In Mart D. Green, Trustee v. United States, the Tenth Circuit has directed a district court to enter summary judgment for the government, having concluded that the amount of the charitable deduction a trust may take under Section 642(c)(1) stemming from its donation of three real estate parcels is limited to the trust's adjusted basis in the donated properties, not their fair market value.

Background

David and Barbara Green created a trust in 1993 "to provide for the relative health, education and maintenance needs of [their] children and descendants … and to provide for charity." Mart Green was designated as the initial trustee. The trust instrument: (1) directed all charitable contributions to be made to entities described in Section 170(c); (2) did not specify whether charitable distributions may be made from the trust's principal, as opposed to from its income; and (3) gave the trustee "'full power and authority to determine the manner in which expenses are to be treated and which receipts are to be credited as between income and principal to determine what constitutes income or principal.'"

The trust wholly owned a single-member LLC (GDT), treated as a disregarded entity for federal income tax purposes. In addition, the trust held a 99% ownership interest in the Hob-Lob Limited Partnership (Hob-Lob), which owns and operates most of the Hobby Lobby retail craft stores nationwide. For the years at issue (2002-2004), the trust's distributive share of Hob-Lob's ordinary business income totaled approximately $201.3 million, and its distributions from Hob-Lob totaled approximately $109.3 million.

The trust used a portion of the Hob-Lob distributions to purchase several pieces of real property, which it then donated to various charities.

— Virginia property. In February 2003, GDT paid approximately $10.3 million for 109 acres and two industrial buildings in Lynchburg, Virginia; in March 2004, GDT donated 73 acres of the land and the two buildings to the National Christian Foundation Real Property Inc. (NCF), an organization described in Section 170(b)(1)(A). On its 2004 income tax return, the trust reported that the adjusted basis of the Virginia property was approximately $10.4 million as of the date of the donation; this amount was the same as the Virginia property's fair market value on the date of donation.

— Oklahoma property. GDT paid $150,000 for a church building and outbuildings in Ardmore, Oklahoma in August 2002, and donated the property in October 2004 to a church that was also described in Section 170(b)(1)(A). The trust reported on its 2004 tax return that the adjusted basis of the property was $160,477 on the date of donation. The fair market value of the Oklahoma property on the date of donation was $355,000.

— Texas property. GDT paid $145,000 for 3.8 acres of land in Dickinson, Texas, in June 2003, and donated the property to a third church in October 2004. On its 2004 income tax return, the trust reported that its adjusted basis in the Texas property was $145,180 on the date of donation; the property had a fair market value of $150,000.

Tax returns for 2004

On its income tax return for 2004, the trust: (1) reported approximately $58.8 million in income, approximately $58.7 of which was unrelated business income (UBI); (2) claimed a $20.5-million charitable deduction, based on the donations of real property and a cash donation to the Reach the Children Foundation Inc.; (3) reported adjusted basis in the three donated real properties as totaling approximately $10.7 million and their fair market value as totaling approximately $30.3 million. The trust did not report as income the properties' unrealized appreciation, which totaled approximately $19.6 million.

In October 2008, the trust filed an amended tax return for 2004, claiming a $3.2 million refund and increasing its reported charitable deduction from approximately $20.5 million to approximately $29.7 million. The IRS disallowed the refund, asserting that the charitable contribution deduction for the real property was limited to the donor's basis in the property. Through the trustee, the trust filed a refund action in federal district court, alleging that the IRS's determination was erroneous and had led the trust to overpay its income tax for 2004 by nearly $3.2 million. The district court granted summary judgment for the trust. The parties subsequently reached an agreement regarding the fair market value of the Oklahoma and Texas properties; the value of the Virginia property was decided at trial. A judgment was ultimately entered, awarding the trust a tax refund of approximately $2.8 million plus interest, and the government appealed.

Tenth Circuit decision

The government argued that the lower court's decision ran contrary to the language of Section 642(c)(1) and effectively provided a double tax benefit to the trust by failing to collect tax on the property appreciation that had never been taxed. Reviewing the district court decision de novo, the Tenth Circuit noted that the parties agreed that Section 642(c)(1) governed the trust's donations of real property in 2004, but disagreed over the allowable amount of the deductions stemming from those donations.

Section 642(c)(1) allows estates and trusts, in calculating their taxable income, to claim charitable contribution deductions reflecting "any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the [tax] year, paid for a purposes specified in [S]ection 170(c) (determined without regard to [S]ection 170(c)(2)(A)." The central question for the appellate court was, "[What] is the authorized amount of the deduction under [Section] 642(c)(1)?" To answer this question, the court addressed various interpretations of the phrase "any amount of the gross income," including:

1. The charitable contribution must be made out of gross income that the trust earned in the tax year at issue (which the IRS had asserted in Old Colony Trust Co. v. Commissioner, 301 U.S. 379 (1937), but the Supreme Court rejected).

