Chapter 4: gifts of property.
While many charitable donations are made by personal check, larger donations tend to involve gifts of non-cash property. The rules that are applied to each charitable gift vary depending on the type of asset donated, the category to which the charitable donee is assigned, and the timing and structure of the gift vehicle used. The laws and regulations governing donations of property were relatively stable from the last major revisions of the charity tax laws in 1969 up until the late 1990s. As a result of Congressional hearings detailing abuses and numerous stories in the press about greedy donors and aggressive techniques, restrictive legislation and regulations have recently been passed. Most of the abuses that have been shut down involved inflated tax deductions, appraisals that provided unrealistic property values, and situations where donors benefited significantly while the charities involved received little or nothing of value. Since further scrutiny from lawmakers is likely, it is imperative that both advisers and charities not only keep current on the changes in the law, but also avoid situations which are likely to trigger more legislative restrictions.
WHEN IS THE USE OF SUCH A DEVICE INDICATED?
1. When a donor has non-cash assets that he or she no longer needs or wants and also is charitably inclined.
2. When a donor wants to combine tax planning with charitable donations.
3. When a donor wishes to give particular assets that the charity can use in its day-to-day operations.
TANGIBLE PERSONAL PROPERTY
Since the deduction rules differ between tangible and intangible gifts, it is important to properly characterize each gift accordingly.
There is an almost unlimited assortment of tangible property donated to charity. Such gifts might include automobiles, furniture, jewelry, art, books, coins, livestock, timber, and crops. IRS Publication 526 Charitable Contributions defines "tangible property" in a charitable context as "any property other than land or buildings that can be seen or touched." Although coins, such as cash money, are considered intangible, collectible coins that have a numismatic value are considered tangible assets.
The income tax deduction limits for tangible property gifts depend on a variety of factors.
Will the donated property be used by the charity in a manner consistent with its charitable purpose? For example, a donation of a valuable book collection to a library which will display the collection in its archives and make the books available for reading by scholars and researchers clearly falls into this category. A donation of office furniture to a charity that uses the gift to furnish its offices again is a related use gift. In comparison, the gift of a rare medieval manuscript to a modern art museum is unrelated, since it is unrealistic that the museum will display the manuscript as part of its collection.
For "related use" gifts that do not fall within the rules for investments or future interests (see below), the donor may deduct the full fair market value up to 30% of his adjusted gross income (AGI). For "unrelated use" gifts, the donor may deduct the lesser of (a) fair market value or (b) adjusted basis, up to 50% of adjusted gross income. (1)
In situations where the donor takes a full fair market value income tax deduction but the charity fails to put the donated property to a related use, the Pension Protection Act of 2006 introduced a new recapture provision for gifts where the value is greater than $5,000. When a charity disposes of a related use item within three years of the gift, the excess of the deduction claimed over the donor's basis is included in the donor's income in the year that the charity disposes of the tangible property. If the disposition by the charity takes place in the same year that the gift is made, the donor's deduction is limited to his or her basis. This new recapture rule only applies to gifts made after September 1, 2006 where the fair market value exceeds $5,000. An exception to this new recapture rule is available when the charity certifies in writing under penalty of perjury detailing how the property was indeed related to the nonprofit's charitable purpose. Any fraudulent certification is subject to a $10,000 penalty. (2)
Investment or Inventory?
If a donor has held tangible personal property as an investment for more than one year, it is generally considered a capital asset and if the related use test, above, is also met, the deduction is equal to the fair market value as of the date of the gift. It is important to distinguish between an investment and inventory. A coin collection held by a hobbyist, for example, would be considered an investment. On the other hand, a similar collection held by a dealer would be considered inventory. If characterized as inventory, the deduction is limited to the lesser of adjusted basis or fair market value, and the deduction is subject to the 50% of AGI limitation. (3)
[FIGURE 4.1 OMITTED]
There are two exceptions to the rule allowing a deduction for gifts of inventory:
* Gifts of inventory by C corporations used for the care of the ill, needy, or infants. (4) The deduction is limited to the lesser of (1) adjusted basis plus 50% of the difference between basis and list price, and (2) 200% of adjusted basis.
* Gifts of qualified research property made to an institution of higher education or scientific research. (5) The deduction is limited to the lesser of (1) adjusted basis plus 50% of the difference between basis and list price, and (2) 200% of adjusted basis.
In 2005, Congress enacted temporary legislation that broadened the deduction limits for donations of food inventory and books to qualified victims of Hurricane Katrina. Anyone (not just C corporations) who donated food inventory that met quality and labeling standards, could claim an enhanced deduction, and C corporations who donated book inventories to qualified schools were allowed the enhanced deduction if the school certified that the books were suitable for their teaching and education purposes. While this law affected only donations made between August 28, 2005 and January 1, 2006, it is possible that the Katrina Act may be used as a model for future natural disasters, and advisors should keep an eye on legislative relief at those times.
Future Interest in Tangible Personal Property
If a donor gives a charity a future interest in tangible property, the gift is not considered complete and there is no tax deduction allowed until the asset passes in its entirety to the charity. (6) Ordinarily, gifts to charity via a charitable remainder trust (CRT) or pooled income fund would be considered future interest gifts because the charity's actual receipt of the donated property is delayed; nevertheless, such gifts are deductible at the time of the gift if the trust meets strict statutory requirements. On the other hand, gifts made to charitable gift annuities, in which the transfer of the property to the charity occurs immediately, are considered to be part outright gift and part sale.
Fractional Interest in Tangible Personal Property
Prior to 2004, a donor could give a fractional interest in tangible personal property (a painting, for example) to a charity and receive a charitable tax deduction equal to the percentage of the asset donated--even if the asset remained in the possession of the donor. The deduction was allowed as long as the donor made the artwork available to the museum for a percentage of the year equal to the percentage donated. This was a popular technique because (1) it allowed a donor to spread a sizable tax deduction over decades when it would otherwise be limited by a percentage of adjusted gross income, (2) if the asset increased in value, each fractional interest donated would result in an larger deduction, and (3) the donor continued to enjoy the property in his home or business for at least part, if not all, of the year.
