the assignment of income doctrine is a legislative

What is “Assignment of Income” Under the Tax Law?

Gross income is taxed to the individual who earns it or to owner of property that generates the income. Under the so-called “assignment of income doctrine,” a taxpayer may not avoid tax by assigning the right to income to another.

Specifically, the assignment of income doctrine holds that a taxpayer who earns income from services that the taxpayer performs or property that the taxpayer owns generally cannot avoid liability for tax on that income by assigning it to another person or entity. The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities.

A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income. And, under the same rationale, an assignment of an interest in a lottery ticket is effective only if it occurs before the ticket is ascertained to be a winning ticket.

However, a taxpayer can shift liability for capital gains on property not yet sold by making a bona fide gift of the underlying property. In that case, the donee of a gift of securities takes the “carryover” basis of the donor.

For example, shares now valued at $50 gifted to a donee in which the donor has a tax basis of $10, would yield a taxable gain to the donee of its eventual sale price less the $10 carryover basis. The donor escapes income tax on any of the appreciation.

For guidance on this issue, please contact our professionals at 315.242.1120 or [email protected] .

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the assignment of income doctrine is a legislative

A recent taxpayer victory in the Tax Court in the case of Jon Dickinson, et ux. v. Commissioner, TC Memo 2020‑128 (Sept. 3, 2020), is an important reminder to donors and potential charitable donees to be well informed of the law when donating, or soliciting donations of, appreciated closely held business interests.

Benefits of Donating Appreciated Interests Ahead of Sales

Wise taxpayers, frequently on the advice of their knowledgeable tax advisors, know that when making a charitable gift, it is typically most beneficial to make a donation to a public charity of an appreciated asset in order to obtain a charitable deduction, rather than donating cash, or even worse, the after-tax proceeds of the sale of the appreciated asset. The benefits, of course, are that the taxpayer will both receive a tax deduction equal to the fair market value of the asset and will not incur tax (i.e., capital gains) on the transaction. This benefit is illustrated in the below example:

Donating appreciated business interests in situations where the business may be sold, or the business owner may otherwise be preparing to divest herself or himself of part of their ownership interest, may be particularly appealing to a philanthropic business owner. As the example illustrates, pre-transaction planning can maximize the amount ultimately available for philanthropic endeavors at the lowest cost to the donor. Savvy gift officers and charities will often suggest this strategy to donors as a way for both the donor and the charity to “win.”

Assignment of Income Doctrine

Donors should be cautious about making a gift of an interest in anticipation of a sale or other liquidation event for a variety of reasons. For example, if the expected transaction does not occur, it may not be advisable for the charity to own an interest in the company (and the company may not be too happy about it either). Under those circumstances a charity is not permitted to “re-gift” the interest back to the donor. In even the best of situations, reversing such a transaction would be become complex, and in fact, in most cases it is usually not possible.

Because of the risk associated with a deal not closing, donors often seek to wait until there is some certainty that a transaction will in fact close. However, the longer a donor waits, the greater the risk that the intended result – a donation of property subject to an unrealized gain (i.e., untaxed) – will not be achieved because of the assignment of income doctrine.

The assignment of income doctrine is one of a handful of judicial doctrines developed by United States courts to try to limit tax evasion. A key principal is that a donor cannot avoid taxation on property by merely making a gift of the property. If the substance of the transaction is to avoid income that is otherwise already subject to taxation, such gift may be disregarded. 1 This boils down to a facts-and-circumstances timing question.

Generally, the assignment of income doctrine provides that gain is realized by the owner of property when all events have occurred such that the final resulting transaction is all but assured. In reality, the interest has “ripened” into a fixed right to receive income. 2 Said yet another way, the question is often whether subsequent to the gift there are independent event(s) of significance to conclude that all substantive events related to the transaction have not yet occurred. The charity receiving the donation cannot simply function as a conduit for a transaction that has progressed to the point where it is almost certainly taking place. Whether a particular transaction or series of transactions have, when considering the reality and substance of the circumstances, proceeded to such a point is a fact-specific determination.

The Tax Court Emphasizes Form of Gift of Appreciated Stock

In the Dickinson case decided earlier this month, Mr. Dickinson had acquired shares over time in a large privately held engineering and consulting firm. He, along with other shareholders, were authorized by the company’s Board of Directors to donate shares to Fidelity Investments Charitable Gift Fund, the donor advised fund, in the years 2013 and 2014. Fidelity Charitable’s policy, known to the firm and its shareholders, was to immediately liquidate donated stock and it did so with Mr. Dickinson’s donated shares by selling them back to the company.

On audit, the IRS determined that Mr. Dickinson did not donate appreciated stock, rather he donated cash because, in substance, the company first redeemed the shares and he then donated the cash to fund a donor advised fund account at Fidelity Charitable. The Tax Court rejected that characterization, however, choosing instead to focus on the form of the transaction, namely that (1) Mr. Dickinson fully transferred his rights to and legal control of the shares to Fidelity Charitable, and (2) he did so before the shares gave rise to income by way of a sale or redemption. Preexisting knowledge of Fidelity Charitable’s policy to immediately dispose of donated stock did not, in and of itself, convert the donation of stock into a pre-donation redemption; Fidelity Charitable received the stock and it had the right to do with it what it pleased. At the time of the donation, it could not have been definitively said that a redemption of the shares, regardless of who the owner was, would have occurred.

While the IRS attempted to base its conclusion on the theory that there was a pre-arranged plan for the redemption of the stock, the Tax Court rejected that argument. The Court found that even if that was the case, that does not mean that had the donor retained the stock it would similarly have been redeemed. Citing its 1974 Palmer decision, the Tax Court stated, “[t]he ultimate question, as noted in Palmer, is whether the redemption and the shareholder’s corresponding right to income had already crystallized at the time of the gift.” 3

Planning Pointers for Donors and Charities

The Dickinson case is a good reminder that the IRS will seek to challenge gifts of appreciated business interests. With such an emphasis by the Tax Court on the proper form of such gifts, donors should be mindful to make the donation sufficiently before the time when the “all events” test has been met, especially in the case of a proposed or impending transaction, or before “the shareholder’s corresponding right to income…[has] already crystallized.” While the taxpayer succeeded in the Dickinson case, the facts-and-circumstances nature of the assignment of income doctrine can make decision-making tricky when donors hope to make donations of appreciated interests in advance of transactions. Taxpayers should seek legal counsel in such cases.

Charities should also take heed. While many charities have wisely begun to focus on soliciting non-cash charitable gifts, such as appreciated stock, charities should become familiar with the legal principles, such as the assignment of income doctrine, which can impact these gifts. Charities should consider their policies and practices with respect to soliciting and accepting such gifts, both in form and in practice. Not all donors will be fully aware of these principles and may be sorely surprised after making a gift if audited. It may behoove a charity to help educate donors so that a gift is successfully completed. Unhappy donors are not typically repeat donors.

1 See Palmer v. Commissioner, 62 T.C. 684, 692 (1974), affd. on other grounds 523 F.2d 1308 [36 AFTR 2d 75-5942] (8th Cir. 1975), acq. 1978-1 CB 2.

2 See Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999).

3 See Palmer v. Commissioner, 62 T.C. at 694-695

Christina Cahill, Nicole Riberio & Erica Seaborne also contributed to this article.

Current Legal Analysis

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Battling Uphill Against the Assignment of Income Doctrine: Ryder

Benjamin Alarie

Kathrin Gardhouse

Benjamin Alarie is the Osler Chair in Business Law at the University of Toronto and the CEO of Blue J Legal Inc. Kathrin Gardhouse is a legal research associate at Blue J Legal .

In this article, Alarie and Gardhouse examine the Tax Court ’s recent decision in Ryder and use machine-learning models to evaluate the strength of the legal factors that determine the outcome of assignment of income cases.

I. Introduction

Researching federal income tax issues demands distilling the law from the code, regulations, revenue rulings, administrative guidance, and sometimes hundreds of tax cases that may all be relevant to a particular situation. When a judicial doctrine has been developed over many decades and applied in many different types of cases, the case-based part of this research can be particularly time consuming. Despite an attorney’s best efforts, uncertainty often remains regarding how courts will decide a new set of facts, as previously decided cases are often distinguished and the exercise of judicial discretion can at times lead to surprises. To minimize surprises as well as the time and effort involved in generating tax advice, Blue J ’s machine-learning modules allow tax practitioners to assess the likely outcome of a case if it were to go to court based on the analysis of data from previous decisions using machine learning. Blue J also identifies cases with similar facts, permitting more efficient research.

In previous installments of Blue J Predicts, we examined the strengths and weaknesses of ongoing or recently decided appellate cases, yielding machine-learning-generated insights about the law and predicting the outcomes of cases. In this month’s column, we look at a Tax Court case that our predictor suggests was correctly decided (with more than 95 percent confidence). The Ryder case 1 has received significant attention from the tax community. It involved tax avoidance schemes marketed by the law firm Ernest S. Ryder & Associates Inc. (R&A) that produced more than $31 million in revenue between 2003 and 2011 and for which the firm reported zero taxable income. The IRS unmasked more than 1,000 corporate entities that R&A’s owner, Ernest S. Ryder , had created and into which he funneled the money. By exposing the functions that these entities performed, the IRS played the most difficult role in the case. Yet, there are deeper lessons that can be drawn from the litigation by subjecting it to analysis using machine learning.

In this installment of Blue J Predicts, we shine an algorithmic spotlight on the legal factors that determine the outcomes of assignment of income cases such as Ryder . For Ryder , the time for filing an appeal has elapsed and the matter is settled. Thus, we use it to examine the various factors that courts look to in this area and to show the effect those factors have in assignment of income cases. Equipped with our machine-learning module, we are able to highlight the fine line between legitimate tax planning and illegitimate tax avoidance in the context of the assignment of income doctrine.

II. Background

In its most basic iteration, the assignment of income doctrine stands for the proposition that income is taxed to the individual who earns it, even if the right to that income is assigned to someone else. 2 Courts have held that the income earner is responsible for the income tax in the overwhelming majority of cases, including Ryder . It is only in a small number of cases that courts have been willing to accept the legitimacy of an assignment and have held that the assignee is liable for the earned income. Indeed, Blue J ’s “Assigned Income From Services” predictor, which draws on a total of 242 cases and IRS rulings, includes only 10 decisions in which the assignee has been found to be liable to pay tax on the income at issue.

The wide applicability of the assignment of income doctrine was demonstrated in Ryder , in which the court applied the doctrine to several different transactions that occurred between 1996 and 2011. Ryder founded his professional law corporation R&A in 1996 and used his accounting background, law degree, and graduate degree in taxation for the benefit of his clients. R&A designed, marketed, sold, and administered six aggressive tax-saving products that promised clients the ability to “defer a much greater portion of their income than they ever dreamed possible, and, as a result, substantially reduce their tax liability.” 3 In 2003 the IRS caught on to Ryder ’s activities when his application to have 800 employee stock option plans qualified at the same time was flagged for review. A decade of investigations and audits of Ryder and his law firm spanning from 2002 to 2011 followed.

What is interesting in this case is that Ryder , through his law firm R&A, directly contracted with his clients for only three of the six tax-saving products that his firm designed, marketed, and sold (the stand-alone products). The fees collected by R&A from two of the stand-alone products were then assigned to two other entities through two quite distinct mechanisms. For the other three tax-saving products, the clients contracted — at least on paper — with other entities that Ryder created (the group-tax products). Yet, the court treated the income from all six tax-saving products identically. The differences between the six types of transactions did not affect the outcome of the case — namely, that it is R&A’s income in all six instances. Blue J ’s predictor can explain why: The factors that our predictor highlights as relevant for answering the question whether the assignment of income doctrine applies have less to do with the particular strategy that the income earner conjures up for making it look like the income belongs to someone else, and more to do with different ways of pinpointing who actually controls the products, services, and funds. In Ryder , the choices ultimately come down to whether that is R&A or the other entity.

