Thursday March 28, 2024

5.5.1 Assignment of Income

Assignment of Income

Palmer - Stock Gift Exchanged for Property:  In Palmer v. Commissioner, donor Daniel D. Palmer was President of Palmer College of Chiropractic.

Rev. Rul. 78-197 - No Binding Obligation:  After review of Palmer and other cases, the IRS in 1978 decided to acquiesce to the Tax Court.

Ferguson - Over 50% Sale Rule:  The next major decision addressing the prearranged sale with C corporation stock was the Ferguson case.

Rauenhorst - IRS Must Follow Its Revenue Rulings:  Donors Harold and Henrietta Rauenhorst owned warrants that allowed them to acquire 772.14 shares of stock in a company named NMG.

Dickinson - Bypass of Gain With Pattern of Redemptions:  Donors Harold and Henrietta Rauenhorst owned warrants that allowed them to acquire 772.14 shares of stock in a company named NMG.

Under general tax principles, income is taxed to the person who earns it. For example, in Helvering v. Horst, 311 U.S. 112 (1940), the Court noted that income is taxed "to those who earn or otherwise create the right to receive it and enjoy the benefit of it when paid."

There are understandable reasons for this principle. If a person were able to earn income and have it taxed to another individual, many parents in high tax brackets would immediately choose to have income paid to children and taxed in the children's lower brackets.

The assignment of income issue potentially applies with a gift of appreciated property to charity. Because the Tax Code does not require recognition of gain when the property is transferred, the donor generally receives a deduction at fair market value. This deduction is usable in the year of the gift up to 30% of the donor's adjusted gross income and the donor bypasses or avoids capital gains. In return, the charity receives an appreciated asset. Because the charity is tax-exempt and the asset normally does not generate unrelated business taxable income, the charity may sell the asset and avoid paying capital gains tax.

With the donor's understandable goal to avoid capital gains tax and the human tendency to wait until the last moment to make the actual transfer to the charity, there have been several cases in which the IRS contested the capital gain bypass. The question most litigated has been whether the gift was a transfer of an appreciated asset to charity with a corresponding bypass of capital gain or in effect a sale of the asset, recognition of capital gain and a subsequent transfer of cash proceeds to charity.

Palmer - Stock Gift Exchanged for Property


In Palmer v. Commissioner, 62 T.C. 684 (1974), affirmed on other grounds 523 F.2d 1308 (8th Cir. 1975), donor Daniel D. Palmer was President of Palmer College of Chiropractic. His grandfather and father founded the field and created the college as a taxable corporation. Dr. Palmer decided to convert the entity to a non-profit corporation. He founded the Palmer College Foundation and obtained tax-exempt status.

Subsequently, the donor and others transferred shares of Palmer College to the foundation. After receiving approximately 80% of the corporate shares, the foundation exchanged all of its shares for the assets of the college. The foundation then operated the college as a nonprofit.

Daniel D. Palmer donated 238 shares of stock to the foundation and claimed a deduction of $52,642.72. The IRS contested the deduction. Because Daniel Palmer was in control of both the for-profit corporation and the charitable foundation, the IRS claimed that he had in effect transferred stock to the corporation in exchange for a taxable dividend of $52,642.72, then made a cash gift to the foundation.

The Tax Court reasoned that there may have been an "expectation" that the stock would be redeemed. However, a mere expectation is not enough for the gain to have "ripened." Therefore, the Tax Court ruled: "In light of the presence of an actual, valid gift and because the foundation was not a sham, we hold that the gift of stock was not in substance a gift of the proceeds of redemption."

Rev. Rul. 78-197 - No Binding Obligation


After review of Palmer and other cases, the IRS in 1978 decided to acquiesce to the Tax Court. It issued Rev. Rul. 78-197 and established a "bright-line" test for prearranged sales.

When a charitable gift is followed by a "prearranged redemption" or "pursuant to a prearranged plan," the IRS will "treat the proceeds as income to the donor under facts similar to those in the Palmer decision only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption."

The obvious benefit of Rev. Rul. 78-197 for donors is that a fairly clear test has been established. The binding nature of contracts is generally defined under state law. If, under applicable state law a contract has proceeded to the point at which the buyer can compel performance by seller, then a binding agreement exists. In this case, capital gains are not avoided if seller transfers assets to charity, even if the transfer occurs prior to actual closing of the sale.

