Basis and Bargain Sales: Income Tax and Other Concerns

Because of the basis apportionment rules, Tom is forced to recognize more gain in the bargain sale to the charity. This result makes sense because the charity is a tax-exempt organization. In most cases, the charity will not owe any income tax on a subsequent sale of the property. Tom recognizes comparatively less gain in the bargain sale to Edwina, but as an individual taxpayer, Edwina likely will realize taxable gain on a subsequent sale of the property. In other words, the government will have “another bite at the apple,” or another chance to tax the gain on the subsequent sale of Blackacre by Edwina, but not by the charity. In this particular case, the government’s combined income and gift tax revenue from the bargain sale to Edwina is less than the tax revenue generated by Tom’s deemed pro rata sale to the charity. Any corresponding income tax deduction as a result of his charitable gift is limited to his pro rata basis in the gifted property.

Since at least 1977, if not before, the Treasury Department itself has criticized the application of the different basis rules for bargain sales to an individual and bargain sales to a charity, suggesting the pro rata allocation of basis in both scenarios as the “logical” choice. The Joint Committee on Taxation also recommended pro rata allocation of basis in both types of transactions. Scholarly commentators, too, have criticized the failure to apportion the transferor’s basis in the case of a part sale/part gift to an individual. The authors are not aware, however, of any recent or pending challenge to the different tax treatment for the two types of transactions.

2. Tax Consequences for the Transferee

To fully understand the income tax consequences of the bargain sale, one must also consider the basis of the acquired property in the hands of the transferee. Generally speaking, modified carryover basis rules apply in the context of bargain sales to individuals. Under the Code and regulations, the transferee’s basis is the greater of the amount paid or the transferor’s basis, plus an increase in basis for any gift tax paid. Using the facts of the previous hypothetical, because the amount Edwina paid is greater than Tom’s basis, Edwina’s basis is $40 million plus some amount attributable to the gift tax paid. Section 1015(d) provides for an adjustment in the transferee’s basis by “the amount of gift tax paid with respect to such gift.” When Tom received $40 million from Edwina for the property worth $60 million, his $20 million gift generated a gift tax of $8 million. At first glance, one might think that Edwina’s basis is $48 million ($40 million + $8 million gift tax). The analysis does not, however, end there.

Section 1015 provides that, with respect to gifts made after December 31, 1976, the increase in basis for gift tax paid is “an amount (not in excess of the amount of tax so paid) which bears the same ratio to the amount of tax so paid as—(i) the net appreciation in value of the gift, bears to (ii) the amount of the gift.” Net appreciation is defined as “the amount by which the fair market value of the gift exceeds the donor’s adjusted basis immediately before the gift.”

In the case of outright gifts (as opposed to bargain sales), the adjustment to basis for gift tax paid is relatively straightforward. For example, instead of the bargain sale to Edwina, assume that Tom had made an outright gift of Blackacre to his son Jerry, with Blackacre having a basis of $10 million and a fair market value of $60 million. The “net appreciation in the gift” would be $50 million: the amount by which $60 million exceeds $10 million. The ratio of net appreciation in the value of the gift ($50 million) to the value of the gift ($60 million), would be five-sixths (5/6), or 83.33%. At a gift tax rate of 40%, the tax on a $60 million gift would be $24 million. Under section 1015, Jerry’s basis would be Tom’s basis ($10 million) increased by $20 million (83.33% x $24 million), for a total basis of $30 million.

In the case of bargain sales, there is an ambiguity about how to calculate the adjustment to basis for gift tax paid. In the case of the part-sale/part-gift transaction between Tom and Edwina, Tom recognizes gain only to the extent that the amount realized ($40 million) exceeds the transferor’s basis ($10 million). Even though Tom is technically selling only part of the property (Edwina is paying $40 million), he must “use” his entire basis ($10 million) in determining his gain. Thus, it would seem that Tom’s basis in the property gifted to Edwina should be zero. If so, then the “net appreciation in the gift” is $20 million: the amount by which the value of the gifted property ($20 million) exceeds his basis in the gift portion ($0). Under the regulations, Edwina’s basis would then be the greater of the amount she paid ($40 million) or Tom’s basis ($10 million), plus any increase in basis authorized by section 1015 for that portion of the gift tax paid ($8 million) that equals the ratio of the net appreciation in the gifted property ($20 million) to the value of the gift ($20 million). In other words, Edwina’s basis would be $48 million. To be clear, this is a practical argument proceeding from the fact that the transferor’s basis has been “used” mathematically in the determination of the transferor’s gain.

