“Better three hours too soon than a minute too late.”
While William Shakespeare and the IRS may not appear to have much in common, delayed timing resulted in a lost charitable income tax deduction and a hefty capital gains tax for the taxpayer in a recent Tax Court case, Estate of Hoensheid v. Commissioner, (T.C. Memo 2023-34) March 15, 2023.
Commerical Steel Treating Corp. (“CSTC”) was owned by three brothers. One of the brothers announced his plans to retire in 2014, and shortly thereafter CSTC began pursuing a sale of the company. In early 2015, CSTC retained an investment banking firm as its advisor to begin soliciting bids for the sale of CSTC. On April 1, 2015, a buyer submitted a letter of intent to purchase CSTC for $92 million.
Meanwhile, in mid-April 2015, Mr. Hoensheid, one of the owners and the taxpayer in this case, began working with Fidelity Charitable to discuss establishing a donor advised fund to accept a pre-sale donation of his CSTC stock to reduce income tax consequences on sale. Taxpayer consulted with his longtime tax and estate planning attorney who advised that a transfer to charity would have to take place before there was a ‘definitive agreement’ to sell in place. Taxpayer responded to his counsel by email, telling her that while he wanted to contribute $3.5M in stock to the donor advised fund, he wanted to “wait as long as possible to pull the trigger” in the event the sale fell through.
On April 23, CSTC and the buyer signed a nonbinding letter of intent, and due diligence commenced, as well as the following events:
- May 21: the parties to the sale transaction negotiated a purchase and sale agreement.
- June 1: the taxpayer signed Fidelity Charitable’s Letter of Understanding which described the planned donation as being shares of CSTC stock but did not specify the number of shares. Also on June 1, in an email to his attorney, taxpayer stated “I do not want to transfer the stock until we are 99% sure we are closing.” He was concerned that if the sale did not go through, he would have to relinquish most of his shares, and his brothers could end up owning more stock than he did.
- June 11: CSTC’s shareholders and board voted to ratify the actions related to the sale of CSTC stock to buyer and consented to taxpayer’s proposed transfer of an unstated number of shares of stock to Fidelity Charitable.
- June 12: buyer’s board approved the acquisition of CSTC.
- July 9: CSTC and the buyer prepared revisions to the purchase agreement which reflected that taxpayer would donate 1,380 shares to Fidelity Charitable. Also on July 9, the parties exchanged a Minority Stock Purchase Agreement for the purchase of shares by Fidelity Charitable.
- July 10: CSTC amended its Change in Control Bonus Plan which resulted in CSTC paying employee bonuses totaling over $6 million in cash.
- July 13: taxpayer delivered to Fidelity Charitable a stock certificate representing 1,380 shares of CSTC.
- July 14: CSTC made a pro rata dividend distribution of $4.7M to taxpayer and his two brothers. Fidelity Charitable did not participate in the dividend distribution which represented all of the remaining cash in CSTC.
- July 15: the sale of the stock to the third party was consummated.
On taxpayer’s 2015 tax return, the taxpayer reported the gift as having been made on June 11, 2015. He did not report any capital gain associated with the donation of the 1,380 shares of CSTC stock and claimed a charitable income tax deduction of $3,282,511.
The IRS denied the deduction on the basis that the taxpayer’s appraisal failed to satisfy multiple substantive requirements of the regulations and issued a notice of deficiency in the amount of $650K and a penalty of $130K. The taxpayer appealed, and in response, the IRS amended its answer to claim that the transfer resulted in an anticipatory assignment of income and that the taxpayer would also have to pay tax on the capital gain.
Gift of Shares of Stock
In determining whether and when the gift of stock was made, the Court applied Michigan law, the law of taxpayer’s domicile. The validity of a gift under Michigan law requires a showing of (1) intent to make a gift, (2) actual or constructive delivery of the gift, and (3) acceptance of the gift. Hoensheid at 13, citing Davidson v. Bugbee, 227 Mich. App. 264 , 575 N.W.2d 574 , 576 (Mich. Ct. App. 1997) (citing Molenda v. Simonson, 307 Mich. 139 , 11 N.W.2d 835 , 836 (Mich. 1943)); see also United States v. Four Hundred Seventy Seven (477) Firearms, 698 F. Supp. 2d 894 , 902 (E.D. Mich. 2010).
With regard to the June documentation on which the taxpayer relied, the Court held that it demonstrated a generalized future intent to make a gift, as the documentation failed to specify a number of shares. The Court also found probative the email exchange expressing taxpayer’s reluctance in making a gift until “the last possible moment, when he was ‘99% sure’” that the sale to the buyer would close.