We will begin the analysis of the case by taking a closer look at two of the six tax-saving products, paying particular attention to the flow of income from R&A’s clients to R&A and Ryder ’s assignment of income to the other entities. We have selected one of the tax-saving products in which Ryder drew up an explicit assignment agreement, and another one in which he tried to make it look like the income was directly earned by another entity he had set up. Regardless of the structures and means employed, the court, based on the IRS ’s evidence, traced this income to R&A and applied the assignment of income doctrine to treat it as R&A’s income.

This article will not cover in detail the parts of the decision in which the court reconstructs the many transactions Ryder and his wife engaged in to purchase various ranches using the income that had found its way to R& A. As the court puts it, the complexity of the revenues and flow of funds is “baroque” when R&A is concerned, and when it comes to the ranches, it becomes “ rococo .” 4 We will also not cover the fraud and penalty determinations that the court made in this case.

III. The Tax Avoidance Schemes

We will analyze two of the six schemes discussed in the case. The first is the staffing product, and the second is the American Specialty Insurance Group Ltd. (ASIG) product. Each serves as an example of different mechanisms Ryder employed to divert income tax liability away from R&A. In the case of the staffing product, Ryder assigned income explicitly to another entity. The ASIG product involved setting up another entity that Ryder argued earned the income directly itself.

A. The Staffing Product

R&A offered a product to its clients in the course of which the client could lease its services to a staffing corporation, which would in turn lease the client’s services back to the client’s operating business. The intended tax benefit lay “with the difference between the lease payment and the wages received becoming a form of compensation that was supposedly immune from current taxation.” 5 At first, the fees from the staffing product were invoiced by and paid to R&A. When the IRS started its investigation, Ryder drew up an “Agreement of Assignment and Assumption” with the intent to assign all the clients and the income from the staffing product to ESOP Legal Consultants Inc. ( ELC ). Despite the contractual terms limiting the agreement to the 2004-2006 tax years, Ryder used ELC ’s bank account until 2011 to receive fees paid by the various S corporations he had set up for his clients to make the staffing product work. R&A would then move the money from this bank account into Ryder ’s pocket in one way or another. ELC had no office space, and the only evidence of employees was six names on the letterhead of ELC indicating their positions. When testifying in front of the court, two of these employees failed to mention that they were employed by ELC , and one of them was unable to describe the work ELC was allegedly performing. Hence, the court concluded that ELC did not have any true employees of its own and did not conduct any business. Instead, it was R&A’s employees that provided any required services to the clients. 6

B. The ASIG Product

R&A sold “disability and professional liability income insurance” policies to its clients using ASIG, a Turks and Caicos corporation that was a captive insurer owned by Capital Mexicana . Ryder had created these two companies during his previous job with the help of the Turks and Caicos accounting firm Morris Cottingham Ltd. The policies Ryder sold to his clients required them to pay premiums to ASIG as consideration for the insurance. The premiums were physically mailed to R& A. Also , the clients were required to pay a 2 percent annual fee, which was deposited into ASIG’s bank account. In return, the clients received 98 percent of the policy’s cash value in the event that they became disabled, separated from employment, turned 60, or terminated the policy. 7

R&A’s involvement in these deals, aside from setting up ASIG, was to find the clients who bought the policies, assign them a policy number, draft a policy, and open a bank account for the client, as well as provide legal services for the deal as needed. It was R&A that billed the client and that ensured, with Morris Cottingham ’s help, that the fees were paid. R&A employees would record the ASIG policy fee paid by the clients, noting at times that “pymt bypassed [R&A’s] books.” 8 Quite an effort went into disguising R&A’s involvement.

First, there was no mention of R&A on the policy itself. Second, ASIG’s office was located at Morris Cottingham’s Turks and Caicos corporate services. Ryder also set up a post office box for ASIG in Las Vegas. Any mail sent to it was forwarded to Ryder . Third, to collect the fees, R&A would send a letter to Morris Cottingham for signature, receive the signed letter back, and then fax it to the financial institution where ASIG had two accounts. One of these was nominally in ASIG’s name but really for the client’s benefit, and the other account was in Ryder ’s name. The financial institution would then move the amount owed in fees from the former to the latter account. Whenever a client filed for a benefit under the policy, the client would prepare a claim package and pay a termination fee that also went into the ASIG account held in Ryder ’s name. The exchanges between the clients and ASIG indicate that these fees were to reimburse ASIG for its costs and services, as well as to allow it to derive a profit therefrom. But the court found that ASIG itself did nothing. Even the invoices sent to clients detailing these fee payments that were on ASIG letterhead were in fact prepared by R&A. In addition to the annual fees and the termination fee, clients paid legal fees on a biannual basis for services Ryder provided. These legal fees, too, were paid into the ASIG account in Ryder ’s name. 9

IV. Assignment of Income Doctrine

The assignment of income doctrine attributes income tax to the individual who earns the income, even if the right to that income is assigned to another entity. The policy rationale underlying the doctrine is to prevent high-income taxpayers from shifting their taxable income to others. 10 The doctrine is judicial and was first developed in 1930 by the Supreme Court in Lucas , a decision that involved contractual assignment of personal services income between a husband and wife. 11 The doctrine expanded significantly over the next 20 years and beyond, and it has been applied in many different types of cases involving gratuitous transfers of income or property. 12 The staffing product, as of January 2004, involved an anticipatory assignment of income to which the assignment of services income doctrine had been held to apply in Banks . 13 The doctrine is not limited to situations in which the income earner explicitly assigns the income to another entity; it also captures situations in which the actual income earner sets up another entity and makes it seem as if that entity had earned the income itself, as was the case with the ASIG product. 14

In cases in which the true income earner is in question, the courts have held that “the taxable party is the person or entity who directed and controlled the earning of the income, rather than the person or entity who received the income.” 15 Factors that the courts consider to determine who is in control of the income depend on the particular situation at issue in the case. For example, when a personal services business is involved, the court looks at the relationship between the hirer and the worker and who has the right to direct the worker’s activities. In partnership cases, the courts apply the similarity test, asking whether the services the partnership provided are similar to those the partner provided. In other cases, the courts have inquired whether an agency relationship can be established. In yet other cases the courts have taken a broad and flexible approach and consulted all the available evidence to determine who has the ultimate direction and control over the earnings. 16

V. Factors Considered in Ryder

Judge Mark V. Holmes took a flexible approach in Ryder . He found that none of the entities that Ryder papered into existence had their own office or their own employees. They were thus unable to provide the services Ryder claims they were paid for. In fact, the entities did not provide any services at all — the services were R&A’s doing. To top it off, R&A did nothing but set up the entities, market their tax benefits, and move money around once the clients signed up for the products. There was no actual business activity conducted. The court further found that the written agreements the clients entered into with the entities that purported to provide services to them were a sham and that oral contracts with R&A were in fact what established the relevant relationship, so that R&A must be considered the contracting party. In the case of the ASIG product, for example, a client testified that the fees he paid to Ryder were part of his retirement plan. Ryder had represented to him that the ASIG product was established to create an alternative way to accumulate retirement savings. 17

Regarding the staffing product in which there existed an explicit assignment of income agreement between R&A and ELC , the court found that ELC only existed on paper and in the form of bank accounts, with the effect that R&A was ultimately controlling the income even after the assignment. A further factor that the court emphasized repeatedly was that R&A, and Ryder personally as R&A’s owner, kept benefitting from the income after the assignment (for example, in the staffing product case) or, as in the case of the ASIG product, despite the income allegedly having been earned by a third party (that is, ASIG). 18

VI. Analysis

The aforementioned factors are reflected in Blue J ’s Assigned Income From Services predictor. 19 We performed predictions for the following scenarios:

the staffing product and R&A’s assignment of the income it generated to ELC with the facts as found by the court;

the staffing product and R&A’s assignment of the income it generated to ELC if Ryder ’s version of the facts were accepted;

the ASIG product and service as the court interpreted and characterized the facts; and

the ASIG product and service according to Ryder ’s narrative.

What is interesting and indicative of the benefits that machine-learning tools such as Blue J ’s predictor can provide to tax practitioners is that even if the court had found in Ryder ’s favor on all the factual issues reasonably in dispute, Ryder would still not have been able to shift the tax liability to ELC or ASIG respectively, according to our model and analysis.

The court found that R&A contracted directly with, invoiced, and received payments from its clients regarding the staffing product up until 2004, when Ryder assigned the income generated from this product explicitly to ELC . From then onward, ELC received the payments from the clients instead of R&A. Further, the court found that ELC did not have its own employees or office space and did not conduct any business activity. Our data show that the change in the recipient of the money would have made no difference regarding the likelihood of R&A’s liability for the income tax in this scenario.

According to Ryder ’s version of the facts, ELC did have its own employees, 20 even though there is no mention of a separate office space from which ELC allegedly operated. Yet, Ryder maintains that ELC was the one providing the staffing services to its clients after the assignment of the clients to the company in January 2004. Even if Ryder had been able to convince the court of his version of the facts, it would hardly have made a dent in the likelihood of the outcome that R&A would be held liable for the tax payable on the income from the staffing product.

With Ryder ’s narrative as the underlying facts, our predictor is still 94 percent confident that R&A would have been held liable for the tax. The taxation of the income in the hands of the one who earned it is not easily avoided with a simple assignment agreement, particularly if the income earner keeps benefiting from the income after the assignment and continues to provide services himself without giving up control over the services for the benefit of the assignee. The insight gained from the decision regarding the staffing product is that the court will take a careful look behind the assignment agreement and, if it is not able to spot a legitimate assignee, the assignment agreement will be disregarded.

The court made the same factual findings regarding the ASIG product as it did for the staffing product post-assignment. Ryder , however, had more to say here in support of his case. For one, he pointed to ASIG’s main office that was located at the Morris Cottingham offices. Morris Cottingham was also the one that, on paper, contracted with clients for the insurance services and the collection of fees was conducted, again on paper, in the name of Morris Cottingham . The court also refers to actual claims that the clients made under their policies. There is also a paper trail that indicates that the clients were explicitly acknowledging and in fact paying ASIG for its costs and services. From all this we can conclude that Ryder was able to argue that ASIG had its own independent office, had one or more employees providing services, and that ASIG engaged in actual business activity. However, even if these facts had been admitted as accurately reflecting the ASIG product, our data show that with a 92 percent certainty R&A would still be liable for the income tax payable on the income the ASIG product generated. It is clear that winning a case involving the assignment of income doctrine on facts such as the ones in Ryder is an uphill battle. If the person behind the scenes remains involved with the services provided without giving up control over them, and benefits from the income generated, it is a lost cause to argue that the assignment of income doctrine should be applied with the effect that the entity that provides the services on paper is liable for the income tax.

C. Ryder as ASIG’s Agent

Our data reveal that to have a more substantial shot at succeeding with his case under the assignment of income doctrine, Ryder would have had to pursue a different line of argument altogether. Had he set R&A up as ASIG’s agent rather than tried to disguise its involvement with the purported insurance business, Ryder would have been more likely to succeed in shifting the income tax liability to ASIG. For our analysis of the effect of the different factors discussed by the court in Ryder , we assume at the outset that Ryder would do everything right — that is, ASIG would have its own workers and office, and it would do something other than just moving money around (best-case scenario). We then modify each factor one by one to reveal their respective effect.

From this scenario testing, we can conclude that if R&A had had an agency agreement with ASIG, received some form of compensation for its services from ASIG, held itself out to act on ASIG’s behalf, and the client was interested in R&A’s service because of its affiliation with ASIG, Ryder would have reduced the likelihood to 73 percent of R&A being liable for the income tax. Add to these agency factors an element of monitoring by ASIG and the most likely result flips — there would be a 64 percent likelihood that ASIG would be liable for the income tax. If ASIG were to go beyond monitoring R&A’s services by controlling them too, the likelihood that ASIG would be liable for the income tax would increase to 82 percent. Let’s say Ryder had given Morris Cottingham oversight and control over R&A’s services for ASIG, then the question whether ASIG employs any workers other than R&A arguably becomes moot because there would necessarily be an ASIG employee who oversees R&A. Accordingly, there is hardly any change in the confidence level of the prediction that ASIG is liable for the income tax when the worker factor is absent.

