Intangible Personal Property

Intangible Personal Property

Technical Report posted in Intangible Personal Property on 2 May 2003| comments
audience: National Publication | last updated: 15 September 2012
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Abstract

Intangible personal property is property that has no intrinsic value but is merely representative or evidence of value. Common examples include securities (both public and private), copyrights, royalties, patents, personal service contracts, installment obligations, life insurance and annuity contracts, and partnership interests. This memorandum examines the most common types and forms of intangible personal property that are considered for contribution to charity, and the special rules that apply to charitable deductions for income, gift, and estate tax purposes.

Introduction

Intangible personal property is property that has no intrinsic value but is merely representative or evidence of value.1Described another way, intangible personal property is personal property (other than real property) whose value stems from its intangible elements rather than from its specific tangible (physical) elements.2

Although the Code does not provide a concise definition of intangible personal property, it does provide several examples. For example, section 936(h)(3)(B) defines intangible property to mean any--

  • copyright, literary, musical, or artistic composition;
  • patent, invention, formula, process, design, pattern, or know-how;
  • trademark, trade name, or brand name;
  • franchise, license, or contract;
  • method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or
  • any similar item, which has substantial value independent of the services of any individual.

With respect to charitable gift planning, the most common types of intangible personal property that gift planners encounter include securities (both public and private), copyrights, royalties, patents, personal service contracts, installment obligations, life insurance and annuity contracts, and partnership interests.

Intangible property is also frequently "bundled" with tangible or real property. Examples include a work of art and its copyright, or mineral rights and the real property from which the minerals are derived. The deductibility of such contributions depends on a variety of factors that frequently depend on whether the interests are given in combination or separately.

The balance of this memorandum examines the most common types and forms of intangible personal property that are considered for contribution to charity, and the special rules that apply to charitable deductions for income, gift, and estate tax purposes. Due to their scope and complexity, however, publicly traded securities and privately-held business interests (which includes corporations, partnerships, and limited liability companies) are the subjects of separate memoranda.

General Tax Deduction Rules

It is important to note that contributions of intangible personal property are not subject to the same rules as apply to gifts of tangible personal property. Specifically, the related-use and future interest rules do not apply to gifts of intangible assets. As will be discussed, however, the partial interest rule and Section 170 reduction rules (applicable to contributions of ordinary income property) frequently come into play with respect to transfers of intangible assets.

For gift and estate tax deduction purposes, intangible personal property is subject to the same general rules as apply to tangible personal property and real property. Specific rules and exceptions are discussed in connection with each type of intangible asset.

Copyrights

Under Title 17 of the United States Code, the holder of a copyright has the exclusive right:

  • to reproduce the copyrighted work in copies or phonorecords;
     
  • to prepare derivative works based upon the copyrighted work;
     
  • to distribute copies or phonorecords of the copyrighted work to the public by sale or other transfer of ownership, or by rental, lease, or lending;
     
  • in the case of literary, musical, dramatic, and choreographic works, pantomimes, and motion pictures and other audiovisual works, to perform the copyrighted work publicly;
     
  • in the case of literary, musical, dramatic, and choreographic works, pantomimes, and pictorial, graphic, or sculptural works, including the individual images of a motion picture or other audiovisual work, to display the copyrighted work publicly;
     
  • and in the case of sound recordings, to perform the copyrighted work publicly by means of a digital audio transmission.3

Works Subject to Copyright

Copyright protection is generally offered to original works of authorship which include literary works; musical works, including any accompanying words; dramatic works, including any accompanying music; pantomimes and choreographic works; pictorial, graphic, and sculptural works; motion pictures and other audiovisual works; sound recordings; and architectural works.4

Copyright protection for an original work of authorship does not, however, extend to any idea, procedure, process, system, method of operation, concept, principle, or discovery, regardless of the form in which it is described, explained, illustrated, or embodied in such work.5 Such "process-oriented" rights are subject to patent law as described in U.S.C. Title 35, discussed supra. Nor is copyright protection extended to an individual who performs work for hire; rather, the employer or other person for whom the work was prepared is considered the owner of the copyright.6

Duration of Copyright

In 1976, Title 17 was revised in its entirety.7 One of the most significant revisions deals with the duration of an owner's copyright.

Works created on or after January 1, 1978

If a work was created on or after January 1, 1978, the duration of the copyright endures for a term consisting of the life of the author and fifty years after the author's death. In the case of a joint work prepared by two or more authors who did not work for hire, the copyright endures for a term consisting of the life of the last surviving author and fifty years after such last surviving author's death. In the case of an anonymous work, a pseudonymous work, or a work made for hire, the copyright endures for a term of seventy-five years from the year of its first publication, or a term of one hundred years from the year of its creation, whichever expires first.8

Works created before January 1, 1978

If a work was created before January 1, 1978, the duration of the copyright depends on when the work itself was published or copyrighted. If the work was created but not yet published or copyrighted prior to January 1, 1978, the duration of the copyright is the same as for works created on or after January 1, 1978.9 Conversely, any copyright, the first term of which is subsisting on January 1, 1978, shall endure for 28 years from the date it was originally secured. Such copyrights are not renewable, as was permitted under pre-1976 law.

Transferring Ownership of Copyright

Section 202 provides that ownership of a copyright, or of any of the exclusive rights under a copyright, is distinct from ownership of any material object in which the work is embodied.10 Accordingly, the transfer of ownership of any material object in which the work is first fixed does not of itself convey any rights in the copyrighted work embodied in the object; nor, in the absence of an agreement, does transfer of ownership of a copyright or of any exclusive rights under a copyright convey property rights in any material object.

Based on this distinction, the owner of a material object subject to copyright can contribute the object, the copyright, or both. As will be discussed momentarily, charitable deductions for such transfers may be limited or unavailable.

The ownership of a copyright may be transferred in whole or in part by any means of conveyance or by operation of law, and may be bequeathed by will or pass as personal property by the applicable laws of intestate succession.11 Such transfers must be evidenced in writing by instrument of conveyance, or a note or memorandum of the transfer, which is signed by the copyright owner or owner's agent.12 The final step in transferring a copyright involves sending the original or a certified copy of the original instrument of transfer to the Register of Copyrights, along with the applicable fee (as prescribed in Title 17, Section 708) for recording. The document will be returned with a certificate of recordation.13

Income Tax Deduction Considerations

The income tax deductibility for a contribution of a copyright is based on three primary questions:

  • Is the copyright in the hands of the donor considered a capital asset or ordinary income property?
     
  • Is the copyright subject to depreciation recapture?
     
  • Does the contribution satisfy the "partial interest rule?"

Tax Character of Copyright

Reg. §1.1221-1(c)(1) states, "A copyright, a literary, musical, or artistic composition, and similar property are excluded from the term "capital assets" if held by a taxpayer whose personal efforts created such property, or if held by a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such property in the hands of a taxpayer whose personal efforts created such property. For purposes of this subparagraph, the phrase "similar property" includes for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection (whether under statute or common law), but does not include a patent or an invention, or a design which may be protected only under the patent law and not under the copyright law."

In brief, a copyright is considered to be a capital asset unless --

  • it is owned by the taxpayer who created the copyrighted property;
     
  • it is was received by a taxpayer as a gift from the creator of the copyrighted property.14

The IRS and courts have further delineated the tax character of copyrights:

Rev. Rul. 60-226 holds that the consideration received by a proprietor of a copyright for a grant transferring the exclusive right to exploit the copyrighted work in a medium of publication throughout the life of the copyright shall be treated as proceeds from a sale of property [emphasis added], regardless of whether the consideration received is measured by a percentage of the receipts from the sale, performance, exhibition, or publication of the copyrighted work, or is measured by the number of copies sold, performances given, or exhibitions made of the copyrighted work, or whether such receipts are payable over a period generally coterminous with the grantee's use of the copyrighted work.15

If, however, the seller [or presumably, a donor] transfers less than the exclusive right to exploit the copyright in a specified medium, or when the transfer does not last for the duration of the copyright, the transfer is not considered a sale of a capital asset.16 Further, a copyright is not a capital asset if its owner holds it primarily for sale to customers in the ordinary course of business.17

Deduction Rule: Assuming the copyright is transferred to a public charity as described in IRC §170(b)(1)(A), if it is considered ordinary income property or short-term capital gain property, the donor's income tax charitable deduction is limited to their adjusted cost basis, subject to the 50-percent deduction limitation. If the copyright is considered a long-term capital asset, the donor's deduction is based on its fair market value, subject to the 30-percent deduction limitation.