The Pension Protection Act of 2006 curtailed some of the more abusive arrangements for these fractional gifts. Under the new law, a donor's tax deduction is recaptured if the donor's entire interest in the asset isn't donated to the charity within 10 years of the original fractional interest gift. The deduction is also recaptured if the charity fails to take physical possession or use the property for its exempt purposes during that time. In either situation, the donor is also fined a 10% penalty in addition to the recaptured tax deduction. And finally, the new laws, in effect for all donations made after August 17, 2006, limit the value of the asset for future tax deduction calculations to the lesser of (1) fair market value as of the date of the original fractional interest donations, or (2) the fair market value when subsequent fractional interests are donated. (7)
Unusual and Special Asset Types
A few types of tangible property have special rules and requirements:
* Used cars, boats, and planes: For donations made after December 31, 2004, new rules apply. (8) The charitable donee must now provide a "contemporaneous" written acknowledgement within 30 days of the gift that discloses to the donor whether (1) the vehicle will be used for the direct purposes of the charity, or (2) the charity plans to sell the vehicle. If the vehicle is donated for the charity's related use, the donor is entitled to a deduction equal to the fair market value as of the date of the gift. If the charity sells a related use vehicle within three years of the donation, it must report the sale to the IRS if the proceeds exceed $500 (the prior threshold was $5,000). However, if the vehicle is donated to a charity which plans on selling it, then the donor's charitable income tax deduction is now limited to the gross proceeds of the sale.
These new rules substantially curbed the abuses where a donor would call up an accommodating nonprofit to tow away their unwanted and practically worthless car, the donor would deduct the Kelly Blue Book value (which is based on a working car in good condition), but the charity would only receive a few dollars for the vehicle in a used car auction. When Congress and the IRS found that numerous taxpayers had taken deductions of $2,000 to $5,000 and more for cars that the charity liquidated at auction netting only an average of $75, it was not surprising that this abuse was shut down.
* Clothing and household items: For donations made after August 17, 2006, the Pension Protection Act of 2006 eliminated the deduction for gifts of used clothing and household unless the items were in "good used condition or better." This disallowance would not apply for items valued at greater than $500 if the donor obtains and files a qualified appraisal with his or her tax return. Certain items such as paintings, coins, jewelry and collectibles, for example, are exempt from this new law and are addressed elsewhere in this section.
* Coins. As mentioned earlier, if coins have a numismatic value that differs from their currency value, they are considered tangible personal property for charitable gift purposes. An exception is made for coins such as Krugerrands, Canadian Maple Leaf coins, and newly issued United States Mint gold coins, where the IRS has concluded that such gifts are equivalent to cash. (9) The IRS has further ruled that such coins can be used to fund a charitable remainder trust since they are readily convertible to other income producing assets. (10)
* Artwork. If an artist donates his own painting to a museum--even if he kept it for more than one year, and the donation meets the related use test--the deduction is, nevertheless, limited to the cost of his canvas, brushes, and paint. (The value of his time, experience, talent, or reputation is irrelevant in measuring the value of the deduction.) If a non-artist donor gives the same painting to a museum, it is instead deductible at full market value if it was held for more than one year by the donor and if it meets the related use test. Furthermore, art can be divided into two components: (1) it is a tangible property in that is can be seen or touched; and (2) it may hold a copyright, which is intangible and can be transferred separately from the work of art itself. Because partial gifts of tangible property do not qualify for a tax deduction, if a donor gives a painting to the museum but retains the copyright, the gift is incomplete and no income tax deduction is allowed. However, this particular partial interest gift would qualify for gift and estate tax deduction purposes.
Example: Mr. Hanford owns an extensive collection of original cartoon art valued at $18,000 that he would like to donate to the San Francisco Cartoon Art Museum. Since Mr. Hanford is neither the artist who created the cartoon art nor a dealer who trades in such pieces, the gift is considered one of an investment rather than inventory. Since he has owned the pieces for more than one year prior to donation, the artwork is considered a long-term capital gain asset. Furthermore, since the cartoon art is being donated to a museum that regularly exhibits such pieces and the museum has promised to display the art to the public, Mr. Hanford's gift will meet the related use test. And finally, Mr. Hanford is making an outright gift of the art this year and is not retaining any use or enjoyment of the pieces, thus avoiding the future and partial interest rules.
To transfer the artwork to the museum, Mr. Hanford delivers the pieces to the museum's planned giving officer. The officer provides him with a receipt that describes the gift and states that he will receive nothing of value in return for making the donation. Mr. Hanford will need to obtain a qualified appraisal of the collection since it is worth more than $5,000 (see Chapter 2). But he will not have not to attach a copy of that appraisal to the IRS Form 8283 because the value of his art gift is not greater than $20,000.
* Livestock. A donor can claim a tax deduction at full fair market value for gifts of livestock donated to a charity that then places the livestock into a related use. In particular, the donor must have owned cattle and horses for more than two years. All other livestock (specifically, hogs, mules, donkeys, fur-bearing animals, goats, sheep and other mammals) must have been held for more than one year. (11)
* Crops. Unharvested crops are considered part of the land. Assuming that the land has been held for more than one year, land that includes crops is long-term capital gain property. In this case, the crops are considered intangible property and the related use test does not apply. Gifts of harvested crops, on the other hand, constitute a tangible property donation; thus, the related use test would apply. However, most crops are produced in a trade or business and are, therefore, inventory. As inventory, crops are considered ordinary income property. This limits the donor's deduction to the lesser of fair market value or basis, and makes the deduction subject to the 50% of adjusted gross income limitation. Finally, a gift of yet-to-be-harvested crops is characterized as a donation of a futures contract, which again limits the income tax deduction to the donor's adjusted basis.
* Timber. Similar to crops, the characterization of a gift of timber depends on whether the timber is still standing and being donated with the land, or whether it has been cut and is being donated separate from the land. Standing timber is considered intangible property and the related use test is irrelevant. If the donor were in the business of producing timber, a gift of cut timber would be considered a donation of inventory. However, if the donor was not in the business but was clearing land that had been held for investment purposes, such a gift would be characterized as tangible personal property.