Interestingly, this is quite different from the effect of the office factor. Keeping everything else as-is, the absence of having its own ASIG-controlled office decreases the likelihood of ASIG being liable to pay the income tax from 82 to 54 percent. Note here that our Assigned Income From Services predictor is trained on data from relatively old cases; only 14 are from the last decade. This may explain why the existence of a physical office space is predicted to play such an important role when the courts determine whether the entity that allegedly earns the income is a legitimate business. In a post-pandemic world, it may be possible that a trend will emerge that puts less emphasis on the physical office space when determining the legitimacy of a business.

The factor that stands out as the most important one in our hypothetical scenario in which R&A is the agent of ASIG is the characterization of ASIG’s own business activity. In the absence of ASIG conducting its own business, nothing can save Ryder ’s case. This makes intuitive sense because if ASIG conducts no business, it must be R&A’s services alone that generate the income; hence R&A is liable for the tax on the income. Also very important is the contracting party factor: If the client were to contract with R&A rather than ASIG in our hypothetical scenario, the likelihood that R&A would be held liable for the income tax is back up to 72 percent, all else being equal. If the client were to contract with both R&A and ASIG, it is a close case, leaning towards ASIG’s liability with 58 percent confidence. Much less significant is who receives the payment between the two. If it is R&A, ASIG remains liable for the income tax with a likelihood of 71 percent, indicating a drop in confidence by 11 percent compared with a scenario in which ASIG received the payment.

To summarize, if Ryder had pursued a line of argument in which he set up R&A as ASIG’s agent, giving ASIG’s employee(s) monitoring power and ideally control over R&A’s services for ASIG, he would have had a better chance of succeeding under the assignment of income doctrine. As we have seen, the main prerequisite for his success would have been to convince the court that it would be appropriate to characterize ASIG as conducting business. Ideally, Ryder also would have made sure that the client contracted for the services with ASIG and not with R&A. However, it is significantly less important that ASIG receives the money from the client. The historical case law also suggests that Ryder would have been well advised to set up a physical office for ASIG; however, given the new reality of working from home, this factor may no longer be as relevant as these older previously decided cases indicate.

VII. Conclusion

We have seen that R&A’s chances to shift the liability for the tax payable on the staffing and the ASIG product income was virtually nonexistent. The difficulty of this case from the perspective of the IRS certainly lay in gathering the evidence, tracing the money through the winding paths of Ryder ’s paper labyrinth, and making it comprehensible for the court. Once this had been accomplished, the IRS had a more-or-less slam-dunk case regarding the applicability of the assignment of income doctrine. As mentioned at the outset, an assignment of income case will always be an uphill battle for the taxpayer because income is generally taxable to whoever earns it.

Yet, in cases in which the disputed question is who earned the income and not whether the assignment agreement has shifted the income tax liability, the parties must lean into the factors discussed here to convince the court of the legitimacy (or the illegitimacy, in the case of the government) of the ostensibly income-earning entity and its business. Our analysis can help decide which of the factors must be present to have a plausible argument, which ones are nice to have, and which should be given little attention in determining an efficient litigation strategy.

1 Ernest S. Ryder & Associates Inc. v. Commissioner , T.C. Memo. 2021-88 .

2 Lucas v. Earl , 281 U.S. 111, 114-115 (1930).

3 Ryder , T.C. Memo. 2021-88, at 7.

4 Id. at 32.

5 Id. at 17, 19, and 111-112.

6 Id. at 51-52, 111-112, and 123-126.

7 Id. at 9-12.

8 Id. at 96.

10 CCH, Federal Taxation Comprehensive Topics, at 4201.

11 Lucas , 281 U.S. at 115.

12 See , e.g. , “familial partnership” cases — Burnet v. Leininger , 285 U.S. 136 (1932); Commissioner v. Tower , 327 U.S. 280 (1946); and Commissioner v. Culbertson , 337 U.S. 733 (1949). For an application in the commercial context, see Commissioner v. Banks , 543 U.S. 426 (2005).

13 Banks , 543 U.S. at 426.

14 See , e.g. , Johnston v. Commissioner , T.C. Memo. 2000-315 , at 487.

16 Ray v. Commissioner , T.C. Memo. 2018-160 .

17 Ryder , T.C. Memo. 2021-88, at 90-91.

18 Id. at 48, 51, and 52.

19 The predictor considered several further factors that play a greater role in other fact patterns.

20 The court mentions that ELC’s letterhead set out six employees and their respective positions with the company.

END FOOTNOTES

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Commissioner v. Banks, 543 U.S. 426 (2005)

SYLLABUS OCTOBER TERM, 2004 COMMISSIONER V. BANKS SUPREME COURT OF THE UNITED STATES

COMMISSIONER OF INTERNAL REVENUE v. BANKS

certiorari to the united states court of appeals for the sixth circuit

No. 03–892.Argued November 1, 2004—Decided January 24, 2005*

Respondent Banks settled his federal employment discrimination suit against a California state agency and respondent Banaitis settled his Oregon state case against his former employer, but neither included fees paid to their attorneys under contingent-fee agreements as gross income on their federal income tax returns. In each case petitioner Commissioner of Internal Revenue issued a notice of deficiency, which the Tax Court upheld. In Banks’ case, the Sixth Circuit reversed in part, finding that the amount Banks paid to his attorney was not includable as gross income. In Banaitis’ case, the Ninth Circuit found that because Oregon law grants attorneys a superior lien in the contingent-fee portion of any recovery, that part of Banaitis’ settlement was not includable as gross income.

Held: When a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. Pp. 5–12.

(a) Two preliminary observations help clarify why this issue is of consequence. First, taking the legal expenses as miscellaneous itemized deductions would have been of no help to respondents because the Alternative Minimum Tax establishes a tax liability floor and does not allow such deductions. Second, the American Jobs Creation Act of 2004—which amended the Internal Revenue Code to allow a taxpayer, in computing adjusted gross income, to deduct attorney’s fees such as those at issue—does not apply here because it was passed after these cases arose and is not retroactive. Pp. 5–6.

(b) The Code defines “gross income” broadly to include all economic gains not otherwise exempted. Under the anticipatory assignment of income doctrine, a taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party, e.g., Lucas v. Earl, 281 U. S. 111 , because gains should be taxed “to those who earn them,” id., at 114. The doctrine is meant to prevent taxpayers from avoiding taxation through arrangements and contracts devised to prevent income from vesting in the one who earned it. Id., at 115. Because the rule is preventative and motivated by administrative and substantive concerns, this Court does not inquire whether any particular assignment has a discernible tax avoidance purpose. Pp. 6–7.

(c) The Court agrees with the Commissioner that a contingent-fee agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client’s income from any litigation recovery. In an ordinary case attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question. However, in the context of anticipatory assignments, where the assignor may not have dominion over the income at the moment of receipt, the question is whether the assignor retains dominion over the income-generating asset. Looking to such control preserves the principle that income should be taxed to the party who earns the income and enjoys the consequent benefits. In the case of a litigation recovery the income-generating asset is the cause of action derived from the plaintiff’s legal injury. The plaintiff retains dominion over this asset throughout the litigation. Respondents’ counterarguments are rejected. The legal claim’s value may be speculative at the moment of the assignment, but the anticipatory assignment doctrine is not limited to instances when the precise dollar value of the assigned income is known in advance. In these cases, the taxpayer retained control over the asset, diverted some of the income produced to another party, and realized a benefit by doing so. Also rejected is respondents’ suggestion that the attorney-client relationship be treated as a sort of business partnership or joint venture for tax purposes. In fact, that relationship is a quintessential principal-agent relationship, for the client retains ultimate dominion and control over the underlying claim. The attorney can make tactical decisions without consulting the client, but the client still must determine whether to settle or proceed to judgment and make, as well, other critical decisions. The attorney is an agent who is duty bound to act in the principal’s interests, and so it is appropriate to treat the full recovery amount as income to the principal. This rule applies regardless of whether the attorney-client contract or state law confers any special rights or protections on the attorney, so long as such protections do not alter the relationship’s fundamental principal-agent character. The Court declines to comment on other theories proposed by respondents and their amici, which were not advanced in earlier stages of the litigation or examined by the Courts of Appeals. Pp. 7–10.

(d) This Court need not address Banks’ contention that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee-shifting provisions, such as those applicable in his case brought under 42 U. S. C. §§1981, 1983, and 2000(e) et seq. He settled his case, and the fee paid to his attorney was calculated based solely on the contingent-fee contract. There was no court-ordered fee award or any indication in his contract with his attorney or the settlement that the contingent fee paid was in lieu of statutory fees that might otherwise have been recovered. Also, the American Jobs Creation Act redresses the concern for many, perhaps most, claims governed by fee-shifting statutes. P. 11.

No. 03–892, 345 F. 3d 373; No. 03–907, 340 F. 3d 1074, reversed and remanded.

Kennedy, J., delivered the opinion of the Court, in which all other Members joined, except Rehnquist, C. J., who took no part in the decision of the cases.

Together with No. 03–907, Commissioner of Internal Revenue v. Banaitis, on certiorari to the United States Court of Appeals for the Ninth Circuit.

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Recognizing when the IRS can reallocate income

C Corporation Income Taxation
IRS Practice & Procedure

Transactions between related parties come under close scrutiny by the IRS because they are not always conducted at arm's length. If the amounts involved in the transaction do not represent fair market values, the IRS can change the characteristics of the transaction to reflect its actual nature.

The IRS may attempt to reallocate income between a closely held corporation and its shareholders based on several sets of rules, including the following:

Assignment-of-income rules that have been developed through the courts;
The allocation-of-income theory of Sec. 482; and
The rules for allocation of income between a personal service corporation and its employee-owners of Sec. 269A.

Income reallocation under the assignment - of - income doctrine is dependent on determining who earns or controls the income. Justice Oliver Wendell Holmes made the classic statement of the assignment - of - income doctrine when he stated that the Supreme Court would not recognize for income tax purposes an "arrangement by which the fruits are attributed to a different tree from that on which they grew" ( Lucas v. Earl , 281 U.S. 111, 115 (1930)).

Reallocation under Sec. 482 is used to prevent tax evasion or to more clearly reflect income when two or more entities are controlled by the same interests. Note the use of the word "or" in the preceding sentence. The Code empowers the IRS to allocate income even if tax evasion is not present if the allocation will more clearly reflect the income of the controlled interests. The intent of these provisions is to place the controlled entity in the same position as if it were not controlled so that the income of the controlled entity is clearly reflected (Regs. Sec. 1. 482 - 1 (a)) .

Example 1. Performing services for another group member: Corporations P and S are members of the same controlled group. S asks P to have its financial staff perform an analysis to determine S' s borrowing needs. P does not charge S for this service. Under Sec. 482, the IRS could adjust each corporation's taxable income to reflect an arm's - length charge by P for the services it provided to S .

Under Sec. 269A(a), the IRS has the authority to allocate income, deductions, credits, exclusions, and other items between a personal service corporation (PSC) and its employee - owners if:

The PSC performs substantially all of its services for or on behalf of another corporation, partnership, or other entity; and
The PSC was formed or used for the principal purpose of avoiding or evading federal income tax by reducing the income or securing the benefit of any expense, deduction, credit, exclusion, or other item for any employee-owner that would not otherwise be available.

