Good Intentions Get Swamped: Corporate Donation of Wetlands Stymied By Regulations

Good Intentions Get Swamped: Corporate Donation of Wetlands Stymied By Regulations

Article posted in Regulations on 4 January 2006| 2 comments
audience: National Publication | last updated: 16 September 2012
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Summary

In a recent article published on the Planned Giving Design Center, Laura Peebles addressed the tax trap of Treasury Regulation 1.337(d)-4 for corporations that contribute "all or substantially all" of their assets to charity. In this article, Philadelphia attorney Morgen Cheshire discusses that regulation's implications for land conservation efforts and calls for a minor adjustment that would effect a major policy change.


by Morgen Cheshire, J.D.

In a recent article entitled, "A Hidden Trap for Generous Corporations," Laura Peebles addressed the tax trap of Treasury Regulation 1.337(d)-4 for corporations that contribute "all or substantially all" of their assets to charity.1

The Asset Sale Rule

Treasury Regulation 1.337(d)-4(a)(1), known as the Asset Sale Rule, in effect provides that, regardless of charitable intent, corporate donors making charitable contributions of all or substantially all of their assets to one or more tax-exempt entities must recognize gain2 on the transfer as if the assets were sold at fair market value.3 The rule is part of a two-pronged regulation that is meant to curb circumvention of General Utilities repeal and therefore is intentionally broad.4 The Asset Sale Rule serves to supplement the Change in Status Rule5 by reaching economically similar liquidations or reorganizations and according them the same tax treatment as conversions of taxable corporations to tax-exempt corporations; however, the breadth of the Asset Sale Rule adversely affects land conservation efforts and its practical implications make for poor policy, particularly where a corporation's only asset is land. The good news is that a carve-out for donations of conservation lands made to government entities could provide a simple solution.

The Asset Sale Rule stems from Section 337(d) of the Internal Revenue Code, which directs the Secretary to prescribe regulations as may be necessary or appropriate to carry out the purposes of General Utilities repeal, including rules to "ensure that such purposes may not be circumvented . . . through the use of a . . . tax exempt entity." IRC 337(d).6 Treasury Regulation 1.337(d)-4(a)(1) provides:

(a) Gain or loss recognition.-(1) General rule.—Except as provided in paragraph (b) of this section, if a taxable corporation transfers all or substantially all of it assets to one or more tax-exempt entities, the taxable corporation must recognize gain or loss immediately before the transfer as if the assets transferred were sold at their fair market values.7

The Asset Sale Rule does not apply to transfers of all or substantially all of the stock of a corporation.8

The regulation's effect on land conservation is apparent in the following fact pattern: Shareholders of a C corporation—which owns only one asset (e.g., wetlands) that has appreciated in value—wish to see the land preserved, either by a governmental entity or a land conservation organization. The shareholders have at least two options. They might direct the corporation to donate the land (which the shareholders might do if they do not desire a charitable deduction),9 or they might donate the stock to a conservation organization.

If the shareholders of the corporation direct the corporation to donate its only asset (the land) to a tax-exempt entity before dissolution, the transfer will be treated as a sale for fair market value pursuant to the Asset Sale Rule, and the corporation would recognize the gain for tax purposes.10 Because the corporation has no other assets, the shareholders would have to provide funds so that the corporation could pay the tax on the gain. For its charitable contribution of the land, the corporation would be entitled to a deduction, which could help offset this gain; however, that deduction would be limited to 10% of the corporation's income, and the individual shareholders would not be entitled to a deduction. Moreover, the five-year carryover of unused charitable deductions would be of no use if the corporation would be transferring all of its assets immediately prior to dissolution because without a future, the corporation has no need to carry forward the deduction.

Alternatively, it may be much more advantageous for the individual shareholders of the corporation to make a charitable contribution of the corporation's stock to an exempt organization, as this approach affords charitable deductions directly to the shareholders (subject to the limits of IRC 170 on deductions by individuals) and does not trigger the Asset Sale Rule.11 Yet, this approach of donating 100% of the stock in a corporation passes on a potential problem to tax-exempt organizations. Consequently, finding an exempt entity to accept donations of 100% of the stock in a corporation may be a challenging task such that this alternative may not be a viable option.

