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Artists are different. Anyone who works with artists, or anyone who knows an artist, can attest that devoting one’s life to the creation of art requires a unique mentality. Artists traffic in a certain kind of alchemy; they take ordinary materials with little to no intrinsic value and turn them into priceless objects of aesthetic and cultural significance.
The Internal Revenue Service, too, recognizes that artists and their artwork are unique and, accordingly, applies different rules to them. Advisors have varying opinions on how best to navigate the rules and regulations applicable to artworks. Sometimes, the best approach from an income tax perspective isn’t the best approach from an estate tax perspective, and advisors must examine all angles when determining what recommendations to make.
Artists and collectors engage in business when they sell their work, but art-related transactions can be imbued with emotion and non-business considerations; the artist’s or collector’s reputation and legacy are part of every transaction. Artists necessarily operate within business structures, but the artist isn’t always focused on business-related details. Often, the creation of the work comes first, and the business structure grows organically around it. The business adapts to the art rather than the other way around. In some cases, advisors recommend changes to the structure of an art-related business in reaction to certain changes in the federal or state income tax regime without sufficient regard to the estate tax consequences.
Income Tax Considerations
Because the IRS recognizes the uniqueness of artwork, income tax provisions relevant to artists and collectors have a few unusual characteristics. Artist-created work isn’t considered a capital asset in the hands of the artist, so sales proceeds are taxed as ordinary income rather than capital gains.1 Artwork by successful artists often constitutes a substantial portion of their financial net worth. Artists often want to express generosity to their family members and friends through gifts of artwork. Typically, gifts of appreciated property carry a tax burden of built-in capital gains because the recipient assumes the tax cost basis of the gift’s donor. Gifts of artwork from artists carry an even greater tax burden because the IRS doesn’t consider the artwork a capital asset in the hands of the donee.2 The IRS determines the tax cost basis of a gift of artwork received from an artist by reference to the artist—the taxpayer whose personal efforts created such property.3 Proceeds of sales of artwork sold by the recipient of a gift of art from an artist are subject to tax as ordinary income rather than as capital gains. It’s important to note that even though the net value of a gift of art from an artist is reduced by the income tax burden on the recipient, for transfer-tax purposes, the gift of artwork is valued at the fair market value on the date of the gift. This enhanced tax cost equates to a waste of lifetime gift exemption and deters advisors from recommending that artists make gifts of art to individuals during their lifetime.
For art collectors, the IRS considers artwork a capital asset but differentiates artwork from other capital assets by categorizing artwork as “collectibles” subject to the highest rate of federal capital gains tax of 28%.4 This top rate is often increased by an additional 3.8% net investment income tax applicable to high earning individuals. When a collector makes a gift of appreciated artwork to another individual, the donee receives the donor’s basis, and any sales proceeds would be subject to the enhanced capital gains tax on collectibles.
Digital art in the form of nonfungible tokens (NFTs) is a new medium that some artists have begun exploring. Although the tax rules around NFTs aren’t yet clear, some practitioners believe that the income taxation of NFTs will follow the basic principles outlined above. The creator of the digital artwork would pay tax at ordinary income tax rates on the initial sale of the NFT. One advantage of NFTs for an artist is that unlike with traditional forms of artwork, the artist can continue to receive a percentage of the sales price of all subsequent sales of the NFT or a percentage of a fee charged to viewers of the NFT, akin to a royalty interest.5 For collectors, it appears that NFT sales proceeds would be subject to capital gains tax as collectibles. In March 2023, the IRS issued Notice 2023-27, requesting comments on this issue and stating that the IRS intends to “look through” the NFT. To determine whether the NFT is a collectible, the IRS would determine whether the NFT’s associated right or asset is an Internal Revenue Code Section 408(m) collectible subject to the 28% capital gains tax. The guidance also states that the IRS is considering the extent to which a digital file can constitute a “work of art” under IRC Section 408(m)(2)(A).6
Prior to the passage of the Tax Cuts and Jobs Act of 2017 (TCJA),7 artists and art owners could exchange artwork as a tax-free transaction under the like-kind exchange rules of IRC Section 1031. The TCJA limited the application of Section 1031 to exclude artwork from the types of property eligible for like-kind exchanges. Without the application of Section 1031, swaps of artworks are deemed sales and purchases and subject to income taxation.
Business Structures
At least at the outset of their careers, most artists operate alone. Their businesses are often sole proprietorships and may convert to limited liability companies (LLCs) or S corporations (S corps) as they generate higher income levels. LLCs and sole proprietorships have the advantage of simplicity; when a work of art is sold, all sales proceeds flow to the owner and are fully taxable. LLCs have the added benefit of the limitation of liability. In both cases, for estate tax purposes, all art inventory owned by a sole proprietorship or an LLC can receive a full step-up in basis at the death of the artist (with the appropriate election under IRC Section 754 in the case of an LLC).