A PSC will not be considered to have been formed or availed of for the principal purpose of avoiding or evading federal income taxes if a safe harbor is met. The safe harbor applies if the employee - owner's federal income tax liability is not reduced by more than the lesser of (1) $2,500 or (2) 10% of the federal income tax liability of the employee - owner that would have resulted if the employee - owner personally performed the services (Prop. Regs. Sec. 1. 269A - 1 (c)).

For purposes of this rule, a PSC is a corporation, the principal activity of which is the performance of personal services when those services are substantially performed by employee - owners (Sec. 269A(b)(1)). An employee - owner is any employee who owns on any day during the tax year more than 10% of the PSC's outstanding stock. As with many related - party provisions, the Sec. 318 stock attribution rules (with modifications) apply in determining stock ownership (Sec. 269A(b)(2)).

Example 2. Reallocation of income: H forms M Corp., which is a PSC. A few months later, he transfers shares of stock of an unrelated corporation to M . The following year, M receives dividends from the unrelated corporation and claims the Sec. 243(a) 50% dividend exclusion. The IRS may reallocate the dividend income from M to H if the principal purpose of the transfer of the unrelated stock to M was to use the 50% dividend exclusion under Sec. 243. However, the amounts to reallocate to H must exceed the safe - harbor amounts.

These rules usually apply when an individual performs personal services for an employer that does not offer tax - advantaged employee benefits (such as a qualified retirement plan and other employee fringe benefits). In those situations, the individual may set up a 100%- owned C corporation that contracts with the employer. The employer then pays the corporation. The individual functions as the employee of the corporation, and the corporation sets up tax - advantaged fringe benefit programs. The individual generally is able to "zero out" the income of the corporation with payments for salary and fringe benefits.

Despite the significant authority that Sec. 269A grants to the IRS, there is little evidence of the IRS or the courts using this statute. In a 1987 private letter ruling, the IRS held that a one - owner , one - employee medical corporation did not violate the statute, even though it retained only nominal amounts of taxable income, and the corporate structure allowed the individual to achieve a significant pension plan deduction. These facts were not sufficient to establish a principal purpose of tax avoidance (IRS Letter Ruling 8737001). In Sargent , 929 F.2d 1252 (8th Cir. 1991), the Eighth Circuit indicated a lack of interest in applying Sec. 269A because, in that case, the court felt the PSC had been set up for other legitimate reasons.

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations , 31st Edition (March 2018), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com ).

Recent developments in Sec. 355 spinoffs

The research credit: documenting qualified services, income tax treatment of loyalty point programs, tax court rules cancellation of debt is part of gain realization, listing of reportable transactions under the apa.

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.

PRACTICE MANAGEMENT

CPAs assess how their return preparation products performed.

A Tax Planning Cautionary Tale: Timing and Formalities Are Critical

A business owner learned the hard way (and at great cost) not to dawdle or cut corners when it comes to tax plans involving the sale of a business.

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A red alarm clock sits atop stacks of coins of varying heights.

This cautionary tale is based upon the recent tax case of Estate of Hoensheid v Commissioner , TC Memo 2023-34. When owners of a company plan to sell their business, there is very often a desire to minimize the resultant income tax. This tax is effectively taxing the increase in the value of the business often earned over many years and decades into a single year. The resultant tax will often be at the highest marginal rate, substantially reducing the net proceeds to the seller.

Many of the tools used to minimize income tax in this situation have a charitable giving component. When properly planned and implemented, three separate goals are achieved.

First, a portion of the otherwise taxable gain on the sale becomes nontaxable because a portion of the asset being sold is transferred to an IRS-recognized charitable structure.

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Second, there is an income tax deduction equal to the fair market value of the appreciated asset contributed to the charitable structure. This compounds the economic value of the tax savings structure. A portion of the gain is sold tax-free by the charitable organization, and the seller receives a charitable deduction equal to the fair market value of the asset contributed. For example, if we are selling a company for a $20 million taxable gain, we could expect a tax of $6 million based upon a 30% combined federal and state tax rate. This leaves net proceeds of $14 million.

Note also that the seller has no say in how the $6 million in tax is spent by the government. If we gift a portion of the company to an IRS-recognized charitable structure, then you could direct the funds to be used for the Wounded Warrior Project , the Make-A-Wish Foundation or any legitimate charitable cause that you wish. Note that those funds would need to be distributed to a 501(c)(3) charity focusing on that desired purpose.

If we transfer $5 million to a charitable structure before the sale, the taxable gain itself is now only $15 million. This is because the net gain is reduced by the $5 million contributed to charity. The stock owned by the charity is sold tax free. Then the taxable gain is further reduced by a charitable contribution deduction equal to the fair market value of the stock contributed to charity. This results in a net tax of approximately $3 million. However, this is only a small part of the story.

The third goal is where the magic happens. Contributing the appreciated asset to a well-planned charitable structure provides an economic benefit to the charity and builds substantial wealth for the family, typically due to the time value of money. These structures provide independent economic value or wealth to the family and to the charity. Careful consideration must be given to each client’s financial and nonfinancial goals.

These charitable structures are typically referred to by acronyms, leading to a veritable alphabet soup of alternatives: CRTs (charitable remainder trusts), CLTs (charitable lead trusts), PIFs (pooled income funds), CHLLCs (charitable limited liability companies), to name just a few overall categories. For my clients, we always recommend a structure that provides the client investment control of the funds while invested within the charitable structure. These structures can also provide significant asset protection for the client and their family.

An example of a $7 million investment into an intergenerational split interest trust PIF (a form of a pooled income fund) would provide the following results for a family where Dad is 49 years old and has kids ages 28, 24 and 11:

$7 million contribution
Income tax deduction: $2,171,200
Projected annual income of 6%: $420,000 per year to Dad for his entire life and, at his death, to his children for their entire lives
Client can maintain investment control
Trust can own investment income real estate, if desired

Alternatively, a $3 million investment into a deferred inheritance trust (a form of CLAT) could provide an overall benefit to the family of over $16 million. The charity would also receive over $8 million. A dollar-for-dollar income tax deduction is provided of $3 million. This provides an estimated tax savings of $1,289,100. With the tax savings, the net cost of the $3 million investment is only $1,710,900.

Here’s how that would work: The client invests $3 million into the deferred inheritance trust. Of that amount, $150,000 is invested in municipal bonds to pay the required annual charitable distributions. $2,850,000 is used to acquire a life insurance policy within the deferred inheritance trust. This will provide over $8 million to the charity and almost $17 million to the client’s children, income- and estate-tax-free.

These are only a few of the economic possibilities available with this type of planning. The key is to first identify your financial and nonfinancial goals, such as establish minimum cash flow and not worth needs. Goals may include providing predictable safe, risk-free income for yourself and your kids or other loved ones, or asset protection for yourself or your loved ones. Then identify the alternatives that best satisfy those goals.

What was lost in the case of Estate of Hoensheid v Commissioner

Any possible benefit from the above type of planning was lost to the owners of Commercial Steel Treaty Corporation (CSTC). CSTC was owned by the taxpayer in the case and his two brothers (collectively, the business owners). The loss in planning benefits is directly attributable to the taxpayer’s own conduct and behavior in waiting too long to implement and trying to save money on appraisal costs.

The business owners received a letter of intent on April 2015 from a buyer who would pay $92 million for their company. The business owners wished to make a contribution to utilize the type of tax planning referred to above, but only if the sale of the company actually closed or was completed. In correspondence with the tax attorney, the brothers indicated that they wanted to “wait as long as possible to pull the trigger” on the contributor. In part, because if the sale did not go through, then the contributor would own less stock than his two brothers and have less control over the company.

The stock was contributed to Fidelity Charitable two days before the sale actually closed. The taxpayer (probably hoping to save a few dollars) did not hire an IRS-recognized and qualified appraiser.

The court relied upon the “assignment of income doctrine” to determine that the sale had progressed too far for Fidelity Charitable to be an owner for income tax purposes. This means that the entire gain, including the portion transferred to Fidelity Charitable, is deemed owned by and taxed entirely to the taxpayer at closing for income tax purposes. In other words, the sale or deal was virtually certain to close or be completed even though the sale did not formally close for two more days.

The assignment of income doctrine is a long-standing “first principle of income taxation” that recognizes that income is taxed to those “who earn or otherwise create the right to receive it” and that tax cannot be avoided by “anticipatory arrangements and contracts however skillfully devised.” The court believed that the charitable transfer of stock was subject to a pending, pre-negotiated transaction with a fixed right to proceeds in the transaction. The court did not believe that Fidelity Charitable or the taxpayer had any meaningful risk that the sale would not close.

A qualified appraisal is important, emphasis on ‘qualified’

The case itself is replete with damaging correspondence and testimony evidence that the taxpayer did not wish to contribute any amount if the sale did not close. The result is that our first goal above was lost because the entire sale was taxable to the owner. The court then went further and denied the charitable contribution deduction itself. The taxpayer did not comply with the regulatory requirements to substantiate the deductions found in Internal Revenue Code Section 170 . In particular, the court determined that the taxpayer did not obtain a “qualified appraisal.” The taxpayer obtained a price quote from a qualified appraiser, but used an unqualified, presumably cheaper, alternative.

The bottom-line result was particularly harsh for the taxpayer. Fidelity Charitable was contractually entitled to a portion of the sale proceeds even though the entire gain was taxable to the business owner. The business owner was also not even entitled to the charitable contribution deduction due to the failure to have a qualified appraiser/appraisal. Definitely not the desired economic result for the taxpayer and his family.

Three lessons to learn from this case

1. All planning should be implemented far sooner. All planning particularly charitable and noncharitable alternatives involving a transfer of ownership prior to the sale must be completed well before the formal closing of the sale or deal. If the sale or deal has progressed too far, you run the risk of any presale transfers being disregarded for tax purposes under the assignment of income doctrine. “Too far” means there is a meaningful possibility that the sale will not actually close.

The issuance of a letter of intent (LOI), which is not typically binding, begins a countdown for completion. Try to implement the plan before the LOI is issued, even though the LOI is subject to negotiation. Note that the best planning is done long before the sale is in progress. Some of the best results are obtained by planning at least two years prior to the sale.

2. Seek a qualified tax attorney’s advice. A qualified tax attorney can guide you through the maze of decisions involved with business sales. Note that many mergers and acquisitions attorneys specifically say that they do not give tax advice. Retain and listen to the advice of your tax attorney. Be candid about concerns that you may have, such as the possibility that the sale may not close. Creative solutions may be available.

3. Carefully follow the IRS rules for the tax planning or structure. In tax planning and in life, we should strive to minimize risk and maximize benefits. Here, the taxpayer did not bother to use an IRS-qualified appraiser.

The appraisal itself did not include a statement that the appraisal was prepared for federal tax purposes, included an incorrect date of contribution (possibly as a result of the application of the assignment of income doctrine), included a premature date of appraisal, did not adequately describe the method of valuation, was not even signed by the appraiser, did not include the appraiser’s qualifications, did not describe the property contributed in sufficient detail, and did not include an explanation of the specific basis for the valuation.

The simplest advice here is to dot the i’s and cross the t’s on a timely basis. The cheapest advice may actually be the more expensive, as happened here.

Gross Income: Tax Benefit, Claim of Right and Assignment of Income (Portfolio 502)

The Portfolio, Gross Income: Tax Benefit, Claim of Right and Assignment of Income, addresses three areas of gross income that are substantially judicial in origin and nature.

Description

The Bloomberg Tax Portfolio, Gross Income: Tax Benefit, Claim of Right and Assignment of Income, No. 502, addresses three areas of gross income that are substantially judicial in origin and nature. It analyzes in depth the nature, concept, scope, and application of the tax benefit doctrine, the claim of right doctrine, and the assignment of income doctrine.

The tax benefit doctrine excludes from a taxpayer’s gross income any recovery or refund of an amount deducted in a prior taxable year to the extent the deduction did not reduce tax liability. Under the claim of right doctrine, a taxpayer must include in gross income for the year of receipt any income received under a claim of right free of restrictions.

