Contributions of Art
Professional Tax & Estate Planning Notes | October 2010
Charitable contributions of art can pose unique challenges. Contributing art can be a very personal decision for a donor and can present legal considerations that are more complex than those for more ordinary types of charitable gifts. At the same time, a gift of art to a qualified charity may have valuable tax benefits for the donor, and the opportunity to create a legacy at an institution may be a matter of great personal satisfaction.
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Because gifts of art often involve unique issues not found in gifts of cash or securities, donors should consult with their legal advisors to determine the most appropriate way to contribute these assets to charity, including the best recipient organization and the most appropriate type of asset to give. A prospective donor may also wish to consult with a nonlegal art advisor about a contemplated donation. And, of course, a donor will need to establish a relationship with a charity in order to structure a charitable contribution of art. Indeed, in all cases, the structure of the contribution will have to be mutually agreeable.
Although we had planned for this issue to cover both gifts of art and real estate, we have decided to split them. Gifts of real estate will be discussed in a special December issue. As part of our series on charitable gifts using unusual assets, this issue largely builds on the general concepts considered in the first issue: Charitable Gifts Using Illiquid Securities (March 2010)
and the second issue: Charitable Gifts Using Interests in Pass-through Entities (June 2010)
. Many concepts, including general tax concepts of certain entities, charitable contributions, appraisals, and valuation, already covered in this series’ two prior issues, are not discussed at length in this issue.
General Overview of Gifts of Art
Certain legal and tax implications generally apply to even the most basic charitable donations of art. This discussion primarily focuses on income tax considerations and, in some instances, expressly states when estate and gift tax consequences are considered.
The tax law provides favorable deductions for donors who contribute art to museums or other “qualified organizations.” For these purposes, “art” includes paintings, sculpture, watercolors, prints, drawings, ceramics, antique furniture, textiles, rare manuscripts (including letters), historical memorabilia, and other similar objects. A “qualified organization” is a public charity or a private operating foundation, but not a private non-operating foundation. Typically, art contributions are made to qualified organizations that are museums or educational institutions that have public charity status. Before each donation, the donor should confirm that the intended recipient is a public charity or private operating foundation.
If a work of art is held by a collector, it is generally considered capital gain property; the sale of the collectibles, such as art, would thus generate capital gain.1
On the other hand, art will be considered ordinary income property if (i) the donor created it; (ii) the donor received it as a gift from the creator; or (iii) it is held as inventory by a dealer. Also, the art will be treated in the same way as ordinary income property if its sale would generate short-term capital gain because it was held for one year or less. Under certain circumstances, donors that collect a large volume of art for the express purpose of contributing it to charity could be considered dealers under the Code.2
If the art work that is contributed is long-term capital gain property, the charitable contribution would qualify for a fair market value deduction for federal income tax purposes, provided the contribution meets the related use rule, which requires that the charity use the art in a manner that is consistent with the charity’s exempt purpose. Otherwise, the deduction will be limited to the donor’s cost basis (or fair market value if it is less than cost basis). For example, a contribution of a painting to a college that will display the painting in its library ordinarily results in a charitable income tax deduction equal to the fair market value of the painting; if the painting is contributed to the college in order for it to sell the painting and receive the sale proceeds, however, the deduction will be limited to the lesser of the painting’s fair market value and the donor’s tax basis in the painting.
The Regulations provide that a contribution of art meets the related use rule if (i) the donor establishes that the work of art is not in fact put to an unrelated use by the donee charity or (ii) at the time of the contribution, it is reasonable to anticipate that the work of art will not be put to an unrelated use by the charity.
The Regulations must be read in light of the Pension Protection Act of 2006 (PPA), which provides that a qualified organization has not put property to a related use if it sells, exchanges, or otherwise disposes of it in the year of the contribution. In that case, the donor must reduce his deduction from fair market value to cost basis, unless the organization provides a required certification. And if the organization disposes of the property after the end of the first taxable year in which the contribution is made, but within three years of the contribution, the donor must recapture the excess of the deduction taken over his basis (and treat the excess as ordinary income in the year the organization disposes of the property), unless the organization provides the certification.
The certification must be signed by an officer under penalties of perjury and must either (i) describe how the organization used the property in furtherance of its purposes or (ii) state how it intended to use the property at the time of the contribution and certify that this intended use became impossible or infeasible to implement.