Application to Conservation Organizations

Many conservation organizations accept stock donations; however, these organizations are often not eager to remain the sole shareholder of a corporation, even if the only assets of the corporation are desirable conservation lands. A primary deterrent is that the corporation itself would still be a taxable entity, incurring corporate costs and administrative expenses such as real estate taxes, franchise taxes, and insurance premiums.12 Thus, as they do with land donations, upon accepting 100% stock in a corporation by donation, many conservation organizations would prefer to direct the corporation to transfer the land to a conservation organization (either its own or to a government conservation agency) and then dissolve the corporate form.

Conservation organizations—especially those with limited resources, that do not view their role as land stewards—have become adept at redirecting land to government entities, which are often better equipped to manage and protect the lands and are better insulated from liability.13 This role of facilitator would serve the initial shareholders well if not for the Asset Sale Rule. For example, a conservation organization might accept the stock donation directed by the initial shareholders and then, as the new shareholder, direct the corporation to donate its land to a government entity. However, because the Asset Sale Rule would require recognition of corporate gain on the donation of the land to the government entity, the rule discourages an organization from getting involved in facilitating such transactions for fear that as the new shareholder it will be liable for tax on the gain when it directs a donation of all or substantially all of the corporation's land to the government entity. Thus, if not for the Asset Sale Rule, these conservation organizations might accept such donations, acting as intermediaries in order to facilitate gifts of this kind.

This fact pattern is a recorded concern of the Nature Conservancy, which has listed the issue among its focus points in recent years and has presented the issue before subcommittees of the Senate Finance Committee and the House Committee on Ways and Means.14 The regulation's effect on conservation efforts has also not gone unnoticed among potential donees, who report that conservation efforts have been abandoned by donors who want the tax benefits afforded by deductions for charitable contributions of stock but are unable to donate the stock because tax-exempt organizations are unwilling to accept the contribution.

With the Asset Sale Rule in place, there are few other options available to the parties involved: The corporation might request a private ruling, or the shareholders might restructure the transaction to try to avoid the application of the Asset Sale Rule. The cost, time, and likelihood of obtaining a private letter ruling makes this first option unfavorable.15 Alternatively, restructuring the transaction may minimize the tax burden. For example, the corporation might donate less than substantially all of its land in one year and then donate the remaining land in subsequent years; however, without justification for doing so, structuring transactions in this manner could make the transfers vulnerable to IRS scrutiny. Because the corporate gain recognition rules apply to "any series of related transactions having an effect similar to" a taxable corporation transferring all or substantially all of its assets to one or more tax-exempt entities or changing its status, the IRS may perceive these separate transactions as a plan to transfer all or substantially all of the assets and step them together, negating the corporation's efforts to minimize gain.16

Anticipating the gain as they would do in the context of a donation of land, conservation organizations are hesitant to accept donations of 100% of the stock in a corporation unless there are sufficient funds to cover the taxes and costs associated with the subsequent transfer of substantially all of the assets to a tax-exempt entity. Before making a donation of the stock, the initial shareholders may consider directing the corporation to sell a portion of its assets to cover these taxes and costs, but in the case of some lands (like wetlands), this may not be a practical or desirable solution. Alternatively, in addition to the stock donation, donors may provide additional funds to the conservation organization, also tax-deductible, to cover the taxes on the gain that would be realized on the subsequent transfer of the land directed by the conservation organization as the new shareholder. Yet, from a policy perspective, it seems incredible that donors—in some cases, the initial shareholders who transfer stock to a tax-exempt organization—should have to finance the taxes for a donation, which is traditionally a non-taxable event.

Because of the application of the Asset Sale Rule, the burden can also fall on government conservation programs, which may seek public financing to pay the donating corporation's taxes if it will help to facilitate a land donation to the government program. Yet, it makes little sense that a government entity may actually end up looking for funds to "buy" property that it could have otherwise received by donation; or rather, in the case of a transfer to the federal government, the government may ultimately provide funding to pay the taxes it has imposed on a transfer to itself.

