Uncle Bill comes to your office in a bit of a tizzy with two beers in one hand and three notices from the IRS in the other.  Unbeknownst to you, he wants to discuss deducting charitable contributions from a trust that doesn’t, technically, permit charitable contributions.  Although you are not unaccustomed to his unannounced visits, they are nevertheless jarring at 7:15 on a Tuesday morning.

You note that Aunt Ethel recently explained that Bill has become more nocturnal in his advancing age, and, as such, he is not, technically, day drinking – at least not in his personal time zone.[1]

Cutting through the hiccups and histrionics, you come to understand that Bill has been making charitable distributions from your Great-Aunt Hilda’s trust for years now and has been taking a charitable deduction on the trust’s tax return.  Having familiarized yourself with Hilda’s trust some years ago, when an issue of successor trusteeship came up after the initial named trustee was sent up the river on what, according to Bill, was a “trumped-up racketeering charge,” you are keenly aware that nowhere in Hilda’s trust is Bill, as trustee, actually permitted to make charitable distributions.

Bill bellyaches about being the trustee and the sole beneficiary of the trust, therefore, having plenary authority to make whatever distributions he damn well pleases.  Although you acknowledge that the trust gives Bill, as beneficiary, the power to make charitable donations, you observe that the trust does not entitle Bill, as trustee, to make such donative transfers.

You explain that the case law on the subject is sparse, but generally speaking, a trust is not entitled to a charitable contribution deduction when the fiduciary, acting without any authority under the trust instrument, distributes trust assets to charity.  Rather, the trust instrument must authorize the fiduciary to make charitable contributions, in order for a court to find that the charitable contributions were made “pursuant to” the terms of the trust instrument.[2]

The color drains from Bill’s face, and after he likewise drains the rest of his second beer (that you’ve seen), he asks if there is any possible upside, or if the charitable deduction avenue is going to be as futile as the time that he tried to train Cooter to fetch him a cold one from the fridge.  (Cooter, for reference sake, was Bill and Ethel’s beloved, albeit high strung, Jack Russell Terrier, who, it later turned out, was actually an abandoned fox kit with a bobbed tail.)  What is he to do, Bill asks, when he’s been deducting charitable contributions from a trust that doesn’t technically permit deductions?

Vulpine domestication aside, you tell Bill that although the trust will most likely not be able to take a contribution deduction, there is a chance that he will be able to claim a personal charitable deduction.  His ears perk up, and you explain that by using the “substance over form” doctrine to his benefit, he may be able to claim that the trust made a direct contribution to the charity on Bill’s behalf rather than going through the rigmarole of transferring the property to Bill and then Bill making the donation.

At the mention of substance and form, Bill looks at you, eyes as glazed as Cooter’s were wont to glaze when Bill fed him a slice of cheese with one of Ethel’s Xanax pills tucked inside to calm the nerves of the frenetic animal.  You bid Bill to sit down, which he does – unsteadily – and, as you begin to explain the law involved, you wonder whether you are actually helping Bill or simply enabling a redneck relative with an affinity for (partially) domesticating wild strays.

Looking First to the Instrument

Although the most recent opinion on the subject comes in the form of a Summary Opinion of the Tax Court, which, pursuant to IRC § 7463(b) is not reviewable by any court or treated as precedent for any other case, the Hubbell opinion is instructive insofar as it gathers the pertinent authority for the necessary analysis on deducting charitable contributions from a trust that doesn’t permit deductions.[3]

The trust instrument need not definitely direct charitable contributions by the trust estate in order to authorize the deduction thereof under the IRC § 642(c)(1); rather, the contributions are deductible if made “pursuant to” the trust instrument, with the term “pursuant to” being defined as agreeing, conforming, swallowing, or according with the language of the trust instrument.[4]  If, however, a trust fails to contain any language either expressly authorizing, or indeed even permitting charitable contributions, such contributions may not be made “pursuant to” the trust instrument.[5]

In order to prove entitlement to a charitable deduction under IRC § 642(c)(1), the trust (which bears the burden of proof) must (1) identify the “governing instrument;” (2) show that the charitable contributions were paid “pursuant to” the terms of that instrument as required by IRC § 642(c)(1); and (3) demonstrate that each contribution was paid for a charitable purpose under IRC § 170(c).[6] Although Bill’s chosen charity – Bassers for Jesus – is more of a drinking club than an benevolent organization, the IRC § 501(c)(3) status of the “charity,” which teaches underprivileged youth to fish with a Christian touch (no cursing, if and when possible), has not been challenged by the IRS.  Yet.

