ART IS LONG, LIFE IS SHORT1:

ART IS LONG, LIFE IS SHORT1: ESTATE PLANNING FOR THE ARTIST AND THE ART COLLECTOR ABA SECTION OF TAXATION 2012 MAY MEETING May 11, 2012 Sarah M. Johnson, Esq. Joshua J. Kaufman, Esq. Venable LLP I. NON-CHARITABLE TRANSFERS DURING LIFE Art is particularly well-suited for charitable transfers if the circumstances fit, but not all collectors or artists want to leave their art to a charitable organization. In order to understand the different ramifications of transfers of art during life and why it may be preferable to wait for death to make the transfer, it is important to first understand the income tax rules particular to art. A. Income Tax Issues 1. Capital Gains versus Ordinary Income Property. In most cases, a work of art is "capital gain collectible property" as opposed to "ordinary income property". o The work of art is long-term "capital gain collectible property" if: • It is a capital asset under Section 1221; • It has appreciated in value; • It is a collectible under Section 408(m); AND • It has been held by the donor for more than one year. o Sales of capital gain collectible property are taxed at a maximum rate of 28%, whereas sales of ordinary income property (including short-term capital gain) are taxed at a maximum rate of 35%. • Despite reductions over the years in the capital gains rate, the rate on gain from the sale of long-term collectible property has remained constant at 28%.2 • The Taxpayer Relief Act of 1997 added Section 1(h)(5)(B) of the Code to prevent taxpayers from converting the 28% rate to the current 15% capital gains rate by creating a partnership, corporation or trust to hold the collectibles. o A work of art is "ordinary income property" if: • It was created by the donor; • It was received by the donor as a gift from the creator; Proverb originating with Hippocrates. 2 IRC Section 1(h)(S). -1- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131014 • It is held in inventory by a dealer; OR • It has been owned for one year or less at the time of transfer. 2. Basis Issues o When the artist sells his or her art, the artist receives ordinary income, and the artist's basis is the cost of the materials used to create the work. o Likewise, when the donee of a work of art received as a gift directly from the artist who created the piece later sells the work, the donee is subject to ordinary income tax and shares the artist's basis? o This ordinary income tax "taint" stays with the art until it is in the hands of a buyer after a purchase or until the owner dies and the art gets a step up in basis. o When art is received as a testamentary bequest, the donee receives art with a stepped up basis and is able to sell the work as a capital asset under Section 1221(a)(3)(C). B. Transferring An During Life versus at Death • Generally, it is preferable to wait until death to make non-charitable transfers of art for the following reasons: o Receive a step up in basis to fair market value. • If an artist is married, the surviving spouse can then gift or sell the art to third parties, or donate the art to a public charity and receive a charitable deduction equal to the full fair market value. o May also be able to get a blockage discount or qualify for Section 6166 relief if wait until death. • There are some circumstances where it is advantageous to make lifetime transfers of art: o If portability is no longer in effect or you still want to take advantage of funding a credit shelter trust at the first spouse's death but one spouse lacks sufficient assets, art can be transferred to the less wealthy spouse. • Marital deduction applies, and this is often less controversial than transferring business assets or liquid assets. • If less wealthy spouse dies first, the art gets a step up in basis and can be sold to the surviving spouse or a third party to fund the credit shelter trust with cash and securities. o If it becomes apparent that one spouse is going to predecease the other, transfer all of the art to the ill spouse so that it gets a step-up in basis at death. • This is helpful when the art will be used to fund a credit shelter trust or will be bequeathed to someone other than the spouse. • If the art is to come back to the spouse within one year of the transfer, the step- up in basis will not apply unless the art comes back in the form of a QTIP trust that is considered a different taxpayer from the surviving spouse .° IRC Section 1221(a)(3)(C). Note, that if gift tax is paid at the time of transfer, the donee's basis is increased by the gift tax paid. IRC Section 1015(a). -2- Venable LLP 575 7' Street NW Washington DC 20004 t) Venable LIP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131015 o If the artist is not yet well-established, but it becomes apparent that his or her works are about to start selling at higher prices, a gift can be made while values are still low. • If an artist has had even a smattering of success — one or two high-priced sales amid a lifetime of struggling to make ends meet, those high-priced sales could cause the Service to place a similar value on the artist's unsold works at the time of his or her death. o If there is a piece that has sentimental value to a child, and the child would likely hold the work until his or her death, a gift could be made to take advantage of the current $5M lifetime gift tax exemption. o If the artist or collector is in a committed same-sex or heterosexual relationship, the client may want to consider a grantor retained income trust (GRIT), which can reduce the gift tax cost of a transfer to a non-family member. • Process of making non-charitable gifts': o Donor should sign a Deed of Gift with a signed acceptance; o File a gift tax return if the value exceeds the annual exclusion amount; o Change the insurance policy to the new owner; o Effect delivery to avoid the Section 2036 argument of retained use and enjoyment. • Beware of the "Empty