Estate Planning Seminar

Transcription

1 Estate Planning Seminar Proudly partnering with Table of Contents Day of Schedule Sponsor Thank You Speaker Biography Presentation Planned Giving Brief Sample Bequest Language OMRF Fact Sheet Tax Credit Postcard Findings publication

2 Estate Planning Seminar Proudly partnering with Day of Schedule Location: Date: Time: 12:30 1:00 1:00 1:10 1:10 2:50 2:50 3:10 3:10 4:00 4:00 4:50 4:50 5:00 Oklahoma City: Oklahoma Medical Research Foundation Thursday, November 30 1 p.m. 5 p.m. Registration Welcome & introduction of Joe Hancock Hancock Presentation, part 1: Black Gold: Gifts of Oil & Gas Made Simple Ethics (25 minutes) Section III, Working with Donors Restroom, Phone & Refreshment Break Hancock Presentation, part 2: Minding the Shop: Creative Planned Giving Strategies for Business Owners Ethics (25 minutes) Case Studies of self-dealing & pre-arranged transactions Hancock Presentation, part 3: Insecure About Securities? Effectively Handling Gifts of Stock Thank you & wrap-up Location: Date: Time: 12:30 1:00 1:00 1:10 1:10 2:50 2:50 3:10 3:10 4:00 4:00 4:50 4:50 5:00 Tulsa: Downtown Doubletree Friday, December 1 8 a.m. 12 p.m. Registration Welcome & introduction of Joe Hancock Hancock Presentation, part 1: Black Gold: Gifts of Oil & Gas Made Simple Ethics (25 minutes) Section III, Working with Donors Restroom, Phone & Refreshment Break Hancock Presentation, part 2: Minding the Shop: Creative Planned Giving Strategies for Business Owners Ethics (25 minutes) Case Studies of self-dealing & pre-arranged transactions Hancock Presentation, part 3: Insecure About Securities? Effectively Handling Gifts of Stock Thank you & wrap-up

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4 Biographical Information Joe Hancock Joe Hancock serves as Vice President & General Counsel for HighGround Advisors, located in Dallas, Texas. HighGround serves churches and nonprofits through professional asset management and planned giving consultation. Joe has practiced extensively in the area of charitable planned giving for the past 20 years. Joe holds a BBA from Baylor University and MBA and JD degrees from the University of Arkansas.

5 BLACK GOLD: GIFTS OF OIL AND DIVIDER TITLE GAS INTERESTS MADE SIMPLE OKLAHOMA MEDICAL RESEARCH FOUNDATION NOVEMBER 30, 2017

6 MINERAL INTERESTS Ownership of the right to exploit, mine, or produce minerals lying beneath the surface of a property Includes: Oil Gas Coal Iron Ore Sulfur Precious Metals 2 HighGround Advisors

7 MINERAL INTERESTS Mineral estate is dominate over surface estate May use surface in a reasonable manner to extract minerals Executive Rights Allows the owner of the interest to lease the interest to others 3 HighGround Advisors

8 HISTORY First oil well drilled in Pennsylvania in 1859 produced 20 barrels a day East Texas oil boom ( Spindletop ) occurred in 1901 produced 100,000 barrels per day. Led to formation of: Gulf Oil Amoco Exxon Today, oil and gas are produced in 32 states 4 HighGround Advisors

9 TERMINOLOGY BONUS: one-time payment to lessor to acquire a lease SHUT-IN: a non-producing well DELAY RENTAL: annual payments to delay drilling DIVISION ORDER: schedule of owners and their respective share of revenues 5 HighGround Advisors

10 TERMINOLOGY LANDMAN: negotiates leases, ensures proper title, monitors ongoing well production and payments OPERATOR: conducts drilling operations for a well 6 HighGround Advisors

11 TYPES OF OWNERSHIP INTERESTS ROYALTY INTEREST: shares in production but is not liable for expenses a 3/16th royalty is common WORKING INTEREST: allowed to use surface for exploration and production and is liable for expenses retains profits 7 HighGround Advisors

12 TYPES OF OWNERSHIP INTERESTS NON-PARTICIPATING ROYALTY: carved out of a prior interest without regard to the terms of the lease OVERRIDING ROYALTY: carved out of working interest to compensate landmen, geologists, attorneys, etc. 8 HighGround Advisors

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14 GIFT ACCEPTANCE POLICIES May include: Minimum values for surface rights Minimum per year royalty amounts Liability review procedures Provision prohibiting working interests Environmental review procedures Ongoing management considerations 10 HighGround Advisors

15 WORKING WITH DONORS Questions to ask: 1. What is the ownership interest? a. Prior or existing leases b. Prior division orders c. Prior transfer orders d. Check stubs from royalty payments 2. How was the interest acquired? 3. Is the interest under lease? 4. What do you want to gift? 11 HighGround Advisors

16 FACILITATING THE GIFT Oil and gas interests are conveyed by: Mineral deed Lease Assignment Conveyance may or may not be recorded May receive interest by testamentary transfer probate process will evidence conveyance and ownership 12 HighGround Advisors

17 VALUATION OF INTEREST FAIR MARKET VALUE (FMV) The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts Reg A-1(c)(2) Rev. Rul , CB80 13 HighGround Advisors

18 VALUATION OF INTEREST The FMV is to be determined in the market which the item is most commonly sold to the public Rev. Rul , CB55 For interests valued in excess of $5,000, a qualified appraisal is required Reg A-13(c)(1)(i) 14 HighGround Advisors

19 VALUATION OF INTEREST Gift of royalty interest or non-participating royalty interest may deduct FMV if held more than 1 year Operators-deduction limited to basis 15 HighGround Advisors

20 VALUATION OF INTEREST General Rule of Thumb: Value = annual income x 4 Formal appraisal will determine expected future cash flows Production history Number of producing wells Discounted to present value 16 HighGround Advisors

21 VALUATION OF INTEREST QUALIFIED APPRAISERS Pension Protection Act of 2006 requires: Appraisal designation or minimum education and experience Regularly perform appraisals for pay In good standing 17 HighGround Advisors

22 VALUATION OF INTEREST QUALIFIED APPRAISERS For real property licensed by the state For other assets College or professional level coursework 2 years experience buying, selling, or valuing the type of property 18 HighGround Advisors

23 VALUATION OF INTEREST QUALIFIED APPRAISERS Highly specialized Geologist or Petroleum Engineer Cost will range from $1,000-$2,000 American Institute of Mineral Appraisers or American Institute of Professional Geologists 19 HighGround Advisors

24 COMPATIBILITY With Planned Gift Vehicles Questions to ask: 1. Will annual income support payment provision of the gift arrangement? 2. Will other assets be involved? 3. Sell or retain the mineral interest? 20 HighGround Advisors

25 QUALIFIED CHARITABLE GIFT ANNUITIES Description of a Gift Annuity DONOR PROPERTY OR CASH CHARITABLE DEDUCTION PAYMENTS CHARITY A contract between one or more individuals and the charity, under which cash or other valuable property is contributed by the donor(s) in exchange for a specified amount paid at stated intervals (no less often than annually) for life. The annuity can be for one or two lives. BENEFICIARY (Also called Annuitant ) Charitable deduction allowed for difference between amount contributed and present value of annuity payments. 21 HighGround Advisors

26 QUALIFIED CHARITABLE GIFT ANNUITIES Types of Gift Annuities IMMEDIATE DEFERRED FLEXIBLE DEFERRED 22 HighGround Advisors

27 QUALIFIED CHARITABLE GIFT ANNUITIES Gift Annuity Rates The American Council on Gift Annuities periodically publishes suggested rates. Greater than 90% of all charities typically follow the ACGA rates. Current ACGA rates became effective on January 1, HighGround Advisors

28 QUALIFIED CHARITABLE GIFT ANNUITIES Income Tax Charitable Deduction AMOUNT TRANSFERRED TO CHARITY - PRESENT VALUE OF ANNUITY INTEREST - CHARITABLE DEDUCTION AMOUNT 24 HighGround Advisors

29 QUALIFIED CHARITABLE GIFT ANNUITIES Donor is 74 year-old female Has $50,000 in CDs that will mature soon and is considering options Would like to make a more significant gift Does not feel able to make a large outright gift Has other assets for personal needs 25 HighGround Advisors

30 QUALIFIED CHARITABLE GIFT ANNUITY DEFERRED FLEXIBLE DEFERRED GIFT ANNUITIES GIFT ANNUITIES IMMEDIATE GIFT ANNUITIES Charitable Annuity start deduction date 5.7% can QUALIFIED in vary the year CHARITABLE the gift is made $50,000 Payment frequency Payments Agreement begin specifies no sooner a range than of start one year datesafter date of gift First payment received at end of first pay period Determination The older the annuitant, of deferred the annuity larger amount the payment Proration of payments GIFT ANNUITY Must claim the lowest charitable deduction Determination of annuity amount DONOR RECEIVES INCOME TAX CHARITABLE DEDUCTION OF $22,122 { $2,129 TAX-FREE INCOME } $721 ORDINARY INCOME DONOR RECEIVES LIFETIME AFTER 13.1 YEARS ANNUITY ANNUITY OF $2,850 IS TAXABLE AS ORDINARY INCOME AT DONOR S DEATH, ANNUITY ASSETS TO CHARITY 26 HighGround Advisors

31 COMPATIBILITY With Planned Gift Vehicles GIFT ANNUITY: Careful consideration is necessary Fixed payment obligation Depleting asset EXAMPLE: Donor, age 72, gifts mineral EXAMPLE: interest valued at $60,000 Donor, (annual age royalty 72, gifts income mineral of interest $15,000). valued at $60,000 (annual royalty income of ACGA rate is 5.4%, $15,000). resulting in annual annuity ACGA obligation rate is of 5.4%, $3,240 resulting in annual annuity Donor life expectancy is obligation of $3, years Donor life expectancy is 14.5 years 27 HighGround Advisors

32 COMPATIBILITY With Planned Gift Vehicles 28 HighGround Advisors

33 CHARITABLE REMAINDER TRUSTS Payments to one or more beneficiaries for life or term of years Remainder passes to charity Two types: Charitable Remainder Annuity Trust (CRAT): donor retains an income interest that is either a fixed dollar amount or a fixed percentage (no less than 5%) of the initial fair market value of the trust Charitable Remainder Unitrust (CRUT): donor retains an income interest that is a fixed percentage (no less than 5%) of the trust assets, as revalued annually 29 HighGround Advisors

34 CHARITABLE REMAINDER TRUSTS CRUT Payment Provisions Net income Net income with make-up Straight Flip 30 HighGround Advisors

35 CHARITABLE REMAINDER TRUST Donor is 72 year-old retired rancher Owns 500 acres in West Texas valued at $2,000 per acre Wants to be free from responsibility and upkeep of property Needs to replace income previously provided from use of the land 31 HighGround Advisors

36 CHARITABLE REMAINDER UNITRUST REAL ESTATE VALUED AT $1,000,000 5% CHARITABLE REMAINDER UNITRUST (FLIP) APPRECIATED ASSETS SOLD TAX-FREE & DONOR RECEIVES INCOME TAX CHARITABLE DEDUCTION OF $554,710 UNITRUST PAYMENTS TO BENEFICIARY AT DONOR S DEATH, REMAINDER TO CHARITY 32 HighGround Advisors

37 COMPATIBILITY With Planned Gift Vehicles CHARITABLE REMAINDER TRUST: CRAT: Some considerations as with the gift annuity, but Trustee may not rely on non-trust assets 33 HighGround Advisors

38 COMPATIBILITY With Planned Gift Vehicles CHARITABLE REMAINDER TRUST: CRUT: Annual revaluation of assets accommodates mineral interest well Annual value based on production Production used to satisfy resulting payment Payment obligation and production rise and fall together 34 HighGround Advisors

39 COMPATIBILITY With Planned Gift Vehicles CRUT EXAMPLE: Donor, age 72, funds FLIP CRUT with both surface and mineral interests Surface appraised at $250,000 and minerals appraised at $60,000 CRUT flips upon sale of surface interest. Mineral interest is retained Annual valuation of invested sale proceeds and retained mineral interest determines payment outcome 35 HighGround Advisors

40 CHARITABLE LEAD TRUSTS Gift of income interest, not remainder interest Reverse of CRUTs and CRATs Charity receives income for a term of years (either a unitrust or annuity interest) At termination of trust, trust corpus is returned to donor, to donor s family or some other non-charitable remainder beneficiary Donor receives gift or income tax charitable deduction 36 HighGround Advisors

41 CHARITABLE LEAD TRUSTS Grantor CLT vs Non-Grantor CLT GRANTOR CLT Off-set large taxable event Fulfill a pledge Donor is able to pay tax on trust s income and gains during the trust term NON-GRANTOR CLT Reduce or eliminate gift tax 37 HighGround Advisors

42 CHARITABLE LEAD TRUSTS Charitable Deduction Grantor Lead Trust income tax deduction Non-Grantor Lead Trust gift or estate tax deduction 38 HighGround Advisors

43 CHARITABLE LEAD TRUST Donor s employer recently acquired by competitor; Donor received large golden parachute payout Donor allocated $500,000 to be gifted to children, ages 13 and 15 Donor wishes to support an ongoing expansion & building campaign of Charity 39 HighGround Advisors

44 CHARITABLE LEAD TRUST DONOR RECEIVES GIFT TAX CHARITABLE DEDUCTION OF $463,480 $500,000 CASH 7% CHARITABLE LEAD TRUST (15-YEAR TERM) CHARITY RECEIVES ANNUAL PAYMENT OF $35,000 AS DESIGNATED BY DONOR AT TERMINATION, CORPUS PASSES TO DONOR S CHILDREN 40 HighGround Advisors

45 COMPATIBILITY With Planned Gift Vehicles CHARITABLE LEAD TRUSTS: CLAT: Same considerations as with the GA and CRAT CLUT: Variable payments work well with fluctuations in mineral production/valuation 41 HighGround Advisors

46 REMAINDER INTEREST IN RESIDENCE/FARM Donor gives charity remainder interest in personal residence or farm Donor retains right to use property until death and receives immediate income tax charitable deduction At donor s death property is sold and proceeds used for benefit of charity 42 HighGround Advisors

47 REMAINDER INTEREST IN RESIDENCE/FARM PERSONAL RESIDENCE: Any property used as a personal residence; need not be the primary residence. Includes vacation homes, yachts, etc. Does not include household furnishings FARM: Generally, any land, along with improvements, that is used for the production of agricultural products or for the sustenance of livestock 43 HighGround Advisors

48 REMAINDER INTEREST IN RESIDENCE/FARM Donor couple ages 68 and 70 Have left their home to Charity in their Wills Plan to maintain residency in their home indefinitely Could benefit from a current income tax deduction 44 HighGround Advisors

49 REMAINDER INTEREST GIFT DONOR RECEIVES INCOME TAX CHARITABLE DEDUCTION OF $262,548 RESIDENCE VALUED AT $450,000 PROPERTY DEEDED TO CHARITY DONOR RETAINS POSSESSION FOR LIFE {DONOR RESPONSIBLE FOR PROPERTY TAXES AND MAINTENANCE } AT DONOR S DEATH, CHARITY BECOMES FULL OWNER 45 HighGround Advisors

50 COMPATIBILITY With Planned Gift Vehicles RETAINED INTEREST IN RESIDENCE OR FARM: Donor conveys both surface and mineral estates, retaining life interest 46 HighGround Advisors

51 COMPATIBILITY With Planned Gift Vehicles Common Law Rules: Life tenant and remainderman must both execute leases Bonus money is considered corpus and paid to remainderman Royalties from production treated as consumption of corpus and paid to remainderman Income from invested payments are considered income for the life tenant 47 HighGround Advisors

52 COMPATIBILITY With Planned Gift Vehicles RETAINED INTEREST IN RESIDENCE OR FARM: Contractual Life Estate trumps Common Law Open Mine Doctrine presumes that life tenant will receive all income if production was occurring when life tenancy was established 48 HighGround Advisors

53 MINERALS MANAGEMENT OPTIONS Sell the interest: Typical purchase price is 1.5 to 2 times annual production Hire minerals management group Larger banking organization Investment management group Financial services firm 49 HighGround Advisors

54 MINERALS MANAGEMENT OPTIONS Active management for producing interests Review division orders Monthly review of revenues and payment status Monitor actual production Obtain releases when necessary 50 HighGround Advisors

55 MINERALS MANAGEMENT OPTIONS Active management for non-producing interests Negotiate maximum bonus and royalty for new leases Update and maintain undeveloped acreage records and shut-in well requirements Coordinate easements or permits for surface owners Monitor existing leases and secure timely releases 51 HighGround Advisors

56 ENVIRONMENTAL ISSUES Operating or working interests Liable for environmental or surface related problems Royalty interests Do not participate in production Not responsible for expenses Not liable Charities holding working interests may want to form a separate legal entity 52 HighGround Advisors

57 PARTIAL INTEREST RULE General Rule: Contribution of less than a donor s entire interest in a property precludes a deduction Key Exception: an undivided portion of the donor s entire interest: Must be a fraction or percentage of every substantial right Extend over entire term of donor s interest 53 HighGround Advisors

58 PARTIAL INTEREST RULE Undivided Interest: Many mineral interests are fractional shares of a larger whole Gift of fractional interest may be entire interest May gift a sub-fraction as an undivided interest 54 HighGround Advisors

59 PARTIAL INTEREST RULE EXAMPLE: Donor owns surface and minerals Wants to gift surface and retain minerals No deduction Charity may want to restrict surface use if minerals are retained 55 HighGround Advisors

60 PARTIAL INTEREST RULE EXAMPLE: Donor owns surface and minerals Donor partitions surface interest from mineral interest Donor gifts surface interest No deduction 56 HighGround Advisors

61 PARTIAL INTEREST RULE EXAMPLE: Standard royalty owner carves out a nonparticipating royalty interest for charity No deduction 57 HighGround Advisors

62 UNRELATED BUSINESS TAXABLE INCOME UBTI: Gross income from an unrelated trade or business that is regularly carried on Unrelated trade or business not substantially related to charitable purpose 58 HighGround Advisors

63 UNRELATED BUSINESS TAXABLE INCOME Passive income includes: Oil and gas royalties Shut-in royalties Delay rentals 59 HighGround Advisors

64 UNRELATED BUSINESS TAXABLE INCOME Income from working interest is UBI To avoid UBI, service requires royalty interest to be free from: Development costs Operating expenses 60 HighGround Advisors

65 UNRELATED BUSINESS TAXABLE INCOME Bonus payments are passive Not regularly carried on Only a one-time payment 61 HighGround Advisors

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67 Black Gold: Gifts of Oil and Gas Interests Made Simple Oklahoma Medical Research Foundation November 30, 2017 Joe Hancock Vice President and General Counsel HighGround Advisors 1717 Main Street Suite 1400 Dallas, Texas Phone:

68 Black Gold: Gifts of Oil and Gas Interests Made Simple As drilling technologies have made significant breakthroughs, oil and gas production has increased dramatically over the past decade, allowing production in states where none existed previously. Approximately thirty two states now realize substantial mineral production each year, creating opportunities for philanthropy that were not formerly available. This presentation will provide an overview of the basic types of mineral interests and equip gift planners to effectively cultivate and close gifts of oil and gas interests. Specific topics will include: I. Overview of Mineral Interests Summary Outline A. History and State Law B. Terminology C. Types of mineral ownership interests II. Gift Acceptance Policies A. Identifying types of mineral interests that may be received B. Clarification of policies related to environmental assessment and ongoing management III. Working with Donors A. Identifying the donor s ownership interest, objectives and options B. Facilitating the gift transaction IV. Valuation of Mineral Interests A. General guidelines B. IRS requirements for the qualified appraisal C. Factors affecting the valuation of mineral interests D. Obtaining a qualified appraisal for mineral interests V. Substantiation Rules A. IRS Forms 8283 and 8282 VI. Special Considerations A. Environmental issues B. Options for minerals management going forward C. Compatibility with specific planned giving vehicles VII. Taxation Issues A. Applicability of the partial interest rules B. Potential for unrelated business income 2