Ferguson - Over 50% Sale Rule


The next major decision addressing the prearranged sale with C corporation stock was the Ferguson case. Roger and Sybil Ferguson founded Diet Center, Inc. and then transferred that entity to a Delaware corporation, American Health Companies, Inc. (AHC). AHC was approached by prospective purchaser CDI Holding, Inc. (CDI). After extensive negotiations, a merger agreement was created on July 28, 1988, and an offer to all of the AHC shareholders to tender their shares was extended on August 3, 1988. The tender was initially to be completed by August 31, 1988, but was extended to September 9, 1988.

On August 23, 1988, Roger and Sybil Ferguson opened a brokerage account with Merrill Lynch and placed 341,366 shares of AHC stock in the account. They also declared their intent to give 57,778 shares to charity. However, since the shares could not be transferred without approval of the Merrill Lynch legal staff, the actual transfer of shares to charity occurred on September 8, 1988. The tender offer expired on September 9, 1988 and the actual acceptance by the buyer was on September 12, 1988.

On August 31, 1988, 52.2% of the shares had been tendered. On September 8, 1988, 57.2% of the shares had been tendered and on September 9, 1988, 95.2% of the outstanding shares had been tendered. While the sale was contingent upon tender of 85% of the shares, the court noted that the buyer had the option of waiving the 85% requirement. Further, under applicable state law, the tendering of more than 50% of the shares enabled the buyer to complete the sale. Therefore, the court determined that the transaction was binding or had "ripened" for tax purposes on "August 31, 1988 - the first date by which over 50% of the AHC shares had been tendered" and before the charitable gift by the Fergusons was completed.

Because over 50% of the shareholders had voted in favor of the completed sale, the buyer had a legally enforceable right to compel performance and the gain had "ripened." Thus, the Fergusons and other stockholders with a similar fact pattern were not permitted to bypass the capital gain on the gifted AHC shares.

The Ferguson case created another "bright-line" test. If, under applicable law, a C corporation buyer can compel performance on the sale following a vote by over 50% of the shareholders in favor of the sale, then the gain has "ripened" and a gift of shares does not bypass the donor's capital gain.

Rauenhorst - IRS Must Follow Its Revenue Rulings


Donors Harold and Henrietta Rauenhorst owned warrants that allowed them to acquire 772.14 shares of stock in a company named NMG. On September 28, 1993, prospective purchaser World Color Press, Inc. (WCP) offered to purchase NMG. On that date, the NMG directors signed a letter of intent describing in general terms the prospective purchase of NMG by WCP. However, the letter of intent was not a legally binding sale contract.

On November 8, 1993, the Rauenhorsts gave warrants for the right to purchase a total of 770 shares to four public charities. On November 12, 1993, NMG reflected the gift on its warrant ledger. On November 19, 1993, the donors, the four charities and the other shareholders agreed to sell all NMG shares to WCP.

The IRS claimed that the gain had "ripened" before transfer of the shares to charity. Therefore, the Rauenhorsts did not bypass capital gain on the gifted warrants. Understandably, counsel for the Rauenhorsts pointed out that there was no binding obligation for sale on either November 8, 1993 or November 12, 1993. Therefore, under the "binding agreement" standard of Rev. Rul. 78-197, the IRS could not claim that the gain had "ripened."

At trial, the IRS argued that the standard created by Rev. Rul. 78-197 was not binding on either the Tax Court or the IRS. In the view of the IRS, the Tax Court could ignore Rev. Rul. 78-197 and find against the taxpayer.

The IRS suggested a new standard that it called the "ripened to a practical certainty" test for deciding when taxpayers would be subject to tax on the gain. The Tax Court disagreed with the IRS. In this case, the Rauenhorsts were not under any binding obligation to sell at the date of transfer to the charities. In addition, the court stated "We cannot agree that the Commissioner is not bound to follow his Revenue Rulings in Tax Court proceedings."

Therefore, the Rauenhorst court determined that the IRS must follow its "no binding agreement" standard with respect to alleged prearranged sales of appreciated assets.