Hook" strategy. o This term refers to the appraiser or IRS agent arriving at the decedent's residence to find bare walls, except for empty hooks showing where art once hung. o Planners should strongly caution clients against placing art in children's homes with no gift or estate tax reporting. o There is no statute of limitations for estate tax fraud. o Heirs miss out on opportunity to get step-up in basis. II. LIFETIME CHARITABLE GIFTS A lifetime transfer of a work of art to charity saves the donor income taxes where the charitable contribution deduction is available, it eliminates the expense and worry connected with the maintenance of valuable art and, where the donor is also the artist, it can increase the artist's popularity with art critics, collectors and the general public. A. Income Tax Rules 1. For the Artist. o Creative property is ordinary income property in the hands of the creator, and the artist's basis in a work is limited to the cost of his or her materials. 6 `Section 1014(e). s Ralph E. Lerner, "The Last Picture Show: What Should Be Done With Artwork", Heckerling Institute, January 2012. 6 Section 170(e)(1)(A). Regs 1.170A-4(b)(1) defines "ordinary income property" to include, for example, "property held by the donor primarily for sale to customers in the ordinary course of his trade or business, a work of art created by the donor, a manuscript prepared by the donor, and letters and memorandums prepared by or for the -3- Venable LLP 575 7" Street NW Washington DC 20004 BD Venable LIP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131016 o The artist's charitable contribution deduction will be limited to his or her basis in the ordinary income property. • The artist has very little tax incentive to donate his or her art to a charity during life. • Nevertheless, there may be substantial non-tax reasons, primarily that the gift might increase the artist's profile and sales. o Same rule applies to donee of a lifetime gift of art from the creator. If the donee tries to donate the work to charity, the donee's charitable contribution deduction will be limited to the creator's basis in the work. • In contrast, the property is not ordinary income property under section 1221(a)(3)(C) in the hands of the person who inherits art from the artist at the artist's death. • In that case, the donor of the art likely will receive a charitable contribution deduction equal to the stepped-up basis of the property. • For this reason, an artist with charitable inclinations may wish to leave the property to his or her spouse, and allow the surviving spouse to donate the works to charity to take advantage of a higher charitable income tax deduction. o Note, the limitation imposed by Section 170(e)(1)(A) on charitable contributions of ordinary income property may not be avoided by transferring the art to a corporation and then gifting shares of the corporation to charity if the corporation was created for the sole purpose of tax avoidance.' 2. For the Art Collector. The Collector's contribution of art to charity is also limited to his or her basis in the property if: o The charity's use of the work of art is unrelated to its exempt purposes; OR o The charity is a private foundation.' Stated another way, in order to obtain a charitable contribution deduction equal to the fair market value of the work of art, the work must be donated to a public charity or private operating foundation, and the charity's use of the work must be related to its exempt purpose. Each of these requirements will be discussed below. 3. Related Use The charitable contribution deduction of a donor of capital gain collectible property will be limited to the donor's basis in the property if the donee's use is unrelated to its exempt purpose. o The Treasury Regulations 10 provide that contributed property is treated as having been put to a related use if: donor." This is consistent with the definition of property denied characterization as a capital asset under Section 1221(0(3). 7 Ford v. Comm'r, TC Memo 1983-556. s IRC Section 170(e)(1)(B)(i). IRC Section 170(e)(1)(6)(ii). -4- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131017 • The donor establishes that the property is not in fact being put to an unrelated use the by donee; or, • If, at the time of the contribution, it is reasonable for the donor to assume that the property will not be put to an unrelated use. • Double negatives aside, this means that if a donor contributes a work of art to a museum, and the work of art is of a type generally displayed by the museum, it is reasonable for the donor to anticipate (unless the donor has actual knowledge to the contrary) that the work of art will be put to a related use, whether or not the museum later sells or exchanges the object.11 o As part of the Pension Protection Act of 2006, a donor now must file Form 8283 for each item of donated property with a value in excess of 5500. On the Form, the charity certifies whether the property will be put to a related use. • If so, the donor should ask the charity to agree to make a "certification" to the IRS if the property is later sold (see below). o The charity should also sign the Taxpayer's Form 8283, which states: "This organization affirms that in the event it sells, exchanges, or otherwise disposes of the [donated] property ... within 3 years after the date of receipt, it will file Form 8282 (Donee Information Return) with the IRS and give the donor a copy of that form." o If the charity in fact sells the work of art within 3 years of the date of contribution, it must file a Form 8282, and the donor's charitable contribution deduction is subject to recapture. 