By allowing generous income tax deductions, US tax laws create valuable incentives for art collectors to give works of art to US charities during their lifetimes. These incentives can make contributions of works of art during life significantly more attractive to the collector than bequests to charities at death. The statutory and regulatory framework governing the deductibility of lifetime contributions of art is complicated, making it imperative for collectors to be well advised before proceeding with any charitable contribution of art.
In any lifetime gift, the collector must first decide what form the gift is to take: a gift of the entire work of art outright, or of only a “fractional” interest in it (with possibly more such gifts over time). Tax benefits may make it attractive to place the work of art in a trust benefiting certain individuals first (which can include the donor) and then the charity. A collector should weigh the tax benefits he will actually be able to use under the various gift possibilities.
This article focuses on outright contributions to charity of a collector’s entire interest in a work of art.
Charitable deductions under US tax law
Subject to certain adjusted gross income limitations, US tax laws in general allow a collector an income tax deduction for the full, fair market value of a work of art contributed to charity, if four conditions are met.
First, the recipient must be a broad-based US public charity, not a private foundation.
Second, the work of art must be “long-term capital gain property” in the collector’s hands, meaning it would give rise to long-term capital gain income, not short-term capital gain or ordinary income, if sold by the collector.
Third, the work of art must be used by the charity in accordance with the purpose or function that is the basis of its tax-exempt status (the “related use” rule).
Fourth, the collector must adhere strictly to the appraisal, reporting and substantiation rules governing charitable contributions of tangible personal property.
The collector can assure himself of the charity’s status as “public” or “private” by asking the charity for a copy of the ruling letter issued by the Internal Revenue Service (IRS). This will indicate whether the charity is a public charity, allowing maximum income tax deductions, or a “private foundation,” for which only limited income tax deductions are permitted.
The deduction for a gift to charity of an appreciated work of art—one that has increased in value since the donor acquired it—is reduced by any gain that would have been ordinary income or “short-term” capital gain if the property had been sold by the collector for its fair market value on the date of gift. Works of art that produce this result, and thus are less than ideal candidates for charitable contributions, include (i) those which the collector has held only short-term (one year or less), (ii) those held by the collector as inventory for sale in the ordinary course of business, and (iii) works of art created by the collector himself, or given to the collector by the artist.
“Related use” by the charity is key
Even if the collector satisfies the ordinary income/short-term capital gain requirement, his deduction will still be reduced to his income basis in the work of art, if the charity’s use of the work is “unrelated” to the charitable purpose or function for which the charity was awarded tax exempt status. The burden of proof on this issue rests squarely on the taxpayer.
A collector may treat a donated work as having been put to a related use if (i) he determines that the charity has not in fact put the work to an unrelated use, or (ii) at the time of gift, it was reasonable for him to anticipate that the work of art would not be put to an unrelated use, including sale by the charity.
As to the latter, the collector would be well advised to obtain written confirmation of the charity’s related-use plans for the proposed contribution. If the gift is to a museum, IRS regulations provide a “safe harbour” for the collector. This safe harbour provides that, if the donation is of the type of property usually retained by the museum for display, the collector may reasonably anticipate that the donation will be put to a related use, unless the collector has actual knowledge that the work will be sold or exchanged, rather than exhibited. Assuming that the collector has no foreknowledge, a museum’s subsequent actions will not retroactively affect his income tax deduction.
In order to police the related use rules, the IRS requires a charitable recipient to file Form 8282 (the so-called “tattle-tale” form) to report to the IRS any sale or disposition of a donated work of art within two years after the contribution. Form 8282 must be filed by the charity within 125 days of the disposition.
Meeting paperwork requirements
To discourage taxpayers from taking inflated income tax deductions for donations of tangible personal property (including works of art) to charity, Congress and the IRS have prescribed strict and sometimes overlapping reporting, appraisal, and substantiation requirements. The collector must observe each and every element of these requirements. Noncompliance may result in total forfeiture of the intended deduction.
First, to obtain a deduction when the total amount of all non-cash gifts exceeds $500, the collector must attach Form 8283 (“Non-cash charitable contributions”) to his income tax return.
Where the deduction exceeds $5000, the “appraisal summary” section of Form 8283 must be completed. In this case, the recipient charity must acknowledge receipt of the contributed item by completing a portion of the appraisal summary, which must be signed by an official of the charity authorised to sign tax returns of the organisation or a person designated by the charity to sign Forms 8283.
Finally, if an appraisal is required, the appraiser must sign the “declaration of appraiser” portion of the appraisal summary.
To take a deduction where the work of art is valued at more than $5,000, the collector must obtain a written, qualified appraisal of the work from a “qualified independent appraiser.” If the work is valued at $20,000 or more, the signed appraisal itself must be attached to the Form 8283.
