Partial Interest - Deduction Disallowed

Partial Interest - Deduction Disallowed

News story posted in Field Service Advice on 16 April 1999| comments
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Summary

In Field Service Advice 1999-951, the Service held that a wholly- owned subsidiary was not entitled to a charitable contribution deduction for its donation of an option to purchase real property.

FSA 1999-951

PGDC SUMMARY:

X is a wholly-owned subsidiary of Y. X entered into a lease agreement with Z, an unrelated third party. The lease agreement provided for the long-term lease of a building and was subsequently modified to provide for consecutive year renewal options. Additionally, the lease provided X with an exclusive and irrevocable option to purchase the building. The purchase price varied depending on the date the option was exercised. With the consent of Z, X assigned its option to Y's charitable trust for no consideration, but retained its leasehold interest in the building. X had the property appraised and claimed a charitable contribution deduction pursuant to section 170.

The Service stated that the essential issue is "whether the contribution of an option to purchase real property constitutes "payment" under section 170(a)(1)." Noting that X was the owner of the option rather than the writer, the Service stated that X's leasehold interest and option to purchase should not be considered as separate property interests for purposes of section 170(f)(3) and that the retained interest is "clearly a substantial interest in the property." Accordingly, the Service held that the gift of the option constituted a "partial interest" and that X could not take a charitable contribution deduction.

FULL TEXT:

INTERNAL REVENUE SERVICE



MEMORANDUM



CC:TL-N-6445-93



DOM:FS:IT&A:DAKahle/KAAqui



date: August 26, 1993

to: District Counsel, * * *
CC:* * *
Attn:* * *

from: Assistant Chief Counsel (Field Service)
CC:DOM:FS

subject: * * *

This responds to the request for field service advice which was submitted by memorandum dated June 2, 1993.

This document may contain taxpayer information subject to section 6103. This document may also contain confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. Therefore, this document shall not be disclosed beyond the office or individual(s) to whom it is addressed and in no event shall it be disclosed to taxpayers or their representatives.

Specifically, if this memorandum is addressed to a District Counsel, then only office personnel working the specific case or subject matter may use this document. If this memorandum is addressed to a District Director, then only office personnel working the specific case or subject matter may use this document. This memorandum shall not be disclosed or circulated beyond such office personnel having the requisite "need to know."

ISSUES

(1) Whether taxpayer's subsidiary is entitled to a charitable contribution deduction for its donation of an option to purchase real property to the taxpayer's charitable trust.

(2) If so, when is the contribution deductible, and what is the proper method for calculating the amount of the deduction.

CONCLUSIONS

(1) The taxpayer's subsidiary is not entitled to a charitable contribution deduction for its donation of an option it held to purchase real property which it occupied as a lessee because it was a contribution of a partial interest in the property. This conclusion renders the remaining issues moot.

FACTS

* * * is a wholly-owned subsidiary of the * * * * * *. is a CEP taxpayer. On * * *, * * * entered into a lease agreement with * * * (hereinafter, together with its successor by assignment, * * * referred to as the Lessor), an unrelated third party. The agreement provided for the long-term lease of a building in * * * The lease ran from * * * through * * *. The lease was subsequently modified to provide for * * * consecutive * * * year renewal options.

Additionally, the lease agreement provided * * * (and its successors or assignees) with an exclusive and irrevocable option to purchase the building. The option permitted the purchase after * * *, but not after * * * The purchase price under the option varied depending upon the date the option was exercised. If the option was exercised during the period from * * * to * * * the purchase price was $* * * (approximately the cost of constructing the facility).

On * * *, with the consent of the Lessor, assigned the option to the * * * (Trust) for no consideration.

In connection with the donation, * * * had the property appraised. The * * * valuation firm determined that the property had a fair market value of $* * * at the time of the donation. Based on this valuation, * * * concluded that if the property was worth $* * *, and the option to purchase it was for $* * *, then the option had a fair market value of the difference, i.e., $* * * Accordingly, * * * claimed a charitable contribution deduction pursuant to I.R.C. section 170 on its * * * return in the amount of $* * *.

On * * *, the Trust entered into an "exclusive right to sell" agreement with unrelated real estate brokers. The listing called for a selling price of $ * * *. On * * * this agreement expired, and the Trust entered into a second listing agreement with other brokers. This listing agreement called for a target selling price of $* * * On * * * * * *, the Trust received an offer to purchase the property for $* * * This offer was rejected. On * * *, the Trust received another offer to purchase the property for $* * * * * * This offer was also rejected. Finally, on * * *, the Trust received an offer to purchase the property for $* * * This offer was likewise rejected.

On * * * the Trust sold the option to the Lessor for $* * *. For purposes of this memorandum, we assume: (1) that the Trust qualified as a charitable organization under I.R.C. section 170(c); (2) that all parties to the various transactions acted in good faith; (3) that * * * possessed the requisite donative intent, that is, * * * did not expect a substantial benefit as a guid pro quo for the transfer; and (4) that the property contribution from * * * to the Trust did not constitute self-dealing under I.R.C. section 4941.