12 • Recapture is avoided if the donee charity makes a certification in accordance with Section 170(e)(7)(D). • A "certificationi 13 is a written statement signed under penalty of perjury by an officer of the charity that certifies that the property was intended to be used for a related use at the time of the contribution but that the intended use has become impossible or infeasible to implement. • If the IRS asserts that the property was not in fact used for a related purpose, the charity may also make a certification stating that the use of the property by the charity was related to the purpose of the charity's exemption and describing exactly how the property was used and how the use furthered the charity's exempt purpose. o Related Use Penalty." Any person who identifies applicable property as having a use related to the donee's exempt purpose and who knows that the contributed property is not intended for such use is subject to a $10,000 penalty. I° Regs. 1.170A-4(b)(3)(ii). II Regs. 1.170A-4(b)(3)(ii)(b) 13 IRC Section 170(e)(7)(A) and 170(e)(7)(B)(ii). 13 IRC Section 170(e)(7)(D). 14 IRC Section 6720B. -5- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131018 o There have been few litigated cases regarding related use, but several Private Letter Rulings show the IRS is somewhat lenient when interpreting whether a use is related: • PLR 7751044. Related use requirement met when lithographs were donated to and displayed by a camp and center devoted to physically and mentally disabled children, where the lithographs were used in connection with an art appreciation program. • PLR 8009027. Related use rule was not satisfied where donor gave an antique car to a university, since the university did not offer a course in antique car restoration. • PLR 8143029. Related use requirement met when donor gave his collection of porcelain art objects to a public charity operating a retirement center, since the display of art was related to the charity's purpose of creating a comfortable living environment for its residents. • PLR 9833011. Related use rule was satisfied when donor gave paintings to a Jewish community center that had an arts wing and library. 4. Type of Charitable Organization The type of charitable organization that receives the donated art will have bearing on the amount of the donor's charitable deduction. o Public Charities. Public charities generally receive part of their support from the general public. IRC Section 509(a). • Typically, public charities include churches, schools, hospitals and museums. • A charity's status can be verified by checking IRS Publication 78. o Private Operating Foundations are described in Sections 170(b)(1)(F)(i) and 4942(j)(3). A private operating foundation is typically funded by one donor or family. Unlike private foundations, it uses its assets and directly makes expenditures for the active conduct of activities related to its exempt purpose. • The donation of a residence and all of the donor's works of art contained therein to be used as a museum that is open to the public could be a private operating foundation. 15 o Private Foundations do not typically use their assets to directly further an exempt purpose; instead, they make grants to public charities or private operating foundations. 5. Percentage Limitations o For contributions of cash and ordinary income property to a public charity or private operating foundation, the charitable deduction is limited to 50% of the taxpayer's contribution base. Section 170(b)(1)(A). o For contributions of cash and ordinary income property to a private foundation, the charitable deduction generally is limited to 30% of the taxpayer's contribution base. Section 170(b)(1)(B). 15 See Regs. 53.4942(b) -1(d), Example 1. -6- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131019 • "Contribution base" means adjusted gross income computed without regard to any net operating loss carryback to the taxable year under Section 172. • The amount of the charitable deduction for ordinary income property is limited to the basis of the property in the hands of the donor (taking into account the percentage limitations discussed above). o For contributions of capital gain property to a public charity or private operating foundation where the related use test is met, the charitable deduction is permitted to the full extent of the fair market value of the property, but not in excess of 30% of the taxpayer's contribution base. Section 170(b)(1)(C)(i). o If the related use rule is satisfied, the taxpayer may elect to increase the 30% limitation to 50% of his or her contribution base, but the election limits the deduction to the donor's cost basis.16 • Thus, the election should only be made when there is very little appreciation in the property, such as when the capital gain property is received from a testamentary disposition. o For contributions of capital gain property to a private foundation, the deduction is generally limited to 20% of the taxpayer's contribution base, and the deductible amount is the donor's basis in the property contributed. o Any amount of charitable contribution in excess of the 50%, 30% or 20% limitations may be carried forward for 5 years. B. Gifts of Partial Interests 1. Section 170(f) Generally, a charitable contribution deduction is disallowed for a gift of a partial interest in property not in trust. Section 170(0(2) and (3). A partial interest is defined as an interest that is less than the donor's entire interest unless the property falls within a specific statutory exception. o A contribution of the right to use the property for a period of time is considered a partial interest. • For example, a donor cannot retain a life estate and contribute the remainder interest in a work of art to charity and receive a current charitable contribution deduction. o Section 170(f)(3)(B)(ii) provides an exception for the outright contribution of an undivided portion of the donor's entire interest in the property. • This exception is of great significance to collectors and heirs of artists who own fractional undivided interests in artwork. • Allows for contribution of vertical divisions (i.e., a 40% tenant in common interest in a