10. Gifts of Partial Interests, Part 2 of 3

10. Gifts of Partial Interests, Part 2 of 3

Article posted in General on 6 April 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 7 April 2016
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Summary

We continue a thorough examination of gifts of partial interests with details about undivided interests.

VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

10. GIFTS OF PARTIAL INTERESTS, Part 2 of 3

Links to previous sections of book are found at the end of each section.

One of the exceptions to the general rule against deducting gifts of partial interests is that the donor can deduct if he or she gives all or and “undivided portion” of his or her ownership interests.  We will be exploring this exception in the rest of this chapter.  Other notable exceptions to the general rule against deductions for partial interest gifts with retained interests include remainder interests (with retained life estate) in a personal residence or farmland, Charitable Remainder Trusts, Charitable Lead Trusts, Pooled Income Funds, and qualified conservation easements.  These other exceptions will be addressed in other chapters.

Why are partial interest gifts allowed if the donor gives all or an “undivided portion” of his or her interests?  The underlying reason why partial interest gifts do not generally create a deduction is because of the potential for the donor to subsequently increase the value of his retained interests while reducing the value of the charity’s interests.  This type of behavior is not a risk when the donor gives all or an “undivided portion” of his or her interests.

If the donor gives away all of his interests, he has retained nothing which could be increased in value at the expense of the charity’s interests.  For example, if the donor owned only the mineral rights to a piece of land, he could deduct the gift of those mineral rights to a charity.  In contrast, no deduction would be allowed if the donor retained ownership in the surface rights of the land, because the donor would not have given away all of his interests in the property.  Thus, it is not the giving of partial interests to a charity that makes the gift nondeductible.  Rather, it is the simultaneous retention of some interests by the donor that makes the gift nondeductible.

However, the donor may retain rights to the property, if the donor gives an “undivided portion” of ALL of the rights owned by the donor.  In this case, the donor gives a percentage (say, for example, 10%) of all of his rights in the property to the charity.  There is no opportunity for the donor to increase the value of his rights while decreasing the value of the charity’s rights, because the donor and the charity have identical types of rights (although perhaps with a different percentage ownership of those otherwise identical rights).  Because the donor and the charity have identical types of rights, thus eliminating the risk of abuse, the retained interest by the donor will not prevent a charitable deduction.  This difference between divided and undivided shares may be, at first, difficult to conceptualize.  So, let’s look at an analogy that may help to clarify this distinction.

Suppose that a donor owns a walnut tree.  Walnut trees are valuable both for their wood and for the walnuts that they produce each year.  Suppose the donor wants to make a partial interest gift, giving something to the charity and keeping something for himself.  The donor could designate a specific branch and give the charity the rights to collect the walnuts from that specific branch.  This is a divided share gift (i.e., the donor is dividing the tree and giving the charity rights to the walnuts from a specific branch of the tree.) Alternatively, the donor could give a 15% ownership interest in the whole tree to the charity.  This would give the charity the rights to 15% of any walnuts collected, 15% of the price of any wood sold from the tree, and the right to force the sale of the tree.  This would be an “undivided share” gift, because the donor has gifted a share of every type of right he owns in the entire tree.
A “divided share” gift is not deductible.  Divided share gifts provide the opportunity for the donor to subsequently reduce the value of the charity’s share relative to the donor’s share.  For example, the donor might designate that the charity receives all of the walnuts from a particular branch.  But, then at some later time the donor might cut off that branch so that it no longer produced walnuts.  By doing this, the donor could increase production for the rest of the tree (which the donor still owns) by leaving the roots to more strongly support the donor’s remaining portion of the tree.  This opportunity for reducing the value of the charity’s share relative to the donor’s share is essentially the same logic that makes such divided share gifts non-deductible where no special exception applies.
In contrast, an “undivided share” gift is deductible.  When the donor gives a 15% ownership interest in the whole tree, this gives the charity the rights to 15% of any walnuts collected, 15% of the price of any wood sold from the tree, and the right to force the sale of the tree.  There is no way for the donor to increase the value of his retained ownership rights relative to the rights given to the charity.  If the donor cuts off a branch, both the donor (85%) and the charity (15%) own that branch as well as the remaining tree.  Anything that decreases the value of the charity’s interests also decreases the value of the donor’s interest in exact proportion to their ownership percentages.  Because there is no opportunity for abuse, this type of “undivided share” gift does generate a taxable deduction.  Let’s now examine some different examples of gifts to determine if they are divided share gifts (not deductible) or undivided share gifts (deductible).
Suppose a donor gives a West Texas cotton farm to a charity, but keeps for himself all of the mineral rights to that farm.  Is that a gift of an undivided share in all of the rights owned by the donor, or a gift of a divided share giving only specific kinds of rights to the charity?  To use our original analogy, is this gift more similar to giving shared ownership in the whole tree (i.e., all types of rights) or more like giving rights only to specific branches (i.e., giving only specific types of rights, but keeping other types of rights)?
Here, the donor is making a charitable gift of a divided share.  The donor is not sharing all of the different types of rights, but is instead keeping some types of rights entirely for himself.  It may be that, to return to the tree analogy, the donor is giving rights to walnuts from a large majority of the tree branches.  (In other words, the value of what the donor is giving may be worth more than the value of what the donor is keeping.) Nevertheless, this is still not sharing ownership in the entire tree (i.e., the charity is receiving an interest in only some types of rights, but is excluded from other types of rights which the donor is keeping).
Suppose, however, a donor gives a 5% ownership interest, as tenants in common, in a West Texas cotton farm, including all mineral rights.  (The “tenants in common” ownership form differs from the “joint tenants” ownership form in that if one “joint tenant” dies, the remaining “joint tenants” receive the deceased tenant’s ownership share, whereas if one “tenant in common” dies, the other “tenants in common” have no automatic inheritance rights.) Is this a gift of an undivided share in all of the rights owned by the donor, or a gift of a divided share giving only specific kinds of rights to the charity while keeping other types of rights for the donor?

