Tax Train Wreck: US IRS Derails Private Wealth Tax Planning Transactions

It’s unusual enough for one or more facets of relatively conservative tax planning to be successfully challenged by the Internal Revenue Service (the “IRS”). But in Keefer vs. United States,¹ the taxpayers suffered the tax equivalent of being struck by lightning—the IRS not only successfully disallowed the anticipated tax consequences of a sale transaction but also the ancillary consequences as well, which, in this case, was a $1.257 million charitable contribution to a donor-advised fund (a “DAF”). In this Legal Update, we’ll explore what went wrong so that taxpayers who might try to navigate this rail line in the future can keep their train on the tracks.

The taxpayers were limited partners in a partnership named “Burbank HHG Hotel, LP” (“Burbank”). Burbank held and operated a hotel property. On April 23, 2015, Burbank exchanged a non-binding letter of intent with a third party (“Buyer”) to sell the hotel property. By June 18, 2015, the price had been agreed to ($54 million) and a contract was drafted but not yet signed. On that date, the taxpayers donated a 4% limited partnership interest in Burbank to the DAF (more on this below). On July 2, 2015, the parties signed the contract for the purchase and sale of the hotel. The contract granted the Buyer a 30-day review period, during which it could have walked away from the deal. Burbank and the Buyer closed the purchase and sale of the hotel on August 11, 2015. On September 9, 2015, the DAF sent a letter to the taxpayers acknowledging the donation.

The opinion does not make clear what portion of the taxpayers’ interest in Burbank was represented by the 4% interest donated to the DAF. What is clear, however, is that the taxpayers retained a significant interest in Burbank following the donation.

The terms of the taxpayers’ donation to the DAF were subject to an unusual stipulation. Specifically, the taxpayers reserved to themselves the right to receive the proceeds from cash reserve accounts held by Burbank as of the date of the donation. The cash reserves could have been used to remediate any conditions at the hotel if the Buyer demanded any such repairs. The court found that these reserves were held back to fulfill potential future liabilities since the contract to sell the hotel had not yet been signed at the date of the donation to the DAF.

The taxpayers obtained a third-party appraisal of the modified 4% interest that the taxpayers donated to the DAF. The appraiser estimated that at the time of the donation, there was a “5% probability of no sale.” The appraisal took account of the fact that cash reserve proceeds would not be paid to the DAF. The appraisal valued the modified 4% interest at $1.257 million.

The taxpayers did not report the allocable share of the gain recognized on the sale of the hotel that was attributed to the 4% interest in Burbank held by the DAF. The taxpayers also reported a charitable donation of $1.257 million, the pre-tax value of the 4% interest they gave to the DAF. The IRS successfully challenged both of these positions.

I. There Was No Anticipatory Assignment of Income Based on the Fact That the Hotel Sale Was Imminent

Under the anticipatory assignment of income doctrine, once a right to receive income has “ripened” for tax purposes, the taxpayer who earned or otherwise created that right will be taxed on any gain realized from it even if the taxpayer transfers the right before actually receiving the income. See Jones v. United States, 531 F.2d 1343, 1346 (6th Cir. 1976); Kinsey v. Commissioner, 477 F.2d 1058, 1063 (2d Cir. 1973); Hudspeth v. United States, 471 F.2d 275, 280 (8th Cir. 1972); Estate of Applestein v. Commissioner, 80 TC 331, 345 (1983). The IRS asserted that the donation of the 4% interest in Burbank was anticipatory assignment of income and the gain allocable to that interest was taxable to the taxpayers not the DAF. The court ultimately agreed with the IRS, but the court’s analysis jackknifed what would have been expected.

To determine whether a right has "ripened" for tax purposes, courts consider the realities and substance of events to determine whether the receipt of income was practically certain to occur (i.e., whether the right basically had become a fixed right) at the time of the transfer. See e.g., Jones, supra, at 1346. While the finding of a mere anticipation or expectation of the receipt of income has been deemed insufficient to conclude that a fixed right to income existed, see, e.g., S.C. Johnson & Son, Inc. v. Commissioner, 63 TC 778, 787-88 (1975), courts also have made it quite clear that the overall determination must not be based on a consideration of mere formalities and remote hypothetical possibilities. See, e.g., Jones, supra, at 1346; Kinsey, supra, at 1063; Hudspeth, supra, at 280; Estate of Applestein, supra, at 345.

