Court Case Puts Crimp in Tax-Saving Maneuver

Donating shares to charity has been one way to avoid capital-gains taxes generated by certain takeover deals. Now it's become more difficult.
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You own stock in a company that's about to be taken over in a cash-only deal. The sale of your stock to the acquiring company will trigger some hefty capital gains, so you decide to donate your shares to charity. Bye, bye capital-gains liability. Hello tax deduction.

Not so fast.

A recent tax court decision will limit taxpayers' ability to use this altruistic maneuver to avoid taxes resulting from all-cash takeover deals. In a case decided in April, the court ruled that such a charitable donation should have been made very early in the takeover process -- before 50% of the target company's shares were tendered to the acquiring company. Previously, it was assumed that shares could be donated anytime before the target company's shareholders voted on the merger.

But the 50% threshold is not a hard-and-fast rule, and it could be altered by future court decisions. That lends an air of uncertainty to a tax-saving maneuver that has become more and more popular in the past few years as the number of all-cash takeover deals has been rising.

Last year, companies being acquired totaled more than $1.6 billion in value, and roughly 19% of those deals were all cash, according to

Thomson Financial Securities Data

in Newark, N.J. Of the $504 billion in takeover deals this year, about 20% are all-cash transactions.

In simple terms, a merger can affect shareholders either through a stock swap or a cash deal. In a stock swap, shares of the target company are literally swapped for shares of the acquirer. So there is no tax effect to shareholders until they sell their new shares.

In a cash deal, the acquiring company buys the target company's shares. That means shareholders in the target company must sell their shares to the acquirer, and that could generate capital gains.

The biggest cash deal this year was announced March 22.

Vivendi SA

, the French conglomerate, announced it's buying

U.S. Filter Corp.

(USF)

for $6.2 billion, or $31.50 per share. If a U.S. Filter shareholder bought those shares, say, back in November when they were trading at 15, he or she could be looking at a short-term capital gain of $16.50 per share. That gain would be taxed at the taxpayer's ordinary federal rate, which could be as high as 39.6%. (Add state taxes onto that.)

That's where the charitable donation comes in. "Giving stock to charity is a great thing to do because you avoid the tax on the gain, plus you get a charitable deduction," says Robert Willens, a managing director and strategic tax guru at

Lehman Brothers

in New York.

To determine the value of your charitable deduction, calculate what your gain would be if you sold the stock today. If you would generate a long-term gain, your charitable deduction will be at the stock's fair market value when you donate. If you only held the stock for the short term, then your charitable deduction would equal the original price you paid. (See

Section 170(e) for more on charitable deductions.)

Either way, you get a deduction and you get that pesky capital gain out of your portfolio as long as you donate the shares before the merger is official, right?

Wrong.

There is a point sometime between the merger's first announcement and the official completion when these shares actually lose their character as stock. As the merger proceedings go forward, the shares become a right to receive cash, says Willens. As the tax guys say, the stock has "ripened" into a title to receive cash.

How do you know when this "ripening" occurs? The guideline used to be anytime before the target company's shareholders voted on the merger.

In

Ferguson v. Commissioner

, a tax court ruled April 14 that Michael Ferguson still owed capital gains on his donation because more than 50% of the target company's stock had been tendered -- or delivered to the acquirer -- before his donation.

"It was practically certain that tender offer and ensuring merger would be completed successfully," the court said. The shares already "ripened" into rights to cash, so technically, there was no stock to donate.

The kicker here is that the tender offer and merger were conditioned on the buyer's acquisition of 85%, not 50%, of the target's stock, according to Willens. But the court still said it was "substantially certain" that the merger would be completed.

Although, in this case, the court ruled that the stock ripened when 50% had been tendered, it might determine in the future that the ripening occurs later in the process, says Willens.

So what do you do? Act fast. "I always advise that people give away their shares much earlier in the process," says Willens. The minute the merger is announced, decide whether you want to donate your shares and then just do it. If the share price is reacting positively to the merger announcement, you might be tempted to hold onto the shares as long as possible and ride the wave. But don't be too greedy.

Wash-Sale Play

The court ruling also will have an impact on taxpayers who use the wash-sale rule as a merger play. We

wrote about this maneuver last year. Here's an excerpt from that story:

If your favorite stock is in the process of a merger but has recently tanked, here's a way to stay in your stock but still take the loss. Let's say you're long the buyer in the merger and the stock is down a lot, but you still like the company. Sell it and buy stock in the target company. The rules say the stocks of two merger partners are not substantially identical as long as there's a contingency that still has to be satisfied before the merger goes through.

Such a contingency may be a shareholder vote to approve the merger. But according to the court case, this contingency may no longer be enough. The ripening might occur well before a vote. So to execute this play, you need to do it before the shares metamorphose into cash rights.

So if you have a stake in a merger stock, pay attention to its status. And if you're going to give your shares away, do it quickly. Take your charitable deduction and be done with it. And who knows, you might even get your name on building or a park bench because of it. That's got to be worth something.

TSC aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.

As originally published, this story contained an error. Please see Corrections and Clarifications.