painting), but not horizontal divisions (i.e., a retained life estate 16 IRC Section 170(b)(1)(C)(iii). -7- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131020 with remainder to charity, or a donation of the work of art with retained rights to the copyright) of art to charity. o Winokur v. Comm'r, 90 TC 733 (1988), acq. 1989-2 C.B. 1. In Winokur, the taxpayer gave the Carnegie Institute a 10% undivided interest in 44 works of art by Scandinavian artists, and another 10% undivided interest the next year. The Carnegie Institute did not exercise its right to take physical possession of paintings for its share of the year. • The IRS argued that the museum's right amounted to a future interest in the art, which is not deductible under Section 170(f). • The Tax Court held the taxpayer is entitled to a charitable contribution deduction equal to 10% of the fair market value of the contributed art. It was sufficient that the museum had the right to claim possession for its proportionate share of the year. o As a result of Winokur, taxpayers could have their deduction and keep their art too. • In addition, having the art partially owned by a renowned museum often provided an added bonus of increasing the value of the art between the year of the first gift and the year of the second gift. 2. Pension Protection Act of 2006 The Pension Protection Act of 2006 effectively shut down the Winokur party by adding Section 170(o), which generally disallows a charitable deduction for an undivided portion of a donor's entire interest in art (or any tangible personal property) unless: o The donor or the donor and the donee held all interests in the property immediately before the contribution. o Section 170(o)(3) imposes recapture of the charitable contribution deduction if: • (1) the donor does not contribute all the remaining interest in the property to the donee (or, if the donee no longer exists, to another public charity) before the earlier of the donor's death or 10 years from the date of the initial contribution, or • (2) the donee has not had substantial physical possession of the property and has not used the property in a manner related to the donee's exempt purpose during the period beginning on the date of the initial fractional contribution and ending on the date described in (1). o In addition to recapture, a 10% penalty is imposed in the year of recapture. o The contributor's initial contribution of a fractional interest is still determined by multiplying the fair market value of the work times the percentage interest, but for subsequent contributions of an interest in the same work of art, the value is limited to the lesser of: • The value used for determining the charitable deduction for the initial fractional contribution or, • The fair market value at the time of the subsequent fractional contribution." IRC Section 170(o)(2). -8- Venable LLP 575 7' Street NW Washington DC 20004 t) Venable LIP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131021 o Because of the timing limitation, the donor should update his or her Will or Revocable Trust to leave the donor's remaining interest in the work to the charitable donee at death. • Generally, before a museum will accept a fractional interest gift, it will want assurances that it will receive the balance of the undivided interest when the donor dies, so that it does not have to negotiate with the heirs over the fractional interests. • Discuss fractional interest gifts with the museum before making them. o Although the Pension Protection Act of 2006 greatly reduced the desirability of fractional interest gifts, the technique may still be useful for a collector who owns a very valuable work of art and wants to spread the contribution deduction over a period in excess of 6 years (year of donation plus the 5-year carry forward). The fractional interest technique allows the gift to be deducted over as many as 12 years. 3. Contributions of Copyrighted Property Copyright ownership is treated differently for income and estate tax purposes. o Under income tax rules, a work of art and a copyright are treated as two interests in the same property, rather than two separate property interests. o Thus, a donor who owns both the work of art and the copyright to the work must donate both the art and the copyright to receive an income tax charitable contribution deduction. o Failure to donate both items is treated as donating only a partial interest in the property under Section 170(0(3) and no charitable contribution deduction is permitted. o Typically, only artists own copyrights in their works. Because the charitable contribution deduction of the creator of a work of art is already limited to his or her cost to produce the work, this rule has little practical effect for the artist. • It still may be desirable to donate the artwork with no charitable deduction and retain the copyright in the work. • This rule does not apply for gift and estate tax purposes, where the work and the copyright are treated as two distinct properties. Section 2522(c)(3) and 2055(e)(4). C. Split Interest Charitable Trusts 1. Selling Art to Fund Annuity Interest Generally, a charitable remainder trust ("CRT") can be funded with art only if it is also funded with sufficient cash or marketable securities to make the annuity or unitrust payments, OR, if the Trustee is instructed to sell the donated property. If the collector or artist wants to sell a work of art without incurring a capital gains or ordinary income tax hit, he or she should consider funding a CRT with the artwork. As a charitable organization, the trust will not be taxed when the work is sold (unless there is UBTI), and the -9- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131022 collector or artist or his or her designated beneficiary will receive a stream of annuity payments in exchange, together with a possible charitable income tax deduction. o The CRT can sell the artwork