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Celebrity baby photograph donations: A case study in charitable contribution tax planning and research
J. of Acc. Ed. 28 (2010) 210–220
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Educational case
Celebrity baby photograph donations: A case study in charitable contribution tax planning and research Hossein Nouri a,⇑, Dustin Opatosky b,1 a
Department of Accounting and Information Systems, School of Business, The College of New Jersey, P.O. Box 7718, Ewing, NJ 08628, United States Ernst & Young, LLP, 5 Times Square New York, NY 10023, United States
b
a r t i c l e
i n f o
Article history: Available online 21 April 2011 Keywords: Charitable contributions Tax research Individual tax planning
a b s t r a c t A recent trend has been the sale for publication in national magazines of the first photographs of celebrities’ babies. It is not unusual for such sales to generate millions of dollars of revenue for these celebrities. Some celebrities have chosen to donate the proceeds from such sales to charity. Despite these charitable intentions, celebrities are not often looking to be charitable to the Federal government. Accordingly, in this case study, your clients, Angie and Bradley, turn to you as their tax advisor for help assessing the tax implications of their potential donations as well as for planning solutions resulting in the most favorable tax treatment for them. By completing this case successfully, you will learn some of the Internal Revenue Code (‘‘IRC’’) rules regarding charitable contributions, how to perform basic tax research, and how to interpret your findings in order to provide beneficial tax-planning advice to your clients. Ó 2011 Published by Elsevier Ltd.
1. Firm background You graduated from college with an accounting degree and have spent eight years working in the tax department of a Big-Four accounting firm, eventually leaving to start your own firm, BB Tax, CPA (BB Tax). You are now one of the largest sole proprietor CPAs in the area and serve many high-net-worth individual clients, small and mid-size businesses, and various estates. Typically, the
⇑ Corresponding author. Tel.: +1 609 771 2176; fax: +1 609 637 5108. 1
E-mail addresses: [email protected] (H. Nouri), [email protected] (D. Opatosky). Tel.: +1 212 773 1497.
0748-5751/$ - see front matter Ó 2011 Published by Elsevier Ltd. doi:10.1016/j.jaccedu.2011.03.007
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primary tax-related goal of most of these clients is to reduce their federal and state and local income tax liabilities to as little as possible within the bounds of the tax law. 2. Client background Two of your clients, Angie and Bradley, recently had a baby. Angie is a world-renowned actress, model, author, and philanthropist. Similarly, Bradley is a famous actor, writer, and director. When discussed in the same sentence the two have come to be known by the nickname ‘‘Angley,’’ and are the true epitome of a Hollywood power couple. Because of the couple’s fame, they are frequently the source of gossip column fodder, are always trailed by paparazzi, and are often featured on covers of national magazines. Both Angie and Bradley have been your clients for a number of years, going back to before the time they were married. Because of their varied endeavors, Angie and Bradley’s taxable income has historically oscillated widely by year, but nevertheless they always seem to need your tax advice for one matter or another, and are willing to pay quite well for it. 3. Tax-planning opportunity On December 6, 201X, Angie and Bradley plan to sell the coveted first baby photos of their newborn daughter, Warlock, to Celebrity Monthly, a national magazine, for $14 million. Warlock was born November 30, 201X. In exchange for the $14 million payment, Celebrity Monthly will obtain the publication rights to the pictures in North America. Angie and Bradley, collectively worth more than $250 million, wish to donate the $14 million proceeds to benefit underprivileged children in Africa. They also would like to complete this transaction as soon as possible, as they are currently being hounded relentlessly by the media for the first pictures of their baby, to the point where they feel that their privacy is being invaded on a daily basis (just last week Angie caught a reporter in a tree outside little Warlock’s window). Angie and Bradley file a joint tax return (married filing jointly) and will have combined adjusted gross income (‘‘AGI’’) of $6 million for 201X, without regard to any expected proceeds from the sale of the photographs. For purposes of this case, ignore any Alternative Minimum Tax (‘‘AMT’’) implications. Unless otherwise noted, assume each requirement set forth below is independent of the other requirements 4. Requirements 1. Identify the tax implications of this charitable contribution if Angie and Bradley sell the photos for $14 million and then claim a charitable contribution deduction on their 201X joint tax return. Assume that the donation meets all requirements to be considered a valid charitable contribution for US Federal income tax purposes. Specifically: a. How much of the $14 million would Angie and Bradley recognize as taxable income on their joint tax return and what would be the nature of such income (i.e., ordinary or capital gain)? What authority (i.e., IRC Section) specifically requires this recognition? b. How much of the $14 million would Angie and Bradley be able to deduct as a charitable contribution in the current year and why? If less than the full amount, what happens to the remainder? Consider charitable contribution limitations and assume that Angie and Bradley do not have any other itemized deductions for this tax year. c. Optional – Same as part b, except Angie and Bradley also have additional qualifying charitable cash contributions during the year of $500,000. d. What is the current-year (201X) cash tax impact to Angie and Bradley in dollars of structuring this transaction as a sale of the photos followed by a charitable contribution of the cash (i.e., how much income tax would Angie and Bradley pay on the transaction based on your findings in parts a and b above)? Ignore any impact of the carryover of excess contributions to later years, if applicable. As part of this solution the couple’s marginal tax rate should be determined.
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Cite specific IRC Sections, Treasury Regulations, and/or IRS Publications2 for support for each part of Requirement 1. [Your answer for Requirement 1 should not exceed two double-spaced pages. There is no minimum length.] 2. Assume now that Angie and Bradley have already sold the photos to Celebrity Monthly and received the $14 million proceeds, but have not yet donated the proceeds to charity. What advice would you give to Angie and Bradley regarding what type of charity to select in order to maximize any potential tax deduction? Cite specific IRC sections, Treasury Regulations, and/or IRS Publications for support. [Your answer for Requirement 2 should not exceed one double-spaced page. There is no minimum length.] 3. Assume now that Angie and Bradley have not yet sold the photos but plan to sell them and donate the proceeds to charity as described above. Prior to entering into the transaction, they come to you, their CPA, seeking advice on how to best structure the transaction in order to receive the most favorable tax treatment in the current year (i.e., minimize any potential current year tax liability resulting from simply selling the photos and then donating the proceeds to charity, as calculated in Requirement 1d), ignoring any tax implications to the charity, while still achieving all of their nontax objectives. a. Prepare a memorandum documenting the advice you would give to Angie and Bradley. Assume that Angie and Bradley are expected to be in a similar taxable income situation in future years and that tax rates are not expected to change. You may make any additional reasonable factual assumptions necessary to support your answer. To the extent required, you should also advise your clients on any record-keeping or other requirements in order to substantiate any deduction claimed. Be prepared to defend your recommended solution in class. Cite specific IRC sections, Treasury Regulations, and/or IRS Publications for support. b. Optional – How would your advice in Requirement 3a differ, if at all, if you knew the following: i. The couple’s estimated AGI for 201X + 1 and 201X + 2 will be $5,000,000 and $9,000,000, respectively; ii. The couple is planning to donate an additional $1,500,000 in cash per year to qualified charitable organizations for 201X + 1 and 201X + 2; iii. Because of recently enacted legislation, the couple’s tax rate will increase to a 40% marginal tax rate in 201X + 1 and a 45% marginal tax rate in 201X + 2 (use the marginal tax rate calculated in Requirement 1d as the marginal tax rate for 201X); and iv. The couple’s relevant discount rate (for present-value purposes) is 10%. [Your answer for Requirement 3a should not exceed three double-spaced pages. Your answer for Requirement 3b, if assigned, should not exceed two double-spaced pages. There is no minimum length.]
5. Teaching note 5.1. Case background This tax research case was developed based on the recent trend of celebrities selling first pictures of their children to popular magazines for large sums of money.3 Such occurrences have been heavily covered in the popular media and are general public knowledge. While this case study is illustrative of a 2 Note that while IRS Publications may be cited as part of your responses to all Requirements, these publications are not considered substantial authority under IRC §6662(d)(2)(B) and therefore should not be the sole support for any answer, but rather should only be cited in addition to Internal Revenue Code (IRC) and/or Treasury Regulations citations. 3 See, for example, Angelina Jolie and Brad Pitt (People magazine), Jennifer Lopez and Marc Anthony (People magazine), and Matthew McConaughey and Camila Alves (OK! Magazine).