It is possible, however, that the Service could take a different approach to determining the transferee’s basis adjustment for the gift tax paid under section 1015. The Service could argue that even though the pro rata allocation of basis is not required for purposes of determining the transferor’s gain as part of a bargain sale to an individual, a pro rata allocation of basis is required for purposes of determining the increase in the donee’s basis. In other words, the Service could argue that the “net appreciation in the gift” is $16.67 million: the amount by which the value of the gifted property ($20 million) exceeds the transferor’s proportional basis in the gift portion (one-third of $10 million, or $3.33 million). Under this approach, Edwina’s basis would be the greater of the amount she paid ($40 million) or Tom’s basis ($10 million), plus an increase in basis authorized by section 1015 for that portion of the gift tax paid ($8 million) that equals the ratio of the net appreciation in the gifted property ($16.67 million) to the value of the gift ($20 million). In that case, the increase under section 1015 in Edwina’s basis for the gift tax paid by Tom would be $6.67 million (83.33% of $8 million). That is the amount which bears the same ratio (83.33%) to the amount of tax so paid ($8 million) as the net appreciation in value of the gift ($16.67 million) bears to the amount of the gift ($20 million). Edwina’s basis in Blackacre would be $46.67 million. This would be consistent with the Service’s approach to charitable bargain sales, but there is no statutory authority for the Service to take this position with respect to noncharitable bargain sales. We do not believe that proportional allocation is the correct result because it is inconsistent with requiring Tom to allocate all of his basis to the sale portion for purposes of calculating his gain. Of course, Treasury regulations are only the Treasury’s interpretation of the meaning of the statute. While regulations are entitled to deference, they are subject to review by the courts.

Practically speaking, whether Edwina has a basis of $48 million or $46.67 million matters tremendously from Edwina’s perspective. After the bargain sale with Tom, if she were to immediately sells Blackacre to a third party for its fair market value of $60 million, Edwina would recognize a short-term capital gain of $12 million (under the correct approach) or $13.33 million (under the approach the Service might take). Assuming a tax rate of 37%, Edwina would owe $4.44 million in income tax and net $55.56 million from the sale to the third party (under the correct approach) or she would owe $4.93 million and net $55.07 million (under the approach the Service might take).

Looking with a bird’s eye perspective at the lifetime transactions taken together, Tom receives $40 million from Edwina for property in which he has a basis of $10 million, and he owes the government $11.1 million in income taxes. If, separate and apart from the bargain sale to Edwina, Tom also contributes $30 million to a charity in the same year, and assuming no caps on his charitable contributions under section 170, then he can reduce his total income tax on both transactions to zero; he would still owe the $8 million in gift tax and have $2 million left.

B. Basis and Death-Time Bargain Sales to Individuals

On their face, the statutes and regulations that apply to lifetime bargain sales may not appear to apply to bargain sales made by an estate after a decedent’s death. Nevertheless, under section 641(b), the taxable income of an estate or trust is computed, in general, in the same manner as that of an individual. For this reason, the rules for lifetime bargain sales should be the same as the rules for death-time bargain sales, with one exception. Instead of determining the transferee’s basis by reference to the greater of the amount paid by the transferee or the transferor’s basis, with an adjustment under section 1015(d) for a certain portion of the gift tax paid, the transferee’s basis should be the fair market value of the property as of the transferor-decedent’s date of death (or as of the alternate valuation date). This is because the assets in the estate receive a stepped-up basis under section 1014. Consequently, just as a taxpayer who intends to make a wholly gratuitous transfer of low-basis property is well-advised to wait to make the transfer at death, if possible, in order to allow the beneficiary to take the property with a stepped-up basis, a taxpayer who intends to make a bargain sale of low-basis property during lifetime will be well-advised, in general, to wait to do so at death, for the same reason.

