Introduction:
Together with two of his brothers, Craig and Kurt, the late Scott Hoensheid [i] was a third-generation owner and operator of Commercial Steel Treating Corporation (“CSTC”), a very successful metals finishing company in Michigan. In 2014, Kurt informed his brothers that he wanted to retire. Craig and Scott did not want the company to assume debt in order to buy him out. (Apparently, this had happened twice in the past with two other brothers.)
Accordingly, they engaged an investment banking firm to find a third-party purchaser. Fairly quickly, their advisor at that firm solicited several letters of intent from various private equity investors. By April 2015, the brothers had identified a likely purchaser, and negotiations began in earnest. Each of the three brothers stood to clear $30 million on the transaction, much of it taxable as long-term capital gain.
Scott decided he would like to mitigate his tax burden by contributing a portion of his stock to a donor-advised fund at Fidelity Charitable. The Internal Revenue Code is very friendly to such an arrangement. To the extent unrealized gain would have been long-term, [ii] a charitable contribution of appreciated property is deductible at fair market value, offsetting ordinary income,[iii] while at the same time, properly structured, it is not an income recognition event.
Scott’s attorney warned him, however, that it would be important to complete the gift “before any purchase agreement is executed,” otherwise the Internal Revenue Service might recharacterize the transaction as an “assignment of income,” and while he could still claim an income tax charitable deduction for the value of the stock contributed, he would not avoid recognizing the capital gain.
As we shall see, this advice fell a little short, but in any event it appears Scott did not quite follow it.
As Scott informed his attorney, he wanted to be “99 percent sure” the deal would close before he let go of the stock, because if the deal fell through, he did not want to be holding less stock than either of his brothers. In addition, because he wanted the value of the gifted stock, as nearly as possible, to equal $3 million, Scott was uncertain until the last moment exactly how many shares he wanted to contribute.
Five days before the July 15 closing, Scott delivered a stock certificate to his attorney, for eventual redelivery to Fidelity. The certificate was undated, and there was a slight discrepancy between the number of shares reflected on the certificate and the number of shares Fidelity ultimately acknowledged receiving. It was not until two days before closing that Fidelity finally had a certificate in hand and was able to sign off on an agreement to sell its shares to the third-party purchaser.
Certainly, this was literally “before the purchase agreement was executed,” but on examination of Scott’s tax return, the IRS nonetheless insisted that the contribution to Fidelity was an anticipatory assignment of income, and that Scott should be taxed on the gain. The Tax Court agreed. [iv]
Taking a Step Back
In fairness to Scott’s attorney, and despite the fact that this is a nonprecedential, memorandum opinion, which should mean that it simply recites existing law, there has been some uncertainty in the caselaw when exactly it is “too late” to make such a transfer to charity and avoid recognition of gain.
The case usually cited as seminal on this subject is Palmer v. Commissioner. [v] In that case, the taxpayer had contributed some of his voting stock in a closely held corporation to a private foundation which he controlled. Simultaneously, the foundation had purchased a controlling interest in the corporation from an irrevocable trust of which the taxpayer was trustee, in exchange for a promissory note. [vi] Literally the next day, the corporation redeemed the contributed stock, and the foundation used the cash proceeds to pay off the note.
The IRS treated this acknowledged prearrangement as an anticipatory assignment of income, but the Tax Court respected the form of the transaction, noting that at the time the gift was made, the taxpayer was not yet entitled to the proceeds of a redemption which was not yet on offer. [vii]
Eventually, the IRS acquiesced in the result in Palmer, but on somewhat different grounds. In a 1978 revenue ruling, [viii] the agency said it would not challenge a similar arrangement, provided the recipient charity did not accept the property subject to an existing, enforceable obligation to sell.
The Tax Court has more than once said it is not bound by this formulation, [ix] most recently in Dickinson v. Commissioner, [x] which also involved a transfer of closely held stock to a donor-advised fund at Fidelity Charitable. The Commissioner had argued that the contribution was made subject to an understanding that Fidelity would immediately tender the stock for redemption, which in fact it did. But again, the Tax Court ruled that the taxpayer was not already entitled, at the time the gift was made, to the proceeds of a redemption that had not yet been approved.
