The Tax Law of Charitable Giving. Bruce R. Hopkins

intended for such a use.⁷⁰

§ 3.7 STEP TRANSACTION DOCTRINE

As discussed, the general rule is that a contribution of appreciated capital gain property to a public charitable organization is deductible on the basis of the fair market value of the property, and the capital gain element is not taxable to the donor.⁷¹

If, however, the donee charitable organization sells the property soon after the contribution is made, the donor may be placed in the position of having to recognize, for federal income tax purposes, the capital gain element. This can happen when, under the facts and circumstances surrounding the gift, the donee was legally obligated to sell the gift property to a purchaser that was prearranged by the donor. In this situation, the law regards the transaction as a sale of the property by the donor to the third-party purchaser and a gift of the sales proceeds to the charitable organization.⁷²

This is the step transaction doctrine, under which two or more ostensibly independent transactions (here, the gift and subsequent sale) are consolidated and treated as a single transaction for federal tax purposes. The key to avoiding this tax-adverse outcome is to be certain that the charitable organization was not legally bound at the time of the gift to sell the property to the prospective purchaser.⁷³

The step transaction rule has been, and continues to be, the subject of considerable litigation. Several court opinions illustrate the nature of this controversy. In one, the court ruled that a gift to a charitable organization of the long-term capital gains in certain commodity futures contracts gave rise to a charitable contribution deduction, and that the gifts and subsequent sales of the contracts were not step transactions within a unified plan.⁷⁴

      The case concerned an individual who formed a private operating foundation in the early 1970s and had been president of it since the date it was established. From time to time, he contributed futures contracts to the foundation and claimed charitable contribution deductions for these gifts. In 1974, he obtained a private letter ruling from the IRS that the charitable contributions deductions were proper and that no gain need be recognized when the foundation sold the contracts.

In 1981, however, the federal tax law was changed. Beginning that year, all commodities futures contracts acquired and positions established had to be marked to market at year-end, and the gains (or losses) had to be characterized as being 60 percent long-term capital gains (or losses) and 40 percent short-term gains (or losses), regardless of how long the contracts had been held.⁷⁵ This posed a problem for this individual because the charitable deduction for a gift of short-term capital gain property is confined to the donor's basis in the property;⁷⁶ there is no deduction for the full fair market value of the property (as there is for most gifts of long-term capital gain property⁷⁷). He resolved the matter by donating only the long-term gain portion of the futures contracts.

In 1982, this individual entered into an agreement under which he contributed the long-term capital gains of selected futures contracts from his personal accounts at a brokerage house and retained for himself the short-term capital gains. For the most part, the selected contracts were sold on the same day the gift was made, and the portions of the proceeds representing the long-term capital gains were transferred to an account of the foundation at the same brokerage house. The donor chose the futures contracts to be donated according to the funding needs of the foundation and the amount of unrealized long-term capital gains inherent in the contracts. Once the contracts were transferred to a special account, they were to be immediately sold, pursuant to a standing instruction. On audit for 1982, the IRS took the position that the full amount of the capital gains on the sales of these contracts was includible in this individual's taxable income. The IRS also disallowed the charitable deductions for that year and prior years. The IRS's position rested on two arguments: (1) The transfers of a portion of the gain to the foundation were a taxable anticipatory assignment of income,⁷⁸ and (2) the step transaction doctrine should apply, thereby collapsing separate interrelated transactions into a single transaction for tax purposes.

      The step transaction doctrine was inapplicable in this instance, the individual argued, because no prearrangements were made with respect to the gifts. He maintained that he donated all of his interest in the long-term capital gain portions of the futures contracts, free and clear. The IRS, by contrast, contended that the gift transfers should be treated together with the later future sales and division of proceeds as a single transaction. The government argued that this individual's plan was to meet the foundation's operating needs by selling selected futures contracts with unrealized appreciation of equal amounts. Rather than donating cash, this argument went, he tried to donate the futures contracts with a restriction that he would keep the short-term capital gains on their sale.

The court said that the question in the case was: “[H]ow related were the decisions to sell the futures to their donation?”⁷⁹ The court looked to the matter of control and found that the donation agreements and powers of attorney executed by the individual supported his position that the trustees of the foundation had control over the sale of the futures contracts once they were transferred into the broker's special account. Thus, the court concluded that the issue of the donor's control over the sale of the contracts “was not such that the donations and sales could be viewed as step transactions encompassed within a unified plan.”⁸⁰

As this case illustrated, the question posed by the step transaction doctrine involves the relationship among various seemingly independent transactions. In this case, the issue was, as the court said, how related the decisions to sell the futures contracts were to the contribution of them. If some prearrangement existed by which the individual donated selected contracts to cover the charitable organization's operating expenses, and if he received in return short-term gains without having to pay taxes on the full amount of the futures contracts, then the transfers could have been viewed as a step transaction within a larger plan. In this connection, one court held:

If, by means of restrictions on a gift to a charitable donee, either explicitly formulated or implied or understood, the donor so restricts the discretion of the donee that all that remains to be done is to carry out the donor's prearranged plan . . . for designation of the stock, the donor had effectively realized the gain inherent in the appreciated property.⁸¹

      As to this case, the individual claimed that the sales were not prearranged but rather were the prudent acts of the trustees of a charitable organization in need of operating funds. The IRS argued that the standing instruction reflected a prearranged plan to use the charity to sell the futures contracts, cover its needs with the long-term gains, and enable the individual to keep the short-term gains without having to pay taxes on the entire proceeds of the sale. The court held that there was no evidence to suggest that the individual was the source of the standing instruction and thus that his control over the sale of the contracts was not such that the contributions and sales could be viewed as step transactions encompassed within a unified plan.

In a similar case, a court held that contributions of appreciated futures contracts to a charitable organization controlled by an individual did not result in income to the individual when the contracts were sold shortly after they had been donated.