Photos, timeliness and contents of appraisal
Although a photograph or colour transparency is no longer required as part of the appraisal, the collector must be ready to produce one if asked by the IRS. The qualified appraisal must be obtained no earlier than sixty days prior to the date of donation and no later than the deadline for filing the taxpayer’s income tax return, including extensions. This deadline is extremely important; if the appraisal is not in the collector’s hands when his tax return is due, the entire charitable deduction is subject to forfeiture. (In a series of gifts of “fractional” interests in a work of art, the donor must obtain an appraisal for each gift.) The fee for a qualified appraisal cannot be based on a percentage of the value of the appraised property or the amount allowed as a deduction.
A qualified appraisal must include (i) a detailed description of the work of art, (ii) the date of gift, (iii) the physical condition of the work, (iv) any terms relating to the donee’s use or disposition of the work of art, (v) the appraiser’s name, address and taxpayer identification number, (vi) the appraiser’s qualifications, especially his education, experience and certification, (vii) a certification that the appraisal was performed for tax purposes, (viii) the date on which the work of art was valued, (ix) the appraised fair market value on the date of gift, (x) the methodology used by the appraiser for determining the value and (xi) a description of the fee arrangement between the appraiser and the collector. To be considered a “qualified independent appraiser”, a person must have the credentials or qualifications to make appraisals of the particular type of property involved in the gift, and must either hold himself out to the public as such an appraiser or do such appraisals on a regular basis. The appraiser cannot be the donor, the charitable recipient, or any “related party” (such as the donor’s spouse or an employee of the charity) whose objectivity regarding the appraisal might be compromised as a result of the relationship.
The choice of appraisers is crucial; if he or she is later found to be disqualified, the entire charitable deduction is lost—as it will be too late to cure the defect.
Works of art are also subject to the general IRS requirement that any charitable donation valued at $250 or more must be substantiated. Thus, in addition to the Form 8283 receipt, the collector must also obtain a separate receipt from the charity, in which the gift is described, as well as any goods or services provided in exchange; if none were received, the receipt must say so. This receipt must be in the collector’s hands before filing his income tax return, or if filed late, by the due date, plus extensions. Failure to obey to this substantiation rule, even if only because the collector filed early, can result in total disallowance of the charitable deduction.
Penalties for overvaluing gifts
Finally, further to deter overvaluations of works of art given to charity, Congress has adopted certain penalties of which collectors should be keenly aware. The penalties are tiered, according to the degree of overvaluation. A 20% penalty is levied on the amount of understated tax when (i) the claimed value of the contributed work of art exceeds 200% of its finally determined fair market value and (ii) an income tax underpayment results that equals or exceeds $5,000. In egregious cases, where the value claimed exceeds 400% of the fair market value as finally determined, the penalty is doubled to 40% of the understated tax.
If the donor’s income tax return is chosen for audit and if he has claimed a charitable deduction of $20,000 or more for a gift of work of art, the claimed valuation must be referred to the IRS Art Advisory Panel in Washington, DC. The panel is comprised of experts in the field, such as museum directors, curators and art dealers. Their valuation becomes the official IRS position if it decides to challenge the collector’s claimed deduction.
A donor may, for a $2,500 fee, find out before filing his income tax return whether the IRS accepts the claimed value of the work of art, by obtaining an IRS advance ruling on valuation. The gift must be already completed, and appraised at $50,000 or more.
In summary, in order to maximize a collector’s US income tax deduction for a contribution of a work of art to charity, the collector and his or her advisors should, at a minimum, (i) make the contribution to a US public charity, (ii) make the contribution only with long-term capital gain property, (iii) be sure the recipient’s intended use of the contribution satisfies the related use rules, (iv) obtain a qualified appraisal of the work of art by a qualified appraiser, (v) obtain the required receipt from the charity prior to filing his income tax return, and (vi) be sure that IRS Form 8283 (properly executed by the collector, the recipient charity and the appraiser) is attached to the taxpayer’s timely-filed income tax return—along with the qualified appraisal, where required.
In private letter rulings and litigated cases, the IRS has repeatedly indicated its determination to require strict adherence to these complex rules, by denying totally deductions for seemingly innocuous and innocent taxpayer transgressions.
The potential income tax benefits from a charitable contribution of a work of art can be significant, but the collector is advised to proceed with due and careful regard for the complex valuation, appraisal and substantiation rules that govern this area.
Ms Billman is counsel to the law firm of Paul, Weiss, Rifkind, Wharton & Garrison of New York, specialising in estate planning and charitable giving.
Mr Silberman is principal of the law firm John Silberman Associates of New York and specialises in art law and estate planning
Originally appeared in The Art Newspaper as 'Give to get'