Paul L. Caron

Tuesday, September 8, 2020

Lesson From The Tax Court: Form Over Substance Gives Taxpayers A Double Tax Benefit

Today’s lesson is about form and substance.  Tax practitioners are often called upon to decide what transactional form best accomplishes a client’s substantive purpose.  The power to choose the form of transactions sometimes creates a tension with the underlying economic substance when taxpayers and their advisors use form to disguise substance in the never-ending quest to gain tax benefits.  Courts and the IRS regularly police transactions using various doctrines to decide when form must yield to substance (e.g. step transaction doctrine, economic benefit doctrine).   When form is too much in tension with substance, substance wins.  Congress has attempted to codify this idea in §7701(o).

Today's lesson illustrates where tax law permits form to triumph over substance.  In Jon Dickinson and Helen Dickinson v. Commissioner, T.C. Memo. 2020-128 (Sept. 3, 2020)(Judge Greaves) the taxpayers were able to obtain the double tax benefit of donating appreciated shares of stock to charity by being very careful with the form of the donation.  Congress explicitly permits the form of a transaction to govern the tax result in charitable stock donation.  The tricky part of this case was that the taxpayers were donating shares of a closely held corporation.  And that implicates the assignment of income doctrine, one of those substance-over-form doctrines that courts use.  To see how Judge Greaves resolves the tension in favor of the taxpayer, see below the fold.

Today’s lesson involves the intersection of two areas of tax law: assignment of income and donations of stock to charities.   

Law: Assignment of Income Is Substance over Form
My students are surprised to learn that the question of who must report gross income is regulated mostly by case law and not by statute or regulation.  The foundational concept was articulated in the classic case of Lucas v. Earl, 281 U.S. 111 (1930).  There, a taxpayer entered into a formal contract with his wife in 1901---long before the income tax was restarted in 1913.  The contract entitled her to half of what he earned in his law practice.  The question was who had to report and pay tax on the income so assigned.  A grumpy Justice Oliver Wendell Holmes said that it was the husband’s income, notwithstanding the formality of the contract.  Holmes introduced a highly useful analogy: the statutes do not permit taxpayers to use formal arrangements “by which the fruits are attributed to a different tree from that on which they grew.” Id. at 115.

The fruit/tree analogy can be particularly useful when evaluating property transactions.  In the classic case of Helvering v. Horst, 311 U.S. 112 (1940), a father owned coupon bonds.  He tore off the interest coupons before their maturity and gave them to his son.  The IRS dinged Dad for the interest income that son later received.  Dad argued that the interest income was unrealized at the time of the gift.  It was his son who realized the income, not he.  An important part of the Supreme Court’s opinion relied on the fruit/tree distinction: the bonds were the tree that produced the income and they were owned by Dad.  So the income should be attributable to Dad.  The Court said that it would not distinguish “between the gift of interest coupons here and a gift of salary” because “in both cases the import of the statute is that the fruit is not to be attributed to a different tree from that on which it grew.”

But the fruit/tree analogy is not the only important factor in law governing assignment of income.  Courts also look at the relationship between the assignor and assignee and at the degree of control the assignor exercises.  For example, in Salvatore v. Commissioner, T.C. Memo 1970-30, Mrs. Salvatore owned a gas station, operated by her children.  The family decided to sell it and split the gain with half going to mom and half going to the children.  After signing a contract for sale, the taxpayer then deeded an undivided half-interest in her property to her children so that when the contract closed, the buyer paid half the purchase price to her and half to her children.

The Tax Court held that Mrs. Salvatore had to report the entire gain from the sale of the property.  Even though at the time of closing she had not formally owned the entire tree, the economic substance of the transaction was evidenced by the contract for sale and not by subsequent events.  At the time she contracted for the sale, she owned the rights to 100% of the gain from the sale.  The attempt to split that right to receive 100% of the gain came too late.

Thus, in the assignment of income area, substance generally trumps form.  However, in other areas of tax law Congress sometimes permits form to trump substance.  It does that in the area of charitable giving.  Let’s take a look.

