Take-Away: The failure to follow highly technical rules will cause a donor to lose a charitable income tax deduction. It seems that these rules are traps where the IRS tends to say ‘gotcha.’

Background: The rules that pertain to charitable income tax deductions are complex, which in turn present traps for unsuspecting  donors who fail to comply with them. This is especially  the case with a charitable contribution to donor advised fund. That existence of two such traps by an unwary donor was on full display in a recent Tax Court decision.

Keffer V. U.S. United States Tax Court, 3:20-cv-00836 (July 6, 2022)

Facts: Kevin owned a 4% interest in a limited partnership that owned a single hotel property. In April, 2015 the partnership and a REIT entered into a nonbinding letter of intent for the REIT to purchase the partnership’s hotel. Other offers were also being considered by the partnership. On June 18, 2015, Kevin contributed his 4% limited partnership interest to a tax-exempt public charity [the Foundation] that established a donor advised fund, named Keefer Donor Advised Fund. As of that date, the partnership had tentatively agreed to sell the hotel for $54 million, but no contract of sale had yet to be signed, and the REIT had yet to review the property which was a condition of the April Letter of Intent. On July 2, 2015 the partnership and the REIT signed a contract of purchase for $54 million. The hotel sale closing was to occur  on August 11, 2015.

Oral Agreement: One of Kevin’s problems  was an ‘oral agreement’ between Kevin and the charity with regard to Kevin’s donation. Specifically, the charity would receive only the net proceeds that resulted from the sale of the hotel attributable to Kevin’s 4% partnership interest, and nothing more. Restated, the charity would not share in any other assets owned by the partnership that was not covered by the sale of the hotel.

Appraisal: Kevin obtained an appraisal of his donated partnership interest, as of June 18, 2015, the date of his contribution. The appraisal estimated the fair market value of Kevin’s 4% partnership interest “subject to an oral agreement between the donor and donee.” The appraisal made note that “The Donee will not share in Other Assets of the Partnership not covered in the sale.” Kevin’s donated interest was valued at $1,257,000 in the appraisal.

Charity’s Contemporaneous Acknowledgement: The Foundation that sponsored the donor advised fund sent to Kevin on June 5, 2015 a 12-page packet of information with regard the formation of the Keffer Donor Advised Fund, which Kevin signed on June 8, 2015.  Later, on September 9, 2015, Kevin received a letter from the Foundation that acknowledged his donation of his partnership interest. However, this acknowledgment sent by the charity did not contain magic language that a donor advised fund must include to comply with IRC 170(f)(18) that “the charity has exclusive legal control over the assets contributed.”

Charitable Deduction: Kevin claimed a $1,257,000 charitable income tax deduction on his income tax return.

Denied Deduction:  The IRS denied Kevin’s claimed charitable income tax deduction. The denial was based on Kevin’s failure to comply with the charitable gift substantiation requirements with respect to the charity’s contemporaneous written acknowledgement (CWA) of the gift. In addition, the appraisal submitted by Kevin in support of his claimed charitable income tax deduction did not include the identifying number of the qualified appraiser.

Tax Court: Not only did the Tax Court deny Kevin’s claim for a charitable income tax deduction,  the Court also found that Kevin was subject to the income taxes on the sale of the hotel, i.e. it held that Kevin had tried, unsuccessfully, to assign his share of the income from the hotel sale to the donor advised fund.

Assignment of Income Trap: Admittedly, the partnership interest was assigned by Kevin to the Foundation on June 18, while the sale of the hotel did not occur until July 2. With these facts, including the REIT’s nonbinding letter of intent, and the REIT’s condition of review of the hotel and its records, it was clear that the sale of the hotel was not practically certain to go through, which is normally one of the key triggers for the IRS to assert an assignment of income argument.

But then we come to one of the hidden ‘traps’ in connection with charitable giving.  Even if the income had not yet been fully earned by the partnership at the time of Kevin’s charitable contribution to the Foundation, the assignment of income doctrine still applies where the whole asset is not transferred to the charity prior to the time that the earnings event ultimately occurs. The Court held that this was the case for Kevin’s contribution of his limited partnership interest, because although the partnership’s right to income from the hotel sale had not yet vested at the time of Kevin’s charitable contribution to the Foundation, Kevin did not contribute his entire 4% partnership interest to the Foundation, just 4% of the hotel sales proceeds. Accordingly, the Foundation would not share in the sale proceeds of any other assets sold by the partnership; rather it  was limited to its 4% share of the hotel proceeds. As a result, the assignment of income doctrine was held to apply to Kevin, so that the income from the hotel sale attributed to Kevin’s contributed 4% limited partnership interest was taxable to Kevin, not to the tax-exempt Foundation.

Charitable Contribution Substantiation Trap:  A contemporaneous written acknowledgment (CWA) is required for contributions that exceed $250,000 in value to a charity. [IRC 170(f)((8)A).] Consequently, a charitable income tax deduction is not allowed unless the donor substantiates the contribution with a CWA of the contribution by the charity that meets the requirements of IRC 170(f)(8)(B). Those requirements that the substantiation must include are: (i) the amount of cash and a description (but not value) of any property other than cash contributed; and (ii) whether the done organization provided any goods or services in consideration, in whole or in part, for the donated property; and (iii) for transfers to donor advised funds,  the added requirement is that the acknowledgement must state that the charity ‘has exclusive legal control over the assets contributed.’ The failure to adhere to these requirements will result in the denial of the claimed charitable income tax deduction. The IRS’s doctrine of ‘substantial compliance’ does not excuse compliance with the Tax Code’s substantiation requirements.

In its decision, the Court stressed that the CWA requirement falls on the donor, not on the charity to which the charitable contribution is made. There is no penalty imposed on the charity for its failure to provide a CWA to a donor (other than obviously alienating its donor.)

Conclusion: Consider Kevin’s situation. He thought he made a $1,257,000 gift to a donor advised fund. Kevin did not claim any of the hotel sales proceeds in his taxable income for the year. Instead, he claimed a $1,257,000 charitable income tax deduction to presumably offset other taxable income of his. Due to two highly technical ‘gotcha’ rules, i.e. Kevin did not transfer his entire interest in the partnership to the charity just his share of the sales proceeds resulting from the hotel’s sale, he had to report his pro rata share of the sales proceeds as part of his taxable. And because the charity did not include the magic language words in its acknowledgment of Kevin’s gift that it had ‘exclusive legal control over the assets contributed,’ Kevin could not claim an offsetting charitable income tax deduction. Taxable income of $1,257,000, no offsetting charitable deduction, and no access to the sales proceeds with which to pay the additional income tax liability. And we are told by politicians that the Tax Code encourages charitable giving by taxpayers. I think not.