Chief Counsel Advice Applies Substance-Over-Form Doctrine in Disallowing Deduction for Charitable Contribution of Partnership Units

Chief Counsel Advice Applies Substance-Over-Form Doctrine in Disallowing Deduction for Charitable Contribution of Partnership Units

Article posted in Email Chief Counsel Advice, Information Release on 16 March 2015| 1 comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 19 March 2015


Richard Fox analyzes a recent CCA which points to a substance over form issue on a complex charitable transaction. Caution to overly aggressive planners.

By Richard L. Fox, Esquire

In Chief Counsel Advice (CCA) 201507018, the IRS concluded that it was appropriate to recast a partner's purported charitable contribution of partnership units to a charitable organization under the substance-over-form doctrine.  The IRS determined that the actual substance of the transaction was the contribution by the donor of a mere promise to pay funds to the charity in the future, with the charity never being a bona fide partner in the partnership despite the form of the transaction.  As a result, the claimed charitable income tax deduction was denied in full and a claimed step-up in the inside basis of the assets held by the partnership with respect to a related corporation purchasing the partnership interest form the charity was similarly disallowed.  In form, the transaction was a charitable contribution of partnership interests to a charity, but when the layers of the contribution were pealed back, all that was left was a mere promise to pay funds to the charity at some future point in time, which does not qualify as a charitable contribution deduction under   IRC § 170(a)(1). 

A Promise to Pay a Certain Amount in the Future to a Charity is Not Deductible as a Charitable Contribution 

Under IRC § 170(a)(1), a charitable contribution deduction is generally allowed for a payment to a charity within the tax year.   Rev. Rul. 68-174, 1968-1 CB 81, provides that a debenture bond or a promissory note issued and delivered by the obligor to a charity represents a mere promise to pay at some future date and is not a “payment” for purposes of deducting a charitable contribution under IRC § 170(a)(1).  Therefore, the issuance of the debenture bond and  promissory note representing a mere promise to pay at some future date, and the delivery of the bond and note to a charitable organization is not a “payment” within the meaning of section 170 of the Code. Therefore, no deduction as a charitable contribution is allowable in such a case.

Substance-Over-Form Doctrine

In determining the tax consequences of a particular transaction, courts look to the objective economic realities of a transaction rather than to the particular form the parties employed. The simple expedient of drawing up papers does not control for tax purposes when the objective economic realities are to the contrary. In the field of taxation, administrators of the laws and the courts are concerned with substance and realities, and formal written documents are not rigidly binding. See Gregory v. Helvering, 14 AFTR 1191 (S. Ct. 1935).   In Palmer, 62 TC 684 (1974), a taxpayer donated shares of a corporation's stock to a foundation and then caused the corporation to redeem the stock from the foundation. The Tax Court rejected IRS's attempt to recast this transaction under the substance-over-form doctrine, in part, because it found that the foundation was not legally bound to go through with the redemption at the time it received title to the shares.   In Rev Rul. 78-197, 1978-1 CB 83, IRS stated that it would follow Palmer, and would treat the proceeds from a stock redemption as income to the donor only if the donee was legally bound, or could be compelled by the corporation, to surrender the shares for redemption.

Under IRC § 743(b), in the case of a transfer of an interest in a partnership by sale or exchange or upon the death of a partner, a partnership, with respect to which an election provided in IRC § 754 is in effect, must increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis of the partnership property, or decrease the adjusted basis of the partnership property by the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership. Such increase or decrease constitutes an adjustment to the basis of partnership property with respect to the transferee partner only. Under the anti-abuse rule of Treas. Reg. § 1.701-2(b), the partnership provisions of subchapter K and its regulations thereunder must be applied in a manner that is consistent with the intent of subchapter K (i.e., the provision of the Internal Revenue Code that apply to the income taxation of partnerships).  Accordingly, if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, the IRS is able to recast a transaction for federal tax purposes, as appropriate.

Facts of CCA 201507018

The partnership (Partnership) in CCA 201507018 was the producer of a popular consumer product and enjoyed exponential growth in sales and profits since the introduction of this product. The partnership had two classes of Partnership interests, Class A voting units and Class B nonvoting units.  The Class B nonvoting units were held by only one partner, a founding partner, its manager, and its tax matters partner (hereinafter the “Managing Partner”).  The Class B nonvoting units entitled the Managing Partner to a preferred return determined by reference to Partnership's earnings. The Partnership Agreement provides that Class B nonvoting units do not represent a capital interest.  Distributions with respect to Class A voting units, when made, were made pro rata based on the percentage of Class A units and were subordinated to the distributions made with respect to Class B nonvoting units.  

Each partner granted the Partnership the right to call all of its units at any time. Upon the exercise of a call, the partner was immediately removed as a member of Partnership. The call price was the fair market value of the unit as determined by the Partnership. The Partnership agreement provided that no partner could transfer any units without the prior written consent of the Managing Partner (which could be granted or withheld in the Managing Partner’s sole discretion) and without the written consent of Class A members.  If a partner transfers units with permission, such transfer doesn't entitle the assignee to become a member of Partnership or to exercise or receive any rights, powers and benefits of a member other than the right to receive distributions to which the assigning member would have been entitled.

