Archive for February, 2014

The Gladstone property today.  Current description:  Large 3 story apartment building with huge upside potential. Most apartments just need updating. Management already in place. Seller will to sacrifice at $145,000

The Gladstone property today. Current description: Large 3 story apartment building with huge upside potential. Most apartments just need updating. Management already in place. Seller will to sacrifice at $145,000

Back in May 2012, a Tax Court memorandum case was decided that reminded us in no uncertain terms that form over substance often prevails in the tax world.  On January 27th, the Tax Court issued another memorandum decision that shows that form AND substance are critical.  Alli v. Commissioner, TC Memo 2014-15, is an example of the old bromide that bulls and bears can make money while pigs generally get slaughtered.Here’s the backstory:  Dr. Ben Alli acquired some rough and tumble “HUD Section 8” real estate in Detroit back in 1983 for a total of $353,000.  In 1988, the two properties were transferred to BSA Corp., an S-corp. in which Dr. Alli was eventually the sole shareholder.  As part of the HUD program, Dr. Alli agreed to keep the properties in a safe, decent and sanitary condition.  I guess that wording was overly subjective because there were… issues… between Alli and HUD throughout the 1990’s, causing HUD, in 1999, to classify the properties as “troubled.”  (Small things like – severe water damage, sink and shower units separating from the walls, actively leaking plumbing, damage or inoperable appliances, doors and lighting and, surprise, surprise, roach infestation.)  In 1999, for HUD purposes, Dr. Alli hired an appraiser to conduct a market rent survey of the properties.  In 2008, the legal wranglings between Alli and HUD finally came to a head and I guess Alli decided it was time to exit the slumlord business.  On April 24, 2008, Dr. Alli had another appraiser “update” the 1999 report; this appraisal concluded that the fair market value of the two properties was $1,562,500.  On September 29, 2008, Alli donated one of the properties, Gladstone, to the Volunteers of America (VOA) and claimed a healthy deduction of $499,000.  VOA acknowledged the donation as of October 23th but, apparently, it had no desire to enter the slumlord business because it immediately sold the building for the first and only offer received of $60,000.  IRS balked at both Alli’s deduction and the amount.  Bottom Line:  Tax Court agreed with the IRS.

How did Dr. Alli screw up?  Let me count the ways…

  1. Ownership:  Although Dr. Alli claimed the charitable deduction, the apartment building was owned in the corporate name of BSA.  The good news here is, since the corporation was an S-corporation and Dr. Alli was the sole shareholder, the Tax Court looked through the deficiency and gave him the benefit of the doubt.  That, however, was the last of their benevolence.
  2. Appraisal Deficiencies:  Dr. Alli used an almost 10 year old “appraisal,” updated 5 months before the contribution, to value the property.  The law says that you have to use a qualified appraisal, completed within 60 days of the date of contribution.  The appraisals fell short in many other ways as well.   They were not completed for income tax purposes, they valued the property at the estimated value “after renovations,” the appraisers omitted their qualifications from the report, etc., etc.  In other words, Dr. Alli used deficient appraisals that were well past their tax expiration dates.
  3. Substantial Compliance:  Dr. Alli lied, point blank, on Form 8283.  (Lying is a “no-no,” but you know that, right?)  The basis of the property was listed as $1,200,000; in reality it was $353,000 (or less, given that only one of the two properties was donated).  The condition of the property was listed as “good”, which is generally an inadequate description; here, it was flat out wrong, unless you consider, among other things, broken elevators, leaky roofs, “heaved up” floors, missing kitchens and even a burnt out apartment unit as indicia of “good condition.”

So, what is the takeaway here?  Be realistic in your approach to all noncash contributions.  Follow the letter of the law in documenting such contributions.  Make sure your deduction is claimed at the proper entity level (don’t just skip the entity level filing;  if your S-corp or LLC owns the property, claim the deduction at that level and then pass it out to the shareholders or members).  Don’t scrimp on the qualified appraisal – good appraisers are worth their weight in gold in constructing bulletproof valuations.