69 I. Overview of Mineral Interests A mineral interest is defined as the ownership of the right to exploit, mine, or produce minerals lying beneath the surface of a property. In the U.S., a majority of the minerals are privately owned which is particularly good for charitable institutions. Other than oil and gas, coal, iron ore, sulphur, and precious metals are considered minerals. Water, sand and gravel, salt, building stone, limestone, and surface shale are not considered minerals and belong to the surface owner. In Texas and many other states, the mineral estate is the dominant estate and allows the owner to use the surface estate in a reasonable manner to exploit, mine, or produce minerals. The mineral owner has the right to lease the interest to others. This right is known as executive rights. The various interests that can be created using this right are the basis for gift possibilities. A. History and State Law The first successful oil well in the United States drilled for the sole purpose of finding oil was located in Titusville, Pennsylvania. The year was It was named the Drake Well after the man responsible for the well, Colonel Edwin Drake. The well was drilled to a depth of 69.5 feet and produced approximately 20 barrels of oil per day. The existence of oil in the Titusville area had been known for hundreds of years. It was used for medicinal purposes by Native Americans and the European settlers used it for lamp fuel and machinery lubrication. Wells had been drilled in the area for some time looking for drinking water or salt water, but not oil. The wells that produced oil were considered nuisances and abandoned. The Drake well could be considered the start of the oil and gas industry. The Pennsylvania area was responsible for 1/2 of the world s production of oil until the East Texas oil boom of From 1859 to the East Texas boom, drilling activity and crude oil production expanded gradually to supply mostly lubricants and kerosene to use in lamps to replace whale oil. Production began to expand in the late 1800s as refineries began producing new petroleum based products to meet demands of U.S. industrialization and the growing number of internal combustion engines. In 1859, the U.S. produced about 2,000 barrels of oil; in 1879, the number rose to approximately 19 million barrels and by 1899 increased to approximately 57 million barrels. The increase in demand led to the search for new sources. On January 10, 1901, a well in Beaumont, Texas, known as the Lucas Gusher, erupted. It was the beginning of an area known as Spindletop. The initial flow rate for this well was nearly 100,000 barrels per day which was more than all of the other producing wells in the United States combined. It is estimated that over 850,000 barrels of oil were lost before the flow of oil was controlled. Spindletop was responsible for producing many companies that were to become giants in the oil industry, including Gulf Oil, Amoco and Humble Oil Company, which would become Exxon. Today, oil and gas are produced in Alabama, Alaska, Arizona, Arkansas, California, Colorado, Florida, Illinois, Indiana, Kansas, Kentucky, Louisiana, Maryland, Michigan, Mississippi, Missouri, Montana, Nebraska, Nevada, New Mexico, New York, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, South Dakota, Tennessee, Texas, Utah, Virginia, West Virginia, and Wyoming. 3

70 Four states produce the bulk of the total United States production Texas, Alaska, California, and Louisiana. Energy Information Administration, Petroleum Supply Annual During the early years of the industry, great progress was made in understanding oil and gas; however, laws regarding oil and gas property rights were formulated with little understanding of the nature of the asset. There are two theories related to the ownership of minerals. The ownership-in-place theory says that the surface owner owns all substances under the land. Texas, New Mexico, West Virginia, Mississippi, Montana and about half of the other states follow this theory. The nonownership/exclusive right-to-take theory says that the surface owner does not own the oil and gas, but merely owns the right to capture oil and gas using the land. After the mineral has been captured, the landowner owns the mineral. This is the Oklahoma doctrine. Minerals are considered real property until extracted. Once extracted, minerals become personal property and personal property laws then control. The mineral owner bears all costs of producing the mineral and gets all profits, but also bears all risk of loss. Once the minerals are leased, the lessee controls the mineral estate subject to the rights retained by the lessor under the lease agreement. B. Oil and Gas Terminology In order to understand the asset, it is helpful to have a working knowledge of certain terminology associated with the oil and gas industry. Terms used to describe the potential donor include: 1. LAND OWNER The person who owns all or part of the minerals under his land and is entitled to lease it. This is known as fee simple ownership. The land owner has the right to the surface, the minerals, the leasing rights, lease bonus payments and the royalty. 2. MINERAL OWNER Generally, one who owns only minerals under a tract of land but not the surface. The mineral owner has the right to remove the minerals along with the right to execute a lease allowing someone else the opportunity to remove them. This right is superior to the surface owner s rights because, in Texas and many other states, the mineral estate is the dominant estate. 3. SURFACE OWNER Usually a landowner who owns no minerals under his land. The surface owner is not entitled to execute a lease. Yet, the surface owner is affected by leasing activity because the surface is used to access the mineral asset. Terms used to describe the legal instruments used to convey a mineral interest include: 4. ASSIGNMENT The legal instrument whereby oil and gas leases or overriding royalty interests are assigned/conveyed. 5. LEASE The agreement outlining the basic terms of developing lands or minerals. The agreement typically includes the royalty to be paid, length of time or term of the lease, and a 4

71 description of the land or interest. Also known as an oil & gas lease or an oil, gas and mineral lease. Other terms to be familiar with include: 6. BONUS An amount paid to acquire an oil and gas lease. 7. DELAY RENTAL Yearly payments paid during primary term to lessor to delay drilling. 8. DIVISION ORDER A schedule of owners and their decimal share in revenues of the well derived from the sale of oil or gas. 9. DIVISION ORDER ANALYST An individual responsible for the proper distribution of revenues obtained from oil and gas production. 10. JOINT OPERATING AGREEMENT An agreement among working interest owners describing how a well is to be operated. 11. LANDMAN The person who secures leases and handles damages for oil companies who are drilling new wells or laying pipelines. 12. OPERATING AGREEMENT Same as Joint Operating Agreement. 13. OPERATING EXPENSES The costs of operating a well. 14. OPERATOR The party designated in the Operating Agreement to conduct the operations of the well. 15. PAID-UP LEASE An oil and gas lease where rental payments are paid along with the bonus. 16. PRIMARY TERM The initial period in an oil and gas lease to develop the property. 17. PUGH CLAUSE A clause added to a lease to limit holding non-producing lands or depths beyond the primary term under the lease. 18. RUN STUB Stub attached to a check disclosing the well name, month of production, price received and total volumes produced. 19. SALT WATER DISPOSAL WELL A well into which oilfield salt water is disposed. 5

72 20. SEVERANCE TAX A tax due the state on oil or gas produced or "severed" from the earth. 21. SEVERED MINERALS Minerals whose title has been severed from the surface title. 22. SHUT-IN An oil or gas well which is inactive. 23. UNLEASED MINERAL INTEREST A mineral interest not subject to a lease. C. Types of Oil & Gas Ownership Interests If an individual owns all of the private rights in land including both surface and subsurface rights, he or she is said to own a fee interest. If only the surface interest is owned, then the individual owns a surface interest, and conversely, if the individual only owns the mineral interest, a mineral interest/mineral estate/mineral right is owned. An individual may own all of the mineral interest or may own a percentage. Additionally, an individual may own a certain mineral type. When the owner of a mineral interest leases the interest to an individual or company, the individual receiving the lease, the lessee, has a leasehold interest. Leasehold interests are typically called working interests or operating interests. In exchange for granting the lease, the lessor typically receives a royalty interest, an initial bonus, delay rental and shut-in royalty. The lessee has the rights to use the surface of the property to obtain the minerals, the right to incur costs of exploration and production of the minerals and to retain profits subject to the lessor s retained rights, typically the royalty interest. The lessor also holds a reverter in the mineral interest. Upon expiration of the mineral lease, ownership of the minerals revert to the lessor. A royalty interest is a share in the production of the mineral free of the costs of producing it when and if there is production on the property. Oil and gas royalties are typically expressed as fractions or percentages and can be created in different ways. There are landowner s royalty interests, nonparticipating royalty interests, and overriding royalty interests. The landowner s royalty interest is generally retained by the owner at the time the oil and gas lease is negotiated. It is the landowner s compensation for granting the lease. A 1/8 th royalty was standard from the 1920s through the mid 1980s. Today, many consider a standard royalty to be 3/16 th, but prevailing royalty amounts will vary somewhat depending on the level of production in a given area. A nonparticipating royalty interest is carved out of the mineral interest and entitles the holder to a stated share of production without regard to the terms of the lease. This can be seen in a situation where a parent conveys a percentage of his or her royalty to children. An overriding royalty interest is carved out of the lessee s working interest and can be used to compensate landmen, lawyers and geologists who helped structure the drilling operation. A net profits interest is similar to a royalty interest but is payable only if there is a net profit. It is important to negotiate what costs are included in the definition. 6

73 II. Gift Acceptance Policies A. Identifying Types of Mineral Interests That may be Received The management and administration of oil and gas assets requires knowledge and expertise. Charities located in states with mineral production have historically received gifts of minerals. These interests may be received in the conveyance of surface ownership which also includes a mineral interest or the conveyance of the mineral interest alone. Institutions should have acceptance policies addressing mineral gifts. The gift acceptance policies should serve to educate staff and board about the critical issues that can be triggered by gifts of these assets. There can be valuation issues, environmental issues, unrelated business income issues and management issues with the acceptance of this asset type. Many oil and gas acceptance policies across the country include provisions that: 1. Set-out a minimum value for gifts of surface rights 2. Set-out a minimum per year royalty 3. Provide for review of liability issues 4. Prohibit acceptance of working interests 5. Provide for environmental review in order to prevent current or future exposure to environmental liability Some charities will sell mineral interests as soon as practical, while others will hold and manage them. The question of whether or not to maintain the asset depends upon the organization s ability to effectively manage this asset type. Is the asset of a size that would allow the charity to obtain third party administration/management? Will the charity accept producing and/or nonproducing assets? Holding non-producing mineral assets does not cost the institution anything. There are no carrying costs (ad valorem taxes, severance taxes, etc) associated with an oil and gas asset that is not in production. Charities typically do not accept working interests because of the liability and tax consequences associated with these interests. As mentioned above in the definition section, the working interest holder has the right to use the surface of the property to obtain the minerals, the right to incur costs of exploration and production of the minerals and to retain profits subject to the lessor s retained rights. All liability issues flow to the holder of the working interest. This includes all environmental issues caused by exploration and production of the asset. Income derived from working interests is considered unrelated business income and therefore subject to unrelated business income tax, as discussed in the last section of this paper. B. Clarification of Policies Related to Environmental Assessment and Ongoing Management It is important to have an environmental assessment policy for all gifts of real property. Most policy statements will be broad enough to cover gifts of mineral interests. The following is an example of an environmental policy statement: It is the policy of [Charity] to minimize and, when possible, avoid environmental liability arising from the ownership or control of property or property interests by taking such action reasonably appropriate to determine the extent of any environmental contamination before taking ownership of the property. This action 7

74 will include inspections and assessments of the property that will be tailored to meet the specific characteristics of the property. The parameters of the inspection and environmental assessment will be set in each instance by the General Counsel of [Charity]. III. Working with Donors A. Identifying the Donor s Ownership Interest, Objectives and Options Who owns the mineral interest? Is the donor single or are the donors married? When you are dealing with husband and wife donors, the questions are: In what state do the donors reside, and how was the mineral interest obtained? In nine states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), community property statutes presume that each spouse owns a ½ interest in property acquired during marriage except by gift, devise or bequeath. If the mineral interest was owned before the marriage or obtained during the marriage by gift, devise or bequeath, it is the separate property of the spouse receiving the gift or inheritance and can be conveyed by that spouse individually. If not, both spouses need to make the conveyance in a community property state. Most states in the U.S. follow the common law property concept property acquired by any spouse in his or her name is owned individually by that spouse and can be conveyed as such. In states that have homestead protection from creditors, an oil and gas conveyance should be signed by both spouses. Does the donor own executive rights or a non-executive interest? An executive right gives the holder the power to lease. What does the donor own and what does the owner want to give? These questions must be answered in order to fully understand the consequences of a charitable gift of a mineral interest as described below. Knowing the basic questions to ask when approached about a mineral interest gift will provide the charity information to make an informed decision on whether or not to accept the gift. The gift planning officer should ask the potential donor the following questions and for copies of any of the following documents that are available: 1. Is the mineral leased 2. How was the mineral acquired 3. What is your understanding of what is owned 4. What do you want to gift 5. Prior or existing leases 6. Prior division orders 7. Prior transfer orders 8. Check stubs from royalty payments B. Facilitating the Gift Transaction Oil and gas interests are created and transferred by conveyance, inheritance, judicial action and adverse possession. A conveyance is a transfer of ownership by an instrument intended to pass ownership of the land interest to a third party. The instrument must be in writing, contain words of grant, include an adequate description of the property, designate the grantor and grantee (lessor 8

75 and lessee), and be properly executed. Oil and gas interests are generally transferred by deed or lease. These documents are formal, legal and recordable. The execution requirements include delivery and acceptance. In an oil and gas context, it is always best to get the deed or lease in hand. Once received, it is a good idea to have it recorded. Most states do not require the document to be recorded for it to be legally binding, but practically speaking, it is a good idea. Recording protects the charity against claims of subsequent purchasers or creditors. Some states do require the deed to be recorded. For example, Kansas requires recording or registration for taxation within a specified time to validate a mineral deed. Additionally, several states have marketability title acts or dormant mineral acts which require special recordings or use to preserve the interest beyond the statutory limitation. Oil and gas interests may also be acquired by inheritance. When a charity receives a mineral interest by devise under a last will and testament, the requirements of probate laws must be met. Transfer of the interest occurs when the last will and testament is offered for probate. The executor may or may not prepare an executor s deed transferring the interest. In many cases, if the interest is non-producing it may or may not be included in the estate inventory because the executor is often not aware of the existence of the interest. The question of ownership will not surface until such time as someone is interested in leasing the mineral interest. Typically, a landman will contact the charity offering to lease the interest having examined deed records for ownership. A. General Guidelines IV. Valuation of Mineral Interests For any type of asset, including minerals, the fair market value of the contribution is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts. Reg A-1(c)(2), Rev. Rul , CB 80. The IRS has further asserted that the most probative evidence of fair market value is the price at which similar quantities of property are sold in arm s length transactions. Rev. Rul , CB 55. Therefore, fair market value is to be determined in the market in which the item is most commonly sold to the public. id. B. IRS Requirements for the Qualified Appraisal In order to receive an income tax charitable deduction for their gift, donors must comply with certain appraisal requirements. The fair market value of the mineral interest on the date of the gift must be determined by a qualified appraisal that follows all the rules set by the IRS. Treas. Reg A-13(c). Specifically, the qualified appraisal rules apply to gifts of property (other than money and publicly traded securities) if the value claimed or reported for the property is in excess of $5,000. Treas. Reg A-13(c)(1)(i). The sole purpose of the appraisal is to allow donors to obtain their income tax charitable deduction, and the IRS will not allow a deduction without this appraisal. Accordingly, donors and their advisors bear the responsibility to obtain the qualified appraisal and to ensure that the appraisal is properly completed in a timely fashion and meets all of the requirements for qualification. The appraisal must be prepared no sooner than 60 days prior to the date of gift; however, donors are not required to have the appraisal in hand until they actually file the income 9

76 tax return on which they will first claim the deduction. Treas. Reg A-13(c)(3)(iv)(B). While the charity may be able to provide helpful information about the qualified appraisal rules, the final determination of the sufficiency of the appraisal rests with the donors and their advisors. C. Factors Affecting the Valuation of Mineral Interests Donors who contribute a royalty interest or a net profits interest may claim a charitable deduction for the fair market value of the interest, if they have held the interest for more than one year. IRC 170(e). And, any such contribution that exceeds $5,000 in value must be substantiated by a qualified appraisal. So, the initial question that will be faced by all donors and gift planners is whether or not the mineral interest would be properly valued in an amount that will necessitate obtaining a qualified appraisal. Unlike donors who gift other assets which also require an appraisal, such as real property and closely-held securities, many donors who wish to gift a mineral interest do not have a general idea or close approximation of the value of the mineral interest. Fortunately, there is a general rule of thumb that is widely accepted in the oil and gas industry to provide a quick estimate of the value of a specific mineral interest. This rule of thumb provides that the value of a mineral interest will closely approximate the annual income produced by the interest multiplied by a factor of four (annual income x 4). This helpful guideline provides donors with a reliable estimate of the overall value of the interest before incurring the expense of obtaining a qualified appraisal. Based upon this rule of thumb, donors can then proceed to obtain the appraisal if the $5,000 threshold is exceeded. The formal appraisal will be based upon a more sophisticated estimate of the expected future cash flows which will utilize factors such as production history and the number of producing wells, discounted to present value. Mineral interests which are not yielding any production are deemed to be without any current value within the oil and gas industry and with the IRS, and contributions of such interests result in no deduction for the donor. Another important distinction that must be made among donors is between those that are merely holding a mineral interest as an estate asset or personal investment and those that are actively engaged in the business of drilling wells for oil and gas production (i.e., operators ). Donors who are not operators may contribute a mineral interest and claim a charitable deduction for the full fair market value of the interest, if they have held the interest for more than one year. IRC 170(e). However, the deduction for operators who contribute a mineral interest will be limited to the operator s cost basis. IRC 170(e)(1)(A). Notwithstanding this limitation, operators who contribute oil and gas interests may deduct any long-term capital gains, if the interest can be treated as real estate used in a trade or business. Reg Finally, the quid pro quo rules may also apply in certain situations. For example, a donor who has previously taken deductions for intangible drilling costs will be required to reduce the amount of their deduction by any amount that would have been treated as ordinary income property if it had been sold. IRC 170(e)(1)(A). And, a gift of an oil and gas lease from which production payments had been previously carved out (explained more fully in the section of this outline detailing with partial interests) will be treated as a gift subject to indebtedness, resulting in the lowering of the deduction amount under the bargain sale rules and the realization of some amount of gain by the donor. IRC 1011(b); Reg

77 D. Obtaining a Qualified Appraisal for Mineral Interests Beyond the familiar requirements for qualified appraisers outlined in Reg A-13(c)(5)(i), the Pension Protection Act of 2006 heightened the requirements necessary to meet the statutory definition of a qualified appraiser. Under the new law, an individual must hold an appraisal designation from a recognized professional appraiser organization or must otherwise meet minimum education and experience requirements set forth in regulations prescribed by the Secretary of the Treasury. IRC 170A-13(c)(3)(ii). The individual must also regularly perform appraisals for which he or she receives compensation. id. In addition, the individual must demonstrate verifiable education and experience in valuing the type of property subject to the appraisal and must not be prohibited from practicing before the IRS at any time during the 3-year period ending on the date of the appraisal. IRC 170A-13(c)(3)(iii). Donors who are seeking to gift a mineral interest with a value in excess of $5,000 will need to find a capable appraiser that is qualified under these new rules to issue a valuation for mineral interests. Specifically, the donor will need to find an appraiser that holds the proper certification and can demonstrate the necessary education and experience needed for this specialized type of appraisal. Under transitional guidance issued by the IRS after the enactment of the Pension Protection Act, the Service provides insight into the types of certification and education that the Service will require. For valuations of real property, the appraiser must be licensed or certified for the type of property being appraised (residential, commercial, etc.) in the state in which the appraised real property is located. Notice , IRB 1, 3.03(3)(a)(ii). For valuations of property other than real property, the appraiser must (1) successfully complete college or professionallevel coursework that is relevant to the property being valued, (2) obtain at least two years of experience in the trade or business of buying, selling, or valuing the type of property being valued, and (3) fully describe in the appraisal the appraiser's education and experience that qualifies the appraiser to value the type of property being valued. Notice , IRB 1, 3.03(3)(b)(ii). While mineral interests are real property interests which are conveyed by mineral deed and whose ownership is evidenced and recorded in the real property records of a given county within a state, the valuation of mineral interests is a more highly specialized task than the valuation of surface interests generally. State licensing and certification requirements for real estate appraisers generally do not extend to the valuation of sub-surface estates/interests. Therefore, for gift substantiation purposes, donors are advised to use a qualified appraiser that can meet the more thorough requirements established by the Service for the valuation of property other than real property. Specifically, donors should seek out a geologist or a professional petroleum engineer (or engineering firm) that has at least a bachelor s level degree in their discipline and that is able to perform an engineering and economic evaluation of the mineral interest to determine a fair market value. This value should reflect an analysis of historical production data, a calculation of production decline rates, and a review of historical cash flows. This information will be used to forecast future well performance, calculate remaining oil and gas reserves, and predict future revenues. An estimate of the cost to obtain this type of mineral appraisal is between $1,000 and $2,000 and will vary according to the number of wells to be evaluated, the production history that must be assessed, etc. To find a capable appraiser in a specific region of the country, a donor or gift planner may wish to consult a professional association such as the American Institute of Mineral Appraisers or the American Institute of Professional Geologists. 11

78 A. IRS Forms 8283 and 8282 V. Substantiation Rules When claiming the deduction for a contribution of a mineral interest, donors must attach an appraisal summary (found on Section B of IRS Form 8283) to the income tax return on which they first claim the deduction. Treas. Reg A-13(c)(2)(i). The appraisal summary must be signed and dated by the donee charity, be signed and dated by the qualified appraiser, and state the appraised fair market value of the property on the date of contribution. Treas. Reg A- 13(c)(4). Subsequently, should the charity sell, exchange, or otherwise dispose of any property for which the charity signed an appraisal summary within three years of the date of gift, the charity must then file an information return (IRS Form 8282) to report the amount received on the disposition. IRC 6050L(a)(1). Should the amount claimed by the donor as a deduction (based upon the value reported on Form 8283) significantly exceed the amount received by the charity to dispose of the property (as reported on Form 8282), the IRS could have grounds to question the validity of the donor s claimed deduction. VI. Special Considerations A. Compatibility with Specific Planned Giving Vehicles When considering the different planned giving vehicles that may achieve the objectives of a prospective mineral donor, two main issues must be considered. First, will the annual income produced from the mineral interest be well suited to allow the payout feature of a specific planned giving vehicle to be fully realized? Because minerals are a depleting asset, the long-term production is not certain, and this decline in realized income over the life of the mineral interest must be taken into consideration. Second, what additional other assets may or may not be used to fund the planned gift? If the depleting mineral interest represents only a minority of the total assets used to fund the planned gift, then the depleting nature of the mineral interest may not have as significant of an impact on the performance of the planned gift instrument going forward. These factors will be considered for each of the planned gift vehicles discussed below. It should also be noted that a charity or trustee could sell a gifted mineral interest immediately upon receiving it in a planned gift context. Just as a gift of a surface interest will typically be sold, a charity or trustee could also readily sell a producing mineral interest and reinvest the proceeds to achieve greater diversity and more predictable long-term income flows. This could provide a greater ability to achieve the stated payout objective of the planned gift arrangement. While selling the interest is an option, charities and trustees will find that they will typically realize a greater economic benefit from retaining a mineral interest over the long term. The options for managing versus selling a mineral interest are more fully discussed below in the section entitled Options for Minerals Management Going Forward. For the duration of this section, we will evaluate each planned gift vehicle based upon the assumption that the mineral interest will be retained and its income utilized to satisfy the payout obligation under the instrument. Perhaps the most popular and most commonly used planned giving vehicle is the qualified charitable gift annuity. While this gift arrangement has the benefit of being relatively straight forward and more familiar to many donors, the gift annuity is not the most compatible planned giving vehicle for gifts of minerals. Because the gift annuity has a fixed annuity obligation that will continue for the duration of the life expectancy of the donor(s), charities should carefully consider 12

