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In still another instance, an individual donated promissory notes issued by a company he controlled to three charitable foundations several weeks prior to their redemption. A court held that he did not realize income in connection with these gifts or the subsequent redemption of the notes by the company. The court observed: “A gift of appreciated property does not result in income to the donor so long as he gives the property away absolutely and parts with title thereto before the property gives rise to income by way of a sale.”88
In one more instance involving facts of this nature, the court took note of the fact that the concept of a charitable organization originated before and independently of the sale, the deed of trust for the property contributed was executed before and independent of the sale, and at the time the deed of trust was executed, “no mutual understanding or meeting of the minds or contract existed between the parties.”89
There are cases to the contrary, however, holding that the transfer of the property to a charitable organization “served no business purpose other than an attempt at tax avoidance.”90
In the end, perhaps the matter of the doctrine comes down to this: “Useful as the step transaction doctrine may be in the interpretation of equivocal contracts and ambiguous events, it cannot generate events which never took place just so an additional tax liability might be asserted.”91
The step transaction doctrine occasionally appears in IRS private letter rulings as well. In one instance, an individual planned to fund a charitable remainder trust92 with a significant block of stock of a particular corporation. It was anticipated that the trust would sell most, if not all, of this stock in order to diversify its assets. The stock first had to be offered to the corporation under a right of first refusal, which allowed the corporation to redeem the stock for its fair market value. The donor was the sole initial trustee of the trust.
The IRS focused on whether the trust would be legally bound to redeem the stock. Although it did not answer that question, it assumed that to be the case and also assumed that the trust could not be compelled by the corporation to redeem the stock. Thus, the IRS held that the transfer of the stock by the donor to the trust, followed by the redemption, would not be recharacterized for federal income tax purposes as a redemption of the stock by the corporation followed by a contribution of the redemption proceeds to the trust. The IRS also held that the same principles would apply if the stock were sold rather than redeemed. This holding assumed that the donor had not prearranged a sale of the stock before contributing it to the trust under circumstances in which the trust would be obligated to complete the sales transaction.93
In another situation, an individual planned to contribute a musical instrument to a charitable remainder trust. The instrument was used in the donor's profession; the donor was not a dealer in this type of instrument, nor was it depreciated for tax purposes. Again, the issue was presented: If the trust subsequently sold the instrument for a gain, would that gain have to be recognized by the donor? The IRS presumed that there was no prearranged sales contract legally requiring the trust to sell the instrument following the gift. With this presumption, the IRS was able to hold that any later gain on a sale of the instrument would not be taxable to the donor.94
§ 3.8 CHARITABLE PLEDGES
The making of a pledge does not give rise to a federal income tax charitable contribution deduction. The deduction that is occasioned, such as it may be, is determined as of the time the pledge is satisfied.95
The enforceability of a pledge is a matter of state law. Some states require the existence of consideration as a prerequisite to the existence of an enforceable pledge; other states will enforce a pledge on broader, social grounds.
Usually, a pledge is made by a potential donor in the form of a written statement—a promise to the potential charitable donee of one or more contributions in the future. An example of the rule is that a pledge of a stock option to a charitable organization produces an income tax charitable deduction in the year in which the charitable donee, having acquired the option, exercises it.96 Another illustration of this is a funding agreement, under which a person commits in writing to make multiple contributions to a charitable organization over a stated period, for purposes such as general operations or endowment: The charitable contribution arises in each year of actual payment.97
As one court case reflects, however, a charitable pledge can arise in other ways. A trustee of a small college and his colleagues were concerned about the long-term financial viability of the institution. He wanted to substantially augment the college's endowment fund. To that end, he caused a company (of which he was the president) to issue (in 1981) to the college a zero-coupon original-issue discount bond, with a term of 50 years and a $20 million face amount, payable upon maturity in 2031 (unless the bond was retired early). The purchase price of the bond was $23,066 (representing the 1981 present value of $20 million, payable in 50 years, discounted semiannually using a 14 percent annual interest rate). The company was obligated to maintain a sinking fund sufficient to retire the bond at full maturity; it had the option to retire the bond at a discount after July 1986. The president of the company personally arranged for contributions to the school to cover the purchase price of the bond.
The company is on the accrual basis of accounting. The total interest that is to accrue over the term of the bond (the original-issue discount) is $19,976,934. One-fiftieth of the total discount is $399,539. That amount is what the company annually transferred to the sinking fund and deducted as interest accrued on indebtedness.98 The mechanics of this transaction were dynamic. The accrued interest would have been taxable to a commercial taxpayer; the college, however, being tax-exempt, was excused from this tax liability. In 2031, it will receive $20 million for a 1981 outlay of $23,066. The company could have retired the bond as early as August 1, 1986; the retirement payment would have been $45,377, with the company enjoying about $2 million in tax deductions. (Even if the IRS recaptured a tax deficiency attributable to the company's deductions for interest accrued but not paid, the company would have had the use of that money to invest in the meantime.) The IRS asserted, however, and a court agreed, that the transaction lacked a business purpose other than tax avoidance, and disallowed the deductions.99 The court concluded that the bond was a legitimate indebtedness for tax purposes and that the transaction had some economic substance for the company. The court made an evaluation of the company's motive for the transaction and found that it was (other than tax benefits) a means to provide the college with an investment that would substantially enhance its endowment. The court wrote that this motive, “while admirable, is wholly unlike the economically self-interested purpose that taxpayers must demonstrate.”100
Thus, in the absence of any other economic, commercial, or business purpose for the bond transaction, the court found that it lacked the requisite independent business purpose and disregarded the debt form of the transaction for tax purposes. Did the company contribute the $19,976,934 to the college? The answer is no, because