Depreciation Recapture

Section 1.167(a)-6(a) of the regulations provides that the cost or other basis of a patent or copyright shall be depreciated over its remaining useful life. If a patent or copyright becomes valueless in any year before its expiration the unrecovered cost or other basis may be deducted in that year. In the event the taxpayer sells a copyright, any depreciation previously claimed by the taxpayer is recaptured as ordinary income.18 For purposes of determining a donor's income tax charitable deduction, the fair market value of the copyright is reduced by this ordinary income element.19

Partial Interest Rule

As was previously mentioned, for purposes of Title 17, a copyright and the material object in which the work is embodied are distinguishable assets. It seems logical, therefore, that an individual can contribute a copyright while retaining the material object, or contribute the object while retaining the copyright and, in either case, enjoy an income tax charitable contribution deduction. However, Title 17 and Title 26 (the repository of the Internal Revenue Code) represent mutually exclusive bodies of law.

In general, a transfer to charity of a copyright without the underlying tangible asset in which the work is embodied constitutes a gift of less than the donor's entire interest in the property because such transfers do not qualify for one the exceptions described in section 170.20 With certain exceptions discussed below, a transfer of a copyright without the underlying tangible asset is not deductible for income, gift, or estate tax purposes.

The regulations cite as an example an outright gift of an interest in original historic motion picture films to a charitable organization where the donor retained the exclusive right to make reproductions of such films and to exploit such reproductions commercially. 21 In such case, an income tax charitable deduction was denied. This rule is distinguished by a private ruling in which an income tax charitable deduction was permitted for a gift of a copyright where the tangible asset, a book with a large circulation, had little intrinsic value.22

In summary, a copyright owned by other than the creator (or a donee of the creator) of the copyrighted work might qualify as a capital asset, thereby qualifying for fair market value deduction. In order to qualify for deduction, however, the donor must transfer their entire interest in the property. If a donor owns both the copyright and the material object which embodies the work (which itself has intrinsic value), both must be contributed (in which case, the related-use rule will come into play with respect to the deductibility of the tangible asset). If the donor owns and transfers only the copyright, or certain rights bundled thereunder, the partial interest rules should not apply, because it constitutes the donor's entire interest in the property.

Special Estate Tax Exception for Qualified Contributions of Art

As was previously mentioned, the partial interest rule generally applies for income, gift, and estate tax purposes. With respect to the estate tax charitable deduction, however, a special exception to the partial interest rule applies. The regulations provide that "qualified contributions" of works of art and copyrights are treated as separate properties.23 Thus, a deduction is allowable under section 2055 for a qualified contribution of a work of art, whether or not the related copyright is simultaneously transferred to a charitable organization.

For purposes of this rule, the term "work of art" means any tangible personal property with respect to which a copyright exists under Federal law.24 The term "qualified contribution" means any transfer of property to a qualified organization if the property can be placed to a use that is related to its tax-exempt purpose. 25

A "qualified organization" means any organization described in section 501(c)(3) other than a private non-operating foundation (as defined in section 509). The regulations provide several examples that clarify the application of this rule:

Example (1). A, an artist, died in 1983. A work of art created by A and the copyright interest in that work of art were included in A's estate. Under the terms of A's will, the work of art is transferred to X charity, the only charitable beneficiary under A's will. X has no suitable use for the work of art and sells it. It is determined under the rules of section 1.170A-4(b)(3) that the property is put to an unrelated use by X charity. Therefore, the rule of paragraph (e)(1)(ii)(a), which treats works of art and their copyrights as separate properties, does not apply because the transfer of the work of art to X is not a qualified contribution. To determine whether paragraph (e)(1)(i) of this section applies to disallow a deduction under section 2055, it must be determined which interests are treated as passing to X under local law.

(i) If under local law A's will is treated as fully transferring both the work of art and the copyright interest to X, then paragraph (e)(1)(i) of this section does not apply to disallow a deduction under section 2055 for the value of the work of art and the copyright interest.

(ii) If under local law A's will is treated as transferring only the work of art to X, and the copyright interest is treated as part of the residue of the estate, no deduction is allowable under section 2055 to A's estate for the value of the work of art because the transfer of the work of art is not a qualified contribution and paragraph (e)(1)(i) of this section applies to disallow the deduction.

Example (2). B, a collector of art, purchased a work of art from an artist who retained the copyright interest. B died in 1983. Under the terms of B's will the work of art is given to Y charity. Since B did not own the copyright interest, paragraph (e)(1)(i) of this section does not apply to disallow a deduction under section 2055 for the value of the work of art, regardless of whether or not the contribution is a qualified contribution under paragraph (e)(1)(ii)(c) of this section.

Patents

The patent laws of Title 35 of the United States Code protects the intellectual property rights of those who invent or discover any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof. Patents are issued in the name of the United States of America, under the seal of the Patent and Trademark Office. They grant to the patentee, his or her heirs, or assigns the right to exclude others from making, using, offering for sale, or selling the property subject to the patent throughout the United States, or importing the property into the United States.

Term of Patent

Patents are granted for a term beginning on the date on which the patent issues and ending 20 years from the date on which the application for the patent was filed in the United States or, if the application contains a specific reference to an earlier filed application or applications under section 120, 121, or 365(c) of Title 35, from the date on which the earliest such application was filed. If the issue of an original patent is delayed for various administrative reasons, the term of the patent shall be extended for the period of delay, but in no case more than five years. 26

Transfer of Ownership of Patent

Section 261 of U.S.C. Title 35 provides that applications for patent, patents, or any interest therein, are assignable in law by an instrument in writing. The applicant, patentee, or his assigns or legal representatives may in like manner grant and convey an exclusive right under his application for patent, or patents, to the whole or any specified part of the United States.

A certificate of acknowledgment under the hand and official seal of a person authorized to administer oaths within the United States, or, in a foreign country, of a diplomatic or consular officer of the United States or an officer authorized to administer oaths whose authority is proved by a certificate of a diplomatic or consular officer of the United States, or apostille of an official designated by a foreign country which, by treaty or convention, accords like effect to apostilles of designated officials in the United States, provides prima facie evidence of the execution of an assignment, grant or conveyance of a patent or application for patent.

An assignment, grant or conveyance shall be void as against any subsequent purchaser or mortgagee for a valuable consideration, without notice, unless it is recorded in the Patent and Trademark Office within three months from its date or prior to the date of such subsequent purchase or mortgage.

In the absence of any agreement to the contrary, each of the joint owners of a patent may make, use, offer to sell, or sell the patented invention within the United States, or import the patented invention into the United States, without the consent of and without accounting to the other owners.27

Income Tax Deduction Considerations for Contributions Prior to June 4, 2004

The income tax deductibility for a contribution of a patent is based on three primary questions:

  • Is the patent in the hands of the donor considered a capital asset or ordinary income property?
     
  • Is the patent subject to depreciation recapture?
     
  • Does the contribution satisfy the "partial interest rule?"

Tax Character of Patent

IRC §1235 provides in part that a transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or undivided interest therein which includes a part of all such rights, by any holder shall be considered a transfer of a sale or exchange of a capital asset held for more than one year. Income is realized on transfer regardless of when payment is received and whether the patent ever produces income.

Deduction Rule: Provided section 1235 would apply if the patent were sold or exchanged, a charitable contribution of the patent (or undivided fractional interest therein) is considered a transfer of capital gain property. Therefore, regardless of the donor's holding period, provided the patent is contributed to a public charity, the donor's income tax charitable deduction is based on the fair market value of the patent and is subject to the 30-percent limitation. If the patent is transferred to a private non-operating foundation, the deduction is limited to the lesser of the patent's fair market value or the donor's adjusted cost basis in the patent. The deduction is subject to the 50-percent limitation.

Effect of Depreciation Recapture

Section 1.167(a)-6(a) of the regulations provides that the cost or other basis of a patent or copyright shall be depreciated over its remaining useful life. Its cost to the patentee includes the various Government fees, cost of drawings, models, attorneys' fees, and similar expenditures.28 If a patent or copyright becomes valueless in any year before its expiration the unrecovered cost or other basis may be deducted in that year. In the event the taxpayer sells a patent, any depreciation previously claimed by the taxpayer is recaptured as ordinary income.29 Depreciation recapture can be avoided by donating the patent to charity; however, for purposes of determining a donor's income tax charitable deduction, the fair market value of the patent is reduced by amount that would have been recaptured as ordinary income element had the donor sold the patent instead.30

Income Tax Deduction Considerations for Contributions Prior After June 3, 2004

On October 22, 2004 President Bush signed H.R. 4520, a $140 billion gross corporate tax cut package that replaced the extraterritorial income exclusion with tax breaks for domestic manufacturers and multinational corporations. Included in the package was a modification of the rules governing contributions of patents and intellectual property.

