In the Eye of the Beholder: Appraisals of Art for Estate Tax Liability

by Emily Lanza*

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In February 2017, the U.S. Tax Court ruled that the estate of a deceased New York woman, Eva Franzen Kollsman, undervalued $2.4 million worth of art on the estate tax return. The assets at issue before the Tax Court were two Old Master paintings by Pieter and Jan Brueghel held by the decedent at her death. The IRS claimed before the Tax Court that the Kollsman estate underreported the values of the two Old Master paintings resulting in a $781,488 federal estate tax deficiency.

In reaching this decision, the Tax Court not only rejected but also criticized the appraisals made for the estate of the two Old Masters by George Wachter, Vice President of Sotheby’s North America and South America. The Tax Court dismissed Estate’s declaration and the valuations made by Wachter, finding that his valuations were “unreliable and unpersuasive” due to his direct conflict of interest and misconstrued analysis of the Old Master paintings. 

The opinion of the Tax Court in the Estate of Eva Franzen Kollsman v. Commissioner of Internal Revenue demonstrates the importance of having a justifiable and objective appraisal when determining the tax liability of an estate. The valuation of art is not an exact science and may change depending on the “eye of the beholder.” However, in order to determine the precise tax liability of an estate, appraisers and estate executors must adhere to Internal Revenue Service (IRS) guidelines, professional codes of ethics, and the legal requirements within the Tax Code to ensure some level of objectivity and consistency. What were the shortcomings of the appraisal conducted for the Kollsman estate and what are the lessons to be learned from this case?

Estate Tax

The federal estate tax is a tax levied against the estate of a decedent, which must be paid by the estate upon the transfer of the property. The top tax rate is statutorily set at 40%. A series of adjustments and modifications of a tax base known as the “gross estate” determines federal estate tax liability. The gross estate includes the value of all property, including real or personal property such as artwork, that the decedent owned on the date of his or her death. The value of the property included in the decedent’s gross estate is the “fair market  value” on the date of the decedent’s death. According to estate tax regulations, the “fair market value” of the property is the price at which the estate property would hypothetically change hands between a willing buyer and willing seller. In such a sale, the buyer and seller would not be compelled to buy or sell the property as such a compulsion would disproportionately raise or lower the price. Additionally, both parties would be expected to have reasonable knowledge of the relevant facts, such as the condition or history of the relevant property. The impact of subsequent events after the death of death on the fair market value depends on the particular facts of the case and whether the parties would be expected to have knowledge of the relevant facts surrounding the subsequent event. The fair market value tends to reflect the hypothetical sale price in a market in which the item is most commonly sold to the public, such as the auction market for art assets.

Next, certain allowable deductions reduce the gross estate to the taxable estate. These allowable deductions include estate administration expenses, certain debts and losses, charitable bequests, and state death taxes. Then, the tax rates are applied to the taxable estate after the total of all lifetime taxable gifts made by the decedent is added to the taxable estate. Any available credits, such as the “unified credit,” are subsequently taken to obtain the actual estate tax liability, the amount of tax paid by the estate. For estates belonging to decedents who died in 2017, they must pay tax on estates valued greater than $5.49 million, the basic exclusion amount under the unified credit for 2017 (the unified credit in 2016 was $5.45 million). The IRS adjusts the unified credit amount every year to account for inflation. The Trump administration has recently proposed to eliminate the estate tax.

Estate of Eva Franzen Kollsman v. Commissioner of Internal Revenue

As explained above, the fair market value of property held by the estate is an important factor in determining the tax liability of the estate. This was the primary issue before the Tax Court in this case. Upon her death in 2005, the decedent, Eva Franzen Kollsman, owned two 17th-century Old Master paintings at issue in this case: Village Kermesse, Dance Around the Maypole (“Maypole”) by Pieter Brueghel the Younger and Orpheus Charming the Animals (“Orpheus”) by Jan Brueghel the Elder or the Younger. Pieter Brueghel’s work was later sold by Sotheby’s for the hammer price of $2,100,000.

In September 2005, a month following the decedent’s death, the estate’s expert, George Wachter, Vice President of Sotheby’s North America and South America, valued the paintings at $500,000 for the Maypole and $100,000 for Orpheus. In reaching these values, Wachter considered the composition and subject matter of the paintings but focused much of his analysis, according to his testimony before the Tax Court, on the extreme yellow discoloration and the dirt and grime on the paintings that accumulated during years of the decedent’s smoking. Wachter’s valuation was included in the estate’s 2005 tax return. After the valuation, the paintings were cleaned by a fine art services firm, Julius Lowry Frame and Restoring Company, at the request of the estate.

 

In 2009, Maypole sold at Sotheby’s for the hammer price of $2,100,000. The executor of the estate, Jeffrey Hyland, retained Orpheus. While the estate tax return listed the fair market value of Maypole and Orpheus at $500,000 and $100,000 respectively, the IRS asserted in a notice of deficiency that the estate had underreported the value of the two paintings and the actual fair market value of Maypole was $2,100,00 and of Orpheus was $500,000, resulting in a $781,488 tax deficiency. The estate petitioned the Tax Court for a redetermination of the paintings’ fair market values.

Before the Tax Court about ten years after the initial evaluation, the estate and the IRS presented the testimony of their respective experts and their valuations of the two paintings at issue. Paul Cardile, Ph.D., an art historian with twenty-five years of experience as a fine art appraiser, served as the expert for the IRS before the Tax Court. After analyzing the testimonies of the two experts, the court rejected Wachter’s valuation, and found the value of the Maypole at $1,995,000 and of Orpheus at $375,000. The estate was found liable for the resulting tax deficiency, the amount of which to be determined later by the IRS.  

Analysis of the Estate’s Appraisal

While the Tax Court routinely weighs in on the valuation of paintings for the purpose of determining estate tax liability, the court in the case of Estate of Eva Franzen Kollsman v. Commissioner of Internal Revenue not only agreed with the analysis of the IRS’s expert but strongly objected to and criticized Wachter’s testimony referring to his valuations as unreliable and unpersuasive. Why did the estate’s appraiser incur such criticism by the Tax Court?

1. Lack of Objectivity

First, the Tax Court found that Wachter held a significant conflict of interest “that could cause a reasonable person to question his objectivity” by adjusting the valuation for his own benefit. Determining the appropriate estate tax liability greatly depends on the objectivity of an appraiser, especially in the context of assessing the fair market value of art. Such calculations demand “insider-knowledge” of the art market, and objectivity must accompany this skill and expertise in order to maintain the integrity of the estate tax framework.

IRS Revenue Procedure 96-15 outlines various conflicts of interest that an appraiser must avoid when crafting his appraisal for tax liability purposes. These prohibitions include the appraiser not inheriting property from the estate as a beneficiary or not being any part of the estate. The appraiser also cannot have been employed by the decedent, because such a relationship may color the motivations of either party. The IRS also requires the appraiser to “hold himself or herself out to the public as an appraiser,” as potentially demonstrated through membership in professional appraisal organizations. These organizations, such as the American Society of Appraisers (ASA) and the Appraisers Association of America (AAA), require their members to follow a code of ethics in order to avoid such conflicts of interest as identified by the IRS. For example, the AAA requires that its members must appraise property objectively, “independent of outside influences and without any other motive or purpose than stated in said appraisal.” The AAA offers a list of certified appraisers, who possess an extensive level of expertise, education, and experience.

In addition to the IRS procedures and ethical “carrots,” appraisers may face potential “sticks” to ensure objective and accurate work. Implemented by the Pension Protection Act of 2006, section 6695A of the Tax Code imposes a penalty on the appraiser who prepared an appraisal used for an estate tax return and the appraisal results in a substantial valuation understatement. An understatement has occurred if the reported value of the property is 65% or less of the amount determined to be the correct value. The penalty imposed is the lesser of 10% of the underpayment (or $1,000 if greater than the 10%) or 125% of the gross income received from the preparation of the appraisal. For example, if an appraisal resulted in an underpayment of $50,000 and the appraiser received $2,000 for the appraisal, the penalty imposed under section 6695A would be $2,500 as the lesser value of 10% of the $50,000 underpayment ($5,000) and 125% of the gross income of $2,000 ($2,500) for the appraisal.

