A Hidden Trap for Generous Corporations

A Hidden Trap for Generous Corporations

Article posted in Income Tax on 17 May 2005| 4 comments
audience: National Publication | last updated: 16 September 2012
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Summary

Can a corporation be too generous? In this article, Laura Peebles, CPA, PFS, tax director at the national office of Deloitte & Touche, LLP, discusses a little known provision that may cause corporations that contribute "substantially all" of their assets to charity outright or via a charitable remainder trust to incur a significant and unforeseen tax.


by Laura H. Peebles, CPA, PFS

Introduction

It is generally assumed among U.S. gift planning professionals that unless there is debt involved, donating property to charity will not be a taxable event giving rise to gain or loss recognition. Even if there is debt involved, only a portion of the gain will be recognized: if a property is mortgaged for 30% of its value, 30% of the gain inherent in the property will be recognized if the property is donated.1

As with most of tax law, however, there is an exception. Because of the unusual location for this exception, in the regulations under Section 337 of the Internal Revenue Code (which covers liquidation of corporate subsidiaries), it may be overlooked. However, anyone who is working with a corporate donor should be aware of these rules. The regulations apply to all corporations, including ones that have made an election to be taxed as Subchapter S corporations. In the case of an S Corporation, the tax on the gain would be paid by the shareholders, and there would probably be a significant offsetting charitable contribution deduction (again, at the shareholder level, although perhaps not a 100% offset). A regular corporation is allowed a charitable contribution deduction as well, but since it is limited to 10% of taxable income, it is unlikely to offset a substantial gain that was unintentionally incurred.

Reg. §1.337(d)-4(a)(1) introduces the regulation:

(a) Gain or loss recognition. -(1) General rule.--Except as provided in paragraph (b) of this section, if a taxable corporation transfers all or substantially all of its assets to one or more tax-exempt entities, the taxable corporation must recognize gain or loss immediately before the transfer as if the assets transferred were sold at their fair market values. But see section 267 and paragraph (d) of this section concerning limitations on the recognition of loss.

The exceptions in paragraph (b) are unlikely to be helpful except in the unusual situation where the donee charity will be using the donated property in an unrelated trade or business. If this circumstance should arise, then the planner should review this exception to see if it applies.

The stated purpose of the regulation is to require gain recognition on all assets if a corporation converts from taxable to tax-exempt status. That is not a transaction that a typical planned giving professional is likely to encounter. However, to preclude a corporation from avoiding the gain recognition rules by simply donating all its property to a tax-exempt entity, the regulations require that gain be recognized, and tax paid, if "substantially all" of the assets of the corporation are transferred to a "tax-exempt entity." "Tax-exempt entity" is defined as an organization exempt from tax under section 501(a), and a charitable remainder trust as defined in Section 664,2 so this provision is obviously going to concern gift planners working with generous corporations, since there is no exception for transfers made with donative intent.

What is Substantially All?

"Substantially all" is also a defined term, by reference to another corporate code section: 368(a)(1)(C).3 Section 368 is a non-recognition provision, which allows a corporation to transfer "substantially all" its assets to another corporation without recognizing gain. Unfortunately for the gift-planning community, this means that the guidance under Section 368 has focused on succeeding in transferring "substantially all" of the corporate assets rather than failing to transfer "substantially all" of them. So referring to the existing rulings, and the IRS ruling policy, provides only minimal guidance. Since that guidance is all we have, we can at least start there. Generally, the Service uses as a ruling guideline that the "substantially all" requirement is satisfied if there is a transfer of assets representing at least 90% of the fair market value of the net assets and at least 70% of the fair market value of the gross assets held by the corporation immediately before the transfer (in this case, "transfer" would be the donation).4

Does that mean that as long as a corporation donates less than those percentages of assets, that it is safe from triggering gain recognition? Unfortunately, no. Early case law held that smaller percentages, 86% of gross and 71% of net, were enough to satisfy the test. Conversely, in Pillar Rock Packing Co. v. Comr.,5 68% was held to be less than substantially all. Case law also considers the type of assets retained. In cases where all operating assets were transferred to the acquiring corporation and the cash, receivables or other non-operating assets were distributed to the shareholders the courts have allowed lower percentages and still considered the "substantially all" test to be met. So although there is a bright-line test for achieving the "substantially all" threshold, there is no bright line for failing to achieve it.