ANALYSIS

Section 170(a)(1) allows, subject to certain limitations, a charitable contribution deduction for contributions to or for the use of organizations described in section 170(c), payment of which is made within the taxable year. A charitable contribution is defined in section 170(c) as a "contribution or gift to or for the use of" an organization described therein. The word "contribution" is not defined in the statute, however, it appears clear that whatever is meant by it would at least require some right to be relinquished by the contributor. Petty v. Commissioner, 40 T.C. 521, 523 (1963).

Section 170 does not specifically address the valuation issues which arise when a taxpayer contributes property other than money. However, the regulations state that if a charitable contribution is made in property other than money, the amount of the contribution is generally the fair market value /2/ of the property at the time of the contribution. Treas. Reg. section 1.170A-1(c)(1). The term "property" is not defined in section 170, the regulations, or the legislative history. Consequently, there is no indication that the term, with respect to a charitable contribution, was intended to be more restrictive or limited than the normal usage accorded to the term.

Section 170(f)(3)(A) denies a deduction in a case of a contribution (not made by a transfer in trust) of an interest in property which consists of less than the taxpayer's entire interest in such property, except to the extent that the value of the interest contributed would be deductible if such interest had been transferred in trust.

Section 170(f)(3)(B)(ii) provides an exception to the general rule of nondeductibility for a contribution of an undivided portion of the taxpayer's entire interest in the property.

Treas. Reg. section 1.170A-7(b)(1) provides that an undivided portion of a donor's entire interest in property must consist of a fraction or percentage of each and every substantial interest or right owned by the donor in such property and must extend over the entire term of the donor's interest in such property and in other property into which such property is converted.

By its terms, section 170(f)(3)(A) does not apply to the contribution of an interest in property that, even though partial, is the taxpayer's entire interest in the property. Treas. Reg. section 1.170(A)-7(a)(2)(i) provides that if the property in which such partial interest exists was divided in order to create such interest and thus avoid section 170(f)(3)(A), the deduction will be disallowed.

The term "property" is generally understood to be a broad concept. Zarin v. Commissioner, 92 T.C. 1084, 1110 (1989) (Ruwe, J., dissenting); see Lawrence v. O'Connell, 141 F. Supp. 316, 321 (D.R.I. 1956) (when used in the tax laws the word "property" is not to be given a narrow or technical meaning). In fact, in a recent decision, the Supreme Court stated:

[p]roperty is more than just the physical thing--the land, the bricks, the mortar--it is also the sum of all the rights and powers incident to ownership of the physical thing. It is the tangible and the intangible. Property is composed of constituent elements . . . . (citation omitted).

Dickman v. Commissioner, 465 U.S. 330, 336 (1984).

Thus, it appears clear that an option to purchase real estate is property that can be contributed or donated to a qualified donee, and that the option can have value separate from, although indirectly related to, the underlying property subject to the option. Helvering v. San Joaquin Fruit & Investment Co., 297 U.S. 496, 498 (1936); Brown v. Commissioner, T.C. Memo. 1989-133; see also, Commissioner v. Smith, 324 U.S. 177, 181 (1945); Lawrence v. O'Connell, supra.

Because the option is clearly property and doubtless is valuable, the resolution of this issue comes down to the question of whether the contribution of an option to purchase real property constitutes "payment" under section 170(a)(1). Actual payment during the taxable year is a prerequisite to allowance of a deduction and a mere pledge or promise to pay, even if legally binding under state law, is not sufficient to support a charitable contribution deduction. Petty, supra; Treas. Reg. section 1.170-2(a)(1). Where payment of a charitable contribution is made in the form of property other than money, the regulations permit a deduction in the year of contribution. Treas. Reg. section 1.170A-1(c)(1). However, in Guren v. Commissioner, 66 T.C. 118, 121 (1976), the court stated that "the term 'payment,' when dealing with monetary terms, must be taken to mean what it says. While a promissory note may constitute 'property' once it leaves the hands of its maker, it does not constitute the 'payment' of a contribution as between the maker and the payee."

The Service considered the transfer of instruments to charitable organizations in three revenue rulings. In Rev. Rul. 68- 174, 1968-1 C.B. 81, the Service set forth its position that a debenture bond or a promissory note issued and delivered by the obligor to a charitable organization represents a mere promise to pay at a future date and is not a "payment" for purposes of deducting a contribution under section 170. In Rev. Rul. 75-348, 1975-2 C.B. 75, the "payment" rationale was applied to a pledge that consisted of the grant of an option. The Service held that a corporation that pledges to sell shares of its common stock at a specified price to an educational organization is entitled to a charitable contribution only for the taxable year in which the pledge is exercised. Finally, in Rev. Rul. 82-197, 1982-2 C.B. 72, the "payment" rationale was carried to the case of a corporation issuing an option to buy real property. The Service concluded that a corporation that donates a transferable option to buy real property to a charitable organization is entitled to a charitable deduction in the year in which the option is exercised.