* Taxidermy: According to stories in the press and a Congressional hearing in 2004, some aggressive promoters were selling hunting and safari packages as tax deductible vacations. The promoters claimed their clients could deduct all travel costs incurred in hunting if the client would simply donate the mounted animals to a charity. The accommodating charity would warehouse the mounted animals for two years, to avoid the IRS reporting requirements, and then sell the animals for far less than the thousands of dollars of deduction claimed by the donors. For donations of taxidermy property made after July 25, 2006, a new law requires the charity to report any sale within three years, not two, and the deduction is limited to the lesser of the donor's basis or fair market value. The basis in this case is limited to the cost of preparing, stuffing, and mounting the animal, not the travel and hunting expenses. (12)
Intangible property has a value that is separate from any physical, intrinsic worth of the assets. Rather than specifically defining intangible assets, the IRS simply provides an outline of examples. In general, intangible gifts are not subject to the related use and future interest rules. Instead, the IRS subjects such gifts to other tests:
1. Partial interest rule. When a donor gives less than a complete interest in an asset to charity, the IRS generally allows no income, gift, or estate tax deduction--unless the gift falls within one of the statutorily specified forms (charitable remainder trust, charitable lead trust, and pooled income fund) (13) or it is one of few other exceptions specifically carved out in the Internal Revenue Code. These exceptions include: (1) a remainder interest in a farm or personal residence; (2) an undivided portion of a donor's interest in a property; (3) qualified conservation contributions; and (4) works of art separated from their copyright (deductible for gift and estate taxes only). (14)
2. Section 170 reduction rules. While most assets donated to charity are subject to long-term capital gains tax, some are characterized as ordinary income property. For such assets, the principal reduction rule states that the charitable income tax deduction is to be reduced by the amount of gain that would have been recognized if the asset were sold and the proceeds were donated to charity. The second reduction rule states that if long-term capital gain property is donated to a private foundation (other than an operating, pooled fund, or pass-through foundation), the deduction is reduced by the amount of gain that would have been recognized if sold. An exception is carved out for donations of "qualified appreciated stock" defined as publicly traded stock that would have been subject to long-term capital gains treatment if sold.
While these rules apply in general to all gifts of intangible property, special planning is required for certain type of gifts:
* Copyrights. The American Jobs Creation Act of 2004 completely changed the tax consequences of such donations. (15) For gifts made after June 3, 2004, the law now allows for a multi-year deduction for gifts of intellectual property. The donor's deduction is now equal to basis in the year the donation is made, but the deduction is reduced by any long-term capital gain. (16) Over the next twelve years, the donor can claim additional deductions that are calculated based on a sliding scale percentage of the royalties received by the charity. The donor qualifies for these additional deductions only after the income amounts exceed the initial basis. The donor must advise the charity at the time of contribution that he or she intends to claims the additional deductions, and the charitable donee has a new burden of tracking the royalty income for that purpose. In order to complete the gift of a copyright to a charity, the transfer must be made in writing, signed by the copyright owner or owner's agent, and the original or certified copy mailed to the Register of Copyrights along with the appropriate fee.
* Patents. Under prior law, the gift of a patent by its creator was considered the gift of a capital asset and was, therefore, deductible at its full fair market value, reduced by any depreciation that had been taken. Under the American Jobs Creation Act of 2004, the tax treatment of patents and copyrights were brought into parity. (17)
* Royalties. Similar to a copyright, royalty income is separate from the item that produces that income. If one is donated without the other, the partial interest rules apply. In addition, most royalties are considered ordinary income assets. (However, royalties on oil and gas interests are usually treated as gifts of real property unless the donor is in the trade or business of producing oil or gas.) And finally, royalties are generally exempt from being characterized as unrelated business income (although this issue should be researched in detail prior to making a gift).
* Installment obligations. The charitable gift of a note or mortgage is considered a taxable disposition that triggers gain recognition at the time of the transfer. However, the donor is entitled to an offsetting charitable income tax deduction equal to the note or mortgage's fair market value.
* Life insurance. While this topic is covered in significant detail in Chapter 13, charitable donations of life insurance are subject to a complex set of rules. Since life insurance is an ordinary income asset, the income tax deduction is limited to the lesser of fair market value or adjusted basis. All interests in the policy must be transferred to charity or the gift will fail the partial interest test. The donor cannot receive any value from the contract, directly or indirectly, or the policy will be considered a personal benefit contract and the charity will face a 100% excise tax. And finally, donations of contracts subject to loans may be considered a forgiveness of debt and cause the transfer to be treated as a bargain sale.
* Annuities. Depending on the issue date of the annuity and the type of contract donated, the tax consequences of this gift can vary widely. For all annuity contracts issued on or after April 23, 1987, upon transfer to a charity, the donor must recognize all gain in the contract as ordinary income and can claim a tax deduction equal to the fair market value. For matured contracts issued after this date, that the donor can deduct the maturity value of the contract. Note, however, that the donor must recognize the gain in the annuity as ordinary income. For nonmatured contracts issued prior to April 23, 1987, the gain is recognized as ordinary income, but the donor's deduction is limited to adjusted basis. (18)
* Options. Listed options and futures contracts are covered under the section below entitled "Publicly traded securities." Charitable planning with employee stock options, however, is a particularly complex field. In general, the gift of an unexercised nonqualified stock option to a charity or charitable trust will result in the donor recognizing ordinary income on the spread between the fair market value and exercise price. Furthermore, since the donor has no basis in the option, there is no offsetting charitable income tax deduction, meaning that the donor pays income taxes to make a charitable donation. (19) Testamentary gifts of nonstatutory options are treated more favorably--any compensation income will be recognized by the charity rather than by the donor's estate. (20)
Example: Ms. Duckworth is an executive at a small, successful software company and has received substantial bonuses in the form of nonstatutory employee stock options. She would like to make a sizable donation of some of these options to the Literacy Volunteers of America and needs to know the best way to structure such a gift.
With nonstatutory options, the employee must generally recognize compensation income when the option is exercised, sold, or transferred in an arm's length transaction. Any offsetting charitable deduction depends on how and when the gift is made:
1. If the stock option plan permits transfers, Ms. Duckworth can simply donate her unexercised options to charity. The transfer to charity will not immediately trigger income taxes. (21) But as soon as the charity exercises the options, she--not the charity--will be taxed on the income realized (the difference between the fair market value on the date of exercise and the option price). Since this is an ordinary income gift, her charitable deduction is limited to the lesser of Ms. Duckworth's adjusted basis or the fair market value. Depending on the timing of the charity exercising the options, Ms. Duckworth could face income tax with no offsetting charitable deduction.