More broadly, the anticipatory assignment of income doctrine prevents taxpayers from gratuitously assigning property ripe with income to a third party (usually a charity or relative) with a purpose of having the assignee taxed on the income inherent in the property. This doctrine, however, does not prevent taxpayers from making gifts of appreciated property. When a right to the proceeds and therefore the gain from the disposition of property has matured or ripened at the time of a transfer, the transferor will be taxed, notwithstanding a technical transfer of the property prior to its disposition. The court in Keefer focused on Humacid Co. v. Comm’r, 42 T.C. 894 (1964), one of many cases that addressed donations of appreciated property to a charity. Under Humacid, supra, courts will respect such a donation if (1) the taxpayer gives the property away absolutely (2) before the property gives rise to income by way of sale. We explore related case law below.

A transferor of a mere anticipation or expectation of income, rather than a fixed right to it, is not subject to tax on that income on the ground that the transfer was anticipatory assignment of income. S.C. Johnson & Son, Inc., supra at 787-88. In S.C. Johnson & Son, Inc., supra, the taxpayer entered into two forward sales contracts with New York City banks with respect to the British pound. After the devaluation of the pound in November 1967, these contracts had substantially appreciated in value. The taxpayer contributed the contracts to a nonprofit corporation that it had previously organized (“Wax Fund”). Wax Fund subsequently entered into negotiations and sold the contracts to an unrelated third party. The Tax Court held that the taxpayer did not realize taxable income when the forward sales contracts were contributed to Wax Fund or when Wax Fund disposed of the contracts. The court explained that the facts of the case demonstrate that a fixed right to the income from the forward contracts did not exist at the time they were assigned to Wax Fund for the following reasons. First, the taxpayer had no right to any gain under the contracts until the pounds were delivered to the banks. Second, when the contracts were contributed to Wax Fund, the taxpayer had taken no steps to close out its forward position under the contracts. Therefore, the amount of gain, if any, was not assured and the taxpayer “simply had no fixed right to any assignable income in either a legal or an economic sense.” Id. at 788.

Additionally, anticipatory assignment of income principles do not require the transferor to include the proceeds of a claim in gross income when recovery on the transferred claim is doubtful or contingent at the time of transfer. Wellhouse v. Tomlinson, 197 F. Supp. 739 (S.D. Fla. 1961). The Wellhouse, supra, case involved a taxpayer who made a loan to a business associate, receiving a demand note carrying 4% interest. The debtor died without having paid the note. The taxpayer filed a claim against the debtor’s estate but, before effecting collection, assigned the note and claim to a charity. The following year, the debtor’s estate voluntarily paid the claim to the charity. The court found that the transferor was not taxable on the interest portion of the note because there was considerable legal doubt at the time of the assignment as to when, if ever, the obligation would be paid and because the taxpayer divested himself of all rights to the note in the year prior to the year of payment. In reaching this conclusion, the court placed considerable emphasis on the fact that there were certain legal defenses available to the debtor’s estate even though it was doubtful whether the defenses could ever be raised because of the possibility of waiver on the part of the debtor’s estate. In this regard, the court stated, “The point is, however, that there was real legal doubt concerning the time and extent of collectability of the note at the time of the assignment.” Id. at 742.

