Tuesday October 3, 2023
Article of the Month
Substantiation of Charitable Gifts of Art Part One
Donating a work of art to a charitable organization can be a meaningful way to align an individual's passion for art and culture with their philanthropic goals. Charitable gifts of art can offer substantial tax advantages provided donors and their professional advisors understand the federal regulations governing these types of charitable gifts.
The Internal Revenue Service (IRS) requires donors who claim charitable income tax deductions to substantiate the value of their charitable contributions. Additionally, charitable gifts of noncash assets valued above a certain threshold require donors to obtain a qualified appraisal of the asset for substantiation purposes. The Service's substantiation rules are strict. If these rules are not closely followed, a donor may lose his or her entire charitable deduction. Several factors may impact a donor's charitable deduction. Advisors should be ready to identify and elaborate on these factors and help donors navigate the process of substantiating charitable gifts of art to meet the Service's requirements.
This article will cover related or unrelated uses of art and the impact of a donor’s classification as an investor or dealer for purposes of deduction limits. Next month’s article will discuss the substantiation rules for noncash gifts, including qualified appraisal requirements, the role of the Commissioner’s Art Advisory Panel and a discussion of gifts of partial interests in art. By understanding the rules and regulations surrounding charitable gifts of art, advisors can help ensure that their clients properly and accurately deduct their charitable donations.
Deduction Valuation for Charitable Gifts of Art
Related vs. Unrelated Use
Art falls within the tangible personal property (TPP) classification, which encompasses a broad range of assets, including antiques, artwork, collectibles and essentially anything other than real estate or intangible personal property. The charitable deduction for TPP depends on how the public charity will use the gift. The classification of the property will either be as a related or unrelated use asset. A related use gift occurs when the charity’s use of the property is related to its exempt purpose. An unrelated use occurs when the charity does not use the property as part of its charitable mission or exempt function. Sec. 170(e)(1)(B)(i).
Many related use examples are straightforward to discern. For example, a painting contributed to an art institute for study by its art students would constitute a related use. Furnishings given to a charity for its offices and buildings in the course of carrying out its functions would also qualify as related use. Reg. 1.170A-4(b)(3)(i). However, a contribution of valuable art to an organization that quickly sells the artwork and uses the proceeds for educational purposes is not a related use.
If the property being donated is a long-term capital gain asset, which is an asset held for more than one year, and qualifies as related use property, the gift of the appreciated property produces a charitable deduction equal to its fair market value. The charitable deduction can be used to offset up to 30% of the donor’s adjusted gross income with a five-year carry forward. If the gift is unrelated to the organization’s exempt purpose, the deduction is limited to the lesser of cost basis or fair market value. The gift will be deductible up to 50% of adjusted gross income with a five-year carry forward.
The charity must provide the donor with substantiation to establish that the gift is related to the organization’s exempt function. The donor would need verification from the nonprofit that the property is not put to an unrelated use by the organization or that at the time of the contribution, it is reasonable to anticipate that the property will not be put to an unrelated use by the organization. Reg. 1.170A-4(b)(3)(b). To affirm the artwork is being used for a related purpose and ensure that donors receive a proper deduction, advisors should prompt donors to obtain written confirmation from the charitable organization. The confirmation letter or certification statement should list the date of the gift, identify the property donated, the intended use of the gift and its relationship to the organization’s exempt purpose. If the donated art is sold or disposed of by the charity within three years of the date of the contribution, the related use requirement will not be met, and recapture of the deduction may occur. The organization is also required to submit Form 8282 to both the IRS and the donor, disclosing the disposal of the gift if it occurs within the required three-year holding period.
To gain insight as to how the IRS applies the related use test, one can refer to private letter rulings (PLR) as a source of guidance but is not precedent. For example, in PLR 8347062, a retirement center collected paintings, sculptures and graphics to exhibit in its corridors, lounges and other public areas to “enrich and enhance the residents’ lives and to provide the stimulation necessary to keep residents motivated and alert.” The donor gave a painting to the retirement center and the painting was showcased in the organization’s facility. The IRS ruled that the donor could deduct the full market value of the donated property because the use of the painting related to the organization’s exempt purpose of providing care for elderly individuals. Additionally, in PLR 8202059, the IRS held that the related use test was satisfied when a donor gave his stamp collection to a college since the school planned on exhibiting the collection and simultaneously held a course in engraving skills as part of its academic program.
While private letter rulings may not be relied on as precedent, they play a crucial role in offering guidance when assessing whether the related use test is satisfied and give insight to the factors the IRS considers when making its determination.
Dealer or Investor
A donor’s tax deduction limits will also depend on the donor’s classification as either an investor or a dealer. The starting point for distinguishing between a dealer and investor lies with IRC Sec. 1221, which, in part, explains that property will not be considered a capital asset in the hands of a taxpayer if the property is “of a kind which would properly be included in the inventory of the taxpayer on hand at the close of the taxable year,” or is “held by a taxpayer whose personal efforts created such property.” An asset may have the correct holding period to be considered long term, but the asset in the hands of the donor may not be a capital asset.
Therefore, if an individual holds artwork for sale or as part of a trade or business or is the creator of the artwork, then he or she may be classified as a dealer and the related use rules will not overrule this classification’s impact on the asset’s deduction limits. When a donor is classified as a dealer and makes a gift of artwork to charity, the asset is considered an ordinary asset and the donor’s deduction will be limited to his or her cost basis. Because property in the hands of the creator is excluded from treatment as a capital asset, art created by an artist is considered ordinary income property and the deduction will also be limited to his or her cost basis. Sec.1221(a)(3)(A). Typically, an artist’s cost basis will consist of the supplies used to create the art such as paint and canvas. The donor can deduct the basis value up to 50% of adjusted gross income in the year of the gift.