Satisfying the related use rule is case specific, and donors should obtain from the prospective donee charity a clear statement of how the charity intends to use the gift.
If the contributed art work is capital gain property and meets the related use requirement, the donor may deduct the fair market value of the work up to a limit of 30 percent of his adjusted gross income. If the art is instead considered ordinary income property or short-term capital gain property, as previously noted, the deduction is limited to cost basis, but the ceiling for deductibility is 50 percent of the donor’s adjusted gross income. Generally, a contribution of art to a private non-operating foundation will generate a deduction for cost basis only (or fair market value, if it is less). Thus, a donor with appreciated art ordinarily will want to contribute the art to a museum or other qualified organization that will use it.
Partial Interest Gifts
Donors often want to give a charity a partial interest in their art or other tangible personal property, retaining the ability to display the work on their own wall part of the year and give fractional interests away over a period of years to maximize their ability to absorb the charitable deduction. In these cases, the charity must have the right to possession of the art work for the amount of time that corresponds to its percentage of ownership. Before accepting a donor’s fractional interest, many museums typically will require the donor to sign a pledge agreement promising to make a gift of the remaining art work at or before the donor’s death.
Generally, no charitable deduction exists for a gift of less than a donor’s entire interest in property. An exception exists, however, for a contribution of an undivided portion of a taxpayer’s entire interest in the property (a fractional interest). For this exception to apply, the donor must fully own the property in which he will give a fractional interest or the property must be owned by the donor and the donee charity. The PPA authorizes regulations making an exception to this rule if each person with an interest in the property makes a proportional contribution of that person’s interest.
Since the enactment of the PPA, donors must contribute all of their interest to a qualified charity within ten years of their initial fractional interest donation or at death, whichever is earlier, and the charity must take substantial physical possession or make use of the property in a way related to its exempt purpose within the same time period. If not, the deduction(s) previously taken by the donor will be recaptured (in the form of imputed ordinary income) and the donor will face a penalty of ten percent of the recapture amount.
The charitable deduction available for the initial fractional interest contribution equals a pro-rata share of the property’s fair market value, assuming it is given to a qualified organization that uses the property in furtherance of its exempt purpose. If the donor makes an additional contribution of a fractional interest, the fair market value of the contribution is the smaller of (i) the fair market value of the portion of the property contributed at the time of the initial fractional contribution and (ii) the fair market value of that portion at the time of the additional contribution. Therefore, if the art work appreciates in value, the donor’s deduction will not increase correspondingly, but will be fixed at the value of the deduction for the initial fractional interest contribution.
Charitable gift planning using fractional interests may be useful for donors seeking to maximize the benefits of charitable deductions by spreading them over several taxable years.
Copyrighted Art Works
The sale, gift, or bequest of a work of art does not include an implied or automatic transfer of the copyright. Rather, the copyright owner must expressly transfer the copyright to a buyer, donee, or legatee. Artists typically prefer to retain their copyrights when they sell or give away their work. Therefore, with rare exceptions, collectors own a work of art but not the copyright in it. However, artists generally own both the physical work and the copyright in their own work, as do heirs of artists who received the physical work and the copyright as a bequest. The discussion that follows is aimed at that relatively small subset of art owners—generally artists and their heirs—who happen to own the physical work as well as the copyright. (It should be borne in mind that many works of art are in the public domain—that is, no longer protected by copyright—and these considerations are not relevant in those cases.)
For federal income tax purposes, the physical work and the copyright are treated as a single asset, even though for federal copyright purposes they are treated as separate assets. Because of the tax treatment of copyrights, an art owner who owns the physical work and the copyright must donate both (or an undivided fractional interest in both) to charity in order for his gift to qualify for an income tax charitable deduction. (However, see above regarding the limitations on deductibility that are imposed on artists and those who have received artwork as a lifetime gift from the artist.)
In many cases, copyright owners are reluctant to donate copyrights to a public charity, because they are unwilling to relinquish royalty rights or to cede to an independent organization control over the rights of reproduction and the enforcement of claims against copyright infringers. A variety of strategies could be considered for the art owner who wants a charitable deduction but does not want the recipient to receive the copyright. One strategy is to make a simultaneous donation of the physical work to an appropriate institution and the copyright to a private foundation controlled by the donor.