1. Estate Tax Consequences of Bargain Sales

Consider again Taxpayer Tom, except now he is Testator Tom. These new hypothetical facts contemplate a bargain sale of Blackacre to Edwina pursuant to the terms of Tom’s will. Assume that Tom took no action with respect to Blackacre during his lifetime and that his will directs that Edwina has the right to purchase Blackacre from Tom’s estate for two-thirds of the property’s fair market value at the time of Tom’s death. Blackacre, which Tom purchased for $10 million, is worth $60 million at the time of Tom’s death. Except for Edwina’s right to purchase Blackacre, the rest of Tom’s estate will pass to the American Cancer Society. The estate tax consequences will depend in large part on the tax clause of the will. For simplicity, assume that there are no assets in Tom’s estate other than Blackacre, he has no debts, and his estate incurs no administration expenses.

a. Payment of Taxes Out of Charitable Portion of the Estate. Assume that the will directs that any estate taxes due will be paid from the portion of Tom’s estate passing to the charity (setting the stage for an interrelated estate tax computation). The direction by Tom to his executors to make a bargain sale of Blackacre to Edwina for $40 million means that Tom is deemed to make a (taxable) death-time transfer of $20 million to Edwina. Assuming no available applicable exemptions or credits and an estate tax rate of 40%, Tom’s estate appears at first glance to owe $8 million in estate tax, the same as in the case of a lifetime bargain sale, but in actuality the estate tax will be significantly higher.

The estate tax is “tax inclusive,” meaning that the funds that ultimately are used to pay the estate tax are included in the decedent’s gross estate under section 2031. In other words, the estate tax comes out of the “pot” of assets that is subject to estate taxation. Consider also the fact that because Tom’s will directs that the portion of the estate passing to charity bear the tax on the portion of the estate passing to Edwina, the value of the charitable deduction is less than $40 million (the amount of cash that Edwina paid) and the amount of the estate tax will increase from $8 million (the estate tax on a $20 million gift) to $13.33 million. This calculation assumes that Blackacre is the only asset in Tom’s estate, that Tom’s estate receives $40 million from Edwina, and that the bargain sale to Edwina creates a gift to her of $20 million. The charitable portion of his estate decreases by the amount of tax due on account of the transfer to Edwina.

In this scenario, Tom’s estate receives $40 million in the bargain sale to Edwina. The estate owes $13.33 million in estate tax. There is $26.67 million left over that will pass to the American Cancer Society. The results are shown in Table 2 below.

Table 2: Wealth Transfer Tax Consequences of Death-Time Bargain Sale; Taxes Paid Out of Charitable Portion

b. Payment of Taxes Out of the Noncharitable Portion of the Estate. Assume now that the will directs that any estate taxes due on account of the bequest to Edwina must be paid from the portion of Tom’s estate passing to Edwina. Recall that Blackacre is worth $60 million. The will directs that she has the right to purchase it for $40 million. Thus, Tom is deemed to make a $20 million gift to Edwina. Assuming no available applicable exemptions or credits and an estate tax rate of 40%, Tom’s estate owes $8 million in estate tax. That tax must be paid out of portion of the estate passing to Edwina (Blackacre). If Edwina herself is unable (or chooses not) to pay the tax in order to take Blackacre in kind, the executors will sell Blackacre to pay the tax. Edwina would be entitled to the net proceeds of sale ($60 million) minus the estate tax owned ($8 million), or $52 million. The $40 million paid by Edwina to the estate passes to charity, giving rise to a $40 million estate tax charitable deduction. The results are shown in Table 3 below.

Table 3: Wealth Transfer Tax Consequences of Death-Time Bargain Sale; Taxes Paid Out of Noncharitable Portion

2. Basis of the Property in the Hands of the Transferee

But what of Edwina’s basis? Regulation section 1.1015-4 provides that in the case of a part sale/part gift, the transferee’s unadjusted basis is the greater of (1) the amount paid by the transferee for the property or (2) the transferor’s adjusted basis of the property at the time of the transfer plus the amount of any increase in basis under section 1015(d) “for any gift tax paid.” As previously described, the transferor’s basis is not allocated in a noncharitable bargain sale between the sale portion and the gift portion. And in any event, section 1014 provides that the basis of property acquired from a decedent or “to whom the property passed from a decedent” is the property’s fair market value as of the date of the decedent’s death (or the alternate valuation date). Under these facts, Edwina acquires Blackacre in a bargain sale from Tom’s estate. Depending on the tax clause of Tom’s will, the charitable bequest may or may not bear the associated estate tax liability.

