5. Valuing Charitable Gifts of Property, Part 2 of 2

5. Valuing Charitable Gifts of Property, Part 2 of 2

Article posted in General on 20 October 2015| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 21 October 2015
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VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

5. VALUING CHARITABLE GIFTS OF PROPERTY, Part 2 of 2

Links to previous sections of book are found at the end of each section.

The answer to this question is actually simpler than it may seem at first.  Because the donor has owned the antique toy car for only six weeks, it is short-term capital gain.  Because it is short-term capital gain, the rules concerning “related use” or “unrelated use” tangible personal property become irrelvant.  The gift must be valued at the lower of fair market value or basis regardless of its usage by the charity.
These exceptions are irrelevant because, as short-term capital gain property, this item may be valued only at cost basis.  (As always, valuing at cost basis assumes that the cost basis is less than fair market value.  Here, the cost basis of $1 is less than the fair market value of $25.)
Now consider a slightly different example.  Suppose that the donor purchased the antique toy car, not six weeks ago, but in 1990.  How does this change the result?
To begin with, since the donor has owned the property for more than 12 months and it has gone up in value, this property is long-term capital gain.
Because this is long-term capital gain property, there is the potential to deduct the full fair market value of the gifted property, rather than only its cost basis.  Of course, this is true only if none of the exceptions apply.
The first exception does not apply, because this is not a gift to a private foundation.  It is a gift to a public charity, in this case a museum of toys.  Next, there was no mention of a special election, so this exception does not apply either.  Finally, this is tangible personal property and consequently the unrelated use exception could apply.  However, in this case, the charity will actually be using the gifted item in furtherance of its charitable purposes.  Thus, this property is related use property, not unrelated use property.  Because none of the exceptions apply, the donor is allowed to deduct the full fair market value of the property donated to the charity.  In this case, it is important that the charity “intended” to use the item in its charitable operations by displaying the toy in its collection.  How can the IRS prevent abuse of this rule by charities that might say they “intend” to use gifts of property, but then simply sell the gifted property?
In this case, abuse is limited by the recapture rule.  If a charity sells (or otherwise transfers) the property item within three years, the valuation could change from fair market value to cost basis.  Such a change of valuation would require the donor to amend his or her tax return to reflect the lower deduction.  This recapture rule applies only to tangible personal property worth more than $5,000.  (The IRS does not want to hassle with recapture for small gifts.) For these larger gifts, a transfer or sale of the property by the charity within three years will lead to the reduced valuation for the charitable deduction.  This occurs unless the charity certifies that it made substantial related use of the property prior to sale or that the intended use became impossible.

For example, if the donor’s toy car were worth $25,000 (instead of $25) and the charity sold the toy three months later, then the original deduction would be subject to recapture.  However, if the reason the charity sold the car was because their museum location burnt down, making it impossible to display the car as originally intended, then no recapture would be required (assuming that the charity certified that the original intended use became impossible).  Alternatively, if the charity had, for example, displayed the car for 2 ½ years in its collection prior to the sale of the item and it was willing to certify this substantial related use, this certification could also prevent recapture.  Obviously, the simplest and cleanest way to avoid recapture is to make sure the charity does not sell the item for at least three years.  If the charity does sell within three years, but it also certifies that one of these two exceptions applies, that will also avoid recapture.  However, this certification must be accurate.  The charity must sign under penalty of perjury, and there is a $10,000 fine if the charity provides false information.