Law: Stock Donations Give Double Tax Benefits To Taxpayers Who Use the Right Formalities
Generally, Congress does not allow taxpayers to get two tax benefits on the same dollars.  For example, taxpayers who adopt a child have two potential tax benefits.  First, §137 allows taxpayers to exclude from gross income those amounts they receive from their employer for adoption assistance, if the employer has a written plan that meets the requirements in §137. That’s a tax benefit: tax free dollars!  Second, §23 allows taxpayers a tax credit for amounts they spend on qualified adoption expenses.  That’s another tax benefit: a direct dollar-for-dollar subsidy by the federal government of a taxpayer’s decision to adopt a child.

But adoption dollars excluded from income cannot also generate the tax credit.  §23(b)(3).  That section is even titled “Denial of Double Benefit.”  One see similar denials of double tax benefits with American Opportunity and Lifetime Learning Credits, and with recovery of medical expenses in personal injury litigation.  Denial of double benefit is the rule.

Donations of appreciated stock to a charity is an exception to this general rule of no double tax benefit.  Such donations generate two tax benefits because Congress allows taxpayers to use the fair market value of the donated stock as the amount of their charitable donation.  See Treas.Reg. 1.170A-1(c)(1), interpreting §170(e)(1).  Thus, the first tax benefit is that taxpayers do not have to pay tax on the economic gain represented by the unrealized appreciation.  The second is that taxpayers can then use those same untaxed dollars to shelter other dollars of income from taxation via the deduction permitted by §170.

Taxpayers get this double tax benefit because Congress allows form to prevail over substance.  That is, a taxpayer could always choose to sell appreciated stock, pay tax on the realized gain, and then donate that gain to charity, taking a deduction therefore.  That strategy would certainly result in one tax benefit, the deduction.  However, if the taxpayer simply donates the stock---and lets the charity sell it---the taxpayer now gets a second tax benefit of escaping taxation on the appreciation while also now getting the same deduction benefit.

My students have a hard time seeing that giving away appreciated stock is a tax benefit to the taxpayer.  They have a hard time seeing how giving away money or property gives an economic benefit to the taxpayer that might be taxable.  They can see it if the stock is used for consumption--- to actually buy something.  But they do not see gifting as consumption.

To help my students, I use the Horst case I discuss above.  Recall that I said the majority did not rely entirely on the fruit/tree analogy.  The more important reason for its decision was based on a recognition that even though Dad did not formally recognize the income from the interest payments, he was economically in the same position as if the interest payments had been made to him and then he gave the money to his son.  Realization, said the Court, is a formality:

“The rule [of realization], founded on administrative convenience, is only one of postponement of the tax to the final event of enjoyment of the income, usually the receipt of it by the taxpayer, and not one of exemption from taxation where the enjoyment is consummated by some event other than the taxpayer's personal receipt of money or property. This may occur when he has made such use or disposition of his power to receive or control the income as to procure in its place other satisfactions which are of economic worth.”

The Court instead focused on the economic substance of the transaction:  giving away the right to receive income is substantively the same as getting the income first and then giving it away---it’s a act of consumption:

“Such a use of his economic gain, the right to receive income, to procure a satisfaction which can be obtained only by the expenditure of money or property would seem to be the enjoyment of the income whether the satisfaction is the purchase of goods at the corner grocery, the payment of his debt there, or such nonmaterial satisfactions as may result from the payment of a campaign or community chest contribution, or a gift to his favorite son. Even though he never receives the money, he derives money's worth from the disposition of the coupons which he has used as money or money's worth in the procuring of a satisfaction which is procurable only by the expenditure of money or money's worth. The enjoyment of the economic benefit accruing to him by virtue of his acquisition of the coupons is realized as completely as it would have been if he had collected the interest in dollars and expended them for any of the purposes named.”

So the first tax benefit of donating appreciated stock is the tax-free consumption of the economic gain represented by the appreciation.   Once students see that, they then easily see how the taxpayer’s donation of appreciated stock generates a double benefit, contrary to the general rule.

Taxpayers get this double dip because Congress allows taxpayers to choose the form of their donation: a sale of stock followed by a donation, or a donation of stock followed by a sale (by the charity).   The fact that it's a no-brainer choice (for appreciated stock, that is) does not change the fact that there is a choice!

Taxpayers must be careful, however, to use the correct form.  That is, sometimes, taxpayers are like Mrs. Salvatore: they arrange for the sale of their property and then, after creating the sale process, they transfer title.  In such cases, the form will not trump substance.  As the Supreme Court explained in Commissioner v. Court Holding, 324 U.S. 331, 334 (1945):

“The incidence of taxation depends upon the substance of a transaction. The tax consequences which arise from gains from a sale of property are not finally to be determined solely by the means employed to transfer legal title. Rather, the transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale, is relevant. A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title.”

