09 April 2020 - Article
In an earlier edition of this Newsletter, we discussed how fractional gifts of artwork can be made to a museum or other charity. By making a fractional gift many collectors are able to increase the tax benefits of their charitable gifts over time while continuing to enjoy some possession and enjoyment of their artwork. The Pension Protection Act of 2006 (“PPA”) signed into law by President Bush last August sets forth new strict rules for making partial gifts of art and collectibles. The new rules contain harsh penalties for non-compliance and therefore may discourage partial gifts. The PPA also tightens the “related use rule”, which reduces the donor’s charitable deduction for gifts of art unless the artwork is given to an institution that will exhibit or otherwise use the art consistently with its tax exempt purpose.
As under prior law, a donor can give an undivided fractional interest in an artwork to charity, resulting in shared ownership. In the case of a fifty percent gift of a Picasso to a museum, for example, the donor and museum have the right to possession of the artwork for half of each year. The donor receives a charitable contribution deduction for income and gift tax purposes equal to fifty percent of the value of the artwork on the date of the gift. Under prior law, the donor was not required at any time to give the remaining percentage interest to charity, although most museums and other charities required that a one hundred percent gift be made no later than the donor’s death as a precondition to accepting a partial gift.
For many donors, a partial gift strategy was preferable to giving the entire artwork to charity in a single year. Charitable gifts of art are deductible up to an annual limit of thirty percent of a donor’s income. If the value of the artwork is in excess of that limit, then the donor can carry the excess deduction forward and deduct the excess value in each of the five successive taxable years. However, many collectors have made gifts that are so large in relation to their annual income that the donor could not use the excess tax deduction over the five year carry-forward period. By making fractional gifts, the donor was able to effectively extend the carry-forward period for using the excess deduction indefinitely. In addition to the tax benefit, the donor benefited from the usual practice that the donee would bear the cost of insuring the work while it was in the donee’s possession.
Under the PPA, a charity that receives a fractional interest in an item of tangible personal property must be given full ownership of the property within ten years from the date of the initial contribution or upon the death of the donor, whichever is earlier. In addition, the charity must take substantial physical possession of the artwork during the ten-year period. This new rule effectively overrules the tax court decision in the Winokur case, which held that the charity merely had to have the right to possession, not actual possession of the artwork. In the event that the tax-exempt organization fails to take possession of the tangible personal property during the ten-year period, or fails to utilize such property for its tax exempt purposes, then the donor’s
charitable income and gift tax deductions for all previous contributions of interests in the same item will be recaptured, plus interest. Regardless of when recapture of the deduction occurs, the PPA imposes an additional ten percent penalty tax on the recaptured amount of the deduction. For example, if you make a gift of fifty percent of a painting worth $100,000, you are entitled to a $50,000 deduction. If you fail to give the remaining fifty percent interest within ten years of the original gift, you will owe the income tax on the original gift, gift tax on the original gift, plus a penalty equal to ten percent of the value of the original gift. Based on the original value of the gift of $50,000, these amounts could be as high as $17,500 (35% of $50,000), $23,000 (46% of $50,000) and $5,000 (10% of $50,000) respectively. Interest on the tax penalty would also apply, likely making the effect of the penalty greater than the value of the original gift!
The PPA provides that the value of the donor’s subsequent charitable deductions for the contribution of further fractional interests will be based upon the fair market value of the property at the time of the contribution of the original fractional interest. So if you make an initial gift of 50% of a painting worth $100,000 in year 1 and the value of the painting increases from $100,000 to $200,000 by year 5, an additional gift of 10% of the painting in year 5 is valued at $10,000, not $20,000 as would be the case under prior law.
Under a special grandfathering rule, a donor who made a fractional gift of artwork prior to the effective date of the PPA (August 17, 2006) is not subject to the new rules unless the donor makes an additional partial gift after the effective date. For that reason, a donor should be able to make a one time gift of his entire remaining interest in the artwork to charity at any time during his lifetime or upon death without invoking the new law.
The “Related Use” Rule
Generally, a donor can deduct the full market value of tangible personal property donated to a public charity if the property has been held by the donor for more than twelve months at the time of the gift and the tangible personal property will be put to a related use by the donee. For example, artwork given to a museum generally is entitled to a charitable deduction equal to its full value. If instead, the art is given to a charity that will not display or otherwise use it in connection with its tax exempt purpose, the donor’s deduction is limited to its cost basis.
The PPA penalizes the donor if the contributed property, originally given for a related use, is disposed of by the charity within three years of the gift. The penalty is a reduction of the donor’s tax benefit corresponding to the difference between the value of the gifted property at the time of the gift and its cost basis. The donor then has to pay the corresponding increase in income tax plus interest. For example, if you make a gift of an art object worth $100,000 to a museum, you can expect to deduct its full value, even if you only paid $20,000 for the work. However, if the museum sells the painting within three years of the gift, you will lose $80,000 of the deduction and be responsible for increased tax and interest from the date of the gift. The PPA provides an exemption from this rule if the donee can certify that the artwork was originally intended for a related use but that the use became unfeasible. To police the new rule, the PPA requires charities to report to the IRS any disposition of contributed property made within three years of receipt. Under prior law, only dispositions made within two years of the gift were reportable.
The PPA also imposes a $10,000 civil penalty on any person who identifies property as having a use related to the donee’s tax-exempt purpose, knowing that it was not intended for such use. This could apply, for example, to the taxpayer himself, the taxpayer’s advisors, or a charity who falsely represents that the artwork will be used for an exempt purpose.
In light of strict enforcement of the related use rule under the PPA, donors would be well advised to obtain a representation from the donee organization that it intends to exhibit or otherwise use the art in furtherance of its tax exempt purpose for at least three years. Otherwise the donee could sell the artwork and thereby create a tax headache for the donor. Donors should also remember that the related use rule, as modified by the PPA, only governs the ability of the donor to deduct the appreciation inherent in a gift of art. If the donor is willing to limit his deduction to the tax basis in the work, the related use rule will not apply. For example, if the donor paid $50,000 for an art object that is now worth $75,000, the art can be given to a charity to be auctioned by that charity. The donor would be entitled to a deduction equal to $50,000 and the charity would be exempt from tax on the sale. A gift of artwork to charity may therefore be compelling in spite of the related use rule.