April 2, 2024 / Newsletters, Publications
Don’t Wait to Donate: Avoiding Capital Gain on Gifts of Appreciated Property to Charity
In a recent case, Estate of Scott M. Hoensheid, et al. v. Commissioner (T.C. Memo 2023-34), the Tax Court provided critical guidance for taxpayers looking to donate gifts of appreciated property to charity. Generally, a taxpayer who donates appreciated property to charity (this includes trusts designed to generate a charitable income tax deduction, such as charitable remainder trusts) will not recognize capital gain when the charity later sells the asset. However, if the donor is under a legal obligation to sell the property to a third party when the property is donated, or if it is “virtually certain” at the time of donation that the property will be sold, the donor will recognize capital gain as if he or she had sold that property before donating it.
In the Hoensheid case, the taxpayer donated stock in his family business to a donor-advised fund at Fidelity Charitable. Shortly after the donation, an unrelated third party bought the company’s stock, including those shares donated to the Fidelity donor-advised fund. The donor claimed a charitable contribution deduction for the donation, based upon the stock’s appraised value at the time of donation, and did not report any capital gain on its sale. The IRS denied the deduction and held that the capital gain from the sale of the donated stock was includible in the taxpayer’s income. After thoroughly scrutinizing the factual history of the sale and donation, including communications between the taxpayer, Fidelity, the stock appraiser, and the company’s buyer, the Tax Court upheld the IRS’ position and simultaneously addressed several notable points regarding charitable deductions:
Pre-arranged Sales
It has been a long-standing rule dating to a 1960’s case called Humacid that a taxpayer may donate an appreciated asset before its sale to a third party and obtain two tax benefits: (i) a charitable contribution deduction for the asset’s value (subject to certain exceptions that could limit that deduction to cost basis) and (ii) avoidance of capital gains on the appreciation. Prior to the Hoensheid decision, many donors and practitioners believed that these benefits should be available as long as there is no legally enforceable agreement to sell the appreciated property at the time of its donation (a “pre-arranged sale”). The Hoensheid case clarifies that a pre-arranged sale occurs whenever, at the time of donation, it is “virtually certain” based upon the facts and circumstances that the appreciated asset will be sold. The Tax Court found the following factors relevant to determining whether a sale is “virtually certain” at the time of a gift:
- Whether the donee has a legal obligation to sell the property;
- The actions already taken by the parties to effect the transaction;
- The remaining unresolved transactional contingencies; and
- The status of the corporate formalities required to finalize the transaction.
In Hoensheid, the Tax Court determined that while Fidelity did not have a legal obligation to sell the donated shares at the time of the gift, a sale of the company was a foregone conclusion, as evidenced by the facts and circumstances, including the company paying significant dividends and bonuses in anticipation of a sale of its stock, the fact that regulatory approval had been obtained and corporate requirements fulfilled, the few minor contingencies in the drafts of the sale documents at the time of the donation, and the integral involvement of the company shareholders in the negotiation of the transaction.
Charitable Deduction Substantiation Issues
The Tax Court also reviewed several aspects of substantiation of charitable gifts. In examining whether the requirements for a “qualified appraisal” had been met, the court noted certain deficiencies in the taxpayer’s appraisal, including that (1) the appraiser was not a qualified appraiser as defined in the regulations; (2) the appraiser’s qualifications were not sufficiently described in the appraisal; (3) the appraiser did not sufficiently describe the method for the valuation; and (4) the appraisal failed to state the correct date of the contribution. The court also noted that the one-month gap between the date used in the appraisal (the donor’s stated date) and the date the court found that the gift was made was significant because, between those two dates, the company had made significant distributions affecting the value of its shares, and the sale of the stock became virtually certain.
Conclusion
The court’s opinion in Hoensheid provides important takeaways. No longer is there a bright-line test for determining if a pre-arranged sale has occurred. Rather, all of the facts and circumstances of a sale transaction may be examined on audit, and if they suggest that a sale was practically certain to occur, a donor can be subject to capital gains tax on the sale of the property transferred to (and sold by the) charity. Would-be-donors should consult with estate planning counsel to determine the appropriate time to gift appreciated assets and should not wait until a sale is virtually certain and imminent. Would-be-donors should also consult with estate planning counsel to ensure that appraisal and substantiation requirements are met, to ensure that a charitable income tax deduction can be taken.