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Thursday, December 27, 2007

Lawsky on The Tax Consequences of Commitment Contracts


From the Winter 2008 issue of the Yale Economic Review:

Yale Law Professor Ian Ayres and Economics Professor Dean Karlan harness the power of economic incentives to revolutionize the way people make resolutions. ... [provides] "commitment contracts" that let individuals set a goal, choose consequences for failing to comply, and decide how to verify their progress. With the options of choosing to lose money every time they fail and designating third-party verifiers to check their success, users will face powerful incentives to meet their goals. In an interview with YER, Ayres and Karlan explain how and why stickK works.

I originally had this post in the queue to run on January 1 with the title, Making Your New Year's Resolution "Stickk."  Sarah Lawsky (George Washington) raises interesting questions about the tax consequences of such commitment contracts:

Ian Ayres (Yale Law School) and Barry Nalebuff (Yale School of Management) have proposed something they call "Commitment Contracts."  Say you want to lose a certain amount of weight.  You give them some amount of money.  If you lose the weight, you get your money back, plus interest.  If you don't, they donate your money to a charity.  Tim Harford of Slate has entered into such a contract with Ayres (and two others): he has given them $1000, and for each week that he does not do 200 sit-ups and 200 push-ups, they will send $100 to a charity of his choice (a 501(c)(3), as it happens).  If Harford does the sit-ups and push-ups, he gets the money back (with interest, presumably, though he doesn't say).   Ayres et al. are also starting a company, Stickk, that will offer similar contracts to the general public.

I'm sure there are plenty of interesting non-tax issues related to commitment contracts and Stickk, but I am (of course) more interested in the tax questions this sort of plan raises.  For example:

(1)  How should Stickk treat the money it receives?  As loans?  If so, is this sort of loan best treated as contingent debt?  Or is Stickk acting more like an escrow agent?  Alternately, does Stickk's treatment of the money it receives depend on what the person is committing to do?  If someone commits to lose 50 pounds and keep it off for 5 years, should Stickk treat the money it receives from him as income, given the extremely low likelihood that a person who loses a large amount of weight will succeed in keeping the weight off?  Should it matter if Stickk can present a study that shows that commitment contracts increase the likelihood that the person will keep the weight off?  Should Stickk have to analyze the likelihood of a payout for each type of commitment? 

(2)  How should Harford and others who sign contracts with Stickk treat their payments?  Should Harford get a bad debt deduction if he doesn't get his money back?  Should that depend on what he has committed to do (i.e., how likely he is to succeed and thus to get his money back--in other words, on the level of risk involved)?  What if his payment is not a loan?  Depending on what he commits to do, could he treat it as a payment for health care?  Can he seek reimbursement from, say, his Flexible Spending Account?

(3)  If Harford does not keep the weight off and the money goes to charity, should anyone get a charitable deduction?  Presumably Harford does not want the money to go to the charity; he would prefer to lose the weight.  Does that affect whether a deduction is available?  Harford in fact chose a charity he refers to as "hugely deserving," but what if Harford had chosen a charity he hated, a charity he really did not want to support, in order to increase his incentive to lose weight?  Would that affect the deduction?

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(1) The receipts are probably not loans because there is no unconditional obligation to repay principal.

They are more like wagers, although Stickk does not risk its own money. Duberstein would in any case likely control whether they are gross income: if the counterparty intends primarily to make a gift, they are not, but if he intends primarily to commit himself, they likely would be. If the contracts do not identify a specific charity, the receipts may be assets of a charitable trust (which may be Stickk itself or the individual account); if they encourage something worthwhile, they may not be UBTI and thus may not be taxable if the trust is recognized as exempt.

If they do identify a particular charity, Stickk is probably just an intermediary, and the beneficiary probably does not have UBTI either because its participation in such contracts is likely infrequent.

They are probably merely deposits and not income until the contingencies are resolved since the committer intends that they will not be paid. (This intent could be questioned if the possibility that Stickk will not retain them is remote.)

(2) It is unlikely that there would be a bad debt deduction because the contracts are not debts (see #1) or that there would be any kind of deduction because they arise from transactions not engaged in for profit. (If they are intended primarily as gifts, a charitable contribution deduction may be available - generally only after the contingency is resolved, unless the likelihood of Stickk not keeping the money is remote. Incidental benefits to donors are permitted, even if fairly significant, so long as they do not cost the charity any meaningful part of the amount for which a deduction is claimed.) They are probably not medical expenses because they are not returned (and result in an expense) only when the committer fails to take care of his health.

(3) See #2 - yes, if a gift was intended at least in principal part. Duberstein's requirement for "generosity" suggests that a deduction may not be available if the committer hates the charity.

Posted by: Anonymous | Dec 27, 2007 2:30:24 PM