Gifts of Private Company Interests to Charity Prior to Sale

A planning technique that is known to most tax professionals is for an owner of a private company to gift an interest therein to charity prior to a sale. This technique is only of interest to taxpayers who are charitably inclined since they forego the sales proceeds paid to charity. For philanthropic taxpayers, such a gift is attractive since the charity will pay no or less taxes on the sale proceeds than the taxpayer, which means that the charity receives more if the gift is made before the sale, rather than after when the sales proceeds are reduced by taxes.

The value of this technique can be enhanced in the view of many taxpayers by making the gift to a donor-advised fund sponsored by a public charity such as Akron Community Foundation. Such a fund is held by the Foundation for distribution in accordance with the directions of the donor and others the donor may designate, such as family members. The Foundation will make the distributions to whatever charity the donor requests as long as it is a legitimate charitable organization in receipt of a determination letter from the Internal Revenue Service.

If the company being sold is an S corporation or a limited liability company taxed as a partnership or proprietorship, the benefits of this technique are less than if the stock of a C corporation is sold. An explanation of the reasons for this difference is beyond the scope of this article, and while it is generally true that taxes must be paid on a gift and sale of an interest in a company that is not a C corporation, the taxes are almost always less than if the donor were the seller.

Charities do not want to hold interests in private companies for the long term as such investments are illiquid and generate little or no annual return. Accordingly, gifts of interests in private companies are usually made only when there is an understanding that the company will redeem the interest gifted, or when it is contemplated that the company will be sold to a third party.

An issue with which tax professionals, and taxpayers, must be concerned with respect to these transactions, is the potential application of the anticipatory assignment of income doctrine.[1] This doctrine was created by the courts many years ago and it precludes a taxpayer who has earned income from avoiding the payment of taxes thereon by assigning it to a tax exempt organization or a family member taxed at a lower tax bracket. The IRS has used this doctrine to claim that the gain recognized upon a sale of appreciated property to a third party must be taxed to the donor if the property was gifted immediately before the sale to a charity.

With respect to a gift followed by a redemption, taxpayers have been able to avoid the application of this doctrine because the IRS has ruled that the sales proceeds will not be taxed to a donor so long as the gift of the property sold is consummated prior to the execution of the contract of sale.[2] The IRS issued this favorable ruling even though in the subject transaction there was a prearranged plan to sell the stock at the time the gift was made. The ruling stated that so long as there was no contractual obligation to make the sale prior to the gift, the sales proceeds would be taxed to the charity.

Many taxpayers assumed that this same bright line test of avoiding the execution of a binding contract would apply to a gift of an interest that is sold to a third party, but a recent case indicates that is not true.[3] In The Estate of Scott M. Hoensheid, the court held that a sale by the Fidelity Charitable Gift Fund (“Fidelity”) of the stock of Commercial Steel Treating Corp. (the “Corporation”) which occurred on July 15, 2023, would be taxed to Mr. Hoensheid’s estate although the gift to Fidelity occurred on July 13, 2023, two days before the execution of the definitive sale agreement and closing of the sale. Mr. Hoensheid’s gift was to a donor advised fund maintained by Fidelity which is the largest sponsor of donor advised funds in the world with assets of nearly $50 billion at the end of its 2022 fiscal year.

Although there was no contractual obligation to sell the stock at the time of the gift, the court held that the sale should be taxed to the donor because the sale was “practically certain to occur” at the time of the gift. The court distinguished the ruling cited above on the grounds that, in the case of a redemption, there is no certainty of a sale as the gift is the event that causes the sale to occur.

With respect to a sale to a third party, the court held there were four factors that should be taken into account in order to determine whether a sale should be taxed to the donor or donee:

1. Was there a legal obligation to sell by the donor?
2. What actions were taken by the parties to effectuate the sale prior to the gift?
3. What, if any, unresolved issues pertaining to the sale remained to be negotiated at the time of the gift?
4. What was the status of the corporate formalities required to finalize the transaction?

