CCA 201443019 Provides a Reminder That Fair Market Value Deduction Not Available for Donor Deemed to be a Dealer of Property Contributed to Charity

CCA 201443019 Provides a Reminder That Fair Market Value Deduction Not Available for Donor Deemed to be a Dealer of Property Contributed to Charity

Article posted in IRS Notices on 20 January 2015| 2 comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 20 January 2015
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SUMMARY

Recently issued CCA 201443019 provides an excellent reminder that for purposes of determining the available charitable income tax deduction, a donor who engages in a frequent and continuous course of conduct involving the acquisition of property and the subsequent contribution of the property to a variety of charities may be considered the equivalent of a dealer selling inventory or other property primarily for sale to customers in the ordinary course of a trade or business.  In such a case, the property contributed will be considered ordinary income property as if the donor were engaged in the trade or business of selling the contributed property, even though the donor has never actually engaged in the business of selling such property.  The application of this “theoretical sales” approach can have a dramatic effect on the amount of the available charitable income tax deduction because the deduction that might otherwise be based on the fair market value of the contributed property is subject to the reduction rule of IRC § 170(e)(1)(A), whereby the charitable income tax deduction is limited to the income tax basis of the property, notwithstanding that its fair market value is much higher.  While this giving situation is certainly not a common one, donors who activities might be subject to this “theoretical sale” rule should attempt to plan accordingly to avoid its application.

DISCUSSION

Application of Reduction Rule of IRC § 170(e)(1)(A) to Sales of Inventory and Other Property Held Primarily for Sale in Ordinary Course of Business

Inventory and other property held primarily for sale to customers in the ordinary course of a trade or business is considered ordinary income property,[1] so that no portion of the gain from the sale of the property is long-term capital gain.[2] As a result, under the reduction rule of IRC § 170(e)(1)(A), a dealer or manufacturer making a contribution of inventory or other property primarily held for sale to customers in the ordinary course of a trade or business can only claim a deduction equal to the tax basis of the property, notwithstanding that its fair market value is significantly greater.[3]  Although fair market value is the starting point in determining a charitable income tax deduction, IRC § 170(e)(1)(A) reduces the deduction otherwise based on fair market value of the property by the amount of the ordinary income that would be realized if the property were sold. For example, if a dealer in artwork contributes to an art museum a painting that was purchased for $20,000 more than a year earlier and that now has a fair market value of $50,000, the deduction is limited to $20,000, the tax basis of the property. This is the case because if the painting were sold at its fair market value, the dealer would realize ordinary income of $30,000 because the contributed painting is an item of property that the donor holds for sale to customers in the ordinary course of a trade or business. Thus, under the IRC § 170(e)(1)(A) reduction rule, the amount of the charitable contribution deduction is equal to the $50,000 fair market value of the painting less the $30,000 of ordinary income that would be realized on a sale, or $20,000, the property’s tax basis.  

CCA 201443019: Application of Reduction Rule of IRC § 170(e)(1)(A) Where Donor is Considered Equivalent to a Dealer of the Contributed Property

The IRS has used a “theoretical sales” approach as the basis for determining that a taxpayer who  engages in frequent and continuous acquisitions of property that is subsequently contributed to various charitable organizations is considered equivalent to a dealer selling inventory or other property primarily for sale to customers in the ordinary course of a trade or business.[4] In this situation, the IRS has ruled that for purposes of computing the available charitable income tax deduction, the contributed property is considered ordinary income property even though the taxpayer has never actually engaged in the business of selling the contributed property.  As a result, the IRC § 170(e)(1)(A) reduction rule is triggered, resulting in a charitable income tax deduction equal to the lesser of the property’s fair market value or income tax basis.  Although CCA 201443019 provides only limited facts, stating that it “presents a scenario in which taxpayer claims a charitable contribution deduction for a gift of large number of items,” it sets forth an array of helpful authority. This, and other authority in this area, are discussed below. 