So, what happens if the charity does not use the item, but instead simply sells it soon after receiving it?  In this case the donor gives his antique toy car to a public charity that displays toys in its museum, but the charity doesn’t want to display the donor’s toy.  The charity just wants to sell it.  So, after the donor has given the toy to the charity, the charity sells the toy at its annual benefit auction.  What happens then?
Once again, this is still long-term capital gain property because the donor has owned it since 1990 and it has gone up in value. 
Because this is long-term capital gain property, there is at least the possibility that it could be valued at fair market value unless one of the exceptions applies.
In this case, one of the exceptions does indeed apply, because this is unrelated use tangible personal property.  It is unrelated use property because the charity did not use it.  Instead, the charity simply sold it for money.  It is tangible personal property because it is a moveable physical item.  Thus, this tangible personal property is not being used by the charity, but is instead simply being sold, and thus the exception to fair market valuation does apply.
Because one of the exceptions applies, the donor cannot use the fair market value for calculating the deduction.  Instead, the valuation must drop down to the cost basis valuation.  So, the gift of an item worth $25 generates a deduction of only $1.
An exception to the exception is the rule related to “qualified stock”.  Qualified stock is typical publicly traded stock.  That is, stocks that are traded on an exchange such that market quotations are regularly available.  For example, any stock traded on the New York Stock Exchange can be qualified stock.  In addition to being a publicly traded stock, the private foundation cannot have more than 10% of the entire company when counting all family member transfers together. 

What is the thought behind this rule?  The intent is to avoid giving special benefit to large, closely-held, insider transactions.  Consider the case of a family owned business where family members transfer most shares of the business to their own private family foundation.  This transaction has some potential for abuse.  The family members controlled the asset before the gift.  And now, as board members of the private family foundation, they control the asset after the gift (at least until it is sold).  Determining the fair market value of shares in a family owned business may be quite difficult.  This is especially true for closely held corporations where other investors may be uninterested in owning a minority share when the family still controls all aspects of the business.  Because private family foundations are often controlled by the donor or the donor’s family, these transfers are generally less desirable than gifts to traditional public charities

The exception is allowed for cases in which the property given is almost like cash.  It is almost like cash because the shares are regularly traded and have an easily identifiable value.  It is also like cash because it is not a very large share of the total ownership of the corporation (even when considering all family members’ transfers together).  Given the cash-like nature of the transfer, there is less concern about inappropriate or abusive transactions, making a fair market value deduction more appropriate.  Let’s look at an example of the mechanics of this kind of transaction.

Suppose a donor owns 10,000 shares of Microsoft Corporation (a publicly traded corporation), which she originally paid $1 per share for and is today worth $25 per share.  The donor gives these 10,000 shares to a private foundation.  What is her deduction for this gift?
Initially, it is useful to note that this is long-term capital gain property.  This is true because the donor has owned it for more than 12 months and it has gone up in value.
Because it is long-term capital gain, there is at least the potential that the donor can deduct its fair market value, unless one of the exceptions apply.
In this case, the donor is giving the property to a private foundation, so one of the exceptions to a fair market value deduction does apply, unless the donor qualifies for the exception to the exception.
Because the donor is giving qualified stock, the normal rule for private foundations does not apply.  As a result, the donor is allowed to deduct the fair market value of the shares of stock.  Thus, the donor’s deduction is $25 per share ($250,000) rather than $1 per share ($10,000).  The property is “qualified stock” because it was publicly traded (meaning that market quotations are available) and because 10,000 shares is nowhere close to a 10% ownership interest in the corporation (given that it has billions of shares).
From time to time there have been special kinds of property that have been used in significant tax abuses.  As a result, Congress has acted to create special rules that apply only to specific types of property, usually in response to these tax abuses.  For these special kinds of property, the normal rules are modified.  Special charitable donation rules apply to clothing, household items, cars, boats, airplanes, taxidermy, inventory, patents, and other intellectual property.
Considering the complexity of the “standard” rules that we have already reviewed, why would Congress add these special rules for specific assets?  The answer is that Congress reacted to ongoing abuses that fit the normal rules, but were still considered to be inappropriate.
There is always a special potential for abuse in the area of deductions for gifts of property when the property has an uncertain valuation.  Consider that if a taxpayer was at the top federal tax rate of 39.6%, and at the top state tax rate in a state like California, where the top rate is 13.3%, that a deduction is worth nearly half of the value of the gifted property even when the federal deduction for state taxes is fully useable.  When a property is difficult to value or difficult to sell, but can be immediately converted into a tax benefit worth nearly $.50 of every appraised dollar, it can make such transfers highly attractive, even to those with little or no charitable intent.  If a difficult-to-value item of property can be appraised for two or three times what it could actually be sold for in an immediate sale, it may be more profitable to donate the property, rather than to sell it.  Such financial incentives make gifts of difficult-to-value assets ripe for abuse.
What do the abuses that led to special rules look like?  For example, a person might have old clothes that she would otherwise throw in the trash because they have little or no resale value.  But instead of throwing them away the person could give them away and generate a charitable deduction.  Perhaps the person may attempt to value the deduction based on the original cost of the clothing or some “estimated” value based on a percentage of the original cost, when in reality the poor quality clothing has little or no resale value.
Another abuse could result from gifts of automobiles where the automobile has some defect that reduces its value below the normal resale value for that model and year of car.  Even though in reality the automobile may be worth nothing, except in a junkyard, taxpayers may be tempted to donate the vehicle and deduct the standard value for a vehicle of that age, make and model (i.e., the “blue book” value).
A particularly egregious abuse occurred in the area of donating stuffed animals to a wildlife museum.  In this scheme, the taxpayer would go on safari to hunt exotic animals, have the animals stuffed, and then donate the animals to a wildlife museum.  An appraisal firm would provide a high valuation for exotic stuffed animals (a valuation which might be difficult to disprove given the rarity of transactions and the high cost of acquiring new exotic stuffed animals).  A few small wildlife museums were willing to accept these donations (often taking in thousands of animals).  The donor would then deduct his cost basis in the stuffed animal, including all of the costs of acquiring the animal, such as the entire expense of the safari travel.  Thus, the tax code was essentially funding a substantial portion of safari tourism intended to kill exotic animals.