upon receipt, and the gains will not be taxable to the charity or the donor, except to the extent the gains are paid out to the donor or non- charitable beneficiary as unitrust or annuity payments under Section 664(b). o While contributions of art to a CRT are eligible for the gift tax charitable contribution deduction, no deduction is allowed to the donor for income tax purposes until all intervening non-charitable interests expire or are no longer held by the donor or a related person. Section 170(a)(3). • Accordingly, when a collector transfers a painting to a charitable remainder trust, if the donor or a related person is the non-charitable annuitant of the trust, the charitable income tax deduction is postponed until the art is sold by the Trustee to an unrelated third party. See PLR 9452026. • The donor's income tax charitable contribution deduction will be the value of the remainder interest at the time of the sale. o The charitable remainder beneficiary may purchase the art, but this should not be agreed upon in advance. If the trust is legally bound or can be compelled to complete a sale, the IRS will treat such sale as income to the donor.° o The CRT's sale of the art is an unrelated use, so the income tax charitable deduction will be limited to the donor's cost basis allocable to the remainder interest.!' 2. Flip CRUT A Flip CRUT could be particularly useful, especially if you are not sure how long it will take to sell the artwork after it is transferred to the Trust. o A Flip CRUT is a NIMCRUT that "flips" to a fixed percentage trust after a triggering event. • A NIMCRUT is a type of CRUT that sets the unitrust payment as the lesser of the trust's net income (which would be zero if it only owned art that was producing no royalties) or the unitrust amount, and that allows the trust to "make-up" for the difference between the net income paid (i.e., nothing) and the unitrust amount in later years when the net income exceeds the unitrust amount. o So, you can allow the trust to make no distributions to the non-charitable annuitant until the work of art is sold, and the sale can be the triggering event that "flips" the NIMCRUT into an "old-fashioned" unitrust, which, in today's market, is likely to give the noncharitable beneficiary a greater payment than would net income alone. 2 See Palmer v. Comm'r, 62 T.C. 684 (1974), aff'd on other grounds, 523 F.2d 1308 (8th Cir. 1975), acq. Rev. Rul. 78- 197, 1978-1 C.B. 83. 19 PLR 9452026. See also Regs. 1.170A-4(b)(3)(i): "The use by a trust of tangible personal property contributed to it for the benefit of a charitable organization is an unrelated use if the use by the trust is one which would have been unrelated if made by the charitable organization." -10- Venable LLP 575 7" Street NW Washington DC 20004 t Venable LIP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131023 o If there is no anticipated sale of the work at the time of contribution, then it is a good idea to do either a Flip CRUT or fund the trust with cash and/or securities that can be used to pay the income interest. o Caution in funding a NIMCRUT or a Flip CRUT: For income-only CRTs, the special valuation rules of Section 2702 will apply unless (1) there are two consecutive noncharitable beneficial interests and the transferor holds the second interest or (2) the only permissible recipients of the unitrust amount are the donor, the donor's U.S. spouse or both the donor and the donor's U.S. spouse. 3. Traps for Unwary o Domestic Charity. While the gift tax rules permit a gift and estate tax charitable contribution deduction for gifts made to foreign charities, Section 664 split interest trusts must name a domestic charity in order to qualify for the income tax charitable contribution deduction. o Independent Trustee. Typically, a grantor may serve as the Trustee of his or her own charitable remainder trust, but where the trust is funded with art, the art must either be valued by an independent trustee, or the grantor as trustee must obtain a qualified appraisal of the art.2° o Accidental Creation of UBTI. The CRT allows the artist to sell his or her works without incurring income tax, so long as the trust does not have UBTI.21 • Section 512(b)(5) excludes from UBTI all gains and losses from the sale of property, other than properly includible in inventory and property primarily for sale to customers in the ordinary course of a trade or business. • Art is properly included in inventory when it has been offered for sale to customers. So, it is important for the artist to fund the trust with a work or works of art that have never been offered for sale. D. Charitable Gift Annuities A charitable gift annuity is a simple contract in which a donor and/or his designated beneficiary is provided with a stream of fixed payments for life in exchange for his or her donated gift. They are sanctioned by IRC Section 5O1(m)(3) and (m)(5), and are further described in IRC Section 514(c)(5). o Many public U.S. charities offer a charitable gift annuity in exchange for contributed property, such as works of art. • Note, however, that some states, such as New York, do not permit gift annuities to be funded with tangible personal property. o The annuity must be payable to the donor or his or her designated beneficiary over life, as Section 514(c)(5)(C) requires that the annuity contract cannot guarantee a minimum or specify a maximum amount of payments. 20 Regs. 1.664-1(a)(7). 