You donate a valuable work of art and expect a big tax break. Here’s why you may not get it.
When we last had seen Mr. Watson, he was a struggling sculptor in upstate New York, but the recent death of his grandparents in a freak mudslide spelled the end of his financial woes. He was now rich. Very, very rich. And on top of a bulging bank account, he was the proud owner of a museum-quality art collection.
Not that his newfound riches put his money worries to rest. Instead of fretting about where his next meal would come from, he now spent nights obsessing about giving the Internal Revenue Service too much and days meeting with accountants and legal advisers trying to figure out how to lower his tax bills. That’s where we came in. Watson wanted to know how to use his art collection to reduce his taxes. Although we aren’t tax lawyers, we do have some experience in how artwork is treated (usually unkindly) under the Internal Revenue Code.
We remarked at the start of our meeting that he could donate some of his grandparents’ art to a museum in exchange for a tax deduction. Under U.S. tax law, he would be able to deduct the full fair market value of any donated works—which, given their quality, could be quite substantial. But Watson wasn’t keen on parting with his newly inherited collection.
“I’ve got a better idea,” he said. “I have the perfect sculpture for the Metropolitan Museum of Art. I finished it last week, and it’s worth millions.” We were polite but skeptical. Watson created sculptures out of Camembert and, occasionally, wheels of Gouda. The Mouse Museum might be interested, but the Metropolitan?
We pointed out that even if a museum accepted the donation (a very big if), Watson could not deduct the fair market value of his sculpture but only the cost of the materials he used to create the work. “Are you telling me that if I donate a masterpiece that I have created to a museum, all I can deduct is the cost of the cheese?” he asked.
“That deduction is correct, my dear Watson,” chortled Thomas. Outraged, Watson demanded to know why an artist’s donation of his own work would be treated differently from other donations. We explained that the longstanding rationale for this law is to prevent artists from manufacturing their own tax benefits. Congress, however, is considering a change that would permit artists to deduct the fair market value of their donations.
Supporters of the proposal say it would encourage living artists to make more donations, which—not surprisingly—plummeted after the current law went into effect in 1969. Potential abuse by artists is minimal, the proponents say, since many museums have strict acquisitions policies that make it difficult for artists to donate just any work.
We told Watson that as an added safeguard, the proposed law might require all art donations to be appraised through the IRS commissioner’s art advisory panel. Critics of the proposal say that this could swamp the panel, which meets only once or twice a year in Washington and often reviews more than 250 works of art in a single day.
“What is this mysterious panel anyway?” Watson inquired. We told him that it is a select group of outside experts who help the Internal Revenue Service verify the market value of charitable donations of art. This ensures that taxpayers’ deductions don’t exceed the market value of the donated works.
Not surprisingly, the IRS pays special attention to big-ticket deductions, and different rules apply depending on whether a taxpayer seeks to obtain a deduction for work valued at less than $10,000, $20,000 or more than $50,000. Generally, the higher the claimed value, the more supporting information the taxpayer must provide. When artwork is valued in excess of $20,000, for example, the taxpayer must supply a detailed report by a reputable appraiser, which is then examined by the IRS’s art appraisal services. This group of agency staffers then refers certain cases to the advisory panel for further review.
“Sounds like fun,” said Watson, who now had a lot of extra time on his hands. “Can I join the panel, too?” We tactfully ducked the question, explaining that the panel is composed of approximately 25 respected art world experts, including dealers, curators, art historians and critics (the actual number varies from year to year). Panel members are not paid for their work and form specialty groups depending on the needs of a particular field. The painting panel, for example, has existed since the 1960s. During the 1980s, the print panel was created and disbanded, as well as the art of the Americas, Africa and Oceania panel, and the Far Eastern and Asian art panel. Recently, a decorative arts panel was created because of the increase in the number of cases in this area.
