Thomas J. Brennan (Harvard) presents The Government’s Gift to Givers: Donating Appreciated Stock at Toronto, as part of its James Hausman Tax Law and Policy Workshop Series hosted by Ben Alarie:

Under Section 170(e), taxpayers can deduct appreciation without paying tax on this gain. This double benefit is well understood. Yet this Article frames the tax benefit somewhat differently, and also quantifies exactly how valuable this tax benefit is from an ex ante perspective when the asset is first purchased.   

To show what makes this tax treatment so favorable, we consider it ex ante–that is, before taxpayers know whether their risky asset’s value will rise or fall. From this ex ante perspective, excluding tax on gains would be less favorable if the government also disallowed deductions, as Domar and Musgrave showed years ago. Yet Section 170(e) does not apply the same way to gains and losses. We show that the tax benefit in Section 170(e) is this imbalance: gains are excluded, while losses can still be deducted.  

We use options pricing to measure the expected value of this imbalance, and also to flag key variables that influence it. We show that when a taxpayer buys a risky asset such as stock to fund a future charitable contribution, there is both a favorable and an unfavorable tax effect. Each is economically similar to an options transaction. By valuing each option and netting them, we calculate the expected value of the tax benefit.

First, every dollar of appreciation reduces the donor’s taxable income by a dollar. With a marginal rate on ordinary income of T%, she saves T cents. This is like a call option, entitling the taxpayer to buy T% of the shares at the initial price. In other words, Section 170(e) essentially gives taxpayers an at-the-money call option on a percentage of the risky asset given by the tax rate on ordinary income.

The second tax effect arises when the stock depreciates, and the taxpayer sells the stock and contributes the proceeds. Every dollar of decline converts what otherwise would have been an ordinary (charitable) deduction into a capital loss. Ordinary deductions are more valuable in avoiding, T, instead of the lower tax rate on capital gain, K. As a result, every dollar of decline in the stock price costs the donor (T–K). This is like granting a put option, entitling the counterparty to sell (T–K)% of the shares to the taxpayer at the initial price. In other words, Section 170(e) essentially takes an at-themoney put option from the taxpayer on a percentage of the risky asset given by the difference between the tax rates on ordinary income and capital gain.

This precise account of the tax effects of Section 170(e) allows us to calculate their expected value: it is the difference between the value of the call option the tax law gives taxpayers and the put option the tax law takes from them. Because the options are at the-money and the call option is on a larger number of shares, the net is positive.