The new law, which is effective for contributions after June 3, 2004 limits deductions for contributions of patents or other intellectual property (other than certain copyrights or inventory) to the lesser of the donor's adjusted cost basis and fair market value. In addition, the donor can deduct additional amounts based on a percentage of the "qualified donee income" ("QDI") the charitable donee subsequently receives from the contributed property. "Qualified donee income" is defined as the net income received or accrued by the donee that is properly allocable to the intellectual propert itself (as opposed to the activity in which the property is used). The amount of QDI that can be claimed as an additional deduction is based on a sliding-scale:

Taxable Year of Donor Deduction Permitted for Such Taxable Year
  1st year ending on or after year of contribution 100%
  2nd year ending on or after year of contribution 100%
  3rd year ending on or after year of contribution   90%
  4th year ending on or after year of contribution   80%
  5th year ending on or after year of contribution   70%
  6th year ending on or after year of contribution   60%
  7th year ending on or after year of contribution   50%
  8th year ending on or after year of contribution   40%
  9th year ending on or after year of contribution   30%
10th year ending on or after year of contribution   20%
11th year ending on or after year of contribution   10%
12th year ending on or after year of contribution   10%
Taxable years thereafter No Deduction Permitted

An additional charitable deduction is allowed only to the extent that the aggregate of the amounts that are calculated pursuant to the sliding-scale exceed the deduction of the amount claimed upon the contribution of the patent or intellectual property.

No additional deductions are permitted for income following the expiration of the patent of intellectual property, or after the tenth anniversary of the date of contribution. The donor must notify the charity at the time of contribution that he or she intends to claim additional deductions and is required to obtain written substantation of QDI from the charitable donee for each year that such deductions are claimed. In addition, the charitable donee is required to file an information return that reports the QDI and other information related to the contribution.

If the donor's and charitable donee's taxable years are different, the donor must properly allocate the QDI to the end of his or her taxable year. Additional deductions from QDI are not available for contributions to private nonoperating foundations.

Partial Interest Rule

In order for the transfer to avoid violating the partial interest rule, the donor must transfer "all substantial rights to the patent" (or an undivided fractional interest in the same) as described in Reg. §1.1235-2(b).

Holder Defined

Of particular interest is the definition of the term, "holder." A holder includes any individual --

  • whose efforts created the patent property, and who would qualify as the "original and first" inventor, or joint inventor, within the meaning of Title 35 of the United States Code, or
     
  • who purchased the patent property prior to the actual reduction of the invention to practice, provided such individual was neither an employee or relative of the inventor.

A partnership cannot be a holder; however, each member of the partnership who is an individual may qualify.31

Based on this definition, the creator of the patent can claim a fair market value deduction. This is distinguishable from contributions of tangible personal property or a copyright by their creator, which are considered ordinary income property and, therefore, limited to the lesser of the property's fair market value or the creator's adjusted cost basis.

Rev. Rul. 58-260 illustrates the application of these rules. An inventor and owner of a patented process granted a nonexclusive license to a corporation (which he and his wife owned) to practice the process and sell the products that were developed. In the request for ruling, the inventor proposed to transfer an undivided one-fourth interest in his patent to the charitable organization. The ruling held that the inventor would be entitled to a charitable contribution income tax deduction in the year of transfer for the patent's fair market value.32

In Ltr. Rul. 8144052, a university biophysics professor developed an anti-cancer drug. Under the terms of the professor's employment agreement, any patent rights applicable to such discoveries would be transferred to a corporation in exchange for a five-percent royalty. The professor proposed to transfer his entire royalty interest to a private foundation.

The ruling held that transfer of the patent rights in the drug in exchange for the five-percent royalty interest would be considered a sale for which the professor would realize capital gain. Further, because the University had furnished all costs associated with the drug's development, the professor's cost basis was zero. The Service further ruled that because the patent was considered capital gain property, the professor's deduction would, based on capital gain rules that existed at the time of the ruling, be limited to 60-percent of the fair market value of the property. This was the same amount that was realized by the professor under the sale.

A subsequent ruling on nearly identical facts clarified two issues left unanswered in the prior ruling: 1) the royalty income will not be income to the inventor after his contribution to the foundation, and 2) the transfer of the partial interest is not a prohibited act of self-dealing.33

Patent Royalties and Unrelated Business Income

Income generated by a patent is generally characterized as royalty income and thereby excepted from characterization as unrelated business income.34 However, Rev. Rul. 73-193 holds that the exception does not apply if the organization holds bare legal title to inventions only for the purpose of performing patent development and management services for the account of the beneficial owners (i.e., the educational or scientific institutions and the inventors on their staffs).35

Distinguishable from Rev. Rul. 73-193, Rev. Rul. 76-297 holds that amounts received from licensees by an exempt organization, the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties, constitute royalty income that is excludable in computing unrelated business taxable income.36

Royalty Intrests

A "royalty" is defined in part as "amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property."26

For purposes of this discussion, it is important to note that a royalty is a payment for the right to use one of the aforementioned property rights. Accordingly, unless otherwise specified, the transfer of a royalty does not include the property or property right which produces it. For example, a work of art is distinguishable from its copyright; so is a royalty received by the copyright owner for right to produce and sell reproductions of the artwork distinguishable from the copyright itself.

Income Tax Deduction Considerations

The first step in evaluating the deductibility of a charitable contribution of a royalty interest is to determine the tax character of the royalty. Although most royalties are considered pure ordinary income assets, others such as certain mineral royalties, discussed supra, are considered interests in real property and, therefore, capital assets.

Transfer on Income Rights Deemed Assignment of Income

In Moore v. Commissioner, a gift of a royalty interest by an author to his children, whereby the author retained the copyright, was held by the court to be an assignment of income.27 In such case, the author remained liable for the payment of income tax attributable to the royalty payments as they were received. Although we find no case law in which a royalty is assigned to charity exclusive of a patent or copyright, we believe that Moore offers analogous guidance.

Income recognition can be avoided if the donor transfers the property right (e.g., copyright or patent) along with its royalty income rights. As a result, the donor transfers the right that produces the income rather than merely assigning the income from a retained asset.

Application of Reduction Rule

Although the transfer of a property right along with its royalty income will relieve the donor of recognition of income attributable to the royalty payments, it may not produce an income tax charitable deduction. In Forrer v. Commissioner, an author transferred the publication rights for a published book to Johns Hopkins University. The donor claimed an income tax charitable deduction in the amount of $77,350 based on the appraised value of the royalty payments under the contract. The IRS challenged the deduction on the basis that 1) the taxpayer acknowledged he had no cost basis in the book; 2) if the taxpayer had sold the book, the proceeds would be taxable as ordinary income under IRC §1221(3), and 3) the royalty payments under the contract were also ordinary income. With no basis in the book, there was no basis in the publishing rights. Accordingly, the court denied the deduction.

Comment: It is interesting to note the IRS did not challenge the contribution deduction on the basis of a violation of the partial interest rule.

Unrelated Business Income Considerations

Code section 512(b)(2) provides that one of the modifications to be taken into account in determining unrelated business taxable income includes "all royalties (including overriding royalties and net profits income) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with all such income." These items are excluded in determining UBTI; however, Reg. §1.512(b)-1 cautions that all the facts and circumstances of each case must be examined to determine whether a particular item of income falls within any of the modifications provided in IRC §512(b).

Royalties from Working Oil and Gas Interests

Royalties from interests in oil and gas fall into three distinguishing categories:

  • Working or operating interests
     
  • Carved out production payments
     
  • Interests transferred by an operator

Working or Operating Interests

A working or operating interest is defined as an interest in oil and gas in place that is burdened with the cost of development and operation of the property.

Where an individual owns subsurface minerals in place and grants the right to develop those minerals to an operator in exchange for a lease bonus and a percentage of all minerals found, such income is generally considered a non-operating interest. Income from a non-operating interest is characterized as royalty income provided the owner does not participate in exploration, completion, or operating costs.28

If the owner of the non-operating interest transfers a royalty, overriding royalty interest, or net profits interest to charity, such interests are considered interests in real property and are treated, for income tax deduction purposes, as long-term capital gain property (provided such interests are held for at least one-year), unless the interest is used by the donor in a trade or business. In the latter case, the property is characterized under IRC §1231 and is subject to the reduction rules applicable to ordinary income property.29 Recapture of intangible drilling costs is not applicable to non-operating interests and, therefore, has no effect on the charitable deduction.30

Carved Out Production Payments

An operator may seek outside financial resources for exploration, development, and operating expenses by carving out a portion of the production payments to an investor.31 Such amounts are considered a mortgage on the property.32 Thus, if a charitable donee is given an interest in carved out production payments, such payments will most likely be characterized as debt-financed unrelated business income.33

Overriding Royalties or Net Profits Interest Contributed by an Operator

The transfer of an overriding royalty interest or net profits interest by the owner of an operating interest under an oil and gas lease to charity will not usually qualify for a charitable contribution deduction under IRC §170(a) because the contributed interest is less than the taxpayer's entire interest within the meaning of IRC §170(f)(3) and is not an undivided portion of the taxpayer's entire interest.34

Ltr. Rul. 9205012 offers an interesting exception to this rule. In the request for ruling, a subsidiary corporation proposed to transfer an overriding royalty interest that had been conveyed to it by its parent to charity. Although the royalty interest was considered a partial interest of both corporations when taken as a whole, it was the entire interest of the subsidiary. The Service held that, for purposes of applying the partial interest rule of section 170(f)(3)(A), the ownership of a property interest by one member of an affiliated group of corporations need not be attributed to other members of the group. The Service also noted that the facts presented in the ruling were so unambiguous that it concluded the overriding royalty interests were not created to avoid compliance with the partial interest rule.