79 the feasibility of retaining a gifted mineral interest and relying upon the annual production to satisfy the annual annuity obligation over the long term. As mentioned in the prior paragraph, mineral interests are depleting assets whose production will ultimately decline. Should a charity issue a gift annuity based upon existing production, it would be wise to set a payout rate that is significantly lower than current income from production so that a reserve amount could be accumulated prior to a decline in production. Should production begin to decline prior to the termination of the gift annuity agreement, then the issuing charity could draw upon this reserve amount to satisfy the annuity obligation going forward. If such a reserve is not sufficient or available, the charity would be forced to draw upon other assets to satisfy the annuity obligation. That having been said, if the mineral interest is only a smaller portion of a larger gift and if the payout amount established under the gift annuity contract is not significantly reliant upon the income from the mineral interest itself, then a retained mineral interest in this context could provide meaningful benefit to the charity going forward without causing concern over the viability of the gift annuity arrangement. When considering funding a charitable remainder trust with a mineral interest, the key issue will be the type of payout provision contained in the trust agreement. For a charitable remainder annuity trust, the very same issues and limitations outlined in the foregoing paragraph dealing with gift annuities will apply. However, the charitable remainder unitrust provides a better option. Specifically, the annual revaluation of trust assets to determine the payout to the income beneficiaries for the year is the distinctive feature of unitrusts that allows them to accommodate mineral interests so well. In the earlier section of this outline that deals with the valuation of mineral interests, it was explained that the value of a mineral interest will closely approximate the annual income produced by the interest multiplied by a factor of four (annual income x 4). It was also explained that a nonproducing mineral interest is deemed to be without any current value within the oil and gas industry. So, for purposes of determining the amount to be paid to an income beneficiary under a unitrust, the trustee will determine the current value of the mineral interest each year based upon the level of production that is being currently realized by the interest. This same income will be utilized over the coming year to satisfy the resulting payout obligation to the income beneficiary. In later years, should the level of production begin to decline, the value of the mineral interest will also decline, resulting in a lower payout to the income beneficiary. As you can see, the annual revaluation of the trust assets allows the actual level of production and income from the mineral interest to closely match or remain in step with the correlated increase or decrease in the payout obligation over time. The most typical scenario where a mineral interest is held in a unitrust occurs when a donor funds the trust with both the surface interest and the mineral interest in the property. When this occurs, our organization will typically market and sell the surface interest while retaining the underlying mineral interest in the trust. The unitrust will include a flip provision which will allow the trust to utilize a straight payout provision beginning on January 1 of the year following the sale of the surface interest (the flip trigger ). The proceeds from the sale of the surface interest will then be reinvested to meet the payout obligation for the income beneficiary(ies). Going forward, the trustee will conduct the annual revaluation of the trust assets, including the value of the investment portfolio (resulting from the proceeds from the surface interest) and the value of the mineral interest (based upon actual production). The combined value will determine the total payout for the income beneficiary for the year, and the return on invested assets taken together with the income realized from mineral production will be used to satisfy the total payout obligation. As explained in the previous paragraph, the mineral interest will carry its own weight due to the correlation of the value of the mineral interest each year (and the resulting payout obligation) and the actual income realized from the mineral interest during that time. 13

80 The considerations for funding a charitable lead trust with a mineral interest are the same as those discussed above for the charitable remainder trust. As with the charitable remainder unitrust, the variable payment provision that is incorporated into the charitable lead unitrust works very well with the fluctuating nature of future mineral production and the corresponding variations in value. And, for the same reasons outlined in the preceding paragraphs which discuss the compatibility of mineral interests with qualified charitable gift annuities and charitable remainder annuity trusts, the annuitized payment provision of the charitable lead annuity trust creates a need for more careful consideration on the part of the donor and/or trustee before funding a lead annuity trust with a mineral interest. For a more complete overview of this issue, please refer to the paragraph above which discusses the qualified charitable gift annuity. Finally, it is also possible for a mineral interest to be included in a retained interest in a personal residence or farm. This occurs when the donor conveys the remainder interest in both the surface estate and the mineral estate to charity. Because the donor/life tenant retains the full use and enjoyment of the property during the term of the life estate, certain issues regarding the benefits and management of the mineral estate must be addressed. The common law rules with regard to mineral interests state that the life estate holder and the remainderman both must execute an oil and gas lease for it to be effective. Bonus monies are considered corpus and therefore should be paid to the remainderman. Delay rentals are considered income and are paid to the life estate holder. Royalties that are paid from production are considered consumption of the corpus and thus belong to the remainderman, but income from payments that are invested belong to the life estate holder. A contractual life estate that states that the life estate holder shall receive all of the income and that the life estate holder can execute a mineral lease without the joinder of the remainderman will trump the common law. The open mine doctrine is also an exception to the common law rules. It provides that if an oil and gas lease is producing at the time the life estate is created, then there is a legal presumption that the party creating the life estate intended the life estate holder to receive all the income. B. Options for Minerals Management Going Forward Once mineral interests have been received by a charity, the charity must then determine how it will effectively manage these interests to ensure that the greatest benefit is realized for the charity over the long term. For many smaller charities that receive mineral interests indirectly through an estate or terminating trust, the initial thought is to immediately sell the mineral interest so that the cash proceeds can be more easily dealt with. And while mineral interests may be readily sold through various brokers, the practical reality is that most buyers will only be willing to pay a purchase price of approximately 1½ to 2 times the amount of annual production being realized from the interest. As a result, it will most often be in the best interest of the charity to retain ownership of the mineral interest. That having been said, most charitable organizations do not have the resources in-house to effectively manage mineral interests. So, most charitable organizations will need to look outside for a capable minerals management group to assist them with these interests. The most prevalent source for such expertise will be found within a larger banking organization, an investment manager, or a financial services organization that is large enough to support a minerals management group. However, there may be other smaller organizations or consulting groups that provide this same type of minerals management expertise. 14

81 Regardless of the group that is selected to manage the mineral interests going forward, the charity needs to be assured that it will receive active management, administration and negotiation for all mineral interest so that it will realize the greatest possible benefit from its mineral interests. Active management should focus on all phases of the oil and gas production process from the initial negotiation of the lease interest through the lifetime of a producing well or field. For producing mineral interests, the manager should continually review all division orders to ensure that the charity s interest is accurately credited and identified. Going forward, the manager will need to conduct a monthly review of revenues to confirm that the charity is being paid properly and timely and to identify any funds that may be held in suspense and subsequently return the interest to a paying status. The manager will also need to continually review and monitor active leases to determine the producing status of the leasehold and to obtain releases when appropriate. For non-producing mineral interests, the manager s goal should be to negotiate the maximum bonus and royalty for non-producing acreage should leasing activity begin, taking into consideration existing trends and current demand. In addition, the manager will update and maintain all undeveloped acreage records and all shut-in well requirements, coordinate any easements or permits that affect the rights of the surface owner, and continually monitor all oil and gas lease terms and secure timely releases for expiring leases. C. Environmental Issues Charities must always exercise caution before accepting any real property interest to protect the organization from liability for an environmental problem existing on the property that could result in significant (or catastrophic) costs to cure. Fortunately, the majority of prospective mineral interest gifts will not create any liability on the part of the charity donee. Only the owner of an operating interest or a working interest will bear the liability for environmental problems or liability related to the surface usage. Royalty interest owners that do not participate in the actual production process or maintain any responsibility for the expenses of production are not liable for any environmental conditions which arise or for any other problems associated with the use of the surface interest. As discussed earlier in this paper, many charitable organizations stipulate in their gift acceptance policies that they will not accept any mineral interest that represents an operating interest or a working interest. By adopting a policy that precludes any type of mineral gift other than a royalty interest, charities will be safeguarded from the potential consequence of an expensive environmental clean-up. While most charitable organizations choose to avoid owning any type of working interest, there may be circumstances where a charity may wish to make an exception to such a policy and receive one or more working interests. Should a charity wish to do so, the organization should consider an appropriate business structure that would provide the greatest possible liability protection for the charity. For example, some charitable organizations have established whollyowned for-profit subsidiaries solely for the purpose of holding these types of interests. Should the charitable organization you work for or advise wish to consider such an option, the organization should seek competent legal counsel to ensure that the best structure is implemented to provide the necessary liability protection for the charity. 15

82 VII. Taxation Issues A. Applicability of the Partial Interest Rule As a general rule, income, gift and estate tax law limits a donor s ability to claim a deduction for a contribution of less than the donor s entire interest in the property contributed. IRC 170(f)(3)(A), Reg A-7(a)(1); IRC 2522(c)(2), Reg (c)-3(c)(1)(i); and IRC 2055(e)(2), Reg (c)-2(e)(1)(i). Notwithstanding this general rule, certain exceptions to the partial interest rule are outlined in tax law, including the deductible contribution of an undivided portion of a taxpayer s entire interest in property. IRC 170(f)(3)(B)(ii), 2522(c)(2), and 2055(e)(2). Because all donors must comply with the partial interest rule (or fall within one of its exceptions) and recognizing that mineral interests are often owned separately from the surface interest and are often fractional interests of a larger whole, gift planners must familiarize themselves with the applicability of the partial interest rules to gifts of various types of mineral interests to ensure that the donors they are working with will not erroneously make a nondeductible contribution. In general, donors of mineral interests must either contribute their entire interest or an undivided fraction or percentage of their entire interest in order to claim a deduction for their gift. As mentioned above, many of the mineral interests held by prospective donors are fractional interests which represent a smaller undivided portion of a larger interest that is owned collectively by many owners (example: a 3/8 net royalty interest). While a contribution of such an interest may appear at first glance to pose a partial interest dilemma, the partial interest rule does not preclude a deduction for a contribution of such an interest if the undivided fractional interest represents the donor s entire interest in the property. One of the most common scenarios where prospective donors run into the partial interest rule involves the situation where a donor that is the current owner of both the surface estate and the mineral estate is contemplating a gift of the surface interest to charity but is planning to retain ownership of the mineral rights. The retention of the mineral interests in the gifted property will cause the gift to be one of a partial interest for which the donor will not be allowed a deduction. Rev. Rul , CB 52; Priv. Later. Rul For many donors, the realization of this consequence will motivate them to also contribute the mineral interest along with the surface interest. The applicable tax regulations also deny a charitable deduction for a contribution of a donor s entire interest in property immediately following a division of a larger interest for the purpose of creating the contributed portion. For example, if a prospective donor owns both the surface estate and the mineral estate in a given piece of property and the donor partitions the two estates and subsequently gifts only the mineral interest, the donor will not be allowed a deduction. The tax regulations make clear that no deduction will be allowed where the gifted interest exists by reason of a division or partition in order to create the interest. Reg A-7(a)(2)(i). While the foregoing rule that donors must convey their entire interest to charity in order to receive a deduction will almost always apply, the IRS has conceded that a donor will not lose his deduction if the retained interest (mineral or otherwise) is deemed to be an insubstantial interest. Such an insubstantial interest is one that cannot effectively reduce the donee s rights to something less than full ownership of the donor s entire interest in the property. For example, one tax court allowed a donor to claim a deduction after retaining mineral interests where the evidence showed that the existing value of the retained mineral interest was nominal and the potential for 16

83 future mineral production was negligible. In that case, there were no known mineral deposits underneath the surface, numerous dry holes had been drilled on adjacent properties in the immediate vicinity, the nearest mineral producing property was thirty-five miles away, the terrain of the property was not conducive to either transporting equipment or maintaining an oil rig, and the value of the mineral interest was determined to be between $1 and $2 per acre (as compared to a value of $1,800 per acre for the surface interest). Based upon these facts, the tax court determined that the retained mineral interest was insubstantial, and the donor was allowed to claim a charitable deduction for the value of the surface interest contributed. Stark v. Commissioner, 86 TC 243 (1986). As a cautionary note to charities, should a donor ever elect to retain a substantial mineral interests while contributing the surface ownership to charity (and foregoing a deduction in the process), the charity receiving the surface interest should seek to restrict the donor s surface use rights so that the donor (or a subsequent owner of the mineral interest) could not later begin drilling operations on the property that would interfere with charity s use of the land. As explained earlier in this paper, the mineral estate is the dominant estate and allows the owner to use the surface estate in a reasonable manner to exploit, mine, or produce minerals. Our organization confronted this issue several years ago while working with a church that was receiving a gift of land to be used for the construction of a new church facility. The donor was planning to forego a charitable deduction for the contribution of the surface rights to the property because of the long term benefit that he believed he would realize from retaining the mineral interest for himself. As a result, a restriction was placed in the deed that precluded the donor from accessing the surface estate for drilling purposes. This restriction ensured that the church would not be hindered in its ability to use and enjoy the surface interest for its charitable purposes. Similar restrictions may also be incorporated into a lease agreement or separate contract to limit the number or location of drill sites on a property. While it is far more typical for a deduction to be denied when an underlying mineral interest is retained by the donor, it is possible for a donor to realize a charitable deduction in this situation when the gift of the surface interest qualifies as a gift of a qualified conservation contribution. In a 1993 letter ruling, the Service allowed a charitable deduction for a contribution of 1,200 acres of unimproved land to a nonprofit that was formed to preserve environmental interests by holding and maintaining land dedicated to be used for outdoor recreation by the general public. The deed which the donor used to convey the property restricted the use of the land for such conservation purposes into perpetuity but also reserved the subsurface mineral rights for the donor and the right of access to those minerals. The deed also specified drill site locations and provided that the method of mining, removal, or extraction of the retained subsurface oil, gas, and other minerals was permitted only if it had a temporary, localized impact on the property and did not frustrate conservation interests. Section 170(h)(1) of the Code defines the term qualified conservation contribution for purposes of Section 170(f)(3)(B)(iii) as a contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. Section 170(h)(2)(A) of the Code provides that the term qualified real property interest includes the entire interest of the donor in real property other than a qualified mineral interest. Section 170(h)(6) provides that for the purposes of Section 170(h), the term qualified mineral interest means subsurface oil, gas, or other minerals, and the right to access such minerals. Accordingly, the Service ruled that the conveyance of the property was a qualified conservation contribution under Section 170(h) and that the individual would be allowed a charitable deduction for the gifted surface interest. Finally, the Service found that the deed provided sufficient safeguards so that the conservation purposes of the proposed conveyance would be protected in perpetuity. Priv. Ltr. Rul

84 As mentioned above, one of the stated exceptions to the partial interest rule for a gift of any type of asset allows the donor to realize a deduction for a conveyance of an undivided portion of the taxpayer s entire interest in the property. IRC 170(f)(3)(B)(ii), 2522(c)(2), and 2055(e)(2). The applicable regulations require that the undivided portion of the donor s entire interest in the property must: consist of a fraction or percentage of each and every substantial interest or right owned by the donor in the property, and extend over the entire term of the donor s interest in the property and in other property into which the property may be converted. Reg A-7(b)(1)(i). As mentioned above, the entire mineral interest of many donors will be only a fractional share of a larger interest (example: a 3/8 net royalty interest). When this is the case, the donor may still make use of the undivided portion exception to the partial interest rule by conveying a subfraction of their original fractional interest. For example, a donor who holds a 1/8th net royalty interest may convey half of their 1/8th interest to a charity and receive a deduction for the gift because it falls within the undivided portion exception. After the gift is completed by conveying a mineral deed to the charity, the charity and the donor will each own an individual 1/16th net royalty interest. By contrast, however, a donor that holds a working interest in minerals cannot receive a deduction for contributing either an overriding royalty interest or a net profits interest that has been carved out of the working interest. In this situation, the donor has not contributed the donor's entire interest in the property but instead has carved out and contributed only a portion of that interest. Further, the portion contributed was not an undivided portion of the donor's interest because it did not convey a fraction of each and every substantial interest or right owned by the donor in the property. By transferring an overriding royalty interest or a net profits interest, the donor has retained the right inherent in the ownership of a working interest to control the development and operation of the lease. This right to control is a substantial right, the retention of which prevents the donated interest from being considered an undivided portion. Rev. Rul , CB 97. B. Potential for Unrelated Business Income Unrelated business taxable income ( UBTI ) includes the gross income derived by any organization from any unrelated trade or business.regularly carried on by it. IRC 512(a)(1). The term unrelated trade or business means, in the case of any organization subject to tax imposed by IRC 511, any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its charitable, educational or other purpose or function. IRC 513(a). Tax-exempt organizations are subject to tax on their UBTI at the regular corporate tax rates. IRC 511. Excessive UBTI for a tax-exempt organization can ultimately jeopardize its tax-exempt status. However, the Code also identifies certain unrelated business activities that, when conducted by a tax-exempt organization, are excluded from UBTI. Such excluded income is often referred to as passive income. One such exclusion is provided under the Code for certain types of royalties paid to a tax exempt organization. IRC 512(b)(2). In the context of oil and gas law, royalties are defined as the right to a share of production reserved to the owner of the property for permitting another to drill for oil or gas or extract other types of minerals from a mine or quarry. Fraternal Order of Police III. State Troopers Lodge No. 41 v. Commissioner, 833 F.2d 717, 723 (7th Cir. 1987). It is also possible for a lessor to receive a shut-in royalty which is a payment made when a gas well, capable of paying in producing quantities, is shut-in for lack of a market for the gas. 18

85 Similarly, a lessor may also receive a delay rental which is a sum or money paid by the lessee for the privilege of deferring the commencement of drilling operations or the commencement of production during the primary term of the lease. Fortunately, for tax-exempt organizations, each of these types of income are generally treated as royalties which are considered passive income that is not subject to unrelated business income tax. IRC 512(b)(2). While most royalty interests that may be conveyed to a charitable organization will constitute passive income that will not generate unrelated business income tax, there are exceptions to this general rule that the gift planner should be aware of. Specifically, if a tax-exempt organization owns a working interest in a mineral property and remains liable for its share of the development costs under the terms of an operating agreement, then the income derived from the working interest will be subject to unrelated business income taxation. Reg (b)-1(b). In one ruling, the Service clarified that a royalty interest holder must not be liable for either development costs or operating expenses to ensure that the income received from the interest would not be subject to unrelated business income tax. Rev. Rul , CB 158. In a 1977 private letter ruling, the Service examined a tax-exempt university's oil and gas interests and focused on the liability for operating expenses as a key factor to determine the applicability of unrelated business income tax. In that case, the university bought interests in oil and gas leases and subsequently assigned 100% of its working interests to various oil companies. After the assignments were made, the university was no longer liable for any development or operations expenses that exceeded gross profits. Said differently, the university was entitled to 100% of the net profits from its original pro rata interests in the leases. The Service determined that the university s mineral interest was a royalty within the Code's definition so long as the holder of the interest isn't liable for development or operations expenses. And, the holder is not liable for such expenses if his interest is a net profits interest not subject to expenses that exceed gross profits. As a result, the income from the university s net profits interest was excluded from the computation of its unrelated business taxable income. Priv. Ltr. Rul However, the Service also made it clear in an earlier 1969 ruling that it would not allow charities to disguise income derived from a working interest that is held by a controlled entity. The facts cited in that ruling involved a tax-exempt foundation that received 100% of the net profits in certain oil properties that were operated by two corporations that were controlled by the foundation. The Fifth Circuit Court of Appeals had earlier ruled in United States v. The Robert A. Welch Foundation, 334 F.2d 774 (1964), affirming per curiam 228 F.Supp. 881 (1963), that the income from this interest was royalty income under Section 512(b)(2) of the Code and therefore not included in the computation of the foundation s unrelated business taxable income. However, in its ruling, the Service made it clear that it would continue to review exempt organizations' transfers of mineral properties to controlled corporations and would characterize the payments according to the substance of the transaction regardless of its form. Therefore, if in substance the income received by an exempt organization is from a working interest, characterization of the income as royalty by the exempt organization will not be accepted by the Service. Rev. Rul , CB 158. Finally, having determined the applicability of unrelated business income tax to the various types of royalty interests that a charity could own, charities will also want to know whether or not bonus payments received from a lessee will be subject to unrelated business income tax. In short, bonus payments received from a royalty interest do not meet the definition of unrelated business taxable income found in IRC 512(a)(1) which requires that the income derived from the unrelated activity be regularly carried on by the charity. Bonus payments represent only a onetime payment received by the royalty interest owner at the time a new mineral lease is executed. 19