If any estate taxes due are paid from the portion of Tom’s estate passing to the charity, then the government collects $13.33 in estate tax. If Edwina immediately sells the property to a third-party purchaser for its fair market value of $60 million, she has no gain and no loss. The government’s combined revenue on the bargain sale by the estate to Edwina and Edwina’s subsequent sale is $13.33 million. In contrast, if estate taxes are paid from the portion of Tom’s estate passing to Edwina, the government collects $8 million in tax. If Edwina were to sell Blackacre for its fair market value of $60 million, she again would have no gain and no loss. If taxes are the family’s primary concern, it is “cheaper” to have the taxes paid from the portion of the estate passing to Edwina.

C. Overall Tax Consequences of Lifetime Bargain Sales Compared to Death-Time Bargain Sales

Compared to the lifetime bargain sale, the part sale/part gift by the estate may be more tax-effective from the family’s perspective, as long as the taxes are paid out of the noncharitable portion of the estate. Table 4 provides a summary of the economic consequences of the two transactions.

Table 4: Income and Wealth Transfer Tax Consequences of a Lifetime and Death-Time Bargain Sale

^{* Note that this figure does not include any subsequent estate tax that may be owed by Tom’s estate if he were to die without consuming the $2 million he retained after the lifetime bargain sale to Edwina. If he were to transfer that amount entirely to charity at death, it should not result in any estate tax liability. See I.R.C. §§ 2031, 2055.}

1. The Charity’s Position

Consider which scenario leads to more money passing to the charity. If, during the year of the lifetime bargain sale to Edwina, Tom gives to the charity only as much as he needs in order to eliminate his gain on the sale of Blackacre, the charity will receive $30 million. Tom might spend, give away or otherwise use the remaining $2 million (after payment of the $8 million gift tax) for any purpose Tom wishes. But if Tom were to die in the same year that he makes the lifetime bargain sale to Edwina, without having consumed any of the funds he retained, and he leaves his entire estate to charity, then the charity would end up with an additional $2 million, for a total of $32 million. In either case, the charity receives more from a bargain sale made during Tom’s lifetime than at his death.

If Blackacre were the only asset in his estate and Tom directs a sale to Edwina for $40 million with the taxes paid out of the charitable portion of the estate, the American Cancer Society would receive $26.67 million after paying the estate tax attributable to the gift to Edwina.

2. The Family’s and Government’s Positions

Looking at the tax consequences of Edwina’s acquisition and subsequent sale of the property, the transactions together may yield more overall tax in the death-time bargain sale scenario than in the case of a lifetime bargain sale. In the lifetime bargain sale, Edwina acquires a basis of $48 million in the property, and her subsequent sale for $60 million triggers gain of $12 million, presumably taxed at a 37% rate, for an income tax liability of $4.44 million. Because Tom paid a gift tax of $8 million, the family’s total tax liability is $12.44 million. In contrast, in the case of a bargain sale at Tom’s death, Edwina acquires a basis of $60 million in the property, and her subsequent sale results in no gain to her and no income tax liability. The estate pays $13.33 million in estate taxes, if attributable to the charitable bequest, and that is the total tax revenue from the two death-time transfers.

IV. Planning Considerations

A. Simple Estate Planning

Calculating the tax consequences of a bargain sale during lifetime or at death is relatively straightforward, except for the lack of clarity under section 1015 concerning the calculation of the increase in the transferee’s basis attributable to the gift tax paid. In a lifetime bargain sale to an individual, the transferor’s entire basis in the property is taken into account for purposes of calculating gain under section 1011(a) and Regulation section 1.1001-1(e). Thus, the transferor “uses” all of his basis in determining gain, and when calculating the increase in the donee’s basis on account of the gift tax paid, it is appropriate to increase the basis by the entire amount of the gift tax paid.

Once the lifetime transferee’s basis is determined, one can readily compare the tax consequences of the bargain sale during lifetime and at death. If all factors are held constant, the death-time bargain sale (such as in Table 3) results in more overall financial benefit for the family, but less tax revenue for the government, as long as the tax clause in the will directs the payment of estate tax from the noncharitable portion of the estate. A charity might benefit more from a lifetime bargain sale followed by a cash gift, but such a result depends on a variety of (possibly) unrealistic assumptions, such as Tom having enough money to make a charitable transfer of $30 million. To be sure, life is never as simple as a hypothetical. One cannot predict whether any transferor’s charitable interests remain constant, what her consumption patterns may be, or the future time of death (unless death is imminent). Health emergencies, a reversal of business fortunes, or divorce have changed many people’s financial portfolios.

