The Tax Law of Charitable Giving. Bruce R. Hopkins
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The court dismissed the importance of control between the business and the recipient charitable organization and the fact that everyone involved anticipated that the gifted property would be sold or otherwise liquidated. Wrote the court: “Only through such a step could the purpose of the charitable contribution be achieved.”83
In another instance, an individual made annual gifts, for 10 consecutive years, to a university of closely held stock in a corporation of which he was the majority shareholder, an officer, and a director. He retained a life interest in the gift property and confined his charitable contribution deduction to the value of the remainder interest. Each year, the university tendered stock to the corporation for redemption; each year, the corporation redeemed it. There was no contract evidencing this cycle of events. The university invested the redemption proceeds in income-producing securities and made quarterly disbursements to the donor.
The IRS argued that the donor employed the university as a tax-free conduit for withdrawing funds from the corporation and that the redemption payments by the corporation to the university were in reality constructive dividend payments to the donor. The court on appeal nicely framed the dispute: “[O]ur aim is to determine whether [the donor's] gifts of the [c]orporation's shares [to the university] prior to redemption should be given independent significance or whether they should be regarded as meaningless intervening steps in a single, integrated transaction designed to avoid tax liability by the use of mere formalisms.”84
The IRS wanted the court to “infer from the systematic nature of the gift-redemption cycle” that the donor and donee had “reached a mutually beneficial understanding.”85 But the court declined to find any informal agreement between the parties; it also declined to base tax liability on a “fictional one” created by the IRS.86 The court so held even though the donor was the majority shareholder of the corporation, so that his vote alone was sufficient to ensure redemption of the university's shares. The court wrote that “foresight and planning do not transform a non-taxable event into one that is taxable.”87
In still another instance, an individual donated promissory notes issued by a company he controlled to three charitable foundations several weeks prior to their redemption. A court held that he did not realize income in connection with these gifts or the subsequent redemption of the notes by the company. The court observed: “A gift of appreciated property does not result in income to the donor so long as he gives the property away absolutely and parts with title thereto before the property gives rise to income by way of a sale.”88
In one more instance involving facts of this nature, the court took note of the fact that the concept of a charitable organization originated before and independently of the sale, the deed of trust for the property contributed was executed before and independent of the sale, and at the time the deed of trust was executed, “no mutual understanding or meeting of the minds or contract existed between the parties.”89
There are cases to the contrary, however, holding that the transfer of the property to a charitable organization “served no business purpose other than an attempt at tax avoidance.”90
In the end, perhaps the matter of the doctrine comes down to this: “Useful as the step transaction doctrine may be in the interpretation of equivocal contracts and ambiguous events, it cannot generate events which never took place just so an additional tax liability might be asserted.”91
The step transaction doctrine occasionally appears in IRS private letter rulings as well. In one instance, an individual planned to fund a charitable remainder trust92 with a significant block of stock of a particular corporation. It was anticipated that the trust would sell most, if not all, of this stock in order to diversify its assets. The stock first had to be offered to the corporation under a right of first refusal, which allowed the corporation to redeem the stock for its fair market value. The donor was the sole initial trustee of the trust.
The IRS focused on whether the trust would be legally bound to redeem the stock. Although it did not answer that question, it assumed that to be the case and also assumed that the trust could not be compelled by the corporation to redeem the stock. Thus, the IRS held that the transfer of the stock by the donor to the trust, followed by the redemption, would not be recharacterized for federal income tax purposes as a redemption of the stock by the corporation followed by a contribution of the redemption proceeds to the trust. The IRS also held that the same principles would apply if the stock were sold rather than redeemed. This holding assumed that the donor had not prearranged a sale of the stock before contributing it to the trust under circumstances in which the trust would be obligated to complete the sales transaction.93
In another situation, an individual planned to contribute a musical instrument to a charitable remainder trust. The instrument was used in the donor's profession; the donor was not a dealer in this type of instrument, nor was it depreciated for tax purposes. Again, the issue was presented: If the trust subsequently sold the instrument for a gain, would that gain have to be recognized by the donor? The IRS presumed that there was no prearranged sales contract legally requiring the trust to sell the instrument following the gift. With this presumption, the IRS was able to hold that any later gain on a sale of the instrument would not be taxable to the donor.94
§ 3.8 CHARITABLE PLEDGES
The making of a pledge does not give rise to a federal income tax charitable contribution deduction. The deduction that is occasioned, such as it may be, is determined as of the time the pledge is satisfied.95
The enforceability of a pledge is a matter of state law. Some states require the existence of consideration as a prerequisite to the existence of an enforceable pledge; other states will enforce a pledge on broader, social grounds.
Usually, a pledge is made by a potential donor in the form of a written statement—a promise to the potential charitable donee of one or more contributions in the future. An example of the rule is that a pledge of a stock option to a charitable organization produces an income tax charitable deduction in the year in which the charitable donee, having acquired the option, exercises it.96 Another illustration of this is a funding agreement, under which a person commits in writing to make multiple contributions to a charitable organization over a stated period, for purposes such as general operations or endowment: The charitable contribution arises in each year of actual payment.97
As one court case reflects, however, a charitable pledge can arise in other ways. A trustee of a small college and his colleagues were concerned about the long-term financial viability of the institution. He wanted to substantially augment the college's endowment fund. To that end, he caused a company (of which he was the president) to issue (in 1981) to the college a zero-coupon original-issue discount bond, with a term of 50 years and a $20 million face amount, payable upon maturity in 2031 (unless the bond was retired early). The purchase price of the bond was $23,066 (representing