86 Accordingly, bonus payments are classified as passive income and not subject to the unrelated business income tax. 20

87 MINDING THE SHOP Creative Planned Giving Strategies for Business Owners OKLAHOMA MEDICAL RESEARCH FOUNDATION November 30, 2017

88 CASE STUDY #1

89 FACTS Tom and Jerry FLIP-CRUT Donors to establish charitable remainder unitrust, funded with highly appreciated, closely-held C Corporation securities. Husband Donor nearing retirement is one of three shareholders. Corporate shares subject to buy-sell agreement giving company First Right of Refusal and containing provisions for determining value at which shareholders may transfer shares (agreement does not contemplate charitable gift of shares). 3 HighGround Advisors

90 FACTS (CONT D) Tom and Jerry FLIP-CRUT Company plans to redeem shares at value of $14 per share, pursuant to terms of buy-sell agreement. Donors plan to claim deduction based upon value of their shares as determined under buy-sell agreement. Donors assure Trustee company will offer to redeem shares after trust is funded. 4 HighGround Advisors

91 ISSUES Tom and Jerry FLIP-CRUT C Corporations generally Redemption process & self dealing Qualified Appraisal rules Prearranged transaction Unrelated business income 5 HighGround Advisors

92 CASE STUDY #2

93 FACTS Betty and Barney Rubble FLIP-CRUTs Donors want to make a gift to hospital using their membership interests in a limited liability company (LLC) Donors want to retain an income stream for their lifetimes and the lifetimes of their five children. Donors have been discussing succession planning for continuation of family business, the LLC, with their attorney. 7 HighGround Advisors

94 ISSUES Betty and Barney Rubble FLIP-CRUTs Limited Liability Companies generally Gifts of LLC interests 8 HighGround Advisors

95 ISSUES Betty and Barney Rubble FLIP-CRUTs Membership Agreements/Business Continuation Agreements Provisions affecting transfer of ownership interests to charity Provisions affecting post-gift redemption or transfer by charity Avoiding step-transactions Valuation issues 9 HighGround Advisors

96 ISSUES Betty and Barney Rubble FLIP-CRUTs Succession planning Redemption Qualified Appraisal/Valuation 10 HighGround Advisors

97 CASE STUDY #3

98 FACTS Foghorn Leghorn FLIP-CRUT Donor owns 47% of outstanding shares of closely-held S Corporation; serves as Chairman of Board of Directors. Donor s ownership interest valued at approximately $4 million. Board is considering an offer to sell the corporation to a larger competitor. Company shareholders meet in three weeks where vote to approve sale expected. 12 HighGround Advisors

99 FACTS (CONT D) Foghorn Leghorn FLIP-CRUT Donor s shares highly appreciated and desires to avoid capital gains tax resulting from sale. Donor s wish to place shares in charitable remainder unitrust to benefit several charitable organizations. 13 HighGround Advisors

100 ISSUES Foghorn Leghorn FLIP-CRUT S Corporations generally Gifts of S Corporation stock Anticipatory assignment of income Qualified Appraisal 14 HighGround Advisors

101 CASE STUDY #4

102 FACTS George and Jane Jetson GIFT ANNUITY Husband and wife (Donors) each own 50% partnership interest in family limited partnership (FLP) owning/managing multiple duplex units near major university campus. University seeking acquisition of neighboring tracts of land for future campus facility expansion. University approached Donors with offer to purchase a duplex unit from FLP at $2,500,000, well above market value. 16 HighGround Advisors

103 FACTS (CONT D) George and Jane Jetson GIFT ANNUITY FLP basis in duplex is $300,000. Donors historically philanthropic and desire to benefit Charity through transaction in most tax efficient manner possible. After consideration of multiple options and on advice of counsel, Donors elect to convey a 40% undivided interest in duplex from FLP to Charity in exchange for gift annuity naming Donors as life annuitants. 17 HighGround Advisors

104 ISSUES George and Jane Jetson GIFT ANNUITY Overview of Partnership Entities General Partnership Limited Partnership Family Limited Partnership Limited Liability Partnership 18 HighGround Advisors

105 ISSUES George and Jane Jetson GIFT ANNUITY Gifts made by Partnership Entities General tax treatment Adjustment of partners bases Limited on deduction Distribution followed by transfer 19 HighGround Advisors

106 ISSUES George and Jane Jetson GIFT ANNUITY Partial Interest Rule Unrelated business taxable income 10% rule concerns 20 HighGround Advisors

107

108 Minding the Shop: Creative Planned Giving Strategies for Business Owners Oklahoma Medical Research Foundation November 30, 2017 Joe Hancock Vice President & General Counsel HighGround Advisors 1717 Main Street, Suite 1400 Dallas, Texas Telephone:

109 MINDING THE SHOP: CREATIVE PLANNED GIVING STRATEGIES FOR BUSINESS OWNERS This presentation will use a case study format to help gift planners recognize unique issues and planning opportunities for business owners. The cases will analyze specific issues that arise for business owners and provide effective strategies to ensure the successful structure, implementation and administration of planned gift arrangements for these donors. This presentation will equip participants with the knowledge to identify potential gifting opportunities while also accomplishing the goals and objectives that are typical of most business owners. Specific topics include: avoiding self dealing and step transactions, dealing with buy-sell and partnership agreements, valuation of closely-held interests, etc. TOM and JERRY FLIP-CRUT Facts: Donors want to establish a charitable remainder unitrust, to be funded with highly appreciated, closely-held C corporation securities. Husband Donor is nearing retirement from the company and is one of three shareholders. Corporate shares are subject to a buy-sell agreement which gives the company a right of first refusal and contains provisions for determining the value at which an individual shareholder may transfer shares. The agreement does not contemplate a charitable gift of the shares. The company plans to redeem the shares at a value of $14 per share, pursuant to the terms of the buy-sell agreement. Donors plan to claim a deduction based upon the value of their shares as determined under the buy-sell agreement. Donors assure Trustee that the company will offer to redeem the shares after the trust is funded. Issues: C Corporations Generally Redemption Process & Self Dealing Qualified Appraisal Rules Prearranged Transaction Unrelated Business Income C Corporations Generally C corporations are established under state law by the filing of articles of incorporation with the appropriate state agency. The operations of the corporation are governed by a 2

110 written set of by-laws that are established by the board of directors. Members of the board of directors establish corporate policies and provide broad oversight, while the officers of the corporation lead the daily activities of the organization. The shareholders are the equity owners of the corporation, as evidenced by the issuance of shares of stock. The stock is a separate asset that may be transferred or gifted. In many closelyheld corporations, shareholders enter into buy-sell agreements that limit the transfer of shares to outside parties and establish the rights of each shareholder when a transfer is contemplated. (A detailed discussion of buy-sell agreements can be found on page 6 of this outline.) As a general rule, the shareholders, directors and officers of a corporation are not legally liable for the acts and debts of the corporation. The taxation of a C corporation is governed by Subchapter C of the Internal Revenue Code. The corporation itself is a separate taxable entity, paying tax on all income and gain incurred by the organization at corporate tax rates. Further, any distributions made to corporate shareholders will be treated as taxable income to the individual shareholder. Accordingly, it is often noted that C corporations are subject to double taxation once at the corporate level and again at the individual shareholder level. Redemption Process & Self Dealing A charitable remainder trust which complies with IRC 664 and for which a deduction is allowed under IRC 170 is a split interest trust described in IRC 4947(a)(2), thereby making it subject to the self dealing rules under IRC Specifically, IRC 4941(d)(2)(F) imposes certain restrictions regarding redemptions of closely-held stock from closely related parties. The tax regulations which speak to this issue provide that a redemption of closely-held shares held by a charitable remainder trust will not result in a self-dealing transaction so long as all the securities of the same class as that held by the trust are subject to the same terms of redemption and such terms provide for receipt by the trust of no less than fair market value. Treas. Reg (d)-3(d). The regulations further state that all of the securities are not subject to the same terms unless the corporation makes a bona fide offer on a uniform basis to the trust and every other person who holds such securities. Id. Appendix A to this outline contains sample correspondence that may be used to properly document the redemption process to further ensure compliance with these regulations. Qualified Appraisal Rules In order to receive an income tax charitable deduction for their gift, the Donors must comply with certain appraisal requirements. The fair market value of the stock on the date of the gift must be determined by a qualified appraisal that follows all the rules set by the IRS. Treas. Reg A-13(c). Specifically, the qualified appraisal rules apply to gifts of property (other than money and publicly traded securities) if the value claimed or reported for the property is in excess of $5,000. Treas. Reg A-13(c)(1)(i). Appendix B to this outline contains a detailed summary of the qualified appraisal rules. 3

111 Note: A special rule exists for gifts of nonpublicly traded stock. If the claimed value of the stock exceeds $5,000 but is less than $10,000, the Donors will not be required to obtain a qualified appraisal. Rather, they will be required to attach a partially completed appraisal summary form (Form 8283, Section B, Parts I and II) to the tax return on which the deduction is first claimed. Treas. Reg A-13(c)(2)(ii). The sole purpose of the appraisal is to allow the Donors to obtain their income tax charitable deduction, and the IRS will not allow a deduction without this appraisal. Accordingly, the Donors and their advisors bear the responsibility to obtain the qualified appraisal and to ensure that the appraisal is properly completed in a timely fashion and meets all of the requirements for qualification. While the Charity may be able to provide helpful information about the qualified appraisal rules, the final determination of the sufficiency of the appraisal rests with the Donors and their advisors. The appraisal must be prepared no sooner than 60 days prior to the date of gift; however, the Donors are not required to have the appraisal in hand until they actually file the income tax return on which they first claim the deduction. Treas. Reg A- 13(c)(3)(iv)(B). Nonetheless, before the trust irrevocably receives these shares of stock from the Donors, it is important to understand the interplay between the appraised value of the stock that will determine the amount of the Donors charitable deduction and the value at which the company will redeem the shares. If the Donors establish the trust and later obtain a qualified appraisal that places a higher value on the shares than $14 per share and subsequently claim a deduction based upon that higher value, the IRS could question the validity of the deduction amount. When claiming the deduction, the Donors must attach an appraisal summary (found in Section B of IRS Form 8283) to the income tax return on which they first claim the deduction. Treas. Reg A-13(c)(2)(i). The appraisal summary must be signed and dated by the donee charity (or the Trustee of the charitable trust), be signed and dated by the qualified appraiser, and state the appraised fair market value of the property on the date of contribution. Treas. Reg A-13(c)(4). Subsequently, should the Trustee sell, exchange, or otherwise dispose of any property for which the Trustee signed an appraisal summary within three years of the date of gift, the Trustee must then file an information return (IRS Form 8282) to report the amount received on the disposition. IRC 6050L(a)(1). Should the amount claimed by the Donors as a deduction (based upon the value reported on Form 8283) significantly exceed the amount received by the Trustee on disposition of the property (as reported on Form 8282), the IRS could have grounds to question the validity of the Donors claimed deduction. In addition, such a discrepancy between the appraised value of the shares (and the resulting deduction) and the amount at which the shares are subsequently sold by the charitable trust could lead the IRS to determine that a self-dealing transaction occurred. As explained above, the charitable trust must receive no less than fair market value for the shares upon disposition in order to avoid a self-dealing transaction. Treas. Treas. Reg (d)-3(d). Should the qualified appraisal show that the fair market value 4

112 of the stock is greater than the $14 per share allowed under the buy-sell agreement, the IRS could establish that a self-dealing transaction has occurred, which could result in the imposition of sanctions under IRC It is also important to note that if the Donors hold less than a full ownership interest in the company, the appraised value of the Donors stock may be discounted. Typically, an ownership interest in a business that represents less than full ownership will be discounted from 30 percent to 40 percent when appraised. This is important to remember because the charitable deduction will be calculated using this discounted appraised value while the company s calculation of the value of its stock may not reflect such a discount. Prearranged Transaction A prearranged transaction, formally known as a step transaction, occurs when a series of separate and independent steps are treated as a single transaction if such steps are in substance integrated, interdependent, and focused upon a particular result. Esmark v. Commissioner, 90 T.C. 171 (1988). When applied, the step transaction doctrine dictates that two or more ostensibly independent transactions (usually the gift of an appreciated asset followed by a subsequent sale of the asset by charity) be consolidated for tax purposes. This can happen when, under the facts and circumstances surrounding the gift, the donee charity is obligated to sell the gifted property to a purchaser that was prearranged by the donor prior to the gift. Hopkins, The Tax Law of Charitable Giving 6.8 (John Wiley & Sons 1993). When this situation occurs, the IRS will view the transaction as a sale of the property by the donor to the third-party purchaser and a subsequent gift of the sales proceeds to charity, causing the donor to recognize the taxable gain from the sale of the gifted property. Martin v. Machiz, 251 F. Supp. 381 (D. Md. 1966). In Palmer v. Commissioner, 523 F.2d 1308 (8 th Cir. 1975), a taxpayer with voting control of both a corporation and a tax-exempt private foundation donated shares of the corporation s stock to the foundation and subsequently caused the corporation to redeem the shares from the foundation, pursuant to a prearranged plan. The United States Tax Court treated the transaction according to its form because the foundation was a legitimate tax-exempt entity, the transfer of stock to the foundation was a legitimate gift, and the foundation was not obligated or required to redeem the shares at the time they were received. In a subsequent revenue ruling, the Service acquiesced to the Palmer ruling, stating that [t]he Service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption. Rev. Rul , CB 83. In the case at hand, the provisions of the governing buy-sell agreement gave the corporation a right of first refusal to purchase any outstanding shares from an existing shareholder. (See page 6 for a full discussion of buy-sell agreements.) However, the corporation did not have any right or authority to compel the charitable trust to surrender 5

113 or sell the gifted shares. In any similar circumstance, great care must be taken to assure that any documentation which governs the transfer of shares among the donor, the donee charity (or charitable trust), and any other party must not be drafted so as to create an obligation on the part of the donee charity to sell the gifted property to a purchaser that was prearranged prior to the gift. Unrelated Business Income Generally, income from closely-held securities in the form of dividends or capital gain is considered passive income and not subject to the unrelated business income tax. IRC 512(b)(1), (2), (3), and (5). However, income derived from a controlled corporation may be taxable. IRC 512(b)(13). For this reason, it is important to be mindful of the percentage ownership that is being acquired by the Charity and the potential for earned income being realized during the length of time in which the Charity is likely to hold the controlling interest in the company. BETTY and BARNEY RUBBLE FLIP-CRUTs Facts: Donors want to make a gift to hospital using their membership interests in a limited liability company (LLC). Donors want to retain an income stream for their lifetimes and the lifetimes of their five children. Donors have been discussing succession planning for continuation of the family business, the LLC, with their attorney. Issues: Limited Liability Corporations Generally Gifts of LLC Interests Documents to Review Membership Agreements / Business Continuation Agreements A. Provisions Affecting Transfer of Ownership Interests to Charity B. Provisions Affecting Post-Gift Redemption or Transfer by Charity 1. Avoiding Step-Transactions 2. Valuation Issues Succession Planning Redemption Qualified Appraisal / Valuation Limited Liability Corporations Generally Limited liability corporations ( LLCs ) are also creatures of state law that are established with the filing of articles of organization with the proper state agency. LLCs offer the 6

114 favorable tax treatment of a partnership while also providing the liability protection that shareholders in a corporation enjoy. The equity owners of an LLC are referred to as members and may either conduct business based upon majority rule or by the appointment of a managing member to carry on the daily activities of the LLC. In either scenario, the members (including the managing member) retain their liability protection despite their level of involvement in the affairs of the business. Further, entities such as for-profit corporations and partnerships may participate as members of an LLC, unlike S corporations that preclude these types of entities from owning shares of S corporation stock. Gifts of LLC Interests While LLCs do not typically provide members with specific evidence of ownership (as do corporations with stock certificates), membership interests are nonetheless a separate asset that may be gifted or otherwise transferred. While most LLCs utilize the advantage of being taxed in the same manner as a partnership, an LLC may elect to be taxed as either a partnership or as an association taxable as a corporation. If the LLC elects to be taxed as a partnership, a charitable contribution of a membership interest will likely be treated the same as a gift of a partnership interest. (A detailed discussion of partnerships and gifts of partnership interests can be found in the last case study in this outline.) Should the LLC elect to be taxed as a corporation, a charitable contribution of a membership interest will likely to be treated the same as a gift of shares in a C corporation. (A detailed discussion of C corporations and gifts of C corporation shares can be found in the first case study in this outline.) Documents to Review In reviewing and analyzing the gift, the hospital will want to review the following documents: Articles of Incorporation and any amendments Membership /Operating Agreement and any amendments List of membership interests Current Valuation Membership Agreements / Business Continuation Agreements: More often than not, for a donor or charity contemplating a gift of closely-held securities, a membership interest in a limited liability corporation, or a partnership interest in a business, the provisions of a buy-sell agreement or business continuation agreement, typically included in the membership/operating agreement, will have to be addressed. The buy-sell agreement for a partnership is found in the partnership agreement and in the shareholder s agreement for a corporation, either C-corporation or S-corporation. Such an agreement provides for the transfer of an ownership interest in the closely-held business entity upon the occurrence of certain contemplated events. Such events 7

115 typically include the owner s death, disability, insolvency, retirement, or other withdrawal from the business at an earlier time than expected. Generally, the agreement will determine the price and payment terms and, often, restrict who can own an interest in the business. Several common versions of the agreement are typically encountered, including: 1. A redemption agreement or a liquidation agreement entered into between the business itself and the individual owners whereby the business agrees to acquire each owner s interest upon the occurrence of certain stated events; 2. A cross-purchase agreement entered into among the individual owners whereby the remaining owners would acquire the withdrawing owner s interest upon the occurrence of certain stated events: 3. A third party business buyout agreement entered into between the individual owners and a specified individual (key person, family member, third party, etc.) whereby the withdrawing owner agrees to sell his interest to the specified individual; or 4. A combination of the foregoing. A. Provisions Affecting Transfer of Ownership Interests to Charity The primary reason that most buy-sell agreements and business continuation agreements are put in place is to prevent all or any part of the business from falling into the hands of outsiders. Accordingly, most of these agreements are drafted in a manner that provides the most protection possible for the business entity and its existing owners by limiting the possibility for an ownership interest to pass to any party not already associated with the business. It is rarely contemplated that a charitable gift of the closely-held business interest will occur, and as a result, you are unlikely to ever see a provision in one of these agreements that provides for a charitable contribution of an ownership interest in the business. What you will see is a provision or multiple provisions that place restrictions on the manner in which the transfer of an existing ownership interest may be accomplished. For example, some agreements provide that an existing ownership interest may not be conveyed to any outside party without the prior approval of the board of directors or a majority of the remaining owners. In this type of situation, it is very possible to complete a gift transaction by following the procedural requirements of the buy-sell agreement or business continuation agreement to obtain the requisite approval. Typically, the members of the board of directors or the remaining owners will be closely connected to the prospective donor 8

116 (family members, long-time business partners, etc.) and will understand the donor s objectives in funding a planned gift with the closely-held business interest. When open lines of communication exist between the donor and these key players within the business and these individuals have a clear understanding of the donor s intentions, it is much more probable that the donor s charitable plan will be supported and that the approval to transfer the donor s interest in the business to the donee charity will be approved. This clear communication and understanding will also benefit the charity after the gift is completed when the charity seeks to redeem or sell the gifted interest. More commonly, a buy-sell agreement or business continuation agreement will grant the remaining individual owners or the business entity itself, or both, a right of first refusal to acquire the ownership interest of the withdrawing owner. Only after the parties who are granted the right of first refusal under the agreement have formally declined their right to purchase may the withdrawing owner transfer his ownership interest to an outside party, such as a charity. Again, this scenario does not preclude a charitable gift of the ownership interest. In such a case, the prospective donor must take the necessary steps to provide proper notice to the relevant parties of his intention to transfer his interest, allow any required time period for the exercise of the right of first refusal to pass, and adhere to any other particulars specified under the agreement. As mentioned in the previous paragraph, clear communication and understanding of the donor s objectives in gifting the shares to charity will preclude many concerns or hesitations among the remaining owners. After all procedural steps are followed, and assuming that no one exercised the right of first refusal, the donor would be able to complete the gift of his business interest. Finally, as a last resort, if certain provisions of the buy-sell or business continuation agreement preclude or do not allow for the transfer of an existing ownership interest to an outside party, then it may be necessary to amend the agreement before a charitable gift of the business interest may be considered. If this is deemed to be necessary, a thorough review of the document should be conducted to determine the possibility and manner in which an amendment may be made. As with other procedural aspects of the agreement, the process of amending the agreement to allow for a gift of the donor s interest to charity should be conducted carefully to ensure that the gift of the business interest to charity cannot be subsequently questioned. Once the amendment is properly made, the new provisions of the agreement should also be carefully followed to complete the gift transaction. In this case, the provisions of the membership agreement provided that the existing members must give prior approval before any membership 9