Despite not conducting a trade or business, however, a donor’s deduction might still be restricted to his or her cost basis if the donor acts like a business owner with regard to the contributed property, which may be related to the frequency of sale transactions. The IRS classifies a donor who acts like a business owner with the contributed property as a dealer rather than as an investor. On the other hand, if a person buys, sells and collects art primarily as a financial investment, with the expectation that the asset will appreciate in value and therefore sell at a profit, he or she may be classified as an investor. If the donor is considered an investor, he or she will be able to claim a fair market value deduction for the gift if it is for a related use and can deduct up to 30% of adjusted gross income.
Clear guidance is lacking related to the dealer-investor determination. Classification is based on facts and circumstances specific to each donation. While a business that is generally involved in the routine of buying and selling art may typically be classified as a dealer, the owners may very well take part in separate transactions of purchasing art for investment purposes that can place them in the category of investors. Investors are given a more favorable charitable deduction if the art is donated for a related use gift. One factor the IRS may consider when differentiating between dealer or investor status includes the purpose for acquiring the art. The IRS may request information related to whether the piece of art was purchased for a quick resale (dealer), or if it was purchased for the purpose of allowing the art to gain value over time (investor). Another factor assessed is the frequency of the sales. Because dealers hold artwork as part of their trade or business, they are more likely to turn over inventory at a quicker rate than an investor, who is more likely to wait to purchase new artwork or sell their existing pieces. The IRS will also consider the donor’s primary business. Investors tend to be engaged in other professions, whereas a dealer is primarily purchasing and selling art.
The distinction between dealer and investor is an important factor that advisors must take into consideration when guiding clients through the charitable giving process. Because there is no bright line test to determine who is considered a dealer and who is an investor, the classification as a dealer or investor will depend on the facts and circumstances. Advisors should ensure they are providing their clients with accurate information and steering them toward a charitable gift that will maximize their tax savings.
Example 1—Related use for Investor
Mitchell is an art investor with a philanthropic spirit and passion for supporting educational initiatives. Mitchell has been collecting contemporary art for years, gathering a diverse collection of paintings and sculptures that explore the intersection of science and art. Mitchell decided to donate his art collection to an organization that runs educational programs for underserved youths, with a specific focus on science and art integration. This organization uses art as a tool to spark interest in science and technology among young people, encouraging creativity and critical thinking. Because the charity intends to hold the assets for the charity’s mission, which directly supports their educational programs, Mitchell is eligible for a charitable tax deduction equal to the qualified appraised fair market value of the artwork.Example 2—Related use for Dealer
Olivia is an independent art dealer with a specialization in representing emerging artists who struggle to gain recognition in the art world. Over the years, Olivia has built a large inventory of artwork by several of these talented artists, with frequent sales transactions as part of her business. With a heart for philanthropy, Olivia decided to support a local youth art program that provides children with access to art classes and other creative opportunities. She donated a selection of artwork from her inventory to charity, which aligns with the organization’s exempt purpose of fostering artistic expression among the youth. Olivia’s gift was of inventory, which is not a capital asset. While Olivia’s donated artwork is a related use item, as a dealer, Olivia is limited to a charitable deduction equal to her cost basis. The items classification as inventory and her position as an art seller will overrule the related use rules for her donation.Example 3—Unrelated use for Investor
Sara is an art enthusiast and investor who has been collecting classical art for several years. Sara has assembled a diverse collection of valuable pieces and would like to support a nonprofit that focuses on providing meals and assistance to those in need. Sara donates some of her high basis artwork from her collection to further the mission. While the nonprofit was grateful for the gift of the artwork, the gift planner spoke with Sara before receiving the gift to explain that the gift policy of the charity was to sell gifts of art and use the proceeds to provide additional meals and assistance. Sara was aware of the policy and understood the impact on her charitable deduction. She moved forward with the gift because her gift could further the impact on the organization’s mission and her cost basis was high. The gift of the artwork is not considered a related use gift because the asset was sold, rather than used in the course of the nonprofit’s exempt purpose of helping those in hardship. Sara will receive a charitable deduction equal to the cost basis.When determining whether the charitable deduction for donating artwork will be based on fair market value or cost basis, the initial consideration is whether the artwork's use will be related to the charity's exempt purpose. In the case of a related use, the subsequent step involves categorizing the donor as either an investor or dealer. If the artwork's use is unrelated to the charity's mission, the classification of the donor as an investor or dealer becomes inconsequential, and the donor will be restricted to a deduction based on the cost basis. Similarly, if the asset is not considered a capital asset in the hands of the donor, even with a related use gift, the donor will be limited to cost basis for the value of the charitable deduction.
Donating artwork can be a significant and valuable way to support charitable causes. Knowing the tax laws on charitable gifts of artwork can help donors claim the correct charitable deduction. Advisors play a pivotal role in educating donors and making sure they follow guidelines closely. It is important that advisors keep donors well informed on relevant regulations related to gifts of artwork and encourage donors to maintain organized records of their contributions. Doing so can protect donors from potential IRS issues, help maximize their deductions and ensure that donors receive the full tax benefits they are entitled to. By complying with the Service’s related use requirements and knowing whether the donor is categorized as a dealer or investor for deductibility purposes, donors can avoid financial penalties and loss of tax benefits from their charitable contributions.