Lesson From The Tax Court: The Reduce-To-Basis Rule For §170 Deductions

Basis is probably the most important concept I teach in my intro income tax course.  I like thinking of basis as the tax history of a piece of property.  It tracks what ought not to be taxed upon eventual sale or exchange of that property under the calculations required by §1001.  But a proper understanding and tracking of basis can also be important for other reasons, such as determining the amount of a §165 loss ... or calculating the amount of a §170 deduction for  charitable donations.

Donald Furrer and Rita Furrer  v. Commissioner, T.C. Memo. 2022-100 (Sept. 28, 2022) (Judge Lauber), teaches a lesson on the importance of basis in determining the amount of a §170 deduction for the donation of property to charity.  We also learn a cautionary lesson on the use and mis-use of Charitable Remainder Annuity Trusts (CRATs).  The taxpayers here were farmers who donated crops to a CRAT and then attempted to claim a §170 deduction based on the fair market value of the donated crops.  That ran afoul of the reduce-to-basis rule.  Details below the fold.

Charitable Gift Planning  First, allow me a brag: Texas Tech has perhaps the top Personal Financial Planning department in the country, as least according to Wealth Management magazine.  One of the reasons is because of faculty like Prof. Russell James.  Prof. James has created outstanding free resources for taxpayers and tax advisors alike on this website.  One I particularly recommend is his Visual Planned Giving: An Introduction to the Law & Taxation of Charitable Gift Planning.

I especially like how Prof. James says proper charitable gift planning boils down to two key benefits for taxpayers: (1) exchanging property for an income stream; and (2) reducing taxes.

Both benefits are important to those taxpayers who may have alternate years of income feast and income famine.  True, some taxpayers can obtain both benefits without using charities.  For example, a tort lawyer can avoid paying taxes on the entire amount of a very large contingency fee in the feast year they earn the fee, if they structure the fee as part of structuring the settlement for their client.  That move converts a single lump into years of reliable income, thus deferring taxes.  Lawyers just need to be careful to avoid constructive receipt. See Childs v. Commissioner, 103 T.C. 634 (1994). Companies such as this one make it their business to help lawyers structure judgment and fees.

Other taxpayers need to use charities.  Farmers, for example, may have wildly fluctuating  income from year to year.  For farmers, proper charitable gift planning allows them to both swap property for income and to reduce taxes ... all while making gifts to charities!  What’s not to like?  They trade property for income by basically buying an annuity with their crops. The idea is to grow and harvest the crop in year 1, place it in a storage facility, while deducting against other income all the ordinary and necessary expenses under §162 to produce the crop.  The farmer creates a tax-exempt entity called a Charitable Remainder Trust (CRT) which, as its name implies, designates certain charities as remainder beneficiaries of the Trust.  The farmer donates the unsold crop to the CRT in year 2.  The CRT sells the crop (tax free since it is a tax exempt entity), sets aside at least 10% of the proceeds for later distribution to the designated charities, then uses the rest to pay a stream of payments to the farmer.  Here’s how Fidelity describes the general idea of CRTs.  Here’s how one charity describes the deal as to farmers, with pictures.  There are lots of rules about how to do this right.  Those rules are far beyond both my competence and your need to know for today’s lesson.

What you do need to know is how this CRT idea interplays with the §170 deduction for contributions to charities.

Law: Section 170 Deductions for Charitable Contributions Taxpayers may only deduct contributions made to a qualifying charitable organization.  §170(c) A CRT is not itself qualified (it flunks at least the §170(b)(2)(C) requirement).  However, since a CRT will eventually donate the remaining assets in the CRT to qualifying charities, Congress allows taxpayers an upfront deduction in the year of contribution for the expected value of that deferred donation but must earmark at least 10% of the value of the donation to do that.  Thus, the extent to which the donating taxpayer can deduct contributions to a CRT depends in part on the present value of the remainder interest given the charities designated in the trust instrument.