Bargain sales, especially to family members, may only make financial sense when the intended beneficiary has sufficient funds to purchase the intended asset or assets and when the family’s charitable interests are generally aligned across generations. For a family of more modest means, if the senior-generation family member wants to make certain that her beneficiaries will receive property either during lifetime or at death, an outright gift or bequest (which may or may not trigger a wealth transfer tax, depending on the availability of exemptions and credits) will be more practical. Also, if a senior-generation family member has a testamentary charitable beneficiary that the intended family beneficiary does not support for whatever reason, even if the intended family beneficiary has the financial means to purchase the particular property, the family member may choose to forgo the estate property with sentimental or practical value. This might give the beneficiary a fragile sense that she has not actively supported an organization that is subjectively undesirable for whatever reason, but the failure to exercise the option to purchase means the property will pass to the charity anyway.

B. Complex Estate Planning

This brief Article has addressed the scenario involving a testator who wishes to confer some postmortem benefit on a family member, but also wishes to leave the remainder of his estate to charity. There are a myriad of other situations in which bargain sales might be appropriate.

Lifetime part-sale/part-gift transactions are effective ways for a taxpayer to transfer an appreciating asset out of her estate, shifting the future asset appreciation to a younger-generation family member, with the transferor receiving some financial benefit at the time of the transfer. If that asset is income-producing, a bargain sale may be a way for the taxpayer to effectively shift some income to a family member who is in a lower income tax bracket as well. If the asset is highly depreciable, a bargain sale may be a way for the taxpayer to effectively shift the deduction to a family member in whose hands the deduction is “worth” more (if the transferee is in a higher tax bracket). A taxpayer who no longer has substantial income may wish to convert a non-income-producing asset into a more liquid form.

Death-time part-sale/part-gift transactions may be helpful beyond the specific scenario contemplated in this Article, in which the testator intends to benefit primarily the charity but wishes his family members to be able to obtain property of sentimental or practical value (and the family members have sufficient assets to buy that property). In any estate, including one with mostly (or entirely) noncharitable beneficiaries, a bargain sale increases estate liquidity, minimizing the likelihood that the executor may be forced to sell valuable property to satisfy pecuniary legacies or pay tax liabilities. But an executor who intends the estate to qualify for the extended time to pay any estate tax under section 6166, for example, will want to take care that any bargain sale does not have the effect of removing from the estate property of the type (or the amount) that would make the otherwise eligible estate ineligible for this treatment. With careful planning, the bargain sale can achieve the desired tax results.

V. Policy Considerations

Basis is fundamental to all of tax law, but it is generally underappreciated as a stand-alone “asset” for estate planning purposes. Given the increases in the wealth transfer tax exemption, income tax basis should not be ignored. It presents many opportunities for tax planning (and savings), especially in the context of donative transfers. Query whether there is any policy reason for treating transactions differently, depending on the identity of the donee-purchaser (e.g., an individual or a charity). The most obvious rationale is that because charities are, for the most part, tax-exempt organizations, the regulations are written in a way that forces greater gain recognition, if any, on the initial transfer by the donor-seller to the donee-purchaser. Otherwise, when the charity later sells the same property, regardless of whether the fair market value of the property has increased, decreased, or remained the same, the government will collect the same amount of revenue: none. In contrast, in the case of a part sale/part gift to an individual, the same economic imperative to tax the initial transaction does not exist. Regardless of the price at which the property is sold by the donee-purchaser, the donee is subject to income tax, and all of the gain (or loss) on the transaction will be captured by the tax system, albeit at a later point in time than if the rules for bargain sales to a charity applied. Nevertheless, the individual donee-purchaser may be in a lower income tax bracket than the donor-seller, so there may be some revenue loss to the government.

In short, the government “loses” by continuing to maintain two sets of rules for bargain sales, based on the identity of the purchaser. A single rule for all such transactions would be more logical, likely increase government revenue (albeit modestly), and eliminate the need for individual donee-purchasers to track the carryover basis of the donor-seller. It should be possible for the Treasury to implement such a rule by revising the regulations.

VI. Conclusion

The bargain sale transaction exists because the human impulse to give is often tempered by a desire to reap some financial reward. There is no reason, though, to have two sets of rules based on whether the transferee is an individual or a charitable organization. Adopting unitary rules is clearer and serves the purposes of tax administration. In the meantime, income tax basis remains a ripe area for estate planning.