More than an investment, collecting artwork is a hobby of passion. For some, the enjoyment of artwork is so intensely personal that collectors may prefer to donate their collections for public enjoyment rather than pass them on to family members who may not share the same appreciation. Some of the inherent difficulty and uncertainty in valuing art may also make a charitable donation at death an easier choice. And of course, the income and estate tax benefits of charitable gifts may make a charitable donation an even more attractive option.
Here’s the charitable giving landscape as it relates to artwork.
Charitable Deductions
The simplest way to donate artwork is a bequest at death. This type of transfer produces a full estate tax deduction equal to the fair market value (FMV) of the work on the date of death. Transfers during life, however, produce both a gift tax deduction and an income tax deduction that can offset ordinary income for the full FMV of the work, as established by appraisal (generally speaking, up to a cap of 30 percent of the donor’s gross income for the year).1 The primary limitation on the availability of these deductions is known as the “related use test.” This test requires that the contribution be made to an organization in which the use of the art is related to its mission (for example, a museum).2 If, on the other hand, a work is contributed, for example, to a church or school with the expectation (or reasonable anticipation) that the organization will sell the work and use the proceeds in furtherance of its mission, the donor’s income tax deduction is limited to the collector’s basis in the asset rather than the (likely substantially higher) FMV.3
Public Museums
Transfers to public museums will always qualify for tax deductions. But, the most significant benefits deriving from a contribution to a public museum from a collector’s standpoint may be non-monetary. Because art is so intensely personal, some collectors derive substantial satisfaction from sharing a work or collection with the public. There may be significant prestige associated with the public attribution of works to its benefactor, especially when the works are displayed at highly regarded institutions. And, depending on the museum and the number of works donated, the institution may be amenable to allowing the collector to specify certain conditions for the display of the artwork—for example, that the works be displayed in a wing named after the donor or that the collection be kept together for a finite period of time.
Because the overhead associated with maintaining a significant collection can be high, thereby increasing the likelihood that an institution would be required to break it up at some point, one way to ensure that the collection stays together is to establish an endowment at the public institution capable of covering the costs of maintenance for a period of years or indefinitely. The endowment makes it more likely that the public museum could accommodate the wishes of the donor, but the parties should negotiate a gifting agreement at the time of the contribution to set appropriate expectations. An income tax deduction is also available for the property contributed to establish an endowment.
Fractional Interests
An income tax charitable deduction is attractive to many donors, but the idea of parting with a work during lifetime may be less so. Fortunately, it’s possible to make a gift of a fractional interest in art during life and to give the remaining interest at death.4 Generally, when fractional interests in assets are transferred, a discount may be taken into account for the lack of marketability or control. Not so in the art world. The most taxpayer friendly aspect of these fractional art gifts is that the fractional interest can be given without the imposition of a valuation discount as it applies to the income tax deduction. That is, if a collector donates a one-half interest in a particular work to a public museum, for example, worth $1 million on the date of the donation, the collector is entitled to a $500,000 charitable income tax deduction, provided the limitation requirements of Internal Revenue Code Section 170(b) are respected. Because the fractional interest donated must consist of a proportional interest of each and every right owned by the donor in the property,5 the collector may continue to enjoy the work in his home for the fraction of the year that corresponds to the interest he’s retained, with the museum having possession for the remainder of the year.
It’s important to note, however, that when a collector contributes a fractional interest in a work of art to a museum, the income tax deduction is subject to recapture if the entire interest doesn’t pass to the museum within 10 years (or on the donor’s earlier death).6 At the time the remaining interest in the work passes to the museum, an income tax deduction is permitted for the remainder interest, also without the imposition of a fractional interest discount.
Because collectors are investors—passionate, though they may be—and because the income tax deduction may be a significant factor in determining how to dispose of certain works of art, it’s important to understand that the income tax deduction available at the time the remaining fractional interest passes to the museum is limited. The deduction is capped at the fraction transferred multiplied by the lesser of the FMV on the date of the original contribution or the FMV on the date of the additional contribution.7 There’s also a risk of recapture of the deduction if the rules regarding shared ownership aren’t respected.
The final consideration relating to gifts of fractional interests is that logistical complications can make many larger public institutions (especially those that are fortunate to have many offers of donation) reticent to accept a fractional interest in art because it requires proportionately shared possession. The time that art is most vulnerable to damage is during transit. In the right situation, however, this arrangement can be mutually beneficial to the donor and the recipient institution. For example, a work of art that hangs in a vacation home or seasonal residence may be better protected from theft and deterioration if, in the months when the home is unoccupied, it’s housed safely in a public museum. And for less widely regarded museums especially, the opportunity to house a significant work of art for even part of the year (with the promise of receiving the whole work within 10 years) can be an exciting prospect.
Private Museums
For a variety of reasons, traditional public museums are selective about what they’ll accept. A museum may not specialize in the genre of the work proposed to be donated. Or, a museum may be flooded with works by the same artist—or the public may be currently less interested in a particular artist’s work. In addition, donating to a public museum means parting with control over the work and—at a maximum—a limited 10-year duration in which to continue to enjoy the art at home. In recent years, the establishment of private museums by collectors has gained significant popularity. But, these museums aren’t a new concept. In fact, private museums have a long and storied history in the United States, and they include the famous Frick Collection in New York City, the long embattled Barnes Foundation in Philadelphia and the Rubell Family Collection, which is housed in a transformed Drug Enforcement Agency warehouse in Miami. In addition, the impressive new Crystal Bridges Museum, established by Wal-Mart heiress Alice Walton in Bentonville, Ark., is technically a private museum. Although a private museum needn’t rise to these standards, the high (but income tax deductible) overhead of running a private museum and the necessity and attendant cost of providing a public benefit means that the collector with a $100 million collection is a better candidate for this strategy than perhaps the collector with a $5 million collection.