2. If she exercises the options prior to donation, she will have to raise the funds to pay the exercise price, and pay taxes on the difference between the fair market value and the exercise price. Assuming that she donates the options in the same year she exercises the shares, she will qualify for a deduction equal only to the lesser of her adjusted basis and fair market value. If she holds the stock acquired by exercising the options for more than one year prior to donation, she will receive a larger charitable deduction, but it will not occur in the same year as the taxes were realized.
3. If Ms. Duckworth arranges for a testamentary transfer of the options, she will avoid the recognition of income while she is alive. But she has a long life expectancy, and would like to see her favorite charity benefit in the near future.
One potentially favorable planning option for this case is to have the corporation itself donate stock options to charity. With this approach, Ms. Duckworth will not pay taxes on any portion of the options, and the corporation will receive a tax deduction at the time the charity exercises the options.
PUBLICLY TRADED SECURITIES
Aside from cash gifts made by personal check, the asset most commonly given to charity is publicly traded securities. From a donor's point of view, such gifts are popular because they: (1) are often highly appreciated and, therefore, generate a large deduction; (2) are relatively simple to transfer; (3) do not usually require expensive appraisals or incur any significant transfer costs; and (4) are welcomed by the charitable donee since they are often readily liquidated.
While highly appreciated stocks are the most common property donated of this type, many advisors also recommend charitable donations of mutual fund shares, closed-end investment company shares, restricted securities, real estate investment trust shares, options and futures contracts, and debt instruments such as bonds.
Gifts of certain publicly traded securities, however, hold potential tax traps, and care should be taken to plan around, or in some cases, completely avoid, such gifts.
There are nine major types of publicly traded securities that are most often used to fund charitable donations:
1. Common and preferred stock. If traded on a public exchange, such investments are considered capital assets. (22) As a result, as long as the donor has held the stock for more than one year, the deduction for such gifts is equal to the fair market as of the date the gift is complete. Otherwise, stock is considered ordinary income property and the deduction is limited to the lesser of the donor's adjusted basis or the fair market value. Fair market value for such gifts is the mean between the highest and lowest quoted selling price on the date the gift is completed. (23)
Example: Mrs. Price wants to make a sizable donation to the San Luis Obispo Symphony. After consulting with her advisor, she has decided to donate highly appreciated stock rather than cash. The end of the tax year is only a few days away, and in order to complete the gift in the current year, special care must be taken to ensure that the delivery requirements are met in time.
Mrs. Price has two major stock holdings that she wishes to donate. She keeps her shares of IBM stock in a safe deposit box in town, but holds her AT&T stock in a brokerage account, which keeps the securities in the street name of the brokerage firm.
To transfer the IBM stock, Mrs. Price will first have to retrieve the certificates from her safe deposit box. She will then have to endorse the certificates over to charity, taking care to sign her name exactly as the shares reflect her as the owner. For example, if the shares show that the owner's name is Sandra J. Price, she will have to sign her name with the middle initial, even if her signature does not usually include such information. As an alternative, she can sign an endorsement form and attach the form to the original certificate. Prior to completing the paperwork, Mrs. Price contacts the charity to review their gift acceptance policy and to determine the exact legal wording of the charity's name to which the shares must be transferred.
If Mrs. Price, her agent, or her broker delivers the IBM shares personally to the charity, her delivery date (the date on which she qualifies for a tax deduction) will be the day she hands the endorsed certificates or the certificates plus the assignment form to the charity. If she chooses to mail the endorsed certificate and/ or forms, her gift is complete as of the date of the mailing, assuming that all the forms are accurately endorsed. She should send the documents certified mail with a "return receipt requested." If she delivers the shares to her broker, bank, or IBM to be reissued in the name of the charity, the gift is not considered complete until the date the change is reflected in IBM's corporate books. Since timing is important to Mrs. Price, it is recommended that she meet with an officer of the charity and personally deliver the stocks.
The AT&T stock is held in the street name of the brokerage firm and Mrs. Price must contact her broker to transfer the stock to SLO Symphony. The gift of stock is not considered complete, however, until the brokerage firm actually transfers title to the charity and the change is reflected on AT&T's corporate books. Since this may take a little time, it is important that Mrs. Price begin this process as soon as possible to meet her year-end deadline.
Since these are publicly traded securities, the value of Mrs. Price's deduction will be determined by taking the mean of the highest and lowest quoted selling prices on the day her gift is complete. She will need to file an IRS Form 8283, since the value of each stock gift is greater than $5,000. No qualified appraisal will be required since the gift is of publicly traded securities.
2. Debt instruments. These gifts include corporate bonds, mortgage backed securities, municipal bonds, and United States Treasury obligations. If such assets, when sold, would result in capital gain tax treatment, then they would make favorable charitable donations--that is, the tax deduction would be equal to the fair market value as of the date of the gift. Some debt instruments, such as zero coupon bonds, often result in ordinary income on sale or redemption. A gift of these assets to charity receives less favorable tax treatment. The donor does not recognize the income when the gift is made, but the ordinary income portion of the bond is not deductible. (24)
3. United States Savings Bonds. For lifetime gifts, Series E, EE, H, and HH savings bonds result in a tax deduction equal to the fair market value of the bond (Series H and HH bonds are no longer sold). The donor, however, will also be taxed on all unrealized income as of the date of the contribution. This diminishes the attractiveness of such gifts from a tax planning viewpoint.