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potential real-life example, it has been entirely fictionalized and does not conform to the actual facts of any specific event(s) or individual(s). 5.2. Learning objectives This case has two broad learning objectives: (1) performing tax research and (2) applying tax research findings to a potential real-life tax-planning situation. The case study allows students to take a topic they will likely recognize from the popular media and utilize it as an actual example of individual income tax planning. Students will apply their basic tax research abilities to a fairly simple, yet multi-faceted area of tax law–charitable contributions. In addition, beyond utilizing and applying their tax research skills, the written memorandum portion of the assignment, including its three-page limitation (without regard to optional Requirement 3b), is designed to increase student communication skills by requiring them to convey their answers in an organized, concise, and clear manner. The subsequent in-class discussion encourages students to express and support their opinions orally while potentially being challenged by the opinions and alternative planning ideas of others. 5.3. Implementation guidance Since this case study is written for students in an introductory-level undergraduate/graduate tax course, only a moderate level of specific tax knowledge is required for students to successfully complete the case. The case is intended to be introduced early in the course, usually several weeks into the semester, once students have a basic understanding of taxable income and deductions in general, with a due date of late in the course (if given as one project), or with due dates throughout the course (if the requirements are broken into separate assignments). The expectation is that students will be taught the basic principles to answer each requirement throughout the course, and by assigning the project early on, students will have ample time to work at their own pace. In addition, students should be exposed to a basic explanation/illustration of tax research prior to assignment of the case. Basic tax research should include a general understanding of how to perform tax research online via LexisNexis, WestLaw, RIA Checkpoint, CCH IntelliConnect or a comparable research database; how to perform tax research using the IRC, Treasury Regulations, and/or IRS website; and a basic understanding of sources of federal tax law/guidance, including the IRC, Treasury Regulations, IRS Publications, and court cases (generally), as well as the level of authority that accompanies each of these sources. While there are numerous ways in which students can reach the conclusions shown in the Solutions section of the Teaching Note (below), students should be able to find citations to all necessary information within IRC §170, Treas. Regs. §1.170, and IRS Publications 78 and 526 (both of which reference back to the IRC as primary authority). All of these sources are readily available on the IRS website or through one of the aforementioned tax research databases. A simple keyword search for ‘‘charitable contributions’’ on the IRS website, for example, will lead to general articles explaining the rules covering income tax deductions for charitable contributions by individuals, including links to Publication 78 (Cumulative List of Organizations), Publication 526 (Charitable Contributions), Publication 561 (Determining the Value of Donated Property), and Publication 1771 (Substantiation and Reporting Requirements). Similarly, searching for ‘‘charitable contributions’’ in the Code via a tax research database (such as RIA Checkpoint) will yield results for IRC §170 within the first page of hits. This case study may be assigned as one comprehensive case study or as a series of smaller projects throughout the semester, and is intended to be a graded written small-group assignment, to best simulate real-world tax planning situations in CPA firms. The authors have found that the case works best with groups of two or three students, although instructors should be cautious to stress to students that any final assignment should not seem as though it was pieced together by different authors. If assigned as one comprehensive case study, the authors recommend giving students at least 7 weeks to complete the project. If broken into separate assignments (likely three, based on the requirements from above, although Requirements 1 and 3 can be further broken down), the authors recommend having the first two requirements due within 3–4 weeks of one another, and the third more comprehensive requirement due 4–5 weeks later. Upon completion, reviewing the entire case
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study in class in moderate detail with participatory discussion from prepared students will likely take 45–60 min with proper guidance from the instructor. While the instructor may deviate from the recommended structure and make the requirements open-ended (e.g., ‘‘What are the tax implications of this transaction and what planning ideas would you recommend to reduce the tax impact of the transaction?’’), the authors’ preferred approach is to utilize the outlined requirements shown above as these requirements help to give the problem structure and allow students with little tax experience to be guided in the right direction, thus minimizing any unnecessary frustration on the students’ part due to lack of more experienced technical tax skills. This approach provides the students with some structure for the detailed work, yet still allows them the flexibility to consider multiple avenues to reach their final recommendation. This structured approach also tends to keep students from seeking assistance/guidance from more experienced classmates, friends, or colleagues outside of the course. Alternatively, rather than providing the issues to students as shown in Requirement 1, instructors may prefer to ask students to identify the issues themselves during an in-class discussion before beginning research. Once the class as a whole has discussed the appropriate issues, the students could then conduct the research. As issue identification is an important skill for students to develop, a broader, group-based approach to identifying the issues could be worthwhile to pursue, at the instructor’s discretion. The post-assignment class discussion period may be used to discuss different approaches to tax research (i.e., how various groups found the information necessary to reach their conclusions) as well as potentially different conclusions reached and recommendations made, with the instructor giving guidance as to the strengths and weaknesses of any potential recommendations discussed. During in-class discussion, it is useful to stress that tax planning often involves non-tax consideration since some groups miss this point. 5.4. Evidence of efficacy This case study is recommended for use with undergraduate tax courses and/or graduate-level tax courses for non-Master’s of Taxation students, such as Master’s of Accounting and/or MBA students. To date this case study has been assigned three times in graduate-level courses at one institution and one time in an undergraduate course at another institution. It was assigned most recently in the Spring and Fall 2010 semesters as a group project in a graduate-level Federal Income Taxation – Individuals course in which both Master’s of Accounting students and MBA students were enrolled. Students worked primarily in groups of two and were given seven weeks to complete the project. The project was introduced four weeks into the semester, at which time students were already generally familiar with income sources, income exclusions, introductory tax theories/concepts, and basic tax research. Students learned about business expenses, deductions from AGI, and deductions for AGI as the semester progressed while working on the case study. Overall, approximately 33–50% of the groups answered all requirements accurately, with the remainder primarily forgetting to discuss the US-versus-foreign charity issues included in Requirement 2 (see teaching notes below) or recommending a sub-optimal alternative to donating the photographs directly to charity as part of the Solution to Requirement 3a (see teaching notes below). These points can be hinted at, if desired, during the class discussions of the case by the instructor prior to the final due date of the assignment. A Likert-type scale questionnaire featuring 11 questions and a section for open-ended responses was administered to each student during the most recent assignment of the case study in a Master’s of Accounting class (Fall 2010). Seventeen students anonymously completed the questionnaire and no outliers were excluded from the results. Mean results (standard deviation shown parenthetically) were as follows (7 = Strongly Agree, . . . , 1 = Strongly Disagree): 1. This project was engaging and interesting: 5.88 (0.83). 2. I am glad I worked on this project as a member of a team rather than individually: 6.00 (1.08). 3. My team interacted well together: 6.35 (0.73).
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4. After completing this project I have a better understanding of how to perform tax research: 6.24 (1.06). 5. After completing this project I have a better understanding of the complexity of federal taxation: 6.12 (0.83). 6. The time allotted for this project was reasonable: 6.59 (0.77). 7. The subject matter of the project was appropriate for an introductory-level tax course: 6.29 (1.27). 8. The length of the assignment was appropriate: 6.29 (0.82). 9. Overall, this project was a good learning experience: 6.29 (0.82). 10. Overall, I was very satisfied with this project: 6.18 (0.78). 11. I believe this project should be used again in future: 6.29 (1.07). Anonymous individual written feedback on the project was also solicited from each student, with the themes frequently emphasizing, among other things: (1) how using a potential real-life example made the case more enjoyable (‘‘very interesting’’ and ‘‘actually fun’’) and easy to relate to (‘‘challenging yet rewarding’’); (2) how the structure of the case made it understandable for tax novices; (3) the appropriateness of the length of the assignment; and (4) the usefulness in actually learning and performing basic tax research. Similarly, constructive criticism of previous versions of the case was taken into account: (1) to make Requirement 1 more direct while still leaving Requirement 3 quite broad; (2) to attempt to reap the benefits of group work while proactively discussing the challenges with the class (e.g., some students enjoyed working with a partner while others felt their partner did not contribute sufficiently); and (3) to add a ‘‘no minimum length’’ note to the page-length restrictions in order to prevent students from thinking the maximum length was the recommended length for some of the potentially more straightforward requirements. 5.5. Recommended solutions It is the authors’ recommendation that AMT implications be ignored because while the theory of AMT may be discussed, the mechanics of the AMT calculation are not often covered in an introductory taxation course, whether undergraduate or Master’s level (e.g., Federal Taxation of Individuals for Master’s of Accounting students).4 5.5.1. Solution to requirement 1 Requirement 1 is intended to introduce the general rules for ordinary income, charitable contributions, and itemized deductions. The main idea to be recognized in this requirement is that without proper planning, Angie and Bradley could end up owing a significant amount of federal tax ($1,400,000) (see Requirement 1d) on a transaction in which the their net income is $0 (i.e., $14 million of proceeds less $14 million of charitable contribution equals $0). a. Angie and Bradley would recognize all of the $14 million as taxable income on their joint tax return in 201X (i.e., in the year of sale of the photos). This is an example of a basic gross income inclusion rule under IRC §61(a)(3) and should be covered by the gross income chapter of the textbook. Furthermore, the gain from the sale of property (the photos) would be determined as the proceeds of $14 million less the cost or basis (effectively $0), and would be considered ordinary income under IRC §64. Note that the photos do not meet the definition of ‘‘capital asset’’ under IRC §1221, as a ‘‘copyright . . . or artistic composition, . . . or similar property, held by a taxpayer whose personal efforts created such property’’ is not a capital asset under IRC §1221(a)(3)(A) (emphasis added). Moreover, the photos are not considered IRC
4 Additionally, a requirement for students to calculate AMT could be problematic because the solution could be out of date very shortly after publication (even before publication) given the ongoing debate surrounding the AMT.