In Rev. Rul. 79-256,[5] the taxpayer had engaged for a number of years in the activity of raising ornamental plants as a hobby. In 1978, as in prior years, the taxpayer contributed a large number of plants to various charities, after having held the plants for the long-term capital gain holding period. The contributions were not made after a period of accumulation and enjoyment by the taxpayer of the property contributed. Rather, the property was produced and then distributed to various donee charities. The IRS ruled that the continuous production and disposition of plants were the equivalent of the activities of a commercial nursery business and that the contributed property was, therefore, considered ordinary income property. As a result, Rev. Rul. 79-256 held that the reduction rule of IRC § 170(e)(1)(A) applied, as the donor was considered to be in the position of a seller of such property in the ordinary course of a trade or business.

A result similar to Rev. Rul. 79-256 was reached in Ltr. Rul. 7849008, where the donor, a retired attorney, engaged in horticulture as a hobby. During several years, he donated over 160,000 homegrown plants valued at approximately $850,000 to a number of charities, which then used the contributed plants for landscaping. The plants did not constitute inventory or other property held primarily for sale to customers in the ordinary course of a trade or business because they were never held for sale, but were only used to make contributions. The IRS, in applying a “theoretical sales” approach, determined that the taxpayer's continuous production and disposition of the plants was the equivalent of a commercial nursery business, stating:

The plants in the subject case would not be ordinary income property under section 1221(1) because the taxpayer did not sell any plants. However, the District Director views the numbers of donations of plants as several ‘theoretical sales’ of the plants that should be taken into account in determining whether the gain from the sale of the donated plants would be ordinary income for purposes of determining the amount of the taxpayer's charitable deduction under section 170(e)(1)(A) of the Code. The District Director further concludes that because of the frequency of the taxpayer's donations (theoretical sales) and his continued practice of cultivating plants for future donations, the taxpayer is in a trade or business for purposes of section 170(e)(1)(A) and his contributions of plants were contributions of ordinary income property.

Because the IRS considered the plants as ordinary income property, such that any gain on the sale of the plants would be other than long-term capital gain, the donor's charitable contribution deduction for income tax purposes was limited to the income tax basis of the plants under IRC § 170(e)(1)(A). The IRS acknowledged that if each donation of a plant were viewed independently for purposes of IRC § 170(e)(1)(A), the income generated from the sale of the plant would have been capital gain. However, in treating the contributed plants as ordinary income property, the IRS emphasized that the donor “claimed charitable deductions for several donations totaling over 160,000 plants with a claimed fair market value in excess of $850,000 for the four tax years at issue. If the taxpayer had sold these plants rather than donated them to charity, he would certainly have realized ordinary income. To characterize the income from the ‘theoretical sale’ of such plants as capital gain would be unrealistic. Thus, by viewing the contributions as ‘theoretical sales,’ the donated plants were considered ordinary income property.”

The IRS came to a similar result in another factual pattern presented in Rev. Rul. 79-256,[6] where a donor bought a substantial number of limited edition prints and then donated the prints to various art museums. The IRS said that the donor's bulk acquisition and later disposal of a substantial part of the edition was the substantial equivalent to the activities of a commercial art dealer. The contribution deduction was limited to his income tax basis in the prints because the contributed property was deemed to be ordinary income property. The ruling stressed that “the contributions were not made after a period of accumulation and enjoyment by the taxpayers of the property contributed.”  On the contrary, the contributed property was purchased in bulk and distributed to various donees, so that the taxpayer's bulk acquisition and subsequent disposal of a substantial part of the total limited edition of prints were substantially equivalent to the activities of a commercial art dealer.  The IRS has applied the same theory to an arrangement involving buying and donating art books. In Rev. Rul. 79-419,[7] the taxpayer purchased books at a volume discount from a company located in a country where the retail price is legally fixed and imported them into the United States. The donor then warehoused the books for just over one year (so as to meet the long-term holding period) and then donated them to various charitable organizations. The IRS ruled that the taxpayer's activity was tantamount to the activity of a dealer selling books. The books were deemed to be ordinary income property and, therefore, the amount deductible was limited to the taxpayer's income tax basis in the property.