Since 2017, Section 199A of the TCJA has allowed owners of certain pass-through businesses such as partnerships, S corps and sole proprietorships to claim an income tax deduction of up to 20% of qualified business income (QBI) in certain circumstances (the Section 199A deduction). The TCJA provided a significant tax cut for
C corporations, and Section 199A was intended to provide a similar benefit to small business owners.8 Along with many TCJA provisions, Section 199A is set to expire at the end of 2025. While there’s been disagreement about whether non-performing artists qualify for the deduction, the income thresholds and limitations mean that the number of artists who would qualify, if any, is limited.9 In a narrow band of situations, it may be possible that the Section 199A deduction could be greater if the art business is structured as an S corp rather than as an LLC, if the business isn’t categorized as a specified service, trade or business and substantial compensation is paid to the business owner and/or other employees.10 After the passage of the TCJA, some artists created S corps to enhance savings using the QBI deduction. Now that the sunset of Section 199A is nearing, artists, art dealers and their advisors have an opportunity to re-examine whether the S corp is the appropriate structure for their business.
Additional S Corp Considerations
Compared to LLCs, S corps can be complex and rigid structures. The types of eligible shareholders are limited, the ownership interest is limited to one class of stock and, in general, transactions between an S corp and its shareholders, including asset contributions and asset distributions, can be taxable events.11 With an LLC, transfers of appreciated property between the LLC and a member are usually non-taxable events.
In addition to the potential for enhanced savings with the Section 199A deduction, the S corp structure offers the possibility of self-employment tax savings. When a business is structured as an LLC and classified as a partnership for federal income tax purposes, members of the LLC are subject to self-employment tax on their share of income flowing through that partnership.12 When a business is structured as an S corp, not all of the income automatically flows through; the S corp can pay the owner a salary, subject to applicable employment taxes, with the remaining S corp income flowing through as a distributive share of profits, not subject to employment or self-employment taxes.13
Some artists have structured their businesses as S corps to take advantage of the ability to split the S corp’s income into salary and distributions. While the salary portion of the payments is subject to the self-employment tax, the distribution portion isn’t subject to the self-employment tax, as long as the IRS considers the wages to be reasonable compensation. Considering that the highest rate of self-employment tax is over 15% (reduced to 2.9% for income over the Social Security wage base), this savings can translate into large numbers for successful artists and owners of art-related businesses, though it’s worth noting that a lower salary today translates into lower Social Security payments tomorrow.14
S Corp Complications
A significant complication of S corp status is the estate tax treatment of S corp shares. On the death of an owner of those shares, the decedent’s estate obtains a step-up in tax cost basis for the S corp shares. However, this basis step-up applies only to the “outside” basis of S corp shares and not to each underlying asset held by the S corp. The basis of each artwork held by an art-related S corp business doesn’t receive a step-up in basis for estate tax purposes at the shareholder’s death. As discussed above, artists are deterred from making lifetime gifts because of the tax burden borne by the recipient—the artwork isn’t a capital asset in the hands of the artist’s donee, so the recipient is taxed on sales proceeds at ordinary income tax rates. It’s essential to many artists’ estates that their artwork, which is often the most valuable component of the artist’s estate, receive a basis step-up at the artist’s death.
Practitioners have proposed solutions to allow a decedent’s estate to obtain a higher basis in S corp shares through a conversion to partnership status. Although a liquidation would result in taxable gain for the estate, the gain would increase the basis of the S corp stock proportionately.15 However, this type of transaction would add complexity to the estate and require expenditures of time and money.
Charitably inclined artists should consider the limitations of donating art held in an S corp. If an artist’s S corp donates appreciated assets directly to charity, the corresponding charitable deduction would flow through to each shareholder on a pro rata basis.16 Note, however, that the deduction amount remains limited to the shareholders’ basis in the stock.17 As a result, the shareholder can deduct only up to the value of their basis in their stock, subject to the individual adjusted gross income percentage limitations on deduction.
The charitable deduction also reduces the shareholder’s income tax basis in their stock by the tax basis of the asset contributed by the S corp to the charity.18 Taxpayers should review the impact of these rules with their tax counsel, as S corp shareholders commonly have a low basis in their S corp stock to begin with.
LLC Benefits
Another option is for artists and art businesses operating S corps to transition away from this structure to obtain a straightforward basis step-up at an artist’s death. An artist could leave the S corp structure in place and create a new LLC to hold future inventory. The inventory held in the S corp could be sold during the art owner’s lifetime, and any new inventory held in the LLC would receive a stepped-up basis at the owner’s death. The owner would lose the benefit of the reduced self-employment tax on distributions from the S corp if the future earnings were paid through the new LLC, but that loss may pale in comparison to the benefit of obtaining a stepped-up basis on the artwork in the hands of the artist’s estate. On the LLC owner’s death, the LLC can make a Section 754 election to step up the tax cost basis of the assets.