If a partner attempts to transfer partnership units without obtaining the required consents, the Partnership would immediately exercise its option to purchase the member's units at the call price (Special Call Price), which is equal the removed member's capital contributions less any offset appropriate to satisfy all obligations of the removed member owing to Partnership and costs of the Partnership for having to effect the call. The Special Call Price is paid by the delivery a promissory note.

The Managing Partner had exclusive and complete discretion to manage and control all decisions affecting Partnership's business and affairs. He made decisions related to the day-to-day operations of Partnership, including hiring, firing, and decisions related to investments and finances. He also had authority to determine all aspects of distributions from Partnership, including the timing and amount of distributions. While the fair market value of Managing Partner's interest in Partnership is significant, his basis in his interest is nominal.

The Managing Partner contributed Class A voting units in the Partnership to a charity. The assignment agreement provided that Partnership and its partners had consented to the assignment.   Following the contribution of the Class A units to charity by the Managing Partner, under a purchase agreement, dated the day after the assignment, a corporation (Corporation), which had no assets or equity, purchased the charity’s Class A units in the Partnership for a promissory note (Note), the principal amount on which was to be paid on or before the expiration of 20 years. The Corporation was as wholly owned by the Managing Partner, who was Corporation’s president and CEO, and its sole director.  The Managing Partner had control over the Corporation. The Managing Partner held, with respect to the Corporation, key offices, had the authority to hire and dismiss employees, and made its investment decisions. The Managing Partner claimed a charitable income tax deduction under IRC § 170 for his charitable donation of Class A voting units in the Partnership to the charity.   And, pursuant to its IRC § 754 election, the Partnership increased its inside basis in Partnership's goodwill under IRC § 170, allowing the Corporation an amortization deduction for the tax year. The Corporation also claimed a deduction for “interest” payments on the Note.  No party recognized any gain on the transfer of Units.  The IRS challenged the transaction on the grounds that had the Managing Partner or Corporation contributed the Note directly to the charity, no charitable income tax deduction would have been allowable because the Note would have been treated as a promise to make a donation, but not an actual donation.  And, the substance of the transaction was just that, a contribution of a Note to the charity, not a contribution of Class A partnership units. 

Holding of CCA 201507018

IRS concluded that the Managing Partner was not entitled to a deduction under IRC § 170(a)(1) because the donee charity never received any interest in the Partnership.  Instead, the charity received the Managing Partner’s mere promise to make payments to the charity via the controlled Corporation through the Note.  Because the Partnership units were never transferred to the charity, but were in substance transferred to the Corporation, the IRS recast the transaction as Partner transferring the units to Corp. Under the recast transaction, the Corporation was entitled to treat payments under the Note as charitable contributions by the Corporation to the charity when payments were actually made. Further, because in substance, the charity never held an interest in the Partnership's property, and no sale of any units took place between the charity and the corporation, the Partnership was not entitled to an adjustment under IRC § 743(b), and the Corporation wasn't entitled to the corresponding amortization deductions.

The IRS noted that, under the Partnership agreement, the donee charity had to obtain the Partner's approval to transfer its interest in partnership units.  The Member, in his sole discretion, could approve or disapprove any transfer, and if the charity attempted to transfer its interest in the units to a third party, the Member had the power to nullify the transfer. And, the Special Call Price provision would limit the call price to charity capital contributions, which were equal to zero. In addition, Manager, through his power to approve of Partnership distributions to the Corporation, controlled when in fact “interest payments” would be made on Note.

The IRS found the Palmer case distinguishable from this case. Palmer dealt with the issue of an anticipatory assignment of income, and not the amount and validity of the charitable deduction. Unlike the taxpayer in Palmer, the Managing Partner had no fiduciary duty to the charity and had complete discretion regarding the approval of any transfer of Partnership units.   The IRS also found that Treas. Reg. § 1.701-2 applied to disregard the charity as a partner in the Partnership and to recast the transaction.  The Managing Partner purportedly transferred Partnership units with a low basis and a high fair market value to the charity, for which he took a charitable deduction based on the fair market value of units on his personal tax return.  The Managing Partner also arranged for the charity to sell those units to the Corporation for the Note, allowing the Corporation to take a deduction for “interest” payments on Note and a goodwill amortization deduction as a result of Partnership's IRC § 743(b) adjustment. As a result, the Managing Partner and his controlled corporate affiliate took three deductions for one charitable contribution that never in substance occurred. The purported transfer of Partnership units to the charity was necessary to significantly reduce the Managing Partner and Corporation’s tax liability.  In fact, the charity, an assignee of the Managing Partner with respect to units, only momentarily had any rights to distributions and no other rights to the units.

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Re: Chief Counsel Advice Applies Substance-Over-Form ...

I'm glad that the IRS ruled this way. Does this strike anyone else as fundamentally just someone attempting to lower, avoid, or evade taxes? Where was there ANY charitable intent in evidence? None that I can see, and as someone who works in a non-profit, this kind of machination infuriates me.

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