The court held that Wachter’s relationship and correspondence with the estate’s executor, Hyland, during the valuation process impaired his objectivity and, correspondingly, his credibility. While Wachter was determining the fair market value estimates for the estate paintings, Wachter and Hyland apparently corresponded about the fate of the paintings. During this correspondence, Wachter, as a Vice President of Sotheby’s, solicited Hyland for the exclusive rights for Sotheby’s to auction the Maypole and Orpheus, if Hyland ever chose to sell the paintings. The Tax Court did not reveal whether or how much Wachter received for this appraisal or whether he differentiated between his two roles as an appraiser or potential seller of the paintings in this correspondence.  Under Sotheby’s terms of service according to the Tax Court, an auction sale would entitle Sotheby’s to a 20% commission on the first $200,000 of the hammer price. Presumably, the employee who would bring in property would also collect a certain fraction of the hammer price as an incentive for bringing business. It appears, according to the Tax Court, that Wachter “had a direct financial incentive to curry favor with Mr. Hyland by providing fair market value statements that benefited his interests as the estate’s residual beneficiary” and that Wachter thus “lowballed” the estimates of the paintings to reduce the estate’s tax liability. The Tax Court further found that the simultaneous timing of the valuations and Wachter’s pitch for exclusive auction rights seemed to imply that the latter influenced the former, demonstrating Wachter’s lack of objectivity.

Wachter’s actions suggest if not directly implicate the various conflicts of interest outlined in the IRS policy about appraisal procedures. While Wachter was not a direct beneficiary inheriting the paintings from the estate, his employer certainly benefited from the sale of the Maypole and the explicit or inexplicit arrangement between Wachter and Hyland. Thus, Wachter violated professional ethics requirements for objectivity with this “quid pro quo” arrangement. However, according to the Tax Court opinion and Wachter’s biography on the Sotheby’s website, he is not a member of any professional organizations that demand some sort of accountability. If Wachter’s valuation had occurred after 2006 (and not the year before), Wachter would likely have been penalized under section 6695A for the gross understatement of the painting’s value. Given the hammer price that was more than four times the value he ascribed to Maypole, Wachter valued that work well under the threshold set in the Tax Code at a quarter of the value determined by the Tax Court. While Wachter seemed to avoid any legal repercussions for his lack of objectivity, at least according to the Tax Court ruling, the estate was settled with the consequences and the adjusted estate tax liability. In order to avoid such scenarios, estates should investigate the objectivity of their appraisers and ensure some type of oversight or accountability when hiring them for this important task.

2. Exaggerating the Poor Condition of the Paintings

Second, the Tax Court objected to Wachter’s emphasis on the poor condition of the paintings when forming his valuations. In his report, Wachter described the condition of both paintings as covered in dirt and grime with extreme yellow discoloration, due to the decedent being a heavy smoker. According to Wachter, one could not be certain of the inherent value of the paintings in this condition, and he concluded that the value of the paintings should reflect the high level of risk involved in cleaning. However, the Tax Court found that such a risk was exaggerated, highlighting testimony of the conservator that the risks involved with cleaning were low. Moreover, the Tax Court pointed out that the cleaning process only took two to three hours, indicating that such a procedure was “comparatively easy and problem free.” Contrary to Wachter’s report, Cardile, the IRS expert, did not adjust for the dirty condition of the paintings as “surface dirt do[es] not affect the intrinsic value of an Old Master painting.”

Upon first consideration, accounting for the state of the painting, as Wachter did when calculating the value, appears to be a logical step in a fair market value analysis. According to IRS policies, an appraisal must include a description of the art item that states the physical condition of the work in addition to the subject, medium, size, visible marks, and provenance. In the past, the Tax Court has acknowledged the physical condition of the work and has adjusted the value accordingly. For example, in the Estate of James J. Mitchell v. Commissioner of Internal Revenue, the Tax Court placed less weight on the testimony of the IRS experts because they did not adjust their valuation of an early twentieth-century watercolor by American artist Charles Marion Russell to account for “its inferior status and for its poor paper quality and back boarding.”

While an appraiser may and should consider the physical condition of a work, Wachter’s assessment of Maypole and Orpheus was inappropriate due to the emphasis on the level of dirt – a condition that could be and was easily remedied. The cleaning and framing of Maypole and Orpheus, which occurred after Wachter’s valuations, cost the estate $4,500 and $4,350 respectively. Unlike the Russell watercolor which was painted with inherently volatile and poor materials, the dirt covering the Maypole and Orpheus was not intrinsic to the painting itself. Wachter’s emphasis on the dirt of the paintings ignores the guiding principle when determining fair market value that the hypothetical buyer and seller have “reasonable knowledge of relevant facts” affecting the potential sale. “Reasonable knowledge” includes facts acquired during the background investigation and negotiations for the sale, and in this particular case would likely involve consulting a conservator about the risks of cleaning a dirty painting. Wachter’s deep deduction in the value of the paintings to account for their dirtiness was misplaced and too substantial, for information about the actual cleaning process, which only took a few hours, was “readily discoverable.” The Tax Court did acknowledge that cleaning carries some risk but calculated only a 5% discount for the Maypole and a 25% discount for Orpheus to account for bowing, a more critical aspect of its condition. But Wachter’s inappropriate consideration of surface dirt demonstrates the importance of taking a holistic approach towards the analysis of a painting and fully accounting for all the facts that a likely buyer or seller would recognize when approaching a sale.

3. Need to Use Comparable Sales

Perhaps the most significant criticism of Wachter’s valuation by the Tax Court is the absence of comparable sales to support his analysis. “Comparables”  (or “comps”) are the recent selling prices of similar pieces of art that are used to help determine the fair market value of a piece of art, with the assumption that it will sell at a similar price of other similar works. The Tax Court referred to this omission as “remarkable” and with the absence of any comparables, “Wachter’s report lacks any objective support for his valuation figures.” According to the Tax Court, comparables of paintings by Pieter Brueghel sold between $1,040,000 and $3,331,000, and paintings by Jan Brueghel sold between $400,000 and $700,000.

The use of comparable sales provides the basic foundation for the valuation of art by offering an objective analysis of the likely market value. Cardile, the expert for the IRS, identified several comparable paintings for both the Maypole and Orpheus. Comparing the subject matter, medium, size, and the provenance (record of ownership) of similar paintings that sold prior to the date of the Kollsman estate was being appraised, Cardile could calculate the likely market price of the Maypole and Orpheus more accurately and confidently. Generally, courts, in their analysis of appraiser testimony, are likely to weigh more favorably comps that were sold closer in time to the date of valuation and are more similar in subject matter to the estate’s property than comparables that are too dissimilar to the painting at issue to provide an objective benchmark. For example, the court in Estate of Murphy v. United States found the testimony of the IRS expert to be particularly problematic and thus gave his testimony less weight than the testimony of other experts. The valuation of the IRS expert was based upon sales too remote in time, from six to nineteen years before the valuation date, while the testimony of the other experts relied upon sales only a few months before the valuation date.

When evaluating suitable comparables, courts focus on the details, such as the date of the sale and similarity in composition to the painting at issue. When an expert such as Wachter completely ignores such evidence, the court has very little information to rely upon when assessing the credibility and accuracy of a valuation and corresponding testimony. There is no reason to believe that Wachter did not know who painted Maypole and Orpheus and even those less familiar with leading artists are likely to recognize the surname Brueghel to find suitable comparables. The practice of using comparable sales in this context is so essential and commonplace that it is unclear why Wachter’s valuation was missing such a critical component. The lesson from this omission is that the strength and credibility of future appraisals depends upon finding pertinent and appropriate comps so that a court may properly analyze the proposed valuation.

Conclusion

The evasive “fair market value” is the cornerstone of determining estate tax liability. Calculating the value of a unique piece of property based upon the price of a hypothetical market transaction is an inherently difficult task. Appraisers rely upon past sales of comparable art pieces in order to predict the future activity of this market. They consider the whole piece of art, including the subject matter, condition, and provenance, from the point of view of a hypothetical buyer and seller for the fair market value analysis. Because such precise analysis requires great skill, knowledge, and years of specialized experience that members of the courts generally do not possess, the courts and accompanying legal system depend upon the objectivity of the appraisers. If such professionalism is absent, the courts and the IRS cannot administer the tax law fairly. Unfortunately for the estate of Eva Franzen Kollsman, its appraiser did not follow these principles, and the estate had to pay penalties for the omissions of its appraiser.

Selected Sources:

  1. Estate of Eva Franzen Kollsman v. Comm’r of Internal Revenue, 2017 T.C.M. (RIA) 2017-040 (2017).
  2. 26 U.S.C. § 2001.
  3. 26 U.S.C. § 2031.
  4. Treas. Reg. § 20.2031-1(b).
  5. 26 U.S.C. §§ 2053, 2054, 2056.
  6. Rev. Proc. 96-15, 1996-3 I.R.B. 41, § 8.04.
  7. Appraisers Association of America, Code of Ethics, https://www.appraisersassociation.org/index.cfm;jsessionid=15426E3A1A9207384153A96906B788A6.cfusion?fuseaction=document.viewDocument&documentid=720&documentFormatId=1353&CFID=3969729&CFTOKEN=a08c8da32b839881-B1374B0E-1C23-C8EB-805AFDB50E7E6B2D.
  8. 26 U.S.C. § 6695A.
  9. 26 U.S.C. § 6662(g).
  10. Sotheby’s, Bio of George Wachter, ttp://www.sothebys.com/en/specialists/george-wachter/bio.html.
  11. Estate of James J. Mitchell v. Comm’r of Internal Revenue, 101 T.C.M. 1435, at *14 (2011).
  12. U.S. v. Simmons, 346 F.2d 213, 217-18 (5th Cir. 1965)(finding that facts revealed during a background investigation of the decedent’s records constituted “reasonable knowledge” for purposes of determining the fair market value of property).
  13. Mary Anderson et al., Art Advisory Panel Helps Courts Sculpt Estate Valuations, 42 Est. Plan. 20, 11 (2015).
  14. Estate of Charles H. Murphy, Jr. v. U.S., No. 07-CV-1013, 2009 WL 3366099, at *18 (W.D. Ark. Oct. 2, 2009).

