A recent report by the New York Times reveals that two LeBron James trading cards have an estimated value of up to $7 million. Just imagine stumbling upon one of these cards and making such a lucrative sale! However, it’s crucial to consider the tax implications when selling collectibles like trading cards. The taxation of income from tangible assets differs from that of other types of investments. The IRS recognizes four distinct types of taxpayers based on their role in a transaction: Collector, Investor, Business Investor, and Dealer. By default, the IRS assumes you are a Collector, subjecting you to the highest capital gains tax and offering the fewest deductions. Nevertheless, with the right qualifications, you may be eligible for the more advantageous tax status of an Investor, which allows for greater deductions and techniques such as like-kind exchanges. Qualifying as an Investor goes beyond a mere declaration; it necessitates a well-documented pattern of behavior. Seeking advice from a qualified expert can help you position yourself for the most favorable tax status.
For the Artist
The creative process of an artist continuously expands the very definition of artwork. Similarly, the mediums through which artists express their craft are also evolving. Throughout an artist’s lifetime and beyond, their work may be sold multiple times and showcased in galleries on numerous occasions. The monetary value of these sales can range from modest sums to staggering amounts, as seen with the masterpieces of Picasso, Van Gogh, and others. Whether an artist attains fame during their lifetime or not, the significance of their creations remains unchanged. Artists may pursue their craft as a profitable trade or business or engage in it as a non-profit endeavor. In the former case, income is subject to ordinary taxation, while expenses typically fall under IRC § 162. However, for activities deemed not-for-profit under IRC § 183, the deductibility of expenses is limited to gross income.
Beyond the Artist: Investor, Hobbyist, Business Collector, and Dealer
Once artwork leaves the hands of the artist, it typically falls into one of four categories, each with distinct tax considerations: investors, hobbyists, business collectors, and dealers. The categorization of a taxpayer depends on the specific facts and circumstances of their case. However, determining the precise line between these categories for tax purposes is often unclear, leading to extensive litigation in areas such as distinguishing between investors and dealers, or between investors and hobbyists. Furthermore, a taxpayer may possess artwork in multiple categories. For instance, a dealer might hold certain pieces as part of their trade or business while also retaining other pieces as an individual investor. It is important to note that the deductibility of expenses and losses in each category varies and is contingent upon the specific facts and circumstances involved. Therefore, any private taxable collector should develop a customized plan based on a meticulous evaluation of each item’s category for purchase, holding, or sale. If necessary, consulting with a subject matter expert is advisable.
Introduction to the Four Categories:
In the realm of art, an investor is someone who purchases, sells, and collects artworks with the sole aim of making a profit. When an investor sells an artwork, it is typically subject to capital gains tax, unless it falls outside the definition of a capital asset. According to IRC § 1221, a capital asset includes all assets except (1) stock in trade or property held for sale to customers, (2) property used in a trade or business subject to depreciation, and (3) an artistic composition held by the creator or someone whose basis is determined by the creator’s basis. If an artist gifts their artwork, it falls under category (3) and is considered taxable as ordinary income property.
To claim a capital loss under IRC § 165(c)(2), an investor must demonstrate that the intent behind the transaction was for profit. The purchase and sale of the artwork must be proven to have been entered into with the intention of making a profit. Various factors are considered based on the taxpayer’s individual circumstances, but personal use and enjoyment of the artwork tend to be critical factors indicating a lack of profit-oriented intent.
The expenses associated with art investments are governed by IRC § 212. These expenses are deductible if it can be proven that the investor’s primary intent was to hold the artwork for the purpose of generating income. The determination of intent is based on established facts and circumstances from relevant court cases. Personal use and enjoyment, once again, play a crucial role. However, not all expenses are eligible for deduction under IRC § 212. Expenses incurred to extend the lifespan or enhance the value of the artwork, as well as selling expenses, are among the disallowed expenses. If the gross income from the activity exceeds the deductions in three or more years within a five-year period, IRC § 183(d) applies, and the activity is presumed to be for profit. If not, IRC § 183 may apply, limiting the deduction of expenses if the activity is considered not-for-profit.
It is important to note that an investor can be classified as a dealer, or a hobbyist based on the facts and circumstances of their case. In some instances, investors may seek to be categorized as dealers to deduct losses as ordinary income rather than capital losses.
A hobbyist is an art collector who acquires pieces purely for enjoyment, without concern for potential profitability. Typically, the hobbyist does not often sell artworks, and if they do, any gains are taxable, while losses cannot be claimed as deductions (as per IRC §§ 1221 and 165(c), respectively). Although expenses related to maintaining the collection are generally not deductible according to IRC § 262, IRC § 183 may allow for some deductions up to the amount of gross income generated by the activity, following the ordering rules of IRC § 183. Due to the tax disadvantages associated with being a hobbyist, many strive to be classified as investors.