A different problem arose with copyrights and other intellectual property not simply because of the risk of fraud, but also because of the enormous difficulty in valuing such intellectual property in advance.  If a best-selling author, like John Grisham, wrote a new book and immediately donated the copyright of the book to charity, such a donation would be enormously valuable.  If a less well-known author did the same, the donation could be highly valuable and it could be worth nothing.  The difficulty is that it may be impossible to tell at the time of the donation how much the gift is worth.  No amount of sophistication, education, experience, or integrity of any appraiser will be able to correct that problem.

Because of the wide variety of problems and issues with these special kinds of property, each of them has their own special rule limited only to that specific kind of property.

Clothing and household items typically cannot be deducted unless they are in “good used condition or better.”  Requiring “good used condition” is intended to exclude worn out clothes.  An exception to this rule is allowed if the donor is giving more than $500 of clothing and the donor includes a qualified appraisal of the clothing with the tax return.  Thus, small donations of clothing in poor condition are not deductible.  Large donations of such clothing may be deductible, but only if accompanied by a qualified appraisal.
This same rule applies not only to clothing, but to other household items.  The term “household items” does not include art, antiques jewelry or collections.  Instead, it refers to items like furniture, electronics, appliances, linens and the like.  These household items may not be deducted unless they are in “good used condition or better” or where the donations is accompanied by a qualified appraisal indicating a value in excess of $500 for the entire donation.
In order to prevent abuse with contributions of automobiles the special rule is that if the charity sells the automobile, the deduction may be no greater than the actual sales price.  For example, suppose a donor paid $5,000 for a vehicle (i.e., basis) and it is currently worth $6,000 (i.e., is fair market value).  The donor gives that vehicle to a charity, and the charity sells it.  Unfortunately, in this case, the charity does a poor job of pricing the vehicle.  As a result, the vehicle sells for only $3,000.  In that case, the donor can only deduct $3,000.  This is true even though both the basis and the fair market value were higher than $3,000.  This rule can only lower the charitable deduction from the amount that would normally result from the standard valuation rules for gifts of property.  If, for example, two benefactors of the charity ran the bid for the vehicle up so that it sold for $10,000, the deduction for the contribution of the car would not be $10,000.  As a gift of tangible personal property not used by the charity, the deduction would be the lower of fair market value or basis, which in this case is $5,000.
This same rule applies not only to automobiles, but also to boats and even planes.  However, the IRS does not require this reduction if the charitable deduction was $500 or less.  (Although it seems unlikely that automobiles, boats, or planes would commonly be worth $500 or less.)
An exception to this rule applies if the charity will actually use the vehicle in furtherance of its charitable purposes, or intends to give the vehicle to a needy person rather than to sell it.  If the charity is willing to certify this usage on IRS Form 1098-C, then the donor can use the normal rules for valuing this gift of property (which in this case means following the rules for either short-term or long-term related use personal property).
To address the problem of taxpayer financed safari trips, Congress limited deductions for taxidermy property to the cost of stuffing the animal only.  Thus, none of the other costs of acquiring the animal may be deducted.
Deducting charitable gifts of copyright (or other intellectual property, such as patents and trademarks) is not simply a problem of fraud or abuse, but is fundamentally a problem of accurately valuing the property in advance.  To resolve this issue, Congress allowed for the deduction of cost basis plus a share of the next 12 years of income from the intellectual property right.  Thus, the full deduction does not come at the time of the initial transfer.  Instead, the donor receives a stream of deductions over 12 years.  In this way, the author giving a copyright to a charitable entity does not need to accurately predict its future value in advance, but instead can simply deduct a share of the actual dollars that go to the charity as a result of the gift.  This deduction of the income stream is only available for gifts to public charities and not to private foundations.

