Philanthropically minded business owners need to plan early if they’re considering charitable donations tied to the sale of a business or appreciated assets — otherwise, they can fall into the assignment of income trap.
A landmark 1930s U.S. Supreme Court case set the foundation for what’s known as the “assignment of income doctrine.”
The principle is simple: “You can’t separate the fruit from the tree,” said Darren Mills, a partner with the law firm of Stern Kilcullen & Rufolo.
That means income or capital gains are generally taxable to the person who earns them, even if the money is later transferred to someone else, including a charity such as the Community Foundation.
The IRS has used this doctrine to argue that certain charitable donations — especially those made shortly before the sale of stock or a business — are taxable events for the donor.
Mills, who serves clients in New Jersey, Florida, and internationally, is an expert in asset protection, tax planning, and wealth transfer. In addition, he’s a Certified Public Accountant in Florida, a Chartered Financial Consultant, and a Chartered Life Underwriter with The American College.
He also serves on the Community Foundation’s Philanthropic Advisory Council.
“It’s about timing,” Mills said. “The farther removed you are from a transaction, the lower your risk is.”
In one court case, the IRS argued that a taxpayer should be taxed on income from a stock sale before donating the proceeds to a donor-advised fund and lost. But in another instance, the taxpayer lost when a transaction had not closed but appeared imminent, or as the court stated, “virtually certain to close.”
That’s why it’s so important for taxpayers and their advisors to assess the risk. Those discussions should be had well before selling the business or entering into a letter of intent.
“This is about risk management,” Mills said. “You don’t want to give the IRS more firepower than they need. Make them climb Mount Everest.”
Business owners often wait too long to consult advisors, he added.
The challenge is that a lot of people don’t call until after they’ve signed a letter of intent — or worse, after they’ve sold the business.
To avoid costly surprises, Mills advises business owners to involve tax professionals early — sometimes even two to three years ahead of a sale — especially if they plan to donate appreciated assets like stock to organizations such as the Community Foundation.
“It’s important to understand the timing so that you don’t have this issue of having the income clawed back to the taxpayer and the taxpayer paying long-term capital gains on it,” he said.
