Funding the Family Foundation: Qualified Appreciated Stock

by Joy S. MacIntyre, Morrison & Foerster LLP

In an earlier post we described some of the tax benefits - and challenges - associated with donating corporate securities to a family foundation or other private foundation.  On the right facts, the donor in such a case can claim a deduction equal to the full fair market value of the securities despite the fact that the donor will never be taxed on any gain built into the securities.  We previously discussed some of the foundation-side implications (specifically, the minimum distribution requirement and the excess business holdings limitation) that must be considered in connection with such a contribution.  This installment will take up the key donor-side income tax constraint that must be considered before making such a contribution, specifically, the requirement that the securities must be "qualified appreciated stock" of a corporate issuer at the time of the contribution or the deduction may be severely curtailed. 

"Qualified Appreciated Stock" Generally

The Internal Revenue Code generally limits the deduction for a contribution of capital gain property to a private non-operating foundation, so that the best a donor in such a case can hope for is a deduction equal to the adjusted tax basis in the contributed property. [IRC § 170(e)(1)(B).] A taxpayer-favorable exception exists for a contribution of "qualified appreciated stock," offering the donor of such stock the possibility of a full fair market value deduction - without accompanying gain recognition - provided all of the following requirements are met [IRC § 170(e)(5)]:

  • The contribution must be of corporate stock; securities issued by a partnership and bonds, notes, warrants or other non-stock interests issued by a corporation cannot qualify even if they are clearly and actively publicly traded.
  • As of the date of the contribution, market quotations for the stock must be readily available on an established securities market (the "Publicly Traded Requirement").
  • The stock must be "capital gain" property; that is, a sale of the stock for its fair market value at the time of the contribution would have resulted in long-term capital gain.
  • The donor (together with certain family members) must not have contributed to private non-operating foundations stock in the same corporation representing, in the aggregate, more than 10% of the value of the corporation (the "10% Limitation").

The donor (together with certain family members) must not have contributed to private non-operating foundations stock in the same corporation representing, in the aggregate, more than 10% of the value of the corporation (the "10% Limitation").

For the typical portfolio investor in publicly-traded stocks, application of the above requirements tends to be fairly straightforward, and the provision easily satisfied.  Much greater care is required, however - and in some cases the exception will be unavailable in whole or in part - where the donor is a founder of the corporation in question and has retained a significant equity stake or other position of influence with the company.  Such a fact pattern can raise nuanced questions under the Publicly Traded Requirement and the 10% Limitation, some of which are illustrated below in the context of a hypothetical fact pattern similar to those sometimes encountered in practice.

Publicly Traded Requirement

Suppose an individual donor ("D") founded a corporation ("Co") many years ago.  In connection with its initial public offering of stock ten years ago, Co recapitalized its shares so that the class of stock owned by D and D's family members had a disproportionately high number of votes per share compared to the class of stock owned by the public investors.  This is a fairly common feature in public offerings of family-owned corporations, as it allows the family to retain voting control (say, 85% of the voting power) while increasing the amount of stock that can be sold to the public (say, 50% of the value). 

Co's low vote stock is traded on the New York Stock Exchange.  Although the class of high-vote stock owned by D is not itself listed on any public exchange, D has complete discretion to convert his shares into the low-vote shares at any time, on a one-for-one basis.

D would like to contribute some of his Co shares to a private non-operating foundation ("Foundation").  Is D's contribution of the high-vote class to Foundation eligible for the exception?  The IRS position, reflected in a 1999 private letter ruling [PLR 199915053], is that the exception is not available because the contributed shares are not of the class that is publicly traded - D's unrestricted, unilateral right to convert into the public class is not enough.  Therefore, D must first convert his shares into the publicly traded, low-vote class before contributing them to Foundation.

Now suppose that the high-vote shares owned by D and his family have not been registered under the securities law.  Alternatively, or perhaps in addition, suppose D remains an officer and director of Co, or owns a significant stake in Co.  In any of the foregoing cases, D's ability to sell his Co shares would be limited by Rule 144 of the Securities Act of 1933.  Rule 144 generally restricts D's sales within any three month period to the greater of (a) 1% of the outstanding shares of Co and (b) the average weekly trading volume of Co within the four week period preceding the sale.  Assume no contractual or other transfer restrictions apply to the shares.

While Rule 144 volume restrictions do not directly apply to a gift transfer such as D's proposed contribution of shares to Foundation, the IRS is of the view that the restrictions nonetheless are relevant in determining whether D's stock satisfies the Publicly Traded Requirement. [See, e.g., PLR 9247018 (stock was not qualified appreciated stock because taxpayer was prohibited from selling the stock under Rule 144); PLR 9320016 (reconsidering and confirming the result in PLR 9247018 on the view that it is required by the legislative history).] Specifically, the IRS has interpreted the Publicly Traded Requirement to mean that the shares in question must actually be freely transferable by the donor at the time of the transfer and by the donee following the transfer. [PLR 200702031.]

It therefore is critical to evaluate whether any contractual or legal restrictions limit the transferability of the shares before or after the contribution.  The answer is likely to require interpretation of the securities laws as well as the corporate charter, corporations code and perhaps investment agreements, and in practice a corporate colleague typically is consulted on these points.  Some generalizations follow, however.

