Nearly 20 years ago the US Tax Court in the Winokur case upheld the right of a collector to make a partial gift of artwork to charity and claim an income tax deduction for the portion contributed. Following Winokur and until the Pension Protection Act of 2006 (the “PPA”) became law, partial gifts were a popular way for US taxpayers to share ownership of their artwork and other collectibles while obtaining significant income tax benefits. The PPA created unintended consequences in that certain fractional gifts or bequests to charity were made subject to gift and estate tax. For that reason advisors had been counseling against such partial gifts pending the enactment of clarifying legislation. The Tax Technical Corrections Act of 2007 (the “TCA”) has eliminated the unintended gift and estate tax consequences of the PPA, thus encouraging potential donors to again consider partial interest gifts.
The PPA Problem and the TCA Remedy
Under the PPA a donor was required to establish the value of the artwork on the date of the first partial gift and use that value for purposes of valuing all subsequent gifts, unless the art decreased in value. If the art decreased in value, the reduced value was used to determine the deduction. For example, a donor who gave a 10% interest in a painting worth $1,000,000 on the date of the gift was entitled to a charitable deduction of $100,000 for income and gift tax purposes. If the donor gave an additional 10% of the painting away five years later when the painting was worth $1,500,000, his charitable deduction for income and gift tax purposes would remain at $100,000. However, since the gift tax applies to the total value of the gift less deductions, the PPA would have required the donor to pay gift tax on $50,000, that is the $150,000 gift value minus $100,000 of deduction. The same problem arose in connection with US estate tax. In the above example, if the donor died five years following the initial gift leaving his remaining 90% interest in the painting to charity, he faced an estate tax on $450,000. That is, the value of his taxable bequest would be $1,350,000 (90% of the new value of $1,500,000) but the value of the estate tax charitable deduction would be $900,000 (90% of the value of the painting on the day of the first partial gift).
The TCA eliminated the potential gift and estate tax “whipsaw” by allowing a gift and estate tax charitable deduction based on current market value rather than the value at the date of the original gift. As such, the charitable deduction value and tax value of partial interests will match for gift and estate tax purposes, regardless of whether the art appreciates or depreciates, resulting in no estate or gift tax. However, the TCA made no change with respect to the PPA income tax rule which caps the value of all subsequent fractional gifts based on the first of such gifts. So, in the previous example, the income tax charitable deduction for all fractional gifts will be capped at $1,000,000, assuming the value of the art remains constant or increases over time. If the art decrease in value, the diminished value must be used to determine the income tax deduction for subsequent partial gifts.
Here’s How it Works Now
Collector would like to make his Renoir, worth $1,000,000, available to the Metropolitan Museum but he would like to retain the right to enjoy the Renoir in his home from time to time. Collector could simply loan the Renoir to the Metropolitan, however, this would not permit him an income tax deduction. He therefore chooses to enter into a written agreement with the museum whereby he transfers an undivided 25% ownership interest in the painting to the museum, which includes the right to possess and control the painting for 92 days (25% of 365) during the current and each succeeding calendar year. The Metropolitan will agree to arrange for transportation of the Renoir to and from the Museum and will insure the work while in its possession. The transaction will entitle Collector to a charitable deduction of $250,000 for US income tax purposes and he retains the right to possession of the painting for 273 days each year thereafter if he chooses.
By law, Collector must donate his remaining 75% interest in the Renoir to the Metropolitan no later than ten years after the first gift or at his death, if earlier. He must obtain an appraisal with respect to each fractional gift to sustain his income tax deduction even though, in an increasing art market, his charitable income tax deduction will remain constant. He will not be charged with any gift or estate tax with respect to the Renoir transfers.
Stretching the Income Tax Benefit
Even collectors who are willing to make an immediate gift of the entire interest in an art object may be better advised to make fractional gifts over a number of years. With a ten year required giving period plus a five year carry-forward provision, a taxpayer has up to fifteen years in which to utilize the income tax deduction pursuant to a partial gifting strategy. Under US law, the income tax deduction available for gifts of artwork is limited to 30% of the donor’s adjusted gross income each year. Although contributions in excess of this amount can be carried forward, they must be used within five years after the original donation or they are lost. In the above example if Collector’s adjusted gross income is $250,000 a year, the maximum amount he can deduct in any one year is $75,000. As such if Collector gives a 100% interest in the Renoir to the Metropolitan Museum in a single year, he will only be able to deduct $450,000 (six times $75,000) over the initial donation year and the five-year carryover period, resulting in a loss of $550,000 in potential income tax deductions. By limiting his initial gift to a fractional interest, Collector can make future fractional gifts, thereby extending his deduction carryover period and ensuring that he is able to take full advantage of his charitable contribution deductions. Over 15 years, he can contribute and deduct the entire $1,000,000 of value.