Under the assignment of income doctrine, gross income from personal services must be included in the gross income of the person who rendered the services. In addition, under that doctrine, gross income from property must be included in the gross income of the person who beneficially owns the property.

The Worksheets include relevant legislative history for provisions discussed in detail and for which regulations have not yet been issued.

I. Introduction II. Tax Benefit Doctrine III. Claim of Right Doctrine IV. Assignment of Income

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What Happens if you Assign your Income?

There are some instances when a person may choose to assign a portion of their income to another individual. You may be able to do this by asking your employer to send your paycheck directly to a third party.

It should be noted, however, that if you choose to assign your income to a third party, then this does not mean that you will be able to avoid paying taxes on that income. In other words, you will still be responsible for paying taxes on that income regardless of whether you decide to assign your income to a third party or not. This guideline is known as the “assignment of income doctrine.”

The primary purpose of the “assignment of income doctrine” is to ensure that a person does not simply assign their income to a third party to avoid having to pay taxes. If they do, then they can be charged and convicted of committing tax evasion .

One other important thing to bear in mind about income assignments is that they are often confused with the concept of wage garnishments. However, income or wage assignments are different from wage garnishments. In a situation that involves wage garnishment, a person’s paycheck is involuntarily withheld from them to pay off a debt like outstanding child support payments and is typically ordered by a court.

In contrast, an income or wage assignment is when a person voluntarily agrees to assign their income to someone else through a contract or a similar type of agreement.

How is Assigned Income Taxed?

Are there any exceptions, should i consult with an attorney.

As previously discussed, a taxpayer will still be required to pay taxes on any income that is assigned to a third party. The person who earns the income is the one who will be responsible for paying taxes on the income, not the person to whom it is assigned. The same rule applies to income that a person receives from property or assets.

For example, if a person earns money through a source of what is considered to be a passive stream of income, such as from stock dividends, the person who owns these assets will be the one responsible for paying taxes on the income they receive from it. The reason for this is because income is generally taxed to the person who owns any income-generating property under the law.

If a person chooses to give away their income-generating property and/or assets as a gift to a family member, then they will no longer be taxed on any income that is earned from those property or assets. This rule will be triggered the moment that the owner has given up their complete control and rights over the property in question.

In order to demonstrate how this might work, consider the following example:

Instead, the person to whom the apartment building was transferred will now be liable for paying taxes on any income they receive from tenants paying rent to live in the building since they are the new owner.

There is one exception to the rule provided by the assignment of income doctrine and that is when income is assigned in a scenario that involves a principal-agent relationship . For example, if an agent receives income from a third-party that is intended to be paid to the principal, then this income is usually not taxable to the agent. Instead, it will be taxable to the principal in this relationship.

Briefly, an agent is a person who acts on behalf of another (i.e., the principal) in certain situations or in regard to specific transactions. On the other hand, a principal is someone who authorizes another person (i.e., the agent) to act on their behalf and represent their interests under particular circumstances.

For example, imagine a sales representative that is employed by a large corporation. When the sales representative sells the corporation’s product or service to a customer, they will receive money from the customer in exchange for that service or product. Although the sales representative is the one being paid in the transaction, the money actually belongs to the corporation. Thus, it is the corporation who would be liable for paying taxes on the income.

In other words, despite the fact that this income may appear to have been earned by the corporation’s agent (i.e., the sales representation in this scenario), the corporation (i.e., the principal) will still be taxed on the income since the sales representative is acting on behalf of the corporation to generate income for them.

One other exception that may apply here is known as a “kiddie tax.” A kiddie tax is unearned or investment-related income that belongs to a child, but must be paid by the earning child’s parent and at the tax rate assigned to adults (as opposed to children). This is also to help prevent parents from abusing the tax system by using their child’s lower tax rate to shift over assets or earned income and take advantage of their child’s lower tax bracket rate.

So, even though a parent has assigned money or assets to a child that could be considered their earned income, the money will still have to be paid by the parent and taxed at a rate that is reserved for adults. The child will not need to pay any taxes on this earned income until it reaches a certain amount.

In general, the tax rules that exist under the assignment of income doctrine can be confusing. There are several exceptions to these rules and many of them require knowing how to properly apply them to the specific facts of each individual case.

Therefore, if you have any questions about taxable income streams or are involved in a dispute over taxable income with the IRS, then it may be in your best interest to contact an accountant or a local tax attorney to provide further guidance on the matter. An experienced tax attorney can help you to avoid incurring extra tax penalties and can assist you in resolving your income tax issue in an efficient manner.

Your attorney will also be able to explain the situation and can recommend various options to settle the assignment of income issue or any related concerns. In addition, your attorney will be able to communicate with the IRS on your behalf and can provide legal representation if you need to appear in court.

Lastly, if you think you are not liable for paying taxes on income that has been assigned to you by someone else, then your lawyer can review the facts of your claim and can find out whether you may be able to avoid having to pay taxes on that income.

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ASSIGNMENT OF INCOME DOCTRINE – SECTION 61 INTERNAL REVENUE CODE – J. RONALD JACKSON

I don’t want to pay tax on this income, assignment of income doctrine.

By: J Ronald “Ron” Jackson, MBA, CPA

Under federal income tax law gross income is taxed to the person who earns it or to the owner of property that generates the income. It is not uncommon for a high tax bracket taxpayer to want to shift income to a lower tax bracket family member in order to save on taxes and the income stay within the family unit. Alternatively, one who has appreciated stock or other type of property that he knows will be sold in the near future may wish to save on income taxes by gifting a portion of the property to a lower tax bracket family member who will report the sale at his or her lower income tax bracket. Alternatively, the individual may want a double benefit by gifting the appreciated property to a qualified charity thereby gaining a charitable income tax deduction for the value of the contributed property and being relieved of paying income taxes on the gain from the sale of the gifted property. This shifting of income, if permitted for income tax purposes, may provide considerable income tax savings.

The assignment of income doctrine was developed from court decisions which decided the issues, including the various methods employed in attempting to determine who earned the income. There was a time during the World War II years and thereafter, until around 1963, that the top income tax brackets could be as high as 91% – 93%. In addition to family members, the issues often arose when a high bracket taxpayer would make a gift of property (often the issues were gifts of appreciated stock that were to be sold shortly) to a qualified charity. The taxpayer would then take a charitable income tax deduction and not report the gain as he no longer owned the stock when sold. This shifting of income to a lower bracket taxpayer could have large savings in taxes for the high bracket taxpayer.

A simple example of income earned and taxed to the one who earns the income is when one works for weekly wages. The work week ends on Friday but the actual paycheck is not delivered until the following Wednesday. The wages are earned, for income tax purposes, at the end of the week (Friday). If the individual tells his employer to pay the earned wages to the individual’s mother, and the employer did that, the wages would still be taxed for federal income tax purposes to the individual since he earned the wages. The fact he may have made a gift of his earned wages does not change the income tax treatment as his employer has to include the earned wages on the individual’s W-2 form.

The above is a simple illustration of the doctrine that one who earns the income has to pay income tax on the wages. Let’s look at another situation. Suppose Perry, an individual taxpayer, owns all of the stock ownership in a very successful corporation (Company A) that he has run for many years. Perry is approached by the owners of another corporation (Company B) with an interest in purchasing Perry’s stock ownership in Company A. Negotiations have progressed and a total value has been tentatively negotiated of $5,000,000.00. The actual contract is still to be finalized and there are some remaining details to settle. Perry believes it will be finalized and signed within a reasonably short time. Perry, who is in a very high federal income tax bracket and who is a very civic-minded individual, has been told of the benefit of donating appreciated property to charity. Perry contacts the local Community Foundation and arranges to create the Perry Charitable Fund through the Community Foundation. The charitable fund will provide donations to his church and to other qualified charities that Perry usually supports. Perry then donates fifteen percent of his stock ownership, valued at $750,000.00 to the Community Foundation. Later after negotiations are completed, all of Company A’s stock is sold to Company B for the negotiated price of $5,000,000.00. Perry is happy. He has made a substantial profit from his years of work, made a donation to his favorite charity for which he plans to take a charitable income tax deduction, and will only have to report and pay income tax at capital gain rates on 85% of his stock as he has given 15% away.

Perry files his income tax return for the year and reports his taxable gain on the sale of his 85% ownership interest in Company A. About one year later Perry is audited by the IRS. The IRS agent questions why he did not report gain on the 15% of stock given to the Foundation. Perry replies that he did not own the stock as it was gifted to the charity before the date of the sale. The IRS auditor states that Perry should pay income tax on the gain on the stock given to the Community Foundation since it appears to have been a “done deal” before Perry gave the stock away and for that reason Perry owes income tax on all of the stock. Perry argues that no contracts were signed until weeks after the gift and that the deal could have fallen through at any time before signed by all parties. Perry disagreed with the audit. His tax dispute is now pending before the United States Tax Court. How will the court decide?

Section 61 of the Internal Revenue Code provides that gross income means all income earned from whatever source derived, and then lists several examples such as wages, services rendered, gains from the sales of property, and several other examples. In 1930, the U. S. Supreme Court summarized when addressing who earned income that “The fruits cannot be attributed to a different tree from that on which they grew.” Lucas v. Earl, 281 U.S. 111 (1930). This in effect clarified that gross income is to be taxed to the one that earns it and led to the fact that one cannot avoid paying income tax on earned income by gifting the property that created the income when it has been earned on or before the gift. An example would be when a corporation declares a dividend payable say on November 1st to stockholders of record on October 10th. A stockholder who owned the stock on October 10th is the one who has earned the income even if he or she sells or assigns their stock between October 10th and November 1st. The dividend is taxed to the owner on October 10, the date the dividend was declared.

In Perry’s case he argues that the negotiations were not complete when he made his gift, and that Company B could have backed out of the deal. When the court decides it will consider the stage of the negotiations, whether Company B had the financial backing to complete the deal, whether any contracts or preliminary statements of intent were prepared for review, and how long was the interval between the tentative agreement and the actual sale will all be considered. Situations like these happen from time to time. When the issue arises, it should be discussed in advance of the transaction, if possible, with your legal tax advisors who should be well versed in this area of tax law. One should be aware of the assignment of income doctrine in situations where it could apply in connection with his/her estate planning. What if this had been a publicly traded company?

If you have questions regarding Assignment of Income Doctrine and would like to discuss these issues, please contact Cody Walls, MBA, CPA at Denton Law Firm at 270-450-8253.

THIS ARTICLE IS DESIGNED TO PROVIDE GENERAL INFORMATION PREPARED BY THE PROFESSIONALS AT DENTON LAW FIRM, PLLC IN REGARD TO THE SUBJECT MATTER COVERED. IT IS PROVIDED WITH THE UNDERSTANDING THAT THE AUTHOR IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICE. ALTHOUGH PREPARED BY PROFESSIONALS, THESE MATERIALS SHOULD NOT BE UTILIZED AS A SUBSTITUTE FOR PROFESSIONAL SERVICE IN SPECIFIC SITUATIONS. IF LEGAL ADVICE OR OTHER EXPERT ASSISTANCE IS REQUIRED, THE SERVICE OF A PROFESSIONAL SHOULD BE SOUGHT.

Frost Brown Todd

Section 1202 Planning: When Might the Assignment of Income Doctrine Apply to a Gift of QSBS?

US dollars in a white envelope on a wooden table. The concept of income, bonuses or bribes. Corruption, salary, bonus.