Not until July 9 did the Court find that there was a present intent to make a gift, when taxpayer took a number of actions to confirm his present intent to transfer, including establishing a donor advised fund with Fidelity Charitable and delivering the stock certificate to his attorney’s office. The Court found that acceptance occurred on July 13, 2015, two days prior to finalizing the sale of the business, when taxpayer divested himself of title to the shares and Fidelity Charitable signed the Minority Stock Purchase Agreement under warranty of good title. Hoensheid at 18.
Anticipatory Assignment of Income
The timing of the donation was also significant in determining whether the doctrine of anticipatory assignment of income would apply, which recognizes that income is taxed “to those who earn or otherwise create the right to receive it” Hoensheid at 18, citing Helvering v. Horst, 311 U.S. 112, 119 (1940), and that tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised.” Hoensheid at 18, citing Lucas v. Earl, 281 U.S. 111, 115, 50 S. Ct. 241 , 74 L. Ed. 731 (1930).
In the case of the charitable contribution of shares of stock followed by a sale, the inquiry is whether the prospective sale is a mere expectation or a certainty. In general, a donor’s right to income from shares of stock is fixed if a transaction involving those shares has become “practically certain to occur” by the time of the gift, “despite the remote and hypothetical possibility of abandonment.” Hoensheid at 19, citing Jones v. United States, 531 F.2d 1343, 1345 (6th Cir. 1976) (en banc), 531 F.2d at 1346. To avoid an anticipatory assignment of income, the Court held, “a donor must bear at least some risk at the time of the contribution that the sale will not close.” Hoensheid at 24. The documentation of the sale must not have proceeded to the point where the right to income from the sale is fixed. Hoensheid at 23, citing Ferguson v. Commissioner, 174 F.3d 997, 108 T.C. at 259 (9th Cir. 1999).
In Hoensheid, the Court found that a number of acts had already taken place at the time of donation that suggested the sale of CSTC was a virtual certainty, including the following: CSTC’s shareholders had unanimously approved the transaction, employee bonuses resulting from the transaction had been paid, the parties had reached a resolution on the final due diligence concern, and the substantive terms of the transaction had been fully negotiated. Hoensheid at 21-24. Thus, on the record before the Court, it found that the delay in transferring the CSTC shares until two days before closing eliminated any risk that the sale would not close. Hoensheid at 24. The Court held that the taxpayer could not escape taxation on the gain and was deemed to have realized income and then assigned it to Fidelity Charitable when the taxpayer donated the stock on July 13, 2015.
While the Court found the gift of stock to be an assignment of income and as a result, the taxpayer would be forced to recognize gain from the sale transaction, the taxpayer nevertheless sought to receive a deduction based on the fair market value of the shares gifted. Having failed to satisfy the charitable donation substantiation requirements, the Court disallowed the charitable contribution deduction.
The appraisal was deficient with respect to key substantive requirements of the regulations. Taxpayer used his advisor employed by the investment banking firm handling the sale transaction to prepare an appraisal of the gift because he charged no fee for the valuation, instead offering to perform the valuation under the fees paid to the firm. Notably, the advisor did not have appraisal certifications, nor did he hold himself out as an appraiser. While the advisor had experience valuing closely held businesses, the Court held that his “mere familiarity with the type of property being valued” did not qualify him as an appraiser. Hoensheid at 30, citing Brannan Sand & Gravel Co. v. Commissioner, T.C. Memo. 2020-76, at *9-10, *15.
In addition to retaining a non-qualified appraiser, the valuation report was deficient in other respects and thus was not a “qualified appraisal” under the regulations. The valuation stated an incorrect date of contribution and did not sufficiently describe the method for the valuation. Although substantial compliance can satisfy regulatory substantiation requirements, taxpayer’s failure to engage a qualified appraiser to complete the valuation along with the defective appraisal did not satisfy the requirements of substantial compliance and the Court disallowed the charitable income tax deduction in its entirety.
While charitable planning can play a powerful role in exit planning for owners of highly appreciated closely held business interests, Hoensheid warns taxpayers to be cautious in proceeding too far down the road in sale transactions. Key takeaways from Hoensheid and to accomplish an effective charitable gift of business interests:
- Assemble the team of advisors, including the attorney, CPA, financial advisor, and qualified appraiser, for pre-planning conversations.
- Take donative steps in advance of sale – sooner rather than a minute too late.
- Substantiate the gift: obtain a qualified appraisal from a qualified appraiser.
For more information or more effective charitable conversations with clients, connect with our Donor Services Team at email@example.com