’s pass on those details.

To a tax geek, the general answer is that anything you give an employee is taxable.

I was looking at a case a couple of weeks back that introduced a spin on this concept.

We have a pastor at a Minnesota church.

For the two years at issue he turned down a salary.

He did take a housing allowance.

And then it got interesting.

The church used donation envelopes. They were different colors, with each color having a different meaning.

The basic envelope was white. That was the weekly offering. It included a space where you could designate the amount of the donation that was for the pastor.

There were gold envelopes for special projects and events.

Then there were the blue envelopes. Blue envelopes were “gifts” to the pastor, and congregation members were instructed that those could not be deducted on their tax returns. The church did not track blue envelope donations, nor did the church make blue envelopes commonly available. If you wanted one, you had to ask for one.

For tax years 2008 and 2009, the pastor received the following;

                                                       2008              2009

          White envelopes              $40,000         $40,000

          Housing allowance          $78,000         $78,000

          Blue envelopes              $258,001        $234,826

When the IRS learned of this, they wanted tax on the blue envelopes.

What do you think?

Here is the Bible:

When I preach the gospel, I may make the gospel of Christ without charge, that I abuse not my power in the gospel.” 1 Cor. 9:18

Here is the Court: 

To decide this case, we must descend from the sacred to the profane."  

What sets up the tension in this case is that the term “gift” has a different meaning for tax than for common law. For common law, a gift is made voluntarily and without legal or moral obligation.

Tax views a gift as made from “detached and disinterested generosity” or “out of affection, respect, admiration, charity or like impulses.”

Huh? What is the difference?

The “disinterested generosity.”

That standard can be hard enough to pin down when reviewing a transaction between two individuals. How much harder can it get when reviewing a transaction between a group and an individual?

But that is what the Court had to decide.

The Court walked us through its decision process.

(1) Were donations provided in exchange for services?

The pastor did provide services, and to a reasonable person those blue envelopes look like an incentive for him to keep providing them.

Looks like a vote for income.

(2)  Did the pastor request the donations?

To his credit, the pastor referred to white envelopes when talking about tithes. He did not talk about blue envelopes, and a congregation member had to ask for one as they were not generally available.

Looks like a vote for a gift.

(3) Were the donations part of a routinized program?

That depends. Is the existence of blue envelopes per se evidence of a “routinized program?”

Can mere existence of a program rise to the level of a “routine?”

One can discern some routine no matter what the facts are, as the repetition of any action can be described as a “routine.” However, is that truly the intent of this test?

Call this one a push.

(4) Did the pastor receive a separate salary and what was the relationship of that salary to the personal donations?

The Court was very uncomfortable here:

We cannot ignore the sheer size of blue-envelope donations in 2008 and 2009, or the facts that they are very similar in amount in both years – within 10% of each other. We find it more likely than not that this means there was a ‘regularity of the payments from member to member and year to year ….’”

Oh, oh. We have our tie-breaker.

The Court had to discern the intent of the group, an almost mythical challenge. It saw blue-envelope donations total almost seven times the amount of white-envelope donations and asked: could it be that the congregation was trying to keep its popular and successful preacher?

CTG: I’ll play along: why, yes they were.

If they paid him more and donated less, perhaps they would not be as concerned.

CTG: By that reasoning, had he won the recent billion-dollar lottery they would not have to pay him at all. 

But he needs a certain amount just to pay his bills.

CTG: True, but how many parents across the fruited plain are giving their post-college kids money to live on? Is that income too?

The relationship between a parent and child is different.

CTG: The relationship between a faithful and his/her religious leader can also be different.

But being a minister is his job. Anything he receives for doing his job is – by definition – income.

CTG: Thank you. This is the clearest statement of your reasoning thus far. Why four criteria? Seems to me you could have fast-forwarded to the last one – the only one that really mattered.

The Court decided the pastor had income. He owed tax.

Register my surprise at zero, none, nada. I knew the ending of this movie from the first scene.

Our case this time was Felton v Commissioner.

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.