Monday May 29, 2017
Gifts of Art Part II Related Use, CRT's and Valuation
Part II - Related Use, CRT's and Valuation
III. Related or Unrelated Use Gifts of Art
Related Use Definition
Since art is tangible personal property, the charitable deduction for a gift of art will depend upon a categorization of the property as a "related" or "unrelated use" asset. A related use gift occurs when the charity actually makes use of the property in a manner consistent with its exempt purpose. Sec. 170(e)(1)(B)(i).
Most related use examples are reasonably straightforward. A gift of art to an art institute for use by art students is related. Furnishings given to a charity used for offices and buildings are related. A collection of rare books given to a library and used for reference purposes would be related. Reg. 1.170A-4(b)(3)(i).
If the gift qualifies as related use property, then the gift of an appreciated artwork produces a charitable deduction equal to its fair market value. This deduction is useable up to 30% of adjusted gross income. This rule is similar to the deduction limit for a gift of appreciated stock or land.
However, a gift of tangible personal property for an unrelated use produces a deduction only for the lesser of cost basis or fair market value. For example, assume that a car has a value of $2,000 and a basis of $4,000. A gift of this car for an unrelated use produces a deduction reduced first to basis, since it is unrelated, and then to the $2,000 fair market value. Thus the deduction is limited to the lesser of basis or fair market value. Sec. 170(e)(1)(B)( i ). Since the deduction is limited to cost basis, the deduction is treated as equivalent to a cash-type deduction and may be used up to 50% of adjusted gross income. In both cases, there is the customary 5-year carry forward for any charitable contribution not deductible under the current year limits.
Example A Painting Given To The Art Institute
Mary Smith purchased a painting several years ago for $50,000. It increased in value and was appraised by a qualified independent appraiser for $100,000. Mary gave the painting to the art institute and it is used as part of their display for that category of art.
This gift of the painting is a related use gift. Mary qualified for an appreciated charitable deduction in the amount of $100,000, useable to 30% of adjusted gross income, with a 5-year carry forward if needed.
Example B Painting Given To The Food Bank
Mary Smith has a second painting that also was purchased for $50,000 and is now valued at $100,000. Since she also supports the local food bank, Mary gives the second painting to the food bank. The food bank sells the painting for $100,000 and uses the funds to provide food supplies for the hungry. They also send Mary a very nice thank you letter. Mary appreciates the thank you letter, but is permitted a charitable deduction of only her $50,000 cost basis. The gift of the art to the food bank is for an unrelated use, since the art was sold and the cash used for food supplies. Therefore, her deduction is $50,000, but it is a cash-type deduction usable to 50% of adjusted gross income. Any unused deduction over the 50% AGI limit may be carried forward for the next 5 years.
Actual or Expected Use
In most cases, the related use charity will give a letter to the donor. The letter should identify the property, the date of the gift and describe briefly the use and the reasons why that use is related to the exempt purpose of the charity.
However, it is permissible to take a related use deduction for a gift to a charity if the donor has a "reasonable anticipation" that the gift will be used for an exempt purpose. For example, if a donor gives art to an art museum, there is a reasonable expectation that the art will be used in a related way by the art museum. Similarly, a gift of a violin to a children's orchestra could entitle the donor to rely on the reasonable expectation use principle. Reg. 1.170A-4(b)(3)(ii)(b).
Duration of Actual Use
Many types of tangible personal property have a useful lifetime. For example, furnishings given to an organization and used in the office or buildings of the organization will eventually wear out and need to be replaced.
There is no specific requirement for the length of time that a related use must be made by the charity. Initially, the charity must truly intend to use the property for a related purpose. However, there is a reasonable opportunity for the charity subsequently to determine that it now is appropriate to sell the property. The property may no longer be useful for its original purpose, or there may be a change of circumstances in the mission of the charity.