And it is this kind of thinking that likely informed the advice Scott’s attorney gave him, that the gift to Fidelity had to be completed before the purchase agreement was signed.
Virtual Certainty
There are, however, other decisions to the effect that the gift to charity is already “too late” if it is made at a time when the redemption or stock sale is “virtually certain” to be completed.
Most notably, in Ferguson v. Commissioner, [xi] the Tax Court itself, in a reviewed opinion, determined that the proceeds of a sale to a third party were taxable to the transferor if, at the time of the contribution, the tender offer and merger were “practically certain to proceed,” despite the need in the particular case to waive certain not insubstantial, emergent contingencies.[xii] The U.S. Court of Appeals for the 9th Circuit affirmed.
And it was this logic, rather than strict enforceability of the pending stock purchase agreement, that the court brought to bear in Hoensheid.
But First …
As a threshold matter, the court determined that although Scott did complete a gift of the stock to Fidelity Charitable, this did not occur until two days before closing. At trial, Scott testified that he had completed the gift a month earlier, on June 11. The court found this testimony not credible. A written acknowledgment from Fidelity, issued contemporaneously with the closing, was withdrawn months later and replaced with a letter reciting the earlier date. But because Scott did not produce the superseded acknowledgment letter at trial, the court presumed its contents would be unfavorable to his position.
Delivery of the stock certificate to Scott’s attorney five days before closing did not place the stock beyond his reach to rescind the transfer, the court said. And the court was unwilling to conclude that a notation on the corporate records five days before the closing was sufficient, under Michigan law, to constitute a transfer of certificated stock.
It was only when Fidelity had the certificate in hand, two days before closing, that the gift was complete, the court said.
The court then considered Scott’s arguments (a) that the case was controlled by the recent memorandum decision in Dickinson [xiii] and (b) that the Commissioner was precluded from taking a position contrary to the 1978 revenue ruling acquiescing in Palmer. [xiv]
While the court acknowledged that its decision in Dickinson hinged on a finding that the stock redemption “was not a fait accompli at the time of the gift,” it distinguished that case on the ground that the causality was reversed. In Dickinson, there would have been no redemption “but for” the charitable gift, thus there was no “practically certain” realization event for the taxpayer to avoid, whereas here there would have been no charitable gift “but for” the pending stock purchase.
And with respect to Rev. Rul. 78-197, the court said the facts of the present case were not sufficiently similar to those of the revenue ruling to justify Scott’s reliance on it. On the other hand, the court was unwilling to accept the Commissioner’s argument that Fidelity accepted the stock under an existing obligation to sell. [xv]
Determining Factors
Having established July 13, two days before closing of the stock purchase, as the date the gift to Fidelity was completed, the court next examined several circumstances suggesting that the closing was then already “virtually certain” to occur.
A week earlier, on July 6, the prospective purchaser had incorporated a subsidiary holding company to receive the target stock. On July 10, the target submitted to the relevant state regulatory agency an amendment to its articles of incorporation, allowing for actions that would otherwise require a shareholder meeting to instead be taken by written consent of the shareholders.
Crucially, on July 10 the target had paid out over $6.1 million in employee bonuses, largely stripping the corporation of cash it might otherwise have required in order to continue operations. While another $4.7 million characterized as “dividends” was not paid out to the three brothers until the day before the closing, the decision to make that distribution had been made on July 7. [xvi] The court observed, “we consider it highly improbable that petitioner and his two brothers would have emptied CSTC of its working capital if the transaction had even a small risk of not consummating.”
Finally, while there were a couple of contingencies still unresolved as of July 13, the court found that these were insubstantial. And the court characterized the remaining formality of shareholder approval as “ministerial.”
While the court recognized that its holding “does not specify a bright line for donors to stop short of in structuring charitable contributions of appreciated stock before a sale,” it also noted that Scott’s attorney had recommended that he complete the transfer considerably before he finally did.