On the donor side of the equation, as discussed above, for one or more reasons we would expect D's ability to transfer the Co shares to be limited in accordance with Rule 144.  Is D's contribution therefore ineligible for the exception?  Not necessarily.  D should be able to donate, and treat as "qualified appreciated stock," a number of shares up to the number that D could have sold on the contribution date without violating Rule 144's volume restrictions [See e.g. PLR 9435007];  

that number of shares is in fact freely transferable in D's hands.  However, while it does not appear the IRS has expressly addressed this point, it may be prudent for D to avoid making additional transfers of Co shares within the three month period following the contribution to Foundation if the combined effect of the later transfers and the contribution to Foundation would be to transfer an aggregate number of Co shares in excess of D's Rule 144 volume limit (treating the charitable contribution as if it were a Rule 144 restricted transfer for this purpose).

As noted above, in order to ensure the exception is available the shares also must be freely transferable in the hands of the donee foundation.  While, again, the point is best confirmed by a corporate attorney on a specific set of facts, our experience has been that in a typical case a private foundation is unlikely to be subject to transfer restrictions on contributed stock.  In general, securities law restrictions might apply if the donee foundation were considered the same "person" as the donor under the securities law, a determination that takes into account the charitable bona fides of the foundation, the "affiliate" status of the foundation and the corporate issuer, and whether the foundation will own "substantially less" than 10% of the issuer's outstanding shares.

"Affiliate" status for this purpose is generally a facts and circumstances determination, with some emphasis on whether, directly or indirectly, one entity controls the other or the two entities are under common control.  For example, ownership by a foundation of ten percent or more of a corporate issuer's outstanding securities would be among the facts tending to indicate affiliate status.  Based upon the foregoing standards, in most situations encountered in practice the donee foundation is able to freely transfer the contributed shares as required for the "qualified appreciated stock" exception to be available.

10% Limitation

Similar care must be exercised in applying the 10% Limitation, both to D's initial contribution of Co shares to Foundation and to any additional contributions of Co shares D might contemplate.  The limitation is seemingly straightforward:  The qualified appreciated stock exception is unavailable for a cumulative contribution of shares having a value in excess of ten percent of the value of all of Co's outstanding stock.  In applying the limitation, D is deemed to have made any contributions of Co shares that in reality were made by members of D's family, which includes for this purpose only D's siblings, spouse, ancestors and lineal descendants.

Interesting questions arise if D has (or is deemed to have) contributed Co shares on one date ("Date 1") and contemplates contributing additional shares on a later date ("Date 2").  Assume the shares contributed on Date 1 were well within the 10% Limitation as tested on that date.  In such a case:

  • Should the shares contributed on Date 1 continue to be valued at their Date 1 value for purposes of applying the 10% Limitation on Date 2? The IRS has indicated in a private letter ruling that the earlier-contributed shares should continue to be valued at their Date 1 value in determining the numerator for the 10% Limitation, even though the denominator is based on the total value of all of the outstanding Co stock on Date 2 [PLR 200112022].This approach will be favorable to D, assuming Co stock has appreciated between Date 1 and Date 2.
  • In applying the 10% Limitation on Date 2, must the Date 1 contribution be taken into account even if as of Date 2 Foundation no longer owns any of the shares that were contributed on Date 1? Yes; this result seems clearly supported by the statute's focus on the quantum of shares contributed by D rather than on the quantum of shares owned by Foundation, and is consistent with the private letter ruling position taken by the IRS [Id.].
  • Does the 10% Limitation apply on a foundation-by-foundation basis? Or does it apply on an aggregate basis to all of D's contributions of Co stock to private non-operating foundations? Although the statute itself arguably is not perfectly clear on this point, the legislative history underscores that the 10% Limitation applies on an aggregate basis taking into account all of D's actual or deemed (by family attribution) contributions of Co stock to all private non-operating foundations, not simply those contributions made to Foundation. [See H. Rep. No. 432, Part 2, 98th Cong., 2d Sess. 1464-65 (1984) (limitation applies to donor's contributions "to all private nonoperating foundations of stock in a particular corporation"); Staff of the Joint Committee on Taxation, General Explanation of Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong. 669 (1984) (requiring aggregation with all other contributions of stock in the same issuer "to all other related or unrelated private nonoperating foundations").] 

Closing Notes

A contribution of qualified appreciated stock to a private non-operating foundation can offer potent income tax benefits to the donor.  Changes in the tax rules that went into effect at the beginning of this year resulted in some refinements - some good, some bad - to the basic framework for assessing those benefits.  The increase in tax rates on long-term capital gains (up from 15% to a maximum of 23.8% for taxpayers in the highest bracket, taking into account the new 3.8% Medicare surtax) increases the value of the "gain nonrecognition" benefit to the donor.  At the same time, the reinstatement of the itemized deduction phase-out limits the value of the charitable deduction benefit to many donors.  All told, the recent law changes place a high premium on careful modeling of the expected tax impact to the donor of donating qualified appreciated stock, but do not undermine the basic advantages of such a contribution compared to a gift of the after-tax cash that might be generated by a sale of the stock.

The above discussion focuses solely on the donor's income tax considerations relating to a contribution of qualified appreciated stock.  A number of corporate law and other practical considerations also should be taken into account in determining the size and attractiveness of such a gift.  Among other things, consideration should be given to securities law restrictions that might apply to a donor's transfer of other stock of the same issuer following the contribution, and to the market impact of any threshold conversion of shares that would increase the number of outstanding shares in the publicly traded class.

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Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.

© Copyright 2013 Morrison & Foerster LLP.  This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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