Tax Train Wreck: US IRS Derails Private Wealth Tax Planning Transactions

• Published date: 08 September 2022
• Subject Matter: Corporate/Commercial Law, Tax, M&A/Private Equity, Corporate and Company Law, Contracts and Commercial Law, Income Tax, Tax Authorities, Shareholders
• Law Firm: Mayer Brown
• Author: Mr Mark Leeds and Charlene Soleimani

It's unusual enough for one or more facets of relatively conservative tax planning to be successfully challenged by the Internal Revenue Service (the "IRS"). But in Keefer vs. United States,¹ the taxpayers suffered the tax equivalent of being struck by lightning-the IRS not only successfully disallowed the anticipated tax consequences of a sale transaction but also the ancillary consequences as well, which, in this case, was a $1.257 million charitable contribution to a donor-advised fund (a "DAF"). In this Legal Update, we'll explore what went wrong so that taxpayers who might try to navigate this rail line in the future can keep their train on the tracks.

The taxpayers were limited partners in a partnership named "Burbank HHG Hotel, LP" ("Burbank"). Burbank held and operated a hotel property. On April 23, 2015, Burbank exchanged a non-binding letter of intent with a third party ("Buyer") to sell the hotel property. By June 18, 2015, the price had been agreed to ($54 million) and a contract was drafted but not yet signed. On that date, the taxpayers donated a 4% limited partnership interest in Burbank to the DAF (more on this below). On July 2, 2015, the parties signed the contract for the purchase and sale of the hotel. The contract granted the Buyer a 30-day review period, during which it could have walked away from the deal. Burbank and the Buyer closed the purchase and sale of the hotel on August 11, 2015. On September 9, 2015, the DAF sent a letter to the taxpayers acknowledging the donation.

The opinion does not make clear what portion of the taxpayers' interest in Burbank was represented by the 4% interest donated to the DAF. What is clear, however, is that the taxpayers retained a significant interest in Burbank following the donation.

The terms of the taxpayers' donation to the DAF were subject to an unusual stipulation. Specifically, the taxpayers reserved to themselves the right to receive the proceeds from cash reserve accounts held by Burbank as of the date of the donation. The cash reserves could have been used to remediate any conditions at the hotel if the Buyer demanded any such repairs. The court found that these reserves were held back to fulfill potential future liabilities since the contract to sell the hotel had not yet been signed at the date of the donation to the DAF.

The taxpayers obtained a third-party appraisal of the modified 4% interest that the taxpayers donated to the DAF. The appraiser estimated that at the time of the donation, there was a "5% probability of no sale." The appraisal took account of the fact that cash reserve proceeds would not be paid to the DAF. The appraisal valued the modified 4% interest at $1.257 million.

The taxpayers did not report the allocable share of the gain recognized on the sale of the hotel that was attributed to the 4% interest in Burbank held by the DAF. The taxpayers also reported a charitable donation of $1.257 million, the pre-tax value of the 4% interest they gave to the DAF. The IRS successfully challenged both of these positions.

I. There Was No Anticipatory Assignment of Income Based on the Fact That the Hotel Sale Was Imminent

Under the anticipatory assignment of income doctrine, once a right to receive income has "ripened" for tax purposes, the taxpayer who earned or otherwise created that right will be taxed on any gain realized from it even if the taxpayer transfers the right before actually receiving the income. See Jones v. United States, 531 F.2d 1343, 1346 (6th Cir. 1976); Kinsey v. Commissioner, 477 F.2d 1058, 1063 (2d Cir. 1973); Hudspeth v. United States, 471 F.2d 275, 280 (8th Cir. 1972); Estate of Applestein v. Commissioner, 80 TC 331, 345 (1983). The IRS asserted that the donation of the 4% interest in Burbank was anticipatory assignment of income and the gain allocable to that interest was taxable to the taxpayers not the DAF. The court ultimately agreed with the IRS, but the court's analysis jackknifed what would have been expected.

To determine whether a right has "ripened" for tax purposes, courts consider the realities and substance of events to determine whether the receipt of income was practically certain to occur (i.e., whether the right basically had become a fixed right) at the time of the transfer. See e.g., Jones, supra, at 1346. While the finding of a mere anticipation or expectation of the receipt of income has been deemed insufficient to conclude that a fixed right to income existed, see, e.g., S.C. Johnson & Son, Inc. v. Commissioner, 63 TC 778, 787-88 (1975), courts also have made it quite clear that the overall determination must not be based on a consideration of mere formalities and remote hypothetical possibilities. See, e.g., Jones, supra, at 1346; Kinsey, supra, at 1063; Hudspeth, supra, at 280; Estate of Applestein, supra, at 345.

More broadly, the anticipatory assignment of income doctrine prevents taxpayers from gratuitously assigning property ripe with income to a third party (usually a charity or relative) with a purpose of having the assignee taxed on the income inherent in the property. This doctrine, however, does not prevent taxpayers from making gifts of appreciated property. When a right to the proceeds and therefore the gain from the disposition of property has matured or ripened at the time of a transfer, the transferor will be taxed, notwithstanding a technical transfer of the property prior to its disposition. The court in Keefer focused on Humacid Co. v. Comm'r, 42 T.C. 894 (1964), one of many cases that addressed donations of appreciated property to a charity. Under Humacid, supra, courts will respect...