117 interest may be conveyed to an outside party. Because the other members of the LLC were all children of Donors who would ultimately receive a benefit from the CRUTs that Donors were establishing, and because the conveyance of Donors interests to the CRUTs would increase the children s proportionate ownership interests in the LLC (following redemption), the children were very willing to approve the gift arrangement. B. Provisions Affecting Post-Gift Redemption or Transfer by Charity 1. Avoiding Step-Transactions After the closely-held business interest has been successfully conveyed to a charitable organization or qualified charitable trust, the charity or trustee must then consider issues which surround liquidation of the closely-held interest. As with the transfer of the interest from the donor to the charity or qualified trust, the provisions of the buy-sell or business continuation agreement can have significant consequences for the charity as a newly established owner of the business interest. Specifically, the provisions of the agreement should be closely reviewed prior to acceptance of the gifted interest in the business to ensure that a prearranged transaction (or step-transaction ) will not occur upon the subsequent disposition of the interest by the charity. The leading case that provides guidance here is Palmer v. Commissioner, 523 F.2d 1308 (8 th Cir. 1975), in which a redemption of gifted securities was at issue. In Palmer, the Court ruled that no step transaction had occurred upon redemption because the done charity was not obligated or required to redeem the shares at the time they were received. A subsequent ruling by the IRS made clear that a step transaction will only occur in this situation when, the donee is legally bound, or can be compelled by the corporation, to surrender the shares for redemption. Rev. Rul , CB 83. A more complete discussion of the case law history and IRS rulings regarding step transactions may be found on page 4 of this outline. Accordingly, great care must be taken to ensure that the documentation which governs the transfer of a business interest must not be drafted so as to create an obligation on the part of the donee charity to sell the gifted interest to a purchaser that is prearranged prior to the gift. It is, however, permissible for the business entity or the remaining business owners to hold a right of first refusal to purchase any outstanding business interest from a withdrawing owner. Such a right does not impose upon the donee 10

118 charity an unavoidable obligation to transfer (by redemption or sale) the gifted interest to a specific party. A right of first refusal merely creates an opportunity for the holder of the right to acquire the interest should the donee charity elect to make it available. In this case, the membership agreement did not contain any provisions whereby a member of the LLC was obligated or could be compelled to surrender his or her membership interest upon a request for redemption by the LLC. The membership agreement simply allowed the LLC to make an offer for redemption of outstanding membership interests, subject to the prior approval of the members. Because the provisions of this membership agreement were favorable, there was no concern in this case that the transaction could be regarded as a step transaction. 2. Valuation Issues It will also be important for the donee charity to review and understand any provisions of the buy-sell or business continuation agreement that specifically determine the value of the gifted business interest for the purpose of a subsequent redemption or sale to other owners. There are several methods which are typically used to arrive at the value of a business interest. One fairly common approach is for the agreement to set the exact redemption or purchase price in advance with a further provision that would allow the parties to amend the amount in the future, as needed. Another approach is to base the purchase price upon the company s book value as determined by the most recent financial statements. A third valuation approach is to include a formula in the agreement that is to be applied at any point in time that a transfer of an interest is to be made. Formula approaches to valuation are often preferred because they allow factors such as net earnings, profitability and even goodwill to be taken into consideration. Regardless of the method of valuation that is to be employed, the donee charity should become familiar with the manner in which valuation will be handled and determine a reasonable expectation of the benefit that actually will be received upon liquidation of the gifted interest. In this case, the membership agreement provided that a valuation formula should be used to determine the value of any membership interest that would be transferred or conveyed. 11

119 Succession Planning Business succession planning deals with the passing of both the ownership and management of the business upon some event such as when the individual decides to sell, becomes incapacitated, decides to retire or withdraw from the business or dies and should be accomplished in light of the overall objectives of the estate plan. In this case, the donors wanted to make a charitable gift to the hospital using their membership interests in the LLC while passing ownership control of the family business to their children. The donors wanted to accomplish the transfer of ownership interest in the business in a manner that would not trigger gift tax. Therefore, the donors membership interests were transferred to five charitable remainder trusts followed by the redemption of the interests by the LLC. By contributing their interests to the CRTs, the Donors effectively increased the percentage ownership of each of their children in the LLC without incurring gift taxes. After the redemption, the children owned 100% of the membership interests in the LLC. Because each trust included the husband and wife and then one of the children, taxable gifts were made when the trust was created. Generally, the gifts to each spouse, even though terminable interests, would qualify for the gift tax marital deduction. IRC 2523(g)(1). However, by adding the children as successor beneficiaries, the marital deduction is lost. Id. The loss of the marital deduction at the death of the first spouse resulting from adding each child as a successor beneficiary was taken into consideration in the planning stage. The Donors retained the right, exercisable only by will, to revoke the gift of the income interest to the children at the death of the surviving Donor in the trust document, thereby delaying, until the death of the surviving Donor, the gift tax implications to the children. If the right to revoke is exercisable during the Donors lifetimes, the CRT is disqualified. Treas. Reg (a)(4), (a)(4). Redemption In order to achieve Donors objective of increasing the respective ownership interests of the children in the LLC and to provide liquidity to the CRUTs which will allow income distributions to begin, the LLC will redeem the ownership interests held in each of the CRUTs. Pages 3and 4 of this outline contains a detailed discussion about the redemption of closely-held business interests from qualified charitable trusts or private foundations and explains the interplay between the valuation of closely-held business interests as part of the redemption process and the potential that exists to create a selfdealing transaction under Treas. Reg (d)-3(d). In this situation, the donor should be advised to carefully consider the applicable regulations and Code sections (identified on pages 3 and 4 of this outline) to ensure that a self-dealing transaction does not occur upon redemption of the gifted business interest from the qualified charitable trust. 12

120 Qualified Appraisal / Valuation As discussed in the prior case, the Donors must comply with certain appraisal requirements in order to receive an income tax charitable deduction for his gift. The fair market value of the contributed membership interests must be determined by a qualified appraisal that follows all the rules set by the IRS. Treas. Reg A- 13(c). Page 3 of this outline contains a detailed discussion of the qualified appraisal rules that apply to closely-held business interests, and Appendix B to this outline contains a detailed summary of the qualified appraisal rules also. Conclusion In addition to passing ownership in the LLC to family, the Donors diversified their holdings and created additional retirement income, reduced their taxable estates, received an immediate charitable income tax deduction and left a legacy to their charity. FOGHORN LEGHORN FLIP-CRUT Facts: Donor owns 47% of the outstanding shares of a closely-held S corporation, and he serves as chairman of the company s board of directors. Donor s ownership interest is valued at approximately $4 million. The board of directors is currently considering an offer to sell the company to a larger competitor. The shareholders of the company will meet in three weeks. A vote to approve the sale is expected to occur at that meeting. Donor s shares are highly appreciated, and he wants very much to avoid the capital gains tax that would result from the sale. Donor wishes to place the shares into a charitable remainder unitrust to benefit several charitable organizations. Issues: S Corporations Generally Gifts of S Corporation Stock Anticipatory Assignment of Income Qualified Appraisal S Corporations Generally Like C corporations, S corporations are also established under state law by the filing of articles of incorporation with the proper state agency. Also similar, the by-laws adopted by the board of directors provide a structure for the governance of the corporation. The roles of board members, officers and shareholders are also the same as with a C 13

121 corporation. And, directors, officers and shareholders are generally not liable for the debts and acts of the corporate entity. Prior to 1998, charitable organizations were not included as eligible shareholders of S corporations. If S corporation shares were transferred to a charity, the corporation would immediately lose its S corporation status and become taxed the same as a C corporation. However, the Small Business Job Protection Act of 1996 (P.L ) allowed charitable organizations to be included among the eligible shareholders of S corporations as of January 1, Other eligible shareholders include individuals, estates, and certain trusts (discussed below). Partnerships and for-profit corporations are not allowed as shareholders of S corporations. Nonetheless, the passage of the Small Business Job Protection Act created new opportunities for donors and charities by allowing gifts of stock in many closely-held companies that were previously not possible. The taxation of S corporations is governed under Subchapter S of the Internal Revenue Code and is notably different from the taxation of C corporations. The foremost difference is that the S corporation is not treated as a separate taxable entity. Rather, all taxable gain and income passes through to the individual shareholders. For this reason, the S corporation is often referred to as a pass through entity. Gifts of S Corporation Stock For a contribution of S corporation stock that qualifies as long-term capital gain property, the donor would be allowed a charitable contribution deduction for the fair market value of the stock, and the donor would not be taxed on any capital gain in the stock. However, this deduction amount must be reduced by the amount of gain that would have been ordinary income had the donor sold the S stock himself. IRC 170(e). Also, once received by the charitable donee, gifted shares of S corporation stock will be treated as an interest in an unrelated trade or business. As such, all items of income or loss will be considered as unrelated business income that is taxable to the charity even if the underlying business activity is a passive one. IRC 512(e). Also, any gain or loss on the disposition of the S corporation shares by the charity will also be taxable as unrelated business income. Id. A transfer of shares of S corporation stock to a charitable remainder trust will cause the corporation to immediately lose the S election for all shares, not just for those shares actually contributed to the trust. IRC 1361(e)(1)(B)(iii). In most cases, the resulting negative tax consequence for all other shareholders will preclude a donor from gifting S stock into a CRUT. However, because all of the company shares in this situation will soon be sold, this otherwise undesirable result may be of little consequence to the other shareholders. 14

122 It is also important for the Donor to be aware that, if the S corporation has operated as a C corporation at any time during the previous ten years, the corporation could have some retained earnings that would be taxed as ordinary income upon the conversion of the corporation by the loss of the S election. Anticipatory Assignment of Income Because the sale of the company is drawing near, care must be taken to assure that an anticipatory assignment of income does not occur upon the transfer of the Donor s shares to the trust. The oft quoted statement regarding the assignment of income doctrine made by Justice Oliver Wendell Holmes states that an arrangement by which the fruits are attributed to a different tree from that which they grew is not recognized for income tax purposes. Lucas v. Earl, Guy (1930, S. Ct.) 8 AFTR 10287, 281 US 11, 74 (Ed 73), 2 USTC. When an anticipatory assignment of income does occur, the gain from the sale of the stock is taxable to the donor on the theory that the asset transferred to the charitable trust by the donor was, in practical effect, a right to receive cash rather than an asset that might or might not be converted to cash at some time in the future. However, a mere anticipation or expectation of the receipt of income is insufficient to conclude that a fixed right to income exists. S.C. Johnson & Son, Inc. v. Commissioner, 63 T.C. 778, (1975). In the situation where the transfer to the charitable trust is made before the shareholder vote to liquidate, the gain will be taxed to the charitable trust, not the donor, but because the remainder trust is a tax exempt entity, no recognition of gain will occur. Stern v. Commissioner, 15 T.C. 521 (1950). So, time is of the essence. Whether the assignment of income doctrine and/or the step transaction doctrine apply are fact sensitive questions. Although control over the disposition of the transferred property is significant to the assignment of income analysis, 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. Ferguson v. Commissioner, 174 F3d 997 (9 th Cir. 1999). Note: In all relevant cases on this point, the Service did not assert that the donation itself was defective or that the charitable deduction should be disallowed. The issue was always the exclusion of capital gain arising from the donated asset. Qualified Appraisal As discussed in the prior cases, the Donor must comply with certain appraisal requirements in order to receive an income tax charitable deduction for his gift. The fair market value of the stock on the date of the gift must be determined by a qualified appraisal that follows all the rules set by the IRS. Treas. Reg A-13(c). Page 3 of this outline contains a detailed discussion of the qualified appraisal rules that apply to closely-held business interests, and Appendix B to this outline contains a detailed summary of the qualified appraisal rules also. 15

123 GEORGE and JANE JETSON GIFT ANNUITY Facts: Husband and Wife ( Donors ) each own a 50% partnership interest in a family limited partnership ( FLP ) that owns and manages multiple duplex units near the campus of a major university ( University ). University is seeking to acquire neighboring tracts of land to provide for much needed expansion of campus facilities. University has approached Donors with an offer to purchase one of the duplex units from the FLP at a price of $2,500,000 well above what the market would otherwise support. The FLP s basis in the duplex is $300,000. Donors have a history of philanthropy and want to benefit a charitable organization ( Charity a different institution from University referred to above) through this transaction in the most tax efficient manner possible. After considering multiple options and upon the advice of counsel, Donors elect to convey a 40% undivided interest in the duplex from the FLP to Charity (not to University) in exchange for a gift annuity that names Donors as life annuitants. Issues: Overview of Partnership Entities A. General Partnership B. Limited Partnership C. Family Limited Partnership D. Limited Liability Partnership Gifts made by Partnership Entities A. General Tax Treatment B. Adjustment of Partners Bases C. Limitation on Deduction D. Distribution Followed by Transfer Partial Interest Rule Unrelated Business Taxable Income 10% Rule Concerns Overview of Partnership Entities A partnership is a business entity in which two or more persons join together in furtherance of a joint purpose. Participants in the partnership typically share in the expenses and profits of the venture in a pro-rata manner, according to their respective ownership interests in the partnership. While a partner s ownership interest in a partnership is not typically evidenced in the manner that a corporate ownership interest would be (i.e., a stock certificate), the partnership interest is nonetheless an identifiable 16

124 separate asset which can be valued and transferred. Generally, there are four types of partnerships: A. General Partnership Under a general partnership arrangement, each partner is legally liable for the debts and actions of the partnership. No formal agreement is necessary to establish a general partnership, and no type of documentation is required to be filed with any state agency. B. Limited Partnership A limited partnership has two types of partners general partners and limited partners. The general partner will be responsible for the management and operations of the partnership and will also be held personally liable for the debts and actions of the partnership. By contrast, the limited partner will have little involvement in the operations of the partnership and will not typically be held legally liable for the debts and actions of the partnership. Care must be taken by limited partners to limit their involvement in the activities of the partnership so as to preserve their limited liability status. Finally, a limited partnership must be formally established by filing a certificate of limited partnership with the appropriate state agency. C. Family Limited Partnership A family limited partnership, as its name implies, is simply a limited partnership in which all of the partnership interests are held by family members. This form of partnership combines the favorable tax treatment provided for family partnerships under IRC Sec. 704(e) along with the advantages of a limited partnership under the Uniform Limited Partnership Act (ULPA). D. Limited Liability Partnership The primary distinctive feature of the limited liability partnership is that none of the partners are usually legally liable for the debts and actions of the partnership, and a non-partner is retained to manage the affairs of the partnership. Gifts made by Partnership Entities A. General Tax Treatment Like S corporations and limited liability companies, partnership entities are commonly referred to as passthrough entities because tax is generally not imposed at the entity level. Unless the entity specifically elects to be taxed as a corporation, the partnership entity will be taxed as a partnership under Subchapter K of the Internal Revenue Code. Reg (a). As such, all tax attributes, including income, loss, gains, credits, and charitable contributions, will pass through to the individual partners and be reported by them in proportion to their ownership interests. IRC 701. The amount of the charitable deduction resulting from a contribution made by a partnership entity will be determined at the entity level based upon the nature of the property given and the type of charity that receives it. The ability of each 17

125 partner to claim their proportionate share of the deduction amount will be determined by the individual partner s adjusted gross income and deduction phase-outs. IRC 702(a)(4). B. Adjustment of Partners Bases Before the decision is made to make a charitable contribution by the partnership entity, consideration should be given to the impact that the contribution will have on each partner s basis in his or her partnership interest. Specifically, the IRS has ruled that when a partnership makes a charitable contribution of property, the basis of each partner s interest in the partnership is decreased (but not below zero) by the partner s respective share of the partnership s basis in the property contributed. Rev. Rul , CB 140. Ultimately, the consequences of this basis reduction would likely be an increase in gains tax on a subsequent sale or cash liquidation of the partnership interest or the disallowance of future partnership losses. In the case at hand, the contributed property had a relatively low basis compared to the total basis of each partner in the partnership entity. As a result, the Donors were not dissuaded from making the gift through the FLP entity, because the impact on each partner s total basis in the FLP was not significantly reduced. C. Limitation on Deduction While an individual owner s basis in another type of pass-through entity (i.e., S corporations or limited liability companies) may limit their ability to claim their proportionate share of a charitable deduction resulting from a gift made by the entity, partners in a partnership do not normally have this constraint. One nationally recognized treatise has noted that the relevant statute (IRC 704(d)) and its underlying regulations do not include charitable contributions among the list of items subject to limitation for partners in a partnership based upon their individual bases and speculates that this omission may be a technical flaw. McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners 10.05[1][b] (Warren, Gorham & Lamont, 3d ed.). In one private letter ruling involving a contribution of land by a partnership entity to a public charity, the IRS noted that IRC 704(d) does not specifically refer to charitable contributions and, therefore, does not impose a limit on the individual partner s ability to claim his proportionate share of the contribution deduction. Priv. Ltr. Rul D. Distribution Followed by Transfer An alternate approach to completing the gift would be to have the partnership entity make a partial or complete distribution of partnership assets to the partner, followed by a gift of the distributed property from the partner in his or her individual capacity. Generally, a distributee partner will only realize gain to the extent that he receives money or marketable securities in an amount that exceeds his basis in the partnership entity. IRC 731(a)(1) and IRC 731(c). When a 18

126 Partial Interest Rule distributee partner receives a distribution of property other than money or marketable securities, he will not generally recognize any gain until he sells or otherwise disposes of the property. The only exception to this rule involves less common scenarios outlined in IRC 736 (relating to payments of a retiring partner or a deceased partner's successor in interest) and IRC 751 (relating to unrealized receivables and inventory items). Therefore, it is possible under certain circumstances, for a partner to forego recognition of gain upon receiving a distribution of property from a partnership followed by the subsequent transfer of the distributed property to a charitable organization. It should also be noted that a distribution of property (which includes money and marketable securities) by a partnership to a partner does not result in recognized gain or loss to the partnership under IRC 731. However, the partnership may have to recognize gain or loss on certain distributions under IRC 751(b) where the distribution must be treated as a sale or exchange of property between the partner and the partnership. In this case, the Donors would have been able to receive the distribution of real property from the partnership without recognition of any gain. Nonetheless, the rules governing the treatment of long-term capital gain from assets gifted in exchange for a qualified charitable gift annuity would still apply. As a general rule, income, gift and estate tax law limits a donor s ability to claim a deduction for a contribution of less than the donor s entire interest in the property contributed. IRC 170(f)(3)(A), Reg A-7(a)(1); IRC 2522(c)(2), Reg (c)-3(c)(1)(i); and IRC 2055(e)(2), Reg (c)-2(e)(1)(i). Notwithstanding this general rule, certain exceptions to the partial interest rule are also outlined in tax law and serve to create the giving opportunities for the majority of planned giving donors. The most familiar exception allows a contribution deduction for gifts of less than a donor s entire interest in property which are made in trust. IRC 170(f)(3)(A). The other primary exceptions include the following: A remainder interest in a personal residence or farm. IRC 170(f)(3)(B)(i), 2522(c)(2), and 2055(e)(2); Qualified conservation contributions. IRC 170(f)(3)(B)(iii), 2522(c)(2), 2522(d), 2055(e)(2), and 2055(f). See also IRC 2031(c) for estate tax exclusion; Works of art separated from their copyright (gift and estate tax deduction only). IRC 2522(c)(3), and 2055(e)(4); and An undivided portion of a taxpayer s entire interest in property. IRC 170(f)(3)(B)(ii), 2522(c)(2), and 2055(e)(2). 19

127 In this case, the Donors elected to convey a 40% undivided interest in one of their duplexes. This percentage was chosen so that Charity would receive $1,000,000 (40% x $2,500,000 sales price) from the subsequent sale of the duplex to University. In this situation, the applicable regulations require that the undivided portion of the donor s entire interest in the property must: consist of a fraction or percentage of each and every substantial interest or right owned by the donor in the property, and extend over the entire term of the donor s interest in the property and in other property into which the property may be converted. Id. By conveying an undivided 40% interest to Charity from its previous 100% ownership interest in the duplex, the FLP was in compliance with the governing Code provisions and regulations regarding the partial interest rule. Unrelated Business Taxable Income Unrelated business taxable income ( UBTI ) includes the gross income derived by any organization from any unrelated trade or business.regularly carried on by it. IRC 512(a)(1). The term unrelated trade or business means, in the case of any organization subject to tax imposed by IRC 511, any trade or business the conduct of which is not substantially related to the exercise or performance by such organization of its charitable, educational or other purpose or function. IRC 513(a). Tax-exempt organizations are subject to tax on their UBTI at the regular corporate tax rates. IRC 511. Excessive UBTI for a tax-exempt organization can ultimately jeopardize its taxexempt status. However, the Code also identifies certain unrelated business activities that, when conducted by a tax-exempt organization, are excluded from UBTI. Such excluded income is often referred to as passive income. One such exclusion is provided under the Code for certain types of rents, and specifically for rents from real property. IRC 512(b)(3)(a)(i). Nonetheless, not all income referred to as rent will qualify for the exclusion. The applicable tax regulation notes that the rendering of certain types of services to the lessee will impact whether or not the exclusion will apply. Specifically, when services are rendered to an occupant primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only, then the exclusion will not apply and the income derived from the lease arrangement will be treated as UBTI. Reg (b)-1(c)(5). For example, providing maid service to an occupant would be a service provided for the convenience of the occupant and would not be typically provided for occupants of private residences, duplexes, other multi-family housing units, office buildings, etc. Id. However, other services such as the furnishing of heat and light, the cleaning of public areas (including entrances, exits, stairways and lobbies), and the collection of trash would not be the types of services that would prevent the exclusion from applying. Id. 20

