The owners of closely-held businesses are among the greatest benefactors of charitable organizations in this country. Although their contributions to charity are usually effectuated through the transfer of cash or marketable securities, it is often the case that the only asset available to satisfy an owner’s charitable inclinations is his or her interest in the closely-held business that the owner founded and/or operated.

Of course, the owner, or the owner’s estate (in the case of a testamentary transfer) will realize a tax benefit by virtue of making a charitable transfer, provided the transfer is completed in accordance with various statutory and regulatory requirements. Thus, where the interest in the closely held business is included in the owner’s gross estate, the bequest of such interest to a qualifying organization will generate a charitable contribution deduction for purposes of determining the owner’s estate tax.

Most charitable organizations, however, have no interest in owning equity in a closely-held business because it is not easily convertible into cash, at least not without some advance planning. Thus, many donors “arrange” for the purchase of such equity from the organization.

This strategy presents many challenges and risks, as illustrated in a recent decision.

Mom’s Testamentary Plan

Decedent and some family members owned DPI, a closely-held real property management corporation that managed a combination of commercial and residential rental properties.

DPI was a C corporation. Decedent owned 81%, and Son E owned 19%, of DPI’s voting shares. Decedent also owned 84% of DPI’s nonvoting shares, and her Sons  owned the remaining 16%.

Decedent and her Sons were officers and directors of DPI at the time of Decedent’s death.

During her life, Decedent had created an irrevocable life insurance trust that distributed the insurance proceeds to her children upon her death, and had established Trust and Foundation. Son E was the sole trustee of Trust and Foundation.

Decedent’s will left her entire estate to Trust. Under the terms of Trust, some cash passed to various charitable organizations. The remainder of Decedent’s estate, consisting primarily of DPI stock, was to pass to Foundation.

The Estate Tax Appraisal

The Estate obtained an appraisal to determine the date-of-death fair market value (FMV) of Decedent’s DPI shares. The appraisal explained that it would be used for estate administration purposes.

The appraisal valued the voting stock at $1,824 per share with no discount because the voting shares represented a controlling interest. It valued the nonvoting stock at $1,733 per share, which included a 5% discount to reflect the lack of voting power.

On its estate tax return, the Estate reported no estate tax liability, claiming a charitable contribution deduction for the date-of-death value of Decedent’s DPI shares.

Post-Death Events

Numerous events occurred after Decedent’s death, but before Decedent’s bequeathed property was transferred to Foundation.

S Corp. Election

Seven months after her death, DPI elected S corporation status in order to accomplish long-term corporate tax planning; specifically, the corporation’s board wanted DPI to avoid the built-in gains tax on corporate assets. The board also wanted Foundation, as an owner of shares in an S corporation, to avoid being subject to the unrelated business income tax (“UBIT”).


In addition, DPI’s board realized that, pursuant to the Code, Foundation would be required to make annual minimum distributions of at least 5% of the value of its assets. Son E, as trustee of Foundation, was concerned that merely owning Decedent’s bequeathed DPI shares would not provide Foundation sufficient cash-flow necessary to make the requisite annual distribution.  Son E was also concerned that Foundation could be subject to excise tax on the value of any “excess business holdings” in DPI held by Foundation.

As a result, DPI agreed to redeem all of Decedent’s bequeathed voting shares, and approximately 72% of  her bequeathed nonvoting shares, from Trust in exchange for cash and promissory notes.

Son E then obtained local court approval for the redemption, to confirm that the redemption would not be a violation of the “self-dealing” rules.

At the same time as the redemption, pursuant to subscription agreements, Decedent’s Sons purchased additional shares in DPI in order to infuse the corporation with cash to assist in paying off the promissory notes DPI gave the Trust as a result of the redemption transaction.

An appraisal of Decedent’s DPI stock for purposes of the redemption and subscription agreements determined that her DPI voting shares had a FMV of $916 per share, and the nonvoting shares of $870 per share. The appraisal of the voting stock included discounts of 15% for lack of control and 35% for lack of marketability. The appraisal of the nonvoting stock included the lack of control and marketability discounts plus an additional 5% discount for the lack of voting power.

The IRS Challenge

The IRS disputed the amount of the Estate’s charitable contribution, arguing that the amount of the charitable contribution should be determined by the post-death events. The Estate argued that the charitable contribution should not be measured by the value of the property received by Foundation.

Because the IRS found that the value of Estate’s charitable contribution was lower than reported on its Estate Tax Return, the IRS also determined that additional estate tax was due. The Estate challenged the asserted deficiency in the Tax Court.

The Court considered whether the Estate was entitled to a charitable contribution deduction equal to the date-of-death FMV of DPI stock bequeathed to Foundation.

The Estate’s lawyer, who also served as DPI’s and Foundation’s lawyer, hired an appraisal firm to appraise the DPI stock. The appraisal specified that it provided a valuation of a minority interest in DPI as of the date of the redemption agreement. His understanding was that the appraisal would be used as support for the redemption. The appraisal treated DPI as a C corporation. The appraisal valued the DPI shares at $916 per voting share and at $870 per nonvoting share, reflecting discounts for lack of control and lack of marketability.

The date-of-death valuation had not included these discounts.

Foundation Tax Return

On its Form 990-PF, Foundation reported that it had received the following contributions from Trust:

  • Approximately 28% of Decedent’s nonvoting DPI shares;
  • A long-term note receivable; and
  • A short-term note receivable (the notes having been received by the Trust from DPI in the redemption transaction).