I won’t even begin to comment on the irony of a medical doctor with a master’s degree in public health operating as a slumlord…

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Philanthropy.  We, optimists, see it as a way to try to fix a broken world but somehow, no matter what we do, the world just stays broken!  But, then again, even assuming that we, as a society, can actually agree on which social ills need fixing… is philanthropy the way to do it?  Many people would argue that society’s ills are just too great for philanthropists to tackle without massive governmental assistance.  Others would argue that government creates more drag on the social system than the ills it cures.  So, what is the answer?

Perhaps it lies at the intersection of philanthropy and capitalism. Marketing and strategy

In 2010, an innovative financial instrument tied to the achievement of social goals made its appearance in Great Britain.  Called a “social impact bond” (SIB) the concept combined private investment with a specific government-sponsored project designed to achieve a certain social goal.   If, according to predetermined metrics, the goal was achieved, the investors would get some or all of their money back along with a rate of return.  If the goal was not achieved, the investors would lose their money.  Any repayment of the debt would come from the savings in costs enjoyed by the sponsoring governmental unit.

Such bonds are in the truly embryonic stage here in the United States and given their complexity and risk profile, may have a hard time gaining traction as real investments.  At this point, Massachusetts and New York lead the nation in their development but, even there, the concept is experimental and little more than a dip of the toe in the water.  Nevertheless, if some of these projects can be even partially successful, the way could be paved for the development of a new form of social investing.

Now, of course, such funding is not philanthropy, since a positive rate of return is expected and desired.  Instead, SIBs are profit-driven investments whose success is based on the attainment of socially desirable goals.  For those of us who believe in the financial market, it is the possibility of this rate of return that makes the very idea of SIB’s a potentially viable alternative to plain, old fashioned “tax and spend” government social programs.  Let’s use New York City’s Social Impact Bond, the first operational SIB in the US, as an example.  Its goal was to fund a program called the Adolescent Behavioral Learning Experience (ABLE) at the city jail at Rikers Island.  ABLE aims to equip incarcerated adolescents between the ages of 16 to 18 with the social and emotional skills needed to help them make better life choices when they leave jail.  The theory is, the ability to make better life choices will lead to reduced recidivism, which will lead to reduced financial and other costs to the City.  To be sure, I would call this a true “BHAG” (Big, Hairy, Audacious Goal) but certainly one worth pursuing at some cost.  In a nutshell, here’s how it works:

  • In this case, the commercial lender/investor is the Urban Investment Group of Goldman Sachs Bank USA.  Their investment of $9,600,000 was turned over for administration to the intermediary, MDRC, a nonprofit social policy research organization. MDRC worked with the various partners to identify the project and negotiate the terms of the SIB.  In addition, it currently oversees the day-to-day implementation of the program.
  • Bloomberg Philanthropies is the philanthropic investor, which has provided a grant of $7,200,000 to partially repay Goldman Sachs if the project fails.  If the project is successful, the money will be rolled forward and used to backstop future projects.
  • The Osborne Association and Friends of Island Academy actually administer the ABLE program at the jail.  They are the boots on the ground, so to speak. 
  • The New York City Department of Corrections has agreed to repay the loan based on the inmate participation rate and the resulting rate of reduced recidivism (as defined). 
  • To keep everyone honest, the Vera Institute of Justice serves as the independent evaluator who will determine whether the project has achieved the desired goals. 

The project was started in 2012 with a five year window.  Several things have to happen in order for Goldman Sachs to be repaid:

  • Over the first four years, there must be a minimum of 9,420 participants in the program
  • If recidivism does not decline by at least 8.5%, there will be no payback
  • Reductions in recidivism between 8.5% and 10% will cause one half of the investment to be repaid
  • A 10% reduction will be the investor’s “breakeven”, with the full $9,600,000 being repaid, but with no additional rate of return
  • Above 10% will cause “success payments” to be made, which essentially represent the rate of return on the investment

Interestingly, even with a 10% reduction in recidivism, the cash savings to the taxpayer are estimated to be less than $1,000,000.  On a purely financial basis, this does not make sense.  In fact, the financial investment breakeven from NYC’s viewpoint occurs with a recidivism reduction of around 15%.  While the hardheaded financial analysts among us might find this “new math” a bit hard to swallow, one must realize that a successful social program will produce many other, not-so-easily-quantifiable benefits, such as safer neighborhoods and a more productive workforce.  Certainly an argument can be made that these goals are just as important as the hard dollar cost savings enjoyed by Rikers Island.  At this point, however, the jury is out on its overall effectiveness.