Personal Service Contracts

With respect to the transfer of a personal service contract (e.g., an athletic player contract), it is a basic principle of federal income tax law that income is taxed to the taxpayer who earns it, whether or not the taxpayer chooses to divert the receipt of such income to a third party. The courts have consistently held that such transfers are considered an anticipatory assignment of income.35 Thus, an assignment or similar transfer of compensation for personal services to another individual or entity is ineffectual to relieve the taxpayer from income tax liability on such compensation.

Although we find no authority directly on point, the taxpayer should be able to claim a charitable contribution deduction for amounts as they are received by the charitable organization, subject to the percentage limitations of section 170.

Personal Services

It is important to distinguish a gift of a personal service contract from a gift of personal services. A contribution of personal services to charity is not deductible.36 However, out-of-pocket expenses directly attributable to performing charitable services are, based on the facts and circumstances, deductible.37

It is interesting to note that IRC §170(j) (added by the Tax Reform Act of 1986) provides that charitable deductions are allowed for travel expenses, including the cost of meals and lodging, incurred in the course of performing services away from home for a charitable organization, "provided there is no significant element of personal pleasure, recreation, or vacation in the travel." The authors believe this test to be subjective, however.

For example, In McCollum v. Commissioner, which preceded the IRC §170(j) requirement, the court was unimpressed by the IRS' argument that the petitioners were not entitled to deduct expenses as charitable contributions to the National Ski Patrol because of the fact, principally, that they enjoyed skiing, enjoyed the work that they were doing, and enjoyed the camaraderie of the other members of the ski patrol.38

The court added, "Surely, the individual who was allowed to deduct out-of-pocket expenses in connection with his voluntary services in the Civil Air Patrol, by Rev. Rul. 58-279, supra, must have been an ardent flier and must have enjoyed flying while on duty with the Civil Air Patrol. Surely, also, the many other volunteers who have been allowed deductions by numerous cases and revenue rulings for expenses incurred in the rendition of services to the Red Cross, churches, hospitals, etc., must have enjoyed and been enthusiastic about the voluntary work that they were doing. We find that an enthusiasm for and an enjoyment of skiing or any other activity engaged in while performing voluntary services for a charitable organization are not grounds for disallowing deduction for out-of-pocket expenses incurred in connection therewith that would otherwise be deductible. If the rule were otherwise, it seems that the regulation would be rendered virtually meaningless."39

With the enactment of section 170(j), the rule is now otherwise; however, at least one court has prospectively placed the Service on notice that it may be difficult to enforce.

Installment Obligations

The transfer of an installment obligation (such as a note secured by a deed of trust or mortgage carried by the seller of real property) to charity is considered a taxable disposition resulting in acceleration of all unrealized gain to the donor. An income tax charitable deduction is allowed for the fair market value of the obligation, however. 40

Example 1: Mr. Jones sells real property (having a $100,000 adjusted cost basis) for $1,000,000. As consideration, Jones receives a $100,000 down payment and carries the $900,000 balance via a first trust deed bearing a 30-year amortization at 7 percent.

Immediately after sale, Jones contributes the trust deed to a public charity. In this case, Mr. Jones will recognize all unrealized gain attributable to the installment obligation -- $810,000. He will, however, be entitled to an income tax charitable deduction for the fair market value of the installment obligation. Because the obligation consists of other than cash or publicly-traded securities, and the deduction exceeds $5,000, the valuation must be established by an independent appraisal. As an illiquid asset, the obligation may be subject to a valuation discount from its principal balance. The resulting deduction will be subject to the 30-percent deduction limitation (provided the deferred gain was long-term capital gain).

In this example, the donor might have "phantom" capital gain in the year of the transfer if 1) the percentage limitations or three-percent itemized deduction floor preclude using the entire deduction in the year of transfer, or 2) if the realized gain exceeds the discounted fair market value of the obligation. This problem can be exacerbated if the obligation is transferred to a vehicle that provides only a partial income tax charitable deduction such as a bargain sale, charitable remainder trust, charitable gift annuity, or pooled income fund; or to one that provides no income tax deduction at all, such as a "nongrantor" charitable lead trust.

Installment Obligation as Charitable Trust Investment

Even though the transfer of an installment obligation to a charitable remainder trust, pooled income fund, or "nongrantor" charitable lead trust is considered a taxable disposition under IRC §453B, the creation by the trustee of a note within such trust causes no adverse tax consequences. The trust will not have debt-financed income because it is serving as lender rather than borrower.

There are several concerns regarding a trustee carrying paper, however. The first is security. If the borrower defaults, is the trustee prepared to foreclose and can the trust and income recipients withstand the loss of income? The second concern is valuation. Will the note be discounted and will such discount effect the annual income amount? With respect to a note secured by real property, in the event of a foreclosure, a lender/trustee may face CERCLA liability, may have to service a prior lien, or may receive UBTI from the property.

Transfer of Installment Obligations to Defective Grantor Lead Trust

The same valuation discount that diminishes the attractiveness of transferring installment obligations to charity via retained income gift vehicles may give rise to another planning opportunity. Consider the following scenario:

Example 2: Using the same facts as presented in Example 1, Mr. Jones desires to make a charitable gift and transfer the value of the note to his children.

Instead of making an outright gift of the note to charity, Jones transfers the note to an "intentionally defective" nonreversionary grantor charitable lead annuity trust. Because a grantor trust and the trustor are treated as one entity for income tax purposes, there is no taxable disposition under 453B. The trustor continues to report capital gain under the installment method as payments are received by the trust; however, he also receives an income tax charitable deduction in the year the trust is created for the present value of the annuity payments to charity. Further, because the remainder interest will be paid to his children, he will also receive a gift tax charitable deduction in the same amount.

Further information regarding this concept can be found in the Gift Vehicle Review - Charitable Lead Trust section of the Reading Room.

Life Insurance Contracts

The sale of a cash value life insurance contract results in the seller realizing ordinary income to the extent the sales price exceeds the owner's basis in the contract.41 Therefore, when an insurance contract is transferred to a charity, the donor's income tax charitable deduction is based on the lesser of fair market value or adjusted cost basis under the reduction rules applicable to ordinary income property. The donor's basis in the contract is equal to the aggregate premiums paid, less dividends paid and outstanding policy loans. For non-modified endowment contracts, partial withdrawals from cash value are considered made on a first-in-first-out (FIFO) basis. Therefore, partial withdrawals are considered made first from basis. For modified endowment contracts (and deferred annuity contracts), withdrawals are considered made on a last-in-first-out basis (LIFO). Therefore, a reduction in basis does not occur until all gain in the contract has first been withdrawn.

Caution: The transfer of an insurance contract having outstanding policy loans may cause the charitable donee to have "debt-financed income" under IRC §514(c)(1)(A).

If the policy is considered paid-up, the fair market value is based on the single premium amount it would cost for a comparable policy having an equal death benefit for an individual the same age as the insured.42 If the cash surrender value of the contributed policy exceeds the policy's replacement cost, the donor could arguably use the interpolated terminal reserve.43

If the policy requires additional premiums, the fair market value is the policy's interpolated terminal reserve on the date of transfer, adjusted for the proportionate value of premiums paid that cover the period of time extending beyond the date of the gift.44

Insurable Interest Concerns

In 1991, the IRS ruled that a gift of a newly issued life insurance policy to charity and gifts of future premium payments were not deductible for income tax and gift tax purposes.

Reason: Under local law (New York), the charity did not have an insurable interest. Therefore, the executor of the estate could maintain an action to recover the death benefit. Since the possibility of the charity's rights in the policy being divested was not so remote as to be negligible, the transfer would be considered a nonqualified gift of a partial interest.45

New York and many other states subsequently amended the definition of insurable interest to accommodate charitable gifts of life insurance (Maryland's amendment even made specific mention of charitable remainder trusts and pooled income funds). The ruling, however, cast a cloud of doubt over the use of life insurance as an investment vehicle within charitable remainder unitrusts. In the case of a two-life trust with one of the income recipients being insured (or both via separate policies), the possibility that the proceeds will be used to provide benefits to a noncharitable survivor income recipient may be distinguishable. Refer to local law.

Life Insurance Contract as Charitable Remainder Trust Investment

In 1979, the Service approved the funding of a charitable remainder unitrust with life insurance. In that ruling, a husband transferred a life insurance policy on his life to a unitrust that named his wife as the sole life income recipient. The husband then made premium payments directly to the insurance company. The trust was deemed a qualified trust to which contributions were deductible (provided the recipient trust could not be changed at the option of the insured). Further, each additional premium payment was considered an additional contribution to the trust for which the husband was allowed a deduction equal to the present value of the remainder interest.46

In Ltr. Rul. 8745013, an individual proposed to transfer appreciated non-income producing real property to a charitable remainder unitrust. The trustee intended to sell the property and use the proceeds to buy life insurance on the lives of the income recipients.