Bill satisfies two of the three tests: he has the trust’s governing instrument in hand, and the charitable contributions were made pursuant to IRC § 170(c).  Nevertheless, Great-Aunt Hilda’s trust fails to authorize the trustee to make charitable contributions.  As one Circuit Court observed, it would be a “legal fiction to say that the trust assets pass to the [charity] pursuant to the terms of the trust instrument.”[7]  Bill harrumphs, but you continue.

The Old Colony case, one of the earliest (and still important) cases on the matter, stands for the proposition that a trust is entitled to a deduction when a trustee who is authorized but not required to make charitable contributions under the trust instrument does in fact make charitable contributions.[8]  The governing instrument need not definitively direct the charitable contribution claimed as a deduction so long as it expressed some charitable intent.[9]  As the Tax Court reaffirmed in Hubbell, even the lenience of the Supreme Court in Old Colony has its limits; the case is not so broad as to entitle a trust to a charitable deduction when a trustee, acting without any authority under the trust instrument, distributes the trust assets to charity.”[10]

Putting the Substance-Over-Form Argument to Work for You

Bill has an impish glint in his good eye, which tells you that the only word he heard in the last sentence was “broad,” and so you continue without further pausing for question or comment.  You explain that when the IRS desires to unwind a transaction, it has two tools at his disposal.  The first is the “substance over form” doctrine, which permits a court to determine a transaction’s characterization according to its “underlying substance of the transaction rather than its legal form.”[11]

The second tool, which is in many ways just an application of the substance over form doctrine, is known as the “step-transaction” doctrine.  This allows the IRS to treat formally separate steps as one transaction for tax purposes, as if the steps were part of a single scheme or plan intended at the outset to achieve a specific result.[12]

Consequences of a transaction are determined on the basis of the substance of the transaction and not its form.[13]  A mere transfer in form, without substance, may be disregarded for tax purposes.[14]  An equally well-established corollary to this principle is the step-transaction doctrine under which independent tax recognition is not given to a series of integrated transactions.  The step-transaction doctrine is a particular manifestation of the more general tax law principle that purely formal distinctions cannot obscure the substance of a transaction.[15]

A transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation is relevant. To permit the true nature of a transaction to be distinguished by formalisms which exist solely to alter tax consequences would seriously impair the effective administration of the tax policies.[16]

Although the step-transaction and substance over form doctrines are traditionally used to pierce tax avoidance schemes, they can be used to a taxpayer’s advantage in certain circumstances.  In Bill’s case, he may be able to claim that, although the form of the transfer of property was from the trust directly to the charity, in substance the trust transferred property “on behalf of” Bill to a charity, and he should, therefore, be entitled to a personal charitable deduction under IRC § 170.

Thus, Bill would argue that the steps of the transaction were (a) the trust transferred the property to Bill, and then (b) Bill transferred the property to the charity.  These two steps, should (under the step-transaction doctrine), be collapsed.  As such, in an effort to streamline the donative process, Bill would argue that he directed the trust to distribute property on his behalf directly to the charity.

Notwithstanding its merits, you emphasize that this argument is by no means foolproof.

In applying the substance-over-form doctrine, the IRS is always concerned with the intentions of the taxpayer at the time of the agreement and economic realities as then perceived by the participants.[17] In determining whether a taxpayer has met its burden of proof to disavow the form of its transaction, courts have looked to whether the taxpayer consistently reported the transaction in accordance with the asserted substance.[18]  This consistent reporting consideration stems, in part, from the courts’ reluctance to permit taxpayers to use hindsight to determine the most advantageous tax position.[19]

As the Tax Court has noted, the “cornerstone of tax planning” is that the same economic or business result may be validly achieved through a variety of routes, each with differing tax consequences.[20]  The step transaction doctrine may be argued by taxpayers in cases where the form chosen does not reflect that transaction’s true substance (which is reflected in the combining of the individual steps).  However, such valid arguments must be distinguished from situations where the substance of the transaction coincides with the form employed.

In these latter situations, it is well-settled that although a taxpayer is “free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not.”[21]  To this end, the taxpayer “may not enjoy the benefit of some other route he might have chosen to follow but did not.”[22]  Further, neither the courts nor the IRS “views with favor” any attempt by a taxpayer to restructure transactions after they are challenged.[23]

The Tax Court, in analyzing the step-transaction doctrine, once posited that the the core analytical issue was whether “the steps taken [were] so interdependent that the legal relationships created by one transaction would have been fruitless without a completion of the series.”[24]  In Bill’s case, because Great-Aunt Hilda’s trust did not permit direct charitable contributions from the trust, the only legal method through which the trust’s property could be transferred to a charitable organization flowed through his donative power.