Note that, as in all other forms of charitable property deductions, the cost basis is deductible only if such basis is less than fair market value.  Thus conceptually, it may still be necessary to estimate the fair market value of an intellectual property right in advance.  However, in practice, many such rights have little or no cost basis.  For example, an author’s cost basis would include only some paper and ink, and would not take into account his or her time spent in producing the work.  (Note that time and effort are excluded from cost basis in other areas as well.  For example, if a taxpayer purchases a dirty car for $5,000 and then spends three months cleaning and detailing it, his basis in the car is still only $5,000.)

Another exception to the standard valuation rules involves an unusual compromise on valuation.  The normal rule for gifts of inventory is that only the cost basis of inventory is deductible.  However, the tax code provides a special increase in the deduction for specific types of inventory gifts.  If the donor is a standard corporation (known as a C-corporation, as opposed to the closely held, S-corporation), and is giving inventory to a public charity for care of ill individuals, needy individuals, or infants, or it is giving qualified research materials to a institution of higher education or other scientific institution, then the donor C-corporation can receive a higher deduction.  This higher deduction will be the average of basis and fair market value.  Thus, the Corporation receives neither the most favored status (which would be fair market value) nor the less favored status (which would be cost basis), but instead receives something in the middle. 

However, this deduction is still limited to no more than double the cost basis in the gifted items.  This is to prevent a scenario where the deduction was worth more than the cost of manufacturing the property.

Although not exceptions to the general rules, some items can be hard to value and consequently, the IRS requires a special kind of valuation for these items.  For example, in determining the fair market value of a used car, taxpayers must use the private party value and not the amount for which it would sell on a dealer lot.  For boats, taxpayers may not estimate fair market value by simply looking at the price of similar size and age of boats.  Instead, boats require an individual appraisal.  This is because there can be dramatic differences in the value and seaworthiness of boats of the same age and size, making generic valuations less relevant.  These rules help to prevent scenarios where it is more profitable to give the item of property than to sell the item of property.  For example, if a donor had a boat that had significant issues with rotting and seaworthiness, its actual value may be only a fraction of what a boat in good condition of a similar size and age would sell for.  If the donor was allowed to deduct a gift of the boat based upon the typical value of such boats of the same age and size, it could create a situation where the deduction was worth more than what the donor could sell the boat for.  This is precisely the situation that tax policy wishes to avoid and hence the reason for requiring individual appraisals for boats.  Similarly, when valuing gifts of clothing, the valuation must be based upon what the used clothing would sell for in a consignment or thrift shop not based upon what it sells for new in a retail environment.  Of course, the difference between what an Armani suit sells for in an upscale retail environment and what a used Armani suit would sell for in a thrift shop is dramatic.