A business collector acquires art not for resale but rather for purposes such as office display or decoration as part of their regular trade or business activities. Art, which lacks a determinable useful life, is generally not subject to depreciation. Additionally, many businesses purchase art as an investment, which may classify them as investors or hobbyists. However, if the nature of the art investment crosses the line into being a dealer, a thorough examination of the facts and circumstances is necessary to determine the appropriate categorization for the activity.
The Art Dealer
An art dealer is someone who engages in the buying and selling of art as a trade or business. This includes art galleries, which function as a type of dealer. Art dealers are subject to the same tax regulations as any other retail operation. All income, including income from art sales, is taxed as ordinary income (IRC §§ 61, 64). If expenses are ordinary and necessary, they can be deducted under IRC § 162. Dealers sometimes prefer to be classified as investors due to the more favorable capital gains rates, rather than being taxed on those gains as ordinary income. Additionally, dealers, including gallery owners, often assume the roles of both an investor in art and a dealer in art, treating these as separate activities. Numerous court cases, such as Williford v. Commissioner, T.C. Memo. 1992-450, have addressed this issue.
One issue that frequently causes problems across all categories is the charitable contributions of art, which will be discussed below.
As of December 31, 2017, the tax-free eligibility of exchanges involving personal property and intangible assets was eliminated under Code Sec. 1031. Consequently, transactions involving machinery, equipment, vehicles, patents, artwork, collectibles, and other intangible business assets no longer qualify for non-recognition of gain or loss as like-kind exchanges.
Alternatives to 1031 Exchanges for Artwork
Charitable Remainder Trusts
A Charitable Remainder Trust is an excellent strategy to defer capital gains tax on appreciated assets. By transferring these assets into the trust before selling them, you can generate income over time while enjoying tax benefits.
When establishing a Charitable Remainder Annuity Trust, you contribute cash or property to an irrevocable trust. As the donor (or another non-charitable beneficiary), you retain a fixed annuity, consisting of principal and interest payments, for a specified period or the lifetime of the non-charitable beneficiaries, which can be up to twenty years. At the end of the term, the remaining trust property is directed to a qualified charity of your choice.
Gifts made to a Charitable Remainder Annuity Trust qualify for income and gift tax charitable deductions. In certain cases, an estate tax charitable deduction may apply to the remainder interest gift, provided that the trust meets the legislative criteria. The annuity payments can be either a specified dollar amount (e.g., $500 per month for each non-charitable beneficiary), a fraction, or a percentage of the initial fair market value of the contributed property (e.g., 5% each year for the beneficiary’s lifetime).
You will receive an income tax deduction for the present value of the remainder interest that will eventually pass to the qualified charity. This deduction is determined by government regulations and is calculated by subtracting the present value of the annuity from the fair market value of the property or cash placed in the trust. The remaining balance represents the amount eligible for deduction when you contribute the property to the trust.
In comparison, a Charitable Remainder Unitrust functions similarly to a Charitable Remainder Annuity Trust, with the key difference being that the annuity is based on a specific percentage of the trust assets’ balance at the beginning of each payment year.
A Charitable Lead Trust presents an ideal solution for accelerating charitable deductions, mitigating the impact of new limitations on itemized deductions, and offsetting up to 50% of your Adjusted Gross Income in a given tax year. Additionally, it can serve as a means to eliminate gift or estate taxes on transfers to children or other beneficiaries.
To establish a CLAT, you transfer cash or other assets to an irrevocable trust. The trust then provides fixed annuity payments, including principal and interest, to a chosen charity for a specified number of years. At the end of this term, the remaining assets in the trust are transferred to the non-charitable remainder person(s) you designated during trust setup. This person can be anyone, such as yourself, a spouse, a child, a grandchild, or even someone unrelated to you. You have the flexibility to create a CLAT either during your lifetime or upon your death. This option is available to both corporations and individuals, proving particularly advantageous when you need to remove appreciated assets from a business tax-free.
As the beneficiary, you receive an immediate and substantial income tax deduction. In subsequent years, you must report the trust’s income reduced by the annuity payments made to the charity. One notable advantage of the CLAT is its ability to accelerate the charitable deduction into the year of the gift, even if the annuity payout is spread out over the trust’s term. This feature proves valuable when anticipating a significant drop in future income, allowing for a generous deduction in a high bracket year while reporting the income in lower bracket years. By spreading out the income and tax liability over multiple years, you achieve greater tax efficiency.