This happens in the charitable donation arena as well.  A donation of appreciated property will result in income to the donor if it is part of a larger transaction whereby the charity is simply functioning as a conduit for a sale of the property that is already going to happen.  For example, in Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), the taxpayers donated to charity 30,000 shares of stock they owned in a privately held company.  But the donation was made in the midst of a larger transaction: a buyout of that privately held company by another company, with the buyout agreement providing for a fixed redemption price for outstanding shares.  Per the buyout agreement, the charities immediately redeemed the donated shares for cash at the pre-determined redemption price.

The 9th Circuit said “the  key issue here is whether the Fergusons had completed their contributions of the appreciated [private company] stock before it had ripened from an interest in a viable corporation into a fixed right to receive cash.”  The eventual answer was “no” and so the Fergusons did not get the double tax benefit:  they had to report as gross income the appreciation in the donated stock that the charity had sold.

Today’s case teaches what form taxpayers who also own shares in a privately held corporation must follow in order to donate their shares to charity and get the double tax benefit.

The tax years at issue are for 2013-2015.  Mr. Dickinson was then (and still is) an executive officer of Geosyntec Consultants, Inc. (GCI), a large privately held engineering and consulting firm, with about 1,200 employees.  He is not on the Board of Directors.  Over some period of time, not disclosed in the opinion, Mr. Dickinson acquired shares in GCI.  The opinions does not disclose how he acquired the shares, or how many he acquired, or at what cost.  Perhaps it does not matter to the outcome, but it would make for a more complete understanding of the case.

In each of these years the Board of Directors authorized shareholders to donate their CGI shares to the Fidelity Investments Charitable Gift Fund (“Fidelity”), a donor advised fund.  The CCI Board appears to have selected Fidelity because Fidelity “has a donor advised fund program which [requires Fidelity] to immediately liquidate the donated stock.”

Donor advised funds are basically a tax-sheltered account, like a 529 account or a retirement account.  The funds are structured as a qualified charity so that donations into the fund are deemed charitable deductions and the taxpayer has no formal control over any subsequent distribution of the amounts in the account.  Functionally, however, taxpayers retain substantial control so long as they recommend distributions to legitimate charities and don’t recommend abusive distributions, like making a “donation” to secure season stadium seats for their college football team or meet a fundraising obligation set by their kids’ school that will be billed as tuition if not met!

Pursuant to the GCI Board’s authorization, Mr. Dickinson donated appreciated GCI shares to the Fidelity.  The opinion does not disclose the number of shares or the amount of appreciation.  The Fidelity immediately sold the shares back to GCI pursuant to its stated policy.  The opinion does not disclose the repurchase price.  The Dickinsons took a charitable deduction, presumably for the repurchase price, although, again, the opinion does not say.

Everyone was happy.  Well, almost everyone.  The IRS was not.  It allowed the deduction but wanted to take away the first tax benefit: the exclusion of appreciation from income.  The NOD said the Dickinsons should have reported the appreciation as income and paid tax on it.

Lesson: Form Trumps Substance
The IRS argued that the donation of shares to Fidelity was simply part of a larger transaction, like in the Ferguson case, above.  The NOD “determined that each donation...should be treated in substance as a redemption of the shares for case by petitioner husband, followed by petitioners’ donation of the cash redemption proceeds to Fidelity.”

The Tax Court disagreed.  It said it would respect the formal transaction so long as the donor (1) made a bona fide transfer of shares and (2) did so before there was any formal or informal larger transaction in which the shares were going to be liquidated for a fixed amount.  Here, as to the first requirement, the Court noted that the donation of shares to Fidelity was bona fide: all t’s were crossed and all i’s were dotted.  As to the second requirement the Court pointed out that “petitioner husband did not avoid receipt of redemption proceeds by donating the GCI shares” because there was no indication that the shares were going to otherwise be liquidated.

Judge Greaves saw nothing wrong with the GCI Board authorizing the donation to Fidelity simply because of Fidelity’s policy of immediate liquidation.  It was parallel play, not a formal agreement between GCI and Fidelity.  Judge Greaves explains that “neither a pattern of stock donations followed by donee redemptions, a stock donation closely followed by a donee redemption, nor selection of donee [by the Board of Directors] on the basis of the donee’s internal policy of redeeming donated stock” is enough to justify ignoring the form of the transaction and denying the double tax benefit that Congress gives taxpayers who choose that form.