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§1231 property as they are not used in a trade or business and were not involuntarily converted. The most important concept of this part of the solution is that the students recognize that the $14 million should be included in gross income, but as a secondary goal, the students should also be able to distinguish between ordinary and capital gain income. The implications of this categorization are more fully illustrated in the Solution to Requirement 3a below. In practice, some students get caught up in the ordinary-versus-capital distinction while others barely address it. b. Angie and Bradley would be able to deduct $10 million as a charitable contribution deduction in 201X (i.e., the year of donation of the photos). The remaining $4 million would be carried forward for up to five years. Before considering charitable contribution limitations, the full $14 million charitable contribution would be deductible as an itemized deduction assuming it was made to a qualified organization, as defined in IRC §§170(c) and 501(c)(3). Note that this assumption is given as part of the requirement’s facts. [Note to Instructor: For tax years beginning January 1, 2010 or after, the itemized deduction limitation is no longer applicable under IRC §68(g); accordingly, it is not included in the case study.] The charitable contribution deduction in this case, however, is limited to $10 million, based on 50% of Angie and Bradley’s adjusted taxable income: Adjusted gross income (AGI) without regard to photos Proceeds from sale of photos Total AGI Charitable contribution limitation percentage Charitable contribution limitation
$6,000,000 14,000,000 $20,000,000 50% $10,000,000
In general, contributions to charitable organizations may be deducted up to 50% of AGI (described as the taxpayer’s ‘‘contribution base’’). See IRC §170(b)(1)(A), IRC §170(b)(1)(G), Publication 526, and Publication 78 Help, Part II. See IRC §170(b)(1)(B)(ii), which allows for a carryover of charitable contributions beyond the charitable contribution limitation in each of the five succeeding taxable years. Note that students may also reference 30% limitations for certain capital gain property as not applicable since the students should have concluded in Requirement 1a that the photos are ordinary income property. c. The charitable contribution limitation would be the same as in Requirement 1b above. Charitable contributions limitation = $10 million ($20 million of AGI inclusive of $14 million proceeds x 50%, not to exceed $14.5 million of charitable contributions). The remaining $4.5 million would be carried forward for up to 5 years. The point of this optional requirement is to reiterate that the charitable contribution deduction limitation is based on adjusted gross income and that a taxpayer may have multiple charitable contributions to consider. d. This transaction would result in $1,400,000 of net tax liability: Gross income (Requirement 1a) Less: charitable contribution limitation (Requirement 1b) Taxable income Tax ratea Tax liability
$14,000,000 (10,000,000) $4,000,000 35% $1,400,000
a Based on 2010 individual tax rate schedules. Marginal tax rate of 35% for married taxpayers filing jointly on the amount of taxable income in excess of $373,650.
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Students should conclude that simply selling the photos and donating the proceeds will cost Angie and Bradley $1,400,000 in current year US Federal income tax expense which they otherwise may have been able to save if they had planned the transaction differently. 5.5.2. Solution to requirement 2 In order to qualify as a tax deductible charitable contribution, Angie and Bradley must make the contribution to a qualified organization, as defined in IRC §§170(c) and 501(c)(3). Generally, any US charity would qualify. This is the crux of the solution to this requirement but it is sometimes overlooked by students eager to focus on Requirement 3 or students who do not give the facts a close enough non-tax technical reading. A complete answer should note that non-US charities would not qualify per IRC §170(c)(2), so Angie and Bradley should be sure to donate to a US §501(c)(3) charity that would use the funds to benefit underprivileged children in Africa, rather than directly donating to an African charity/organization. Publication 78 Help, Part II, and Publication 526 also list the organizations considered ‘‘qualified organizations’’ to which charitable contributions may be deducted and Publication 78 explicitly notes that except as indicated (within Publication 78 Help, Part II), contributions to a foreign organization are not deductible. Students may also list potential qualifying charities such as UNICEF, Save the Children, or the Red Cross as found in Publication 78. Some students may even note that Angie and Bradley may call 877-829-5500 to find out if a particular charity is a qualified organization. 5.5.3. Solution to requirement 3a While there are a number of potential tax-planning ideas to obtain the most favorable tax treatment for Angie and Bradley, the best solution to this requirement is that Angie and Bradley donate the photos themselves to charity, with the charity then selling the photos to a magazine and keeping the proceeds. Under this scenario, Angie and Bradley would not recognize any gross income as they did not receive any proceeds, which means they will not have a tax liability from this transaction. Angie and Bradley would likely also not be entitled to a charitable contribution deduction, as discussed in more detail below, but because of the lack of gross income from the transaction, Angie and Bradley’s net tax effect would be $0, resulting in a tax savings of $1,400,000 (based on the reduction in the tax liability calculated in the Solution to Requirement 1d from $1,400,000 to $0). Furthermore, without reviewing the tax treatment to the charitable organization, the organization would still receive the $14 million proceeds, which satisfies Angie and Bradley’s original eleemosynary intent with regard to the proceeds. Generally speaking, contributions of property to a qualified organization are valued at the fair market value (‘‘FMV’’) of the property at the time of contribution. See Treas. Regs. §1.170A-1(c). FMV is defined as the price at which the property would change hands between a willing buyer and a willing seller – in this case, $14 million, since $14 million represents the expected armslength price that would be paid for the photos on the open market. See Treas. Regs. §1.170A1(c)(2). Treas. Regs. §1.170A-4, however, provides for reductions in the amount of charitable contributions of certain appreciated property. In the case of a contribution of ordinary income property (as determined in Requirement 1a) by an individual, the amount of charitable contribution shall be reduced by the amount of gain. The amount of reduction is equal to the amount of recognized gain that would not have been long-term capital gain if the property, at the time of its contribution to the charitable organization, had been sold by the donor at its FMV (see Treas. Regs. §1.170A-4(a)(1)). In this case, the amount of the charitable contribution would be reduced to $0 ($14 million FMV of contributed ordinary income property less $14 million of non-long-term capital gain, which would have been recognized if the photos were sold by Angie and Bradley rather than donated). A small number of students (<10%) with more advanced tax experience may discuss the ‘‘Step Transaction Doctrine’’5 or assignment-of-income concept as regards this solution, but should not
5 The ‘‘Step Transaction Doctrine’’ combines a series of formally distinct tax steps/transactions to determine the tax treatment of the single integrated series of events.
