Donating Digital Tech for Tax Breaks Opens Valuation Pitfalls

There is nothing improper or illegal about acquiring and donating software subscriptions to charity. But the same is true with buying land and donating a conservation easement.

The IRS has made illegitimate or overvalued charitable conservation easement donations a top enforcement target for years. The agency’s latest settlement offer involving pending conservation easement disputes may prompt investors to look at digital technology donations as a tax reduction opportunity.

But investors need to beware and proceed thoughtfully. Just like some conservation easements, this new type of property donation may also be too good to be true.

Digital Donations

Digital technology can be a lot of things, but in this context, it’s essentially a subscription to software applications. In the investment programs offered by Solidaris Capital, for example, the donated property—transformative intangibles—was nothing more than multi-year subscriptions to niche or generic software products.

One product was a mobile application designed to interact with physical transponders at commercial businesses that would assist visually impaired individuals’ navigation inside the businesses. Another product was digital coloring books.

Conceptually, a taxpayer might be able to donate a subscription to any software, assuming they have the authority to do so under the subscription agreement.

In theory, these transactions aren’t abusive. In any of these arrangements, the transaction’s structure is rarely the issue. The IRS almost always challenges how the transaction was carried out. For non-cash charitable contribution, that often means valuation, which should cause taxpayers some concern.

Valuing software technology isn’t easy. Companies such as Meta Platforms Inc. and Amazon.com Inc., which have well-established technology, have fought with the IRS over the value of that technology in the context of transfer pricing. Lesser-known firms with the type of software involved in potential tax shelter arrangements provide opportunities for misvaluation.

Easement Comparisons

Conservation easement valuation should be straightforward, but it’s often the core issue in most cases. Because easements require appraisers to value the land as if the easement didn’t exist, appraisers sometimes value the property based on wildly speculative uses that result in significant overvaluation.

In Jackson Crossroads, LLC v. Commissioner and Boltar, LLC v. Commissioner, the US Tax Court found the appraisers to have valued the unencumbered land based on unrealistic uses for which there was no demand. Despite 13 years between the Boltar and Jackson Crossroads opinions, the fundamental issue was still the same.

Software valuation isn’t immune from similar issues. For example, the appraisal report for one of the software subscriptions concluded a donation value of $11.8 million. The appraisal, however, never identified in detail what property was being valued. Along with the value conclusion, it references a software license with a sub-reference to thousands of licenses. There is no information about the terms of the licenses or the intended purchaser.

Mathematically, the value conclusion appears to be based on an expected price paid per license, yet the appraisal includes no analysis of prior sales of the subject licenses or of licenses for comparable software. The appraisal, rather, acknowledges that none of the financials for the company were reviewed and that the appraiser assumed the company was a profitable going concern.

Assumptions Matter

In addition to hypothetical conditions as described above, Uniform Standards of Professional Appraisal Practice require appraisers to identify and disclose assumptions, and extraordinary assumptions, made as part of a valuation assignment. Identifying and disclosing assumptions fulfill an appraiser’s ethical requirements under USPAP, but it doesn’t mean the appraisal is accurate.

In Boltar, the appraisers assumed the eased property had been annexed by the local town and was zoned in a certain way. Neither assumption was true. Because of that and other issues, the court excluded the appraiser’s testimony as to value.

In Jackson Crossroads, the appraisers assumed the minimal due diligence work that was done was sufficient to reach a certain conclusion about the property’s highest and best use, but it wasn’t. As a result, the court accepted the conclusions reached by the government.

It’s only a matter of time before there is a court opinion addressing the valuation of software license donations. After years of enforcement litigation relating to easements, the IRS has increasingly succeeded in valuation litigation. It shouldn’t take much to apply those same skills to software license valuations. Appraisals of digital technology donations like the one reviewed above likely won’t hold up in court and may even fall short of being a qualified appraisal under Internal Revenue Code Section 170(f)(11)(C).

Looking Ahead

With software technology valuations, investors need to be diligent in reviewing the property appraisals. As a minimum, the appraisal should include:

• A clear description of what is being valued—software licenses, term of license, type of license, or possibly the underlying code base and intellectual property
• A clear analysis of how the value was determined, including the basis for any per license pricing relied upon when developing the concluded value

Any assumptions identified in the appraisal should be reviewed closely and vetted thoroughly.

If it’s not clear what is being donated or how it was valued, it may be best to pass on the opportunity or seek the advice of counsel on how best to proceed. The perceived tax savings may end up being far less than the cost of an examination defense, litigation, and possible penalties and interest.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Miles Fuller is senior director of government solutions for Taxbit and a former attorney with the IRS Office of Chief Counsel.

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