It Gets Worse
The bottom line, although Scott did complete the gift, he was nonetheless taxable on the gain. Still, this should be essentially a wash, yes? Well, no.
The subject of the gift was stock in a closely held corporation, not the cash proceeds, and the amount of the claimed deduction was well in excess of $5,000.00. In that circumstance, Code section 170(f)(11)(C) [xvii] and section 170A-13(c) of the regulations [xviii] require that the claimed deduction be substantiated by a “qualified appraisal,” [xix] which, among other things, requires a written report from a “qualified appraiser.” [xx] If the taxpayer fails to satisfy these requirements, the deduction will be disallowed altogether.
What exactly those two cited terms mean could be the subject of another thousand or more words. Suffice it to say that, again contrary to his attorney’s advice, the late Scott decided to cut a corner here and engage the investment banker who had put the deal together to write up a curbstone opinion of the value of the contributed stock. This did not fly.
But the court did find that the late Scott Hoensheid (or his estate) was not liable for a penalty for substantial understatement of tax, [xxi] as he had placed reasonable reliance on his attorney’s (erroneous) advice that it would be sufficient to complete the gift to Fidelity before the sale actually closed.
[i] The petitioner died after the case was submitted, but before the opinion was issued. His executor was substituted as petitioner.
[ii] See 26 U.S.C. § 170(e)(1)(A).
[iii] Subject, however, to an annual limit of 30 percent of adjusted gross income, with the excess carried forward up to five years. See 26 U.S.C. § 170(b)(1)(C).
[iv] Estate of Hoensheid v. Commissioner, T.C.Memo. 2023-34 (March 15, 2023).
[v] 62 T.C. 684 (1974), aff’d on other grounds, 523 F.2d 1308 (8th Cir. 1975).
[vi] This transaction occurred prior to the enactment of Code section 4941 (26 U.S.C. § 4941) as part of the Tax Reform Act of 1969, Pub.L. 91-172, which imposes a steep excise tax on “self-dealing” transactions between “disqualified persons” and private foundations.
[vii] In light of the discussion that follows, and setting aside the self-dealing issues noted in footnote 5, supra, one might ask whether Palmer would be decided favorably for the taxpayer today.
[viii] Rev. Rul. 78-197, 1978-1 C.B. 83.
[ix] See, e.g., Rauenhorst v. Commissioner, 119 T.C. 157 (2002).
[x] T.C.Memo. 2020-158 (2020).
[xi] 108 T.C. 244 (1997), aff’d 174 F.3d 997 (9th Cir. 1999).
[xii] More recently, in its memorandum opinion in Chrem v. Commissioner, T.C. Memo 2018-164 (September 26, 2018), the court cited Ferguson and, oddly, Rev. Rul. 78-197, by way of concluding that there were “genuine disputes of material fact” that prevented it granting the Commissioner’s motion for summary judgment. That case was ultimately settled on terms somewhat favorable to the taxpayer.
[xiii] See supra note 9 and accompanying text.
[xiv] This, in fact, was the grounds on which the Tax Court rejected the Commissioner’s arguments in Rauenhorst, supra note 8.
[xv] However, in a footnote citing Chrem, supra note 11, the court did say there might be circumstances in which a donor-advised fund sponsor would have a fiduciary responsibility to dispose of a minority position in a closely held business entity, and that in a particular case this might amount to an existing obligation to sell, triggering an anticipatory assignment of income.
[xvi] The Commissioner argued that the fact that no part of this “dividend” was paid to Fidelity was yet further evidence that the stock gift was not yet complete even then, the day before closing. The Tax Court dodged that question by citing a nonprecedential Michigan appeals court decision to the effect that a gift of stock may be complete even if the transferor retains the right to receive a pending dividend.
[xvii] 26 U.S.C. § 170(f)(11)(C).
[xviii] 26 C.F.R. § 170A-13(c).
[xix] Defined at reg. section 170A-17(a), 26 C.F.R. § 170A-17(a).
[xx] Defined at reg. section 170A-17(b), 26 C.F.R. § 170A-17(b).
[xxi] 26 U.S.C. § 6662(b)(1).