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conclude that either argument precludes the planning idea. Specifically, Rev. Rul. 78-197 (1978-1, CB 83), in which the IRS acquiesced to the Tax Court’s ruling in Palmer v. Commissioner (62 T.C. 684 (1974)) rules out these conclusions – although with respect to appreciated stock rather than appreciated property in general – as long as the property was given away unconditionally.6 For students who do go down this route, the unconditional gift portion of the planning idea should be stressed (i.e., students should not conclude that the taxpayers may give away the photos to a charity along with a binding agreement that the charity sell them to a magazine). Notwithstanding the Solution to Requirement 1a, students may also attempt to argue that the photos were not ordinary income property, but rather capital gain property. In such a case, the amount of reduction is equal to only 50% of the amount of the gain that would have been recognized as long-term capital gain if the property, at the time of its contribution to the charitable organization, had been sold by the donor at its FMV (see Treas. Regs. §1.170A-4(a)(2)). Students exploring this argument, however, should conclude that even if the photos were considered capital gain property, the amount of the charitable contribution deduction would still be reduced to $0. To begin with, a strong argument can be made that the photos qualify as ordinary income property as defined by Treas. Regs. §1.170A-4(b)(1) because they are ‘‘works of art created by the donor,’’ in which case the basis would be cost ($0).7 Similarly, in order to qualify as long-term capital gain property, the photos would have to be held by the donor for one year or greater, which they were not. Assuming students suggest that the photos be held by Angie and Bradley for one year or greater in order to potentially qualify as capital gain property, the amount of the charitable contribution deduction would still be reduced to $0 (cost) if the property was sold by the charitable organization in the year the contribution was made. Similarly, if the property was sold by the charitable organization within three years of donation, the donor would have to recapture the gain in gross income, again resulting in an overall net charitable contribution deduction of $0. See, e.g., Publication 526. Finally, from a non-tax perspective, based on the facts presented, Angie and Bradley are eager to get the photographs published and do not want to hold onto them for any length of time, certainly not for another year. Students who consider the capital gain property treatment should recognize this point, as it is a crucial non-tax fact that should set the tone for the tax planning for which they have been engaged. Students that ignore this point will have very unhappy clients regardless of the potential tax savings generated! Students may also recommend that Angie and Bradley defer the sale of the photos until 201X + 1 (only a few weeks away) if they expect to have a higher AGI (in this case, AGI in excess of $28 million inclusive of the $14 million proceeds from the sale of the photographs, resulting in a charitable contribution limitation of $14 million or greater under IRC §170(b)(1)(A)). While this is a viable solution from a tax-planning perspective, it is not the best answer as it requires the client to wait to do something that the client wants to do now until a later time for a tax benefit that could otherwise be obtained currently. That is, practically speaking, donating the photos to charity with the charity subsequently selling them obtains the same tax savings for Angie and Bradley and does not require deferral during a time when Angie and Bradley are looking to complete the transaction as soon as possible in order to avoid continued harassment by the media. This suggestion alone, when coupled with the given facts surrounding the harassment, could result in Angie and Bradley selling the pictures anyway, despite your advice, and justifying the tax cost as a necessary expense in order to maintain their
6 In Palmer, a taxpayer donated highly appreciated stock to a non-profit organization, with the charity selling the stock soon thereafter. The IRS argued that the gift was ‘‘illusory, incomplete, and transitory, and that in any event, it should be disregarded as an intermediary step of a single, integrated transaction.’’ The Service further argued that the gift was ‘‘an anticipatory assignment of the proceeds of redemption which would otherwise be taxable to [the taxpayer].’’ The Court in Palmer held, citing Humacid Co. (1964), that ‘‘[a] gift of appreciated property does not result in income to the donor so long as he gives the property away absolutely and parts with title thereto before the property gives rise to the income by way of a sale.’’ Following Palmer, the IRS issued Rev. Rul. 78-197 which states, in relevant part, ‘‘[t]he Service will treat the proceeds of 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 shares for redemption.’’ 7 See also, e.g., PLR9335017, in which the Service ruled that autographed celebrity photos (as well as recordings of performances) are not capital assets. Accordingly, the charitable contribution deduction for those items is limited under §170(e)(1)(A) to their basis.
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sanity. Clearly this is not the most ideal solution to the problem. Moreover, given the high amount of expected proceeds from sale of the photos compared to Angie and Bradley’s current year AGI, coupled with the given fact that Angie and Bradley’s AGI varies widely by year, it would be unclear if Angie and Bradley would have sufficient AGI to support such a deduction in the next year. For example, if Angie and Bradley’s combined AGI in 201X + 1 were $4 million without regard to the sale of the photos, their charitable contribution limitation would actually be lower in 201X + 1 than in 201X ($9 million, calculated as $4 million AGI plus $14 million proceeds from sale of photos = $18 million x 50% limitation = $9 million charitable contribution deduction). Exploring this solution in class is also helpful to bring in real-world considerations to satisfying client needs. Other less optimal student recommendations include structuring the transaction as an installment sale or having Angie and Bradley set-up their own §501(c)(3) charitable organization/private foundation. While installment sale treatment is likely beyond the scope of an introductory tax course, without exploring the technical tax merits, it is a sub-optimal answer because it is more complicated, more cumbersome, and likely more time consuming than simply donating the photographs themselves to charity. Moreover, at a high-level in this specific case, such a transaction could include legal and administrative issues, run afoul of the ‘‘Step Transaction Doctrine,’’ and not qualify for installment sale treatment. Similarly, having Angie and Bradley set-up their own charitable organization/private foundation runs into timing issues, administrative requirements, record-keeping requirements, and annual filing obligations, to list a few obstacles. A careful reading of the facts should alert students that this potential solution is not the most optimal for their clients in the short-term. Finally, from a record-keeping perspective, Treas. Regs. §1.170A-13, Publication 526, and Publication 1771 provide the necessary substantiation and disclosure requirements in order to claim a charitable contribution on one’s tax return and have it sustained upon audit. Note that to the extent students conclude that Angie and Bradley are not entitled to any charitable contribution deduction due to the conclusions reached above in the Solution to Requirement 3a, further consideration of substantiation and disclosure requirements is not applicable. To the extent students reach any other less optimal conclusion resulting in a charitable contribution deduction on Angie and Bradley’s joint tax return, however, the following substantiation and disclosure requirements should be included in the Solution as applicable: (1) Cash contributions–Since any cash contribution from this transaction made by Angie and Bradley would exceed $250, Angie and Bradley would need to obtain a written acknowledgment from the charitable organization including the amount of cash contributed and whether the qualified organization gave any goods or services to Angie and Bradley in return for the contribution. The acknowledgment must be obtained prior to the filing date of the return. Proof of date of contribution must also be made (either on the acknowledgment or via bank record or receipt). (2) Non-cash contributions–Since any non-cash contribution made by Angie and Bradley would exceed $5000, they would need to obtain a written acknowledgment from the charitable organization including the name of the charitable organization, the date and location of the charitable contribution, a description of the property, and whether the qualified organization gave any goods or services to Angie and Bradley in return for the contribution. Angie and Bradley should also maintain written records indicating, in addition to the above, the FMV of the property at the time of contribution, including how it was determined, the cost or other basis of the property, how the property was obtained, the approximate date it was created, and a qualified written appraisal (see Publication 561 for more information regarding appraisals; note that the appraisal must be attached to the tax return if the amount exceeds $500,000, see Publication 1771). In addition, Section B of Form 8283 is required to be completed as part of the tax return for the year in which the charitable contribution deduction is claimed. 5.5.4. Solution to requirement 3b [Note to Instructor: Most tax textbooks provide basic single payment present value tables, but the instructor may want to provide the present value factors for the 10% discount rate depending on whether this topic was covered in the course materials.]
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Based on the Solutions to Requirements 1d and 3a, the net present value (‘‘NPV’’) of the tax savings Angie and Bradley would recognize in 201X if they donate the photos to charity, with the charity subsequently selling the photos to a magazine and keeping the proceeds, would be $1,400,000 (based on the difference in tax liabilities between $1,400,000 from the Solution to Requirement 1d and $0 from the Solution to Requirement 3a). That is, by implementing the tax-planning strategy suggested in the Solution to Requirement 3a, Angie and Bradley would decrease their 201X tax liability by $1,400,000 and have $0 charitable contributions carryover to 201X + 1. Given the additional facts provided in Requirement 3b, students should determine that it may be advantageous not to implement the charitable contributions tax-planning idea from the Solution to Requirement 3a and instead advise the clients to simply sell the photos to the magazine and donate the proceeds to charity, as originally planned. By doing so, a charitable contribution carryover from 201X will be generated that will likely be more valuable in future years due to expected increases in the couple’s marginal tax rate. To properly make this determination it is necessary to calculate the NPV of the tax savings Angie and Bradley would recognize in future years from the charitable contribution carryover of $4000,000 (as calculated in the Solution to Requirement 1b), as shown:
Charitable contribution limitation Adjusted gross income (AGI) Charitable contribution limitation (%) Charitable contribution limitation ($) Less: actual charitable contributions made Additional charitable contribution limitation available Charitable contribution carryover Charitable contribution carryover claimed (lesser of A, B) Tax rate Tax benefit of charitable contribution carryover 10% present value factor Present value of charitable contribution carryover Total tax benefit of charitable contribution carryover Net present value of charitable contribution carryover
201X±1
201X±2
$5,000,000 50% 2,500,000 (1,500,000) 1,000,000 4,000,000 1,000,000 40% 400,000 0.909 363,600 1,750,000 1,478,700
$9,000,000 50% 4,500,000 (1,500,000) 3,000,000 3,000,000 3,000,000 45% 1,350,000 0.826 1,115,100
A B
C E (C + D) (E + F)
A B
D F
Accordingly, if the facts provided in Requirement 3b are known prior to implementing the planning idea from the Solution to Requirement 3a, students should conclude that the overall increase in tax savings from selling the photos, donating the proceeds to charity, and utilizing the charitable contribution carryover in future years is greater than the tax savings from donating the photos directly to charity in order to pay less tax in 201X. Given the expected increased tax rates in 201X + 1 and 201X + 2, the net tax savings is $350,000 ($1,750,000 total tax deduction from charitable contribution carryover with donation of proceeds from sold photos less $1,400,000 benefit in 201X from donating photos directly to charity). After applying the appropriate 10% present value factors as shown above, the NPV of the charitable contribution carryover from selling the photos in 201X and donating the proceeds to charity is $78,700 higher than the $1,400,000 tax benefit derived in the Solution to Requirement 3a from donating the photos to charity in 201X. Acknowledgments The authors would like to thank Richard Harvey for his assistance during testing of the case and two anonymous reviewers for their comments. The views expressed are those of the authors and do not necessarily represent those of Ernst & Young, LLP.