“How does the panel reach a decision?” asked Watson. The process is fairly detailed, we explained. A few weeks before the panellists meet, the IRS staff sends each member photographs and a data sheet with information from the appraiser, together with the staff’s own research on each of the objects in question. The information might include the object’s provenance, exhibition history, references in publications and market data on works by the same artist. The staff tends to focus on records of public and private sales of comparable works. The panellists and the IRS staff may view the actual works firsthand but are not required to do so.
To keep the process objective, the IRS lists all works alphabetically by the artists’ last names (so panellists are less likely to recognize an entire collection or identify the taxpayer) and does not tell the panel whether the work is from an estate or is a charitable donation. To avoid any conflicts of interest, panellists must excuse themselves from meetings if, say, the object happened to be in their museum or if they were ever involved in appraising the work. The panellists discuss the valuation and quality of each piece behind closed doors and determine whether more evidence is needed, such as a better photograph or a live visit to see the work.
If the IRS ultimately disagrees with the taxpayer’s market valuation, it provides a report detailing the basis for its conclusions. Not all rejections happen because the value of a work has been overstated; some taxpayers deliberately lowball their valuation, for instance, to reduce the taxable value of an overall estate. The panel will reconsider its determination only if the taxpayer can provide new evidence to support his claim. The taxpayer can also fight the decision in court, in which case panellists often serve as expert witnesses for the IRS.
The very meaning of fair market value has been the subject of much legal wrangling, and the IRS adopted a specific provision to address this point. The term essentially refers to the price that a “willing buyer” would pay to a “willing seller” for an object, assuming both have a “reasonable” knowledge of the relevant facts surrounding the piece and are under no compulsion to complete the sale.
We added that the panel’s most common method of determining fair market value is to look at the prices at which comparable works have sold, including gallery sales and auction results. Some courts, however, have questioned whether auction sales are an accurate gauge of fair market value, since auction buyers typically include trade customers who aren’t necessarily the ultimate consumers in the retail market.
“Instead of donating one of my own sculptures, perhaps I could give a museum my unrivalled collection of paintings by Henri Fromage,” Watson suggested. “Couldn’t I just add up the value of the pictures and take the deduction?”
“Possibly,” we replied. “But in that case, the IRS might consider imposing a blockage discount on the donation.” Courts have recognized in previous cases that the onetime sale of a large number of works by the same artist may result in a lower market price than if the works had been sold over a longer period of time. As a result, the IRS may apply a formula (the “blockage discount”) that reduces the valuation of the collection as a whole.
“If a work is stunning and unique, is the fair market value higher?” Watson asked, not unreasonably. We reminded him that as far as the IRS is concerned, the fair market value is what a piece is worth in the market and has nothing to do with whether the work is well executed or even has intrinsic merit. Just because something is unique doesn’t mean people want it. The only question for the IRS is what someone would pay for it.
“This all sounds pretty complicated,” Watson said. “Can’t I just use the insurance value of artwork as the fair market value?” Unfortunately, no. We told him about the 1985 case of Lightman v. Commissioner, in which several taxpayers claimed that the fair market value of the 19 paintings they donated to the El Paso Museum of Art in Texas should be the value at which they were insured. The court disagreed, ruling that because the taxpayers themselves determined the insurance amounts, they had “no probative value.”
Watson had one more idea. “I do have an antique ivory sculpture that is too big for the yacht,” he mused. “I bet I could donate that to a museum to get a tax savings.”
“Not necessarily,” we cautioned, referring Watson to our recent Art + Auction column on artwork that violates endangered species laws. We told him that the IRS might try to disallow such a deduction by arguing that the work violated federal import restrictions. In fact, the IRS tried to do just this in the 1986 case of Sammons v. Commissioner, which involved the donation of Native American artifacts (including bird claws and feathers) that may have violated the Eagle Protection Act and related laws.
Watson left our office resigned to the fact that he was going to have to pay the IRS one way or another. The tax laws are complicated, but that much, at least, was elementary.