*About the Author: Emily Lanza is currently Counsel for Policy and International Affairs at the U.S. Copyright Office and had worked previously as a legislative attorney for the Congressional Research Service, advising Congress on intellectual property and estate tax issues. She received her J.D. in 2013 from the Georgetown University Law Center. Before her law career, she studied archaeology and worked for museums in various capacities. She can be reached at emilyla8@gmail.com.

Disclaimer: The opinions expressed here are solely of the author and do not express the views and opinions of the U.S. Copyright Office.

Broad or narrow: Taxman reviews “Private” Museums

By David Honig, Esq.*

screen-shot-2016-11-23-at-1-48-18-pmLast year, on November 20, 2015, Senator Orrin Hatch (R-Utah) launched a review of eleven US private museums in response to a recent New York Times Article that exposes a possibility for abuse of 501(c)(3) nonprofit status. Every “domestic or foreign organization described in section 501(c)(3)” is considered a private foundation, unless it fits into one of four scenarios, dealing with where the organizations “support” is derived, set out in § 509(a).  Senator Hatch’s investigation did not include all nongovernment owned museums as the term “private museum” suggests – after all many of the most renowned museums in the United States, such as the Metropolitan Museum of Art in New York and the National Gallery of Art in Chicago are private museums even if they are not thought of as such. Instead, Senator Hatch looked into a subset of museums that only have one donor and are designated private foundation under 26 U.S.C. § 509.

The investigation, which concluded in May of 2016, sought to determine whether, and how much, these museums benefit the public. This inquiry was ignited by the fear that these private foundation museums are offering minimal benefit to the public while affording the donors substantial benefits including tax deductions. For example, the New York Times article mentions that at least two of these museums, Glenstone in Potomac, MD and the Brant Foundation Art Study Center in Greenwich, CT, require reservations and “[are] open only a few days a week to small groups.” The reason this matters is the tax advantages afforded to charities with 501(c)(3) nonprofit status are granted because of the public benefit these organizations provide. Logic suggests, if these museums are not providing a public benefit they should not be given preferential treatment. The real issue is not whether these museums provide a public benefit but whether the benefit provided can justify the private reward. In other words, should individuals capable of purchasing multi-million dollar artworks be afforded a discount on creating and maintaining private viewing salons?  Before determining whether these museums provide enough or any public benefit some background should be given, first on the museums themselves then on the tax benefits associated with this setup.

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The Private Museums

The United States has a long history of encouraging private enterprise. This can be seen in airlines, railroads, institutions of higher education and charitable organizations. The investment of private capital helps alleviate some of the financial strain felt by the state, while encouraging private organizations or individuals to provide public services. Seeking to reward private investment for the public good, “Congress sought to provide tax benefits to charitable organizations, to encourage the development of private institutions that serve a useful public purpose or supplement or take the place of public institutions of the same kind.”

One way Congress provided tax benefits to charitable organizations was by creating 26 U.S.C. § 501. Section 501(a) grants tax exempt status to certain organizations. Relevant here are corporations “organized and operated exclusively for … charitable … or educational purposes … ”. Seeking to take advantage of this section of the internal revenue code collectors have created organizations and donated artworks to them in order to establish museums for their private collections.

The Tax Scheme

One benefit of creating a nonprofit organization and donating artworks to it is clear – if the museum charges an entry fee the revenues can be used to maintain the artworks and space without the donor having to pay taxes. By relinquishing ownership of these works the donor no longer bears sole responsibility for upkeep. Since 9 of the 11 museums surveyed by Senator Hatch do not charge an admission fee, most of the founding donors have to donate more funds to insure the works and premises do not deteriorate. On its face, the free admission scheme is detrimental to the founding donor. In addition to paying for the upkeep, although possibly at a subsidized rate, the founding donor must also relinquish control of the works to the nonprofit corporation for the corporation to be eligible for the tax benefits under the internal revenue code.

Taking these issues in turn, the first, having to pay for upkeep, could actually be a benefit. The internal revenue code, specifically section 170, allows a donor to deduct a “contribution or gift” made to, among other organizations, corporations that qualify for 501(c)(3) tax exempt status. This means that besides possibly paying a reduced rate for the upkeep and maintenance of her art and a facility to house said art, the founding donor can deduct the amount donated to the museum to cover these costs.

In addition to allowing deductions for contributions section 170 also allows a donor to deduct gifts made to authorized organizations. By converting a collection that was privately owned by an individual into one that is held by a museum for the “public’s benefit” the founding donor can use money that would have been personally spent for upkeep of the art to reduce her taxes. By combining tax exempt status granted by 501 with the deductions afforded for charitable contributions in section 170 a founding donor is duly rewarded. Note: the internal revenue code places a limit, usually 50% of gross income, on the amount of deductions a person can take each year for charitable donations.

Tax deductions are not the only reason for a founding donor to entertain creating this type of organization. Once the works are donated the museum owns them and a donor no longer has no control, or so it would seem. If the donor serves on the board of directors, acts as president or serves in some other executive position the donor could execute control over the works of art. In fact, this is exactly what “many” of the founding donors are doing. An example of this is the Broad in downtown Los Angeles, whose founders Eli and Edythe Broad serve on the Board of Governors.

A donor that serves on the board or as an executive will be involved in not only how the artwork is managed but more importantly the operations of the museum. This includes determining hours of operations, admission price, what works should be bought and sold, displayed, put into storage or on loan. It is easy to see why Senator Hatch was worried about abuse of these tax exemptions since donors are able to reap huge tax benefits while seemingly giving up little in their enjoyment and control of art. In fact, some of the museums surveyed said that they are located on land owned by or partially by the founding donor. In other instances, museums are located on land adjacent to the donor’s residence. In order for this scheme to make sense and continue the public must get some benefit.

Public Benefits

“[C]harities [are] to be given preferential treatment because they provide a benefit to society.” It follows, that if there is no benefit to the public then the charity should not be given preferential treatment and a donor should not be allowed to receive tax deductions for donations to that charity. But the issue here is not one of existence of benefit it is one of degree of quality and quantity of benefit. The question ultimately boils down to whether or not these museums provide enough public benefit to be given preferential treatment and how is that determination made. In other words, what is the required level of public benefit that an organization must produce in order to receive preferential tax treatment under section 501 and how is it determined?

Unfortunately, it is hard to determine whether action actually benefits the public and the Internal Revenue Service (“IRS”) guidelines are not very helpful on this front. Besides being open to the public for viewing and informing the public of access, it really is not clear what is required of an organization to achieve tax exempt status.

There are clear benefits to founders of private museums but the question remains are those benefits enough. For instance, of the 11 museums that received a letter from Senator Hatch 10 of them responded that they engage in or have engaged in loan programs. This means that a work of art that would normally be displayed in someone’s home or sit in storage was put on display for a large number of people to see. The creation of more museums allows works to be displayed that otherwise would sit in a basement or storage facility and never be seen by the public.  

Not only does the creation of more museums allow for more work to be shown it allows different work to be shown and curated in different ways. Private museums allow the whims of one person to dictate how and what art is acquired and later displayed. This type of museum does not have to focus on what it thinks would be the most educational exhibit for its visitors as traditional public museums do. Instead the exhibits can focus on art or whatever emotion or reaction a curator wants to provoke. This too is “educational” in its own right even though it is not designed with that purpose in mind.

Maybe the best example of this would be Eli and Edythe Broad’s Broad Museum in Los Angeles, California. The Broad is the poster child for what these types of private museums can be. It is open most days of the week and draws large crowds of young people. In addition to its visitors having a lower average age than the national average of museum goers, 32 compared to 45.8, as of March 2016 70% of the Broad’s visitors were younger than 34 years old.

The Broad represents what these museums can be, but just because others do not do as much as the Broad does not mean they do not do enough to benefit the public. The limited hours and days of operation and reservations requirements can be justified: the founder wanted to create unique and more intimate experiences for visitors. Should it matter that this type of public benefit is intangible?