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Educational case
Celebrity baby photograph donations: A case study in charitable contribution tax planning and research Hossein Nouri a,⇑, Dustin Opatosky b,1 a
Department of Accounting and Information Systems, School of Business, The College of New Jersey, P.O. Box 7718, Ewing, NJ 08628, United States Ernst & Young, LLP, 5 Times Square New York, NY 10023, United States
b
a r t i c l e
i n f o
Article history: Available online 21 April 2011 Keywords: Charitable contributions Tax research Individual tax planning
a b s t r a c t A recent trend has been the sale for publication in national magazines of the first photographs of celebrities’ babies. It is not unusual for such sales to generate millions of dollars of revenue for these celebrities. Some celebrities have chosen to donate the proceeds from such sales to charity. Despite these charitable intentions, celebrities are not often looking to be charitable to the Federal government. Accordingly, in this case study, your clients, Angie and Bradley, turn to you as their tax advisor for help assessing the tax implications of their potential donations as well as for planning solutions resulting in the most favorable tax treatment for them. By completing this case successfully, you will learn some of the Internal Revenue Code (‘‘IRC’’) rules regarding charitable contributions, how to perform basic tax research, and how to interpret your findings in order to provide beneficial tax-planning advice to your clients. Ó 2011 Published by Elsevier Ltd.
1. Firm background You graduated from college with an accounting degree and have spent eight years working in the tax department of a Big-Four accounting firm, eventually leaving to start your own firm, BB Tax, CPA (BB Tax). You are now one of the largest sole proprietor CPAs in the area and serve many high-net-worth individual clients, small and mid-size businesses, and various estates. Typically, the
⇑ Corresponding author. Tel.: +1 609 771 2176; fax: +1 609 637 5108. 1
E-mail addresses: [email protected] (H. Nouri), [email protected] (D. Opatosky). Tel.: +1 212 773 1497.
0748-5751/$ - see front matter Ó 2011 Published by Elsevier Ltd. doi:10.1016/j.jaccedu.2011.03.007
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primary tax-related goal of most of these clients is to reduce their federal and state and local income tax liabilities to as little as possible within the bounds of the tax law. 2. Client background Two of your clients, Angie and Bradley, recently had a baby. Angie is a world-renowned actress, model, author, and philanthropist. Similarly, Bradley is a famous actor, writer, and director. When discussed in the same sentence the two have come to be known by the nickname ‘‘Angley,’’ and are the true epitome of a Hollywood power couple. Because of the couple’s fame, they are frequently the source of gossip column fodder, are always trailed by paparazzi, and are often featured on covers of national magazines. Both Angie and Bradley have been your clients for a number of years, going back to before the time they were married. Because of their varied endeavors, Angie and Bradley’s taxable income has historically oscillated widely by year, but nevertheless they always seem to need your tax advice for one matter or another, and are willing to pay quite well for it. 3. Tax-planning opportunity On December 6, 201X, Angie and Bradley plan to sell the coveted first baby photos of their newborn daughter, Warlock, to Celebrity Monthly, a national magazine, for $14 million. Warlock was born November 30, 201X. In exchange for the $14 million payment, Celebrity Monthly will obtain the publication rights to the pictures in North America. Angie and Bradley, collectively worth more than $250 million, wish to donate the $14 million proceeds to benefit underprivileged children in Africa. They also would like to complete this transaction as soon as possible, as they are currently being hounded relentlessly by the media for the first pictures of their baby, to the point where they feel that their privacy is being invaded on a daily basis (just last week Angie caught a reporter in a tree outside little Warlock’s window). Angie and Bradley file a joint tax return (married filing jointly) and will have combined adjusted gross income (‘‘AGI’’) of $6 million for 201X, without regard to any expected proceeds from the sale of the photographs. For purposes of this case, ignore any Alternative Minimum Tax (‘‘AMT’’) implications. Unless otherwise noted, assume each requirement set forth below is independent of the other requirements 4. Requirements 1. Identify the tax implications of this charitable contribution if Angie and Bradley sell the photos for $14 million and then claim a charitable contribution deduction on their 201X joint tax return. Assume that the donation meets all requirements to be considered a valid charitable contribution for US Federal income tax purposes. Specifically: a. How much of the $14 million would Angie and Bradley recognize as taxable income on their joint tax return and what would be the nature of such income (i.e., ordinary or capital gain)? What authority (i.e., IRC Section) specifically requires this recognition? b. How much of the $14 million would Angie and Bradley be able to deduct as a charitable contribution in the current year and why? If less than the full amount, what happens to the remainder? Consider charitable contribution limitations and assume that Angie and Bradley do not have any other itemized deductions for this tax year. c. Optional – Same as part b, except Angie and Bradley also have additional qualifying charitable cash contributions during the year of $500,000. d. What is the current-year (201X) cash tax impact to Angie and Bradley in dollars of structuring this transaction as a sale of the photos followed by a charitable contribution of the cash (i.e., how much income tax would Angie and Bradley pay on the transaction based on your findings in parts a and b above)? Ignore any impact of the carryover of excess contributions to later years, if applicable. As part of this solution the couple’s marginal tax rate should be determined.
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Cite specific IRC Sections, Treasury Regulations, and/or IRS Publications2 for support for each part of Requirement 1. [Your answer for Requirement 1 should not exceed two double-spaced pages. There is no minimum length.] 2. Assume now that Angie and Bradley have already sold the photos to Celebrity Monthly and received the $14 million proceeds, but have not yet donated the proceeds to charity. What advice would you give to Angie and Bradley regarding what type of charity to select in order to maximize any potential tax deduction? Cite specific IRC sections, Treasury Regulations, and/or IRS Publications for support. [Your answer for Requirement 2 should not exceed one double-spaced page. There is no minimum length.] 3. Assume now that Angie and Bradley have not yet sold the photos but plan to sell them and donate the proceeds to charity as described above. Prior to entering into the transaction, they come to you, their CPA, seeking advice on how to best structure the transaction in order to receive the most favorable tax treatment in the current year (i.e., minimize any potential current year tax liability resulting from simply selling the photos and then donating the proceeds to charity, as calculated in Requirement 1d), ignoring any tax implications to the charity, while still achieving all of their nontax objectives. a. Prepare a memorandum documenting the advice you would give to Angie and Bradley. Assume that Angie and Bradley are expected to be in a similar taxable income situation in future years and that tax rates are not expected to change. You may make any additional reasonable factual assumptions necessary to support your answer. To the extent required, you should also advise your clients on any record-keeping or other requirements in order to substantiate any deduction claimed. Be prepared to defend your recommended solution in class. Cite specific IRC sections, Treasury Regulations, and/or IRS Publications for support. b. Optional – How would your advice in Requirement 3a differ, if at all, if you knew the following: i. The couple’s estimated AGI for 201X + 1 and 201X + 2 will be $5,000,000 and $9,000,000, respectively; ii. The couple is planning to donate an additional $1,500,000 in cash per year to qualified charitable organizations for 201X + 1 and 201X + 2; iii. Because of recently enacted legislation, the couple’s tax rate will increase to a 40% marginal tax rate in 201X + 1 and a 45% marginal tax rate in 201X + 2 (use the marginal tax rate calculated in Requirement 1d as the marginal tax rate for 201X); and iv. The couple’s relevant discount rate (for present-value purposes) is 10%. [Your answer for Requirement 3a should not exceed three double-spaced pages. Your answer for Requirement 3b, if assigned, should not exceed two double-spaced pages. There is no minimum length.]
5. Teaching note 5.1. Case background This tax research case was developed based on the recent trend of celebrities selling first pictures of their children to popular magazines for large sums of money.3 Such occurrences have been heavily covered in the popular media and are general public knowledge. While this case study is illustrative of a 2 Note that while IRS Publications may be cited as part of your responses to all Requirements, these publications are not considered substantial authority under IRC §6662(d)(2)(B) and therefore should not be the sole support for any answer, but rather should only be cited in addition to Internal Revenue Code (IRC) and/or Treasury Regulations citations. 3 See, for example, Angelina Jolie and Brad Pitt (People magazine), Jennifer Lopez and Marc Anthony (People magazine), and Matthew McConaughey and Camila Alves (OK! Magazine).