Jan 26, 2022

Categories:

Blogs Qualified Small Business Stock (QSBS) Tax Law Defined™ Blog

Scott W. Dolson

Section 1202 allows taxpayers to exclude gain on the sale of QSBS if all eligibility requirements are met. Section 1202 also places a cap on the amount of gain that a stockholder is entitled to exclude with respect to a single issuer’s stock. [i] A taxpayer has at least a $10 million per-issuer gain exclusion, but some taxpayer’s expected gain exceeds that cap. In our article Maximizing the Section 1202 Gain Exclusion Amount , we discussed planning techniques for increasing, and in some cases multiplying, the $10 million gain exclusion cap through gifting QSBS to other taxpayers. [ii] Increased awareness of this planning technique has contributed to a flurry of stockholders seeking last-minute tax planning help. This article looks at whether you can “multiply” Section 1202’s gain exclusion by gifting qualified small business stock (QSBS) when a sale transaction is imminent.

This is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice.  Much of this interest can be attributed to the reduction in the corporate rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion.  Recently proposed tax legislation sought to curb Section 1202’s benefits, but that legislation, along with the balance of President Biden’s Build Back Better bill, is currently stalled in Congress.

The Benefits of Gifting QSBS

Section 1202(h)(1) provides that if a stockholder gifts QSBS, the recipient of the gift is treated as “(A) having acquired such stock in the same manner as the transferor, and (B) having held such stock during any continuous period immediately preceding the transfer during which it was held (or treated as held under this subsection by the transferor.” This statute literally allows a holder of $100 million of QSBS to gift $10 million worth to each of nine friends, with the result that the holder and his nine friends each having the right to claim a separate $10 million gain exclusion. Under Section 1202, a taxpayer with $20 million in expected gain upon the sale of founder QSBS can increase the overall tax savings from approximately $2.4 million (based on no Federal income tax on $10 million of QSBS gain) to $4.8 million (based on no Federal income tax on $20 million of QSBS gain) by gifting $10 million worth of QSBS to friends and family. [iii]

A reasonable question to ask is whether it is ever too late to make a gift of QSBS for wealth transfer or Section 1202 gain exclusion cap planning? What about when a sale process is looming but hasn’t yet commenced? Is it too late to make a gift when a nonbinding letter of intent to sell the company has been signed? What about the situation where a binding agreement has been signed but there are various closing conditions remaining to be satisfied, perhaps including shareholder approval? Finally, is it too late to make a gift when a definitive agreement has been signed and all material conditions to closing have been satisfied?

Although neither Section 1202 nor any other tax authorities interpreting Section 1202 address whether there are any exceptions to Section 1202’s favorable treatment of gifts based on the timing of the gift, the IRS is not without potential weapons in its arsenal.

Application of the Assignment of Income Doctrine

If QSBS is gifted in close proximity to a sale, the IRS might claim that the donor stockholder was making an anticipatory assignment of income. [iv]

As first enunciated by the Supreme Court in 1930, the anticipatory assignment of income doctrine holds that income is taxable to the person who earns it, and that such taxes cannot be avoided through “arrangement[s] by which the fruits are attributed to a different tree from that on which they grew.” [v] Many assignment of income cases involve stock gifted to charities immediately before a prearranged stock sale, coupled with the donor claiming a charitable deduction for full fair market value of the gifted stock.

In Revenue Ruling 78-197, the IRS concluded in the context of a charitable contribution coupled with a prearranged redemption that the assignment of income doctrine would apply only if the donee is legally bound, or can be compelled by the corporation, to surrender shares for redemption. [vi] In the aftermath of this ruling, the Tax Court has refused to adopt a bright line test but has generally followed the ruling’s reasoning. For example, in Estate of Applestein v. Commissioner , the taxpayer gifted to custodial accounts for his children stock in a corporation that had entered into a merger agreement with another corporation. Prior to the gift, the merger agreement was approved by the stockholders of both corporations. Although the gift occurred before the closing of the merger transaction, the Tax Court held that the “right to the merger proceeds had virtually ripened prior to the transfer and that the transfer of the stock constituted a transfer of the merger proceeds rather than an interest in a viable corporation.” [vii] In contrast, in Rauenhorst v. Commissioner , the Tax Court concluded that a nonbinding letter of intent would not support the IRS’ assignment of income argument because the stockholder at the time of making the gift was not legally bound nor compelled to sell his equity. [viii]

In Ferguson v. Commissioner , the Tax Court focused on whether the percentage of shares tendered pursuant to a tender offer was the functional equivalent of stockholder approval of a merger transaction, which the court viewed as converting an interest in a viable corporation to the right to receive cash before the gifting of stock to charities. [ix] The Tax Court concluded that there was an anticipatory assignment of income in spite of the fact that there remained certain contingencies before the sale would be finalized. The Tax Court rejected the taxpayer’s argument that the application of the assignment of income doctrine should be conditioned on the occurrence of a formal stockholder vote, noting that the reality and substance of the particular events under consideration should determine tax consequences.

Guidelines for Last-Minute Gifts

Based on the guidelines established by Revenue Ruling 78-197 and the cases discussed above, the IRS should be unsuccessful if it asserts an assignment of income argument in a situation where the gift of QSBS is made prior to the signing of a definitive sale agreement, even if the company has entered into a nonbinding letter of intent. The IRS’ position should further weakened with the passage of time between the making of a gift and the entering into of a definitive sale agreement. In contrast, the IRS should have a stronger argument if the gift is made after the company enters into a binding sale agreement. And the IRS’ position should be stronger still if the gift of QSBS is made after satisfaction of most or all material closing conditions, and in particular after stockholder approval. Stockholders should be mindful of Tax Court’s comment that the reality and substance of events determines tax consequences, and that it will often be a nuanced set of facts that ultimately determines whether the IRS would be successful arguing for application of the assignment of income doctrine.

Transfers of QSBS Incident to Divorce

The general guidelines discussed above may not apply to transfers of QSBS between former spouses “incident to divorce” that are governed by Section 1041. Section 1041(b)(1) confirms that a transfer incident to divorce will be treated as a gift for Section 1202 purposes. Private Letter Ruling 9046004 addressed the situation where stock was transferred incident to a divorce and the corporation immediately redeemed the stock. In that ruling, the IRS commented that “under section 1041, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of the asset. The spouses are thus free to negotiate between themselves whether the ‘owner’ spouse will first sell the asset, recognize the gain or loss, and then transfer to the transferee spouse the proceeds from the sale, or whether the owner spouse will first transfer the asset to the transferee spouse who will then recognize gain or loss upon its subsequent sale.” Thus, while there are some tax cases where the assignment of income doctrine has been successfully asserted by the IRS in connection with transfers between spouses incident to divorce, Section 1041 and tax authorities interpreting its application do provide divorcing taxpayers an additional argument against application of the doctrine, perhaps even where the end result might be a multiplication of Section 1202’s gain exclusion.

More Resources

In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning. Venture capitalists, founders and investors who want to learn more about QSBS planning opportunities are directed to several articles on the Frost Brown Todd website:

Planning for the Potential Reduction in Section 1202’s Gain Exclusion
Section 1202 Qualification Checklist and Planning Pointers
A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
Maximizing the Section 1202 Gain Exclusion Amount
Advanced Section 1045 Planning
Recapitalizations Involving Qualified Small Business Stock
Section 1202 and S Corporations
The 21% Corporate Rate Breathes New Life into IRC § 1202
View all QSBS Resources

Contact  Scott Dolson  or  Melanie McCoy  (QSBS estate and trust planning) if you want to discuss any QSBS issues by telephone or video conference.

[i] References to “Section” are to sections of the Internal Revenue Code.

[ii] The planning technique of gifting QSBS recently came under heavy criticism in an article written by two investigative reporters. See Jesse Drucker and Maureen Farrell, The Peanut Butter Secret: A Lavish Tax Dodge for the Ultrawealthy. New York Times , December 28, 2021.

[iii] But in our opinion, in order to avoid a definite grey area in Section 1202 law, the donee should not be the stockholder’s spouse. The universe of donees includes nongrantor trusts, including Delaware and Nevada asset protection trusts.

[iv] This article assumes that the holder of the stock doesn’t have sufficient tax basis in the QSBS to take advantage of the 10X gain exclusion cap – for example, the stock might be founder shares with a basis of .0001 per share.

[v] Lucas v. Earl , 281 U.S. 111 (1930). The US Supreme Court later summarized the assignment of income doctrine as follows: “A person cannot escape taxation by anticipatory assignments, however skillfully devised, where the right to receive income has vested.” Harrison v. Schaffner , 312 U.S. 579, 582 (1941).

[vi] Revenue Ruling 78-197, 1978-1 CB 83.

[vii] Estate of Applestein v. Commissioner , 80 T.C. 331, 346 (1983).

[viii] Gerald A. Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[ix] Ferguson v. Commissioner , 108 T.C. 244 (1997).

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Tax Alert | Tax Court Guidance on Charitable Contributions and Assignment of Income

February 26, 2024

Tax Court Guidance on Charitable Contributions and Assignment of Income

Today is the first of two alerts dealing with the Estate of Hoensheid v. Commissioner of Internal Revenue, T.C. Memo 2023-34 (2023). In this, the first, the standard for determining whether a taxpayer has made an anticipatory assignment of income is discussed. The judicially created anticipatory assignment of income doctrine recognizes that income is taxed to those who earn or otherwise create the right to receive it and that it cannot be assigned or gifted away.

Hoensheid involves a common fact pattern. The taxpayer was one of three owners of a closely held business, wishing to both sell and to contribute part or all of the proceeds to a tax exempt charity or donor advised fund, the assignee. If properly structured, the owner receives a charitable deduction equal to the fair market value of the contributed property and the built in gain on the investment is taxed to the charity. In order to do so, the owner must contribute the ownership interest (in this case 1380 shares of stock) to the charity, but when? Like most owners, the taxpayer in Hoensheid wanted to wait as long as possible before making the actual contribution. During the course of the negotiations concerning the sale, the taxpayer was advised that the contribution had to be completed before any purchase agreement was executed. This is referred to the binding agreement test and has its origin in Rev. Rul. 78-197. If you contribute before the purchase agreement is signed, no anticipatory assignment. If you contribute after the purchase agreement is signed, anticipatory assignment. It provides a bright line for taxpayers. But is it that simple? The Tax Court first analyzed the requirements under state law to determine when the gift was completed. It concluded the gift took place on July 13, 2015 two days before the signing of the SPA on July 15, 2015 seemingly within the bright line test of Rev. Rul. 78-197. The Tax Court agreed that the gift occurred before the sale and that the charity was not obligated to sell at the time of the gift, but that although the donee’s legal obligation to sell is significant to the assignment of income analysis, it was only one factor.

In short, there is no bright line but there are multiple factors in an assignment of income analysis of a fact pattern. Instead, the ultimate question is whether the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in the property at the time of transfer. If the sale was virtually certain to occur, the anticipatory assignment of income doctrine is satisfied and the taxpayer, not the charity, is taxed on the sales proceeds from the charities sale.

In this case, the relevant factors in determining whether the sale of shares were virtually certain to occur include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transactions.

With regard to the first factor, the Tax Court held that there was no proof of any obligation of the charity to sell the shares either formal or informal. This was a favorable factor for the taxpayer.

With regard to the second factor, the Tax Court found that their were bonus and shareholder distributions made before the SPA was executed. This factor indicates that the income was earned at an earlier point in time.

With regard to the third factor, the Tax Court found that there were major transactional contingencies (environmental obligations) but that they had been resolved before the SPA was executed. This factor indicates that the income was earned at an earlier point in time.

With regard to the fourth factor, the Tax Court found that after the SPA was executed there were only ministerial actions remaining. This factor indicates that the income was earned at an earlier point in time.

The tax court, based on the various factors mentioned above that the income or gain from the sale was earned at an earlier point in time, resulting in the taxpayer being treated as the seller of the shares of stock purportedly gifted to the charity.

In summary, as the Tax Court found, to avoid an anticipatory assignment of income on the contribution of appreciated shares of stock followed by a sale of the donee, a donor must bear at least some risk at the time of contribution that the sale will not close. The bright line of Rev. Rul. 78-187 was a factor but compliance with that alone did not provide a safe harbor. Other factors needed to be considered to determine if the gain was earned before the sale and taxable to the donor.