4. Restricted securities. Some stocks are subject to sales restrictions by the SEC, by corporate charter, or by trust agreement. As a result, charitable gifts of private placement holdings, controlled stock, and unregistered securities can be both difficult and fraught with problems. For example, when a donor places restricted stock into a charitable remainder or lead trust, since the donor retains an interest in the stock, the restrictions remain in place. For outright charitable donations, however, as long as the charitable organization does not own at least 10% of the company's outstanding shares and the charity is not considered an affiliate, outright donations of restricted stock will generally be deductible as long as two years have elapsed since the donor acquired the stock from the issuer. While donations of listed securities do not generally require a qualified appraisal, if the restrictions placed on a stock alter its value in any way, an appraisal may be required. (25)
5. Options and futures contracts. Since all gains and losses from listed options (also called Section 1256 contracts) are taxed according to the "60-40 Rule" (i.e., gains and losses and allocated 60% to long-term capital gain or loss and 40% to short-term capital gain or loss), charitable gifts of such assets will trigger the reduction rules for the short-term capital gain or loss portion of the gift. Section 1256 contracts include all listed equity and nonequity options, including stock index futures and foreign currency contracts.
6. Mutual funds. Like stocks, these investments make popular charitable gifts since they are considered capital assets; therefore, the deduction is based on the fair market value as of the date of the gift, provided that the donor had held the mutual fund shares for more than one year. The fair market value is defined as the public redemption price for the date of the gift. However, if there is no public redemption price because the gift was made on a Saturday, Sunday, or holiday, then the market value is the public redemption price for the first day preceding the date of the gift for which a quote is available. (26) Furthermore, in some cases, where the mutual fund company has withheld taxes from the account, the donor is entitled to a refund for the amount withheld.
7. Closed-end investment companies. These investments trade in a manner similar to publicly traded stock, are valued in the same manner as listed stock and are, therefore, subject to the same favorable tax deduction.
8. Real estate investment trusts (REITs). Many REITs produce income that may result in unrelated business taxable income (UBTI) to the charitable organization. Other investment trusts specifically prohibit transfers to charitable entities. Great care should be taken in arranging such gifts.
9. Publicly traded master limited partnerships (MLPs). Since many MLPs may trigger unrelated business income tax (UBIT), it is imperative that such gifts be carefully reviewed prior to donation.
PRIVATELY HELD BUSINESSES
In terms of tax planning, charitable donations of privately held businesses are among the most complex and potentially troublesome. There are five primary types of business structures, each of which has a distinct combination of ownership, tax, liquidity, and transferability issues. Planners must navigate around numerous potential traps to successfully arrange such donations.
In general, this is a very simple business structure, with one person who owns and controls the entire business. The company's value may include tangible, intangible, or capital assets. All risk, income, and losses inure to the sole proprietor.
* Outright gifts. Charitable donations of sole proprietorships generally make poor gifts from the charity's perspective. This is because any income generated by the business will be considered unrelated business income and, therefore, taxable to the charitable donee. If the gift is substantial in relation to the charity's other assets, such high levels of unrelated business income may even jeopardize the tax-exempt status of the charity. A good alternative may be for the sole proprietor to donate individual assets of the company to charity instead.
* Planned gifts. A charitable remainder trust cannot own a sole proprietorship. This is because any income will generally be considered unrelated business income and cause the trust to be subject to a 100% excise tax. For grantor charitable lead trusts, this is not a problem--the income is taxable to the donor anyway. For nongrantor trusts, however, the trust receives a deduction for the amounts distributed to charity, but such a deduction is unavailable for unrelated business income.
This business structure can be either general (all partners share management, control, income and expenses) or limited (varying levels of control are assigned to different classes of ownership).
* Outright gifts. Charitable donations of partnership interests must, first of all, be specifically allowed under the terms of the business agreement. Furthermore, the planner must be aware that the intermediate sanction rules may apply in the case of outright gifts to public charities, and penalties for self-dealing, excess business holding, and jeopardy investments may apply when partnership interests are donated to private foundations. And, similar to gifts of sole proprietorships, unrelated business income taxes are a substantial concern when donating partnership interests. To plan around this potential problem, gifts of underlying partnership assets may be more appropriate than gifts of partnership interests.
* Planned gifts. Under the Tax Relief and Health Care Act of 2006, a charitable remainder trust is subject to a 100% excise tax in any year in which the trust generates unrelated business income--no matter how little unrelated business income it receives. Furthermore, if the partnership has any debt whatsoever, the transfer of partnership interests to a charitable remainder trust would be considered relief of indebtedness to the donor. On the other hand, gifts of partnership interests to grantor charitable lead trusts can be quite advantageous.
Gifts of nonpublicly traded (i.e., closely held) C corporation shares can generate sizable charitable deductions as long as certain restrictions are met and the donor plans around the potential problems carefully.
* Outright gifts. Once again, unrelated business income taxes are a concern for the charitable donee and the gift must not violate private foundation self-dealing rules and public charity intermediate sanction rules. Furthermore, if the donor directly or indirectly receives any significant benefit from the charitable donation, the IRS may consider such benefit as an indirect taxable dividend to the donor and disallow the donor's deduction.
* Planned gifts. If closely held stock is transferred to a charitable trust and held for investment, unrelated business income, self-dealing, excess business holdings, and jeopardy investment rules may apply. The liquidation of nonpublic traded C corporation stock through a charitable remainder trust, however, can be quite advantageous to the donor if careful attention is paid to the details. If a donor transfers stock to a charitable remainder trust and then the trust sells it to an unrelated third party, the donor recognizes no capital gains tax (unless the sale is considered to have been prearranged).
For donations to charitable lead trusts, if the closely held stock is to be held as an investment, income planning to pay the charitable income beneficiary is extremely important. Furthermore, if a nongrantor lead trust is established, the donor may be required to recognize income without receiving a corresponding deduction if the lead interest is characterized as unrelated business income.
For donations made on or after January 1, 1998, a charitable organization is eligible to own S corporation stock. The stockholder agreement, of course, must permit such transfers, and a gift to several different charities may cause the S corporation to lose its status if the resulting ownership is divided among too many shareholders.
* Outright gifts to qualified charities. The same three main issues apply to S corporation donations as to C corporation gifts. The donor must consider self-dealing rules if the donation is made to a private foundation, or intermediate sanction rules if donated to a public charity. Finally, if the holding of the underlying business triggers unrelated business taxable income (UBTI), the charitable donee will face taxes and potentially lose its tax-exempt status. One planning option to consider is having the S corporation donate assets to the charity rather than having the shareholders donate S corporation stock. The tax benefit will be claimed by the shareholder and UBTI risk will no longer be a problem. Furthermore, the valuation discounts such as the lack of marketability discount or minority interest discount will not reduce the amount of the tax deduction available if underlying assets are donated rather than the shares themselves.