While there are no specific rules, there are two useful guidelines in common practice. First, if the charity receives a gift, signs Form 8283 and sells an asset within two years of the gift, then the charity must file Form 8282 and report the sale of the property and the sale price. Second, there is normally a three-year statute of limitations on tax returns. Thus, some charities will hold the artwork for at least two or three years before selling the asset. Both limits are a matter of policy. Charities should not ordinarily sell the asset unless there is a specific reason or a change of circumstances.
IV. Art to Charitable Remainder Trusts
Transfer of Art
Art may be transferred to a charitable remainder unitrust or annuity trust. Since it may be difficult to sell the art, it is nearly always preferable to transfer the art to a charitable remainder unitrust. Generally, the unitrust will use either a net income plus makeup or a FLIP formula payout. If a FLIP unitrust were selected, then the trigger event for the FLIP would be the sale of the art. The FLIP trust will be a net income trust until the art is sold. On the following January 1, the FLIP trust may then become a straight unitrust.
Charitable Tax Deduction
When tangible personal property is transferred to a charitable remainder trust, there are two specific rules that limit the deduction. First, there is no charitable deduction for a future interest in tangible personal property. The deduction applies only after all "intervening interests" have expired. Sec. 170(a)(3).
Therefore, when the art is transferred to a charitable remainder unitrust, there is no charitable deduction at that time. However, if the art is then sold by the trust, the charitable deduction is available in the year of the sale. After the art has been sold and cash received by the trust, the intervening interest in the tangible personal property has expired. Reg. 1.170A-5(a)(1).
The second rule also operates to reduce the charitable deduction from fair market value to cost basis. Even after the art is sold and the intervening interest has terminated, there still has been a transfer of tangible personal property for unrelated use. Therefore, the charitable deduction is the cost basis of the property times the remainder factor. Reg. 1.170A-5(b)(7).
Calculation of Charitable Deduction
In order to calculate the charitable deduction, both of the above rules plus the rules for selecting the Applicable Federal Rate must be applied. This calculation will be different from a unitrust funded with cash or public stock, since the valuation date is deferred under the "intervening interest" rule.
Each transfer to a charitable trust must be valued on a "valuation date." Sec. 7520(d). For a gift of tangible personal property to a unitrust, the value is first reduced from fair market value to cost basis under the unrelated use rule. However, there still must be a valuation, since a charitable deduction is permitted at cost basis only if the fair market value is equal to or greater than cost basis.
Therefore, when the asset is sold, the intervening interest has terminated and the charitable deduction will be the appropriate factor times the lesser of cost basis or fair market value. The required Applicable Federal Rate will be the rate for the month of that valuation date or either of the prior two months. Sec. 7520(a)(2).
Example C Gift of Porcelain
Mary Smith loves Chinese porcelain and has collected over 50 exquisite pieces of porcelain in her lifetime. The collection is valued at approximately $300,000.
Since it is a very large and valuable collection, after it is transferred to the unitrust, the trustee confers with an agent who is experienced in sales of these items. The agent proposes that they have a public auction of the Chinese porcelain at three different times and in three different locations. A plan is established to sell at auction a third of the collection in New York in December, a third of the collection in London in January and a third of the collection in Paris in May of that year.
Since the valuation date will then be December for the first sale, the calculation is made using the AFR from December or one of the prior two months. Similarly, the valuation dates and charitable deductions for the January and May sales in the following year will be done separately using the AFR for the sale month or one of the prior two months. Each deduction calculation will use the cost basis of that part of the collection and the AFR for the month of sale (or the prior two months).
Gifts To Trust By The Artist
When an artist has created a painting, the artwork represents potential ordinary income. If the artist were to sell that painting, since that is the profession of the artist, the difference between the cost basis of the painting and the amount received would be ordinary income. Since the cost basis is the value of the canvas and paints, artists typically have near-zero cost basis in a painting.