Another benefit of the CLAT is the opportunity for a “discounted” gift to family members. Under current law, the value of a gift is determined at the time it is made. However, the family member remainder man must wait until the charity’s term expires, resulting in a discounted value for their interest due to the “time cost” of waiting. Essentially, the cost of making a gift is reduced because the value of the gift decreases by the annuity interest donated to charity.
Furthermore, when the trust’s assets are transferred to the remainder man, any appreciation in their value becomes exempt from gift or estate taxation within your estate.
It is worth noting that a Charitable Lead Annuity Trust is similar to a Charitable Lead Trust, with the distinction that the annuity payments to charity are a percentage of the trust assets at the beginning of the year when the payments are due.
A Deferred Sale Trust
A Deferred Sale Trust involves selling a highly appreciated asset to an irrevocable trust in exchange for an installment note, which is then sold to a third party by the trust. According to IRC section 453, you are only liable for taxes on the gains and interest as they are paid out to you. Additionally, the trust is not subject to taxes on the sale of the assets to the third party because the trust received a new cost basis during the installment sale. The proceeds from the sale can be reinvested by the trust in other assets or in a wealth replacement vehicle, such as life insurance, where the death benefit is triggered when the term of the note ends, such as upon your passing. This strategy allows for tax efficiency while providing flexibility and potential for wealth growth.
An Art Exchange
An art exchange is a non-profit organization established with the purpose of selling, leasing, exchanging, or otherwise disposing of assets. These assets primarily consist of donated merchandise or items directly connected to the charitable mission of the art exchange. By utilizing an art exchange, a Charitable Remainder Trust can protect its underlying non-profit entity from generating Unrelated Business Income, especially when the donated tangible property is not closely aligned with the non-profit’s charitable purpose. Additionally, an art exchange serves as a platform for generating lease income or facilitating exchanges of tangible property, all while avoiding income tax implications.
Artwork Trades
Trades involving artwork are a common income concern. This occurs when galleries, dealers, or artists exchange inventory with other galleries or individuals. There are three ways in which trades are typically treated:
1. Recording trades on the books as nontaxable: The basis of the new item received is the same as the item given up, plus any additional boot received. Any boot received would be reported as income.
2. Recording trades as taxable events: The basis of the new item is determined by its fair market value or cost.
3. Utilizing a hybrid method that combines elements of both approaches.
Considering the following reasons, it is advisable to treat trades as taxable events:
a. Gross income definition: Section 61 defines gross income as income derived from any source, unless excluded by law. Treasury Regulation 1.61-1 states that gross income includes income realized in various forms, such as money, property, services, meals, accommodations, and stock.
b. Legal precedent: In the case of James A. Lewis Engineering, Inc. v. Commissioner, the court ruled that income encompasses the fair market value of assets received.
c. Exception for stock in trade: Although Section 1031 allows for tax-free exchanges of like-kind assets, I.R.C. § 1031(a)(2)(A) makes an exception for stock in trade held primarily for resale, thereby excluding inventory.
d. Materially different property: According to Treas. Reg. 1.1001-1(a), gain or loss is realized when property is exchanged for other property that differs materially in kind or extent. In Cottage Savings Association v. Commissioner, the Supreme Court held that exchanged properties are “materially different” when their respective possessors enjoy legal entitlements that vary in terms of kind or extent. Since the owner of one artwork possesses different legal entitlements than the owner of another artwork, trading artwork for other artwork constitutes an exchange of materially different property.
Based on the law’s clear guidance, income must be recognized up to the fair market value of the asset received when engaging in inventory exchanges.
Despite the clear legal requirement to recognize income from inventory exchanges, trades are still often treated as nontaxable events within the industry. This is often justified by claiming that it has always been done this way, and/or that determining fair market value is challenging. Nevertheless, an adjustment to a taxable event remains necessary.
Charitable Contributions of Artwork
The subject of charitable contributions of artwork and income taxation is extensive and intricate. While this brief introduction will cover some important aspects, it is crucial to note that there are numerous additional details to consider.
When it comes to the donation of artwork by art galleries, dealers, or the artists themselves, there are specific limitations to keep in mind. Generally, the deduction for charitable contributions is limited to the lower of the artwork’s fair market value on the date of the contribution or its adjusted basis. It is also essential to make adjustments to the cost of goods sold in order to avoid double deductions.
For investors who donate artwork, the deduction is typically based on the fair market value of the property. However, there may be reductions and limitations on the allowable deduction under different circumstances. The term “fair market value” refers to the price at which the property would change hands between a willing buyer and a willing seller, both of whom have reasonable knowledge of the relevant facts and are not under any compulsion to buy or sell.