Deductibility of State/Local Taxes
Under TCJA, the deductibility of state and local tax (SALT) payments for federal income tax purposes was limited to $10,000 per household. For taxpayers in high tax jurisdictions, this limitation has resulted in much higher federal income tax obligations since 2017. The limitation of the SALT deduction is scheduled to sunset at the end of 2025. The SALT limitation deduction applies to individuals but not to pass-through entities, so taxpayers who operate their business through partnerships, S corps and certain LLCs have an advantage in certain jurisdictions. Some states have created new tax treatment for pass-through entities since the TCJA, which allows certain entity owners to exceed the federal limits on state tax deductibility. In New York, partnerships or S corps can elect to pay pass-through entity tax (PTET) on certain income, and their shareholders may be eligible for a PTET credit on their New York State income tax returns.19 Practitioners should re-examine any structural changes made to artists’ businesses to qualify for the pass-through entity exemption in light of the sunset of this provision.
Sunset of Estate/Gift Tax Exemption
The increased transfer-tax exemption amounts provided in the TCJA are scheduled to sunset at the end of 2025. The current exemption level of $13.61 million will be reduced to approximately half that amount, depending on inflation adjustments. Advisors everywhere are encouraging individuals who may have taxable estates after 2025 to make significant gifts to irrevocable trusts using the historically high exemption amount available now. Ideally, the transfers are made with high cost basis assets or cash because the trust will share the donor’s basis in the trust assets.
Artists and art collectors differ from other high-net-worth individuals because a sizable portion of their net worth lies in illiquid artwork. It may be difficult for an artist or collector to part with enough liquid assets to take full advantage of the exemption, even though their taxable estates are projected to be higher than the 2026 exemption amount. If an art owner wishes to make a large gift to a trust and doesn’t have enough liquid assets to fund the gift, they can consider taking out a loan secured by artwork and funding the trust with cash if they have sufficient liquidity to make loan payments. If a loan can’t be obtained or is inadvisable, another riskier option may be to partially fund the trust with artwork. If the trust is structured as a grantor trust and the grantor has a power to substitute assets of equivalent value, the grantor could plan to swap cash for the artwork as cash becomes available through sales of artwork outside of the trust. This option carries risks in terms of the grantor’s mortality and in the valuation of the artwork (and the volatility of the broader art market).
Sunsets as Opportunities
Artists see the world differently. Sunsets can inspire artists and spur creation of great works of art; for advisors to artists, the sunset of the provisions of the TCJA covering the QBI deduction, the limitation on deductibility of SALT payments and the increased estate and gift tax exemption can inspire advanced planning techniques and re-examination of the structures being used for art businesses. In some situations, the reasons for creating the business structure may no longer be relevant. As the scheduled sunset nears, artists, collectors and their advisors should assess and compare the current and future benefits of their structures and consider opportunities for estate planning before 2026.
Endnotes
1. Internal Revenue Code Section 1221(a)(3)(A).
2. David Stutzman and Elizabeth Minnigh, Portfolio 815-3rd: Planning for Authors, Musicians, Artists, and Collectors, VII, https://pro.bloombergtax.com/portfolio/planning-for-authors-musicians-artists-and-collectors-portfolio-815/.
3. IRC Section 1221(a)(3)(C).
4. IRC Sections 1(h)(4), 1(h)(5) and 408(m).
5. Walter Effross, Leonard Goodman, Anthony Pochesci and Jay Soled, “Tax consequences of nonfungible tokens (NFTs),” Journal of Accountancy (June 24, 2021).
6. IRC Notice 2023-27 (March 21, 2023).
7. Tax Cuts and Jobs Act of 2017, P.L. 115-97; IRC Section 1031.
8. Tony Nitti, “Understanding the New Sec. 199A Business Income Deduction,” The Tax Adviser (April 1, 2018).
9. Judith Folse Witteman, “Sec. 199A: Regulations shed light on QBI deduction,” Journal of Accountancy (Feb. 1, 2019).
10. Beth Y. Vermeer, Brian R. Greenstein and Mark B. Persellin, “Optimal choice of entity for the QBI deduction,” The Tax Adviser (March 1, 2020).
11. See Treasury Regulations Section 301.7701-3(g)(1)(ii).
12. Shaun M. Hunley, “Self-employment tax and LLCs,” The Tax Adviser (Oct. 1, 2022).
13. Treas. Regs. Section 1.1402(a)-2.
14. See Revenue Ruling 74-44, Rev. Rul. 73-361 regarding reclassification risk.
15. Herbert R. Fineburg and Charles A. McCauley III, “Avoiding an Adverse Tax Impact on Death of an S Corporation Shareholder,” ABA Tax Times (Vol. 40, Winter 2021).
16. IRC Section 1366(a)(1).
17. Section 1366(d)(1).
18. Section 1367(a)(2)(E). The Protecting Americans From Tax Hikes Act of 2015 permanently gives parity to the basis reduction rules applicable to S corporations and partnerships. P.L. 114-113, Section 115.
19. See, e.g., New York Tax Law Article 24-A (2022), www.tax.ny.gov/bus/ptet/faq.htm. In New York, a single member limited liability company can’t make a pass-through entity tax election unless it has elected to be treated as an S corporation for New York purposes.