The IRS and the courts have stated that a donor will be taxed on the gain recognized on a corporate redemption or sale of shares that the donor has recently contributed to a charity only if there is, at the time of the stock contribution, a binding commitment for the corporation to redeem the donated shares. The leading case on point is Palmer v. Commissioner, 62 TC 684 (1974). In Palmer, supra, the taxpayer had voting control of both a corporation and a tax-exempt private foundation. Pursuant to a single plan, the taxpayer donated shares of the corporation's stock to the foundation and then caused the corporation to redeem the stock from the foundation. The IRS argued that there was an anticipatory assignment of the proceeds of the redemption. The Tax Court disagreed and held that the anticipatory assignment of income doctrine was not applicable because there was no binding, legally enforceable commitment that would force the foundation to submit the shares for redemption. The court noted, “Even though the donor anticipated or was aware that the redemption was imminent, the presence of an actual gift and the absence of an obligation to have the stock redeemed have been sufficient to give such gifts independent significance.” Id. at 695 (citing Carrington v. Commissioner, 476 F.2d 704 (C.A. 5, 1973); DeWitt v. United States, 503 F.2d 1406 (Ct. Cl. 1974); Sheppard v. United States, 361 F.2d 972 (Ct. Cl. 1966)). The court rejected the IRS’s argument and treated the transaction according to its form because the foundation was not a sham, the transfer of stock to the foundation was a valid gift, and the foundation was not bound to go through with the redemption at the time it received title to the shares.

In Revenue Ruling 78-197, 1978-1 CB 83, the IRS acquiesced to the decision in Palmer, supra, and in doing so, devised a bright-line test which focuses on the donee's control over the disposition of the appreciated property. The ruling provides that the IRS will treat the proceeds of a redemption of stock under facts similar to those in Palmer, supra, as income to the donor only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption.

In contrast to the situations considered above, in Estate of Applestein, supra, the taxpayer transferred stock in a corporation that had entered into a merger agreement with another corporation to custodial accounts for his children. The merger agreement was approved by the shareholders of both corporations before the transfer of stock. Although the transfer occurred before the effective date of the merger, the Tax Court held that the "right to the merger proceeds had virtually ripened prior to the transfer and that the transfer of the stock constituted a transfer of the merger proceeds rather than an interest in a viable corporation." Id. at 346; see also Greene v. United States, 13 F.3d 577, 581 (2d Cir. 1994); Jones, supra at 1346; S.C. Johnson & Son, Inc., supra at 788. In rejecting the taxpayer's argument that the consummation of the merger was not a certainty, the court stated:

[I]n the instant case, at the time of transfer, the merger had been agreed upon by the directors and shareholders of both companies and there were no other necessary steps to be taken before the merger became effective. Any possibilities that the merger would be abandoned by the companies themselves or stopped by a regulatory agency were "remote and hypothetical."

Estate of Applestein, supra at 346-47.

In Hudspeth, supra, a majority stockholder in a closely held corporation donated part of his holdings to nine tax-exempt charities before articles of dissolution were filed and actual payments of proceeds were received but after shareholders adopted a plan of liquidation and the corporation had sold its principal assets. The court stated that the taxpayer’s retention of control of the corporation after the stock gifts was important because it foreclosed the possibility that his intent to liquidate the corporation would be vitiated by the donees. The court continued that this evidence of the taxpayer’s intent to liquidate was reinforced by the corporation's contracting to sell its principal assets and the winding up of its business functions. Therefore, the court held that the taxpayer had made contributions of the proceeds of the liquidation, not of stock, and therefore was taxable on the gain arising from the stock sale.

The anticipatory assignment of income doctrine was also applied in the Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1997), case. The Ferguson family owned approximately 18.8% of the shares of a public company (“AHC”), which entered into a merger agreement with a private equity firm (“CDI”) and CDI’s wholly-owned subsidiary (“DC Acquisition”) for the purchase of AHC’s stock. Pursuant to the merger agreement, DC Acquisition would first acquire all of the stock of AHC through a tender offer, and then DC Acquisition would merge into AHC so that AHC would become a wholly owned subsidiary of CDI. The offer was conditioned on a minimum tender of 85% of the stock of AHC. On August 3, DC Acquisition made a tender offer for AHC's stock at $22.50 a share, and on August 31, more than 50% of the AHC stock had been tendered or guaranteed. After announcing the merger, the Fergusons began a slow process of transferring some of their shares to charity, completing that process on September 9.

