This article highlights some of the more critical income tax issues that taxpayers and their advisors must address when claiming the charitable contribution deduction for the gift of art to art museums. This article does not reflect all tax issues that must be considered in claiming a charitable contribution deduction on a United States income tax return. Rather, this article provides a broad and selective overview of a complex area of the United States income tax law.
What is a “Boring” Charitable Contribution Deduction?
Taxpayers want and expect a “boring” charitable contribution deduction that is part of a “boring” income tax return. A “boring” income tax return will:
- Be “true, correct and complete.”
- Be timely filed.
- Be rarely audited – and if audited, the income tax return likely will be “accepted as filed” by Internal Revenue Service auditors without significant audit changes.
- Not subject the donor, the tax return preparer or the appraiser to valuation penalties.
It takes foresight, creativity and effort to craft a “boring” charitable contribution deduction as part of a “boring” income tax return. The process for crafting such a “boring” income tax return is anything but boring.
How is the Amount of the Charitable Contribution Deduction Determined?
The amount of the charitable contribution deduction is sensitive to issues such as:
- Is the donor a collector or an investor – or a dealer in art?
- Will the donor hold the art for more than one year at the time of the contribution?
- Is the gift to a public charity or a private foundation?
- Is the art intended to be held by the charity – or to be sold by the charity, with the proceeds of sale added to the charity’s permanent endowment?
Let us assume:
- A Gift of Long-Term Capital Gains Property – that is, the contribution is of tangible personal property held by a collector or investor for over one year.
- A Gift to Public Charity – that is, the donee is a public charity supported by contributions and endowments from the broad general public. Example: Boston’s Museum of Fine Arts.
- The Gift Meets the Related-Use Rule – that is, the object will be held in the museum’s permanent collection and, generally, not sold for at least three years following the date of contribution with the proceeds of sale added to the museum’s endowment.
Based on these three assumptions:
- Amount of Charitable Contribution.
The charitable contribution is equal to the fair market value of the contributed art – regardless of the donor’s basis in the art. The amount of the contribution deduction will be supported by an appraisal. See the section on Appraisals, immediately below.
- Limitation of Contribution Deduction to 30 Percent of AGI
The charitable contribution deduction is limited to 30 percent of the donor’s adjusted gross income with a five-year carryforward of unused charitable contributions. The five-year carryforward of unused charitable contributions can be extended through Gifts of Fractional Interests, discussed below.
- Phase-Out of Certain Itemized Deductions
The charitable contribution deduction is further limited by the itemized deduction phase-out for certain itemized deductions. The AGI deduction limitation and the itemized deduction phase-out are further discussed under Tax Modeling, below.
- How Much is the Art Worth?
The charitable contribution deduction can never exceed the value of the contributed art. For gifts over $5,000 the value of the contributed art must be supported by an appraisal, which, as a “best practice,” should always be attached to the income tax return along with all exhibits.
- Obtaining a Qualified Appraisal
A qualified appraisal must include:
- A description of the property contributed.
- The cost, date and manner of acquisition.
- A history of the contributed item and proof of authenticity.
- Factors involved in the appraisal – such as sales of similar works by the same artist.
- Facts about the appraiser – such as, that the appraiser is an expert and is qualified to appraise the art.
The qualified appraisal must be received by the donor not more than 60 days before date of contribution by the donor and, generally, not later than the time that the return containing the related charitable contribution is filed.
It is critically important that the tax return preparer oversee the timeliness and quality of the appraisal drafting process. The tax return preparer must read the appraisal to make sure that there is full compliance with the IRS appraisal rules and that the appraiser’s methodology and conclusions appear reasonable. Typically, the tax return preparer and the appraiser will have several conversations and the appraiser will submit several iterations to the tax return preparer and the donor before the appraisal is completed. During this process, the tax return preparer’s sole involvement is to confirm that the appraisal meets all published criteria for a qualified appraisal acceptable to IRS – and that the appraisal in its entirety appears reasonable.
All of this takes time. Thus, the tax preparer’s first step in crafting a “boring” charitable contribution deduction is to arrange for a qualified appraisal that will be received by the donor within a time window beginning not earlier than 60 days prior to the contribution and not later than the tax return filing deadline. It is often wise for the tax return preparer to obtain a timely automatic six-month extension of time to file the donor’s income tax return.
- Avoiding Appraisal Penalties
The penalties for “getting it wrong” can be severe. Valuation overstatements of 150 percent or more of the correct value can result in a valuation penalty equal to 20 percent of the additional assessment arising from the valuation error. Valuation overstatements of 200 percent or more of the correct value can result in a valuation penalty equal to 40 percent of the additional assessment. For example, if an additional tax assessment $100,000 is due to a substantial valuation error, the valuation penalty can be as much as $40,000 (40 percent of $100,000), plus interest. See Section 6662, IRC. Valuation penalties can also be assessed on tax return preparers and appraisers.
Gifts of Fractional Interests
Due to the 30 percent of AGI limitation on charitable deductions, donors cannot always achieve a full charitable contribution deduction within the five-year charitable contribution carryforward period. If, however, a donor thoughtfully contributes fractional interests in art, it is more likely that the donor’s contribution deductions will be maximized.
One method for contributing fractional interests in art is to transfer title in the art to a Limited Liability Company (“LLC”). Under the LLC operating agreement, each LLC member will have the right to terminate the LLC at any time and obtain a partition of the property held by the LLC. This is similar to a so-called real estate trust under Massachusetts law. The donor then gifts fractional membership interests in the LLC to a public charity in annual amounts consistent with maximum use of the donor’s charitable contribution deduction. Of course, the donor will want to arrange for the gift of the fractional interest with the charity before setting up the LLC.
If fractional interests are contributed:
- The gift of fractional interests must be completed at the earlier of 10 years from the date of the first gift or the death of the donor.
- The value used for computing the first fractional gift must be used for computing the remaining fractional gifts.
The effect of the above rules is to extend the five-year charitable contribution carryforward period so that donors will be able to maximize their charitable contribution deductions.
It is important that the donor receive the tax result which the donor and her advisors expect. Therefore, it is important to model the tax return with several iterations as we consider how changes in the donor’s anticipated adjusted gross income (“AGI”) affect (1) the donor’s contribution deduction limitation and (2) the donor’s itemized deduction phase out.
- For example, it might be wise to postpone a gift in the year of a liquidity event. The increased AGI permits an increased contribution deduction. But the itemized deduction phase-out limits the charitable contribution deduction by up to 80 percent of the amount that might otherwise be deducted but for the phase-out. The charitable contribution deduction might produce stronger tax savings in the years following the liquidity event.
Art contributors who follow these common-sense observations will have both the satisfaction of contributing to the public good along with the peace of mind from having a “boring” charitable contribution deduction.
 In reported cases, the United States Tax Court has allowed a discount in the gift tax area equal to the cost of the legal action that a donee might otherwise have to take to obtain a partition of the property. If the donee has the right to collapse the LLC and partition the property at any time, IRS should not demand that a fractional gift to charity be discounted for the cost of partition.