Over the past several years, Congress has grown increasingly concerned about "loopholes" in charitable contribution deductions. These concerns have been fueled, in part, by IRS audit results and articles in the mainstream press. The recently passed Pension Reform Act of 2006 further complicates the reporting requirements of the current system. Unfortunately, the burden of compliance with many of these rules falls squarely on the shoulders of recipient organizations, including museums and arts-related foundations, and must be kept in mind while soliciting donations. The level of responsibility will depend on the type of donation received.
In the past, the charitable contribution deduction for tangible personal property (i.e., artwork) was equal to the fair-market value of the piece as long as it was used by the recipient organization in its exempt purpose and provided the donor had owned it for more than a year. Donations over $5,000 in value required a written appraisal. A museum or art foundation was required to "accept" the donation and also provide written confirmation of any value that the donor received in exchange. The "thank you note" requirement could be met with a simple letter as long as the magic words "no goods or services were received in exchange" appeared on the thank-you note. The museum or foundation was not permitted to comment on the value of the piece for tax purposes. All these rules still apply.
The new rules require the recipient organization to report back to the donor (and the IRS) if the piece is sold within three years. This new reporting rule is in effect for donations made after September 1, 2006. While the IRS does not currently have regulations regarding the recipient organizations reporting requirement, it is likely some form of criteria will be developed.
If the piece is sold within three years, the donor's income-tax deduction must be "recaptured" by including in current-year income the amount of the appreciation at the time of the donation. For example:
Mildred donates a Picasso to the Museum in early 2007. The current value of the piece is estimated at $5,000,000. Although Mildred originally purchased it for $400,000 in 1964, her charitable deduction is $5,000,000 (she must get an appraisal and color picture for the tax return). However, the Museum decides it cannot exhibit the piece and sells it to another collector in 2008 for $4,567,000. The Museum is required to report back to Mildred if the piece is sold within three years. Mildred must include in her 2008 taxable income $4,600,000 (the amount of "gain" when she donated the piece). Mildred's opinion of the Museum may change.
As a practical matter, this means that recipient organizations must go through an internal process every time a piece is sold to determine how long it has been owned by the organization, who the original donor was, and whether IRS/donor reporting is required. Further, donors undoubtedly will get advice from their tax professionals and are likely to insist (in the donation finalization process) that the recipient organization keep the piece for at least three years. While this may not require bar codes, some type of record-keeping system must be in place.
There is a special exception to the recapture provision which requires that the charity provide a written statement concerning the original planned use and why that planned use was impossible or not feasible. The written statement must be provided to the donor and the IRS at the time of sale. This is an avenue of last resort.
The new legislation imposes a similar recapture restriction on fractional donations of tangible personal property such as art or art collections. Organizations accepting fractional ownership of a piece (such as unlimited use for a set number of months per year) must be ready to deal with another set of rules:
- The donee organization must take actual possession of the piece and use it in its exempt purpose (this seems to imply that actual exhibition is required); and
- The museum or organization must actually gain full ownership of the piece within the sooner of ten years or upon the donor's death
Failure to follow these new rules will result in a 10 percent penalty tax on the "gain" as well as a recapture of the tax deduction. Again, it is up to the recipient organization to report to the donor (and the IRS), and the organization's tracking system must go back ten years in order to capture this important data.
This provision is effective for fractional donations made after August 17, 2006. For example:
Robert donates an undivided 50 percent interest in a Monet painting which he purchased for $56,000 in 1949 to the Museum. The value of the undivided interest is $6,000,000. Robert dies unexpectedly the next day and does not make any special arrangements for the painting in his will. Robert's estate must recapture $5,944,000 in income and owes a penalty of $594,400. The additional tax and penalty will impact the estate settlement process.
Recipient organizations must now begin tracking all donations of tangible personal property. The tracking system must include:
- The name or identity of the piece
- The date of the donation
- Name, address, and taxpayer identification number of the donor(s)
- Any restrictions on the donation (such as sales within three years); and
- The planned use for the piece (so that an unexpected sale can be explained)
Each time a piece is considered for sale, the tracking system must be consulted to determine whether any donor restrictions will be violated (causing a return of the property or payment of damages) or whether IRS/donor reporting is required.
These new tax law changes may also require changes to the solicitation strategies of museums or arts foundations. Should a museum solicit only items that will be exhibited or retained for at least three years? Should it solicit or refuse fractional interests? Should it accept pieces with donor restrictions (no sale within three years)? Those involved in the solicitation and disposition processes must be keenly aware of these new requirements. Donors are going to be more demanding. And organization tracking systems will be required.
[Editor's Note: For additional information, visit the Policy and Advocacy section of the Americans for the Arts Web site to find issue briefs on tax policy and reform, directories of the Congressional Arts Caucus and the Senate Cultural Caucus, and more.]
Bill Fleming is an attorney and managing director of Personal Financial Service in the Hartford and Boston offices of PricewaterhouseCoopers Private Company Services Practice.