Assignment of Income Doctrine Affects Charitable Deduction Chrem, TCM 2018-164
In Chrem,1 the Tax Court denied motions for summary judgment in a case involving a transfer to a charitable organization of stock in a corporation being acquired by another corporation. In denying the charitable deduction, the IRS applied the assignment of income doctrine and contended that the taxpayers failed to comply with the charitable deduction substantiation requirements.
The taxpayers (along with eight other individuals or couples) owned 100% of the stock of Comtrad Trading, Ltd. (Comtrad) consisting of 7,000 shares. Comtrad's principal customer was SDI Technologies, Inc. (SDI). Almost all of SDI's stock was owned by an employee stock ownership plan (ESOP). SDI and Comtrad were related through common management because a majority of each company's board of directors served as directors for both companies.
In 2012, SDI made a proposal to acquire 100% of Comtrad's stock in a two-step transaction:
- First, SDI would first purchase 6,100 Comtrad shares from the taxpayers and the other Comtrad shareholders. The proposed purchase price was $4,500 per share.
- The second step involved the remaining 900 shares of Comtrad, which the taxpayers had agreed to donate to the Jewish Communal Fund (JCF), a tax-exempt charitable organization. SDI agreed to purchase these shares from JCF also for $4,500 a share. The taxpayers agreed to use all reasonable efforts to cause JCF to tender the 900 shares to SDI.
If the taxpayers failed to persuade JCF to do this, it was expected that SDI would use a "squeeze-out merger, a reverse stock split or such other action that will result in SDI owning 100% of Comtrad." If SDI failed to secure ownership of JCF's shares within 60 days of acquiring the 6,100 shares, the entire acquisition would be reversed out, and SDI would return the 6,100 shares to the tendering Comtrad shareholders.
Because almost all of the SDI shares were owned by an ESOP and because SDI and Comtrad were related parties, the trustee for the ESOP believed that ERISA required it to secure a fairness opinion to ensure that SDI paid no more than adequate consideration for the Comtrad stock. Therefore, the ESOP trustee hired Empire Consultants, LLC (Empire), to provide a fairness opinion supported by a valuation report. Empire understood that SDI would acquire 100% of the stock of Comtrad in the two-step process described above. In its valuation report, Empire concluded that the fair market value of Comtrad valued on a going-concern basis was between $4,214 to $4,626 per share, and therefore concluded that the proposed transaction at $4,500 a share was fair to the beneficiaries of the ESOP.
The parties disputed the date that the taxpayers donated the 900 shares to JCF. The taxpayers assert that the donation occurred on December 5, while the IRS contended that the donation of the stock occurred no earlier than December 10, which is after JCF unconditionally agreed to sell its shares to SDI. On December 12, SDI purchased all the Comtrad shares from JCF and the other Comtrad shareholders.
On their 2012 income tax returns, the taxpayers claimed charitable deductions for the stock they donated to JCF. The IRS selected all the taxpayers' returns for examination and issued notices of deficiency disallowing the charitable deductions based on the anticipatory assignment of income doctrine and for failure to satisfy the substantiation requirement of Section 170. The taxpayers filed petitions in Tax Court, and both parties filed motions for summary judgment.
A longstanding principle of tax law is that income is taxed to the person who earns it. In a typical scenario, the taxpayer donates to a charity stock that is about to be acquired by the issuing corporation via redemption, or by another corporation by merger or acquisition. In determining whether the taxpayer has assigned income in these circumstances, the court has stated that one relevant question is whether the prospective acquisition is a mere expectation or a virtual certainty. In order to apply the assignment of income doctrine, more than a mere expectation is required. Another relevant question is whether the charity is obligated, or can be compelled by one of the parties to the transaction, to surrender the donated shares to the acquirer. The existence of an understanding among the parties, or the fact that transactions occur simultaneously or according to prearranged steps, may be relevant in answering that question.