Remarkably, in the context of land conservation, the Asset Sale Rule is triggered even where donations are made to the federal government, the state, or their political subdivisions. Tax-exempt entity is defined for a dual purpose—"tax-exempt entity" is defined for the purpose of defining a taxable corporation ("any corporation that is not a tax-exempt entity") and for the purpose of defining a tax-exempt transferee—and includes "the United States, the government of a possession of the United States, a state, the District of Columbia, the government of a foreign country, or a political subdivision of any of the foregoing."17 Amending the regulation to carve out an exception for land donations to government entities, or redefining "tax-exempt entity" in Treas. Reg. 1.337(d)-4(c)(2) to exclude government entities as transferees, would encourage donations for land conservation purposes and would preserve funds for other conservation projects. With a carve-out in place, conservation organizations would be more willing to accept sole stock ownership in a corporation whose only asset is land because the subsequent donation of the asset to a government entity would not trigger the Asset Sale Rule. Shareholders would get deductions for their contributions of the stock, and their conservation intentions could be facilitated through their donation of stock to a land conservation organization. Such an amendment is limited in scope, allowing for circumvention of General Utilities repeal only in a narrow instance, and would effectuate a positive policy change by eliminating a major disincentive for making corporate donations of land for conservation purposes.

By adding Section 337(d) to the Internal Revenue Code, Congress gave the Treasury broad discretion to prevent abusive situations in which corporate assets are transferred by donation to avoid the recognition of gain at the corporate level. Pursuant to this section, Treasury constructed the Asset Sale Rule to require recognition of corporate gain upon the transfer of assets. The regulation is intentionally broad in scope and most likely was meant to address transactions involving assets transferred to related entities, in conversions and in similar contexts.18 The unfortunate result is that the regulation was not tailored to allow for a narrow exception for charitable donations of land to government entities for conservation purposes. As assets often donated substantially all at once, conservation lands inevitably are captured by the sweeping provision. Yet, transfers of this type do not fall under the traditional merger model that the regulation was meant to address. Furthermore, it is unlikely that preventing such transactions furthers efforts to prevent circumvention of General Utilities repeal because government entities are not the targeted related entities involved in the circumvention scenarios that the regulation was meant to curb.

It makes for poor public policy that land donations—especially those intended for conservation, which end up in the stewardship of government entities—are discouraged by a regulation that was meant to curb an abuse that does not involve donations of land to government entities for conservation purposes. It also makes for poor policy to have a different result simply because the land is the only asset or the last asset of a corporation; a corporation that donates a parcel of land (i.e., less than substantially all) to the government for conservation is entitled to a deduction without having to recognize gain on the appreciation of property.

Because the Internal Revenue Code does not preclude the Treasury from tailoring a narrower definition of tax-exempt entity, a definition that excludes government entities as transferees would provide a simple solution—one that is particularly well-suited to conservation efforts and one that still aptly targets circumvention situations. Because it does not create circumvention opportunities for other entities, such a narrow exception would be unlikely to frustrate efforts to preclude circumvention.

Call for Change

At the crux of the issue are competing policies: capturing inherent corporate gain for taxation vs. encouraging charitable donations. At the risk of frustrating charitable intentions, the regulation currently prioritizes taxing gain at the corporate level. Meanwhile, lawmakers have found comfort in the fact that donations of less than substantially all of the corporation's assets may still be made and that donations of all or substantially all of the corporation's stock are also not taxable events. Yet, these considerations do not address the policy concerns of land preservation. Instead, the provision as written frustrates donative intent altogether or leaves donors to pass on the problem—if they can—to exempt organizations that may or may not be equipped to deal with the issue as the new shareholders. In the context of charitable giving in general, this prioritization may prove a satisfactory choice; however, within the very narrow context of land preservation, it is possible to reconcile the conflict. In this instance, a provision a little less inclusive would promote land preservation without undermining the ultimate legislative purpose.



The author would like to thank Carolyn Nachmias and John P. Young for their guidance in the development of this article.




  1. Laura H. Peebles, A Hidden Trap for Generous Corporations (May 18, 2005) at http://www.pgdc.com.back

  2. The regulation also provides for recognition of loss, but losses may be disallowed in certain circumstances by Treas. Reg. 1.337(d)-4(d).back

  3. Treas. Reg. 1.337(d)-4(a)(1) (effective January 28, 1999).back

  4. The General Utilities repeal generally refers to a series of amendments by Congress beginning in 1969 and its ultimate repeal by the Tax Reform Act of 1986 of a doctrine established by General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935) and later codified by the Internal Revenue Code. The doctrine was an exception to the general rule that corporate income is taxed at two levels: at the corporate level when it is earned and at the shareholder level upon distribution of the earnings. The doctrine provided that corporations were not required to recognize gain or loss when they distributed appreciated or depreciated property to shareholders. As a result of the repeal of this doctrine, corporations are now required to recognize the gain or loss in the context of complete liquidations.back