Ruled: If the trustee borrows from an insurance policy and invests proceeds to create income, acquisition indebtedness under IRC §514(c)(1)(A) will exist. The transaction will not violate Reg. §§1.664-1(a)(3) and 1.664-3(a)(4) under specified conditions. A life insurance contract was not considered a jeopardizing investment under IRC §4944 under specified conditions.

Grantor Trust Concerns

In a request for private ruling, a donor proposed to create charitable remainder trust payable for the life of the donor and his wife. Upon creating the trust, the donor would transfer to the trust a policy of insurance on his life, together with other assets. The donor would also assign ownership of the policy to the trustee, and the trustee will designate the trust as the beneficiary of the policy. The donor would serve as trustee.

The governing instrument also provides that the unitrust amount will be the lesser of the trust's income, as defined in section 643(b) of the Code, or five percent of the net fair market value of the trust's assets valued annually. The unitrust amount for any year will include any amount of the trust's income in excess of the amount required to be distributed under the general rule above to the extent the aggregate amounts paid in prior years was less than the aggregate amounts computed as five-percent of the net fair market value of the trust's assets on the valuation dates.

The governing instrument will provide that premiums on the insurance will be charged to the trust's principal account. Any proceeds paid on the insurance upon the death of the insured, any dividends paid on the insurance during the life of the insured, any withdrawals made from the insurance during the life of the insured, and any amount paid on the surrender of the insurance during the life of the insured will be credited to the trust's principal account. No part of any such receipt shall be credited to the trust's income account notwithstanding any statute, rule, or convention to the contrary. In addition, local (state) law has no statutory provision concerning underproductive property that would allocate to income a portion of the proceeds received from the sale or other disposition of underproductive assets.

Rulings were requested on (a) whether the existence or exercise of the trustee's power to pay annual premiums on an insurance policy on the donor's life causes the donor to be treated as the owner of all or any portion of the trust under section 677(a)(3), and (b) whether the existence or exercise of such power disqualifies the trust as a charitable remainder unitrust under section 664.

Section 677(a)(3) of the Code provides that the grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party, is or in the discretion of the grantor or a nonadverse party, or both, may be, applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse (except policies of insurance irrevocably payable for a purpose specified in section 170(c), relating to definition of charitable contributions).

In the present situation, any amount received by the trust with respect to insurance policies on the donor's life, whether received during the donor's life or upon his death, is allocated to the trust's principal, and not to income. Because the trust is a net income unitrust within the meaning of section 664(d)(3) of the Code and section 1.664-3(a)(1)(i)(b) of the regulations, the unitrust amount payable to the noncharitable recipients is limited to the trust's income (as defined in section 643(b)) if such income is less than the fixed percentage of net value of the trust's assets. Because amounts received on account of insurance policies on the donor's life will not be allocated to income under the terms of the governing instrument, these amounts will not be used in computing the amount of the trust's income and thereby will not be used in determining the income limitation on the unitrust amount payable to the noncharitable recipients. Rather, amounts received on account of insurance policies on the life of the donor will be allocated to principal and will become part of the remainder that is payable to qualified charitable organizations.

The Service concluded that under these circumstances the insurance policy on the donor's life is irrevocably payable for a charitable purpose within the meaning of the parenthetical of section 677(a)(3) of the Code. Because the policy is so payable, the existence or exercise of the trustee's power to pay annual premiums on the insurance policy on the donor's life does not cause the donor to be treated as the owner of all or any portion of the trust under section 677(a)(3) of the Code.47

Tax Deferred Annuity Contracts

The transfer of an existing tax deferred annuity contract to charity can present special tax problems for the donor. Because of changes in the annuity rules made in 1987, a distinction is made between contracts issued before and after April 22, 1987.

Annuity Contracts Issued before April 22, 1987

The transfer of a tax deferred annuity contract that was issued prior to April 22, 1987 to a charitable organization will cause the donor to recognize income in the year in which the trust receives proceeds from the contract. The amount of the recognized income is equal to the excess of the value of the contract over its basis.

In Friedman v. Commissioner, the taxpayer argued that a gift of four endowment life insurance policies to charity constituted a gift of appreciated property. As such, the donor, upon contribution, would not recognize any gain in the contract. The Court, however, characterized the appreciation element as "earned but unpaid income" rather than gain. Therefore, the donor's contribution was tantamount to an anticipatory assignment of income. Because the donor could have received the income by surrendering the policies, the court concluded that the donor would recognize income in the year in which the recipient charity actually received the policy proceeds. While the case law cites a lump-sum payment, periodic payments received by charity should have no effect on this outcome.48

In addition to recognition of income, the timing of the recognition presents a potential charitable deduction tax trap for the donor. Normally, when ordinary income property is transferred to charity, the donor's income tax deduction is limited to the lesser of fair market value or cost basis.49 However, this rule does not apply when, by reason of the transfer of the contributed property, ordinary income or capital gain is recognized by the donor in the same year in which the contribution is made50. When this exception is applied, the deduction is based on the full fair market value of the contract.

In effect, if a charitable donee does not surrender a pre-April 22, 1987 annuity contract in the same year as it is received, the donor's deduction will be limited to the lesser of fair market value or basis. In addition, the donor will recognize income in any tax year in which the charity (or charitable trust) receives contract proceeds.

Annuity Contracts Issued after April 22, 1987

If an individual who holds an annuity contract that was issued after April 22, 1987 transfers it without full and adequate consideration, the individual is treated as having received an amount equal to the excess of the cash surrender value, at the time of transfer, over the investment in the contract at that time.51 The donor recognizes income in the same year as the transfer regardless of when the beneficiary (charity or charitable trust) receives proceeds from the contract.

Because the recognition of income is linked to the year of transfer, a donor's charitable contribution income tax deduction is based on the full fair market value of the contract.52

Options

An option is a contractual right made by one party to sell property to another party for a fixed price for a stated period of time. The most common types of options used in conjunction with charitable gift planning include --

Listed Equity and Non-Equity Options

Listed equity and non-equity options are discussed in Publicly Traded Securities.

Employee Stock Options

An employee stock option is an offer made by a corporation to an employee to sell stock in the corporation to the employee at a bargain price for a stated period of time. Employee stock options fall into two general categories: (a) nonstatutory options, and (b) statutory options.

Nonstatutory Employee Stock Options

Nonstatutory employee stock options are governed by IRC §83. Under section 83(a), property transferred to an employee or independent contractor in connection with the performance of services is not taxable until it has been transferred to such person and become substantially vested in such person. At that time, the property received by the employee is considered compensation income taxable as ordinary income.

With respect to nonstatutory stock options, the mere grant of an option to purchase stock does not constitute a transfer of property unless the option itself has a "readily ascertainable value" at the time of grant.53 The value is not readily ascertainable unless --

  • the option is actively traded on an established market at the time of the grant, or
     
  • the taxpayer can show that all of the following conditions exist at the time of the grant:
    • The option is transferable by the optionee;
       
    • The option is exercisable immediately in full by the optionee;
       
    • The option or the property subject to the option is not subject to any restriction or condition (other than a lien or other condition to secure the payment of the purchase price) which has a significant effect upon the fair market value of the option; and
       
    • The fair market value of the option privilege is readily ascertainable in accordance with paragraph (3) of Reg. §1.83-7(b).

Compensation income is generally recognized when a nonstatutory option is exercised, sold, or otherwise disposed of in an arm's length transaction.54 The amount recognized is equal to the excess of the fair market value of the stock subject to the option on the date of exercise or transfer, over the exercise price of the option. Further, the compensation income recognized by the employee will constitute "wages," under section 3401 of the Code, that are subject to federal income tax withholding.55

a. Section 83(b) Election

As an alternative to realizing income on exercise, the employee can make an election to recognize compensation income when the option is granted.56 In such case, the amount recognized is equal to the difference between the strike price of the option and the fair market value of the stock on the date of grant. When the employee subsequently exercises the option, no income is realized on the subsequent exercise of the option; however, gain is realized when the optionee subsequently sells the stock. The optionee's basis in the acquired shares is the amount paid for the shares increased by the amount included in gross income under section 83(b) at the time of grant. In other words, the basis is the fair market value of the stock on the date of grant.

According to the Internal Revenue Service ,57 the 83(b) election is not available with respect to a stock option, unless the option is actively traded on an established market. This is a difficult pre-condition to the 83(b) election. If the section 83(b) election is available, it must be filed no later than 30 days following the grant of the option with the IRS office with which the person rendering the services files his or her income tax return.58 In addition, a copy of the election must be included with that employee's income tax return for the taxable year in which the property is transferred.59 In addition, state filing requirements may apply.