In analyzing whether the Fergusons had completed their contributions of the appreciated AHC stock before it had ripened from an interest in a viable corporation into a fixed right to receive cash, the court concluded that realization occurred before the satisfaction of the 85% tender requirement. The Tax Court held that the taxpayers were taxable on the gain under the anticipatory assignment of income doctrine because the substance of the events showed that, on the date of the gifts, the AHC stock represented only a right to receive cash. The court noted that the tender or guarantee of a majority of the AHC shares was the functional equivalent of shareholder approval of the merger, although shareholders had the legal ability to withdraw their approval. Therefore, absent a withdrawal of approval, DC Acquisition would unilaterally be able to complete the merger by the close of business on August 31. The court also held that the existence of the right of shareholders to cancel their approval was insufficient to negate the anticipatory assignment of the income. Therefore, the court held that the Fergusons were taxable on the gain in the appreciated stock because the Fergusons’ contributions of their AHC stock were completed nine days after the stock ripened into a right to receive cash.

The court in Keefer, supra, applied the standard set forth in Humacid, supra, and recognized that Ferguson, supra, could be read to find that the imminent nature of the sale to Buyer could compel a finding that the gift to the DAF was an anticipatory assignment of income. The court, however, “decline[d] to extend the Ferguson approach to the real estate transaction at issue here.” First, the court found the 14 days between the gift and the signing of the contract for purchase and sale to be a compelling amount of time and ignored the appraiser’s estimate that a sale was 95% likely to occur. Second, in contrast to the authorities discussed above, it found the condition subsequent, that is, the fact that the Buyer had 30 days thereafter to walk away was a sufficient basis on which to conclude that the date of signing was the date on which the right to receive the income as the date the income ripened. Stated otherwise, in the court’s view, the right to receive the income did not ripen until the expiration of the 30-day walk-away period. While both of these taxpayer-favorable holdings would have seemed sufficient to end the inquiry, the court pursued another path, which turned out to be devastating to the taxpayers.

II. The Cash Reserve Account Holdback Caused the Gift to Constitute an Assignment of Income

In Caruth Corp. v. US, 865 F.2d 644 (5th Cir. 1989), a taxpayer made a charitable gift of stock after the dividend declaration date but before the dividend record date. Accordingly, the charity, rather than the taxpayer received the dividend. The IRS argued that the donor should be taxed on the dividend. The court focused on the fact that the taxpayer had given away the stock itself and not just the right to receive the dividend:

When a taxpayer gives away earnings derived from an income-producing asset, the crucial question is whether the asset itself, or merely the income from it, has been transferred. If the taxpayer gives away the entire asset, with accrued earnings, the assignment of income doctrine does not apply.

Citations omitted.

The court held that so long as the entire “tree” is given away before the “fruit” is harvested, there is no assignment of income. The court found that the fruit was harvested on the dividend record date. The Keefer court relied heavily on Caruth, supra, in finding that the taxpayer had given away the Burbank interest “absolutely.”

The court in Keefer, supra, found the taxpayer’s retention of the right to receive the cash reserve accounts separated the tree (the income-generating asset) from the fruit (the right to receive the sales proceeds). This finding is difficult to reconcile with the tree and fruit analogy. In Keefer, the tree should have been the capital investment in the hotel property, and the fruit should have been the right to receive the sales proceeds. Although the taxpayer retained the cash reserve accounts, he gave away his right to the tree, that is, the interest in the hotel, before the fruit has ripened, that is, the contract was signed (and/or the walk-away period had lapsed). The retention of the right to receive the cash account balances does not appear to have anything to do with the income-generating property. In this respect, the court seems to have extended the “absolutely” factor beyond the way earlier courts had interpreted this requirement.

If Burbank itself had made a gift of 4% of the hotel, it is highly unlikely that the Keefercourt would have found that the donor (here, Burbank) did not give away the property “absolutely.” The court, by holding that the taxpayer has retained an interest in the “tree” by retaining the cash account balances, treated the interest in Burbank as an interest in an entity and not as an aggregate of the properties held through the partnership. The use of the entity versus aggregate approach in Keefer seems inappropriate inasmuch as the retained interest had nothing to do with the income-generating asset.