21 Regs. 1.664-2(d) and 1.664-3(d) contemplate the contribution of ordinary income property to CRTs by referencing Section 170(e)(1)(A) and the regulations thereunder for the applicable rules. LOOK UP. -11- Venable LLP 575 7' Street NW Washington DC 20004 t) Venable LIP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131024 o The value of the annuity must be less than 90% of the value of the property received by the charity. o The annuity can be paid over one or two lives in being, such as the donor and the donor's spouse. o Income and gift tax charitable deductions are permitted for the difference between the value of the annuity and the value of the contributed property. o A charitable gift annuity is a form of bargain sale — part gift and part sale to the charity. o A portion of each annuity payment may not be subject to income tax for a number of years, and a portion may generate income for the annuitant, the character of which depends on whether capital gains or ordinary income property is contributed. III. TESTAMENTARY CHARITABLE GIFTS A testamentary transfer of art to a tax exempt organization saves the decedent's estate a great deal in estate taxes and headaches by removing an illiquid, difficult to value, and often unwanted (from the heirs' perspective) asset from the estate. A. Formation of Charitable Foundation The artist or collector may want to form a foundation during life or at death. The benefit of establishing the foundation during life is that the client can play an active role in its administration, and then additional works may be contributed at death. The client may want to form a private, grant-making foundation or a private operating foundation. 1. Operating Foundation If the client wants to open his house up as a museum (preferably after death), this may qualify as a private operating foundation. • If the donor turns his house into a museum while living, the donor would have to move to a new residence, as any personal use of the contributed assets after the donation has been made can result in denial of tax-exempt status.22 • Could convert a vacation home into a museum at death or while living, so long as the home is no longer used as a residence after the contribution is made. • May require re-zoning of the property. 2. Private Foundation There is no 20% limitation on gifts of art to a private foundation at death. The estate tax charitable contribution deduction generally covers the full fair market value of the property contributed to a private foundation at death. • In addition, there is no requirement that the art be used in a manner related to the foundation's purpose. • An outright testamentary transfer of the artist's or collector's art to a private foundation allows the art to be kept together as a unit and eliminates the problem 22 See, e.g., Rev. Rul. 74-600. -12- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131025 of raising money to pay the estate taxes attributable to the inclusion of illiquid art in the gross estate. B. Bequests to Existing Charities o Before making a charitable bequest of art in a Will, make sure the charity will accept the work. o If the donor wants to remain private and not reach out to the charity, then give the Executor the power to make alternate dispositions to other charities if the named charity will not accept it. IV. SPECIAL RULES FOR COPYRIGHTS A. Related Use and Testamentary Transfers Often, an artist will transfer ownership of an artwork to a charity at death, but give his or her family the interest in the copyright. o The US Copyright laws treat a work of art and the copyright as two separate property interests, but the tax regulations have always treated works of art and copyrights therein as two interests in the same property. o This inconsistency made it impossible to obtain a charitable contribution deduction for a work of art transferred to charity if the copyright was not also specifically bequeathed to the charity, due to the inability to receive a charitable deduction for split interest gifts. o While the income tax rules are unchanged, the estate and gift tax rules were changed in 1981 to treat the work of art and the copyright as two separate property interests, but only in certain cases. o Section 2055(e)(4) provides that for estate tax purposes, a work of art and its copyright are treated as separate properties where the decedent makes a "qualified contribution of a work of art." • A "qualified contribution" is a transfer to a public charity or a private operating foundation if the use of the property by the organization is related to its exempt purpose.23 • If the contribution is qualified, the estate will be entitled to a charitable deduction for the value of the art, and the value of the copyright will be included in the artist's estate. • Unrelated use will cause the painting and its copyright to fall outside Section 2055(e)(4) and be treated as one property for which the estate tax charitable contribution deduction will be denied under the partial interest rules. o This is a huge trap, and is best illustrated by the following example: • The Will of an artist bequeaths "my painting entitled 'XYZ' to the ABC Church. All the rest and residue of my property of any kind I bequeath to my son." • The artist owned the copyright at the time of his death (copyrights come into existence when the original work is created). 23 IRC Section 2055(e)(4)(C). -13- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131026 • Under state law,24 the copyright probably passes with the residue. • If the ABC Church cannot satisfy the related use rules, the estate tax charitable contribution deduction is denied. • A provision that bequeaths "all my right title and interest in and to" the work of art may not be sufficient to transfer the copyright to the charity. • The best course of action is to specifically include the copyright with the bequest of the art, unless the testator is certain that the charity's use of the art will be related to its exempt purpose. o The collector typically purchases art without the copyright, since the artist retains the copyright unless it is specifically transferred in writing. o If the collector does not own the copyright to the work of art, he or she does not have to be concerned with the related use requirement of Section 2055(e)(4). B. Right of Termination Every original work of art created on or after January 1, 1978 