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potential real-life example, it has been entirely fictionalized and does not conform to the actual facts of any specific event(s) or individual(s). 5.2. Learning objectives This case has two broad learning objectives: (1) performing tax research and (2) applying tax research findings to a potential real-life tax-planning situation. The case study allows students to take a topic they will likely recognize from the popular media and utilize it as an actual example of individual income tax planning. Students will apply their basic tax research abilities to a fairly simple, yet multi-faceted area of tax law–charitable contributions. In addition, beyond utilizing and applying their tax research skills, the written memorandum portion of the assignment, including its three-page limitation (without regard to optional Requirement 3b), is designed to increase student communication skills by requiring them to convey their answers in an organized, concise, and clear manner. The subsequent in-class discussion encourages students to express and support their opinions orally while potentially being challenged by the opinions and alternative planning ideas of others. 5.3. Implementation guidance Since this case study is written for students in an introductory-level undergraduate/graduate tax course, only a moderate level of specific tax knowledge is required for students to successfully complete the case. The case is intended to be introduced early in the course, usually several weeks into the semester, once students have a basic understanding of taxable income and deductions in general, with a due date of late in the course (if given as one project), or with due dates throughout the course (if the requirements are broken into separate assignments). The expectation is that students will be taught the basic principles to answer each requirement throughout the course, and by assigning the project early on, students will have ample time to work at their own pace. In addition, students should be exposed to a basic explanation/illustration of tax research prior to assignment of the case. Basic tax research should include a general understanding of how to perform tax research online via LexisNexis, WestLaw, RIA Checkpoint, CCH IntelliConnect or a comparable research database; how to perform tax research using the IRC, Treasury Regulations, and/or IRS website; and a basic understanding of sources of federal tax law/guidance, including the IRC, Treasury Regulations, IRS Publications, and court cases (generally), as well as the level of authority that accompanies each of these sources. While there are numerous ways in which students can reach the conclusions shown in the Solutions section of the Teaching Note (below), students should be able to find citations to all necessary information within IRC §170, Treas. Regs. §1.170, and IRS Publications 78 and 526 (both of which reference back to the IRC as primary authority). All of these sources are readily available on the IRS website or through one of the aforementioned tax research databases. A simple keyword search for ‘‘charitable contributions’’ on the IRS website, for example, will lead to general articles explaining the rules covering income tax deductions for charitable contributions by individuals, including links to Publication 78 (Cumulative List of Organizations), Publication 526 (Charitable Contributions), Publication 561 (Determining the Value of Donated Property), and Publication 1771 (Substantiation and Reporting Requirements). Similarly, searching for ‘‘charitable contributions’’ in the Code via a tax research database (such as RIA Checkpoint) will yield results for IRC §170 within the first page of hits. This case study may be assigned as one comprehensive case study or as a series of smaller projects throughout the semester, and is intended to be a graded written small-group assignment, to best simulate real-world tax planning situations in CPA firms. The authors have found that the case works best with groups of two or three students, although instructors should be cautious to stress to students that any final assignment should not seem as though it was pieced together by different authors. If assigned as one comprehensive case study, the authors recommend giving students at least 7 weeks to complete the project. If broken into separate assignments (likely three, based on the requirements from above, although Requirements 1 and 3 can be further broken down), the authors recommend having the first two requirements due within 3–4 weeks of one another, and the third more comprehensive requirement due 4–5 weeks later. Upon completion, reviewing the entire case
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study in class in moderate detail with participatory discussion from prepared students will likely take 45–60 min with proper guidance from the instructor. While the instructor may deviate from the recommended structure and make the requirements open-ended (e.g., ‘‘What are the tax implications of this transaction and what planning ideas would you recommend to reduce the tax impact of the transaction?’’), the authors’ preferred approach is to utilize the outlined requirements shown above as these requirements help to give the problem structure and allow students with little tax experience to be guided in the right direction, thus minimizing any unnecessary frustration on the students’ part due to lack of more experienced technical tax skills. This approach provides the students with some structure for the detailed work, yet still allows them the flexibility to consider multiple avenues to reach their final recommendation. This structured approach also tends to keep students from seeking assistance/guidance from more experienced classmates, friends, or colleagues outside of the course. Alternatively, rather than providing the issues to students as shown in Requirement 1, instructors may prefer to ask students to identify the issues themselves during an in-class discussion before beginning research. Once the class as a whole has discussed the appropriate issues, the students could then conduct the research. As issue identification is an important skill for students to develop, a broader, group-based approach to identifying the issues could be worthwhile to pursue, at the instructor’s discretion. The post-assignment class discussion period may be used to discuss different approaches to tax research (i.e., how various groups found the information necessary to reach their conclusions) as well as potentially different conclusions reached and recommendations made, with the instructor giving guidance as to the strengths and weaknesses of any potential recommendations discussed. During in-class discussion, it is useful to stress that tax planning often involves non-tax consideration since some groups miss this point. 5.4. Evidence of efficacy This case study is recommended for use with undergraduate tax courses and/or graduate-level tax courses for non-Master’s of Taxation students, such as Master’s of Accounting and/or MBA students. To date this case study has been assigned three times in graduate-level courses at one institution and one time in an undergraduate course at another institution. It was assigned most recently in the Spring and Fall 2010 semesters as a group project in a graduate-level Federal Income Taxation – Individuals course in which both Master’s of Accounting students and MBA students were enrolled. Students worked primarily in groups of two and were given seven weeks to complete the project. The project was introduced four weeks into the semester, at which time students were already generally familiar with income sources, income exclusions, introductory tax theories/concepts, and basic tax research. Students learned about business expenses, deductions from AGI, and deductions for AGI as the semester progressed while working on the case study. Overall, approximately 33–50% of the groups answered all requirements accurately, with the remainder primarily forgetting to discuss the US-versus-foreign charity issues included in Requirement 2 (see teaching notes below) or recommending a sub-optimal alternative to donating the photographs directly to charity as part of the Solution to Requirement 3a (see teaching notes below). These points can be hinted at, if desired, during the class discussions of the case by the instructor prior to the final due date of the assignment. A Likert-type scale questionnaire featuring 11 questions and a section for open-ended responses was administered to each student during the most recent assignment of the case study in a Master’s of Accounting class (Fall 2010). Seventeen students anonymously completed the questionnaire and no outliers were excluded from the results. Mean results (standard deviation shown parenthetically) were as follows (7 = Strongly Agree, . . . , 1 = Strongly Disagree): 1. This project was engaging and interesting: 5.88 (0.83). 2. I am glad I worked on this project as a member of a team rather than individually: 6.00 (1.08). 3. My team interacted well together: 6.35 (0.73).
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4. After completing this project I have a better understanding of how to perform tax research: 6.24 (1.06). 5. After completing this project I have a better understanding of the complexity of federal taxation: 6.12 (0.83). 6. The time allotted for this project was reasonable: 6.59 (0.77). 7. The subject matter of the project was appropriate for an introductory-level tax course: 6.29 (1.27). 8. The length of the assignment was appropriate: 6.29 (0.82). 9. Overall, this project was a good learning experience: 6.29 (0.82). 10. Overall, I was very satisfied with this project: 6.18 (0.78). 11. I believe this project should be used again in future: 6.29 (1.07). Anonymous individual written feedback on the project was also solicited from each student, with the themes frequently emphasizing, among other things: (1) how using a potential real-life example made the case more enjoyable (‘‘very interesting’’ and ‘‘actually fun’’) and easy to relate to (‘‘challenging yet rewarding’’); (2) how the structure of the case made it understandable for tax novices; (3) the appropriateness of the length of the assignment; and (4) the usefulness in actually learning and performing basic tax research. Similarly, constructive criticism of previous versions of the case was taken into account: (1) to make Requirement 1 more direct while still leaving Requirement 3 quite broad; (2) to attempt to reap the benefits of group work while proactively discussing the challenges with the class (e.g., some students enjoyed working with a partner while others felt their partner did not contribute sufficiently); and (3) to add a ‘‘no minimum length’’ note to the page-length restrictions in order to prevent students from thinking the maximum length was the recommended length for some of the potentially more straightforward requirements. 5.5. Recommended solutions It is the authors’ recommendation that AMT implications be ignored because while the theory of AMT may be discussed, the mechanics of the AMT calculation are not often covered in an introductory taxation course, whether undergraduate or Master’s level (e.g., Federal Taxation of Individuals for Master’s of Accounting students).4 5.5.1. Solution to requirement 1 Requirement 1 is intended to introduce the general rules for ordinary income, charitable contributions, and itemized deductions. The main idea to be recognized in this requirement is that without proper planning, Angie and Bradley could end up owing a significant amount of federal tax ($1,400,000) (see Requirement 1d) on a transaction in which the their net income is $0 (i.e., $14 million of proceeds less $14 million of charitable contribution equals $0). a. Angie and Bradley would recognize all of the $14 million as taxable income on their joint tax return in 201X (i.e., in the year of sale of the photos). This is an example of a basic gross income inclusion rule under IRC §61(a)(3) and should be covered by the gross income chapter of the textbook. Furthermore, the gain from the sale of property (the photos) would be determined as the proceeds of $14 million less the cost or basis (effectively $0), and would be considered ordinary income under IRC §64. Note that the photos do not meet the definition of ‘‘capital asset’’ under IRC §1221, as a ‘‘copyright . . . or artistic composition, . . . or similar property, held by a taxpayer whose personal efforts created such property’’ is not a capital asset under IRC §1221(a)(3)(A) (emphasis added). Moreover, the photos are not considered IRC
4 Additionally, a requirement for students to calculate AMT could be problematic because the solution could be out of date very shortly after publication (even before publication) given the ongoing debate surrounding the AMT.