An art owner who owns the copyright in a work of art must also be mindful of the gift tax rules. If the physical work is donated to a public charity or private operating foundation that will put the work to a related use (known as a “qualified contribution”), a gift tax deduction will be allowed even if the copyright is retained or given to a non-charity. However, if the physical work is given in order that it be sold (as is often the case when artists donate their own work to charity for, say, a charity auction), no gift tax charitable deduction is allowable for the transfer unless the copyright is donated as well.
The same considerations arise in the estate tax context. If the physical work is bequeathed to a museum or some other type of public charity or private operating foundation that will put the work to a related use, the testator is free to leave the copyright to someone else, including a non-charity, without triggering estate tax on the charitable gift. However, if the physical work is left to charity with the expectation it will be sold, the rule does not apply, and the bequest to charity would not qualify for the estate tax charitable deduction unless it is accompanied by a bequest of the copyright either to the same charity that receives the physical work or to some other charity.
The “qualified contribution” exception in the gift and estate tax area is available only when physical works are donated to charity and copyrights are not. In the reverse situation, where the copyright is donated to charity but the physical work is not, no gift or estate tax deduction is available for the donated copyright.
A bargain sale is a sale or exchange for less than a property’s fair market value to a qualified charity. It can be a useful tool because it enables a donor both to receive some cash and claim a charitable deduction for the discount from the fair market value of the property. Generally, if the property sold was capital gain property and charity’s use of the property is intended to be a related use, the donor’s charitable contribution deduction would be limited to the property’s fair market value reduced by the proceeds of the sale.
When appreciated property is transferred as part of a bargain sale, tax law requires that the basis for determining gain or loss be allocated between the sale and gift portions. The amount of gain recognized may be partially or wholly offset by the accompanying charitable deduction. Bargain sale treatment is available only for transactions where the donor establishes the intent to make a charitable gift prior to the sale; merely selling for what later turns out to be a favorable price for the purchasing charity will not give rise to bargain sale treatment. A donor and the charity might therefore agree to include in the documentation of the transaction: (i) the appraisal value relied upon by the donor and an expression of the donor’s intention to make a gift; (ii) a requirement that the charity provide a receipt acknowledging the existence of a charitable contribution of the property and that no goods or services were received in exchange for the contribution; and (iii) a requirement that the charity execute IRS Form 8283 in order for the donor to claim the deduction. The charity, however, should not be expected to vouch for the donor’s claimed value of the property or the amount of the donor’s claimed deduction.
A bargain sale can also be structured as an installment bargain sale where the sale price is paid in installments over more than one year, creating an income stream for the donor for the duration of the installment agreement. An installment bargain sale is reported using the regular installment method prescribed in the Code. Donors should be aware that if a sale of property would not qualify for installment sale reporting, even if it is a bona fide bargain sale, the bargain installment sale of such property to charity will also not qualify as such. Additionally, if the sales contract does not carry a sufficient amount of interest, as described in Code Section 1274, a portion of the sales price may be recharacterized as unstated interest, which would reduce both the amount of the charitable deduction and the amount of gain that may otherwise qualify for reporting as long-term capital gain.
Charitable Remainder Trusts
A donor who owns a work of art and is interested in liquidating it to create a stream of income, with an ultimate gift to charity, should consider the use of a type of charitable remainder trust (CRT) known as a flip charitable remainder unitrust (Flip-CRUT).
In general, CRTs provide for the eventual transfer of trust property to charity after the property has been held for a period of time to generate an income stream for one or more non-charitable beneficiaries. If a CRT meets the strict requirements under Code Section 664, it typically offers: (i) a current income tax deduction for the present value of the remainder that is deemed committed to charity; (ii) the avoidance of capital gains tax on the trust when the trustee sells appreciated assets; and (iii) an exemption from tax for trust income (except to the extent the income is distributed to the income beneficiary). A CRT makes annual payments in the form of either an annuity amount (a fixed amount determined on the day the trust is established) (CRAT) or a unitrust amount (a fixed percentage of the trust’s annual fair market value) (CRUT). The unitrust payment therefore will increase or decrease from one year to the next based on the trust’s market value.