2. The charitable contribution must be made exclusively out of gross income earned by the trust and kept separate from the trust's principal until donated (which, although consistent with Old Colony Trust, was not argued by either party in the instant case).

3. The charitable deduction need not be made directly from current or accumulated gross income, but must be traceable to it (which both parties appear to be arguing).

4. The charitable deduction is limited by the amount of gross income that the taxpayer earned during the year at issue (which neither party argued).

The fact that "any amount of the gross income" could be interpreted multiple ways led the court to conclude that the phrase was ambiguous.

The appeals court determined that the IRS's regulatory construction of Section 642(c)(1) was reasonable — it interpreted "any amount of the gross income" to mean the trust must make any charitable donations out of its gross income. Although this interpretation is consistent with interpretations 2 and 3, it does not favor one over the other, the court noted.

Both parties agreed with the Service's assertion that the charitable donation must be made out of the trust's gross income "but that real property purchased with gross income can also be treated as the equivalent of gross income for purposes of the deduction outlined in [Section] 642(c)(1)," which the circuit court found to be "an entirely reasonable interpretation of the statute."

Turning to the allowable amount of the deduction, the court noted that the IRS had consistently asserted that the trust's charitable deduction in the instant case was limited to the trust's adjusted basis in the donated property, and the court found this to be "the most reasonable interpretation of the statutory language, particularly when considered in light of the Code as a whole."

Although tax provisions that provide charitable deductions are considered "public policy" positions that should be liberally construed in the taxpayer's favor, the court rejected the trust's assertion that liberal construction meant the deduction should be construed to be as large as possible (based on the fair market value rather than the basis). Agreeing with the IRS, the court concluded "the better argument is that, construing [Section] 642(c)(1) in light of other provisions of the Code, the amount of the deduction must be limited to the adjusted basis of the property."

Further, the court noted that the gain on the property had never been previously taxed, and that allowing it to escape tax "would be inconsistent with the Code's general treatment of gross income."

Finally, the court rejected the trust's contention that, because the donated properties were allocable to the trust's UBI, Section 512(b)(11) operates to allow the charitable deduction. The IRS noted that the trust had not raised this argument previously, so the court could not consider it now; the Tenth Circuit agreed, characterizing the argument as "a substantial variance of the legal component of the refund claim" and therefore barred.

Implications

The Tenth Circuit likely reached the correct result. The holding, however, was not a total win for the government. Because gross income can be traced to the basis in the donated land, the court agreed the trust should be entitled to claim that amount as a deduction. But the land in the instant case was purchased and donated within two years. Would the trust still be entitled to a deduction if the land was acquired 20 years earlier? What about the donation of a partnership interest — the initial purchase could be traced to gross income, but as basis fluctuates over time, would the rule still apply?

Additionally, the trust raised a unique argument when it brought up the limitation on deductions imposed by Section 681 when such a contribution is attributable to UBI. Section 681 disallows a deduction under Section 642(c) for contributions of UBI. Although the deduction under Section 642(c) is entirely disallowed by Section 681(a), a partial deduction is nevertheless allowed for such amounts by the operation of Section 512(b)(11), which allows a trust to deduct actual payments allocable to unrelated business taxable income (UBTI) made to organizations described in Section 170. The deduction is subject to the percentage limitations applicable to contributions by an individual under Section 170(b)(1)(A) and (B). The amount of the Section 512(b)(11) deduction is determined on the basis of UBTI computed without regard to Section 512(b)(11) and (12). In general, a trust in this position can deduct 50% or 30% of its UBTI, depending upon the status of the charitable recipient. The Tenth Circuit, however, was able to sidestep the issue because it was not raised in the lower court. But if it had been raised below, would it have carried the day? That chapter will have to be written by another taxpayer.

Interestingly, as part of the 2017 tax reform package, Congress amended the charitable deduction rules for the S portion of an electing small business trust (ESBT) to substitute the Section 170 rules for the Section 642(c) rules. (Generally, the S portion of an ESBT is the portion of the trust: (i) consisting of S corporation stock; and (ii) not treated as owned by the grantor or another person.) Thus, if these donations were made by an S corporation after 2017, the trust would have been allowed a fair market value deduction. But, based on the facts in this case, tax reform wouldn't have changed the answer.

In the end, trusts and estates should not view this case as a green light for allowing deductions for tax basis of appreciated property.

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