  5. The Change in Status Rule requires gain recognition when a taxable corporation converts to a tax-exempt entity. See Treas. Reg. 1.337(d)-4(a)(2).back

  6. The Tax Reform Act of 1986 added Section 337(d) to the Internal Revenue Code, and the Technical and Miscellaneous Revenue Act of 1988 amended the section. See T.D. 8802, 1999-4 I.R.B. 10. The legislative history of the 1988 Act explains that the "Treasury Department shall prescribe such regulations as may be necessary or appropriate to require the recognition of gain if appreciated property of a C corporation is transferred . . . to a tax-exempt entity in a carryover basis transaction that would otherwise eliminate corporate level tax on the built-in appreciation." S. Rep. No. 445, 100th Cong., 2d Sess. 66 (1988).back

  7. See Peebles article, note 1, regarding the limited applicability of the regulation's exceptions.back

  8. T.D. 8802, 1999-4 I.R.B. 10 ("the regulations do not affect . . . the shareholders' tax treatment when transferring all or any part of the corporation's assets to charity by transferring all or any part of the corporation's stock to charity"). But see Charles F. Kaiser and Thomas Miller, 2000 EO CPE Text, U. Treas. Reg. Section 1.337(d)-4 and Exempt Organizations at 288, who characterize stock as an asset for purposes of triggering the Asset Sale Rule: "It is very important to understand that transferring assets includes liquidating the corporation's assets, which was previously a taxable event to the taxable corporation, as well as transferring the taxable corporation's stock, which is considered an asset under IRC 1.337(d)-4."back

  9. Unlike shareholders of S-corporations—which are allowed deductions for charitable contributions of the corporation's asset subject to the limits of IRC 170 on deductions by individuals—the shareholders of C-corporations must donate their stock in order to receive a deduction.back

  10. See note 2 regarding treatment of losses.back

  11. See note 8.back

  12. Alternatively, the organization could retain the corporate form, and in some states, the costs associated with this alternative may be eliminated or minimized if the corporation's purpose is conservation. Some states and local governments exempt from taxation those corporations that exist solely for conservation. Additionally, if the corporation does not have any income, it would owe no federal income tax.back

  13. Unfortunately, these government entities, which are in the practice of accepting donations of land, are also not likely to accept stock of a for-profit corporation (even if it means effectively a donation of land).back

  14. Michael Dennis, the Vice President and General Counsel of the Nature Conservancy, spoke before the Subcommittee on Oversight of the House Committee on Ways and Means (September 30, 1999), noting that a change in the corporate liquidation rules where conservation lands are involved would encourage the sale, gift or exchange of land or easements for conservation. Austin Cleaves, speaking on behalf of the Nature Conservancy before the Subcommittee on Taxation and IRS Oversight of the Finance Committee (July 25, 2000), delivered the same message. Both explained: "This proposal would allow small corporations whose primary asset is land to donate such land for conservation purposes without triggering a tax, as is the case under current law."back

  15. See Peebles article, note 1, discussing the disincentives of time and cost. Query whether the Internal Revenue Service would issue a ruling given the clarity of the regulation and its intentional breadth.back

  16. Treas. Reg. 1.337(d)-4(a)(4).back

  17. Treas. Reg. 1.337(d)-4(c)(1)&(2).back

  18. See Charles F. Kaiser and Thomas Miller, 2000 EO CPE Text, U. Treas. Reg. Section 1.337(d)-4 and Exempt Organizations at 284 (noting that the provision applies to "large exempt organizations or related entities, especially hospitals"). The article is riddled with examples of how the regulation applies to hospital mergers.back

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Exempt status vs. liquidation

Could a corp. whose only asset is conservation property seek exempt status? What would happen taxwise if property was distributed in a complete liquidation after corp. received 501c3 status? Alternatively, could it become a support org for an existing conservation organization?

Exempt status v. liquidation

The Change in Status Rule applies to the situation you raised (i.e., when a taxable corporation seeks exempt status). See the Change of Status Rule in Treas. Reg. 1.337(d)-4(a)(2). Your last question is an interesting one. I would want to know if the supporting organization would be a "tax-exempt entity" as defined in Treas. Reg. 1.337(d)-4(c) and whether the Change in Status Rule might also apply in this situation.

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