The term of a CRT must be the lifetime of one or more income beneficiaries (customarily, the donor and the donor’s spouse) or a fixed term of years not to exceed 20 years. The payout rate of a CRT must be at least five percent of the trust’s initial value, in the case of CRAT, or at least five percent of the trust’s annual value in the case of a CRUT. The payout rate may not exceed 50 percent, and other limitations are applicable in the case of CRATs. Additionally, the present value of charity’s remainder interest in a CRT must be at least ten percent of the initial net fair market value of all property placed in the trust. The trust instrument may name one or more charities to receive the trust remainder or may give the trustee the discretion to select one or more charitable beneficiaries of the remainder.
Ordinarily, a Flip-CRUT would be the preferred type of CRT for a donor looking to fund a CRT with tangible personal property, such as a work of art. In its initial phase, a Flip-CRUT distributes only its accounting income to the income beneficiaries. So long as the work of art generates no income (which would ordinarily be the case during the period before it is sold), the Flip-CRUT would make no distributions to the income beneficiary. In its second phase, in the tax year following the occurrence of a predetermined “triggering event,” such as the sale of contributed art work, the trust “flips” and becomes a standard CRUT that pays out a fixed percentage of its annual fair market value. In other words, the Flip-CRUT solves the problem of funding a trust with a non-income producing asset by deferring the requirement for unitrust distributions to the point in time when the trustee has the liquidity to make them.
However, there are some drawbacks to a Flip-CRUT. First, the tax deduction for a gift of art work to a Flip-CRUT will be the present value of charity’s remainder interest in the donor’s basis in the donated work, not its fair market value. That is because the Flip-CRUT is not itself a charity and therefore cannot put the donated work to a related use. For a highly appreciated work, therefore, the Flip-CRUT will not generate a significant income tax charitable deduction relative to the value of the property contributed. However, for donors who are truly interested in the financial well-being of the charitable remainder beneficiary and are seeking a tax-efficient way to convert an illiquid asset (a work of art) into an income-producing portfolio, the Flip-CRUT may be a worthwhile option even with the limitations on the charitable deduction.
Furthermore, no deduction is allowed until the trustee of the Flip-CRUT actually sells the donated property. There could, therefore, be a delay between the time the Flip-CRUT is created and the time a deduction (however modest) can be claimed. And finally, CRTs are subject to some of the same rules that are applicable to private foundations, including the Code Section 4941 excise tax on “acts of self-dealing.” As a consequence, a work of art contributed to a Flip-CRUT could not be retained by the donor for personal use or enjoyment during the period prior to its sale, and the work could not be sold to the donor or any other person that is a “disqualified person” for tax purposes. For example, a sale to another family trust probably would be a taxable act of self-dealing, even if the sale is at fair market value.
Appraisal and Valuation
The same appraisal rules and requirements, including qualified appraisal requirements and penalties, discussed in the March issue, apply to appraisals for art.
Generally, a donor should obtain a professional appraisal of a work of art that is under consideration as a gift to charity. The appraised value of the art, along with other factors, including its quality, size, condition, rarity, and authenticity, will help the donor determine which charity is an appropriate recipient of the work. As with other non-cash donations, donations of art do not require a qualified written appraisal, unless the deduction is for more than $5,000.
The authenticity of the donated art must be determined by the appraiser. The IRS generally gives more weight to an appraiser specializing in the kind and price range of the art being appraised than the opinions of more generalized art dealers or appraisers. Important items in the valuation of antiques and art are physical condition and the extent of restoration. A separate qualified appraisal is required for each item of property that is not included in a group of similar items of property. Donors should review their appraisals to ensure that they contain the information required by the IRS for a qualified appraisal.
For paintings, antiques, and other objects of art, the IRS has provided specific valuation requirements. If a donor in a given tax year claims an aggregate deduction of $20,000 or more for donations of art, the donor must attach a complete copy of the signed appraisal to his return. For a fee, a donor can request a Statement of Value from the IRS before filing his tax return reporting a contribution of a work of art that has been appraised at $50,000 or more. The Statement of Value asks the IRS to conduct a review of the art valuation claim prior to filing the return. The Statement of Value can then be used in completing the donor’s tax return and can help a donor avoid penalties for underpayment of tax. Statements of Value are reviewed by the IRS Art Advisory Panel, which is described in detail below.