But the amount of deduction also depends on what is being donated to the CRT.  Cash is easy.  The amount is the face value of the cash donated.  Property is more difficult.  In general, §170(e) says the amount contributed must be reduced to basis under certain circumstances.  That implies that otherwise a taxpayer uses the fair market value (FMV) of the property.  Treas. Reg. 1.170A-1(c) makes that implication explicit as follows:

“If a charitable contribution is made in property other than money, the amount of the contribution is the fair market value of the property at the time of the contribution reduced as provided in section 170(e)(1) ...170(e)(3) ....”

So unless 170(e) requires reduction, taxpayers use FMV.  What are the circumstances that require a taxpayer to use their basis in property as the amount of their contribution?  Well, I teach this as a two step inquiry.  First, inquiry whether the sale or exchange of the donated property produce long term capital gain (LTCG)?  If not, then §170(e)(1)(A) requires reducing the amount of the contribution from FMV to basis.  Naturally, if basis is greater than FMV, there is nothing to reduce to.  That’s why taxpayers generally ought not to donate built-in loss property!  If sale would produce LTCG, then second, inquire as to what kind of charity the donation is made.  Section 170(e)(1)(B) gives a bunch of situations where taxpayers must still reduce to basis, depending on the recipient.  The two big ones I teach are (1) if the donation is made to a private foundation you must reduce to basis, and (2) same result if the donation is personalty and is made to public charity but is “unrelated to the purpose or function constituting the basis” of the public charity’s status as a charity.  For example, property given to a Library simply for the charity to sell at auction to raise money would be unrelated to the purpose or function of the Library.  But books would be related.  There are all kinds of other wonky rules in §170(e)(1)(B) but they are beyond the scope of today’s lesson.

Facts
The tax years at issue are 2015-2017.  Mr. and Ms. Furrer were farmers in those years.  In 2015 they created a Charitable Remainder Annuity Trust (CRAT), which is a particular flavor of CRTs.  As I understand it, CRATs are a one-time shot where the taxpayer makes the donation and gets locked into an annuity based on that donation, rather than having the stream of payments linked to investment performance of the donated assets.  The farming literature talks about CRATs as a retirement tool because of it’s one-off nature.  In contrast, a Charitable Remainder Uni-Trust (CRUT) is a CRT into which a taxpayer can donate repeatedly in multiple years.

So ... Mr. and Ms. Furrers created a CRAT in 2015, with their son as the trustee.  They gave it 100,000 bushels of corn and 10,000 bushels of soybeans.  They had previously deducted all of the expenses associated with growing and harvesting those crops, so at the time of the donation they had zero basis in the crops.  The 2015 CRAT sold the crops in August 2015 for $470,000, distributed 10% (the statutory minimum) to the designated charities and then used the remaining funds to buy an annuity from Symetra, an insurance company.  It appears Symetra paid the CRAT $84,000 in 2015 and 2016 and the CRAT then distributed that to the Furrers.  I infer that from where the opinion says “Symetra issued to the trustee a Form 1099–R” which implies the payments were channeled through the CRAT.  Op. at 2. Again, I welcome comments on how that works.  But its not directly important for the lesson on whether the annuity payments went directly to the Furrers or first to the CRAT.

Mr. and Ms. Furrer created a second CRAT in 2016 to do the same thing.  That year they donated crops (again with zero basis) to the 2016 CRAT, the CRAT sold the crops for $892,000, paying 10% to charities, then bought a second annuity from Symetra that paid the Furrers $125,000 in 2016 (and out years).  Again, Symetra issued 1099-R’s to report the annuity.

I don’t know why the Furrers created two CRATs instead of a single CRUT.  I welcome comments on whether this was a good idea. I would think the transaction costs would be less to create a single CRUT that could receive the crops over multiple years.

Three weird facts set up the Lesson.