One potential issue arises when artwork is donated by an art gallery owner or dealer. It is important to determine whether the artwork being donated is held as an investment or part of the owner’s inventory. The deduction for long-term capital gain property is generally based on its fair market value, while the deduction for inventory is limited to the lower of cost or fair market value.
The deduction for artwork gifted by the artist to an investor is generally limited to the smaller of the gift basis or the fair market value on the date of the charitable contribution. According to IRC § 1221(a)(3)(C), the property retains its status as ordinary income property, just as it would for the artist who gifted it. IRC § 1015 specifies that the basis of gifted property is determined by the basis in the hands of the donor (the artist). Furthermore, IRC § 1221(a)(3)(C) excludes property from being a capital asset if its basis is determined, in whole or in part, by reference to the basis of the property in the hands of a taxpayer who falls under subparagraph (A) or (B). Subparagraph (A) refers to “a taxpayer whose personal efforts created such property.” Consequently, the charitable contribution deduction amount follows the rules for artwork donated by the artist, with the basis being the gift tax basis (adjusted for any gift tax under IRC § 1015(d)). When a taxpayer donates art acquired through inheritance (regardless of whether it was part of the artist’s estate), they are generally eligible for a deduction based on the artwork’s fair market value.
Limitation:
The contribution of artwork to a charity cannot exceed 30% of the taxpayer’s contribution base for the tax year. This is because it is considered appreciated capital gain property, as stated in the IRS Letter Ruling 8143029.
Valuation of Art for Income Tax Purposes:
Cases selected for audit that involve artwork with a claimed value of $50,000 or more per item must be referred to Art Appraisal Services. This referral is required by IRM 4.48.2, which also outlines the necessary procedures and information. Even if the value is below $50,000, Art Appraisal Services can aid the examiner upon request.
Donations of $250 or more require a contemporaneous written acknowledgment from the recipient. For charitable contributions exceeding $500 in value, Form 8283 must be attached to the tax return, and the taxpayer must maintain specific records. Additional substantiation rules can be found in IRC 170(f)(11), Treas. Reg. §§ 1.170A-13(b) and (c), 1.170A-13(f), and Notice 2006-96, 2006-45 I.R.B. 902.
For charitable donations of property exceeding $5,000, the donor must obtain a “qualified appraisal” as mandated by IRC 170(f)(11). If the donated art is valued at $20,000 or more, Form 8283 requires attaching the appraisal to the tax return. An appraisal summary must be included for property valued above $5,000. IRC § 170(f)(11)(D) mandates attaching all appraisals exceeding $500,000 to the return. The specific requirements for a “qualified appraisal,” as well as the “appraisal summary” and related details, can be found in IRC § 170(f)(11), Treas. Reg. § 1.170A-13(b) and (c), and Notice 2006-96, 2006-45 IRB 902.
Charitable donees must file Form 8282 if they sell, exchange, or dispose of charitable deduction property (or any portion) within 3 years of receiving the property. This form is submitted to the IRS and provided to the property donor. It is recommended to contact a third party to confirm if Form 8282 was required but not provided.
To claim a deduction for the full fair market value of tangible property donated to charity, the property must be used by the charitable organization in a way related to its charitable purpose. Please refer to IRC §170(e)(1)(B)(i) and Treas. Reg. §1.170A-4(b)(3). Art is generally considered related-use property for an art museum or school, but likely not for a rescue organization. See IRC § 170(e)(7) for capturing the deduction on certain dispositions of exempt use property.
Deductions for fractional interests in art are possible, but prior to the donation, the property must be wholly owned by the donor or shared between the donor and the charity. Special valuation rules apply to subsequent fractional gifts, and the deduction may be recaptured if the gift is not completed within 10 years of the initial fractional gift or the donor’s date of death. Please refer to IRC § 170(o).
Section 6695A imposes penalties on appraisers under certain circumstances, while Section 6662 provides accuracy-related penalties for donors.
The rules surrounding charitable contributions of artwork are complex and multifaceted. It is crucial for both donors and donees to understand the nuances of IRC regulations to ensure proper compliance. Missteps can result in severe penalties for both appraisers and donors. Therefore, it is always advisable to consult with a tax professional or legal advisor when considering such donations. This ensures that the process is carried out correctly, maximizing the potential benefits for both the donor and the charitable organization.
In conclusion, the legal landscape surrounding the donation of artworks to charitable organizations is laden with intricacies that require careful navigation. The IRS regulations, while complex, serve to ensure fair practices and protect the interests of both donors and donees. As potential donors contemplate such philanthropic endeavors, they must bear in mind the necessity of comprehensive understanding and adherence to these regulations. Seeking counsel from tax professionals or legal advisors is a prudent step towards ensuring a smooth, compliant, and mutually beneficial donation process.