Planning Tip: Assuming it is possible to make an 83(b) election, taxpayers may wish to consider doing so even if it results in some current income tax. By making the election, any gains from the subsequent sale of optioned shares are considered capital gains rather than compensation income. As a result, provided the shares are held for at least one year after exercise, gains from sale of are taxable at favorable capital gains rates without mandatory withholdings. And as will be discussed further, the conversion of stock into a capital asset via the 83(b) election sets the stage for charitable applications.
 

b. Inter Vivos Charitable Transfers of Nonstatutory Stock Options

The regulations provide that if the option is sold or otherwise disposed of in an arm's length transaction, sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option.60

An arm's length inter vivos transfer of an unexercised, nonqualified stock option to a charitable organization or charitable trust will result in ordinary income to the employee in an amount equal to the spread between the exercise (strike) price and the fair market value of the stock on the date of transfer. Furthermore, because the employee has no cost basis in the option and all gain is considered ordinary income, no income tax charitable deduction is available for IRC §170(b)(1)(E). Accordingly, the employee will have phantom ordinary income with no offsetting charitable deduction.61

1. Retained Control Delays Income Recognition

Ltr. Rul. 9737016 offers a creative alternative to the recognition of compensation upon transfer of a nonqualified option to charity. In that ruling an employee proposed to transfer nonqualified stock options through an intermediary to a qualified charitable organization. The employee would, however, retain during his lifetime a power that would require the charitable donee to obtain his permission to exercise the options. If he died, the charity could immediately exercise the options without regard to any specified exercise dates.

The Service ruled that because the employee retained a power restricting the exercise of the option, the charitable gift was not complete until the power lapsed. Therefore, the employee would not recognize compensation income or receive a charitable deduction until the options were exercised.

The ruling also confirmed that compensation income recognized in connection with the exercise of a nonqualified stock option is subject to withholdings and that the charitable donee would be required to pay the required withholding tax to the company.

2. Exercise Followed by and Contribution of Stock without Section 83(b) Election

As an alternative to transferring an unexercised option, the employee can exercise the option and contribute optioned shares. However, the employee must provide the exercise price and will have ordinary income to the extent the fair market value of the stock exceeds the exercise price.

The optionee's basis in the optioned shares is the fair market value of the shares on the date of exercise. The exercise date establishes the holding period of stock in the hands of the optionee for capital gains purposes. Therefore, if exercised shares are transferred to charity within one year of exercise, the donor's income tax charitable deduction will be limited to the lesser of fair market value and basis.

If the donor transfers exercised shares held at least one year following exercise, the income tax charitable deduction is based on the fair market value of the shares (provide the stock is publicly traded or, if not, is transferred to a public charity). Although the donor may be able to claim a larger charitable deduction (provides the shares have appreciated), the donor will not be able to claim the charitable deduction in the same year he or she realizes income from the exercise of the option.

3. Exercise Followed by and Contribution of Stock with 83(b) Election

As mentioned previously, an employee can avoid recognition of compensation income upon exercise of a nonqualified option by electing to take the "in the money" portion of the option into income when the option is granted. More importantly, the election converts potential ordinary income into potential capital gains that can be eliminated or delayed through a carefully designed charitable gift.

c. Testamentary Charitable Transfers of Nonstatutory Employee Stock Options

As an alternative to lifetime transfers, nonstatutory options may, subject to plan provisions, be transferred to charity on a testamentary basis. In this way, the optionee will avoid recognition of compensation on transfer and exercise by the donee.

Reg. 1.421-6(d)(5) provides that if an employee dies before realizing compensation from a nonstatutory employee stock option, compensation income is realized by the person who transfers or exercises the option, or the person who receives property subject to a restriction which has a significant effect on its value. For example, this rule is applicable --

(i) when an option not having a readily ascertainable fair market value is granted to an employee, and he dies before transferring or exercising the option;

(ii) when an option not having a readily ascertainable fair market value is granted to the employee, and he dies after the transfer of the option in a transaction which is not at arm's length, but before the option is exercised; or

(iii) when an option not having a readily ascertainable fair market value is granted to another person, and the employee dies before realizing all of the compensation which would result from any transfer or exercise of the option.

If the option is one which was granted to the employee and he or she dies before transferring or exercising the option, the option shall be considered a right to receive income in respect of a decedent to which the rules of section 691 apply. In any such case, if the option is transferred, section 691 provides that the amount received for such transfer or the fair market value of the property transferred at the time of transfer, whichever is greater, is income realized at the time of such transfer. Moreover, if a transfer is subject to this rule, it will be treated as a transfer in an arm's length transaction.

In application, if an unexercised nonstatutory employee stock option is transferred on a testamentary basis to a charitable organization or trust, income will be realized by the estate of the decedent in an amount equal to the fair market value of the option. The estate will, however, receive an estate tax charitable deduction based on the fair market value of the option. For this reason, it may be preferable to transfer the option on an inter vivos basis with a retained power of exercise as outlined in Ltr. Rul. 9737016, discussed above.

Statutory Employee Stock Options

There are two types of statutory employee stock options available under current law: incentive stock options and employee stock purchase plans.62 Qualified stock options and restricted stock options are also included under the category of statutory options; however, they have not been available since 1976 and 1963, respectively.

Incentive stock options (ISOs) replaced qualified stock options in 1981 and are described in IRC §422. Employee stock purchase plans are described IRC §423. Statutory stock options are commonly referred to "qualified" stock options.

Statutory stock options are distinguishable from nonstatutory stock options in that the employee (optionee) is not taxed upon either the grant or exercise63 provided the option:

  • is in writing,
     
  • is not transferable by the employee (other than by will or by laws of descent and distribution), and
     
  • is exercisable, during the lifetime of the employee, only by the employee64 or, if the employee is incompetent, by the employee's legal representative.65

It is important to note that for incentive stock option exercised prior to 1983, the difference between the exercise price and the fair market value of the stock subject to an incentive stock option is an item of tax preference for alternative minimum tax purposes in the year the option is exercised. This rule does not, however, apply to the exercise of shares pursuant to an employee stock purchase plan nor does it apply to the exercise of a nonqualified option for which an election was made under IRC 83(b).

a. Effect of Disqualifying Dispositions

Statutory options are subject to holding period requirements relating to disposition of exercised shares. In the case of incentive stock or employee stock purchase plan, an optionee avoids recognition of compensation provided the stock is disposed of after the latter of --

  • two years from the date of grant, and
     
  • one year from the date of exercise.

IRC 424(c) and the regulations thereunder define the term "disposition" to include a sale, exchange, gift, or transfer of legal title, but does not include --

  • a transfer from a decedent to an estate or a transfer by bequest or inheritance.
     
  • an exchange to which section 354, 355, 356, or 1036 (or so much of section 1031 as relates to section 1036 applies.
     
  • a mere pledge or hypothecation (however, a disposition of the stock pursuant to a pledge or hypothecation is a disposition by the individual, even though the making of the pledge or hypothecation is not such a disposition.66
     
  • the acquisition of a share of stock in the name of the employee and another jointly with the right of survivorship or a subsequent transfer of a share of stock into such joint ownership (however, a termination of such joint tenancy, except to the extent such employee acquires ownership of such stock, shall be treated as a disposition by the employee occurring at the time such joint tenancy is terminated).
     
  • certain transfers of statutory option stock pursuant to the exercise of incentive stock options.
     
  • transfers between spouses or incident to divorce.

    b. Inter Vivos Charitable Transfers of Statutory Employee Stock Options

    With respect to charitable transfers, the disposition rules of section 424 provide that an inter vivos transfer of an unexercised statutory option to a charitable organization or charitable trust will trigger phantom compensation income to the optionee.

    Accordingly, a lifetime transfer of exercised shares to a charitable organization or charitable trust prior to the expiration of the applicable holding period would be deemed a disqualifying disposition within the meaning of IRC §421(b).

    One taxpayer proposed to exercise an incentive stock option that had been held for longer than two years, then transfer the exercised shares into a charitable remainder trust within one year of exercise. The Service ruled that such a transfer causes the taxpayer to recognize compensation in the amount equal to the difference between the exercise price and the fair market value of the stock on the date of exercise. The Service further stated that if the taxpayer transfers the stock after the one-year holding period, no compensation is recognized.67

    Planning Opportunity: Holders of qualified options may exercise their options one of several ways (with borrowed funds, a portion of the optioned stock, or cash), wait the mandatory one year holding period, and transfer the a portion of the exercised shares to a charitable gift vehicle such as a charitable remainder trust, pooled income fund, or charitable gift annuity.
     

    c. Testamentary Charitable Transfers of Statutory Employee Stock Options

    As mentioned earlier, a statutory option is not transferable by the employee other than by will or by laws of descent and distribution. The regulations provide further that if the option (or the plan under which the option was granted) contains a provision permitting the individual to whom the option was granted to designate the person who may exercise the option after his death, neither such provision, nor a designation pursuant to such provision, disqualifies the option as a statutory option.68 The term "person" includes an individual, trust or estate, partnership, association, company, or corporation.69 Accordingly, a charitable organization or trust can, providing the plan so permits, receive a testamentary transfer of an unexercised statutory option.