Trust Tax Return

On its Form 1041 for the taxable year of the redemption, Trust reported a capital loss for the sale of its shares of DPI voting stock, and a capital loss for the sale of its shares of DPI nonvoting stock (the redemption appraisal having been lower than the date-of-death appraisal from which the Trust’s adjusted basis for the shares was derived).

The Court’s Analysis

In general, the value of a decedent’s gross estate includes the FMV of all property that she owned, or in which she had an interest, at the time of her death. The value of stocks is the FMV per share at that time. “Fair market value” is defined as the price that a willing buyer would pay a willing seller, both persons having reasonable knowledge of all the relevant facts and neither person being under compulsion to buy or sell. The “willing buyer” and “willing seller” are hypothetical persons, rather than specific individuals or entities, and all relevant facts and elements of value as of the valuation date must be considered.

Charitable Deduction

In calculating a decedent’s taxable estate, a charitable deduction is generally allowed for bequests made to charities. The deduction from the gross estate generally is allowed for the value of property included in the decedent’s gross estate and transferred by the decedent at her death to a qualified, charitable organization. In general, the courts have held that the amount of the charitable contribution deduction is based on the amount that passes to the charity.

In the case at hand, the Estate contended that the applicable valuation date for determining the value of the charitable contribution was the date of death.

The Estate also argued that the charitable contribution deduction should not depend upon or be measured by the value received by Foundation. The Estate contended that consideration of post-death events that may alter the valuation of property would not truly reflect the FMV of Decedent’s assets. The Estate further contended that there was neither a plan of redemption nor any other precondition or contingency affecting the value of Decedent’s charitable bequest.

The IRS argued that the value of the charitable contribution should be determined by post-death events. It argued that the Sons thwarted Decedent’s intent to bequeath all of her majority interest in DPI or the equivalent value of the stock to Foundation, contending that the manner in which the two appraisals were solicited, as well as the redemption of Decedent’s controlling interest at a minority interest discount, indicated that the Sons never intended to effect Decedent’s testamentary plan.

The Valuations

The Court acknowledged that, normally, the date-of-death value determines the amount of the charitable contribution deduction, which is based on the value of property transferred to the charitable organization. There are circumstances, however, where the appropriate amount of a charitable contribution deduction does not equal the contributed property’s date-of-death value.

The Court noted that numerous events occurred after Decedent’s death, but before Decedent’s property was transferred to Foundation, that changed the nature and reduced the value of Decedent’s charitable contribution. DPI elected S corporation status. On the same date, DPI agreed to redeem all of Decedent’s voting shares and most of her nonvoting shares from the Trust, in exchange for promissory notes from DPI. Additionally, using the appraisal for the date of the redemption agreement, the Sons signed subscription agreements purchasing additional shares in DPI for $916 per voting share and $870 per nonvoting share.

The Estate contended that the foregoing subsequent events occurred for business purposes and should not affect the amount of Decedent’s charitable contribution.

The subsequent events did appear to have been done for valid business purposes. DPI elected S corporation status in order to avoid the section 1374 built-in gains tax on corporate assets. Additionally, DPI believed that the redemption would allow it to freeze the value of its shares (that would pass to Foundation) into a promissory note, which would mitigate the risk of a decline in stock value. The redemption also made Foundation a preferred creditor of DPI so that, for purposes of cash-flow, it had a priority position over DPI’s shareholders. The Sons purchased additional shares in DPI in order to infuse the corporation with cash to pay off the promissory notes that DPI gave the Trust as a result of the redemption.

The same firm that had completed the date of death appraisal was hired to perform an appraisal of Decedent’s bequeathed shares for purposes of the redemption. This appraisal included a 15% discount for lack of control and a 35% discount for lack of marketability, plus an additional 5% discount for the lack of voting power in the case of the nonvoting stock. The appraisal did not explain why these discounts were included.

Decedent’s bequeathed majority interest in DPI therefore was appraised at a significantly higher value only seven months before the redemption transactions without explanation.

Even though there were valid business reasons for the redemption and subscription transactions, the record did not support a substantial decline in DPI’s per share value. The reported decline in per share value was primarily due to the specific instruction to value Decedent’s interest as a minority interest with a significant discount.

Given that intra-family transactions in a close corporation receive a heightened level of scrutiny, Sons’ roles (especially Son E’s) needed to be examined, the Court said. Son E, as executor of the Estate and President, director, and a shareholder of DPI, instructed DPI’s attorney to inform the appraiser that Decedent’s bequeathed shares should be valued as a minority interest. He was also sole trustee of Trust and of Foundation. Decedent’s majority interest, therefore, was redeemed for a fraction of its value without any independent and outside accountability. The Sons thereby altered Decedent’s testamentary plan by reducing the value of the assets eventually transferred to Foundation without significant restraints.

Accordingly, the Tax Court held that the Estate was not entitled to the full amount of its claimed charitable contribution deduction.

Still A Good Idea

Notwithstanding the Court’s decision, the Decedent and her Sons had the right idea. The family was charitably inclined, and Foundation provided an effective vehicle through which to engage in charitable giving.

The bequest to Foundation would have enabled the Estate to escape estate tax if the Sons had not gotten greedy by “depressing” the value of the DPI shares.

The redemption would have removed the Foundation from the reach of the UBIT and some of the excise taxes (mentioned above) that apply to private foundations.

Importantly, the redemption would have removed from Foundation, and shifted to the Sons, the future appreciation in the value of decedent’s DPI shares.

Finally, if the Foundation and DPI were ever controlled by different persons in the future, the redemption would have removed the potential for shareholder disputes.