A survey of the case law does lead to one possible guideline: When determining "substantially all" for purposes of Section 368, the courts have focused on the percentage of the corporate operating assets rather than all corporate assets. If it were possible to rely on those cases, a corporation that donates non-operating assets and keeps all its operating assets would not incur taxable gain on the donation no matter what percentage of the overall assets were donated. Unfortunately, we will have to wait for the IRS and the courts to see how they apply the pre-existing case law under Section 368 to the new application under the Section 337 regulations.

What to Do?

What about obtaining a private letter ruling from the IRS? This may be possible: This is not one of the areas that the IRS has on its "no ruling" list for 2005. 6 However, many potential donors would not want to delay their donation long enough to obtain a ruling7 (not to mention incur the expense).

So, what should a professional do if a potential donor happens to be a corporation? First, the corporation's tax advisors should review this provision in light of the corporation's potential donation, considering its specific assets and liabilities and the type of assets available for contribution. They should determine what the consequences would be if gain were triggered by a contribution. Is the potential tax impact small enough that the corporation can accept the risk? If so, then perhaps further analysis is unnecessary, and the donation can be made.

If it appears that the contemplated donation might trigger significant additional tax if this issue were to be lost on audit, serious consultation with the donor's tax advisors is in order. Since there are no bright-line tests, and the potential consequences are expensive, the donor and its advisors may decide to limit or restructure the donation, or obtain a ruling. A bit of translation and patience may be needed, since the relevant code sections are in the corporation reorganization sections. The "reorg" folks are typically not familiar with large donative transactions, and the people who spend their time with charitable giving will be unfamiliar with the reorg vocabulary and technical provisions.

{C}


  1. Reg. §1.1011-2(a)(3) All references are to the Treasury Regulations and Internal Revenue Code.back

  2. Reg. §1.337(d)-4(c)(2) also includes Section 529 plans, U.S. and foreign governmental entities, Indian Tribes, and certain international organizations. No discussion is included of these organizations since gift planners are unlikely to be planning transfers to them.back

  3. Reg. §1.337(d)-4(c)(3)back

  4. Rev. Proc. 77-37, 1977-2 CB 568back

  5. See, for example, Smothers v. U.S., 642 F2d 894 (5th Cir. 1981) where 15% of the assets were held to be "substantially all"back

  6. Rev. Proc. 2005-3 , I.R.B. 2005-1, 118, January 3, 2005back

  7. The "rule of thumb" is that a ruling takes six months once it is submitted to the IRS. As of spring 2005, the backlog in Exempt Organizations section was closer to a year.back

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Comments

hidden trap for generous corps...

If my comments, past and present, show me to be a tax hawk, so be it. And it's articles like this that fill me with resolve. Please scrap the Code. A well-meaning corp is damned if they do and damned if they don't. Pay the tax or pay tax professionals who will counsel you on not paying the tax. The resultant loss in tax revenue by scrapping the Code will be made up for by tax payers keeping the billions paid to tax professionals and putting it to more productive use. The Code is ambiguous, contradictory, and confiscatory and crafted by those who have made themselves exempt. Why do we continue to use such a poor guideline to govern ourselves?

Section 337 liquidations

Its a timely comment. When the statute was changed in 1986, there was considerable publicity about it and the reasoning for the change -- but that was 10 years ago, and memories fade. Thanks for refreshing us.

Substantially All

Several years ago Jon Ackerman wrote a piece on this issue for PGDC and suggested that since the corp. was retaining a significant income interest in the CRT, they arguably were not transferring substantially all of their assets. Has anyone tried to pursue this line of reasoning?

"Substantially All" and CRTs

Thanks for reminding us all of Mr. Ackerman's 1999 article entitled, "Final Regs Under Section 337- More Taxation for Tax-Exempts." Interested readers can find it at http://www.pgdc.com/home/item/?itemID=57939. The CRT issue is addressed in the last few paragraphs. With respect to this issue, we contacted Emil Kallina, who posed it originally to the IRS. Mr. Kallina is not aware of any further developments in this area. Neither are we; however, it would seem that this issue is ripe for a private ruling. On an aside, as Ms. Peebles pointed out in the present article, what constitutes "substantially all" varies depending who is interpreting it. Mr. Kallina added that during his informal conversation with IRS, the Service said it was inclined to view 51% or more as "substantially all." What a surprise.

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