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§1231 property as they are not used in a trade or business and were not involuntarily converted. The most important concept of this part of the solution is that the students recognize that the $14 million should be included in gross income, but as a secondary goal, the students should also be able to distinguish between ordinary and capital gain income. The implications of this categorization are more fully illustrated in the Solution to Requirement 3a below. In practice, some students get caught up in the ordinary-versus-capital distinction while others barely address it. b. Angie and Bradley would be able to deduct $10 million as a charitable contribution deduction in 201X (i.e., the year of donation of the photos). The remaining $4 million would be carried forward for up to five years. Before considering charitable contribution limitations, the full $14 million charitable contribution would be deductible as an itemized deduction assuming it was made to a qualified organization, as defined in IRC §§170(c) and 501(c)(3). Note that this assumption is given as part of the requirement’s facts. [Note to Instructor: For tax years beginning January 1, 2010 or after, the itemized deduction limitation is no longer applicable under IRC §68(g); accordingly, it is not included in the case study.] The charitable contribution deduction in this case, however, is limited to $10 million, based on 50% of Angie and Bradley’s adjusted taxable income: Adjusted gross income (AGI) without regard to photos Proceeds from sale of photos Total AGI Charitable contribution limitation percentage Charitable contribution limitation
$6,000,000 14,000,000 $20,000,000 50% $10,000,000
In general, contributions to charitable organizations may be deducted up to 50% of AGI (described as the taxpayer’s ‘‘contribution base’’). See IRC §170(b)(1)(A), IRC §170(b)(1)(G), Publication 526, and Publication 78 Help, Part II. See IRC §170(b)(1)(B)(ii), which allows for a carryover of charitable contributions beyond the charitable contribution limitation in each of the five succeeding taxable years. Note that students may also reference 30% limitations for certain capital gain property as not applicable since the students should have concluded in Requirement 1a that the photos are ordinary income property. c. The charitable contribution limitation would be the same as in Requirement 1b above. Charitable contributions limitation = $10 million ($20 million of AGI inclusive of $14 million proceeds x 50%, not to exceed $14.5 million of charitable contributions). The remaining $4.5 million would be carried forward for up to 5 years. The point of this optional requirement is to reiterate that the charitable contribution deduction limitation is based on adjusted gross income and that a taxpayer may have multiple charitable contributions to consider. d. This transaction would result in $1,400,000 of net tax liability: Gross income (Requirement 1a) Less: charitable contribution limitation (Requirement 1b) Taxable income Tax ratea Tax liability
$14,000,000 (10,000,000) $4,000,000 35% $1,400,000
a Based on 2010 individual tax rate schedules. Marginal tax rate of 35% for married taxpayers filing jointly on the amount of taxable income in excess of $373,650.
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Students should conclude that simply selling the photos and donating the proceeds will cost Angie and Bradley $1,400,000 in current year US Federal income tax expense which they otherwise may have been able to save if they had planned the transaction differently. 5.5.2. Solution to requirement 2 In order to qualify as a tax deductible charitable contribution, Angie and Bradley must make the contribution to a qualified organization, as defined in IRC §§170(c) and 501(c)(3). Generally, any US charity would qualify. This is the crux of the solution to this requirement but it is sometimes overlooked by students eager to focus on Requirement 3 or students who do not give the facts a close enough non-tax technical reading. A complete answer should note that non-US charities would not qualify per IRC §170(c)(2), so Angie and Bradley should be sure to donate to a US §501(c)(3) charity that would use the funds to benefit underprivileged children in Africa, rather than directly donating to an African charity/organization. Publication 78 Help, Part II, and Publication 526 also list the organizations considered ‘‘qualified organizations’’ to which charitable contributions may be deducted and Publication 78 explicitly notes that except as indicated (within Publication 78 Help, Part II), contributions to a foreign organization are not deductible. Students may also list potential qualifying charities such as UNICEF, Save the Children, or the Red Cross as found in Publication 78. Some students may even note that Angie and Bradley may call 877-829-5500 to find out if a particular charity is a qualified organization. 5.5.3. Solution to requirement 3a While there are a number of potential tax-planning ideas to obtain the most favorable tax treatment for Angie and Bradley, the best solution to this requirement is that Angie and Bradley donate the photos themselves to charity, with the charity then selling the photos to a magazine and keeping the proceeds. Under this scenario, Angie and Bradley would not recognize any gross income as they did not receive any proceeds, which means they will not have a tax liability from this transaction. Angie and Bradley would likely also not be entitled to a charitable contribution deduction, as discussed in more detail below, but because of the lack of gross income from the transaction, Angie and Bradley’s net tax effect would be $0, resulting in a tax savings of $1,400,000 (based on the reduction in the tax liability calculated in the Solution to Requirement 1d from $1,400,000 to $0). Furthermore, without reviewing the tax treatment to the charitable organization, the organization would still receive the $14 million proceeds, which satisfies Angie and Bradley’s original eleemosynary intent with regard to the proceeds. Generally speaking, contributions of property to a qualified organization are valued at the fair market value (‘‘FMV’’) of the property at the time of contribution. See Treas. Regs. §1.170A-1(c). FMV is defined as the price at which the property would change hands between a willing buyer and a willing seller – in this case, $14 million, since $14 million represents the expected armslength price that would be paid for the photos on the open market. See Treas. Regs. §1.170A1(c)(2). Treas. Regs. §1.170A-4, however, provides for reductions in the amount of charitable contributions of certain appreciated property. In the case of a contribution of ordinary income property (as determined in Requirement 1a) by an individual, the amount of charitable contribution shall be reduced by the amount of gain. The amount of reduction is equal to the amount of recognized gain that would not have been long-term capital gain if the property, at the time of its contribution to the charitable organization, had been sold by the donor at its FMV (see Treas. Regs. §1.170A-4(a)(1)). In this case, the amount of the charitable contribution would be reduced to $0 ($14 million FMV of contributed ordinary income property less $14 million of non-long-term capital gain, which would have been recognized if the photos were sold by Angie and Bradley rather than donated). A small number of students (<10%) with more advanced tax experience may discuss the ‘‘Step Transaction Doctrine’’5 or assignment-of-income concept as regards this solution, but should not
5 The ‘‘Step Transaction Doctrine’’ combines a series of formally distinct tax steps/transactions to determine the tax treatment of the single integrated series of events.