If a donated work of art is disposed of within three years from the date of the gift, the donee charity must report that disposition to the IRS and the donor on IRS Form 8282. This reporting alerts the Service if a work of art is sold at a price significantly less than its appraised value at contribution or within the three-year period that triggers recapture of the charitable deduction under the related use rule discussed above. A report of selling the piece at a significantly lower value than the appraised value may have consequences for both the appraiser and the donor.
Art Advisory Panel
Certain valuations of art selected for audit by the IRS may be referred to a special IRS panel—the Art Advisory Panel (the Panel)—that consists of 25 volunteers who are nationally prominent art museum directors, curators, scholars, art dealers, auction representatives, and appraisers. The IRS’s Office of Art Appraisal Services reviews fair market value claims on works of art and cultural property in cases under examination and manages the Panel. All cases selected for audit by the IRS that contain art work with a claimed value of $20,000 or more per item must be reviewed by the Panel. The valuations under review may arise in the context of determining a decedent’s gross estate, the amount of gift tax, or a charitable income tax deduction.
The Panel members review relevant documentation provided by the taxpayer and research by the staff appraisers, and make recommendations on the acceptability of the claimed values. IRS staff may then make an adjustment to the claimed value. Under certain circumstances, the taxpayer may request reconsideration of the adjustment.
The Panel’s most recent Annual Summary Report (for 2008) states that the Panel reviewed 973 items donated by 179 taxpayers. Interestingly, the Panel recommended adjustments amounting to a 51 percent reduction on overvalued items in income tax charitable contribution claims and a 91 percent increase on items that had been undervalued on gift and estate tax returns.
Donating art generally involves greater tax and legal complexities than other types of donations. If structured properly and as part of thoughtful charitable gift planning, however, contributions of art often provide substantial benefits to both donors and charity.
For further reference see:
Code Section 170(b)(1)(C): Contributions of certain capital gain property
Code Section 170(e): Contributions of ordinary income and capital gain property
Code Section 170(f)(3): Denial of deduction in case of certain contributions of partial interests
Code Section 170(o)(1): Special rules for fractional gifts
Code Section 170(o)(3): Recapture of deduction in certain cases
Code Section 512(b): Unrelated business taxable income modifications
Code Section 664(c): Taxation of trusts
Code Section 664(d): Charitable remainder annuity trust and charitable remainder unitrust definitions
Code Section 1011(b): Bargain sale to a charitable organization
Code Section 2055(e)(4): Works of art and their copyright treated as separate properties
Treas. Reg. Section 1.170A-4(b)(1): Ordinary income property
Treas. Reg. Section 1.170A-4(b)(3): Unrelated use
Treas. Reg. Section 1.170A-4(c)(4): Donee’s basis of property acquired
Treas. Reg. Section 1.170A-5: Future interests in tangible personal property
Treas. Reg. Section 1.170A-7(b)(1): Undivided portion of donor’s entire interest
Treas. Reg. section 1.170A-14(h)(3)(iii): Allocation of basis
IRS Publication 526: Charitable contributions
IRS Publication 561: Determining the value of donated property
Internal Revenue Manual 4.48.2
Internal Revenue Manual 18.104.22.168
Rev. Proc. 96-15, 1996-1 CB 185
Rev. Rul. 79-419, 1979-2 CB 107
Private Letter Ruling 9452026
Stark v. Comm’r., 86 TC 243 (1986)
Winokur v. Comm’r., 90 TC 733 (1990)
IRS Form 8282: Donee Information Return1 The net capital gain from selling collectibles is subject to a maximum federal income tax rate of 28 percent.
2 All references to the Code are to the Internal Revenue Code of 1986, as amended, and all Regulation Section references are to the regulations promulgated thereunder.
© The New York Community Trust 2010.
Written by Jane L. Wilton, general counsel and A. Nicole Spooner, former associate general counsel of The New York Community Trust. Special thanks to John Sare of Patterson Belknap Webb & Tyler for his invaluable assistance.
This material was developed for the use of professionals by The New York Community Trust. It is published with the understanding that neither the publisher nor the author is engaged in rendering legal, accounting, or other professional advice. If legal advice or other expert assistance is required, the services of a competent professional should be sought.