Ignore for a second the obvious benefit of public access to these artworks. Also ignore the limited circumstances some of the museum allow the public access to these works – a reason for reduced access might be that these museums are new and the operating expenses associated with keeping more traditional matters currently do not make sense because of number of guest expected. How is it determined whether the public receives enough or any benefit at all? Maybe the benefit is not clear or scientific, maybe it is indirect, or maybe it will take years to manifest but once it does it will be incalculable. The fact is public benefit can be difficult to pinpoint.

This difficulty is reminiscent of a Copyright issue raised over 100 years ago. When approached with the question of whether an advertisement could be protected under copyright law in Bleistein v. Donaldson Lithographing Co., Justice Holmes pointed out that judges should not determine the worth of “pictorial illustrations”. His reasoning, which boils down to the tastes of any portion of the public should not be looked down upon. Following that logic, maybe Congress, the IRS or a court adjudicating the issue of public benefit should determine that if any portion of the public benefits from an organization that organization should be allowed to keep its tax exempt status.

 *  *  *

Note: This Article is being reprinted with the permission from Entertainment, Arts and Sports Law Journal, Fall 2016, vol. 27, no. 3, published by the New York State Bar Association, One Elk Street, Albany, New York, 12207

*About the Author: David Honig is a member of the Brooklyn Law School Class of 2015. While attending law school he was a member of the Brooklyn Law Incubator & Policy (BLIP) Clinic. He is admitted to New York and New Jersey state bars. From 2015 to 2016 he served as a postgraduate fellow at the Center for Art Law. David is currently pursuing an LL.M. in taxation from NYU Law.

The Cost of Donating Artwork: Can Artists Afford to Donate Their Own Artwork?

 

By Emma Kleiner*

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Sample press release about a gift (2011 The Philadelphia Museum of Art).

At the Tucson Medical Center in Tucson, Arizona, the Healing Art Program’s mission is to fill the hospital with art that lifts the spirits of the patients and creates a serene environment. Lauren Rabb, the Curator of the Healing Art Program, manages that task, which includes arranging works from the hospital’s private collection and searching for new donations. It may seem curious, then, that when Rabb began her work at the Hospital she would not consider asking an artist to donate his or her own work. To professionals in the art world this hesitance makes sense: unlike art collectors, who are incentivized to donate artwork because they may deduct the fair market value of the work from their taxable income, artists may only deduct the value of their supplies – which likely amounts to the negligible cost of paper, brushes, and paint. In an interview for Center for Art Law, Lauren Rabb, who once also owned a gallery and worked as a museum curator, stated: “Everyone in the art world has come into contact with this [tax provision].”

Under § 170 of the Internal Revenue Code of 1986 and § 1.170-1(c)(1) of the Code of Federal Regulations, when a taxpayer makes a charitable contribution of tangible property, including artwork, he or she may deduct the fair market value of that tangible property from his or her taxable income. The law is designed to provide an incentive to collectors to donate artworks to nonprofit educational institutions such as museums and libraries. However, as a result of the passage of the Tax Reform Act of 1969, “creators,” such as artists, writers, and choreographers, are excluded from this tax provision. Instead, creators may only deduct the cost of their supplies from their taxable income. Thus, while collectors may be motivated to donate artwork due to the favorable tax benefits, artists are asked to give away their artwork essentially for free.

The origin for the disparate treatment of artists and non-artists dates back to the 1960s, when Congress was galvanized to close a perceived loophole after public officials and politicians capitalized on their status as creators of their own papers and manuscripts. Presidents Truman through Johnson reaped very favorable tax benefits when donating their presidential papers. Supporters of the Tax Reform Act of 1969 derided the ability for public officials and politicians to deduct the fair market value of their papers – papers that arguably belonged to the public in the first place. The timing of this reform put President Nixon’s donation of a portion of his vice presidential papers in 1969 at risk. President Nixon’s Vice Presidential papers were valued for tax purposes at $576,000, which appeared to be a very favorable appraisal to many observers, even exceeding Nixon’s gross income for 1970. To take advantage of the pre-1969 tax break though, Nixon backdated the deed transferring title of his papers. That deduction helped to reduce his taxable income to zero – in fact, the $792 he paid in taxes in 1970 was a result only of the alternative tax minimum. In passing the Tax Reform Act of 1969, Congress was concerned that if they failed to close this loophole, other creators would take advantage of the tax provision allowing for a deduction of fair market value of their works. Notably, these examples relate to documents and written materials rather than works of visual art.

The effect of the revision of the Internal Revenue Code in 1969 was immediate: donations of works, including artwork, manuscripts, and other scholarly collections, by their creators came to a halt. For example, in the three years prior to 1969 the Museum of Modern Art in New York received 321 donations from artists, but in the three years after 1969 the Museum received only 28 donations from artists. Strikingly, the Library of Congress, which customarily received around 15 donations from authors per year, received one donation in the four years after 1969. The National Archives, within just days of the passage of the Tax Reform Act of 1969, noted a visible decline in gifts of papers made to the government.  

This trend was particularly significant for museums and libraries, which depend on the public to a large extent to grow their collections. Museums, which must rely on their endowment and funds to support their staff and the costs of running a museum, need donations to grow their collections. It is estimated by the Performing Arts Alliance that 80% of objects in U.S. museums arrive as donations. Furthermore, the connection between donations and tax benefits is clear. In Artful Ownership, author and attorney Aaron Milrad wrote, “Historically, most museums and public institutions have received their finest works through donations[,] . . . [and] the donations are made, at least in part, for the tax benefits available to the donor.” Today, because of the insignificant tax break for donating artwork, artists often sell work that they would otherwise consider donating to a cultural institution or nonprofit, and the public is thus denied the benefit of that art.

Although the possibility for valuation abuse that spurred support for the Tax Reform Act of 1969 will always exist, there are many reasons to believe that deceptive or exaggerated valuations are not likely to occur and that Congress could safely adopt a measure restoring the law to its pre-1969 condition. The Senate currently has such a bill in front of it: the Artist-Museum Partnership Act (“the Act”). The Act, proposed by Senator  of Vermont, would give artists the ability to deduct the fair market value of their works while providing additional safeguards to prevent any abuse of the tax provision.

The Act has been introduced in the Senate seven times since 2000, most recently on April 14, 2015, but it has not gained much traction or become law. To reduce the ability for creators to take advantage of a tax provision allowing for the deduction of their donated works at fair market value, a qualified appraiser must determine the fair market value of the tangible property. Moreover, the tangible property must be created no less than 18 months prior to the contribution, which stops an artist from creating and donating a piece of tangible property in quick succession simply to gain a tax advantage. Finally, the Art Advisory Panel at IRS, which was established in 1968 to help IRS review the fair market value of works of art, should also help to curb any appraisals of art that raise red flags. Given these safeguards, such “phantom abuses” should not prevent the United States from supporting creators in their artistic work.

 

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Note credit line of the controversial Rauschenberg work that includes a stuffed bold eagle. MoMA.

Amending the IRC by passing the Act or comparable legislation would be one step towards rectifying the unfairness with which artists and other creators have been treated for the past decades and undoing the harm to museums, libraries, and other institutions that have limited acquisition funds. It would serve the fundamental goal of generating public access to the arts and helping museums grow their collections. In advocating for passage of the Artist-Museum Partnership Act, Senator Leahy stated: “We have a lot of contemporary artists in this country who have this artwork, and ultimately the public wins. The public gets to see artwork they might not have seen otherwise, unless they were visiting somebody who’s a private collector.”

 

At present, by disallowing the deduction of the fair market value of artwork when donated by its creator, the Internal Revenue Code creates a schism between taxpayers where there should be none. It is only fair that collectors and creators, who are identical taxpayers and donate the same types of works, receive the same tax benefit of a donation.

Note: For this interview, author interviewed Lauren Rabb, Curator of the Healing Art Program at Tucson Medical Center in Tucson, Arizona. More information about the Program is available on their website: http://www.tmcaz.com/healing-art-program.

Sources:

*About the Author: Emma Kleiner is a student at Stanford Law School. She can be reached at ekleiner@stanford.edu.

Disclaimer: This article is for educational purposes only and is not meant to provide legal advice. Readers should not construe or rely on any comment or statement in this article as legal advice. Instead, readers should seek an attorney.

Donating Art – Not as easy as you may think…

By Aaron M. Milrad, first published on the Dentons website on 2 April 2015.

Owner

In advising potential art donors I find my clients are surprised when I ask “Are you the owner of the art?” At times there is no quick or obvious answer. Who was the buyer of the art? Who was listed on the Bill of Sale? Is it you, your spouse or your corporation? What if you and your spouse are no longer married and living together, but the Bill of Sale shows that the artwork was sold to Mr. and Mrs. X? Who can donate it? Keeping the original Bill of Sale is an important aspect of donating art as a museum or art institution will ask you to sign a Deed of Gift confirming that you are the owner of the art and have authority to donate it.

The deed of gift

The Deed of Gift will also ask you to warrant that the artwork is free and clear of any encumbrances; that is, that you have not pledged it to the bank for a loan or an ongoing loan agreement and that no creditor has filed any claim against your assets, including the artwork.