* Recent improvements in the laws effecting donations of S corporation shares: The Pension Protection Act of 2006 provided temporary additional incentives for gifts made in 2006 and 2007. For gifts in those years, shareholders could reduce the basis in their stock only by the pro rata share of the entire contribution. This effectively made that tax treatment the same as a partnership. In other tax years, however, basis had to be reduced by the shareholder's pro rata share of the entire contribution.
* Planned gifts. While outright gifts of S corporation stock to a qualified charity are deductible, transfers of S stock to charitable remainder trusts are generally not deductible. If such a transfer occurs, the company will lose its S corporation status. Even if this consequence is acceptable to the remaining shareholders, self-dealing and unrelated business income issues still apply. S corporation stock can be transferred to a charitable lead trust as long as it is a grantor trust for income tax purposes or, if established at death, as long as the trustee is able to make a small business trust election. If transferred to a grantor trust, unrelated business income is not an issue because all income is taxable to the donor. Furthermore, when transferred to a lead trust, the donation must adhere to all self-dealing, excess business holding and jeopardy investment rules.
Example: Mr. Holm is a shareholder in a successful technology firm that is structured as an S corporation. In recent years, he has made a substantial profit in the business. He is considering donating some of his shares to a charitable remainder trust for the future benefit of the American Cancer Society.
Upon reviewing the situation with an advisor, Mr. Holms reconsiders his decision. First of all, there is a buy-sell agreement in place that limits Mr. Holm's ability to transfer shares to anyone other than an existing shareholder. Secondly, a charitable remainder is not considered to be a Qualified Subchapter S Corporation Trust (QSST). So, a transfer of the S corporation stock to a charitable remainder trust will cause a loss of the S corporation's special status and immediately convert the entity to a C corporation. This could trigger substantial income taxes for all of the shareholders. After discussing these disadvantages with his advisor, Mr. Holm decides to donate other highly appreciated, publicly traded stock instead.
Tax Shelter Notice involving S Corporation Donations
The IRS issued Notice 2004-30 to address an abusive tax shelter that closely resembled the Charitable Family Limited Partnership (CharFLP). (27) The scheme that had been promoted attempted to shift income taxes from the S corporation shareholder to the tax exempt entity, and was labeled as a "listed transaction" by the IRS for the purpose of tax shelter disclosure requirements.
According to the terms of the plan, the S corporation would issue both voting and non-voting stock plus warrants that were exercisable to non-voting stock. The non-voting stock would be donated to charity, the donors would take a charitable deduction for the gift, and all income from the company would be allocated to the non-voting stock. Later, the charity's stock would be redeemed or repurchased by the voting stockholders, but by claiming that the strike price of the warrants was equal to the value of all the non voting stock, the promoters artificially reduced the fair market value of the non-voting stock to zero.
Limited Liability Companies (LLCs)
While LLC rules and requirements vary by state law, in general, these companies are taxed either as a partnership or as a corporation. If an LLC is treated as a partnership, the partnership information discussed above applies. If treated as a corporation, any donation will be treated the same as the C corporation gifts outlined earlier.
Gifts of real estate generally fall into five main categories: (1) residential property; (2) investment property; (3) raw land; (4) agricultural land; and (5) commercial property. When helping clients plan charitable donations involving these assets, it is imperative that the advisor takes into account the various real property ownership structures.
This is the most common and simplest form of real property ownership. The term "fee simple" means the owner holds all rights to the property, including the right to transfer the property during lifetime or at death. Donating fee simple property is a rather simple transaction from a legal viewpoint although the actual steps involved in transferring title may be quite complex and will be outlined in more detail in the later example entitled "Gift of Real Estate."
Example: Ms. Baldessari owns an apartment complex and is considering contributing it to a charitable remainder trust that will benefit the University of California upon her death. She knows that several other complexes in the area have recently sold for a very high price. Ms. Baldessari knows that her building could sell easily if it were listed in the near future. Since she is planning on leaving a sizable bequest to the University anyway, contributing it to a charitable remainder trust makes sense for Ms. Baldessari.
Ms. Baldessari owns the property outright and, therefore, does not need to plan around any transfer restrictions that might be associated with partial interest or indirect ownership structures. She has owned the property for more than one year as an investment. However, she does have an outstanding mortgage on the property, and has depreciated the asset on her past tax returns.
If Ms. Baldessari transfers her property subject to a mortgage to a charitable remainder trust, several problems arise. She may run afoul of the grantor trust rules, and the transfer may be considered an act of self-dealing. She may also face problems with prohibited payments, bargain sale treatment, and unrelated debt-financed income. Ms. Baldessari decides to repay the mortgage with other assets prior to transferring the real estate to the charitable remainder trust.
As a final step, the advisor calculates Ms. Baldessari's tax deduction, taking into account the depreciation amount that she has deducted on past tax returns. While she will not have to realize this amount upon transferring the property to the charitable remainder trust, the fair market value of the asset will have to be reduced by the amount that would have been recaptured as ordinary income had she sold the property instead of donating it to the charitable remainder trust.
Once all of the background planning is complete, Ms. Baldessari must complete many detailed steps to fund her charitable trust. First of all, the donor must be able to prove that she owns the property by producing a Full Covenant and Warranty Deed. To complete the transfer to the charitable remainder trust, she must transfer the title of property to the trust, generally through an escrow company or attorney.
As part of their services, the escrow company or attorney will usually perform a title search, arrange for title insurance, contract for a survey of the property, hire a specialist to perform an environmental hazard report, contract for an inspection report, outline all the necessary disclosures, and make arrangements to bring the property up to local code.
And finally, in order to qualify for an income tax deduction, Ms. Baldessari must obtain a qualified written appraisal from an independent appraiser no earlier than 60 days prior to the transfer to the trust, and no later than the date on which she files her income tax return. Once the property is transferred to the charitable remainder trust, the trustee is free to sell the complex and reinvest in other investments, from which Ms. Baldessari will receive income for her lifetime.