has a copyright with a term that extends for the life of the creator, plus 70 years.25 o Under the Copyright Act of 1976, the artist has a right to terminate any inter vivos (but not testamentary) transfer or license of a copyright or of any of the separate rights therein 26 o If the artist exercises the termination right, he or she can terminate the transfer and get back the copyright. o The exercise must be made within certain narrow time periods: 35 years after the date of the grant or license, there is a five-year window during which the grant or license can be terminated!' • The artist must give notice of termination, and the notice must specify a termination date that falls within the 5 year window. • The earliest the artist can give notice is the first day of the 25th year (to take effect on the first day of the 35th year); the latest notice is the last day of the 37th year (to take effect on the last day of the 39th year). o If the artist dies before exercising the termination right (that is, before year 25), or dies between years 25 and 38 without having given notice of termination, the right to exercise the termination right passes by law.29 • The artist's surviving spouse has a 50% interest in the termination right (or 100% if there are no children), and the artist's descendants, per stirpes, have a combined 50% interest in the termination right.29 24 Regs. 20.2055-2(e)(1)(ii)(e), Ex. 1. makes clear that the IRS looks to state law to determine whether the copyright was transferred with the art. 25 17 USC Section 302(a). Works created prior to 1978 are subject to different copyright rules and are beyond the scope of this outline. 26 17 USC Section 203(a). 2? 17 USC Section 203(a)(3). " 17 USC Section 203(b)(2). 29 17 USC Section 203(a)(2) -14- Venable LIP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131027 • Only those individuals who hold a majority of the termination rights can exercise the notice of termination (i.e., spouse plus one child). • The artist has no ability or right to change this statutory design by estate planning documents. o Techniques exist to avoid the forced heirship of the termination right. • If the artist is able to give notice before he or she dies, the termination will continue to take place on the notified date and the forced heirship rules will not come into effect?' • If the planning is being done before the notice period arises, the artist can include an in terrorem clause in the will to provide that a beneficiary who attempts to exercise a termination right (or who fails to exercise a termination right, depending on the artist's wishes) will have no right to receive further distributions from the estate. V. VALUATION ISSUES Valuing works of art is difficult, given the subjective aesthetic judgments involved and the fickle favor of critics, collectors and the general public. Knowing the value of a collector's or artist's work of art is imperative in the following situationsn: • For income tax purposes if the art is transferred during life to a charitable donee; • For gift tax purposes if the art is transferred during life to a non-charitable donee; • For estate tax purposes if the art is owned at death; and • For property insurance purposes (appraisal is required to determine premiums for coverage). A. Appraisal Requirements and Penalties 1. Income Tax Valuations o For the deduction of an item with a value in excess of $5,000, the Regulations require a qualified appraisal, made not more than 60 days before the date of contribution, to be attached to the income tax return.i2 • The $5,000 amount applies to a single item of property or to a collection of similar items of property donated in one calendar year, such as a set of coins, stamps, lithographs or books. • The aggregation rule applies whether all the items are donated to one charity or to two or more charities. • Important: The appraisal is required even if the donor is the artist contributing ordinary income property, or if the donor is contributing capital gains property to a private foundation, where the charitable contribution deduction is limited to basis. • This is likely because the deduction is measured by the fair market value of the property, reduced by the amount that would be ordinary income, 3° 17 USC Section 203(b)(2). 31 Lerner, "The Last Picture Show: What Should Be Done With Artwork", Heckerling Institute, January 2012. 32 Regs. 1.170A-13(c). -15- Venable LLP 575 7' Street NW Washington DC 20004 43 Venable LIP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131028 short term or long-term capital gain (as the case may be) if the property were sold. o A "qualified appraiser" 33 is an individual who holds himself or herself out to the public as an appraiser and who is an expert as to the particular type of property being valued, who understands that he or she will be subject to civil penalties under Section 6701 for fraudulent misstatements of value, and penalties under Section 6695A for gross misstatements of value, and who is completely independent of the donor. • The dealer who sold the donor the artwork cannot be the appraiser, nor can any employee of that dealer. • Often times, auction houses offer appraisal services. Do not use the auction house that sold the donor the artwork as the appraiser. • The Pension Protection Act of 2006 also requires the qualified appraiser: • to have earned an appraisal designation from a recognized professional appraiser organization; • to have verifiable education and experience in valuing the type of property subject to the appraisal; and • to have not been prohibited from practicing before the IRS at any time during the three-year period ending on the appraisal date.34 • The donor must now check the credentials of the appraiser to ensure the appraiser is an expert in the item being appraised. The donor may need different appraisers for donations of an Impressionist painting and a contemporary