First, on each year’s Form 1099-R, Symetra “listed the annuity payments as gross distributions and showed a small amount of interest as the taxable amount.” Op. at 2.  Yet, while the Furrers reported the interest as income, “they did not report the balance of the annuity distributions, taking the position that these payments constituted a nontaxable return of corpus under section 664(b)(4).” Op. at 2.  That section gives the ordering rules of how to characterize distributions from CRTs.

Second, for each year the Furrers reported their donations of the crops on gift tax returns, showing zero basis for each donation.  Yet the CRAT trustee (their son, remember) assigned basis to the crops when reporting gross receipts from sale of the crops.  In fact, the CRAT reported a loss on the 2015 sale, claiming a cost basis in excess of the amount realized.

Third, there was weirdness in the examination.  When the IRS audited the 2015 and 2016 years, the IRS Revenue Agent dinged them on the annuity payments.  But the Furrers were able to convince the RA to allow them a charitable deduction, partially offsetting the ding!

“During the examination petitioners contended that they had neglected to claim on their 2015 and 2016 returns, but should be allowed, noncash charitable contribution deductions for portions of their donations to the CRATs. In petitioners’ view, the allowable deduction for each year was equal to the proportion of the FMV of the donated crops that was destined to the charitable remaindermen. *** The examining agent ... agreed with their position and allowed additional charitable contribution deductions of $67,788 for 2015 and $106,413 for 2016.”  Op. at 4.

Do you see why I almost titled today’s lesson “Hogs Get Slaughtered”?  If not, read on!

Lesson: The Reduce-To-Basis Rule
Rather than accepting the RA’s examination result, which at least gave them an offsetting charitable deduction, the Furrers petitioned Tax Court to redetermine the proposed deficiency.  Someone at IRS (perhaps a keen-eyed Chief Counsel attorney?) caught the charitable donation issue and the IRS asked the Tax Court to disallow the §170 deduction that the RA had allowed.

Judge Lauber obliged.  He disallowed the §170 deduction by a straightforward application of the reduce-to-basis rule because the sale of the crops could not produce LTCG.  In order to have LTCG one must sell a type of property called a “capital asset.” §1222. Section 1221(a)(1) provides that property which is either “inventory of the taxpayer ... or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business” is not a capital asset.  For a farmer, crops are not capital assets because they are held for sale to customers in the ordinary course of the farming business.  Their sale produces ordinary income, not LTCG.

Judge Lauber explains the importance of that: “Thus, any charitable contribution deduction would be limited to [the Furrers’] cost or adjusted basis in the crops. As petitioner husband conceded when filing the 2015 and 2016 gift tax returns, petitioners’ basis in the corn and soybeans transferred to the CRATs was zero.”

No Basis in the property donated?  No §170 deduction when the reduce-to-basis rule applies.

Comment:  The Furrers also lost on the issue they petitioned about: the extent to which the annuity distributions from the CRATs were taxable.  Again, the issue came down to basis.  Since they had zero basis in the crops transferred to the CRATs, that meant the CRATs took the crops with a zero basis as well.  §1015.  And that meant that all of the amounts realized on sale of the crops were ordinary income, which remained untaxed in the hands of the CRAT, but all of which was taxed when distributed from the CRAT to the Furrers — whether directly or by purchase of an annuity from a third party.  When a CRAT does have a basis in property it receives, then §664 gives what Prof. James calls the “Worst In, First Out” ordering rule.  That is, distributions from a CRT are deemed first to be ordinary income until that is used up and only then other types of income, such as LTCG, or non-income such as return of corpus.  The Furrers’ attorney tried to find some reason the CRAT had basis in the crops, but I did not think any of the reasons were worth your time.

Coda: Regular readers know that I routinely link to each Tax Judge’s Wikipedia page.  It seems to me (unscientifically) that more of those pages are now showing pictures of the Tax Court judge.  I, for one, am glad to (literally) see that happening. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return every Monday (or Tuesday when Monday is a federal holiday) for another Lesson From The Tax Court.