If you are the owner of a closely held business and are contemplating a charitable gift of a portion of your ownership interest do not hesitate to contact either David Ritter, Stuart Gladstone, Bob Kosicki or Cheryl Ritter for guidance in dealing with the multiple factors set forth in the anticipatory assignment of income doctrine.

For more information or assistance, please contact:

David J. Ritter, Esq. , Member and Chair, Tax Practice , at [email protected] or 973-403-3117

Stuart M. Gladstone, Esq. , Member, Tax Practice , at [email protected] or 973-403-3109

Robert A. Kosicki, Esq. , Counsel, Tax Practice , at [email protected] or 973-403-3122

Cheryl L. Ritter, Esq. , Counsel, Tax Practice , at [email protected] or 973-364-8307

About Brach Eichler LLC

Brach Eichler LLC, is a full-service law firm based in Roseland, NJ. With over 80 attorneys, the firm is focused in the following practice areas: Healthcare Law; Real Estate; Litigation; Trusts and Estates; Corporate Transactions & Financial Services; Personal Injury; Criminal Defense and Government Investigations; Labor and Employment; Environmental and Land Use; Family Law Services; Patent, Intellectual Property & Information Technology; Real Estate Tax Appeals; Tax; and Cannabis Law. Brach Eichler attorneys have been recognized by clients and peers alike in The Best Lawyers in America©, Chambers USA, and New Jersey Super Lawyers. For more information, visit www.bracheichler.com .

This alert is intended for informational and discussion purposes only. The information contained in this alert is not intended to provide, and does not constitute legal advice or establish the attorney/client relationship by way of any information contained herein. Brach Eichler LLC does not guarantee the accuracy, completeness, usefulness or adequacy of any information contained herein. Readers are advised to consult with a qualified attorney concerning the specifics of a particular situation.

Related Practices: Tax

Related Attorney: Cheryl L. Ritter , David J. Ritter , Stuart M. Gladstone , Robert A. Kosicki

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Anticipatory assignment of income, charitable contribution deduction, and qualified appraisals.

Estate of Hoenshied v. Comm’r, T.C. Memo. 2023-34 | March 15, 2023 | Nega, J. | Dkt. No. 18606-19

Summary: In this 49-page opinion the Tax Court addresses a deficiency arising from the charitable contribution of appreciated shares of stock in a closely held corporation to a charitable organization that administers donor-advised funds for tax-exempt purposes under section 501(c)(3). The contribution in issue was made near contemporaneously with the selling of those shares to a third party. The timeline (truncated heavily for this blog) is as follows:

On June 11, 2015, the shareholders of the corporation in issue unanimously ratified the sale of all outstanding stock of the corporation. Immediately following the shareholder meeting, the corporation’s board of directors unanimously approved Petitioner’s request to be able to transfer a portion of his shares to Fidelity Charitable Gift Fund, a tax-exempt charitable organization under section 501(c)(3). Thereafter, the corporation and the purchaser of shares continued drafting and revising the Contribution and Stock Purchase Agreement.

On July 13, 2015, Fidelity Charitable first received a stock certificate from Petitioner.

On July 14, 2015, the Contribution and Stock Purchase Agreement was revised to specify that Petitioner contributed shares to Fidelity Charitable on July 10, 2015, and on July 15, 2015, the Contribution and Stock Purchase Agreement was signed and the transaction was funded.

Fidelity Charitable, having provided an Irrevocable Stock Power as part of the transaction, received $2,941,966 in cash proceeds from the sale, which was deposited in Petitioner’s donor-advised fund giving account.

On November 18, 2015, Fidelity Charitable sent Petitioner a contribution confirmation letter acknowledging a charitable contribution of the corporate shares and indicating that Fidelity Charitable received the shares on June 11, 2015.

In its 2015 tax return, Petitioner did not report any capital gains on the shares contributed to Fidelity Charitable but claimed a noncash charitable contribution deduction of $3,282,511. In support of the claimed deduction, a Form 8283 was attached to the return.

Petitioner’s 2015 tax return was selected for examination. The IRS issued to Petitioners a notice of deficiency, determining a deficiency of $647,489, resulting from the disallowance of the claimed charitable contribution deduction, and a penalty of $129,498 under section 6662(a).

Key Issues:

Whether and when Petitioners made a valid contribution of the shares of stock? Whether Petitioners had unreported capital gain income due to their right to proceeds from the sale of those shares becoming fixed before the gift? Whether Petitioners are entitled to a charitable contribution deduction? Whether Petitioners are liable for an accuracy-related penalty under section 6662(a) with respect to an underpayment of tax?

Primary Holdings:

(1) Petitioners failed to establish that any of the elements of a valid gift was present on June 11, 2015. No evidence was presented to credibly identify a specific action taken on June 11 that placed the shares within Fidelity Charitable’s dominion and control. Instead, the valid gift of shares was made by effecting delivery of a PDF of the certificate to Fidelity Charitable on July 13.

(2) Yes. None of the unresolved contingencies remaining on July 13, 2015 were substantial enough to have posed even a small risk of the overall transaction’s failing to close. Thus, Petitioners, through the doctrine of anticipatory assignment of income, had capital gains on the sale of the 1,380 appreciated shares of stock, even though Fidelity Charitable received the proceeds from that sale.

(3) No, Petitioners failed to show that the charitable contribution met the qualified appraisal requirements of section 170. The appraiser was not shown to be qualified, per regulations, at trial or in the appraisal itself, and the appraisal did not substantially comply with the regulatory requirements. “The failure to include a description of such experience in the appraisal was a substantive defect. . . . Petitioners’ failure to satisfy multiple substantive requirements of the regulations, paired with the appraisal’s other more minor defects, precludes them from establishing substantial compliance.” In addition, Petitioners failed to establish reasonable cause for failing to comply with the appraisal requirements “because petitioner knew or should have known that the date of contribution (and thus the date of valuation) was incorrect.” Thus, the IRS’s determination to disallow the charitable contribution deduction is sustained.

(4) No. While Petitioners did not have reasonable cause for their failure to comply with the qualified appraisal requirement, their liability for an accuracy-related penalty was a separate analysis, and the IRS did not carry the burden of proof. Petitioners did not follow their professional’s advice to have the paperwork for the contribution ready to go “well before the signing of the definitive purchase agreement.” But, Petitioners adhered to the literal thrust of the advice given: that “execution of the definitive purchase agreement” was the firm deadline to contribute the shares and avoid capital gains (even if that proved to be incorrect advice under the circumstances).

Key Points of Law:

Gross Income. Gross income means “all income from whatever source derived,” including “[g]ains derived from dealings in property.” 26 U.S.C. § 61(a)(3). In general, a taxpayer must realize and recognize gains on a sale or other disposition of appreciated property. See id. at § 1001(a)–(c). However, a taxpayer typically does not recognize gain when disposing of appreciated property via gift or charitable contribution. See Taft v. Bowers, 278 U.S. 470, 482 (1929); see also 26 U.S.C. § 1015(a) (providing for carryover basis of gifts). A taxpayer may also generally deduct the fair market value of property contributed to a qualified charitable organization. See 26 U.S.C. § 170(a)(1); Treas. Reg. 16 § 1.170A-1(c)(1). Contributions of appreciated property are thus tax advantaged compared to cash contributions; when a contribution of property is structured properly, a taxpayer can both avoid paying tax on the unrealized appreciation in the property and deduct the property’s fair market value. See, e.g., Dickinson v. Commissioner, T.C. Memo. 2020-128, at *5.

Donor-Advised Fund. The use of a donor-advised fund further optimizes a contribution by allowing a donor “to get an immediate tax deduction but defer the actual donation of the funds to individual charities until later.” Fairbairn v. Fid. Invs. Charitable Gift Fund, No. 18-cv-04881, 2021 WL 754534, at *2 (N.D. Cal. Feb. 26, 2021).

Two-Part Test to Determine Charitable Contribution of Appreciated Property Followed by Sale by Donee. The donor must (1) give the appreciated property away absolutely and divest of title (2) “before the property gives rise to income by way of a sale.” Humacid Co. v. Commissioner, 42 T.C. 894, 913 (1964). Valid Gift of Shares of Stock. “Ordinarily, a contribution is made at the time delivery is effected.” Treas. Reg. § 1.170A-1(b). “If a taxpayer unconditionally delivers or mails a properly endorsed stock certificate to a charitable donee or the donee’s agent, the gift is completed on the date of delivery.” Id. However, the regulations do not define what constitutes delivery, and the Tax Court evaluates applicable state law for the threshold determination of whether donors have divested themselves of their property rights via gift. See, e.g., United States v. Nat’l Bank of Com., 472 U.S. 713, 722 (1985). In determining the validity of a gift, Michigan law, for example (and as applied in Estate of Hoensheid), requires a showing of (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee, 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

Present Intent. The determination of a party’s subjective intent is necessarily a highly fact-bound issue. When deciding such an issue, the Tax Court must determine “whether a witness’s testimony is credible based on objective facts, the reasonableness of the testimony, the consistency of statements made by the witness, and the demeanor of the witness.” Ebert v. Commissioner, T.C. Memo. 2015-5, at *5–6. If contradicted by the objective facts in the record, the Tax Court will not “accept the self-serving testimony of [the taxpayer] . . . as gospel.” Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Delivery. Under Michigan law, the delivery requirement generally contemplates an “open and visible change of possession” of the donated property. Shepard v. Shepard, 129 N.W. 201, 208 (Mich. 1910). Manually providing tangible property to the donee is the classic form of delivery. Manually providing to the donee a stock certificate that represents intangible shares of stock is traditionally sufficient delivery. The determination of what constitutes delivery is context-specific and depends upon the “nature of the subject-matter of the gift” and the “situation and circumstances of the parties.” Shepard, 129 N.W. at 208. Constructive delivery may be effected where property is delivered into the possession of another on behalf of the donee. See, e.g., In re Van Wormer’s Estate, 238 N.W. 210, 212 (Mich. 1931). Whether constructive or actual, delivery “must be unconditional and must place the property within the dominion and control of the donee” and “beyond the power of recall by the donor.” In re Casey Estate, 856 N.W.2d 556, 563 (Mich. Ct. App. 2014). If constructive or actual delivery of the gift property occurs, its later retention by the donor is not sufficient to defeat the gift. See Estate of Morris v. Morris, No. 336304, 2018 WL 2024582, at *5 (Mich. Ct. App. May 1, 2018).

Delivery of Shares. Retention of stock certificates by donor’s attorney may preclude a valid gift. Also, a determination of no valid gift may occur where the taxpayer instructs a custodian of corporate books to prepare stock certificates but remained undecided about ultimate gift. In some jurisdictions, transfer of shares on the books of the corporation can, in certain circumstances, constitute delivery of an inter vivos gift of shares. See, e.g., Wilmington Tr. Co. v. Gen. Motors Corp., 51 A.2d 584, 594 (Del. Ch. 1947); Chi. Title & Tr. Co. v. Ward, 163 N.E. 319, 322 (Ill. 1928); Brewster v. Brewster, 114 A.2d 53, 57 (Md. 1955). The U.S. Court of Appeals for the Sixth Circuit has stated that transfer on the books of a corporation constitutes delivery of shares of stock, apparently as a matter of federal common law. See Lawton v. Commissioner, 164 F.2d 380, 384 (6th Cir. 1947), rev’g 6 T.C. 1093 (1946); Bardach v. Commissioner, 90 F.2d 323, 326 (6th Cir. 1937), rev’g 32 B.T.A. 517 (1935); Marshall v. Commissioner, 57 F.2d 633, 634 (6th Cir. 1932), aff’g in part, rev’g in part 19 B.T.A. 1260 (1930). The transfers on the books of the corporation were bolstered by other objective actions that evidenced a change in possession and thus a gift. See Jolly’s Motor Livery Co. v. Commissioner, T.C. Memo. 1957-231, 16 T.C.M. (CCH) 1048, 1073.