    Regarding the income tax consequences of testamentary transfers, IRC 421(c) states that if a statutory option is exercised after the death of the employee by the estate of the decedent, or by a person who acquired the right to exercise such option by bequest or inheritance or by reason of the death of the decedent, the provisions of 421(a) shall apply to the same extent as if the option had been exercised by the decedent, except that--

    • the holding period and employment requirements of sections 422(a) and 423(a) shall not apply, and
       
    • any transfer by the estate of stock acquired shall be considered a disposition of such stock for purposes of section 423(c).

    IRC 423(c) provides that if the option price of a share of stock acquired by an individual pursuant to an employee stock purchase plan was less than 100 percent of the fair market value of such share at the time such option was granted, then, in the event of any disposition of such share by him which meets the holding period requirements, or in the event of his death (whenever occurring) while owning such share, there shall be included as compensation (and not as gain upon the sale or exchange of a capital asset) in his gross income, for the taxable year in which falls the date of such disposition or for the taxable year closing with his death, whichever applies, an amount equal to the lesser of--

    • the excess of the fair market value of the share at the time of such disposition or death over the amount paid for the share under the option, or
       
    • the excess of the fair market value of the share at the time the option was granted over the option price.

    Further, if the option price is not fixed or determinable at the time the option is granted, the option price is determined as if the option were exercised at such time.

    Note: IRC 423(c) applies only to employee stock purchase plans and not to ISOs because the exercise price of ISOs must be at least 100 percent of the fair market value of the stock on the date of grant.
     

    If an amount is required to be included under section 423(c) in gross income of the estate of the deceased employee, or of a person who acquired the right to exercise such option by bequest or inheritance or by reason of the death of the decedent, there shall be allowed to the estate or such person a deduction with respect to the estate tax attributable to the inclusion in the taxable estate of the deceased employee of the net value for estate tax purposes of the option. The deduction is determined under section 691(c) as if the option acquired from the deceased employee were an item of gross income in respect of the decedent under section 691 and as if the amount includible in gross income under section 423(c) were an amount included in gross income under section 691 in respect of such item of gross income.

    Planning Tip: In order to avoid income in respect to a decedent in connection with charitable transfers of stock acquired via an employee stock purchase plan, the decedent's estate can transfer exercised shares rather than selling such shares and transferring cash.
     

Purchase Options

Purchase options are frequently created to facilitate the transfer of real property, business interests, or other tangible and intangible assets. Can the maker or holder of such an option transfer it to a charitable organization or split-interest charitable gift vehicle? Are such transfers deductible for income, gift, and estate tax purposes?

Assignable Option Transferred to Charitable Remainder Trust

There are several types of assets that, if transferred to a charitable remainder trust, will either terminate the trust's tax-exempt status or that will adversely affect the qualification of the transferred asset itself. Examples of incompatible assets include, but are not limited to, stock in an S-corporation or professional corporation, and real property that is debt-encumbered, generates unrelated business income, or that may be subject to environmental hazards.

In 1992, the IRS published a letter ruling that offered a unique but short-lived solution to this problem. The solution called for the creation of and transfer to the trust of an assignable call option in place of the incompatible asset. The following case study illustrates how such a strategy operates.

The Facts:

Mr. Smith owns unencumbered real property that he wants to sell to Mr. Jones for $2,000,000. Smith would like to sell the property via a charitable remainder unitrust and, in the process, avoid immediate realization of a $1,500,000 capital gain. The property is unencumbered; however, Smith has been advised that the property produces unrelated business income that will jeopardize the tax-exempt status of the trust.

An Exotic Solution: Creating a Charitable Option

Step 1. Smith creates an assignable three-year option that allows the holder to purchase the property for $100,000.

Step 2. Smith transfers the option to a charitable remainder trust.

Step 3. Trustee sells option to Jones for $1,900,000 (the difference between the fair market value and exercise price).

Step 4. Jones exercises the option to buy by paying Smith $100,000.

Result:

Because the trust never owns the property or any income rights therein, the unrelated business income produced by the property should not taint the trust. Smith will recognize capital gain allocable to the $100,000 received upon exercise of the option. Gain attributable to the remaining $1,900,000 will be recognized by the trust.70

a. IRS Rules on Option with Unencumbered Property

In Ltr. Rul. 9240017, the IRS concluded that, under facts similar to those presented above, the trustee's contractual right to acquire a fee interest in the property for an amount below the fair market value of the property is an asset of the trust for purposes of meeting the requirements of IRC §664(d)(2). In addition, the trustee's contractual right to acquire a fee interest in real property with substantial value ($2,000,000) for an amount substantially lower ($100,000) has substantial fair market value. This substantial fair market value must be included each year in determining the net fair market value of the trust's assets and the resulting unitrust amount payable to the income recipient.

Regarding the availability and sequencing of the trustor's income tax charitable deduction, the IRS's opinion was disappointing, but logical. Rev. Rul. 82-19771 holds that an individual who grants an option on real property to a charitable organization is allowed a charitable deduction in the year in which the charitable organization exercises the option. The amount of the deduction is equal to the excess of the fair market value of the property on the date the option is exercised over the exercise price.72 The IRS concluded the trustor is not entitled to a deduction for the remainder interest, either when the purported option is granted [to the trust] or when the trustee sells it. The trustor will, however, be entitled to a deduction for the remainder interest if the trustee or another charitable organization (including the charitable remainderman) exercises the option. The deduction is based on the spread between the fair market value and the exercise price ($1,900,000).

b. IRS Rescinds Ltr. Rul. 9240017

One month after receiving a favorable ruling regarding the use of an option with unencumbered real property, the same taxpayer requested a new ruling on the use of the same technique with debt-encumbered real property. This triggered an unanticipated result: the Service responded by immediately by issuing Ltr. Rul. 9417005 in which it rescinded Ltr. Rul. 9240017 stating only that it was reconsidering the issues raised in that ruling.

c. IRS Rules on Use of Options for Unencumbered and Encumbered Assets

In September of 1994, the Service responded to the second ruling request by issuing Ltr. Rul. 9501004 in which it answered two questions: Is a charitable remainder trust that receives as its sole funding asset an assignable call option a qualified charitable remainder trust? And will the trustor or such a trust be treated as the owner of the trust, thereby causing the gain realized on the sale of the option to be realized by the taxpayer?

With respect to the first issue, the Service first stated,

"To qualify as a charitable remainder trust within the meaning of section 664 of the Code and the regulations thereunder, a trust must be one with respect to which a deduction is allowable under one of the specified sections-section 170, 2055, 2106, or 2522. Further, the trust must be a charitable remainder trust in every respect and must meet the definition of and function exclusively as a charitable remainder trust from its creation. The requirements of being a charitable remainder trust in every respect and functioning exclusively as a charitable remainder trust from its creation cannot be met unless each transfer to the trust during its life qualifies for a charitable deduction under one of the applicable sections (IRC §§170, 2055, 2106, or 2522)."

This being an inter vivos trust, the Service then focused its attention on the qualification for income tax deduction under section 170 and qualification for gift tax deduction under section 2522.

With respect to qualification for an income tax deduction, the IRS concluded,

"The transfer to a charitable organization of an option by the option writer is similar to the transfer of a note or pledge by the maker. In the noted situation there is a promise to pay money at a future date. In the pledge situation there is a promise to pay money or transfer other property, or to do both, at a future date. And in the option situation there is a promise to sell property at a future date. Although the promise may be enforceable, a promise to pay money or to sell property in the future is not itself a 'payment' for purposes of deducting a contribution under section 170 of the Code. Thus, the grant of the option to [the charitable organization] in this case is not a contribution for which a deduction is allowable under section 170."

With respect to the availability of the gift tax charitable deduction under section 2522, the IRS cited Rev. Rul. 80-186. The ruling concludes that a transfer of an option to purchase real property for a specified period is a completed gift under section 2511 of the Code on the date the option is transferred, if, under state law, the option is binding and enforceable on the date of the transfer.73 In the instant case, under local law, the purported option was not binding on the taxpayer when it was granted. Accordingly, the proposed transfer of the purported option to the trust was not a completed gift on the date of transfer under section 25.2511-2(b) of the regulations because the taxpayer would not have made a binding offer on that date.

In absence of income and gift tax charitable deductions, the Service ruled the trust is not a qualified charitable remainder trust. With respect to the second issue (i.e., whether the grantor would be treated as the owner of the trust and, accordingly, be taxable on the gain from the sale of the option), the IRS's conclusion was obvious. If the trust is not a qualified charitable remainder trust, it must be a grantor trust the income from which, including gain from the sale of trust assets, is taxable to the grantor.74

Property Subject to Right of First Refusal

Can a donor transfer property in which a first right is retained by the donor or another person to purchase the property in the event the charitable donee decides to sell it? Are transfers of property subject to rights of first refusal deductible for income, gift, and estate tax purposes?

In Ltr. Rul. 8641017, an individual proposed to contribute real property to a charitable organization on the condition that, if the organization ever intends to sell the property to other than a charitable organization during the twenty year period following the gift, the donor can purchase the property at the price offered by a bona fide third-party. In addition, the donor placed other restrictions on the property related to its use.