However, while there is little or no potential charitable income tax deduction, it still may be very desirable for the artist to transfer the art to a charitable remainder trust. Sec. 170(e)(3). When the artist transfers the painting to a charitable remainder unitrust, the painting may then be sold by the trust and the tax on the ordinary income is avoided. Since this trust has been funded with an ordinary income asset, it will pay out ordinary income for the duration of the trust.
Example D Gift By The Artist
Mary Artist has created an exquisite landscape. Her painting titled "Mountain Wildflowers" has a net sale value of $300,000. Her cost of the canvas and paints are nominal and she has in essence a zero basis in the painting.
Mary transfers the painting into a two-life charitable remainder unitrust for herself and her husband John. While there is no income tax deduction for the ordinary income asset, she avoids payment of 40% federal and state ordinary income tax on the artwork and saves $120,000 that otherwise would have been paid in tax. She and John then receive the 6% income for two lives. At the end of the two lives, the trust principal will be distributed to a favorite art museum.
For an artist, this plan is excellent. Avoiding the ordinary income tax can in some cases generate greater total savings than the combined capital gain bypass and charitable tax savings with a capital asset transferred to trust.
Example E Gift By Collectors
John and Mary Art Collector are purchasers of western art. They discover an extraordinary Charles Russell oil painting of western Montana and purchase it for $100,000. Many years later, the painting is worth $400,000. John and Mary are pleased with the painting, but also desire increased income during their retirement years.
They transfer the painting into a FLIP unitrust. Based on an appraisal by a qualified independent appraiser, the $400,000 value is first reduced to the $100,000 basis. Applying the applicable remainder interest factor, the charitable tax deduction then equals $36,149. This deduction applies in the year that the painting is sold.
After 15% sale costs, the trust now holds $340,000 in cash. John and Mary receive 6% of this amount for their lifetimes. If the principal increases in value, the income will also increase proportionately. Over their estimated 20.6-year life expectancy, John and Mary could receive a total of $541,168.
When the art is transferred to the charitable trust, the trustee must be able to sell the property. The donor or donor's family may not retain the use of the property or restrict the sale. Retaining the use of the property or restricting the sale would cause the trust to fail to be qualified. Rev. Rul. 73-610.
V. Valuation of Art
Noncash charitable contributions in excess of $500 require filing a Form 8283. Part A of 8283 includes the description of the property. However, if the value of the property exceeds $5,000 then an appraisal is required. The appraisal must be by a qualified person who "holds himself or herself out to the public" as an art appraiser.
The art appraiser must state the date of the appraisal, that the property was valued as of the date of the gift, that the appraisal was done for income tax purposes and the appraisal must disclose the methodology used in deriving the property value. Reg. 1.170A-13(c)(3).
Artwork Over $20,000 in Value
If a deduction is claimed for a gift of artwork and the value is greater than $20,000, then the complete signed appraisal must be submitted with the Form 8283. In addition, either an 8 X 10 color photo or a 4 X 5 color transparency of the art object must be provided.
Statement of Value Option
If art with an appraised value of $50,000 or more has been contributed to a charity, it is permissible to obtain a "Statement of Value" from the IRS. This "Statement of Value" is available only after the art has been transferred. Thus, since many donors desire to know the deduction value prior to the gift, it may be preferable to rely on a valuation by an independent appraiser. There is a user fee of $2,500 for obtaining a "Statement of Value" from the Service. Rev. Proc. 96-15. Notice 95-1.
IRS Art Advisory Panel
Periodically, the IRS Art Advisory Panel meets and reviews the valuation of items reported on income tax, gift tax and estate tax returns. With respect to the charitable deductions on income tax returns, the Art Advisory Panel typically reduces approximately one-third of the valuations.
Similarly, on the gift tax returns and the estate tax returns, the Art Advisory Panel generally increases valuation on approximately one-third of the returns. The Art Advisory Panel reports may be obtained from: Director, Disclosure Operations Division, Attn: FOI Reading Room, Box 388, Benjamin Franklin Station, Washington, DC 20224.
Published January 1, 2002