Acceptance. Donee acceptance of a gift is generally “presumed if the gift is beneficial to the donee.” Davidson, 575 N.W.2d at 576.

Anticipatory Assignment of Income. The anticipatory assignment of income doctrine is a longstanding “first principle of income taxation.” Commissioner v. Banks, 543 U.S. 426, 434 (2005). The doctrine recognizes that income is taxed “to those who earn or otherwise create the right to receive it,” Helvering v. Horst, 311 U.S. 112, 119 (1940), and that tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised,” Lucas v. Earl, 281 U.S. 111, 115 (1930). A person with a fixed right to receive income from property thus cannot avoid taxation by arranging for another to gratuitously take title before the income is received. See Helvering, 311 U.S. at 115–17; Ferguson, 108 T.C. at 259. This principle is applicable, for instance, where a taxpayer gratuitously assigns wage income that the taxpayer has earned but not yet received, or gratuitously transfers a debt instrument carrying accrued but unpaid interest. A donor will be deemed to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income. See Cold Metal Process Co. v. Commissioner, 247 F.2d 864, 872–73 (6th Cir. 1957), rev’g 25 T.C. 1333 (1956). The same principle is often applicable where a taxpayer gratuitously transfers shares of stock that are subject to a pending, prenegotiated transaction and thus carry a fixed right to proceeds of the transaction. See Rollins v. United States, 302 F. Supp. 812, 817–18 (W.D. Tex. 1969).

Determining Anticipatory Assignment of Income. In determining whether an anticipatory assignment of income has occurred with respect to a gift of shares of stock, the Tax Court looks to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities. See Jones v. United States, 531 F.2d 1343, 1345 (6th Cir. 1976) (en banc); Allen v. Commissioner, 66 T.C. 340, 346 (1976). In general, a donor’s right to income from shares of stock is fixed if a transaction involving those shares has become “practically certain to occur” by the time of the gift, “despite the remote and hypothetical possibility of abandonment.” Jones, 531 F.2d at 1346. The mere anticipation or expectation of income at the time of the gift does not establish that a donor’s right to income is fixed. The Tax Court looks to several other factors that bear upon whether the sale of shares was virtually certain to occur at the time of a purported gift as part of the same transaction. Relevant factors may include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transaction.

Corporate Formalities. Also relevant is the status of the corporate formalities necessary for effecting the transaction. See Estate of Applestein, 80 T.C. at 345–46 (finding that taxpayer’s right to sale proceeds from shares had “virtually ripened” upon shareholders’ approval of proposed merger agreement). Under Michigan law, a proposed plan to exchange shares must generally be approved by a majority of the corporation’s shareholders. Formal shareholder approval of a transaction has often proven to be sufficient to demonstrate that a right to income from shares was fixed before a subsequent transfer. However, such approval is not necessary for a right to income to be fixed, when other actions taken establish that a transaction was virtually certain to occur. See Ferguson, 104 T.C. at 262–63. Charitable Contribution Deduction. Section 170(a)(1) allows as a deduction any charitable contribution (as defined) payment of which is made within the taxable year. “A charitable contribution is a gift of property to a charitable organization made with charitable intent and without the receipt or expectation of receipt of adequate consideration.” Palmolive Bldg. Invs., LLC v. Commissioner, 149 T.C. 380, 389 (2017). Section 170(f)(8)(A) provides that “[n]o deduction shall be allowed . . . for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the contribution by the donee organization that meets the requirements of subparagraph (B).” For contributions of property in excess of $500,000, the taxpayer must also attach to the return a “qualified appraisal” prepared in accordance with generally accepted appraisal standards. 26 U.S.C. § 170(f)(11)(D) and (E). Contemporaneous Written Acknowledgement (“CWA”). A CWA must include, among other things, the amount of cash and a description of any property contributed. 26 U.S.C. § 170(f)(8)(B). A CWA is contemporaneous if obtained by the taxpayer before the earlier of either (1) the date the relevant tax return was filed or (2) the due date of the relevant tax return. Id. at § 170(f)(8)(C). For donor-advised funds, the CWA must include a statement that the donee “has exclusive legal control over the assets contributed.” 26 U.S.C. § 170(f)(18)(B). These requirements are construed strictly and do not apply the doctrine of substantial compliance to excuse defects in a CWA.

Qualified Appraisal for Certain Charitable Contributions. Section 170(f)(11)(A)(i) provides that “no deduction shall be allowed . . . for any contribution of property for which a deduction of more than $500 is claimed unless such person meets the requirements of subparagraphs (B), (C), and (D), as the case may be.” Subparagraph (D) requires that, for contributions for which a deduction in excess of $500,000 is claimed, the taxpayer attach a qualified appraisal to the return. Section 170(f)(11)(E)(i) provides that a qualified appraisal means, with respect to any property, an appraisal of such property which—(I) is treated for purposes of this paragraph as a qualified appraisal under regulations or other guidance prescribed by the Secretary, and (II) is conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed under subclause (I). The regulations provide that a qualified appraisal is an appraisal document that, inter alia, (1) “[r]elates to an appraisal that is made” no earlier than 60 days before the date of contribution and (2) is “prepared, signed, and dated by a qualified appraiser.” Treas. Reg. § 1.170A-13(c)(3)(i).

Qualified Appraisal Must Include: Treasury Regulation § 1.170A-13(c)(3)(ii) requires that a qualified appraisal itself include, inter alia:

(1) “[a] description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was (or will be) contributed;”

(2) “[t]he date (or expected date) of contribution to the donee;”

(3) “[t]he name, address, and . . . identifying number of the qualified appraiser;”

(4) “[t]he qualifications of the qualified appraiser;”

(5) “a statement that the appraisal was prepared for income tax purposes;”

(6) “[t]he date (or dates) on which the property was appraised;”

(7) “[t]he appraised fair market value . . . of the property on the date (or expected date) of contribution;” and

(8) the method of and specific basis for the valuation.

Qualified Appraiser. Section 170(f)(11)(E)(ii) provides that a “qualified appraiser” is an individual who (I) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations, (II) regularly performs appraisals for which the individual receives compensation, and (III) meets such other requirements as may be prescribed . . . in regulations or other guidance. An appraiser must also demonstrate “verifiable education and experience in valuing the type of property subject to the appraisal.” The regulations add that the appraiser must include in the appraisal summary a declaration that he or she (1) “either holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis;” (2) is “qualified to make appraisals of the type of property being valued;” (3) is not an excluded person specified in paragraph (c)(5)(iv) of the regulation; and (4) understands the consequences of a “false or fraudulent overstatement” of the property’s value. Treas. Reg. § 1.170A-13(c)(5)(i). The regulations prohibit a fee arrangement for a qualified appraisal “based, in effect, on a percentage . . . of the appraised value of the property.” Id. at subpara. (6)(i).

Substantial Compliance with Qualified Appraisal Requirements . The qualified appraisal requirements are directory, rather than mandatory, as the requirements “do not relate to the substance or essence of whether or not a charitable contribution was actually made.” See Bond v. Commissioner, 100 T.C. 32, 41 (1993). Thus, the doctrine of substantial compliance may excuse a failure to strictly comply with the qualified appraisal requirements. If the appraisal discloses sufficient information for the IRS to evaluate the reliability and accuracy of a valuation, the Tax Court may deem the requirements satisfied. Bond, 100 T.C. at 41–42. Substantial compliance allows for minor or technical defects but does not excuse taxpayers from the requirement to disclose information that goes to the “essential requirements of the governing statute.” Estate of Evenchik v. Commissioner, T.C. Memo. 2013-34, at *12. The Tax Court generally declines to apply substantial compliance where a taxpayer’s appraisal either (1) fails to meet substantive requirements in the regulations or (2) omits entire categories of required information.

Reasonable Cause to Avoid Denial of Charitable Contribution Deduction. Taxpayers who fail to comply with the qualified appraisal requirements may still be entitled to charitable contribution deductions if they show that their noncompliance is “due to reasonable cause and not to willful neglect.” 26 U.S.C. § 170(f)(11)(A)(ii)(II). This defense is construed similarly to the defense applicable to numerous other Code provisions that prescribe penalties and additions to tax. See id. at § 6664(c)(1). To show reasonable cause due to reliance on a professional adviser, the Tax Court generally requires that a taxpayer show (1) that their adviser was a competent professional with sufficient expertise to justify reliance; (2) that the taxpayer provided the adviser necessary and accurate information; and (3) that the taxpayer actually relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). “Unconditional reliance on a tax return preparer or C.P.A. does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise ‘[d]iligence and prudence’.” See Stough v. Commissioner, 144 T.C. 306, 323 (2015) (quoting Estate of Stiel v. Commissioner, T.C. Memo. 2009-278, 2009 WL 4877742, at *2)).

Section 6662(a) Penalty. Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any underpayment of tax required to be show on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax. Negligence includes “any failure to make a reasonable attempt to comply” with the Code, 26 U.S.C. § 6662(c), or a failure “to keep adequate books and records or to substantiate items properly,” Treas. Reg. § 1.6662-3(b)(1). An understatement of income tax is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 26 U.S.C. § 6662(d)(1)(A). Generally, the IRS bears the initial burden of production of establishing via sufficient evidence that a taxpayer is liable for penalties and additions to tax; once this burden is met, the taxpayer must carry the burden of proof with regard to defenses such as reasonable cause. Id. at § 7491(c); see Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001). The IRS bears the burden of proof with respect to a new penalty or increase in the amount of a penalty asserted in his answer. See Rader v. Commissioner, 143 T.C. 376, 389 (2014); Rule 142(a), aff’d in part, appeal dismissed in part, 616 F. App’x 391 (10th Cir. 2015); see also RERI Holdings I, LLC v. Commissioner, 149 T.C. 1, 38–39 (2017), aff’d sub nom. Blau v. Commissioner, 924 F.3d 1261 (D.C. Cir. 2019). As part of the burden of production, the IRS must satisfy section 6751(b) by producing evidence of written approval of the penalty by an immediate supervisor, made before formal communication of the penalty to the taxpayer.

Reasonable Cause Defense to Section 6662(a) Penalty. A section 6662 penalty will not be imposed for any portion of an underpayment if the taxpayers show that (1) they had reasonable cause and (2) acted in good faith with respect to that underpayment. 26 U.S.C. § 6664(c)(1). A taxpayer’s mere reliance “on an information return or on the advice of a professional tax adviser or an appraiser does not necessarily demonstrate reasonable cause and good faith.” Treas. Reg. § 1.6664-4(b)(1). That reliance must be reasonable, and the taxpayer must act in good faith. In evaluating whether reliance is reasonable, a taxpayer’s “education, sophistication and business experience will be relevant.” Id. para. (c)(1).

Insights: Going forward, this opinion of Estate of Hoenshied v. Commissioner will likely be a go-to source for any practitioner involved in a taxpayer’s proposed transfer of corporate shares (or other property) to a donor-advised fund or other charitable organization as part of a buy-sell transaction that is anywhere close in time to the proposed donation.

Have a question? Contact Jason Freeman , Managing Member Legal Team.

Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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The rationale for the so-called anticipatory assignment of income doctrine is the principle that gains should be taxed "to those who earn them," Lucas, supra, at 114, a maxim we have called "the first principle of income taxation," Commissioner v. Culbertson, 337 U. S. 733, 739-740 (1949). The anticipatory assignment doctrine is meant ...
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FAQ: What is assignment of income under the tax law?
The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities. A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income.
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Study with Quizlet and memorize flashcards containing terms like T or F: The assignment of income doctrine requires that in order to shift income from the property producing the income to another person, the taxpayer must transfer only the income to the other person, T or F: Gross income includes all income realized during the year., T or F: A taxpayer includes in gross income the amount of ...
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