What struck me in a negative way about this project was the sheer audacity of the goal compared to the extraordinarily meager investment.  I mean, c’mon – $9.6 million from Goldman Sachs?  It’s barely a rounding error on their balance sheet, so where is the real risk?  Nevertheless, I am rooting for its success.  The fact is, as a society we need to employ out-of-the-box thinking to more seriously address such social issues, which is pretty difficult in these resource-constrained times.  Investing a few bucks to reduce recidivism?  Let’s give it a shot – it’s gotta beat banning large sugary sodas at the bodega!

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Last week, I had the privilege of participating in the Fourth Annual Family Office Conference sponsored by the New York State Society of CPA’s (NYSSCPA).  While the entire concept of a family office is, at best, amorphous, I think it is safe to say that the one common bond they all share is money – and money in all its forms.  Money means investment, which implies tax, which impacts spending, which necessitates tracking and budgeting, which causes family feuds, which arise from sinister motives, which then inspire more pure motives which, of course, leads to philanthropy. (You knew we would get there sooner or later!) So it was fitting at the conference for us to consider some aspect of philanthropy during lunchtime as we munched on our catered sandwiches and salads.  We chose to frame the discussion by first viewing a TED talk posted last March:  Dan Pallotta’s “The Way We Think About Charity Is Dead Wrong.”  I was very excited when we chose this foundational video because I had actually blogged about it back in March.  It was both interesting and provocative and I encourage you to watch it if you can.  Back then I blogged about not confusing frugality with morality.  While still a good topic, I want to focus today on something else Dan said but didn’t really catch my ear at that time:

Businessweek did a survey, looked at the compensation packages for MBAs 10 years out of business school, and the median compensation for a Stanford MBA, with bonus, at the age of 38, was $400,000.  Meanwhile, for the same year, the average salary for the CEO of a $5 million+ medical charity in the U.S. was $232,000 and for a hunger charity, $84,000.  Now, there’s no way you’re going to get a lot of people with $400,000 talent to make a $316,000 sacrifice every year to become the CEO of a hunger charity.

Some people say, “Well, that’s just because those MBA types are greedy.”  Not necessarily.  They might be smart.  It’s cheaper for that person to donate $100,000 every year to the hunger charity, save $50,000 on their taxes, so still be roughly $270,000 a year ahead of the game, now be called a philanthropist because they donated $100,000 to charity, probably sit on the board of the hunger charity, indeed, probably supervise the poor SOB who decided to become the CEO of the hunger charity, and have a lifetime of this kind of power and influence and popular praise still ahead of them. 

Whoa!  Tough stuff!  Those greedy MBA’s!  All kidding aside, this observation does makes you think, but not about the money per se. It makes you think about values, philanthropic and otherwise.

I think it is safe to say that none of us should presume to have answers about values for anyone other than, perhaps, ourselves.  Is earning a high salary at (some would say) a socially questionable job right or wrong?  Then again, who is to say that a particular job is socially questionable?  Is making substantial contributions to charity a “good thing” or is it “penance” for working in that socially questionable job?  Take, as an example, John D. Rockefeller who, in his day, was one of the most vilified of the robber barron set, but also a most accomplished philanthropist.  (University of Chicago, Rockefeller University, and the Rockefeller Foundation, among others).   Did Rockefeller’s philanthropic accomplishments arise from noble intentions or did they represent more of a justification of the rough and tumble way he earned his money?

IMHO – I applaud the Rockefeller philanthropic results but am troubled by the source of the funds.  But frankly, that is neither here nor there.  In reality, this is not one but two questions, the answers to which have, or should have, nothing to do with each other.  Whether one’s vocation is good, honorable, honest, and socially desirable is the first question.  Barring illegal activity, this decision is determinable only by the individual in question based on a whole host of personal considerations.  The second question regarding philanthropy is also quite opaque – we might agree with the statement that “philanthropy is good” but really, how do we define philanthropy?  I have argued repeatedly that the “marketplace of philanthropic impulses” will drive charitable capital into areas that the market deems worthy but that such results are neither “good” nor “bad” – they just “are”.  That being the case, we know that a lot of money ends up in religious organizations.  Good? Bad?  Whom do these organizations really help – and how?  What about cultural institutions like the symphony or opera?  Is it worthwhile to support them when millions of people the world over are starving?  What about higher education?  Personally, I argue for the support of public higher education, but does that mean that the rich Ivy League universities are not worthy?  The list goes on and on.