After all, built into the rule that taxpayers get a double tax benefit is the idea that taxpayers can legitimately choose form to prevail over substance in this area of the tax law.

Comment:  Disguised Compensation?
According to this article by the Wall Street Journal (sorry, it’s behind a paywall), large privately held companies like GCI regularly authorize their high-level executives to donate shares to donor advised funds.  However, in order not to lose control, the companies pair the donation authorization with a buyback. According to the article: “More companies are accommodating senior executives' charitable goals," says Kim Laughton, president of Schwab Charitable.  But at the same, while companies are helping to facilitate giving among their executives, they're buying back donated stock so as not to dilute the company's control of its shares, she says.”

It appears that in this case Judge Greaves believed GCI and Fidelity were simply engaged in parallel play: Fidelity probably has its liquidation policy precisely so companies like GCI will allow their high-level employees to donate stock.  But just because Fidelity's policy met GCI and similar companies' need to buy back donated shares did not create the kind of larger transaction as in Ferguson.

I am less sanguine, perhaps because of my ignorance in this area.  I can understand that IRS concern, especially for smaller closely held corporations where accurate valuation is difficult because of a lack of arms-length market transactions.  If the donation authorization is predicated on a repurchase requirement and especially if the repurchase price is determined in the donation authorization, that begins to look much more like the Ferguson fact pattern or other fact patterns where a donation in form was in substance a cash-out.

Additionally, what is not clear, either from articles I read or from this opinion, is how the GCI buyback worked or how or when the shares were valued.  One can imagine this idea: “well, let’s ensure that Mr. Dickinson [and other executive officers] gets a non-taxable bonus this year by authorizing a rather large valuation for the repurchase of shares he donates to Fidelity.”  Thus the stock donation (and ensuing deduction) becomes, in substance, disguised compensation.  Is that a crazy thought?  I welcome comments from folks better versed in these matters than I am.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School Thereof.  He invites readers to return every Monday (except when Mondays are federal holidays, like yesterday) for another Lesson From The Tax Court.

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Thanks for sharing such an informative.

Posted by: raja9393 | Sep 14, 2020 12:18:07 AM

@Joseph: Pat Cain has a terrific account of the Earl case in her chapter in Paul's "Tax Stories" book, which I highly recommend to anyone for fun reading. Pat explains that the contract was likely an estate planning tool similar to what folks now do with inter vivos trusts. She spends about a page explaining it and explaining that such agreements were regularly used by folks like the Earls.

Posted by: bryan | Sep 9, 2020 8:20:07 AM

I've always wondered why the taxpayer in Lucas v. Earl had a contract with his wife entitling her to half his earnings. They lived in California which is a community property state. If she recognized half his earnings, isn't that just the operation of the community property regime? And if he reported it all, shouldn't we all wonder how her income got "assigned" to him? I'd be interested if someone has an answer to this.

Posted by: Joseph W. Mooney | Sep 9, 2020 8:03:17 AM

Bryan, interesting case. I'm skeptical of the disguised comp theory. First, the Board would be violating its fiduciary duties to shareholders. Second, the transaction would be highly tax-inefficient. The company gets no deduction for paying redemption proceeds. So $100 of too-high price is $100 after-tax cost. Had the company paid $133 in cash comp, it would incur the same after-tax cost (assuming 25% combined effective rate). Had it paid $133 cash, the employee would be left with $73 (assuming 45% rate). By paying $100 in too-high price, the employee only receives $45 in tax benefits. So $28 is up in smoke; perhaps that can be justified by charitable intent but if this is a company-wide policy surely that would overestimate the charitable intent of some employees who would prefer to receive the extra $28 in their own pocket (if they wanted to be more charitable they could have just donated more stock). Bottom line is that, even leaving aside fiduciary duties, it's just not smart tax planning.
I'm also less suspicious of the transaction overall. The Board's policy puts its employees is in the same place as employees of public companies, who can donate their highly liquid stock and get a FMV deduction. The real problem, as you allude to, is the allowance of a FMV deduction in the first place.

Posted by: Gregg Polsky | Sep 8, 2020 6:48:23 AM