Dickinson - Bypass of Gain With Pattern of Redemptions


In Jon Dickinson et ux. v. Commissioner; No. 9526-19; T.C. Memo. 2020-128, the Tax Court ruled that a stock charitable donation bypassed capital gain, even though there was a pattern of redemptions.

Dickinson was the chief financial officer and a shareholder in Geosyntec Consultants, Inc. (GCI). The GCI Board authorized donations of GCI shares to Fidelity Investments Charitable Gift Fund (Fidelity), a qualified Section 501(c)(3) organization. The authorization from GCI acknowledged that Fidelity "has a donor advised fund program, which incorporates procedures requiring * * * [Fidelity] to immediately liquidate the donated stock."

The stock donations were approved in years 2013, 2014 and 2015 by written minutes of the GCI Board meetings. After each stock gift, GCI confirmed in writing that Fidelity was the owner of the transferred shares. Taxpayer signed a letter of understanding (LOU) with Fidelity that stated the gifted stock was "exclusively owned and controlled by Fidelity." Fidelity had full control of any subsequent sale of the stock and "is not and will not be under any obligation to redeem, sell, or otherwise transfer" of the gifted shares.

Fidelity provided a letter that stated it had "exclusive legal control over the contributed assets." Following the gifts, Fidelity promptly tendered the shares to GCI and received cash payments. Taxpayers reported a deduction for the fair market value of the gifted shares. The IRS issued a notice of deficiency for the failure of taxpayer to pay the capital gains tax on the gifted shares. The IRS also assessed a penalty under Section 6662(a).

Taxpayers are permitted to deduct the fair market value of appreciated property charitable gifts. Reg. 1.170A-1(c)(1). Dickenson intended to benefit from the gift of appreciated property rather than a gift of cash proceeds.

The IRS claimed that the substance of the transaction was a redemption by the taxpayer of the GCI shares followed by a gift of cash to Fidelity. The Tax Court stated, "We respect the form of this kind of transaction if the donor (1) gives the property away absolutely, and parts with title thereto (2) before the property gives rise to income by way of a sale."

The court reviewed the documents to determine whether donor transferred all rights in the GCI stock. The court stated, "GCI's letters to Fidelity confirming ownership and transfer, Fidelity's letters to petitioners, explaining that Fidelity had exclusive legal control over the donated stock, and the LOU's to the same effect all support petitioners? claim that petitioner husband transferred all his rights in the shares. Respondent makes much of the fact that Fidelity regularly redeemed the GCI shares shortly after each donation, according to what the Board understood to be Fidelity's internal procedures."

The IRS claimed there was a pre-existing understanding that Fidelity would promptly redeem the shares. However, a pattern of stock redemptions does not change the fact that Fidelity had clear title to the stock and could decide whether or not to redeem.

The IRS also claimed assumption of income because the pattern indicated that a redemption was imminent. See Rev. Rul. 78-197, 1978-1 C.B. 83. The Court noted the redemption was under the control of Fidelity and there had been no decision that required a redemption. The court stated, "The ultimate question, as noted in Palmer, is whether the redemption and the shareholders? corresponding right to income had already crystallized at the time of the gift." See Palmer v. Comm., 62 T.C.at 694-695.

The Court determined there was an absolute and clear gift of the GCI shares. The pattern of redemptions did not change the fact that title had clearly been transferred and the redemption was under the control of the charity. The bypass of capital gain on the gift was permitted.

Case Studies on Assignment of Income

Sam Storeowner and the Tax-Free Buyout:   Sam Storeowner was having coffee at Small Town Café when his friend Bob Banker walked into the café. Bob motioned Sam to a booth in the back and said that he wanted to talk to Sam. It turns out that Bob and several friends were in the process of obtaining a charter for a new bank. They were contacting a number of business owners in town and offering them the opportunity to invest.

Private Letter Rulings

PLR 200321010 Transfer of Restricted Stock to CRUT Neither Taxable to Donor nor Prearranged Sale:   Edward Executive is a retired officer of Big Corp. However, Edward continues to serve on Big Corp's Board of Directors and continues to hold a substantial amount of Big Corp's stock. In fact, in connection with Big Corp's executive stock purchase plan, Edward entered into 14 stock purchase plans during his time at Big Corp.


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