Finally, for gifts of large quantities of individual items, valuation must be based upon the value of the entire lot of items.  It is not permitted to estimate the value of a single item and multiply that by the total number of items gifted.  For example, suppose a donor found a box of 1,000 beanie babies on sale on eBay for $1,000.  If the donor purchased these then gave them to an orphanage over a year later for use in their charitable activities, the donor could be entitled to a deduction of fair market value (long-term capital gain related use personal property).  However, even if the fair market value for a single beanie baby toy was $5, the donor could not claim a fair market value for the gift of $5,000 ($5 X 1000).  Instead, the fair market value would be the value of the entire lot of 1,000 such beanie babies sold as a single lot.

If during an audit a charitable gift is found to be overvalued, thi will result in the need to reduce the deduction to an appropriate value and the consequent need to pay for additional taxes and any interest accrued since the due date for those taxes.  In addition to this repayment and interest there can be penalties for overvaluing a charitable gift.  Those penalties depend upon the amount of the gift and the degree of over-valuation.  If the gift was valued at greater than 50% of its true value and, as a result, there was more than $5,000 in underpayment of tax, then the taxpayer must pay not only the taxes due, but also an additional 20% of the unpaid taxes.  If in the previous case, the valuation was more than double the item’s true value, then the penalty would be an additional 40% of the unpaid taxes.  Finally, if the misstatement of value was due to fraud, the penalty would be an additional 75% of the unpaid taxes, regardless of the amount of underpayment or the degree of over valuation.  (Tax fraud can lead not only to financial penalties, but also to imprisonment.)

As discussed in the chapter on documenting charitable gifts, the donor is often required to obtain an appraisal in order to deduct gifts of property.  Can the taxpayer avoid the penalties discussed above if the taxpayer had a qualified appraisal for the amounts reported?  The answer is: it depends.
There will be no taxpayer penalty if the valuation was based upon a qualified appraisal, the donor made a good-faith investigation of value, and the valuation was less than double the actual value of the item.  This exception would not apply if the appraisal was not a qualified appraisal based upon IRS guidelines.  Even if the appraisal was a qualified appraisal, the donor is still required to have made a good-faith investigation of the value of the item, besides simply relying upon the appraisal.  But if both of those conditions apply, and the appraised value was less than double the actual value, then no penalty will apply.  However, the unpaid tax resulting from the overvaluation and any interest must still be paid.
What are the penalties to the appraiser for making an excessive appraisal of an item of property gifted to a charity?  If the valuation was more than 50% greater than the actual value of the item, the appraiser’s penalty will be the greater of $1,000 or 10% of the tax underpayment.  This penalty could be potentially catastrophic for appraisers who appraise items of extremely high value.  Recognizing that such a rule would prevent even legitimate appraisers from functioning, the tax code limits the penalty for appraisers to 125% of the appraiser’s fee for making the appraisal.  If an appraiser charges $1,000 and values a piece of artwork at $10 million when it was actually worth only $5 million and this error results in a $1.5 million tax underpayment, the appraisers penalty will not be $150,000 (10% of the tax underpayment), but instead would be 125% of the appraisal fee, or $1,250.

One interesting case that illustrates the sometimes unusual results from property valuation is that involving a work of art called “Canyon.”  This work of art was inherited by the heirs of an estate.  The IRS appraised the value of the artwork at $65 million and charged $29.2 million in estate taxes on the item.  This valuation was based upon the IRS definition of fair market value, which is the price that property would sell for on the open market.  The problem in this case is that the artwork incorporated the use of a taxidermy eagle.  The sale of such taxidermy eagle feathers or parts is prohibited by federal law.  Consequently, the estate was required to pay a large tax on an item that could not be sold.  This is an interesting example of what could happen with items where the sale is restricted by law, but the valuation is based upon the price that the item would sell for on the open market.  In this case, the heirs would have been much better off if the artwork have been gifted to a charity, rather than inherited by them.  In the final settlement, the IRS allowed the heirs to retroactively donate the artwork, treating it as if the gift had been made by the estate, thus generating no net estate taxes on the donated artwork.

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