A direct transfer from the trust to a charity could, therefore, arguably be voidable and, thus, “fruitless.”  This is certainly not the intent behind the donation.  The substance of the transaction was that trust property, available to Bill as a beneficiary, was transferred to a charity.  Although the form was a direct transfer from the trust to the charity, Bill should argue that the form controls, and that the transfer was made on Bill’s behalf (if not at Bill’s direction).

Conclusion

Although the method is untested, you explain to Bill that it is, perhaps, the only way that he will be able to salvage a charitable deduction from the transactions.  He begrudgingly agrees that he will not try to sweet-talk you into arguing that the trust was entitled to the deductions.  You appreciate the gesture, though you doubt his resolve (and his memory at this point in his day).

You thank Bill for the opportunity to assist, and as you do at the end of all legal consultations with Dear Ol’ Bill, you tell him that you will send him a comprehensive email documenting precisely what you talked about – and more importantly, what he agreed not to do in the future.

He departs, leaving the IRS notices and empties on your desk, and you question your career choice and wonder if animal husbandry would have been easier in the long run.  Shaking off this ephemeral doubt, as you thus far have been able to do in your career, you drift off into a daydream about what type of cockamamie scheme Bill will come to you with next.

Footnotes:

[1] The song It’s Five O’Clock Somewhere is somewhat of an anthem for Bill, with Jimmy Buffett and Alan Jackson being personal idols and visionaries, as well.

[2] Hubbell v. Commissioner, T.C. Sum. Op. 2016-67, at *7 (2016) (citing Old Colony Tr. Co. v. Commissioner, 301 U.S. 379, 382-83 (1937)).

[3] Id.

[4] Old Colony Tr., 301 U.S. at 383-84.

[5] Hubbell, T.C. Summ. Op. 2016-17, *7.

[6] Id. at *6; Brownstone v. United States, 465 F.3d 525, 529 (2d Cir. 2006).

[7] John Allan Love Charitable Found. v. United States, 710 F.2d 1316, 1319 (8th Cir. 1983).

[8] Id. at 1320.

[9] Brownstone v. United States, 465 F.3d 525, 529 (2d Cir. 2006).

[10] Id.

[11] Estate of Streightoff v. Commissioner, 954 F.3d 713, 719 (5th Cir. 2020)

[12] In re Stapley, 609 B.R. 209, 216 (Bankr. N.D. Cal. 2019) (citing King Enterprises, Inc. v. U.S., 418 F.2d 511 (Ct. Cl. 1969); Andantech v. Comm’r, T.C. Memo 2002-97).

[13] Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945).

[14] Id.; Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958); Commissioner v. Sunnen, 333 U.S. 591 (1948); Helvering v. Clifford, 309 U.S. 331 (1940); Corliss v. Brown, 281 U.S. 376 (1930).

[15] Redding v. Commissioner, 630 F.2d 1169, 1175 (7th Cir.1980).

[16] Court Holding Co., 324 U.S. at 334; see also IRS TAM 8552009 (Sept. 25, 1985).

[17] Groetzinger v. Commissioner, 87 T.C. 533, 542 (1986); IRS TAM 9803002 (Jan. 16, 1998).

[18] See, e.g., Estate of Juden v. Commissioner, 865 F.2d 960, 962 (8th Cir.1989); Estate of Weinert v. Commissioner, 294 F.2d 750, 755 (5th Cir.1961); Estate of Durkin v. Commissioner, 99 T.C. 561, 574 (1992); Illinois Power Co v. Commissioner, 87 T.C. 1417, 1429-34 (1986).

[19] Id.

[20] Glacier State Elec. Supply Co. v. Commissioner, 80 T.C. 1047, 1058 (1983)

[21] Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974).

[22] Id.

[23] Hoover Co. v. Commissioner, 72 T.C. 206, 248 (1979); Legg v. Commissioner, 57 T.C. 164, 169 (1971), affd. per curiam 496 F.2d 1179 (9th Cir. 1974); Acro Manufacturing Co. v. Commissioner, 39 T.C. 377, 385 (1962), affd. 334 F.2d 40 (6th Cir. 1964).

[24] Manhattan Building Company v. Commissioner, 27 T.C. 1032, 1042 (1957).

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