Another comparison further supports the conclusion that the taxpayers gave away all of their interest in the “tree.” Posit that Burbank recapitalized into “A” and “B” units. The “A” units had all rights to the hotel, its income and gains. The “B” units represented the rights to all non-hotel property, income and gains. The taxpayers then contributed the “A” units to the DAF. On these facts, again, it is difficult to conclude the taxpayers would not have donated the tree and not just the income earned thereon. The fact that the taxpayers retained the “B” units with the right to receive the reserve account proceeds should not mean that they gave less than their entire interest in the hotel to the DAF. Conceptually, this is exactly what the taxpayers in Keefer, supra, did.

III. The Charitable Contribution Deduction Is Denied

Unfortunately for the taxpayers in Keefer, supra, the court’s assignment of income analysis wasn’t the end of the line. The court sent the taxpayer’s charitable deduction off the rails as well. Code § 170 specifies that a taxpayer can claim a deduction only if the charity provides the taxpayer with a contemporaneous written acknowledgement (“CWA”) if the amount of a single charitable contribution is $250 or greater. Code § 170(f)(8) requires that a CWA state (1) the amount of cash and a description (but not value) of any property other than cash contributed; and (2) whether the donee organization provided any goods or services in consideration, in whole or in part, for the donated property. Additionally, the CWA for a donation to a DAF must demonstrate that the donee organization “has exclusive legal control over the assets contributed.” 26 I.R.C. 170(f)(18).

Although Code § 170(f)(8) sets forth the information that must be included in a qualifying acknowledgement, neither Congress nor the IRS defined the term “acknowledgement” for purposes of that section. Thus, courts use the “ordinary, contemporary, common meaning” of the term “acknowledgement” when applying Code § 170(f)(8). Pioneer Inv. Servs. Co. v. Brunswick Associates Ltd. Pship., 507 U.S. 380, 388 (1993). The term “acknowledgment” is defined as “the act of making it known that one has received something.” Black's Law Dictionary 23 (7th ed.1999); see also Merriam-Webster's Collegiate Dictionary 10 (10th ed.1997).

The Court in Keefer looked to Bruce v. Comm’r, T.C. Mem. 2011-153, to determine whether a pre-donation document can serve as a CWA. There, a landowner and a county executed a settlement agreement on August 27, 2004, under which the landowner would give up development rights in his parcel in return for a driveway easement over neighboring county property. The substantive rights and obligations created by the settlement agreement were subject to the county obtaining approval to dispose of the driveway easement—which was approved 15 months later. On December 22, 2006, the county sent the landowner a letter acknowledging his donation of the development rights, and a few days later the two parties conveyed the respective interests to one another by reciprocal deeds. The landowner claimed a charitable deduction for the development rights on his 2004 tax return. The landowner claimed that the August 27, 2004, settlement agreement satisfied Code § 170(f)(8)’s CWA requirement because it legally obligated him to donate his development rights and simultaneously acknowledged that obligation. The Tax Court rejected this argument and reasoned that the county could not have acknowledged receipt of the landowner’s development rights at that time because the landowner’s obligation had not matured.

While the time gap between the pre-donation “acknowledgment” and the Keefers’ assignment of the interest was not as large as in Bruce, the Tax Court found Bruce, supra, to be controlling and denied the deduction. The Court held that a CWA acknowledges a completed contribution or one that is legally obligated to occur and that the actual assignment did not occur when the DAF packet was signed. The Keefers argued that the acknowledgement letter and DAF packet together constitute a statutorily compliant CWA. The IRS argued, and the court agreed, that multiple documents cannot be combined to constitute a CWA unless the documents include a merger clause, and neither document in this case stated that the DAF had “exclusive legal control” over the donated assets.

The court gave Code § 170(f)(8) a very tight reading. The case will serve as a warning to sponsors of DAFs to include the required language of Code § 170(f)(18) in the gift acknowledgment. Under the court’s logic, a CWA might not be contemporaneous with subsequent donations to the fund if the required language is in the setup papers. A DAF sponsor might as well avoid the question by putting all required language in a single compliant CWA at the time of each gift.

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¹ 2022 WL 2473369 (N.D.Tx. July 6, 2022), rehearing denied (N.D.Tx. August 10, 2022).