Private museums can be run exclusively by a private operating foundation (POF) controlled by the donor and may—with due caution—even be situated near the donor’s residence. There are two primary requirements for a foundation to qualify as a POF. The first is that the foundation must make “qualifying distributions” directly in pursuit of its purpose equal to the lesser of: (1) its adjusted net income, or (2) its minimum investment return.8 Qualifying distributions are any amounts reasonably paid by the foundation to accomplish the foundation’s purpose, so long as that purpose is charitable.9 In the case of a private museum, the charitable purpose is considered to be educational. The second requirement is that substantially more than half of the foundation’s assets are devoted to the foundation’s primary activity (that is, the operation of the museum).10 In the case of important artwork, the most valuable assets of the foundation almost certainly consist of the collection, the display of which is a use in furtherance of the foundation’s charitable purpose. The foundation must report its activities, income and disbursements annually on the foundation’s informational tax return, Form 990-PF.
The tax benefits associated with a private museum include the ability to take a charitable income tax deduction for the full FMV of any assets contributed to the museum and for contributions to cover the museum’s overhead and the purchase of additional works of art. These expenses can include the costs of conserving and insuring the works, as well as the expenses of establishing a storage facility and display space. A significant added benefit is that contributions to POFs are deductible up to 50 percent of the taxpayer’s gross income for the year.11 Moreover, assets contributed to a private museum to purchase new art can produce a sales tax benefit in addition to the income tax benefit because the purchase by the private museum of new artwork is exempt from state and local sales tax. A private museum is also a guaranteed way to keep a collection together, which may be impractical or even impossible in the public realm. Because many public museums can afford to be picky when it comes to what they’re willing or able to accept, and then, as to how a work or collection of works will be displayed, a private museum affords a collector the opportunity to display his collection in exactly the desired manner.
As noted above, the purpose served by a private museum is educational. But, the educational nature of a private museum isn’t served by merely hanging paintings on the wall of a room in your home, inviting a group of school children to view them and calling this a museum. Instead, the publicly subsidized tax benefit to the collector depends on the educational benefit actually bestowed on the public. Experts agree that, although the Tax Code clearly permits the establishment of private museums, the spirit (and not just the letter) of the law should be complied with to avoid Internal Revenue Service objection. The regulations are vague about the amount of “public benefit” that’s sufficient to justify preferential tax treatment.
Private museums take advantage of a Tax Code that encourages collectors to share their artwork with the public—a premise based on the educational benefits provided by the museum—so the most important element to a successful private museum is ensuring public access. This access can be accomplished through advertisement and opening the doors to the public with regular hours (or even potentially by appointment only), lending out works of art, giving grants, making the collection available for research and engaging in public education. The IRS position is that merely having visiting hours won’t suffice; there must also be sufficient advertisement and signs encouraging visitors if that’s the basis on which the public benefit position relies.
The IRS also tends to look down on those museums that are located in close proximity to the donor’s home or office because that could signal that the primary benefit provided by the collection is to the donor and not to the public.12 Close proximity to the donor’s home also suggests a higher likelihood that the painting could be used in the donor’s home. It’s generally accepted that this use is impermissible even for the duration of a cocktail party. However, there are many private museums located on the same property as the collector’s home that manage to retain their exempt status by complying with the public benefit requirement in other ways.
The IRS is also likely to look down on private museums that are secluded or difficult to find, don’t encourage and advertise their location, hours or events or permit visitation by only a few groups annually. In reality, there’s very little guidance as to what amount of public benefit is enough, so it’s important to advise clients to be practical and generous when it comes to the public benefit in establishing their private museums because they’re likely to receive special scrutiny. If it doesn’t pass your smell test, it probably won’t pass the IRS’ either.
For a charitably inclined collector, the takeaway is that retaining full ownership of a collection of artwork is the only way to retain unfettered control and enjoyment at home indefinitely. For works with which a collector has an intensely personal connection, this option may be the most viable. Of course, donation to a public or private museum during life has its own significant benefits, and for the collector who’s willing to part with at least partial control or enjoyment, these may be good options.
Endnotes
1. 26 U.S.C. Section 170(b)(1).
2. Treasury Regulations Section 1.170A-4(b)(2), (3).
3. 26 U.S.C. Section 170(e)(1)(B)(i).
4. Treas. Regs. Section 1.170A-7(b).
5. Treas. Regs. Section 1.170A-7(b)(1)(i).
6. 26 U.S.C. Section 170(o)(3)(A).
7. 26 U.S.C. Section 170(o)(2).
8. 26 U.S.C. Section 4942(j)(3)(A)
9. 26 U.S.C. Section 4942(g)(1); 26 U.S.C. Section 170(c)(2)(B).
10. 26 U.S.C. Section 4942(j)(3)(B)(i).
11. 26 U.S.C. Section 170(b)(1)(A)(vii); 26 U.S.C. Section 170(b)(1)(F)(i).
12. Patricia Cohen, “Writing Off the Warhol Next Door,” The New York Times (Jan. 10, 2015); Ruth McCambridge, “Personal Art Collection or Tax-Exempt Museum? The Rules are Vague,” Nonprofit Quarterly (Jan. 12, 2015).