Bottom line – this is a question of values – your values – how you make your money, how you spend it, and yes, the institution and causes you choose to support.  The imperative from my vantage point is that all of us should constantly reflect on our own values, let them thoughtfully evolve as we challenge our personal ways of thinking, and promote those causes we believe in by putting our money where our mouths are.

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Last week, we discussed the implementation of philanthropic giving plans and the fact that the rote application of conventional wisdom is not always wise.  Today, I would like to discuss another “real world” event where the outcome was a bit surprising.

We have a client who is a senior level executive in a firm that is a publicly traded limited liability company (LLC).  Over time, he has accumulated a large number of LLC units as part of his compensation package as well as through open market purchases.  Because of this, a good deal of his net worth is wrapped up in this one concentrated, highly appreciated investment.

Except for the fact that the security in question is denominated in LLC units rather than shares of common stock, this is not an unusual situation.  In the normal case, the executive finds him/herself on the horns of a dilemma, with a diversification problem involving both his/her investments and career path.[1]  Diversification is generally called for, but there are numerous issues to consider, especially political (how will the markets react to a senior executive dumping stock) and legal (the timing of any divestment plan).  Sell too much and there is the distinct possibility of adversely moving the market.  And, more close to home, the capital gain tax on the realized appreciation is not insubstantial[2].  A possible, partial solution to this dilemma, if the executive is so inclined, is to use highly appreciated securities to fund deductible charitable contributions.

The general rule for individuals is that contributions of long term, appreciated securities to public charities are valued at the average fair market value of the securities on the date of contribution, limited in total to 30% of the taxpayer’s adjusted gross income (AGI).  This is the case whether or not the securities are publicly traded or privately held.  However, in the case of a private foundation (PF), such contributions have further restrictions.  Only “qualified appreciated STOCK” (in essence, publicly traded STOCK) qualifies to be valued at fair market value.  Any other securities, including LLC units, are valued at tax cost basis.

Therefore, our client, who ideally wanted to give the securities to his PF, was hamstrung by the limitation on the value of the charitable contribution because the securities were not qualified appreciated stock.  The loss of the market value deduction made such a choice both uneconomic and irrational.

To maximize the value of the contribution of the LLC units, our client would instead have to make the contribution to a public charity rather than his private foundation.  If he had a favorite public charity, let’s say for argument’s sake, the American Cancer Society, then he could contribute the units directly.  But in reality, he wanted to fund his PF for use in making future grants to charity, i.e., he wanted to engage in “time shifting” his deductions/grants (the philanthropic equivalent of using the DVR or Tivo on your television set) rather than make a current major gift to one or two public charities.  The solution to this problem was to use a donor advised fund (DAF) in place of the PF.  DAF’s are, by definition, public charities.  They are subject to the larger “30% of AGI” limitation on gifts of long term appreciated securities, and they are not limited to the use of publicly traded stock to get the full FMV valuation.  The resulting capital gain from the sale of the LLC units by the DAF escapes taxation, and our client received a full fair market value deduction for his gift while indefinitely postponing the decision about the ultimate disposition of the funds to outside charities.  The downside of using a DAF instead of a PF is that there is less flexibility in the DAF as to the ultimate disposition of the assets.  Stated another way (and discussed in a previous blog post), the PF enables the client to engage more robustly in the business of philanthropy while the DAF serves as a charitable pocketbook to fund public charities in a more passive way.  If this loss of flexibility is not an issue for the client, then the use of the DAF will be a win/win.

This may be a nonconventional solution to the valuation issue of substantial charitable contributions, but it preserves the value of the charitable deduction while not rushing the disbursement of funds to the ultimate charitable beneficiaries.


[1] Think of it this way – if the investment goes south, so might the career path – and vice versa.  The investment value and career path are highly correlated.

[2] Top Federal rate on long term capital gains is 20%, however, adding in the new surtax on net investment income (3.8%) and the effect of the reduction in itemized deductions for high income taxpayers (1.2%) and the real Federal rate BY ITSELF is more like 25%.  State taxes are extra.

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