Although Fidelity was not legally obligated to sell the shares at the time of the gift, the other factors examined by the court weighed in favor of concluding that the sale was a certainty. Among the facts identified by the court as supporting this conclusion were the following:

1. The Corporation had formed a new corporation and had undertaken other corporate acts required in connection with the sale prior to the gift.
2. On July 10, 2015, the Corporation paid @$6.1 million in employee bonuses that were contingent upon the sale.
3. On July 7, 2015 the shareholders of the Corporation approved distributions of all of the Corporation’s cash prior to the sale which occurred on July 14, 2015.
4. Mr. Hoensheid’s counsel sent an email to him cautioning against making the gift too close to the date the contract of sale was signed and the sale consummated. Mr. Hoensheid responded by email that he did not want the gift to Fidelity to be made until he was 99% certain that the sale would occur. [4]
5. On June 11, 2015 the shareholders of the Corporation adopted shareholder action approving the sale.
6. On May 22, 2015 the taxpayer filed a notice with the FTC of its intent to sell the Corporation’s stock as required by the Hart-Scott-Rodino Act.[5]

While the decision of the court was very disappointing to the taxpayer in that it required that Mr. Hoensheid’s estate pay the tax incurred upon the sale of the stock by Fidelity, the taxpayer suffered an even greater loss in that the court denied any deduction for the charitable gift. The reason for the denial of the deduction was that for a charitable contribution of property with a value in excess of $500,000, the Internal Revenue Code requires that the tax return reporting the gift must be accompanied by a qualified appraisal prepared by a qualified appraiser.[6] In order to save costs, the taxpayer in this case had the appraisal prepared by the investment banker who solicited the sale and who did not charge therefor since he earned a substantial fee upon the sale. This was penny wise and pound foolish, however, in that the investment banker had no certifications as a valuation expert and the appraisal did not include a number of provisions that were required, including the correct date of the gift, since the taxpayer attempted to claim that the gift was made a number of days prior to the delivery of the stock certificate to Fidelity.[7]

It is said that bad facts make bad law and that certainly seems to be the case here. In addition to the facts cited above, it appears the Court was put off by the taxpayer’s claim that the gift was made on June 11, 2015, which was the date the Corporation’s shareholders approved the gift. The approval did not, however, specify the number of shares gifted or the date of the gift. An assignment of the gifted stock was prepared and signed by the Mr. Hoensheid, but the number of shares was not completed and the assignment was not signed and delivered until July 13, 2015.

Conclusion

The Hoensheid opinion did not challenge the validity of the ruling upholding gifts to charity followed by pre-arranged redemptions and so that technique is still viable. While the bright-line test of the cited ruling allowing a deferral of a gift until immediately prior to the execution of a contract of sale does not apply to the sale to a third party, taxpayers should not conclude that a gift of a private company interest should not be made to a charity when a sale of the company is contemplated. In the first instance, if the technique fails, the taxpayer would not be required to pay any more tax than would be the case than if the gift were made after the sale.

More importantly, the taxpayer made a number of errors in the Hoensheid case that could have been avoided with better advice and better compliance by the taxpayer with the advice Mr. Hoensheid received. The opinion suggests that, in order to cut costs, Mr. Hoensheid disregarded some of the advice of his professionals and that cost him far more than the professional fees that he saved. The lesson to be learned is that professionals should be involved early in the development of a plan for a gift prior to a sale, and the gift completed, not only before a contract is signed, but before any actions are taken to consummate the sale.

[1] Helvering v. Horst, 311 U.S. 112 (1940) and Lucas v. Earl, 281 U.S. 111 (1930).

[2] Rev. Rul. 78-197, 1978-1 CB 83.

[3] The Estate of Scott M. Hoensheid, et ux. v. Commissioner, T.C. Memo 223-34.

[4] The opinion does not indicate why these communications were not excluded from evidence as the subject of the attorney client privilege. It may be that the taxpayer’s financial advisors who are not covered by the privilege were copied on the emails.

[5] See 16 C.F.R. § 803.5(b).

[6] Internal Revenue Code of 1986 as amended (“IRC”) §170(f)(11)(A)(i) and (D) and (E).

[7] See IRC §170(f)(11)(E) and Treas. Reg. §1.170A-13(c)(2), (3), and (5).