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conclude that either argument precludes the planning idea. Specifically, Rev. Rul. 78-197 (1978-1, CB 83), in which the IRS acquiesced to the Tax Court’s ruling in Palmer v. Commissioner (62 T.C. 684 (1974)) rules out these conclusions – although with respect to appreciated stock rather than appreciated property in general – as long as the property was given away unconditionally.6 For students who do go down this route, the unconditional gift portion of the planning idea should be stressed (i.e., students should not conclude that the taxpayers may give away the photos to a charity along with a binding agreement that the charity sell them to a magazine). Notwithstanding the Solution to Requirement 1a, students may also attempt to argue that the photos were not ordinary income property, but rather capital gain property. In such a case, the amount of reduction is equal to only 50% of the amount of the gain that would have been recognized as long-term capital gain if the property, at the time of its contribution to the charitable organization, had been sold by the donor at its FMV (see Treas. Regs. §1.170A-4(a)(2)). Students exploring this argument, however, should conclude that even if the photos were considered capital gain property, the amount of the charitable contribution deduction would still be reduced to $0. To begin with, a strong argument can be made that the photos qualify as ordinary income property as defined by Treas. Regs. §1.170A-4(b)(1) because they are ‘‘works of art created by the donor,’’ in which case the basis would be cost ($0).7 Similarly, in order to qualify as long-term capital gain property, the photos would have to be held by the donor for one year or greater, which they were not. Assuming students suggest that the photos be held by Angie and Bradley for one year or greater in order to potentially qualify as capital gain property, the amount of the charitable contribution deduction would still be reduced to $0 (cost) if the property was sold by the charitable organization in the year the contribution was made. Similarly, if the property was sold by the charitable organization within three years of donation, the donor would have to recapture the gain in gross income, again resulting in an overall net charitable contribution deduction of $0. See, e.g., Publication 526. Finally, from a non-tax perspective, based on the facts presented, Angie and Bradley are eager to get the photographs published and do not want to hold onto them for any length of time, certainly not for another year. Students who consider the capital gain property treatment should recognize this point, as it is a crucial non-tax fact that should set the tone for the tax planning for which they have been engaged. Students that ignore this point will have very unhappy clients regardless of the potential tax savings generated! Students may also recommend that Angie and Bradley defer the sale of the photos until 201X + 1 (only a few weeks away) if they expect to have a higher AGI (in this case, AGI in excess of $28 million inclusive of the $14 million proceeds from the sale of the photographs, resulting in a charitable contribution limitation of $14 million or greater under IRC §170(b)(1)(A)). While this is a viable solution from a tax-planning perspective, it is not the best answer as it requires the client to wait to do something that the client wants to do now until a later time for a tax benefit that could otherwise be obtained currently. That is, practically speaking, donating the photos to charity with the charity subsequently selling them obtains the same tax savings for Angie and Bradley and does not require deferral during a time when Angie and Bradley are looking to complete the transaction as soon as possible in order to avoid continued harassment by the media. This suggestion alone, when coupled with the given facts surrounding the harassment, could result in Angie and Bradley selling the pictures anyway, despite your advice, and justifying the tax cost as a necessary expense in order to maintain their
6 In Palmer, a taxpayer donated highly appreciated stock to a non-profit organization, with the charity selling the stock soon thereafter. The IRS argued that the gift was ‘‘illusory, incomplete, and transitory, and that in any event, it should be disregarded as an intermediary step of a single, integrated transaction.’’ The Service further argued that the gift was ‘‘an anticipatory assignment of the proceeds of redemption which would otherwise be taxable to [the taxpayer].’’ The Court in Palmer held, citing Humacid Co. (1964), that ‘‘[a] gift of appreciated property does not result in income to the donor so long as he gives the property away absolutely and parts with title thereto before the property gives rise to the income by way of a sale.’’ Following Palmer, the IRS issued Rev. Rul. 78-197 which states, in relevant part, ‘‘[t]he Service will treat the proceeds of 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 shares for redemption.’’ 7 See also, e.g., PLR9335017, in which the Service ruled that autographed celebrity photos (as well as recordings of performances) are not capital assets. Accordingly, the charitable contribution deduction for those items is limited under §170(e)(1)(A) to their basis.
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sanity. Clearly this is not the most ideal solution to the problem. Moreover, given the high amount of expected proceeds from sale of the photos compared to Angie and Bradley’s current year AGI, coupled with the given fact that Angie and Bradley’s AGI varies widely by year, it would be unclear if Angie and Bradley would have sufficient AGI to support such a deduction in the next year. For example, if Angie and Bradley’s combined AGI in 201X + 1 were $4 million without regard to the sale of the photos, their charitable contribution limitation would actually be lower in 201X + 1 than in 201X ($9 million, calculated as $4 million AGI plus $14 million proceeds from sale of photos = $18 million x 50% limitation = $9 million charitable contribution deduction). Exploring this solution in class is also helpful to bring in real-world considerations to satisfying client needs. Other less optimal student recommendations include structuring the transaction as an installment sale or having Angie and Bradley set-up their own §501(c)(3) charitable organization/private foundation. While installment sale treatment is likely beyond the scope of an introductory tax course, without exploring the technical tax merits, it is a sub-optimal answer because it is more complicated, more cumbersome, and likely more time consuming than simply donating the photographs themselves to charity. Moreover, at a high-level in this specific case, such a transaction could include legal and administrative issues, run afoul of the ‘‘Step Transaction Doctrine,’’ and not qualify for installment sale treatment. Similarly, having Angie and Bradley set-up their own charitable organization/private foundation runs into timing issues, administrative requirements, record-keeping requirements, and annual filing obligations, to list a few obstacles. A careful reading of the facts should alert students that this potential solution is not the most optimal for their clients in the short-term. Finally, from a record-keeping perspective, Treas. Regs. §1.170A-13, Publication 526, and Publication 1771 provide the necessary substantiation and disclosure requirements in order to claim a charitable contribution on one’s tax return and have it sustained upon audit. Note that to the extent students conclude that Angie and Bradley are not entitled to any charitable contribution deduction due to the conclusions reached above in the Solution to Requirement 3a, further consideration of substantiation and disclosure requirements is not applicable. To the extent students reach any other less optimal conclusion resulting in a charitable contribution deduction on Angie and Bradley’s joint tax return, however, the following substantiation and disclosure requirements should be included in the Solution as applicable: (1) Cash contributions–Since any cash contribution from this transaction made by Angie and Bradley would exceed $250, Angie and Bradley would need to obtain a written acknowledgment from the charitable organization including the amount of cash contributed and whether the qualified organization gave any goods or services to Angie and Bradley in return for the contribution. The acknowledgment must be obtained prior to the filing date of the return. Proof of date of contribution must also be made (either on the acknowledgment or via bank record or receipt). (2) Non-cash contributions–Since any non-cash contribution made by Angie and Bradley would exceed $5000, they would need to obtain a written acknowledgment from the charitable organization including the name of the charitable organization, the date and location of the charitable contribution, a description of the property, and whether the qualified organization gave any goods or services to Angie and Bradley in return for the contribution. Angie and Bradley should also maintain written records indicating, in addition to the above, the FMV of the property at the time of contribution, including how it was determined, the cost or other basis of the property, how the property was obtained, the approximate date it was created, and a qualified written appraisal (see Publication 561 for more information regarding appraisals; note that the appraisal must be attached to the tax return if the amount exceeds $500,000, see Publication 1771). In addition, Section B of Form 8283 is required to be completed as part of the tax return for the year in which the charitable contribution deduction is claimed. 5.5.4. Solution to requirement 3b [Note to Instructor: Most tax textbooks provide basic single payment present value tables, but the instructor may want to provide the present value factors for the 10% discount rate depending on whether this topic was covered in the course materials.]
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Based on the Solutions to Requirements 1d and 3a, the net present value (‘‘NPV’’) of the tax savings Angie and Bradley would recognize in 201X if they donate the photos to charity, with the charity subsequently selling the photos to a magazine and keeping the proceeds, would be $1,400,000 (based on the difference in tax liabilities between $1,400,000 from the Solution to Requirement 1d and $0 from the Solution to Requirement 3a). That is, by implementing the tax-planning strategy suggested in the Solution to Requirement 3a, Angie and Bradley would decrease their 201X tax liability by $1,400,000 and have $0 charitable contributions carryover to 201X + 1. Given the additional facts provided in Requirement 3b, students should determine that it may be advantageous not to implement the charitable contributions tax-planning idea from the Solution to Requirement 3a and instead advise the clients to simply sell the photos to the magazine and donate the proceeds to charity, as originally planned. By doing so, a charitable contribution carryover from 201X will be generated that will likely be more valuable in future years due to expected increases in the couple’s marginal tax rate. To properly make this determination it is necessary to calculate the NPV of the tax savings Angie and Bradley would recognize in future years from the charitable contribution carryover of $4000,000 (as calculated in the Solution to Requirement 1b), as shown:
Charitable contribution limitation Adjusted gross income (AGI) Charitable contribution limitation (%) Charitable contribution limitation ($) Less: actual charitable contributions made Additional charitable contribution limitation available Charitable contribution carryover Charitable contribution carryover claimed (lesser of A, B) Tax rate Tax benefit of charitable contribution carryover 10% present value factor Present value of charitable contribution carryover Total tax benefit of charitable contribution carryover Net present value of charitable contribution carryover
201X±1
201X±2
$5,000,000 50% 2,500,000 (1,500,000) 1,000,000 4,000,000 1,000,000 40% 400,000 0.909 363,600 1,750,000 1,478,700
$9,000,000 50% 4,500,000 (1,500,000) 3,000,000 3,000,000 3,000,000 45% 1,350,000 0.826 1,115,100
A B
C E (C + D) (E + F)
A B
D F
Accordingly, if the facts provided in Requirement 3b are known prior to implementing the planning idea from the Solution to Requirement 3a, students should conclude that the overall increase in tax savings from selling the photos, donating the proceeds to charity, and utilizing the charitable contribution carryover in future years is greater than the tax savings from donating the photos directly to charity in order to pay less tax in 201X. Given the expected increased tax rates in 201X + 1 and 201X + 2, the net tax savings is $350,000 ($1,750,000 total tax deduction from charitable contribution carryover with donation of proceeds from sold photos less $1,400,000 benefit in 201X from donating photos directly to charity). After applying the appropriate 10% present value factors as shown above, the NPV of the charitable contribution carryover from selling the photos in 201X and donating the proceeds to charity is $78,700 higher than the $1,400,000 tax benefit derived in the Solution to Requirement 3a from donating the photos to charity in 201X. Acknowledgments The authors would like to thank Richard Harvey for his assistance during testing of the case and two anonymous reviewers for their comments. The views expressed are those of the authors and do not necessarily represent those of Ernst & Young, LLP.