128 In addition, rental income may also be treated as UBTI when the amount of the rent paid to the tax-exempt lessor is based upon the net income of the lessee. Specifically, the passive rent test stipulates that where the determination of the amount of rent depends in whole or in part on the income or profits derived by any person from the property leased, then the exclusion shall not apply, and the rent income will be treated as UBTI. Reg (b)-1(c)(2)(iii)(b). This rule precludes avoidance of unrelated business income tax by tax-exempt lessors who are involved in a profit sharing arrangement and are therefore an active participant in the operation of the property. Hopkins, The Law of Tax-Exempt Organizations 24.6(h) (John Wiley & Sons, 9 th ed. 2007). However, the applicable regulation makes it clear that the exclusion will apply in any situation where the rent is based upon a fixed percentage or percentages of the gross receipts or sales of the lessee. Reg (b)-1(c)(2)(iii)(b). The recipient Charity in this case was free from any concern about UBTI from the duplex. First, the applicable regulation cited above also states that payments for the use or occupancy of entire private residences, or living quarters in duplex or multiple housing units, or offices in any office building, etc., are generally treated as rent from real property. Reg (b)-1(c)(5). In addition, Donors had not historically provided any non-typical services to the tenants of the duplex and the rental amount was based upon an agreed flat rate. For these reasons, Charity was comfortable that UBTI would not be realized from its ownership of the duplex unit after the gift was completed. 10% Rule Concerns In this case, the Donors chose to gift the duplex to Charity (not the same institution as University) in exchange for a qualified charitable gift annuity. Because of the burden of having to make immediate annuity payments to donors under an immediate gift annuity obligation, many charities have gift acceptance policies that preclude receiving illiquid assets, such as real property, in exchange for a gift annuity. Charity was willing in this case to issue the gift annuity in exchange for the interest in the duplex because of the great probability that University would purchase the property soon after the date of gift. In reviewing documentation related to the gift arrangement, counsel for the Donors reviewed the gift annuity agreement and related information provided by Charity and all documentation related to the conveyance of the duplex. Specifically, Donors counsel reviewed a proposed contract for sale of Donors retained 60% undivided interest in the duplex to University, which would occur only after the gift arrangement was completed. Because University was involved in numerous real estate negotiations for properties near the duplex and adjacent to the campus, the proposed contract (which was prepared by University s general counsel) contained a confidentiality provision which prohibited Donors from later disclosing the sales price to any outside party. It was later realized that all neighboring properties near the duplex were acquired by University with the same type of confidentiality provision. In reviewing the proposed contract for sale, Donors counsel failed to realize the impact that the confidentiality provision would have on the Donors subsequent effort to obtain a qualified appraisal. 21

129 After the gift was completed, Donors and Charity both sold their respective undivided interests to University, subject to the confidentiality provision described above. In the weeks that followed, Donors realized that they would be unable to obtain a qualified appraisal for the duplex that would approximate the total sales price of $2,500,000 that was paid by University to Donors (60%) and Charity (40%) for their respective undivided interests. Because the sales amounts for all comparable properties in the area (limited to those zoned as multi-family) were unavailable to any third-party appraiser because of the confidentiality provisions, the Donors soon realized that they would only be able to obtain an appraisal placing a total value of approximately $1, 200,000 on the duplex. Charitable organizations could jeopardize their tax-exempt status by issuing annuity contracts that constitute commercial-type insurance. IRC 501(m)(1). However, the definition of commercial-type insurance, as it relates to this section of the Code, specifically excludes charitable gift annuities. IRC 501(m)(3)(E). To qualify as a charitable gift annuity, the arrangement must meet the requirements of IRC 514(c)(5). Among those requirements is the stipulation that the present value of the annuity must be less than 90 percent of the value of the property received in the exchange. IRC 514(c)(5)(A). Said differently, the present value of the charitable benefit must equal at least 10 percent of the value of the property given in exchange for the gift annuity. In this case, it was soon realized that the Donors inability to establish a fair market value for the gifted property that approximated the amount of the proceeds actually received on the subsequent sale created a 10% rule dilemma. Charity issued the gift annuity at the recommended ACGA rate or 6% for joint donors aged 71 and 73 (based upon rates in effect as of the date of gift in 2007), but Charity based this annuity payout rate on the anticipated amount of sales proceeds that would ultimately be received from University. Because all comparable real estate sales were unavailable to appraisers due to University s confidentiality provisions, the amount of the annuity payments appeared disproportionately high (well above what the recommended rate would be) compared to the value that could be shown by a qualified appraisal. As a result, this gift annuity arrangement failed to qualify under the applicable provisions of the Code. IRC 514(c)(5). After consulting with several advisors over a period of weeks, Donors ultimately concluded that they would need to step the transaction. Accordingly, the Donors elected to treat the transaction, for tax reporting purposes, as if they had sold the entire 100% interest in the duplex to University for $2,500,000 and subsequently gifted $1,000,000 cash to Charity in exchange for the gift annuity. While Donors were disappointed to pay the gains tax that resulted, they were benefitted from the greatest possible deduction amount resulting from the cash gift, the ability to claim the deduction at 50% of their adjusted gross income (compared to the 30% limitation allowed for appreciated property gifts) and a significantly higher amount of tax-free income received through the annuity payments for the duration of their lifetimes. From Charity s perspective, the issuance of a gift annuity that failed to meet the requirements of IRC 514(c)(5) will cause the annuity obligation to be treated as acquisition indebtedness, resulting in possible unrelated business taxable income for 22

130 Charity. Frank Minton, Charitable Gift Annuities The Complete Resource Manual 2.10 (2007). The moral of this story: proceed with caution when funding charitable gift annuities with illiquid assets whose value may be difficult to determine. In this case, Donors would have been well advised to obtain a qualified appraisal before finalizing the gift. If they had done so, the issue with the 10% rule would have become a red-flag and would have allowed the Donors to weigh their options and make a determination of the best way to complete the gift and obtain the greatest tax benefit. 23

131 24

132 Appendix A Sample Letters Documenting Redemption of Closely-Held Securities from a Qualified Charitable Trust or Private Foundation 25

133 [CLOSELY-HELD CORPORATION, INC. STATIONARY] [THIS IS A DRAFT OF AN OFFER LETTER TO SEND TO ALL CLASS A STOCK SHAREHOLDERS], 2017 Mr. John Doe President Charity 1717 Main Street, Suite 1400 Dallas, Texas Dear Mr. Doe: As you are aware, Charity currently owns 12,400 shares of Closely-Held Corporation, Inc. Class A stock as Trustee of the Charitable Remainder Unitrust No. 1. This letter is to inform Charity that a redemption of Closely-Held Corporation, Inc. Class A stock will be open from, 2017, until, 2017, during which time the corporation will purchase from the shareholders any or all Class A shares held by them for $ per share. All purchases will be made in cash. The valuation of the Closely-Held Corporation, Inc. Class A stock was made on, 2017, and it was this valuation which was used to determine the purchase price stated above. You may redeem your Class A shares at fair market value until, Sincerely, President Closely-Held Corporation, Inc. 26

134 [THIS IS A DRAFT LETTER THAT THE CHARITY MAY SEND TO THE CLOSELY- HELD CORPORATION IN RESPONSE TO THE REDEMPTION OFFER.], 2017 Mr. President Closely-Held Corporation, Inc. Dear Mr. : We have received your offer to redeem the 12,400 shares of the Class A stock of Closely-Held Corporation, Inc. held by a charitable remainder unitrust established by Mr. and Mrs., of which Charity is Trustee. As you may know, charitable remainder trusts are subject to certain self-dealing rules under the Internal Revenue Code that impose restrictions regarding redemptions of stock from closely related parties. Those restrictions allow for a redemption of the trust s shares, so long as the offer price is at fair market value and so long as the same offering is made on the same basis to all other holders of the same class of stock which is the subject of the redemption. Charity, acting as Trustee of the referenced trust, is prepared to accept the offer of redemption of all of its 12,400 shares at $ per share, for a total price of $. We request that you verify the accuracy of the information above to confirm that a selfdealing transaction does not occur. Upon verification of that information, we would request that you provide a check payable to Charity in the amount of $. If there is any variance from the assumptions stated above that would cause this transaction to be treated as an act of self-dealing, please advise us of what assumptions are incorrect prior to mailing the check. Thank you very much for your help with this matter. If I can provide anything further, please let me know. Sincerely, John Doe President Charity 1717 Main Street, Suite 1400 Dallas, Texas

135 [CLOSELY-HELD CORPORATION, INC. STATIONARY] [VERIFICATION LETTER TO BE SENT TO THE CHARITY FROM THE CLOSELY- HELD CORPORATION], 2017 Mr. John Doe President Charity 1717 Main Street, Suite 1400 Dallas, Texas Dear John: On, 2017, a valuation of Closely-Held Corporation, Inc. Class A stock was made and, as of that date, the fair market value per share of Closely-Held Corporation, Inc. Class A stock was determined to be $. All Class A stockholders of Closely- Held Corporation, Inc. were informed in writing on, 2017, that a redemption of Closely-Held Corporation, Inc. Class A stock would be open from that date until, 2017, during which time the corporation would purchase from the shareholders any or all Class A shares held by them for $ per share. All purchases would be made in cash. Accordingly, the offer to redeem shares held by the charitable remainder trust created by Mr. and Mrs. on December, 2016, with Charity, as Trustee, was made on the same terms as the offer made to all other Class A shareholders, and the offer was made at fair market value. The offer to Charity, as Trustee of the Charitable Remainder Unitrust No 1, was made on, 2017, and the redemption occurred on, 2017, which was in the redemption period referenced above. Sincerely, President Closely-Held Corporation, Inc. 28

136 Appendix B 29

137 QUALIFIED APPRAISAL REQUIREMENTS These steps must be followed by a qualified appraiser to meet the criteria established by the Internal Revenue Service for non-cash charitable gifts. 1. The appraisal must be prepared no earlier than 60 days prior to the date that the contribution is made, and must be prepared not later than the due date of the return on which the deduction is claimed or the date an amended return is filed if the amended return is the first return on which the deduction is claimed. 2. The appraisal must be prepared, signed and dated by a qualified appraiser as defined below. 3. The appraisal must include the following information: a. 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; b. In the case of tangible property, the physical condition of the property; c. The date (or expected date) of contribution to the donee; d. The terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of the donor which relates to the use, sale or other disposition of the property contributed. This includes restrictions on the donee s right to use or dispose of the donated property, all provisions which confer on anyone, other than the donee charity, the right to income from the donated property or the right to possession of the property, including voting rights to securities, a right of purchase, or a right to designate the person to receive income, possession or right of purchase, or a provision which earmarks the donated property for a particular use. As an added precaution, all agreements between the donor and the donee charity relating to the gift should be attached to the appraisal and incorporated into it by reference; e. The name, address, and taxpayer identification number of the qualified appraiser and, if the qualified appraiser is a partner in a partnership, an employee of any person (whether an individual, corporation, or partnership), or an independent contractor engaged by a person other than the donor, the name, address and taxpayer identification number of the partnership or the person who employs or engages the qualified appraiser; f. The qualifications of the qualified appraiser who signs the appraisal, including the 30

138 appraiser s background, experience, education, and any membership in professional appraisal associations, A qualified appraiser is an individual who meets all the following requirements. (1) The individual either: i. Has earned an appraisal designation from a recognized professional appraiser organization for demonstrated competency in valuing the type of property being appraised, or ii. Has met certain minimum education and experience requirements. For real property, the appraiser must be licensed or certified for the type of property being appraised in the state in which the property is located. For property other than real property, the appraiser must have successfully completed college or professional level coursework relevant to the property being valued, must have at least 2 years of experience in the trade or business of buying, selling, or valuing the type of property being valued, and must fully describe in the appraisal his or her qualifying education and experience. (2) The individual regularly prepares appraisals for which he or she is paid. (3) The individual demonstrates verifiable education and experience in valuing the type of property being appraised. To do this, the appraiser can make a declaration in the appraisal that, because of his or her background, experience, education, and membership in professional associations, he or she is qualified to make appraisals of the type of property being valued. (4) The individual has not been prohibited from practicing before the IRS under section 330(c) of title 31 of the United States Code at any time during the 3-year period ending on the date of the appraisal. (5) The individual is not an excluded individual. g. A statement that the appraisal was prepared for income tax purposes; h. The date or dates on which the property was valued; i. The appraised fair market value of the property on the date (or expected date) of contribution; j. The method of valuation used to determine the fair market value, such as the income approach, the market data approach, or the replacement-cost-lessdepreciation approach; 31

139 k. The specific basis for the valuation, if any, such as any specific comparable sales transactions; l. A description of the fee arrangement between the donor and the appraiser. 4. The appraiser must sign and complete Internal Revenue Service Form 8283, Section B, Part III, denoted Appraisal Summer. The Appraisal Summary includes declarations by the appraiser that: I declare that I am not the donor, the donee, a party to the transaction in which the donor acquired the property, employed by, or related to any of the foregoing persons, or married to any person who is related to any of the foregoing persons. And, if regularly used by the donor, donee, or party to the transaction, I performed the majority of my appraisals during my tax year for other persons. Also, I declare that I perform appraisals on a regular basis; and that because of my qualifications as described in the appraisal, I am qualified to make appraisals of the type of property being valued. I certify that the appraisal fees were not based on a percentage of the appraised property value. Furthermore, I understand that a false or fraudulent overstatement of the property value as described in the qualified appraisal or this Form 8283 may subject me to the penalty under section 6701(a) (aiding and abetting the understatement of tax liability). In addition, I understand that I may be subject to a penalty under section 6695A if I know, or reasonably should know, that my appraisal is to be used in connection with a return or claim for refund and a substantial or gross valuation misstatement results from my appraisal. I affirm that I have not been barred from presenting evidence or testimony by the Office of Professional Responsibility. 5. The following persons cannot be qualified appraisers with respect to particular property. a. The donor or the taxpayer who claims or reports the deduction under Section 170 for the contribution of the property being appraised; b. A party to the transaction in which the donor acquired the property being appraised (i.e., the person who sold, exchanged or gave the property to the donor, or any person who acted as an agent for the transferor or for the donor with respect to such sale, exchange or gift), unless the property is donated within two months of the date of acquisition and its appraised value does not exceed its acquisition price; c. The donee of the property; d. Any person employed by any of the foregoing persons or related to any of the foregoing persons under Section 267(b) (e.g. if the donor acquired a painting 32

140 from an art dealer, neither the art dealer nor persons employed by the dealer can be qualified appraisers with respect to that painting); e. Any person whose relationship with any of the persons listed in (1) through (4) above would cause reasonable person to question the independence of such appraiser. For example, an appraiser who is regularly used by any person described in (1) through (3) above and who does not perform a substantial number of appraisals for other persons has a relationship with such person that is similar to that of an employee and cannot be a qualified appraiser with respect to the property contributed. 33

141 INSECURE ABOUT SECURITIES? OKLAHOMA MEDICAL RESEARCH FOUNDATION November 30, 2017

142 TAXATION ISSUES Basis Step-Up IRC 1014-(a) Carry-Over IRC 1015 (a) Long-term vs. Short-term 2 HighGround Advisors

143 LONG TERM CAPITAL GAINS Required Holding Period One year beginning on the day after the trade date that the stock was acquired by the donor and ending on and including the gift date Rev. Rul , CB HighGround Advisors

144 LONG TERM CAPITAL GAIN PROPERTY Deduction = Fair Market Value May offset up to 30% of AGI with 5 year carry over 4 HighGround Advisors

145 SHORT TERM CAPITAL GAIN PROPERTY Deduction = Donor s Basis May offset up to 50% of AGI with 5 year carry over 5 HighGround Advisors

146 ELECTION BY DONOR Donor may elect to claim deduction up to 50% of AGI if deduction is limited to basis. 6 HighGround Advisors

147 OTHER RULES Gifts to private non-operating foundations Deduction of lesser of FMV or Basis Limited to 20% of AGI Gifts by Corporations Limited to 10% of taxable income 7 HighGround Advisors

148 CAPITAL GAINS Split Interest Gifts Gift Annuities Charitable Remainder Trusts Charitable Lead Trusts 8 HighGround Advisors

149 IRC 306 STOCK Stock distributed as a tax-free dividend Stock received in non-taxable reorganization plan (not common stock) Stock exchanged for other 306 Stock 9 HighGround Advisors

150 IRC 306 STOCK A dividend masquerading as a preferred stock. When sold, produces ordinary income rather than long-term capital gain. 10 HighGround Advisors

151 IRC 306 STOCK Gift Value For deduction purposes, the gift value is the difference between the value of the stock on gift date and its value when issued. IRC 1366(a)(1) 11 HighGround Advisors

152 CLOSELY HELD SECURITIES UBTI Unrelated business taxable income The gross income derived by any organization from any unrelated trade or business regularly carried on byit IRC 512(a)(1) 12 HighGround Advisors

153 CLOSELY HELD SECURITIES Dividends and gains from closely-held securities are generally passive income and not taxable as UBTI Income from a controlled corporation may be taxable Taxable at regular corporate rates 13 HighGround Advisors

154 VALUATION ISSUES Publicly traded securities Closely-held securities Restricted securities Gift Date/Timing of gift 14 HighGround Advisors

155 PUBLICLY TRADED SECURITIES FMV The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. IRC 1.170A-1 C(2) 15 HighGround Advisors

156 PUBLICLY TRADED SECURITIES FMV The most probative evidence of FMV is the price at which similar quantities of property are sold in arm s length transactions FMV is to be determined in the market in which the item is most commonly sold to the public Rev. Rul , CB HighGround Advisors

157 PUBLICLY TRADED SECURITIES Gift amount Fair Market Value (FMV) on date of gift FMV Mean between the highest and lowest quoted selling price on gift date Reg (b)(1), (b)(1) 17 HighGround Advisors

158 PUBLICLY TRADED SECURITIES FMV If no sales on the gift date Use weighted average of the means between the highest and lowest sales on the nearest dates before and after gift date Reg (b)(1), (b)(1) 18 HighGround Advisors

159 PUBLICLY TRADED SECURITIES FMV If Security is listed on more than one exchange Use records of exchange where security principally traded Reg (b)(1), (b)(1) 19 HighGround Advisors

160 PUBLICLY TRADED SECURITIES CAUTION Gift Substantiation vs. Gift Recognition 20 HighGround Advisors

161 CLOSELY HELD SECURITIES Reg (a)- Valuation of interests in business Rev. Rul , CB 237 In valuing the stock of closely-held corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes. 21 HighGround Advisors

162 CLOSELY HELD SECURITIES CON T Rev. Rul , CB 370 Separate appraisals needed to value the tangible and intangible assets of a business Rev. Rul , CB 319 Deals with securities that cannot be immediately resold because they are restricted from resale pursuant to Federal securities laws 22 HighGround Advisors

163 CLOSELY HELD SECURITIES CON T Rev. Rul , CB 101 Valuation of stock of a subsidiary corporation that may only be sold with shares of the parent organization (i.e., paired stock) Rev. Rul , CB 170 Factors to consider in valuing common and preferred stock of a closely-held corporation 23 HighGround Advisors

164 RESTRICTED STOCK What is it? Stock not offered through public offer Also referred to has unregistered securities, investment letter stock, control stock, or private placement stock SEC RULE Provides safe harbor for sale Rev. Rul , CB 319 provides guidelines for valuation 24 HighGround Advisors

165 GIFT DATE/TIMING OF GIFT Certificate Form Hand delivery Mailbox rule Delivery through broker By corporation Street Name LOA (Medallion Guarantee) Mutual Funds 25 HighGround Advisors

166 GIFT DATE/TIMING OF GIFT Year-end Gifts / Liquidation or Sale My company is being sold, I want to transfer stock to you today! 26 HighGround Advisors

167 QUALIFIED APPRAISALS Closely held Securities What gifts must be appraised? Gifts greater than $5,000 Non-publicly traded security exception $10,000 or less Appraisal fee 27 HighGround Advisors

168 QUALIFIED APPRAISALS Qualified appraiser must hold himself out to the public and regularly perform appraisals Qualified appraiser may not be: Donor Party to transaction whereby donor received stock Representative of charity Employee or relative of any of these 28 HighGround Advisors

169 QUALIFIED APPRAISALS Appraisal Summary Forms 8283 and 8282 Form 8282 ~ sanctions for failure to file (Pension Protection Act extends the 2 year filing to 3 years) 29 HighGround Advisors

170 S CORPORATION STOCK Characteristics of S Corporations: Less than 100 shareholders Limits personal liability of shareholders Income and deductions attributed directly to shareholders 30 HighGround Advisors

171 S CORPORATION STOCK Small Business Job Protection Act of 1996 included charities as eligible shareholders of S corporations Other eligible shareholders include: Individuals Estates Certain trusts 31 HighGround Advisors

