Double whammy! Be careful to properly time pre-sale gifts of appreciated stock to charity

One solution often discussed among business owners looking to minimize taxes from the potential sale of their business is the pre-sale gift of stock to charity. In these discussions, one of the main topics of conversation involves timing. In particular, how much time should they allow between the gift and the ultimate sale of the company?

On one hand, business owners have an interest in not making the gift prematurely out of fear that if the hoped for sale does not occur, they will have a smaller interest in the company. On the other hand, advisors often recommend making the gift well in advance of any sale to avoid the potential negative tax consequences of cutting it too close.

In its March 15, 2023 opinion in Estate of Scott M. Hoensheid v. Commissioner (T.C. Memo 2023-34), the Tax Court addressed what can happen when the gift and sale occur in close proximity. The result was a double whammy for the taxpayer — tax on the gain attributable to the shares contributed to charity and no charitable deduction.

Estate of Hoensheid facts

Ralph Hoensheid founded Commercial Steel Treating Corp. (CSTC) in 1927. CSTC remained in the family and, as of Jan. 1, 2015, was owned equally by Ralph’s grandchildren, Scott Hoensheid and his two brothers, Craig P. Hoensheid and Kurt L. Hoensheid.

In the fall of 2014, Kurt informed his brothers that he wished to retire, but instead of incurring debt to finance the redemption of Kurt’s interest, the brothers decided to pursue a potential sale of the company.

On April 1, 2015, a private equity firm (HCI) submitted a letter of intent to acquire CSTC. Thereafter, in mid-April 2015, Scott began discussing the prospect of making a pre-sale contribution of CSTC stock to a Fidelity donor advised fund (DAF). However, in emails to his estate planning attorney, Scott indicated that he “would rather wait as long as possible” to fund the DAF and did “not want to transfer the stock until we are 99% sure we are closing.”

The exact date of transfer to the DAF was disputed but, ultimately, the court decided Scott divested himself of title and made a valid gift on July 13 — two days before the sale of CSTC closed.

Two years after closing, the IRS selected Scott’s 2015 tax return for examination and sought to (1) apply the anticipatory assignment of income doctrine to charge the capital gains tax attributable to the gifted shares to Scott and (2) disallow the charitable deduction.

Anticipatory assignment of income

The anticipatory assignment of income doctrine seeks to tax income “to those who earn or otherwise create the right to receive it.” See Helvering v. Horst, 311 U.S. 112, 119 (1940). Under the doctrine, a person who has a fixed right to income but who has yet to receive that income cannot avoid tax by gratuitously assigning the right to someone else. In determining whether the doctrine applies, courts will “look to the realities and substance of the underlying transaction, rather than to the formalities or hypothetical possibilities.” See Jones v. United States, 531 F.2d 1343 (6th Cir. 1976); Allen v. Commissioner, 66 T.C. 340 (1976); Cook v. Commissioner 5 T.C. 908 (1945). And if the doctrine applies, the person who assigned the right to income will have to pay tax on income the person did not in fact receive.

To determine whether Scott had a fixed right to income, the Tax Court considered the realities of the transaction. Particularly, the court considered these factors: (1) any legal obligations Fidelity had to sell the stock, (2) the parties’ actions before the transaction, (3) any unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transaction.

Although the Tax Court found favorably for Scott that Fidelity did not have an obligation to sell the CSTC shares, that fact alone was not enough for Scott to avoid the anticipatory assignment of income doctrine. Instead, the Tax Court found that the other factors outweighed the lack of an obligation to sell.

In considering the parties’ actions prior to the sale, the court noted that one week before the gift date, HCI formed a holding company to acquire the CSTC shares. Three days before the gift date, CSTC amended its Articles of Incorporation at HCI’s request and in anticipation of sale. And, most significantly, prior to the gift date, Scott and CSTC distributed or determined to distribute its working capital reserves (nearly $10 million), an action the court noted would have been highly improbable if there was any risk the transaction would not close.

Moreover, the Tax Court determined there were no major unresolved sale contingencies at the time of the gift. In other words, when Scott made the gift of CSTC shares to the DAF, the sale to HCI was a virtual certainty. Accordingly, the Tax Court found the anticipatory assignment of income doctrine applied, and Scott was required to recognize gain on the CSTC shares contributed to the DAF.

The Estate of Hoenscheid case demonstrates that there is no bright line rule for determining how much time should separate a gift and later sale. Instead, the four factors noted above need to be considered. As the Tax Court pointed out, “donors must bear at least some risk at the time of contribution that the sale will not close.”

Charitable deduction

Individuals are allowed deductions for charitable contributions made during each tax year as long as they meet certain substantiation requirements. One such requirement for contributions of $500,000 or more is that taxpayers must attach to their tax return a qualified appraisal. An appraisal is qualified if (1) it does not predate the contribution by more than 60 days, (2) is prepared by a qualified appraiser, and (3) contains certain information required by the Treasury Regulations, including a description of the property contributed, the contribution date, a description of the appraiser’s qualifications, and the valuation method used.

To save money, Scott hired a member of the investment banking firm representing CSTC to appraise the CSTC shares he contributed to the DAF. Unfortunately for Scott, however, the appraiser did not hold himself out as an appraiser, did not have appraisal certifications, and performed valuations only on a limited basis and never for substantiating charitable contributions of shares in a closely held corporation. Moreover, the appraisal did not describe the appraiser’s qualifications or include the correct contribution date. As a result, the Tax Court found Scott failed to substantially comply with the qualified appraisal requirements and denied Scott’s charitable deduction.

Conclusion

Estate of Hoensheid reinforces the importance of careful planning in making pre-sale charitable contributions. Among other things, those contributions should be properly timed and substantiated with qualified appraisals. Failing to thoughtfully plan can result in taxpayers being taxed on income not received, without the benefit of an offsetting deduction — a true double whammy!

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.