It is also common for the Deed of Gift to ask, and have you confirm, that the artwork has not been imported into Canada in contravention of any cultural property laws of the country of origin of the artwork (a Mexican object, as an example) or in contravention of Canadian law.

Canada is a signatory to UNESCO Convention dealing with the rules for importing and exporting of cultural property from member states.

Where to donate?

Mandates of collecting differ significantly from one institution to another. Selecting the right institution is important as the donor does not wish to be embarrassed by having an institution refuse the work as being outside its mandate. For example, the George Gardiner Museum of Ceramic Art collects only ceramics and related material. Other museums may collect only Canadian art or military art – or may not collect at all and may only exhibit art on loan.

Institutions will consider other factors:

  1. How important is the artwork;
  2. How the work fits into its collection;
  3. The size of the work;
  4. Whether it can be easily accommodated in storage; and
  5. How often the institution will want to show the work to the public (that is, its importance as art).

Your personal appreciation of the work in question does not necessarily make it an important work for an institution to receive as a donation. There must be a value and a relationship to the institution’s existing collection to warrant its acceptance of the work. You should ask the institution in advance as to its mandate and what the institution may be looking for in the way of art donations.

Donation of money

It is not unusual for an institution to tie its acceptance of the art donation to a requirement that the donor also contribute money to help cover the cost of “the care and feeding of the artwork”, and/or the cost of independent appraisals by professional appraisers to establish the fair market value of the art donation that will be reflected on the donor’s tax receipt. Often times, such a monetary contribution can be made to the institution for its general purposes. Care has to be taken to avoid direct or directed payment to the appraisers, as this may not qualify as a donation for income tax purposes.

Fair market value

If a tax receipt is requested or required, the artwork must be valued by independent appraisers at or near the time of the donation. Sometimes the curator of the institution itself may appraise the work. If the artwork has an original cost and a current value less than $1,000, there is no tax ramification for a capital gain under the Income Tax Act.

“Fair market value” is not defined in the Income Tax Act. However, it has been established by various court decisions as being the highest price an artwork is expected to bring in the context of willing buyers and willing sellers in the appropriate “sales market” applicable to that artwork, and under no compunction to transact. Often times, in seeking to quantify the artwork’s value, the tax authorities will look at the original price paid by the donor as the starting point, as well as the qualifications of the independent appraisers who valued the artwork.

Acceptance

Many institutions will require that the donation of the artwork be approved not only by the relevant curator, but also by an acquisition committee or even by the institution’s board of trustees. This is not a quick process. Usually, acquisition committees sit only three or four times a year. If timing of acceptance of a donation of artwork is important for tax reasons (i.e. the receipt is required for a particular tax year), sufficient time has to be given to the institution to process the artwork for donation in accordance with the rules of the institution and the tax authorities.

The institution must be a ‘charitable organization’ in order to issue tax receipts. It will not wish to put its status in jeopardy for having a faulty donation acceptance program.

Certified cultural property

A donation may be made by a collector to an institution under normal donation rules for a tax receipt for fair market value of the artwork. However this process will result in a taxable capital gain to the donor based on the increased value of the work from the time of purchase to the time of donation. There may be different tax issues for an art donation made by an art dealer, or artists donating their own artworks, but that is outside the purview of this article. However, an art donation made under Canada’s Cultural Property Export Import Act may qualify for a special benefit given to the donor.

Wish You Were Here: Sotheby’s Institute of Art (CA) Conference, January 2015

by Jessica Newman*

On January 30 and 31, the Sotheby’s Institute of Art gathered attorneys and art professionals together in Los Angeles, California for their Art Law Conference entitled “The Practice of Law in the International Art World.” The two-day expansive agenda featured twelve modules and nearly forty speakers, including artist Shepard Fairey giving an inspired keynote speech. The Conference addressed a number of issues at the confluence of art and law, including authenticity, looting, collecting, restitution, investment, public art, the future of art, and the art market. Following is a brief write up of the most memorable topics:

1. Liability v. Leadership: Advising Arts Organizations

Melody Kanschat, Executive Director of the Getty Leadership Institute at Claremont Graduate University, chaired a panel entitled “Liability v. Leadership: Advising Arts Organizations,” which featured Stephen Clark (J. Paul Getty Trust), Fred Goldstein (Los Angeles County Museum of Art), David Galligan (Walker Art Center), and Eva Schieveld (Van Gogh Museum). As multidimensional institutions, museums face a myriad of issues that extend far beyond the world of art. The panel emphasized that general counsel should be a part of all senior management conversations and budget discussions. One common concern was the avoidance of conflicts of interest (both real and apparent), particularly when dealing with a board of trustees.

One question posed to the panel was whether a museum can invest in a company which is run by a member of the museum’s board. As with many legal questions, the answer is, “Yes, but…” Although some museums have a strict zero tolerance policy when it comes to such investments, it is possible to structure transactions in a manner that avoids direct conflicts of interest. In part, the soundness of such a transaction turns on who is making the decision. It is important to ensure that the transaction is done at arm’s length and that no one who will directly benefit is personally involved in the decision whether or not to invest. In addition, transparency and continued management play important roles in preventing conflicts from arising.

2. Restitution Panel

Jonathan Petropoulos moderated the Restitution Panel, which explored the continuing evolution of restitution claims. Although issues of restitution have been around for some time, they remain a major concern for purchasers, heirs, and museums alike. Lucian Simmons of Sotheby’s observed that investigation into potential restitution issues remains a steady part of his work even today. Accordingly, as Simon J.Frankel (Covington) reiterated, research into proper provenance is as important as ever, and several conference speakers strongly advocated title insurance. As for the future of the field, Lawrence M. Kaye (Herrick), identified Russia as the next potential hotspot for restitution claims if access to Russian archives and collections becomes a possibility.

3. Secured Transactions

The second day of the conference began with a panel on Secured Transactions, moderated by Franklin Boyd and featuring John Arena (Bank of America), Stephen D. Brodie (Feinstein), and Karen McManus (Jacqueline Silberman & Assocs. Inc.). Art as an alternative asset has become increasingly popular for wealthy investors looking to diversify their portfolios. Art can also be used as a financial tool without having to sell the works by using the art as collateral. However, this option is only open to a select number of collectors.

The target collector is one with at least $10 million in well-established works (i.e., Old Masters, Modern, etc.) which can be quickly and easily sold were such a sale to become necessary for the lender. These works are appraised and, from a collector’s perspective, title insurance is recommended. Additionally, art must be the “second way out” of the deal. In other words, the borrower must have demonstrated equity in other assets. For those who can meet these criteria, using art to finance loans can be an attractive option. The fact that the United States is the only country where owners can maintain control of their collateralized works makes this option particularly appealing.

4. Art Collecting in the Current Legal Market

“Art Collecting in the Current Legal Market,” panel which was chaired by Mary Rozell (Sotheby’s) and featured Carol Bradford (California Community Foundation), Josh Roth (United Talent Agency, formerly Glaser Weil), and Katie Tolson (Gurr Johns). Although the increasingly global and technology-driven world of art collecting makes it easier than ever to access art, it also poses a number of challenges for the contemporary collector. For instance, documents can now be forged with the push of a button. However, one area in which technology has significantly enhanced the collecting experience is in inventory management. Ensuring proper documentation of one’s inventory is vital and a number of new software options have emerged that can assist a collector in doing just that. These software programs range in price, but at a minimum it should offer the collector a means of inputting photographs, descriptions of the works and details such as collection history, exhibition history, location, and inventory number. Ms. Tolson described her firm’s custom-designed Art Collection Management Software, which offers collectors a sophisticated means of managing their collections.

Roth discussed the increasing use of Section 1031 like-kind exchanges as a tool that can be utilized to expand one’s collection. Section 1031 of the Internal Revenue Code, entitled “Nonrecognition of gain or loss from exchanges solely in like kind,” provides a means for investors to defer taxes on capital gain from the sale of a work of art. In effect, 1031 Exchanges provide a collector with an interest-free loan from the government that can be used to subsidize future acquisitions so long as certain conditions are met. First, this section does not apply to personal property, as it applies only to property used for business or investment purposes. The exact parameters for this requirement are somewhat vague, however a work purchased solely for personal display in one’s home is not likely to qualify. Defining a like-kind property in this context can be equally difficult as there is no definitive guideline as to what type of art would be of like-kind to another. For instance, it is conceivable that the IRS may determine that a sculpture is not of like-kind to a painting.

Lastly, there are strict timing and designation requirements which are intended to distinguish a 1031 Exchange from a taxable transaction in which the purchaser merely uses the proceeds from a previous sale to purchase a new property. There are several ways to structure such an exchange, though the forward, or deferred exchange is most common. Broadly speaking a forward exchange works as follows: upon the sale of a work, the collector can use a 1031 exchange to defer the gain by investing the proceeds in a like-kind replacement property (i.e. another work of art) of equal or greater value. The replacement work must be identified within 45 days of the initial sale, and the collector has 135 days to close the sale upon identification. The appeal of such exchanges is evident, and Roth expects that they will only continue to grow in popularity.