Citing Rev. Rul. 76-151, in which a corporate donor reserved the right to purchase the land and building at its fair market value if the charitable organization ceased to use the property and decided to dispose of it, the Service ruled that the taxpayer was entitled to a charitable contribution deduction, subject to the limitations of section 170(b)(2) of the Code for the land and building transferred to the charitable organization.75 In addition, the Service cited Rev. Rul. 85-99 in which it ruled the amount of the donor's charitable contribution deduction is the fair market value of the property at the time of the contribution determined in the light of the restriction placed by the donor on the use of the property.76

Caution: Ltr. Rul. 8641017 and the other rulings referenced therein contemplate an outright gift to charity. Planners should note that if assets are transferred to a private non-operating foundation or a split-interest gift vehicle to which the private foundation excise tax rules apply (i.e., a charitable remainder trust or charitable lead trust), a repurchase by the donor or other disqualified person of a contributed asset would constitute a prohibited act of self-dealing.
 

The previous rulings deal with transfers of real property. Do the same rules apply to transfers of securities? In Rev. Rul. 80-83, a transfer of stock of a publicly held corporation subject to a first right of refusal by the corporation to a charitable remainder trust which named the trustor as trustee qualified for a gift tax charitable deduction under IRC 2522. The right required any shareholder desiring to sell stock to first offer the shares to the corporation at the same price and terms as offered to any other buyer.77

The ruling holds, "The value of the charitable beneficial interest is presently ascertainable as that term is used in section 25.2522(c)-3 of the regulations. Accordingly, the charitable deduction is allowable for gift tax purposes, with respect to the remainder interest."

Query: What if the corporation is a disqualified person? Normally, a transfer of stock to a charitable remainder trust or charitable lead trust of more than 35 percent of the voting stock of the corporation followed by a corporate redemption is a prohibited act of self-dealing. However, IRC 4941(d)(2)(F) provides that such a transaction will be exempt from the self-dealing rules "if all of the securities of the same class as that held by the foundation are subject to the same terms and such terms provide receipt by the foundation of no less than fair market value."



  1. 73 C.J.S. Property 5 (1951)back

  2. Texas Instruments, Inc. v. U.S. (CA-5, 1977), 551 F.2d 559, 39 AFTR 2d 77-1383back

  3. . U.S.C. Title 17, Sec. 106back

  4. . U.S.C. Title 17, Sec. 102(a)back

  5. . U.S.C. Title 17, Sec. 102(b)back

  6. . U.S.C. Title 17, Sec. 201(b)back

  7. . Pub. L. 94-553, Title I, Sec. 101, Oct. 19, 1976, 90 Stat.back

  8. . U.S.C. Title 17, Sec. 302back

  9. . Ibidback

  10. . U.S.C. Title 17, Sec. 202back

  11. . U.S.C. Title 17, Sec. 201(d)(1)back

  12. . U.S.C. Title 17, Sec. 204(a)back

  13. . U.S.C. Title 17, Sec. 205(a)back

  14. . Ltr. Rul. 9335017back

  15. . Rev. Rul. 60-226, 1960-1 C.B. 26back

  16. . Ltr. Rul. 9326043back

  17. . Griffin v Comm., 33 TC 616 (1959)back

  18. . IRC §1239(e)back

  19. . IRC §170(e)(1)(A)back

  20. . IRC §170(f)(3)(A), specifically, a charitable remainder trust, charitable lead trust, pooled income fund, remainder interest in personal residence or farm, undivided interest in every right owned by donor, or qualified conservation easement.back

  21. . Reg. §1.170A-7(b)(1)(i)back

  22. . Ltr. Rul. 7944030back

  23. . IRC §2055(e)(4)back

  24. . IRC §2055(e)(4)(B)back

  25. . See Reg. §1.170A-4(b)(3) for rules used to determine if the use of property by a charitable organization is related to such purpose or function.back

  26. GCM 38083back

  27. Moore v. Comm., 27 T.C.M. 536(1968); See also Lucas v. Earl, 281 U.S. 11, 8 AFTR 10287 (1930)back

  28. IRC §614; Rev. Rul. 69-179, 1969-1 C.B. 158. See also The J. E. and L. E. Mabee Foundation, Inc., Plaintiff-Appellant v. United States of America, Defendant-Appellee (CA-10), U. S. Court of Appeals, 10th Circuit, No. 75-1231 (74-C-135), 533 F2d 521, 4/12/76, Affirming District Court decision, 75-1 USTC 9266, 389 F. Supp. 673back

  29. Rev. Rul. 73-428, 1973-2 C.B. 303back

  30. IRC §1254back

  31. Reg. §1.636-3(a)back

  32. IRC §636(a)back

  33. IRC §514back

  34. Rev. Rul. 88-37, 1988-1 C.B. 97back

  35. Francine Schuster v. Comm., Doc. No. 20396-82, 84 TC --, No. 51, 84 TC 764, (Filed April 29, 1985); Lucas v. Earl, 281 U.S. 111 (1930); Helvering v. Horst, 311 U.S. 112 (1940), 1940-2 C.B. 206; Helvering v. Eubank, 311 U.S. 122 (1940), 1940-2 C.B. 209; Rev. Rul. 77-290, 1977-2 C.B. 26; Allen Leavell v. Comm., (January 30, 1995) Doc. No. 29996-91., 104 TC 140; Ltr. Rul. 8624007back

  36. Rev. Rul. 75-257, 1975-2 C.B. 251; Lussy v. Commissioner, (August 16, 1995) T.C. Memo. 1995-393; Levine, et ux v. Comm., (August 24, 1987) T.C. Memo. 1987-413; Boynton v. Comm., (December 19, 1985) T.C. Memo. 1985-619back

  37. Rev. Rul. 56-508, 1956-2 CB 126; Rev. Rul. 58-279 , 1958-1 CB 145, as modified by Rev. Rul. 84-61, 1984-1 CB 39back

  38. Charles L. and Marilyn F. McCollum v. Commissioner, Doc. No. 10863-77, 37 TCM 1817, TC Memo. 1978-435, Filed November 1, 1978back

  39. Rev. Rul. 58-279, 1958-1 C.B. 145 is modified by Rev. Rul. 84-61, 1984-1 C.B. 39back

  40. IRC §453B(a); Rev. Rul. 55-157, 1955-1 C.B. 293back

  41. Comm. v. Phillips (4 Cir; 1960), 275 F.2nd 33,5 AFTR 2d 855back

  42. Reg. §25.2512-6(a), Example 3back

  43. Rev. Rul. 78-137, 1978-1 C.B. 280back

  44. Reg. §25.2512-6(a); Rev. Rul. 59-195, 1959-1 C.B. 18back

  45. Ltr. Rul. 9110016back

  46. Ltr. Rul. 7928014back

  47. Ltr. Rul. 9227017back

  48. Friedman v. Comm., 41 T.C. 428 (1963), aff'd 346 F.2d 506 (6th Cir. 1965)back

  49. IRC §170(e); Reg. §1.170A-4(a)(1)back

  50. Reg. §1.170A-4(a)(3)back

  51. IRC §72(e)(4)(C)back

  52. Reg. §1.170A-4(a)(3)back

  53. Reg. §1.83-7(a)back

  54. Reg. §1.83-7back

  55. Rev. Rul. 67-257, 1967-2 C.B. 359back

  56. IRC §83(b)back

  57. Reg. §1.83-7back

  58. Reg. §1.83-2(b)back

  59. Reg. §1.83-2(c)back

  60. Reg. §1.83-7back

  61. See, Rev. Rul. 98-21, 1998-18 IRB 1 and Rev. Proc. 98-34, 1998-1 IRB 1 for an in-depth analysis on the gift tax consequences and valuation methods when transferring a stock option.back

  62. IRC §421back

  63. It should be noted that the Alternate Minimum Tax of Section 56 can impose significant taxes on an employee who exercises an ISO.back

  64. Reg. §1.421-7(b); IRC §§422(b)(6); 423(b)(9)back

  65. Rev. Rul. 62-181, 1962-2 C.B. 113back

  66. Reg. §1.425-1(c)back

  67. Ltr. Rul. 9308021back

  68. Reg. 1.421-7(b)(2)back

  69. Reg. 7701(a)(1)back

  70. The trust, however, will not pay any tax unless it has unrelated business taxable income.back

  71. Rev. Rul. 82-197, 1982-2 C.B. 72back

  72. Ltr. Ruls. 8714013; 8825069; 8826008back

  73. Rev. Rul. 80-186, 1980-2 C.B. 280back

  74. Ltr. Rul. 9501004back

  75. Rev. Rul. 76-151, 1976-1 C.B. 59back

  76. Rev. Rul. 85-99, 1985-2 C.B. 83back

  77. Rev. Rul. 80-83, 1980-1 C.B. 210; See also Ltr. Rul. 9452020back

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