Category: Charitable Contributions; Sales & Exchanges;
Deductions & Credits Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Various private companies and individuals are interested in the research conducted by XWORL and are willing to donate waste oil for XWORL's use. The issue is what are the tax consequences to the donors. In general, there is an established market for the waste oil in question. For purposes of this research, existence of such a market serves to establish a valuation for determining the amount of any potential charitable contribution. In addition, existence of a market clarifies that the waste oil in question is not simply a by-product item the donor would otherwise be forced to incur additional cost to be rid of. In other words, the donor is clearly parting with something of value in this instance as opposed to being relieved of a costly nuisance. In all instances, I will assume the waste oil in question has been held by the contributing party for one year or less. Case A Case B Case C The corporation obtains the material used to flush the pipeline system by simply reimbursing the customer whose goods are about to be transported in the pipeline for the cost of the amount of product needed to flush the pipeline system. In all cases, the corporation expenses this cost, and thus the waste oil has zero tax basis. The corporation plans to sell the mixed product to XWORL at a price considerably below market value. The waste oil is not viewed as inventory or held for sale to customers in the ordinary course of business. Case D 2. To what extent do the bargain sale rules (Section 1011 and 1012) apply? 3. With respect to Case D, would the corporation be able to expense its funding of the research under Section 174 and/or claim an incremental research credit under Section 41? Answers 2. Given that there is no possibility of a charitable deduction and (more importantly) the donors have no tax basis in the products contributed (or bargain-sold) to XWORL, the bargain sale rules of Section 1011 and 1012 have no relevance to this situation. The taxpayers selling products to XWORL at a below-market price will be taxed on the sale based on the amount for which the product is sold. 3. Using waste oil as a means of acquiring rights to research produced by XWORL is a taxable exchange requiring the pipeline company to recognize the full fair market value of the waste oil transferred to XWORL. If full gain is recognized, use of the waste oil as a medium of exchange for the research rights is no different from the standpoint of Sections 174 and 41 than using cash to purchase the same rights. Discussion: Charitable Contributions Generally speaking, it is possible to take a charitable deduction for non-cash property contributions equal to the fair market value of the property so contributed, irrespective of the basis of the property. Moreover, the contribution does not trigger recognition of any gain inherent in the contributed property. See for example, Campbell v. Prothro, (1954, CA5) 45 AFTR 131, 209 F2d 331, 54-1 USTC ¶9155; L.O. 1118, II-2 CB 148 (1923); Revenue Ruling 59-196, 1959-1 CB 56. Of course, the availability of a charitable deduction with respect to contribution of appreciated property is subject to substantial limitations and prerequisite conditions. It seems to me there is a common factual thread running through the various scenarios submitted for consideration: the donor's have already taken ordinary business expense deductions (presumably under Section 162) for the waste oil in question. Accordingly, the donors have no basis in the donated property. Generally speaking, Sections 170 and 162 are mutually exclusive: if a taxpayer obtains a deduction under one section, no deduction is allowed under the other section. Letter Ruling 7939013 deals with an issue very similar to the one we face here. While it is true that under IRC Section 6110(j)(3), letter rulings cannot be cited as precedent, the reasoning set forth in the ruling is, in my opinion, quite sound and should apply to this situation. The taxpayer in Letter Ruling 7939013 acquired some paintings to be used for promotional purposes. The painting were expensed as acquired. Later, the taxpayer donated the paintings to a charitable organization and attempted to take a deduction for the fair market value of the paintings at the time of the deduction. The ruling presents the following arguments. Regulation Section 1.161-1 provides in pertinent part that double deductions are not permitted. Amounts deducted under one provision of the Code cannot again be deducted under any other provision thereof. The Supreme Court in Charles Ilfeld Co. v. Hernandez,
292 U.S. 62, 68 (1934), expressed the principle that the Code should not
be interpreted to allow the practical equivalent of a double deduction absent
a clear declaration of intent by Congress. Neither section 162 of the Code
nor section 170 express such an intention. As I said, I find the reasoning to Letter Ruling 7939013 to be compelling, and I believe it to be applicable here. In addition, there is yet another obstacle. Assume, arguendo, that the double deduction issue set forth above were not a factor. Any deduction for the fair market value of oil contributed (or the differential between the fair market value and the selling price for product transferred under a bargain sale arrangement) would be disallowed under IRC Section 170(e). IRC Section 170(e) provides in pertinent part that the amount of any charitable deduction otherwise allowable must be reduced by the amount of any gain (other than long-term capital gain) that would have been recognized if the contributed property had been sold at its fair market value. It seems to me that the waste oil under the various scenarios set forth above should be a capital asset in the hands of the contributing party. Section 1221 defines the phrase capital asset by providing a comprehensive list of items which cannot be capital assets. None of the categories set forth in Section 1221 apply to the waste oil in question. Accordingly, it seems to me the waste oil should be a capital asset in the hands of the contributing party. If a sale or exchange is to produce long-term capital gain, the asset in question must be a capital asset and, under Section 1222(3), the asset must have been held for more than one year. Under the circumstances described in the various scenarios under consideration here, none of the taxpayers in question have held the waste oil for more than one year. Accordingly, the sale of the waste oil at its fair market value would produce short-term capital gain, which under Section 170(e) would be deducted from the amount of any otherwise allowable charitable deduction. Since the taxpayers in this case have zero basis in the waste oil, they would recognize gain in the amount of the full fair market value of the oil if it were sold; hence, the net charitable contribution allowable after consideration of Section 170(e) would be zero. Deduction or Credit for Research Expense If the transaction is not a charitable contribution, then what is it? I submit that this is simply a taxable exchange of the waste oil for the rights in the research. It is well settled that a charitable contribution of appreciated property does not give rise to gain provided the taxpayer receives no compensation in connection with the transfer. See, for example, Campbell v. Prothro, (1954, CA5) 45 AFTR 131, 209 F2d 331, 54-1 USTC ¶9155; Revenue Ruling 59-196, 1959-1 CB 56; L.O. 1118, II-2 CB 148 (1923). Absent this protection against recognition of gain, however, transfer of waste oil in exchange for rights to research conducted by XWORL would be a taxable exchange giving rise under IRC Section 1001 to gain equal to the market value of the oil. In my view, the taxable exchange of waste oil
for research rights would be the same for purposes of Sections 174 and 41
as payment of cash for such rights. Collateral Issue: Classification of
Waste Oil as Inventory I would not presume to tell the operator of the pipeline system or the quick oil change establishment how to run their businesses. As I understand it, neither company considers waste oil as inventory. Having said that, however, I would like to offer my view on this matter for the benefit of anyone who may be interested in hearing it. I am of the opinion that there is a reasonable measure of risk that the waste oil products sold by the pipeline company and by the quick oil change establishment could be characterized as inventory. There is a case, Guardian Industries Corp. v. Comr., 97 TC 308 (1991), aff'd 73 AFTR 2d 94-1903 (CA6, 1994), in which a taxpayer engaged in processing photographic film sold various silver compounds that were a waste by-product from the film finishing business. The court held that even though the taxpayer was not per se in the business of selling the waste products, it did in fact make regular, frequent, and substantial sales of those products. Accordingly, the waste materials had to be classified as inventory. I submit for the benefit of anyone concerned that the facts of Guardian closely resemble the facts of any taxpayer who has frequent, regular, and substantial sales of waste by-products.
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