172 S CORPORATION STOCK Charitable Remainder Trusts are not eligible shareholders Would cause a loss of the S election for all shares 32 HighGround Advisors

173 S CORPORATION STOCK Certain trusts qualify as shareholders, including: Grantor trusts Former grantor trust for 2 year period after grantor s death Testamentary trust for 2 years after funding 33 HighGround Advisors

174 S CORPORATION STOCK So, the following charitable trusts are eligible as shareholders: Grantor lead trust Testamentary lead trust (for 2 years after funding) 34 HighGround Advisors

175 S CORPORATION STOCK Charity will be subject to UBTI as long as it holds the S shares Gain realized upon sale of S stock by a charity is subject to UBTI 35 HighGround Advisors

176 ANTICIPATORY ASSIGNMENT OF INCOME When a corporation is in the process of liquidation or is subject to a taxable takeover, shareholders are forced to: Realize income from involuntary disposition of shares Recognize any appreciation 36 HighGround Advisors

177 ANTICIPATORY ASSIGNMENT OF INCOME In such situations, a gift of the shares would allow the shareholder to: Avoid realization of taxable gain Claim charitable deduction But, if the Anticipatory Assignment of Income Doctrine applies, the gift will be viewed as a right to receive cash rather than an asset that may be converted to cash in the future. 37 HighGround Advisors

178 ANTICIPATORY ASSIGNMENT OF INCOME If a taxable takeover is pending, shares must be transferred to charity before the final outcome of the takeover attempt is certain. A binding contract or legal obligation must exist before the IRS may assert the doctrine. 38 HighGround Advisors

179 ANTICIPATORY ASSIGNMENT OF INCOME Corporate stock subject to liquidation must be transferred to charity before liquidation process becomes irreversible, either legally or practically. IRS may assent the doctrine if the liquidation plan cannot be practically withdrawn as of the gift date. 39 HighGround Advisors

180 STOCK WITH PENDING DIVIDEND Declaration date corporation announces upcoming dividend Record date owners of stock become entitled to receive the dividend Caruth v. United States, 865 F2d 644 (5 th Cir. 1989) 40 HighGround Advisors

181 STOCK OPTIONS Holder of the option may purchase shares of the company stock at a stated price on or before a set date. Charity donee must exercise the option before donor may claim a deduction FMV of Deduction = stock on exercise date Option price 41 HighGround Advisors

182

183 INSECURE ABOUT SECURITIES? EFFECTIVELY HANDLING GIFTS OF STOCK Oklahoma Medical Research Foundation November 30, 2017 Joe Hancock Vice President and General Counsel HighGround Advisors 1717 Main Street Suite 1400 Dallas, Texas Phone:

184 INSECURE ABOUT SECURITIES? EFFECTIVELY HANDLING GIFTS OF STOCK This outline will focus on the issues which charities, donors and advisors must consider when contemplating gifts of securities. The information provided in this outline will equip all parties involved in stock gift transactions with the information needed to capitalize on the potential benefits associated with gifts of stock while also helping them avoid the potential risks involved with gifting this type of asset. I. Taxation Issues SUMMARY OUTLINE A. Long-Term vs. Short-Term Capital Gain Property B. Section 306 Stock C. Unrelated Business Taxable Income from Controlled Corporations II. Valuation Issues A. Publicly Traded Securities B. Closely-Held Securities C. Restricted Securities D. Timing of Gift E. Donor s Percentage of Ownership or Control in Closely-held Securities III. Qualified Appraisal Rules for Closely-Held Securities A. What Securities Must be Appraised B. Qualified Appraisal Requirements C. Selecting a Qualified Appraiser for Gifts of Stock D. Appraisal Fees E. IRS Forms 8283 and 8282 IV. Special Situations A. S Corporation Stock Issues B. Anticipatory Assignment of Income C. Stock that is Pregnant with a Dividend D. Gifts of Stock Options Probably the most common non-cash gifts involve securities, either publicly traded or closely-held. Publicly traded stocks are easy to handle from the charities perspective and easy for the donor to transfer. The valuation of these stocks is well established and, therefore, makes them attractive gift options. However, the gift planner should be 2

185 aware of all the various forms of stock and issues associated with each in order to advise potential donors of the consequences of their gift. I. Taxation Issues As the taxation issues for a gift of stock are examined, several pieces of information will be helpful as the gift planner outlines the gift for the donor. The length of time the donor has held the security will determine whether the security has been held long-term and thereby qualifies for long-term capital gain treatment. How the donor acquired the stock determines the donor s basis in the security. If the stock is acquired by reason of a testamentary gift, the stock receives a step-up in basis. The step-up in basis equates to the fair market value of the stock on the date of the testator s death (or, if elected, the alternate valuation date). IRC Obviously, if the stock was purchased by the donor, the basis will be what the donor paid for the stock at the time of acquisition. However, when the donor transfers stock or mutual funds with a dividend reinvestment program, this becomes less certain. If the stock is acquired by any other means, then a carry-over basis is attached, and the donor s basis is the same as that of the person from whom the gift was received. IRC 1015(a). The stock s basis determines whether the stock has a gain or loss. This knowledge helps the gift planner counsel the donor regarding the tax consequences of the gift and the advisability of using the stock as a gift asset. A. Long-Term vs. Short-Term Capital Gain If the gifted stock has been held by the donor for more than the required holding period of one year, the gift qualifies for long-term capital gain treatment, and the donor does not incur any tax on the long-term capital gains. IRC 170(e). The required holding period of one year begins on the day after the trade date that the stock was acquired by the donor and ends on and includes the date of gift. Rev. Rul , CB 168. The charitable income tax deduction for an appreciated stock gift held for more than the required holding period is equal to the fair market value of the stock on the date of the gift and may be used to offset up to 30% of the donor s adjusted gross income in the year of the gift with a carryover for any excess deduction for up to five years. IRC 170(e); IRC 170(b)(1)(C)(i); Reg A-8(d)(1); and IRC 170(b)(1)(C)(ii). For gifts to private non-operating foundations, the deduction is generally the lower of cost basis or fair market value and is limited to 20% of the donor s adjusted gross income. IRC 170(e)(1)(B)(ii) and IRC 170(b)(1)(D). If the donor is a corporation, the deduction is limited to 10% of the corporation s taxable income, with the same five-year carry over. IRC 170(b)(2) and IRC 170(d)(2). A donor may choose to take a 50% deduction for a gift of stock, if an election to reduce the value of the gift by the amount of the capital gain is made by the donor. IRC 170(b)(1)(D)(iii); IRC 170(e)(1)(B); Reg A-8(d)(2); and Reg A-4(a). 3

186 For appreciated securities that have been held by the donor for less than one year, different rules apply. Such securities, if sold by the donor at fair market value rather than contributing them to charity, would generate gain that is not long-term capital gain. Reg A-4(b)(1). The charitable deduction for such short-term capital gain property must be reduced by the amount of gain which would have been recognized as gain which is not long-term capital gain if the securities had been sold by the donor at fair market value rather than contributed. IRC 170(e)(1)(A); and Reg A- 4(a)(1). In other words, the donor s deduction for a contribution of short-term capital gain property will be limited to the donor s basis. However, the deduction may be claimed up to 50% of the donor s adjusted gross income in the year of the gift. IRC 170(b)(1)(A). And, as mentioned above, the donor is allowed five years after the year of the gift to carry over any unused portion of the deduction, subject to the same 50% limitation. IRC 170(d)(1); and Reg A-10. B. IRC 306 Stock Generally, as Conrad Teitell has said, it s a dividend masquerading as a preferred stock. 306 stock is stock distributed to the individual as a tax-free dividend, stock that is not common stock received in a non-taxable reorganization plan where gain or loss is not recognized, or is stock either received in exchange for other 306 stock or was equivalent to a stock dividend. The purpose of 306 stock is to prevent a corporation from distributing earnings to stock holders by means of a second class of stock that the holder could then sell as a capital asset. A 306 stock, when sold, produces ordinary income rather than long-term capital gain. The gift value of 306 stock is reduced for deduction purposes by any amount that would be taxed as ordinary income once sold or redeemed. IRC 170(e)(1)(A); Reg 1.170A-4. This equates to the difference between the value of the stock on the date of contribution and its value when issued. C. Unrelated Business Taxable Income from Controlled Corporations Unrelated business taxable income ( UBTI ) includes the gross income derived by any organization from any unrelated trade or business.regularly carried on by it. IRC 512(a)(1). Tax-exempt organizations are subject to tax on their UBTI at the regular corporate tax rates. IRC 511. Excessive UBTI for a tax-exempt organization can ultimately jeopardize its tax-exempt status. Generally, income from closely-held securities in the form of dividends or capital gain is considered passive income and not subject to the unrelated income tax. IRC 512(b)(1), (2), (3), and (5). However, income derived from a controlled corporation may be taxable. IRC 512(b)(13). For this reason, it is important to be mindful of the percentage ownership that is being acquired by the charity and the potential for earned 4

187 income being realized during the length of time which the charity is likely to hold the controlling interest in the company. II. Valuation Issues A. Publicly Traded Securities The valuation of publicly traded securities is very clear. The gift amount is the fair market value ( FMV ) of the security on the date of the gift the date on which the charity takes possession of the stock. FMV is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. Reg A-1(c)(2). The IRS has further asserted that the most probative evidence of FMV is the price at which similar quantities of property are sold in arm s length transactions. Rev. Rul , CB 55. Therefore, FMV is to be determined in the market in which the item is most commonly sold to the public. Id. For publicly traded stock, the stock market provides the forum for determining the value. The value is determined by the mean between the highest and lowest quoted selling prices on the valuation date. Reg (b)(1), (b)(1). For publicly traded securities with no sales on the valuation date but sales within a reasonable period before and after the valuation date, the value is the weighted average of the means between the highest and lowest sales on the nearest dates before and after the valuation date. Reg (b)(1), (b)(1). If the securities are listed on more than one exchange, the records of the exchange where the securities are principally traded are those used to determine FMV on the valuation date. Reg (b)(1), (b)(1). For publicly traded securities, the tax rules are clear as to valuation, but charities must provide the correct substantiation to the donor. Most charities have a policy to sell gifted securities immediately. Typically, the security will be sold the day the gift is made or shortly thereafter. The charity must be diligent in its record keeping. The gift of stock must be recorded and not credited to the account as cash from the sale of the security. Charities must pay attention to the written substantiation and clearly define the gift as one of stock. If the charity is going to credit the donor with a dollar amount for gift recognition purposes that amount should be reported separately. B. Closely-Held Securities Closely-held securities generally provide difficult issues with the valuation. The Service has detailed approaches, methods and factors that should be considered in these valuations. Reg (a)- Valuation of interests in business 5

188 Rev. Rul , CB 237 In valuing the stock of closely-held corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes. Rev. Rul , CB 370 Separate appraisals needed to value the tangible and intangible assets of a business Rev. Rul , CB 319 Deals with securities that cannot be immediately resold because they are restricted from resale pursuant to Federal securities laws Rev. Rul , CB 101 Valuation of stock of a subsidiary corporation that may only be sold with shares of the parent organization (i.e., paired stock) Rev. Rul , CB 170 Factors to consider in valuing common and preferred stock of a closely-held corporation C. Restricted Securities In some instances, transferring shares of publicly traded corporations may be restricted. Stocks are restricted if they are acquired, directly or indirectly, in a transaction not involving a public offering. SEC Rule 144 provides a safe harbor for the sale of these securities. Charities should know how to recognize a restricted stock. In Rev. Rul , CB 319, the Service has provided information and guidance concerning the valuation of securities that cannot be immediately resold because they are restricted from resale pursuant to Federal securities laws. D. Timing of Gift There is a formal system for transfer of title to stock. Stocks can be held in certificate form or in street name at a broker. To transfer a stock held in certificate form, the donor can endorse the back of the certificate or execute a stock power to accompany the certificate. In either case, the transfer is then handled by a broker and transfer agent. A charitable gift is made when the properly endorsed and transferable stock is delivered to the institution or agent for the institution. A donor can hand deliver the certificate and stock power to the charity. The date of the gift is the date on which the charity takes possession of the certificates. If the donor mails the stock to the charity, the date of the gift is the date on which the envelope containing the certificate is postmarked. If the donor wants to mail the certificate, the gift planner should advise the donor to mail the certificate (without endorsement) and the executed stock power in separate envelopes to prevent any unintended person from coming into possession of the certificate in a negotiable form. The donor can deliver the certificate to the corporation that issued the stock or to his broker for purposes of transferring title to the charity. In such case, the gift date is the date on which the transfer of the security is recorded on the corporate books. If the 6

189 certificate is delivered to a broker representing the charity, then the gift date is the date of delivery. In the case of securities held in street name, generally, the donor will provide a letter of instruction to the corporation or broker holding the shares requesting that a transfer be made to the charity. An example of such a letter is attached hereto as Appendix A. The donor s signature on the letter must be Medallion guaranteed. Particular attention should be paid to ensure that the shares are transferred into the charity s name before being sold to avoid any recognition of gain on the part of the donor. The transfer process can be slowed in the case of some mutual fund companies that require the charity to create an account into which the shares are transferred. In order for the gift to be completed, the charity must complete an application and all paper work to open an account. This takes time! Typically, the date of a gift of stock does not raise any issue unless you are dealing with a year end gift and the donor wants to ensure the gift will be counted in that year or there is an event that sets the price of the stock. In these cases, timing of the gift is therefore crucial. What happens when a donor calls and says, I want to transfer stock to you today, because the company is being sold! One of the first questions the gift planner should ask is whether or not the donor is legally bound to sell the securities to a purchaser with the price having already been negotiated and set. If so, the Service takes the position that the sale of the property was by the donor, and the gift was one of the proceeds to the charity. The Service calls this a step-transaction. The doctrine says that two or more seemingly independent transactions are consolidated and treated as a single transaction for federal tax purposes. The charity must not be legally bound at the time of the gift to sell the property to the prospective purchaser. Further discussion of the history and application of the step-transaction doctrine can be found in Section V.B.1 of this outline. E. Donor s Percentage of Ownership or Control in Closely-Held Securities If a donor holds less than a full ownership interest in a closely-held corporation, the appraised value of his stock may be discounted. Typically, an ownership interest in a business that represents less than full ownership will be discounted from 30% to 40%. This is important to remember because the charitable deduction that the donor will be entitled to claim will be calculated using this appraised value. III. Qualified Appraisal Rules for Closely-Held Securities A. What securities must be appraised? When a donor makes a gift of closely-held securities and the amount claimed as a charitable deduction exceeds $5,000, a qualified appraisal must be obtained in order to 7

190 substantiate the claimed value. Reg A-13(c)(1)(i). A fully completed appraisal summary must be attached to the return on which the deduction is first claimed. Reg A-13(c)(2)(i)(a)-(c). B. Qualified Appraisal Requirements A comprehensive overview of the requirements for completing a qualified appraisal is attached hereto as Appendix B. C. Selecting a Qualified Appraiser for Gifts of Stock The individual selected must hold himself or herself out to the public as an appraiser or perform appraisals on a regular basis and not be one of the persons described in Reg. 170A-13(c)(5)(iv). Under this Regulation, the following persons cannot be a qualified appraiser: (1) the donor, (2) a party to the transaction whereby the donor acquired the property, (3) a representative of the donee charity, or (4) any person that is employed by or related to any of the foregoing persons. D. Appraisal Fees Appraisal fees for valuing closely held stock can be substantial. The gift planner should discuss this subject with the donor prior to the completion of a gift. The economics of the situation may or may not make sense. Donors often do not think about making a significant outlay of cash in order to substantiate their gift value. E. IRS Forms 8283 and 8282 When the donor is required to obtain a qualified appraisal to substantiate the claimed deduction, an appraisal summary must be attached to the return on which the deduction is first claimed. Reg (c)(2)(i)(B). The summary is made on the IRS prescribed Form Non-Cash Charitable Contributions. A contribution of non-publicly traded stocks where the claimed deduction is greater than $5,000 but less than $10,000 requires a partially completed appraisal summary. Form 8283 must be signed by the charity to acknowledge receipt of the gift and by the appraiser who prepared the qualified appraisal. By signing the form, the charity is not agreeing with nor endorsing the value placed on the stock by the appraiser. The charity is only acknowledging receipt of the gift on the date specified in the summary. Additionally, the charity s signature acknowledges that it has certain reporting requirements to which it is subject if the property is sold, exchanged, consumed or otherwise disposed of within three years after the date of the gift. Reg A- 13(c)(4)(iii). The charity s signature must be made by the official authorized to sign the tax or information returns or a person specifically authorized to sign appraisal summaries by 8

191 the official authorized to sign the charity s tax or information returns. Reg A-13(c)(4)(iii). There are no sanctions imposed on the charity if it does not sign Form 8283, but it is good policy to do so. A file copy should be maintained. If the property is sold within three years of the date of the contribution, the charity is required to file Form Donee Information Return and to provide a copy to the donor. IRC 6050L(a), Reg L1(a)(1), IRC 6050L(c), Reg L-1(d). Substantial penalties are possible when a charity fails to file Form 8282, fails to include all required information, or includes incorrect information. For each occurrence, a penalty of $50 may be imposed, with a maximum penalty of $250,000 for all such failures within a calendar year. IRC 6762(a). The penalty may be less in some instances and can be mitigated if the charity can show reasonable cause and not willful neglect in not filing. IRC 6721(b), 6721(c), 6721(d), and 6724(a). IV. Special Situations A. S Corporation Stock Issues Unlike corporations which are described in Subchapter C of the Internal Revenue Code, whose income is subject to taxation at both the corporate level and the individual level, Subchapter S of the Code provides an alternative manner of taxation for certain corporations with less than one-hundred shareholders that also meet other specified criteria. In most every respect, an S corporation functions in the same manner as a C corporation, except that the corporation s income is taxed directly to the shareholders, avoiding the double taxation that occurs with C corporations. Operating under the corporate form limits the shareholders personal liability, while the income and deductions of S corporations are allowed to pass through to its shareholders. IRC 1363 and Prior to 1998, charitable organizations were not included as eligible shareholders of S corporations. If S corporation shares were transferred to a charity, the corporation would immediately lose its S corporation status and become taxed the same as a C corporation. However, the Small Business Job Protection Act of 1996 (P.L ) allowed charitable organizations to be included among the eligible shareholders of S corporations as of January 1, Other eligible shareholders include individuals, estates, and certain trusts (discussed below). Partnerships and for-profit corporations are not allowed as shareholders of S corporations. Nonetheless, the passage of the Small Business Job Protection Act created new opportunities for donors and charities by allowing gifts of stock in many closely-held companies that were previously not possible. 9

192 While charities may now receive outright contributions of S corporation shares without jeopardizing the favorable tax treatment of the corporation, it is very important to note that charitable remainder trusts may not receive S stock without significant consequences. Specifically, a transfer of S corporation stock to a charitable remainder annuity trust or charitable remainder unitrust is prohibited under IRC 1361(e)(1)(B)(iii) and will cause the corporation to immediately lose the S election for all shares, not just for those shares actually contributed to the trust. In most cases, the resulting negative tax consequence for all other shareholders will preclude a donor from gifting S stock into a charitable remainder trust. However, if all outstanding shares of the S corporation will soon be sold or gifted, this otherwise undesirable result may be of less consequence to the other shareholders. Nonetheless, all shareholders should be aware that, if the S corporation has operated as a C corporation at any time during the previous ten years, the corporation could have some retained earnings that would be taxed as ordinary income upon the conversion of the corporation by the loss of the S election. It is possible to fund a charitable lead trust with S stock, but only in limited circumstances where the trust is structured in a manner that complies with the Code provisions that allow certain trusts to qualify as shareholders of S stock. Specifically, IRC 1361(c)(2)(A) identifies the trust types which are allowed, including (1) qualified subchapter S trusts, (2) electing small business trusts, (3) grantor trusts, (4) former grantor trusts for the two year period following the grantor s death, and (5) any testamentary trust for a two year period following the funding of the trust. So, either a grantor lead trust or a testamentary lead trust (for two years after funding) may hold shares of S stock without jeopardizing the company s S election. In any context in which a charitable organization (or charitable trust) contemplates holding S corporation shares, the charity should be mindful that it will be subject to unrelated business income tax ( UBIT ) for its portion of the S corporation s accounting income for as long as it holds the shares. IRC 512(e)(1). Further, even the gain that may be realized upon the sale of the S stock by charity will be subject to UBIT. IRC 512(e)(1)(B)(ii). Accordingly, a charity should be sure that it will be able to satisfy this potential tax liability prior to accepting the gift of S stock. B. Anticipatory Assignment of Income On occasion, stockholders find themselves in a situation where they will be forced to realize income from the involuntary disposition of their stock because of a taxable takeover of the corporation or because the corporation is in the process of liquidation. If such events run their course, the stockholder will be forced to recognize any appreciation in the shares once they are sold. This type of situation often causes shareholders to consider making a charitable gift of the shares so that they may avoid realization of the taxable gain and also obtain the benefit of a charitable income tax deduction for the value of the shares contributed. However, under the anticipatory assignment of income doctrine, the gain from the post-gift sale of the stock may be taxable to the donor on the theory that the asset transferred to charity by the donor is, in 10

