It looks like fractional interest gifts of art will be a viable strategy for the wealthy once again.
On Aug. 6, 2009, Senator Charles Schumer (D. New York) introduced Senate Bill 1605 to restore many, but not all, of the tax benefits of fractional gifts of art and collectibles to charity that were wiped out by the Pension Protection Act of 2006 (PPA). Senate Bill 1605 is likely to become law, as it represents a compromise with Senator Charles Grassley (R. Iowa) — the architect of the 2006 effort to effectively nix fractional gifts.
Museums around the country, surprised by the PPA's attack on fractional gifts of art and collectibles, have been fighting for congressional relief ever since. No wonder. Since 2006, fractional interest gifts have ground to a halt. But before then, they facilitated some of the largest gifts of art ever made to museums. Think the Hope Diamond and the entire 53-painting Annenberg collection of impressionist and post-impressionist paintings at the Metropolitan Museum of Art.
It made sense for the wealthy to donate art in this way and they did so regularly. After all, they got very favorable tax treatment from donating just a fraction of their interest in art and collectibles to museums. Yet they still were able to keep the art in their homes some, if not all, of the time from the date of the gift until they died.
Set the Stage
In general, gifts of tangible personal property, including art and collectibles, are subject to some special tax rules. First, the income tax charitable deduction for a gift of appreciated art works or collectibles to a public charity depends on whether the charity's use of the gift is deemed “related” or “unrelated” to the charity's exempt purposes. If the gift's use is related, the donor is entitled to a deduction for the property's fair market value (FMV) — up to 30 percent of the donor's adjusted gross income with a five-year carryforward for any unused deduction. If the gift is unrelated to the charity's exempt purposes, the donor is entitled to a deduction equal only to his cost basis in the property — up to 50 percent of the donor's adjusted gross income with a five-year carryforward for any unused deduction.
So, for example, if a painting is contributed to the Metropolitan Museum of Art to be used for display, the use is related to the museum's exempt purposes, and therefore an FMV value deduction is available. But if the painting is given to the American Red Cross to be sold, the use of the property is unrelated to the organization's exempt purposes, and the donor would be entitled only to a cost basis deduction.
The second special rule relates to the distinction between gifts of partial interests versus gifts of an undivided interest. An income tax charitable deduction is not allowed for an outright gift of a partial interest in property; that is, a gift of less than the donor's entire interest in the property. But a deduction is allowed when a donor gives an undivided portion of his entire interest in the property. What is the difference between a partial interest (no deduction) and an undivided interest (deduction allowable)? When a donor retains a “substantial” right or interest in property donated to charity, he has given a “partial interest” for which a charitable deduction will not be allowed, unless the partial interest is in a specific form sanctioned by federal tax law (for example, a charitable remainder trust or a charitable lead trust). An “undivided interest” of the donor's entire interest, on the other hand, consists of a fraction or percentage of each and every substantial interest or right the donor has in the property: It must extend over the entire term of the donor's interest. If a donor contributes an undivided interest in artwork, he can retain personal possession proportionate to the non-charitable interest in the artwork.
For example, if an individual gives a one-sixth interest in a painting to a museum, he will be entitled to an income tax charitable deduction equal to the value of one-sixth of the painting and will be able to continue hanging the painting in his home for 10 months out of the year. The painting will technically be in possession of the museum for two months each year. If he decided to gift a second one-sixth interest in the fifth year, he would be entitled to receive an additional deduction at the then FMV. So, if the value appreciated from the time of the first fractional gift, such appreciation would be reflected in the deduction for future fractional gifts. Although the tax law did not require that the painting ultimately be completely owned by the museum, most museum's refused to accept such fractional interest gifts without a written agreement that the painting ultimately would belong exclusively to the museum.
Because of the costs and risk associated with the requirement that the painting or collectible be in the physical possession of the museum each year, fractional gifts of art were not that common before 1988. Then, in 1988, the Tax Court decided Winokur v. Commissioner, 90 T.C. 733 (1988).
The Winokur Court had to rule on the issue of whether a collector was entitled to an income tax charitable deduction for a gift of a 10 percent interest each year for several years in 44 works of art to a museum even though the museum did not take physical possession of the paintings in any of the years following the contribution. The court ruled for the taxpayer, holding that the donor was entitled to a deduction because the museum had the right to possess the paintings for the gifted portion of the year, even though it chose not to take actual possession. The Internal Revenue Service subsequently acquiesced on the decision.
Winokur opened the floodgates on fractional gifts of art. Between 1988 and 2005, an estimated 10 percent of art contributions were structured as fractional interest gifts. It was a deal that was too good to pass up. Wealthy donors could make fractional interest gifts of appreciating art, taking ever increasing charitable deductions over the years, without having the artwork leave their living room until they died.
Things changed on July 6, 2005 when reporter Rachel Silverman published an article in the Wall Street Journal extolling the benefits of fractional gifts of art titled “Joint Custody for Your Monet; Fractional Giving Hits the Art World, as Donors Share Works.” Senator Grassley read the article with great interest — and anger. At the time, he was preparing to introduce sweeping charitable legislation, which ultimately became part of the PPA.
Almost without warning, Section 1218 of the PPA essentially wiped out the fraction gift technique. This Section required donors engaging in fractional interest gifts of art to:
1. donate the entire painting within 10 years from the initial gift or the earlier death of the donor;
2. transfer physical possession of the painting during some part of the gifting period; and
3. limit the deduction for future fractional interest gifts to the lesser of the value at the time of the first contribution and the FMV of the painting at the time of the subsequent donation.
The law had real teeth: Failure to comply with the requirements led to a 100 percent recapture of any deduction taken — plus a penalty.
If this wasn't bad enough, the law was mistakenly written in such a way as to cause an inadvertent gift or estate tax to the donor. This error was corrected only in 2008.
The 2006 law basically ended fractional gifts of art as a viable tax technique.
Big Boys Compromise
Once museums realized the impact of the new law, serious lobbying began. Museums found a friend in Senator Charles Schumer, who along with Grassley is a member of the powerful Senate Finance Committee.
After more than two years of negotiating, Schumer and Grassley agreed to a compromise bill, which, if enacted, would restore most, but not all, of the benefits of fractional interest gifts of art.
Senate Bill 1605 modifies the existing law with respect to fractional interest gifts so that:
1. It extends the time to complete the contribution from 10 years to 20 years;
2. It allows fractional gifts after the initial contribution to be valued at the FMV at the time of the subsequent gift, rather than at the value at the time of the initial gift;
3. It requires the initial gift be at least 10 percent of the total value of the art and that by the eleventh year at least 20 percent be contributed; and
4. It requires that the museum have physical possession of the contributed property and use it in accordance with its exempt purposes for an amount of time proportionate to its ownership every five years.
Because of Grassley's support, the bill should pass with ease. But precisely when that might happen is still not clear. When it does, although the new regime won't be quite as donor-friendly as the rules during the Winokur days, it should be enough to quiet the museum world's Munch-like scream over the loss of the fractional interest gift — and leave art donors and museums sporting a Mona Lisa smile.