sculpture. • Notice 2006-96 offers guidance and states that the appraiser must have at least two years' experience in the trade or business of buying, selling or valuing the type of property being valued. o Completion of Form 8283 will satisfy the appraisal summary requirements. • The Instructions to the Form no longer require that an 8" x 10" color photograph (or a transparency no smaller than 4" x 5") be attached, but the photograph must be made available to the IRS upon request. • The Form 8283 must be signed by the appraiser and the charitable donee. • The Instructions also provide that the donor must provide the charitable donee with a copy of the qualified appraisal. o The charitable donee must also file Form 8282, Donee Information Return (Sale, Exchange or other Disposition of Donated Property), notifying the IRS of any sale or exchange of the gifted property within three years of the date of the gift. o Penalties. Thresholds were made more strict under the Pension Protection Act of 2006: • A "substantial valuation misstatement" occurs if the value is overstated by 150% or more, in which case a penalty of 20% of the underpayment of tax is added to the tax, but only if the underpayment exceeds $5,00035 (formerly, the threshold was a 200% overstatement). • A "gross valuation misstatement" occurs if the value is overstated by 200% or more, in which case a penalty of 40% of the underpayment is imposed36 (formerly, the threshold was a 400% overstatement). 33 Regs. 1.170A-13(c)(S)(i). IRC Section 170(f)(11)(E)(ii). 35 IRC Section 6662(e)(1). 36 IRC Section 6662(h)(1). -16- Venable LIP 575 7°' Street NW Washington DC 20004 O Venable LIP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131029 • The "substantial valuation misstatement" penalty can be waived if there is reasonable cause for the underpayment and the taxpayer shows he or she acted in good faith!' • The "reasonable cause" requirement can be satisfied if the claimed value was based on a qualified appraisal by a qualified appraiser. 3s • To satisfy the "good faith" requirement, the taxpayer should keep a diary or write a memorandum about his or her personal investigation into the value of the property. • The "gross valuation misstatement" penalty cannot be waived.'' 2. Estate and Gift Tax Valuations If a decedent's estate includes household and personal effects articles having "marked artistic or intrinsic value of a total in excess of $3,000", an appraisal of an expert, under oath, must be submitted with the return.° o The appraiser must be reputable and of recognized competency to appraise the particular class of property involved. • Unlike income tax rules, estate and gift tax rules do not require a qualified appraisal by a qualified appraiser. o For appraisals of paintings, the size, subject and artist's name must be stated. o Penaltiesd1: • If the value claimed on the return is 50% or less of the value determined to be the correct value, a penalty of 20% of the underpayment of the tax is imposed, but only if the underpayment of tax exceeds $5,000. • If the value claimed on the return is 25% or less of the value determined to be the correct value, a penalty of 40% of the underpayment of the tax is imposed. • The IRS has discretionary authority to waive all or part of the Section 6662 penalty if the taxpayer establishes a reasonable basis for the claimed value and the claim was made in good faith. 3. Art Advisory Panel All taxpayer cases selected for audit that contain artwork with a claimed value of $50,000 or more per item must be referred to Art Appraisal Services for review by the Commissioner's Art Advisory Panel.d2 o In 2011, the IRS changed the threshold for works of art that are subject to review by the Art Advisory Panel from $20,000 to $50,000. Not all of the IRS publications have been updated to reflect this change. o The Panel consists of 25 nationally prominent art museum directors, curators, scholars, art dealers, auction representatives, and appraisers. o The Panel meets once or twice a year for one day, and reviews hundreds of works per session. 37 IRC Section 6664(c)(3). 38 IRC Section 6664(c)(3)(A) and (8). 39 IRC Section 6664(c)(3). 60 Reg. 20.2031-6(b). 41 IRC Section 6662(g)(1) 63 See IRM 4.48.2 and IRM 8.18.1.3. -17- Venable LLP 575 7th Street NW Washington DC 20004 OD Venable LLP 2012. No copying or distribution is permitted without permission of the authors, Sarah Johnson or Joshua Kaufman EFTA01131030 o To ensure objectivity, the Panel is not told whether the appraisal was for an income tax charitable contribution deduction or for estate or gift tax purposes. o The Office of Art Appraisal Services provides staff support and coordination of the Panel's functions. o The Panel members, after reviewing photographs or color transparencies, along with relevant documentation provided by the taxpayers and research by the staff appraisers, make recommendations on the acceptability of the claimed values. If unacceptable, the Panelists make alternate value recommendations. Such recommendations are advisory only; however, after review by the Office of Art Appraisal Services, these recommendations generally become the position of the Service. • But see, Mitchell Estate v. Comm'r, TC Memo 2011-94. The Estate of James J. Mitchell (son of the co-founder of United Airlines) distributed a Frederic Remington painting and a Charles Russell painting to non-charitable beneficiaries. The IRS discounted the evidentiary value of appraisals made by the Art Advisory Panel and asserted appraised values nearly double what the Art Advisory Panel and estate's attorney claimed. The Court sided with the estate's values, which were within the range of the Art Advisory Panel's recommendations. o Reconsideration of Value Determinations. If agreement cannot be reached with the taxpayer, further assistance may be requested of the Panel and the Office of Art Appraisal Services. • The taxpayer ma