Over the course of the two days, several takeaways emerged. First, many of the traditional issues within the field of art law – looting, restitution, importing/exporting, authenticity – remain at the heart of any art law practice. Secondly, the search for new uses and new means of valuing art has produced a number of creative options for investment and exchange of art. These options, however, are complex and require thorough due diligence by all parties. Lastly, the digital age has brought with it a host of new challenges for collectors, museums, artists, and attorneys alike. At the same time, technological advances also are opening up the art world in exciting ways.

Selected Sources:

About the Author: Jessica Newman is a third year dual-degree student pursuing a Juris Doctor and a Masters in Art History at Duke University. She can be reached at Jessica.newman@lawnet.duke.edu.

The European VAT: Good for Tax Revenue, Bad for the Commercial Art Market?

by Elizabeth R. Lash, Esq.

As an American, one might be forgiven for assuming that Europe, with its traditional support for the arts (at least, as a cultural phenomenon), would be equally supportive in its tax regime for the same. While in some limited instances, the European Union continues to provide a more favorable regime for the independent artist, the trend towards an ultimately higher value-added tax (“VAT”) on the sale, import and export of artwork, particularly with respect to art sold by galleries and in the resale market, may discourage the growth of an EU-wide commercial art market in comparison with more favorable tax regimes outside the EU.

VAT was initially intended to be used as a single tax rate applicable to all goods and services across all European Union member states. While the standard rate was originally set at 15% in 2006, member states could theoretically request reduced rates in one or two categories, set at no less than 5%. In reality, as each member state negotiated the terms of its entry into the EU, the list of categories has expanded to at least 21, with rates above and below the standard rates (which already varies from 17% to 27%), along with multiple categories of rates below 5% (zero rates, “parking rates” (i.e., rates negotiated with entry into the EU), and super reduced rates). As well, categories of rates are inconsistently drawn, from too narrow to overly broad: it includes, among others, such categories as printed books, e-books, cultural institutions, household cleaning, sporting facility use, bicycles, and writers and composers.

When it comes to artwork, VAT rates vary widely, ranging from 5% (Malta) to 25% (Sweden) (although there is a reduced rate for independent artists’ sales). In addition, VAT may be calculated on the margin (i.e., the difference between the original sale price and the purchase price), instead of under the standard or reduced rate (whichever is applicable to artwork in that particular member state). In a number of member states, the VAT may be set at multiple rates: one for independent artists; another for galleries and dealers; and still another for the import or export of art.

Further complicating this picture, the EU Commission may not only pressure (or even sue) a member state as to the categories for which reduced rates are permitted, but may also regulate individual tax cases affecting artists and collectors. One example in particular is the Flavin case, whose outcome confounded the international art community (and sets an unfavorable precedent in future, similar circumstances). In 2006, a British gallery (named the “Haunch of Venison”) imported two well-known American conceptual artists’ sculptures: Dan Flavin’s light sculpture, and Bill Viola’s video installations. The former consisted of several tubes of fluorescent lights, while the latter consisted of several audio-visual productions playing on various projection screens. The British customs office imposed a 20% rate instead of the reduced 5% rate for artwork. However, upon appeal to the British VAT and Duties Tribunal (the “Tribunal”), the reduced rate was re-instituted in 2008.

But despite this local regulator’s final decision (with no further appeal by the parties to the EU courts), the EU Commission weighed in anyway with its own regulation, issued in September 2010, which specifically overturned the Tribunal’s decision, ostensibly to effectuate the uniform taxation rules on imported goods. The EU Commission found that it was not the installations themselves which constituted artwork, but the results of such installations, whether of the “light effect” of Dan Flavin’s light sculpture, or the videos screened on Bill Viola’s video installations. Thus, in effect, the EU Commission found that the installations should have been taxed just as if a hardware or electronics store had imported lightbulbs and video components. For conceptual artists, this represented a major blow to the sale in and import of their artwork into Europe.

Then take Germany. Germany formerly assessed a reduced VAT of 7% on sales of art (other than photography). However, due to pressure from the EU Commission, which had opened proceedings against Germany regarding this reduced rate category, Germany passed legislation to raise the rate to 19%, effective January 1, 2014 (Germany’s standard VAT rate since 2007). In response, German federal legislators passed a national directive that permitted the tax to be assessed on only 30% of the purchase price, relying in part on an exception to the VAT directive that had been used in France for several years. But the application of this directive was restricted less than a year later by the German states to artwork priced under 500 Euros, and a few other categories, essentially undercutting the law’s essential purpose—to provide a more favorable rate for the commercial art market. Meanwhile, artists selling out of their studios remain subject to the 7% rate. While this may be acceptable for those select artists who sell out of their own studios, it does not bode well for those who are represented by galleries.

In 2014, in another instance of muddying the tax waters, the French government increased VAT on the sale of art in France from 7% to 10%, while still permitting imports of non-EU artwork to be taxed at 5.5%. Only a year later, the French legislators acknowledged this inconsistency, and reduced the VAT on direct sales by French artists to 5.5%, effective January 1, 2015. Meanwhile, in Spain, the current VAT on artwork was raised from 8% to 21% in September 2012, initially as part of the general rate assessed on goods and services related to “culture.” Within a year, after much hue and outcry, Spain decreased the rate again to 10%. Meanwhile, in Italy, the VAT on the sale and import of artwork is still 22%.

The dust may eventually settle on the various VAT rates and their application, but the newest wrinkle is a regulation (Council Implementing Regulation (EU) No 1042/2013) which changes how VAT is assessed—from the place of supply to the place of purchase. While this does not affect traditional visual artists and sculptors, it does impact those who are considered to supply services or goods digitally to consumers—for instance, freelance website designers. The regulation, effective January 1, 2015, requires such businesses to assess VAT based on the country of the purchaser, rather than the VAT of their own country, placing yet another burden on artists in figuring out the application of VAT—even though the regulation was meant, in part, to apply to the likes of e-retailers such as Amazon.com.

In light of the fluctuations in tax rates and their applications, with the ultimate trend inching towards a uniformly high VAT rate, the art market looks nowhere near as enticing in the EU as it does in those countries and locales not subject to the vagaries of the VAT rate debate. In the U.S., for instance, no VAT exists (although, of course, the U.S. does have a sales tax), and there is no import duty assessed on original works of art. Hong Kong does even better—it has no sales tax, import tax, or export tax on artwork. To some degree, the numbers back this up: according to an annual study conducted by Arts Economics for the European Fine Art Foundation, in 2013, the U.S. accounted for 38% of the global market by value, while the EU as a whole dropped 3% points to 32%. (The UK ranked separately at 20%–perhaps not a surprise in light of its 5% reduced VAT rate on artwork, the Flavin case notwithstanding.) Moreover, in the EU itself, the numbers for those member states with the highest VATs declined or remained the same. And while Hong Kong and Singapore did not rank individually as the top winners in 2013 (having perhaps to do with factors other than VAT or customs duties), still, such figures may show in part the effect of applicable tax regimes.

Then there are the so-called “free ports,” located around the globe, which have become popular as a way to store works of art intended primarily as an investment. A free port is essentially a tax haven: artwork may be shipped directly to the free port, and as long it is stored there, VAT will not be assessed on the import. (Of course, once the work is shipped outside the free port to its new destination, any applicable tax will be assessed.) An additional benefit for potential purchasers (depending on the local laws applicable to the free port) is that VAT may not be assessed on any sales of artwork made within the free port—at least not until the artwork has left the free port. (So, hypothetically speaking, if a sale has been made, but the work never leaves the free port, VAT will never be assessed.) Arguably, the art fair Art Basel became popular just for that reason, having made its initial home base in a Swiss free port. As of right now, there are free ports located in Switzerland, Luxembourg, Singapore, and Beijing. (One of the best indications of how popular the Singapore free port has become is that Christie’s auction house now has an office located there.)

The EU Commission has previously expressed that VAT rates are not to be used to control social and economic policy in the EU, and clearly is increasingly attempting to pressure member states, whether through regulation, litigation, or other alternative avenues, to raise VAT rates to a uniformly high rate. However, in the face of global competition, one can only wonder what this trend may mean for the EU in the future as a major player in the commercial art markets.

 

Sources:

About the Author: Elizabeth R. Lash, Esq., serves as in-house counsel at Kroll, where she focuses on reviewing agreements relating to cyber security and data breach notification.

DISCLAIMER: This article was prepared by Ms. Lash in her personal capacity; the opinions are the author’s own, and do not reflect the view of Kroll Associates, Inc. or of its affiliates.