Where the donor makes a contribution of property after a substantial period of enjoyment, the donor will not be placed in the position of a seller for purposes of the reduction rule of IRC § 170(e)(1)(A). In Ltr. Rul. 8145085, for example, the donor contributed paintings that he had held since 1955. The IRS ruled that because the contribution was made “after a substantial period of enjoyment,” the donor would not be placed in a position of a seller of the contributed property under Rev. Rul. 79-256 and the amount of the available deduction, therefore, was not subject to reduction under IRC § 170(e)(1)(A).  Revenue Ruling 79-256 was also held to be inapplicable in Anthony J. Pasqualini,[8] a case where the donors contributed a total of 180,000 Christmas cards to one charitable organization, Catholic Charities. The cards were purchased specifically for the purpose of donating them to the charitable organization and they were delivered to and stored in a warehouse, where they remained until they were contributed to the charitable organization slightly more than a year after their purchase.  (The cards were purchased on December 10, 1981, and were contributed around December 27, 1982.)  The court held that, notwithstanding that the cards were purchased specifically to donate to charity and were held for only a little more than one year prior to the contribution, the donors were not considered dealers of Christmas cards because they made only one gift of the cards to the one charity, made no improvements to the cards, did no advertising, and made relatively little effort to arrange the gift of the cards to the charity. In determining that the IRS's reliance on Rev. Rul. 79-256 was “misplaced,” the court held that “the factors show that, if petitioners had sold the cards at their fair market value rather than donated them, the gain would have been long-term capital gain” and, therefore, the reduction rule of IRC § 170(e)(1)(A) did not apply.

 CCA 201443019 should be kept in mind whenever a donor’s pattern of charitable given resembles (or might resemble) that of a dealer selling inventory or other property primarily for sale to customers in the ordinary course of a trade or business. While the issue is inherently factual, if the contribution were instead a sale that would have resulted in ordinary income, the amount of the charitable income tax deduction that might otherwise be based on fair market value is subject to the reduction rule of IRC § 170(e)(1)(A). While this giving situation is certainly not a common one, donors whose activities might be subject to this “theoretical sale” rule should attempt to plan accordingly to avoid its application.



[1] IRC § 1221(a)(1), which excludes from capital asset classification “stock in a trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” The function of IRC § 1221(1) is “to differentiate between the profits and losses arising from the everyday operation of a business… and the realization of appreciation in value accrued over a substantial period of time.” Malat v. Riddell, 383 US 569, 17 AFTR2d 604 (1966).  Note that in this context, the word “primarily” means “principally” or “of first importance.”

[2] Because it is not considered a capital asset, gain from the sale of inventory can never result in capital gain and, therefore, no matter how long the holding period, never results in long-term capital gain.

[3] See, e.g., Rev. Rul. 85-8, 1985-1 CB 59 (“Thus, as a general rule, the deduction for contributions of appreciated inventory property is limited to the taxpayer's basis in the contributed property”).

[4]  See Rev. Rul. 79-256, 1979-2 CB 105, and 16,012. See also GCM 37611 (July 25, 1978), issued in connection with Rev. Rul. 79-256, which framed the issue as follows: “For purposes of I.R.C. § 170(e)(1)(A), are the number of donations of plants to charity by the taxpayer taken into account as ‘theoretical  sales ' of these plants in determining the character of the gain that would have been realized if the taxpayer had sold the plants?”

[5] Rev. Rul. 79-256, 1979-2 CB 105.

[6]  Rev. Rul. 79-256, 1979-2 CB 105 (Situation 2).

[7] Rev. Rul. 79-419, 1979-2 CB 107.

[8] 103 TC 1 (1994).

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Re: CCA 201443019 Provides a Reminder That Fair Market Value ...

CCA stands for Chief Counsel Advice in case you don't know that abbreviation. Chief Counsel of the IRS.

Re: CCA 201443019 Provides a Reminder That Fair Market Value ...

Thanks, Lynda. I had no freakin' clue and I thought I knew most of the IRS acronyms

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