193 practical effect, a right to receive cash rather than an asset that might or might not be converted to cash at some point in the future. 1. Corporate Stock Subject to a Taxable Takeover In the case of a taxable takeover of the corporation, a shareholder will be able to avoid recognition of gain only by gifting the shares before the final outcome of the takeover attempt is certain. Any failure to complete the gift before the outcome of the takeover bid is known will cause the gain to be attributed to the shareholder/donor. In the case of a cash tender offer for the stock, ownership and control of the shares which are subject to the tender offer must be conveyed to the charitable donee before the tender offer is accepted, and the charitable donee must subsequently take the required procedural steps to accept the tender. Richardson v. Commissioner, T.C. Memo Several key cases speak to the application of the assignment of income doctrine in a taxable takeover situation. In its Ferguson decision, the Ninth Circuit applied the assignment of income doctrine to a complicated tender offer fact situation. Ferguson v. Commissioner, 108 T.C. 244 (1997), aff d, 174 F3d 997, 83 AFTR2d (9 th Cir. 1999). In its ruling, the Court determined that the donor s transfer of shares to charity occurred after the right to the takeover proceeds had ripened into a fixed right to receive cash because the merger that would result from the tender offer was substantially certain to occur. As a result, the donor was taxed on the gain that was represented in the gifted shares. While the donor was still entitled to claim a charitable deduction, the conveyance was treated as a gift of cash rather than stock. Despite the seemingly negative consequence of the Ferguson case, a close examination of the facts still leaves room for comfort for donors and charitable gift planners. Specifically, the Ferguson decision is not inconsistent with the doctrine established in Palmer v. Commissioner that a gift will still be effective so long as the charitable donee can not be legally compelled to surrender the donated property. Palmer v. Commissioner, 523 F.2d 1308 (8 th Cir. 1975). After the Palmer decision was reached, the IRS acquiesced to the decision by issuing Rev. Rul which states that the IRS will treat stock proceeds as income to the donor only in situations where, as of the date the charitable donee receives the shares, the charitable donee is legally bound or may be compelled by the issuing corporation to surrender the shares. This position was further supported by the decision reached in the case of Rauenhorst v. Commissioner, 119 T.C. 157 (2002), wherein the donor gifted stock-purchase warrants to four charities who subsequently converted them to stock and tendered them to the issuer for cash. The IRS asserted that, similar to the Ferguson fact pattern, the proceeds had ripened to a practical certainty. However, the Tax Court ruled in favor of the donor, finding that the charitable donees were not legally bound to sell the warrants at the time they were received. Thus, a binding contract or legal obligation to act must exist before the IRS may successfully assert the assignment of income doctrine. 11

194 2. Corporate Stock Subject to Liquidation For donors who hold shares in a corporation that is in the process of liquidation, the ability to avoid income recognition by gifting the stock may be less certain. Some lower courts have held that a donor may avoid the recognition of income so long as the stock is conveyed to charity prior to the final vote of the stockholders or board of directors to liquidate the corporation. However, higher courts have created more uncertainty by ruling that income will be attributed to the donor in situations where the liquidation plan cannot be practically withdrawn at the time the shares are conveyed to charity. Jacobs v. United States, 390 F2d 877 (6 th Cir. 1968); Rushing v. Commissioner, 441 F2d 593 (5 th Cir. 1971); Hudspeth v. United States, 471 F2d 275 (8 th Cir. 1972); Kinsey v. Commissioner, 477 F2d 1061 (2 nd Cir. 1973). The conclusion to be drawn from these decisions is that a donor must complete the gift transfer before the liquidation process reaches a point where it cannot be reversed, either legally or practically. Otherwise, the donor will be forced to recognize the proceeds from the liquidation of the shares as income. Note: In all relevant cases on this point, the Service did not assert that the donation itself was defective or that the charitable deduction should be disallowed. The issue was always the recognition of income and capital gain arising from the proceeds of the donated asset. C. Stock that is Pregnant with a Dividend Frequently, donors will gift securities to charity that are soon to receive a dividend from the issuing corporation. To determine the tax treatment that applies in this situation, it is important to be familiar with the significant dates related to the pending dividend distribution. The declaration date is the date upon which the corporation makes known its intention to pay a future dividend of a given amount for each outstanding share of stock. On the stated record date, those individuals who own outstanding shares become entitled to actually receive the dividend distribution. After the declaration date and before the record date, the value of a stock will typically increase to reflect the value of the upcoming dividend distribution. Once the record date has passed, the value of the stock will usually decline again. The Fifth Circuit Court of Appeals considered a fact situation involving these factors in the case of Caruth v. United States, 865 F2d 644 (5 th Cir. 1989). In this case, the donor conveyed preferred shares of stock to a charity soon after a dividend had been declared but a few days before the dividend record date. The donor subsequently claimed a charitable deduction for the enhanced market value of the shares, including the value of the pending dividend. The IRS did not challenge the legitimacy of this deduction amount, but rather argued that the amount of the dividend should be attributed to the donor as income. The IRS based this argument on the donor s control over the issuing corporation (and therefore the key dates surrounding the dividend) and the fact that the donor later reacquired the gifted shares eleven months later. The Court disagreed with the arguments made by the Service and concluded that the pregnant stock was an 12

195 appreciated asset, and that because the donor had given away the appreciated value without first realizing it, the donor was not required to include the appreciation in his income stream. D. Gifts of Stock Options A stock option issued by a corporation allows the holder of the option to purchase shares of the corporation s stock at or before some future date at a price determined at the time the option is granted. It is not uncommon for corporations to grant stock options to qualified charitable organizations. By doing so, the corporation is able to realize an income tax charitable deduction without having to actually expend existing cash or other assets. However, the corporation is not entitled to any charitable deduction merely by transferring the option to a charitable organization. The charitable donee must first exercise the option before the deduction may be claimed. Rev. Rul , C.B. 72; Rev. Rul , C.B The amount of the charitable contribution deduction is measured by the excess of the stock s fair market value on the exercise date over its option price. Rev. Rul , C.B. 72; Rev. Rul , C.B. 75; Priv. Ltr. Ruls , , , , and Extra caution must be exercised if an option is to be conveyed by a corporation to a private foundation. IRC 4941 imposes sanctions on self dealing transactions that occur between certain disqualified persons and private foundations. If the corporation meets the definition of a disqualified person under IRC 4946(a)(1), then the subsequent exercise of the option by the private foundation would constitute a self dealing transaction pursuant to IRC 4941(d)(1) for which sanctions would be imposed under IRC 4941(b). However, in a 1993 private letter ruling, the Service stipulated that a donor/corporation would be allowed a deduction when an option conveyed to a private foundation was subsequently sold to a public charity that then exercised the option. As mentioned in the preceding paragraph, the deduction amount was equal to the excess of the fair market value of the stock over the exercise price on the date that the unrelated public charity exercised the option. Priv. Ltr. Rul

196 14

197 Appendix A Sample Letter of Authorization from Donor to Donor s Broker 15

198 DONOR NAME Donor s Address City, State Zip Code Mr. Broker s Name Brokerage Firm Address City, State Zip Code RE: Account No. XXXXXXXXXXX Dear Mr. Broker: I hereby authorize and direct you to transfer the following securities to HighGround Advisors, using the delivery instructions listed below: List of Securities Delivery instructions for HighGround Advisors account are as follows: BROKERAGE FIRM DTC # Acct. No. Should you have any questions concerning this matter, please contact Larry Jones from HighGround Advisors at Thank you for your prompt attention to this matter. Sincerely, Donor s Name [Medallion Signature Guarantee] 16

199 Appendix B Qualified Appraisal Requirements 17

200 QUALIFIED APPRAISAL REQUIREMENTS These steps must be followed by a qualified appraiser to meet the criteria established by the Internal Revenue Service for non-cash charitable gifts. 1. The appraisal must be prepared no earlier than 60 days prior to the date that the contribution is made, and must be prepared not later than the due date of the return on which the deduction is claimed or the date an amended return is filed if the amended return is the first return on which the deduction is claimed. 2. The appraisal must be prepared, signed and dated by a qualified appraiser as defined below. 3. The appraisal must include the following information: a. 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; b. In the case of tangible property, the physical condition of the property; c. The date (or expected date) of contribution to the donee; d. The terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of the donor which relates to the use, sale or other disposition of the property contributed. This includes restrictions on the donee s right to use or dispose of the donated property, all provisions which confer on anyone, other than the donee charity, the right to income from the donated property or the right to possession of the property, including voting rights to securities, a right of purchase, or a right to designate the person to receive income, possession or right of purchase, or a provision which earmarks the donated property for a particular use. As an added precaution, all agreements between the donor and the donee charity relating to the gift should be attached to the appraisal and incorporated into it by reference; e. The name, address, and taxpayer identification number of the qualified appraiser and, if the qualified appraiser is a partner in a partnership, an employee of any person (whether an individual, corporation, or partnership), or an independent contractor engaged by a person other than the donor, the name, address and taxpayer identification number of the partnership or the person who employs or engages the qualified appraiser; f. The qualifications of the qualified appraiser who signs the appraisal, including 18

201 the appraiser s background, experience, education, and any membership in professional appraisal associations, A qualified appraiser is an individual who meets all the following requirements. (1) The individual either: i. Has earned an appraisal designation from a recognized professional appraiser organization for demonstrated competency in valuing the type of property being appraised, or ii. Has met certain minimum education and experience requirements. For real property, the appraiser must be licensed or certified for the type of property being appraised in the state in which the property is located. For property other than real property, the appraiser must have successfully completed college or professional level coursework relevant to the property being valued, must have at least 2 years of experience in the trade or business of buying, selling, or valuing the type of property being valued, and must fully describe in the appraisal his or her qualifying education and experience. (2) The individual regularly prepares appraisals for which he or she is paid. (3) The individual demonstrates verifiable education and experience in valuing the type of property being appraised. To do this, the appraiser can make a declaration in the appraisal that, because of his or her background, experience, education, and membership in professional associations, he or she is qualified to make appraisals of the type of property being valued. (4) The individual has not been prohibited from practicing before the IRS under section 330(c) of title 31 of the United States Code at any time during the 3-year period ending on the date of the appraisal. (5) The individual is not an excluded individual. g. A statement that the appraisal was prepared for income tax purposes; h. The date or dates on which the property was valued; i. The appraised fair market value of the property on the date (or expected date) of contribution; j. The method of valuation used to determine the fair market value, such as the income approach, the market data approach, or the replacement-cost-lessdepreciation approach; k. The specific basis for the valuation, if any, such as any specific comparable 19

202 sales transactions; l. A description of the fee arrangement between the donor and the appraiser. 4. The appraiser must sign and complete Internal Revenue Service Form 8283, Section B, Part III, denoted Appraisal Summer. The Appraisal Summary includes declarations by the appraiser that: I declare that I am not the donor, the donee, a party to the transaction in which the donor acquired the property, employed by, or related to any of the foregoing persons, or married to any person who is related to any of the foregoing persons. And, if regularly used by the donor, donee, or party to the transaction, I performed the majority of my appraisals during my tax year for other persons. Also, I declare that I perform appraisals on a regular basis; and that because of my qualifications as described in the appraisal, I am qualified to make appraisals of the type of property being valued. I certify that the appraisal fees were not based on a percentage of the appraised property value. Furthermore, I understand that a false or fraudulent overstatement of the property value as described in the qualified appraisal or this Form 8283 may subject me to the penalty under section 6701(a) (aiding and abetting the understatement of tax liability). In addition, I understand that I may be subject to a penalty under section 6695A if I know, or reasonably should know, that my appraisal is to be used in connection with a return or claim for refund and a substantial or gross valuation misstatement results from my appraisal. I affirm that I have not been barred from presenting evidence or testimony by the Office of Professional Responsibility. 5. The following persons cannot be qualified appraisers with respect to particular property. a. The donor or the taxpayer who claims or reports the deduction under Section 170 for the contribution of the property being appraised; b. A party to the transaction in which the donor acquired the property being appraised (i.e., the person who sold, exchanged or gave the property to the donor, or any person who acted as an agent for the transferor or for the donor with respect to such sale, exchange or gift), unless the property is donated within two months of the date of acquisition and its appraised value does not exceed its acquisition price; c. The donee of the property; d. Any person employed by any of the foregoing persons or related to any of the foregoing persons under Section 267(b) (e.g. if the donor acquired a painting from an art dealer, neither the art dealer nor persons employed by the dealer can be qualified appraisers with respect to that painting); 20

203 e. Any person whose relationship with any of the persons listed in (1) through (4) above would cause reasonable person to question the independence of such appraiser. For example, an appraiser who is regularly used by any person described in (1) through (3) above and who does not perform a substantial number of appraisals for other persons has a relationship with such person that is similar to that of an employee and cannot be a qualified appraiser with respect to the property contributed. 21

204 825 NE 13th Street Oklahoma City, OK Phone Fax omrf.org/plannedgiving MULTIPLY YOUR GIFTS TO FAMILY With a Family Lead Trust HOW DOES A CONSIDER A A family lead trust will pay fixed income to us for a period of time. After that, what is left will go to your family at a substantial tax savings. While you or your estate may pay some tax up front, the value transferred to family could be two, three or even four times that cost. You may select the appropriate term of years for the trust, enabling you to schedule when the principal will pass to your family. A testamentary lead trust is a family lead trust that is funded when you pass away. The trust pays income to our organization for a period of time, after which the trust assets go to your family. The benefit of the testamentary lead trust is that it provides you with a charitable estate tax deduction, reducing your estate transfer tax. This plan works especially well for scheduling inheritance for children and grandchildren to begin at an age of financial responsibility. Your estate and your family will benefit from this plan. LIVING FAMILY LEAD TRUST WORK? ARE YOU LOOKING FOR A WAY TO LEAVE AS MUCH AS YOU CAN TO YOUR FAMILY? Every gift has a cost. If you make a gift of your stock or real estate to your family during your lifetime, your gift may be subject to gift tax. If you make a future gift to family, your estate may be subject to estate tax. A family lead trust can help you achieve your goals of passing on property to your family while reducing or even eliminating gift or estate taxes. The benefit of this plan is that it provides you with a charitable gift tax deduction when the trust is funded that will reduce or even eliminate the cost of making the future gift to your family. If the property has grown since the time of the gift, your family will enjoy the benefits of that growth. You have the satisfaction of knowing that you helped our organization, and made a significant gift to your family. TESTAMENTARY LEAD TRUST CONTACT US FOR MORE INFORMATION For more information on the benefits of creating a family lead trust either now or in the future, please visit our website or call us today.

205 825 NE 13th Street Oklahoma City, OK Phone Fax omrf.org/plannedgiving OIL AND GAS PRODUCTION IN THE UNITED STATES IS ON THE RISE. As America moves to energy independence, you may be one of those leading the way. At the same time, precious metals are increasing in demand and in price. If you own land or an interest in land with any of the following, we can help you avoid taxes. OIL, GAS, GOLD, SILVER. OTHER PRECIOUS METALS Gift of All or a Portion of Your Land You can receive the most direct tax benefit by giving all or part of your ownership interest in your land to a qualified charity. With the help of an appraiser who specializes in valuing this type of donation, you receive an income tax deduction for the value of the portion you give. This reduces your income and provides immediate tax savings while supporting the causes important to you. Gift of Royalties A common problem for oil and mineral rights holders is income that pushes them into the upper tax brackets with higher rates and fewer deductions. Landowners can agree to give a portion of their royalties to a qualified charity for a term of years. The landowner will not be taxed on the income. By making a gift of your royalties, you can achieve your charitable goals while lowering income and saving taxes. Life Estate When you give a charity a life estate in your land, you may continue using the land for as long as you live. Even though the land will not pass to charity right away, you receive an immediate income tax deduction for the present value of the remainder interest. The charitable deduction is useable up to 30% of your adjusted gross income and may be carried over up to five additional years if not used the first year. Charitable Remainder Trust To maintain the most income while also maximizing charitable intent and charitable deductions, place your land into a charitable remainder unitrust. You receive an income tax deduction and payments based on a percentage (such as 5%) of the trust s value each year. Because the production will likely add more than 5% to the trust annually, the trust has the potential to grow and pay you more each year. After a lifetime of payments to you, the remainder goes to help further our mission. OS sl

206 Oklahoma Medical Research Foundation (OMRF) For any gift to OMRF through your will, trust or retirement account, please include the following: Name: Oklahoma Medical Research Foundation (Federal Tax ID ), or its successor organization, a 501(c)(3) nonprofit organization, 825 N.E. 13 th Street, Oklahoma City, OK Gift: Use: (a) Specific Bequest dollar amount or specific property (b) Residual Bequest all or a percentage (of what remains after expenses & specific bequests are paid) (c) Retirement Accounts or Life Insurance all or a percentage of the account or proceeds (d) Contingent Bequest takes effect if a specific or residual bequest cannot be fulfilled (a) Unrestricted to be used where it is needed most ( general use and charitable purposes ) (b) Restricted designated for a specific purpose or area(s) of research: to support research for o Diseases of aging o Arthritis o Cancer o Cardiovascular disease o Lupus o Multiple Sclerosis o Neurological diseases o (other o Diabetes program, research area or disease) Suggested language Specific Bequest unrestricted or restricted I give $ or (specific property) to the Oklahoma Medical Research Foundation (Federal Tax ID ), or its successor organization, a 501(c)(3) nonprofit organization, 825 N.E. 13 th Street, Oklahoma City, Oklahoma 73104, for its general use and charitable purposes (or specific purpose). Residuary Bequest unrestricted or restricted I give all or _% of the rest, residue, and remainder of my estate, both real and personal, wherever situated, which I may own or be entitled to at my death, to the Oklahoma Medical Research Foundation (Federal Tax ID ), or its successor organization, a 501(c)(3) nonprofit organization, 825 N.E. 13 th Street, Oklahoma City, Oklahoma 73104, for its general use and charitable purposes (or specific purpose). Contingency Bequest unrestricted or restricted If (name of beneficiary) does not survive me, or shall die during the administration of my estate, or as a result of a common disaster, then I give her/his/its/their gift or share to the Oklahoma Medical Research Foundation (Federal Tax ID ), or its successor organization, a 501(c)(3) nonprofit organization, 825 N.E. 13 th Street, Oklahoma City, Oklahoma 73104, for its general use and charitable purposes (or specific purpose). To Prepare for the Unexpected Including the following language is optional, but suggested, for restricted gifts. In the event the purposes of the restriction, in the opinion of the Board of Directors of OMRF, can no longer be served, the Board my use the remaining assets for charitable purposes that are within the scope of the charitable purposes of OMRF and most nearly approximate the original purpose of the gift. Retirement Plan or Insurance Policy Naming OMRF a beneficiary of a qualified retirement plan accomplishes your charitable goals while realizing significant tax savings. You maintain complete control over the asset while living, but at your death the remaining assets (or specified %) pass to OMRF free of both estate and income taxes. For gifts of Retirement Plans or Life Insurance, a Change of Beneficiary form must be completed with the Plan Administrator. These assets do not pass by will or trust. Use the Name and Use instructions above. For more information or assistance please contact Ginny Bass Carl, Senior Director of Development and Gift Planning, at or ginny-carl@omrf.org. Our planned giving website omrf.org/plannedgiving provides calculators, a step-by-step will planning guide and other useful information. We also encourage you to visit with your attorney, tax advisor and/or financial advisor to determine the best estate and gift planning strategies for your particular situation.

207 50+ labs 1946 The Oklahoma Medical Research Foundation is born. Working to understand and develop new treatments for disease ,000+ patient visits since ,000 Oklahomans attended an open house for a newly dedicated OMRF research building. Patients travel from across Oklahoma, the U.S. and even from around the world for treatment in OMRF clinics On April 21, at a ceremony led by Gov. Mary Fallin, OMRF dedicated its new 186,000 square foot research tower OMRF celebrated its 70th anniversary with champagne, cupcakes and commemorative t-shirts 3 FDA approved drugs PLUS one diagnostic test on the market and another in development 1,800 Patents filed with OMRF technologies. Current portfolio numbers near 400 active patents Publications Active Research Cited worldwide Grants Active Clinical Trials Two drugs our patients helped test in trials are now FDA-approved medications available everywhere. 10 drugs Your support means the world to us A dozen industry collaborations 100% of your gift goes to research. in the pipeline GSK, Biogen, Lilly, Merck, EMD Serono, Myriad Genetics, Novartis 14 spin-off companies Includes collaborations with Stanford, Duke, Harvard, Johns Hopkins, Mayo Clinic, MD Anderson, Yale, MIT, Cornell, UPenn and many others Administrative costs are paid through a private trust and other funding sources. 10,043 gifts last year honoring 8,120 people More than a 20 individuals with 500 or more lifetime gifts OMRF treated some of the state s sickest children (most suffering from leukemia) in its research hospital. 400 employees representing 30 countries Training the next generation 70 post-doc and graduate students training at OMRF each year 550 Fleming scholars since Saxon Scholars 200 Teen Leaders in Philanthrophy A consecutive Top Workplaces in Oklahoma award winner since 2013