Ownership of less than a fee simple in real property can take several forms, each of which requires specialized planning when transferring the donor's ownership to a charity. The following are examples of partial ownership of real estate:
* Community property. Currently, several states are community property states and while property ownership laws vary somewhat between these states, in general, real property purchased by spouses during marriage is considered to be owned equally by both spouses. (28) Community property can be donated to charity either during life or at death, with each spouse controlling the disposition of his half of the property.
* Tenancy by the entirety. In some non-community property states, when spouses co-own assets, it is assumed that each spouse owns the entire property. When one dies, the entire asset passes directly to the survivor; as a result, charitable bequests of such property cannot be arranged by will or trust. For partial donations during life, the transfer to charity severs the tenancy by the entirety and the remaining owner becomes a tenant in common with the charity (see below).
* Joint tenancy with right of survivorship. With this form of ownership, two or more people own equal but undivided shares of a property. At the death of a joint tenant, his ownership interest passes automatically to the remaining owners. Many clients have established this form of ownership under the misconception that it will remove the asset from their taxable estate. Although it is true that property transferred under a joint tenancy with rights of survivorship avoids probate, such a transfer does not avoid estate taxes. Instead, by entering into a joint tenancy with their children, many parents may have inadvertently triggered a taxable gift. A joint tenant (in a tenancy with right of survivorship) cannot leave a charity his interest at death since by contract it must pass to the surviving joint owner. It is possible to make a gift of such an interest during the joint tenants' lifetimes. If a gift of one tenant's interest is made during lifetime, the joint tenancy is severed and the charity becomes a tenant in common with the remaining owner.
* Tenancy in common. Commonly referred to as a "TIC," tenancy in common occurs when two people own undivided fractional interests in a property. They may own equal or unequal percentages of the property, and both income and expenses are divided proportionately depending on their ownership percentages. Before a TIC interest is contributed, it is imperative to ascertain that the donor has the right to dispose of his share to an outside party. If a tenant donates his interest to a charity, then the charity becomes a tenant in common.
* Condominiums. This is a form of co-ownership where two or more owners retain exclusive rights to inhabit or rent a specific unit on the property while sharing ownership and expenses of the common grounds. Each owner has the right to sell, transfer, or donate his interests during life or at death. Condominium ownership between two or more persons can also take the form of community property, tenants in common, tenants by the entirety, or joint tenancy (as explained above).
* Life estates. In addition to concurrent forms of ownership, property can be divided between current and future rights. For example, one person may have to right to use, control, and enjoy property for life (i.e., a life estate) or for a specified period of years, at which time, the same or different rights pass to a second party. Naturally, any transfers to charity cannot violate the terms of the life estate. If the life tenant has a right to use the property for life, but is prohibited from selling the property, he can donate the use of the property to the charity only for the length of his life.
* Leaseholds. In some situations, property may be subject to a long or short-term lease of the land and/or structures on that land. If the donor is both the owner and lessor of the land, the gift is fairly straightforward, so long as the donor gives away his entire interest. However, if the donor gives the lease by itself to the charity, the transfer would most likely be considered a gift of a partial interest and would, therefore, be nondeductible.
(For rules governing "partial interest gifts," which are more commonly gifts of less than the donor's entire interest, see Chapter 5.)
In some situations, the donor may own an interest in an entity, which in turn owns real property. When the donor wishes to transfer the real property to charity, special planning considerations should be taken into account depending on the type of indirect ownership structure:
* Inter vivos trusts. Many donors hold title to their real property through a revocable living trust. In this situation, it is often advisable to transfer the title to the donor first, who then makes a direct donation to the charity. This extra step will ensure the donor an unambiguous charitable deduction.
* Partnerships. When real estate is held by a partnership, it is important to remember that the partnership owns the real property and the partners (either general or limited) own interests in the partnership. The partnership agreement may place limitations on the transfer of partnership interests during life or at death and must be carefully reviewed prior to making any charitable donations. Charitable planning can then take on either of two forms depending on the goals of the donor: (1) the partnership can donate the real property to charity; or (2) the partners can donate partnership interests. If the latter gift is chosen, it is imperative to review the partnership terms and income characterization to ensure that the charity will not realize unrelated business income.
* Corporations. Similar to a partnership, a donor may have established a corporation to own and manage his real property. Again, the donor will have a choice of donating corporate shares to charity or having the corporation make a donation of the underlying property to charity.
* Cooperative housing corporations. Often referred to as a "co-op," this property ownership is usually a multi-tenant residential property that finances the purchase by selling equity shares in the corporation. Some tenants/shareholders have arranged their co-op shares to be considered real property; others have characterized them as intangible personal property.
WHERE CAN I FIND OUT MORE ABOUT IT?
1. Internal Revenue Service, Publication 526 Charitable Contributions, (2006).
2. Toce, Joseph, Abbin, Byrle, Vorsatz, Mark, and Page, William, Tax Economics of Charitable Giving 2006-2007 (Warren Gorham & Lamont, 2006).
3. Teitell, Conrad. Guide to Tax Benefits for Charitable Gifts, updated regularly (PG Calc, distributed by Trusts and Estates Magazine).
4. Lyon, James. "Reflections on Deductibility of Contribution of Items of Tangible Personal Property to Museums", February 16, 2007 at: www.pgdc.com.
5. Ashton, Debra. The Complete Guide to Planned Giving, Revised Third Edition (Ashton Associates, 2004).
6. Kestenbaum, Avi. "Know the Differences: Why All Charitable Contributions Are Not Equal," Trusts & Estates Magazine (May 2006).
7. Raby, Burgess and Raby, William, "Property Contributions: It's All About the Details," Tax Analysts Tax Practice (March 20, 2006).
8. Fox, Richard. "Practical Charitable Planning for Employee Stock Options," Estate Planning Journal (May 2005).
9. Internal Revenue Service Publication 561 Determining the Value of Donated Property (April 2007).
QUESTIONS AND ANSWERS
Question--Why is it often better to donate highly appreciated assets rather than cash?