Art Law Visiting the Non-profit Side: On Qualifying for 501(c)(3) Status as an Arts Organization

By Benjamin Takis*

2014-05-25 collage

Background

New non-profit organizations often find that the world is not a hospitable place. While innovation, entrepreneurship, and risk-taking by new for-profit companies are lauded, fledgling non-profits typically struggle to gain the acceptance and support of private foundations, donors and others in the non-profit community. There is, after all, only a limited supply of grants and donations to fund charitable, artistic, and educational endeavors. Furthermore, the administrative burden of forming and administering a non-profit can be staggering. New non-profits are therefore often advised to pair up with an existing organization, use a for-profit structure, or explore other alternatives before forming a new entity and applying to qualify under section 501(c)(3) of the Internal Revenue Code (the “Code”).

Despite these challenges, arts organizations share certain traits that can help them thrive as non-profit 501(c)(3) organizations, with fewer of the hurdles faced by other kinds of non-profits. First, while many organizations rely largely on foundation grants and private donations, arts organizations can raise funds from ticket sales to performances, exhibits, and other events. For many kinds of organizations, these “fee-for-service” revenue sources can trigger “unrelated business income tax” or endanger 501(c)(3) status under the “commerciality doctrine” applied by the Internal Revenue Service (“IRS”) and the courts. However, these revenue sources are generally consistent with the tax-exempt status of arts organizations. Additionally, these types of revenue sources can more easily satisfy the “public support” tests that enable an organization to qualify as a public charity, and thereby avoid classification as a private foundation and the stringent oversight to which private foundations are subjected.

The Benefits and Burdens of 501(c)(3) Status

501(c)(3) is a special tax status under federal law, generally available to organizations formed and operated for a charitable, educational, scientific or religious purpose, and promotion of the arts is recognized as a valid educational purpose. Treas. Reg. § 1.501(c)(3)-1(d)(3)(ii), Example 4 (Educational organizations include “[m]useums, zoos, planetariums, symphony orchestras, and other similar organizations,” provided that the organizations otherwise satisfy the requirements of section 501(c)(3) of the Code). However, before embarking on the 501(c)(3) qualification process, it is important to carefully consider whether the benefits of 501(c)(3) status are worth the burdens.

There are three legal benefits to having 501(c)(3) status: (1) the organization’s net revenue (after expenses) is generally not subject to tax; (2) contributions to the organization are eligible for the charitable deduction; and (3) the organization is eligible for grants from private foundations.

These benefits are not quite as advantageous as they may appear. Most non-profits (including arts organizations) do not have large amounts of excess revenue – most struggle to earn enough revenue to pay their expenses. Therefore, the tax exemption on net revenue may not be crucial. Second, while the charitable deduction is a powerful incentive for individuals inclined to give money to non-profit organizations, it is still a difficult task to convince people to give. The charitable deduction tends to be important only when an organization’s Board of Directors has a strong and committed network of high-wealth individuals. Lastly, it can be difficult to get grants from private foundations. Finding grant opportunities takes significant research, and the grant writing process requires preparation, perseverance, and commitment.

Maintaining 501(c)(3) status can also be quite burdensome. A 501(c)(3) organization must be run by a Board of Directors (generally 3 or more people) in accordance with Articles of Incorporation, Bylaws, and various corporate policies that comply with requirements set forth under federal tax law and state non-profit corporation law. In addition, any compensation to Directors or Officers must be closely scrutinized to ensure that such payments are reasonable. And complex tax filings called the Form 990 (or Form 990-EZ) are generally required for organizations with gross revenue exceeding $50,000 per year, and are open to public inspection. (Organizations whose annual gross receipts are normally $50,000 or less, file a much simpler electronic form called the Form 990-N). These and other administrative difficulties are not typically worth the trouble unless 501(c)(3) status would significantly enhance an organization’s fundraising capabilities, or at least its image in the arts community.

Designing a Program of Activities to Qualify under 501(c)(3)

An arts organization that has thoroughly considered the benefits and burdens of 501(c)(3) status and wishes to move forward with the qualification process will need to design a program of activities consistent with 501(c)(3) status. It is important to be aware of which types of activities are acceptable and which activities raise suspicions at the IRS, and be able to show the IRS several bona fide activities that fit squarely within the traditional notions of a 501(c)(3) arts organization.

The exemption under section 501(c)(3) for arts organizations is based on the statutory exemption for “educational” organizations, so educational activities carry significant weight in the approval of 501(c)(3) status. Examples of educational arts organizations include:

  • An organization formed to promote the advancement of young musical artists by conducting weekly workshops, and sponsoring public concerts by the artists. Rev. Rul. 67-392, 1967-2 C.B. 191.
  • An organization formed to promote public appreciation of group harmony singing by holding frequent meetings of members where they receive training and instruction in vocal harmony and opportunities to practice under trained supervision. Rev. Rul. 66-46, 1966-1 C.B. 133.
  • A dance school with a regular faculty, daily comprehensive curriculum, and a regularly enrolled body of students. Rev. Rul. 65-270, 1965-2 C.B. 160.

Educational activities can also include individual instruction, or the dissemination of instructional materials for free or for a nominal charge. See Rev. Rul. 68-71, 1968-1 C.B. 249 (approving the 501(c)(3) status of an organization that provided career education by distributing educational publications at a nominal charge and providing free vocational counseling services).

Public exhibits or performances are also typically valid 501(c)(3) activities, provided that steps are taken to ensure that the selection of artists is disinterested (i.e. the organization is not merely a vehicle for showing the work of founders, directors or other insiders of the organization), and provided that the artists or works are chosen for their artistic merit rather than their ability to appeal to a mass audience. See Plumstead Theatre Soc’y, Inc. v. Comm’r, 74 T.C. 1324, 1332-1333 (1980), aff’d 675 F.2d 244 (9th Cir. 1982) (contrasting commercial theaters, which “choose plays having the greatest mass audience appeal … run the plays so long as they can attract a crowd …[and] … set ticket prices to pay the total costs of production and to return a profit,” with 501(c)(3) theaters, which “fulfill their artistic and community obligations by focusing on the highest possible standards of performance; by serving the community broadly; by developing new and original works; and by providing educational programs and opportunities for new talent.”). It helps if at least some of these exhibits or performances are open to the public for free.

For example, the IRS has approved the 501(c)(3) status of the following organizations:

  • An organization whose sole activity was sponsoring an annual art exhibit of artists selected by a panel of qualified art experts. Rev. Rul. 66-178, 1966-1 C.B. 138.
  • A filmmaking organization that organized annual festivals to provide unknown independent filmmakers with opportunities to display their films. Rev. Rul. 75-471, 1975-2 C.B. 207.
  • An organization that presented public jazz concerts featuring aspiring jazz composers and high school students performing alongside established jazz musicians. Rev. Rul. 65-271, 1965-2 C.B. 161.
  • A touring repertory theatre company that focused on works that were part of college curricula. Rev. Rul. 64-175, 1964-1 C.B. 185.

Note that the IRS views the exhibition of art much differently than the sale of art, especially with respect to the visual arts. The IRS typically denies 501(c)(3) status to art galleries that engage in the sale of art for a commission. See Rev. Rul. 76-152, 1976-1 CB 151 (rejecting the 501(c)(3) status of a gallery formed to promote modern art trends by exhibiting works of modern artists and selling the works on consignment basis with the artist setting the selling price and the organization keeping a 10% commission, even though this commission was lower than that charged by commercial entities and the gallery planned to supplement its revenue through donations); Rev. Rul. 71-395, 1971-2 CB 228 (rejecting the 501(c)(3) status of a gallery formed and operated by approximately 50 artists for the purpose of exhibiting and selling the work of the founders).

Gallery sales activities are permitted only under very limited circumstances when sales activities are sufficiently minor in comparison to educational and other valid 501(c)(3) activities. Goldsboro Art League, Inc. v. Comm’r, 75 T.C. 337 (1980) (approving the 501(c)(3) status of a gallery that engaged in some sales for commissions in addition to educational activities, based on the following factors: (1) there were no other museums or galleries in the area, thus, the exhibition of art works showed a purpose primarily to educate rather than to sell and the selling activity served merely as an incentive to attract artists to exhibit their work; (2) works were selected by an independent jury for their representation of modern trends rather than salability; (3) the organization demonstrated that educational activities were its priority; (4) the art sales were not conducted at a profit; and (5) of more than 100 works of arts exhibited in the organization’s galleries, only 2 members of the organization had their art exhibited).

Most 501(c)(3) arts organizations focus predominantly on education and/or public exhibits or performances, but other types of activities can be acceptable as well. For example, the awarding of grants to aspiring artists and students is a permissible 501(c)(3) activity, provided that procedures ensuring disinterested selection of winners are developed and scrupulously followed. See Rev. Rul. 66-103, 1966-1 C.B. 134 (approving the 501(c)(3) status of organization formed for the purpose of making grants available to writers, composers, painters, sculptors, and scholars for projects in their respective fields which they would not otherwise be able to undertake or finish due to the lack of funds. In awarding grants, preference was given to persons showing distinction or promise in their respective fields, and the recipients promised to make their work available for the benefit of the public in ways customary and appropriate to the particular work. The organization received no financial benefit from these grants).