The court dismissed both parties' motions for summary judgment on the issue of the application of the assignment of income doctrine concluding instead that there existed genuine issues of material fact. For example, the court noted that because Comtrad and SDI were related by common management, this fact may support the conclusion that the acquisition was virtually certain to occur. In addition, the record contained emails that the court believed may support the IRS's contention that JCF agreed in advance to tender its shares to SDI and that, therefore, all steps of the transaction were prearranged. Furthermore, the parties disputed the date that the taxpayers transferred their shares to JCF with the IRS, arguing that JCF did not acquire its shares until a date after it had unconditionally agreed to tender its shares to SDI.
With respect to the substantiation requirements, a taxpayer who claims a deduction for a contribution of property (other than publicly traded securities) valued in excess of $5,000 must obtain a qualified appraisal of the property and must attach to the return a fully completed appraisal summary on IRS Form 8283. When a contribution of property is valued in excess of $500,000, the taxpayer must attach a copy of the appraisal to his or her return. The court recognized that in appropriate circumstances these requirements can be satisfied by substantial, rather than literal, compliance. However, the substantial compliance doctrine offers no relief to taxpayers who have failed to disclose information that goes to the essential requirements of the governing statute.
Failure to comply with the substantiation requirements may be excused if such failure is due to reasonable cause and not to willful neglect. Reasonable cause is determined on a case-by-case basis, taking into account all pertinent facts and circumstances and requires that the taxpayer have exercised ordinary business care and prudence as to the challenged item. Reasonable cause may be shown by establishing reliance on the advice of a tax professional. However, such advice must generally be from a competent and independent advisor unburdened with a conflict of interest.
The court dismissed the taxpayers' motion for summary judgment on the issue of whether the taxpayers had substantially complied with the substantiation requirements, concluding instead that there existed genuine issues of material fact. For example, the IRS contended that the valuation report prepared by Empire was not a qualified appraisal. The taxpayers argued that they substantially complied with all of the regulatory reporting requirements or, in the alternative, that they had reasonable cause for failing to do so.
In addition, the IRS argued that Empire did not value the specific property that each taxpayer actually contributed but rather valued Comtrad as an on-going business concern. The court noted that when an appraisal values property in a different manner from that which was actually contributed to charity, that failure can be fatal because it goes to the essence of the information required. The taxpayers argued that because SDI was offering to buy 100% of Comtrad's shares and to pay the same price of $4,500 for each share, all of Comtrad's shares had equal value, and therefore this is a case of "no harm, no foul."
With respect to the four taxpayers who made contributions valued in excess of $500,000, they failed to attach a copy of the appraisal report to their tax returns as was required. These four taxpayers argued that they nevertheless substantially complied with this requirement by attaching to their return a fully completed IRS Form 8283. The Code requires that they attach both an appraisal summary and a copy of the appraisal itself. The court stated that when a statute separately requires that a taxpayer satisfy two requirements, it is not obvious that literal compliance with the first constitutes substantial compliance with the second.
The taxpayers argue that any failure to comply with the substantiation rules should be excused because it was due to reasonable cause and not willful neglect since the returns were prepared by an experienced accountant who had not advised them to attach a copy of the Empire valuation report to their returns. However, the record was silent concerning what advice the accountant had provided regarding this issue. Therefore, the court concluded that the taxpayers' ability to rely on the reasonable cause defense presented genuine issues of material fact that were not susceptible to resolution by summary judgment.
This case illustrates the failure to comply with well-established rules regarding charitable contributions so as to avoid the application of the assignment of income doctrine as well as the substantiation rules for charitable contributions. For example, with respect to the assignment of income doctrine, the taxpayers should have donated the stock to the community fund well before the taxpayers tendered their stock to the acquiring corporation. With respect to the substantiation requirements, those rules are clearly set forth in the Code and in the regulations and, therefore, should have been easy to comply with. It will be interesting to see if this case settles or if it will be resolved by ruling by the court in a written opinion.
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the February 2019 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.