Additionally, in several private letter rulings, the Service, relying on the "payment" rationale of Rev. Rul. 68-174, concluded that a corporation that donates options to purchase its stock or property is entitled to a charitable contribution deduction in the year in which the charitable organization exercises or assigns the options. The basis for this conclusion is that an option is a promise to sell property at a future date and 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. In these situations, the amount of the contribution is the excess of the fair market value of the property on the date the option was exercised over the exercise price.

In all of the aforementioned situation involving options to purchase stock or property, the taxpayer contributing the option was also the writer of the option, i.e., the taxpayer "created" the option. The underlying concern in this situation is that the taxpayer, by merely contributing his promise to fulfill his obligation under the option contract, may refuse to perform, and thus, the taxpayer has parted with nothing more than his promise /3/. See Don E. Williams Co. v. Commissioner, 429 U.S. 569, 578 (1977); Helvering v. Stein, 115 F.2d 468 (4th Cir. 1940). Furthermore, if the taxpayer were permitted a deduction in this situation, the taxpayer could manipulate his taxable income by writing options and donating these options to charitable organizations, thereby, reducing his taxable income by generating unlimited charitable contribution deductions for the current year while parting with nothing more than his mere promises.

However, in the instant case, * * * is not the writer of the option, rather, * * * is the owner of the option. An unrelated third party (the lessor) wrote the option. In Winston v. Commissioner, T.C. Memo. 1984-248, the court, citing Guren, stated that in order to satisfy the "payment" requirement, there must be "an outlay of cash or property." In the instant case, the option to purchase real property, in the hands of * * * is clearly property and it is clearly valuable. Helvering v. San Joaquin Fruit & Investment Co., supra.; see Brown, supra.

In Rev. Rul. 88-37, 1988-1 C.B. 97, the Service published its position that the owner of a working interest under an oil and gas lease is not entitled to a charitable contribution deduction under section 170(a) for the value of an overriding royalty or a net profits interest. It is reasoned that, although a working interest under a lease is itself a partial interest in property, an overriding royalty or net profits interest constitutes a portion of the donor's entire interest and no deduction is allowable for the value of such property if carved out of the working interest. The ruling also notes that:

In enacting section 170(f)(3) Congress was concerned with situations in which taxpayers might obtain a double benefit by taking a deduction for the present value of a contributed interest while also excluding from income subsequent receipts from the donated interest. In addition, Congress was concerned with situations in which, because the charity does not obtain all or an undivided portion of the significant rights in the property, the amount of a charitable contribution deduction might not correspond to the value of the benefit ultimately received by the charity. The legislative solution was to guard against the possibility that such problems might arise by denying a deduction in situations involving partial interests unless the donation is cast in certain prescribed forms. (citations omitted). The scope of section 170(f)(3) thus extends beyond situations in which there is actual or probable manipulation of the non-charitable interest to the detriment of the charitable interest, or situations in which the donor has merely assigned the right to future income. (citations omitted).

1988-1 C.B. at 97.

Although the ruling considered whether certain carved out mineral interests qualify as charitable contribution deductions, the same rationale is applicable to any case where a taxpayer donates less than his/her entire interest in property. In the instant case, taxpayer acquired a leasehold plus an option to purchase the encumbered property. These two interests should not be considered as separate property interests for purposes of section 170(f)(3). /4/ Taxpayer donated the option to purchase the property but retained the right to occupy the premises for the dur ation of the lease term. This retained interest is clearly a substantial interest in the property. As a result of bifurcating and donating a partial interest in the property, taxpayer rendered the donated interest nondeductible under the stringent statutory conditions plainly applicable in this case. See Estate of Brock v. Commissioner, 71 T.C. 901, 913 (1979).

Based on the foregoing, we conclude that taxpayer is not entitled to a charitable contribution deduction for the value of the option to purchase the property it held as a lessee. In view of this conclusion, the timing and valuation questions are moot.

If you have any questions or need additional information, please contact Mr. Keith A. Aqui at (202) 622-7900.

Daniel J. Wiles

By: George E. Bowden
Senior Technician Reviewer
Income Tax & Accounting Branch
Field Service Division

FOOTNOTES

/1/ Because the option was sold for $* * * we assume that the fair market value of the property at this time was $* * *. That is, the value of the option ($* * * is calculated by subtracting the cost to exercise the option ($* * * from the fair market value of the property subject to the option ($* * *).

/2/ "Fair market value" is defined as the price at which the property would change hands between a willing buyer and a willing seller, where neither party is under any compulsion to buy or sell and both parties have reasonable knowledge of relevant facts. Treas. Reg. section 1.170A-1(c)(2).

/3/ Rev. Rul. 78-181, 1978-1 C.B. 261, states that the writer of an option has created no rights in the writer, but only an obligation to perform in the event the holder exercises the option. Therefore, the option writer does not have a capital asset, and the option does not represent property to the option writer within the meaning of section 62(4) (relating to deductions for losses from the sale or exchange of property).

/4/ See Gen. Couns. Mem. 39729 (Jan. 14, 1986), considering Rev. Rul. 88-37, supra.

END OF FOOTNOTES

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