The IRS has also approved of activities promoting the appreciation of art by less traditional means, such as the recording and sale of obscure classical music pieces to educational institutions, Rev. Rul. 79-369, 1979-2 C.B. 226, and a museum’s sale of greeting cards displaying printed reproductions of selected works from the museum’s collection and from other art collections. Rev. Rul. 73-104, 1973-1 C.B. 263. However, these types of non-traditional promotional activities should be approached with caution, as they implicate difficult issues that can lead to unpredictable results from the IRS. See e.g. Rev. Rul. 76-206, 1976-1 C.B. 154 (rejecting the 501(c)(3) status of an organization formed to generate community interest in classical music by urging the public to support the classical music program of a for-profit radio station).

In summary, when applying for 501(c)(3) status, an arts organization should be prepared to describe several activities similar to those approved by the IRS. There should be at least some educational component, whether through workshops, classes, online publications or tutorials, or other means. It is helpful to show engagement with the public or local community through free exhibits or performances, and to focus on art that lacks mainstream commercial viability. Lastly, an organization founded or run by artists should make sure to focus on a wide variety of artists rather than just its founders or members.

About the Author: Benjamin Takis is the founder and principal attorney of Tax-Exempt Solutions, PLLC. He may be reached at btakis@taxexemptsolutions.com.

Disclaimer: This publication is provided for educational and informational purposes only and does not contain legal advice. Accordingly, you should not act on any information provided without consulting legal counsel. To comply with U.S. Treasury Regulations, we also inform you that, unless expressly stated otherwise, any tax advice contained in this publication is not intended to be used and cannot be used by any taxpayer to avoid penalties under the Internal Revenue Code, and such advice cannot be quoted or referenced to promote or market to another party any transaction or matter addressed in this publication.

The Race for a Tax Break: How Buyers Circumvent ‘Use Taxes’ on Art

By Emma Kleiner

Francis Bacon, "Three Studies of Lucian Freud," (1969). © The Estate of Francis Bacon.

Francis Bacon, “Three Studies of Lucian Freud,” (1969). © The Estate of Francis Bacon.

When Three Studies of Lucian Freud (1969) by Francis Bacon sold last November in New York for $142.4 million, the art world wondered about the identity of the unnamed buyer and the location of the triptych’s new home. Subsequently, the identity of the triptych’s anonymous buyer was revealed: the buyer was Elaine Wynn, who divorced Las Vegas casino owner Stephen A. Wynn in 2010. Although Ms. Wynn is a resident of Nevada, in December 2013, Three Studies of Lucian Freud made its surprising post-auction debut at the Portland Art Museum in Oregon. While the decision to anonymously lend the painting to the Museum may appear surprising at first, the Portland Art Museum regularly attracts recently auctioned items to display in its galleries. The decision for collectors to regularly lend to the Portland Art Museum originates from a reason more basic than the Museum’s location, collection, or galleries – it is based on a tax break.

Although Ms. Wynn has not released the tax plan for Three Studies of Lucian Freud, her tactical decision to show the triptych in Oregon instead of shipping it to her Las Vegas home from Christie’s in New York likely helped her to avoid use taxes in her home state, which, in her case, may have reached $11 million. Use taxes incur when an individual sends home an out-of-state purchase. By shipping recently purchased artwork out of state immediately, the collector avoids the state’s sales tax, but use taxes are in place to make up for that loss. Still, a collector can avoid their home state’s use tax by utilizing a little known loophole. Usually, artwork is subject to a use tax in the state where it arrives after it is shipped from its purchase location, but five states—Alaska, Delaware, Montana, New Hampshire, and Oregon—do not have a use tax. In contrast, California, which established a use tax in 1935, has a use tax rate of 8.75% and Nevada, which established a use tax in 1955, has a use tax rate of 6.85%.  By the time the artwork arrives in the owner’s home state, it has already been “used” in another state, and thus no use taxes are owed. This clever tactic allows art buyers, who sometimes pay tens of millions for artwork, to relocate the artwork to their private residence tax-free.

Similar to the Portland Art Museum, museums in tax-free use states often encourage collectors to loan recently purchased artwork before it disappears into private homes. For example, the Jordan Schnitzer Museum of Art at the University of Oregon in Eugene, Oregon, has experienced such an influx of recently auctioned artwork that they established a program called Masterworks on Loan, which “invites private collectors to share their masterworks with our constituents.” With a nod to the favorable tax breaks provided by Oregon, the Museum’s website proclaims, “Some lenders may receive tax benefits for participating in our Masterworks on Loan program and should consult a tax advisor to learn more.”

Francis Bacon, THREE STUDIES FOR A PORTRAIT OF JOHN EDWARDS (1984)

Francis Bacon, “Three Studies for a Portrait of John Edwards” (1984)

While the decision for an art buyer to exhibit their purchase at a small museum in a tax-free use state may at first seem like an innocuous opportunity for the expansion of arts education, there is a tension between that idea and the harm to the buyer’s home state that usually receives the revenues from use taxes. Upcoming auctions will provide the art world with the opportunity to see if this tax loophole becomes more prevalent. If it does become popular, individual states may be motivated to change their tax code to make up for the loss that is incurred when art is first displayed in a tax-free use state. Later this month, Christie’s in London will auction another triptych by Francis Bacon, entitled Three Studies for a Portrait of John Edwards (1984), estimated sales value between $4.4 and 5.8 million If purchased by an American collector, it is easy to imagine that this work, too, may head to an exhibit in Oregon shortly thereafter.

Sources:

About the Author: Emma Kleiner is a student at Stanford Law School.

Disclaimer: This article is intended as general information, not legal advice, and is no substitute for seeking representation.

Even in the Opaque Art World, Taxes are Certain: Glafira Rosales/Gonzalez Indicted for Income Tax Evasion

Knoedler Gallery was a reputable art gallery, in existence for over 150 years. When it closed in 2011, accusations that it sold forgeries were just starting to mount. Art collectors are still steaming over purchases of suspect artworks. In fact, another case, according to the New York Times Reporter Patricia Cohen this one is No.6, has been filed earlier this month by the former ambassador to Romania, Nicholas F. Taubman who bought a fake Clyfford Still from the now defunct gallery in 2005. Like dozens of other suspect works, this Clyfford Still came to Knoedler from the stock of the Long Island art dealer Glafira Rosales, a.k.a. Glafira Gonzales (“Rosales”).

Naturalized citizen of the United States, Rosales sold dozens of art works attributed to important 20th century artists, including Mark Rothko, Robert Motherwell, and Jackson Pollock on behalf of fictitious clients. As a part of her elaborate scheme, Rosales lead the Knoedler staff to believe that all of the works she offered were owned and consigned to her by others. Between 2006 and 2008, the proceeds of Rosales’ sales exceeded $14 million. Now, the charges brought against her allege that she was “dealing in fake artworks for fake clients;” however, this is not the thrust of the accusations. In a complaint dated May 20, 2013, Rosales is accused of evading taxes owed on the proceeds from the sale of these fake works. It is an Al Capone story all over again, minus the murder and prostitution.

For years, Rosales omitted or significantly understated her gross receipts; she also failed to comply with mandatory IRS filing requirements. Specifically, Rosales under-reported her income, by omitting at least $12.5 million from her returns between 2006 and 2008. Also, between 2007 and 2011, she failed to report to the IRS the existence and worth of her foreign bank accounts, a mandatory requirement for U.S. taxpayers with foreign holdings in excess of $10,000 during any given year. The IRS investigators were able to trace money transfers to accounts connected to Rosales located in La Coruna and Lugo, Spain.

The eight counts of violations brought against Rosales, if combined (three false tax returns and five years of willful failure to file disclosures), carry a maximum penalty of 34 years in prison and a maximum fine of $1,550,000.

If Glafira Rosales qualifies as the Trojan Horse of the Knoedler Gallery, the Achilles hill of that horse may be her income tax forms.

Source: Sealed Complaint; The New York Times.

Estate of Lucian Freud Gives Art In Lieu of Tax

Grandson of Sigmund Freud and the renowned artist, Lucian Freud, died in 2011 leaving his heirs a sizable art trove. Instead of paying the full inheritance tax owed, his heirs are reported as taking advantage of the British law that allows artists and collectors to donate cultural artifacts instead of paying taxes to the government. Lucian Freud’s estate is in the process of gifting such major cultural objects as a Corot portrait and three Degas sculptures. The Corot is destined for the National Gallery in London; Degas are going to the Courtald Gallery.

Source: Larry Rohter, Arts, Brief, The New York Times, February 5, 2013, C3.