Answer--With a cash donation to charity, the asset has a 100% adjusted basis. By choosing to donate an appreciated long-term capital gain asset instead, a donor can reduce future taxes significantly. For example, let us suppose a donor has two assets: $10,000 of cash in a checking account (adjusted tax basis of $10,000), and Microsoft shares that have been held for several years worth $10,000 (adjusted tax basis of $3,000.) If the donor writes a check for $10,000 to the American Lung Foundation, he is effectively giving away cash and keeping the Microsoft investment intact. If the donor instead gives $10,000 of Microsoft stock, the charity will still receive a gift worth $10,000, but the donor will now have $10,000 of cash that he can reinvest (after a 30-day waiting period) in Microsoft stock. With both options, the donor is left with $10,000 of Microsoft stock. But by donating the highly appreciated asset to charity instead of cash, the donor has increased the tax adjusted basis in his holdings by $7,000. Should the donor later choose to sell the stock, his future gain--and therefore his taxes--would be substantially reduced. Of course, the income percentage limitations (see Chapter 3) should also be considered.
Question--What is a Charitable Family Limited Partnership?
Answer--Sometimes referred to as a "Char-FLP," in this planning technique a donor establishes a family limited partnership with his heirs, then donates a substantial percentage of the partnership interests (anywhere between 30% and 98% is typical) to a public charity. (29) While the donor's charitable income tax deduction is reduced by a variety of valuation discounts (e.g., marketability and minority discounts), the immediate tax deduction can be significant. In addition to the upfront charitable deduction, the partnership is able to sell the highly appreciated asset and reinvest the proceeds with much of the resulting capital gains tax being absorbed by the charity's tax-exempt status. (Since the charity owns--say 98% of the limited partnership interests--98% of the capital gain is attributable to the charity, which of course is tax- exempt.)
While these plans vary substantially depending on the planner or promoter involved, there are some significant problems that are likely to be addressed either through future legislation or through Treasury regulations. In particular, the donor's children or other future heirs usually purchase the charity's interests a few years into the plan for an amount that is substantially less than either the fair market value of the interests or the deduction taken by the donor when the interests were donated. Secondly, this plan is more of a business arrangement than a charitable contribution, and as such, the donor's deduction may be at risk; furthermore, the charity is likely to be subjected to unrelated business income taxes. (30) For additional details, see Appendix A.
Question--Is there any advantage to donating tax shelter interests to charity?
Answer--Contributions of "burned-out" tax shelters offer little or no benefit to either a donor or a charity. The value of the gift must be reduced by the full amount of the debt associated with it. Furthermore, charities must be wary of such gifts since debt-financed shelters could potentially result in unrelated business income.
Question--Are there any circumstances in which a donor can donate S corporation stock to a charitable remainder trust without forfeiting the S corporation status of the company?
Answer--Under the Small Business Job Protection Act of 1996, Congress changed the S corporation laws to permit charities to own S corporation stock when the donation was made directly to the charity. Unfortunately, it did not extend the safe harbor rules to include charitable remainder trusts. Some planning options do exist for donors who desire to make such gift. These possibilities range from being relatively simple to quite complex. One of the more creative solutions is for the S corporation itself to establish the charitable remainder trust. The charitable contribution deduction will then pass through to the S corporation's shareholders. (31)
Question--Is there any way to fund a charitable remainder trust with real estate subject to a mortgage?
Answer--By using a specially designed Real Estate Investment Trust (REIT), donors may be able to convert appreciated, debt-encumbered real estate to a debt free security that can then be donated to a charitable remainder trust without triggering gain recognition or potential self-dealing problems. (32)
(1.) IRC Sec. 170(e)(1)(B).
(2.) IRC Sec. 170(e)(7).
(3.) Treas. Reg. [section]1.170A-4(b)(1).
(4.) IRC Sec. 170(e)(3)(A)(i).
(5.) IRC Sec. 170(e)(4).
(6.) IRC Sec. 170(a)(3).
(7.) IRC Sec. 170(o)(1)(A), Sec. 170(o)(3), and Sec. 2522(e)(3).
(8.) IRC Sec. 170(f)(12), Sec. 170(e)(3).
(9.) Rev. Rul. 69-63, 1969-1 CB 63.
(10.) Let. Rul. 9225036.
(11.) IRC Sec. 1231.
(12.) IRC Sec.170(f)(15).
(13.) IRC Secs. 170(f)(2)(A), 2055(e)(2)(A) and 2522(c)(2)(A).
(14.) IRC Secs. 170(f)(3)(B), 2055(e)(2) and 2522(c)(2).
(15.) IRC Sec. 170(m).
(16.) IRC Sec. 170(e)(1)(B)(iii).
(17.) IRC Sec. 170(e)(1)(B)(iii).
(18.) Treas. Reg. [section]1.170A-4(a).
(19.) Rev. Rul. 98-21, 1998-1 CB 975, Rev. Proc. 98-34, 1998-1 CB 983.
(20.) Treas. Reg. [section]1.421-6(d)(5).
(21.) Treas. Reg. [section]1.83-7; Let. Rul. 9713012.
(22.) IRC Sec. 1221.
(23.) Treas. Reg. [section]1.170A-13(c).
(24.) IRC Secs. 1271, 1272, 1273, 1274, 1275.
(25.) Rev. Rul. 77-287, 1977-2 CB 319.
(26.) Treas. Regs. [section][section]20.2031-8(b)(1), 25.2512-6(b)(1).
(27.) 2004-1 CB 828.
(28.) Ten states are community property states: Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
(29.) See Stephan R. Leimberg, "Charitable Family Limited Partnerships: Prudent Planning or Evil Twin," at: http://www.pgdc.com/usa/item/?itemID=24424&g11n.enc=ISO-8859-1.
(30.) See, e.g., Field Service Advice 200122011, in which the IRS determined that a formula clause, which allocated additional value to a charity if the value of the transferred property was redetermined for transfer tax purposes, was ineffective.
(31.) Let. Rul. 9340043.
(32.) Let. Rul. 199952071.
|Printer friendly Cite/link Email Feedback|
|Publication:||Tools & Techniques of Charitable Planning, 2nd ed.|
|Date:||Jan 1, 2007|
|Previous Article:||Chapter 3: income percentage limitations.|
|Next Article:||Chapter 5: partial interest rules.|