Here, the donor is sharing a portion of all types of rights owned in the property.  Consequently, this is a gift of an undivided share (i.e., it is similar to giving a percentage ownership in the entire “tree”).  Because it is a gift of an undivided share, it is a deductible gift.

Suppose a donor gives a painting to a museum for it to own and hang in its gallery.  However, the donor keeps for himself all of the digital and reproduction rights of the painting.  (The donor plans to sell prints and online images of the painting even after the donation of the painting itself.) Is this a gift of a divided or an undivided share?  In other words, does the charity receive only specific kinds of rights or a share of all rights owned by the donor?
This gift is a gift of a divided share in the property and is therefore not deductible.  The donor is keeping all of certain types of rights for himself.  To return to the tree analogy, there are some “branches of the tree” in which the charity has rights and other “branches of the tree” in which the charity will have no rights.
Now suppose that the donor gives a 1/12 ownership interest in all rights to a painting.  This gift includes the right for the charity to possess the painting for one month out of every year.  It also includes 1/12 of all other ownership rights owned by the donor in the painting.  Is this a gift of a divided share (not deductible) or an undivided share (deductible)?
Because the charity receives a share of all of the rights owned by the donor, this is a gift of an undivided share.  Such gifts of undivided shares are generally deductible.  However, here we have a special rule that applies only to these kinds of fractional shares in tangible personal property.  The reason for this special rule was because of the popularity of these fractional interest undivided share gifts of artwork.  A donor might have a large art collection, which he displays in his home on a rotating basis.  Instead of rotating the artwork into his basement, the donor could rotate the artwork into an art museum by donating a fractional ownership interest.  In this way, the donor’s use of the property does not functionally change, yet, the donor can obtain a substantial charitable tax deduction.  This type of gift clearly meets the general rules for a deductible gift of an undivided share of property.  However, there was some concern about the overuse of this type of charitable deduction, which resulted in some special rules.

In order to deduct the gift of a fractional share in tangible personal property, the donor must be in the process of contributing the entire ownership of the tangible personal property to the charity.  Specifically, all of the donor’s rights must be given to charity within 10 years of the initial deduction for the first fractional share gift.  Additionally, the donor must arrange his estate in such a way that if he dies prior to the end of the 10-year deadline then the charity will receive all remaining rights to the tangible personal property.  Although this example is of artwork, the rule applies to all forms of tangible personal property, such as gifts of a fractional interest in an automobile, an antique, jewelry or other collectible item.

The amount of the deduction will be based upon the lesser of the value of the property during the year of transfer of a fractional interest or the value of the property during any previous year of transfer of a fractional interest.  Thus, if the property increases in value after the initial gift of a fractional interest, the donor will not benefit from this increase in value. Although these rules reduce the attractiveness of gifts of fractional shares in tangible personal property, they do still allow for the deduction under these special circumstances.

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