During Easter, children hunt for colored eggs, perhaps to earn a prize. When it’s tax season, the prizes adults hunt for are expenses that can be deducted from their earnings to lower their tax liabilities. Both artists and art collectors can take part in this hunt, but they need to know the rules set by Congress and the Internal Revenue Service to get the maximum benefits and stay out of trouble.
Tax deductions for artists
On the most basic level, artists who may not earn much or any of their income from the sale of their artistic output need to prove to the IRS that they are professionals and not just dilettantes. Hobbyists are not permitted to deduct their costs, which in this case could include the price of materials, studio rent, insurance, travel expenses, advertising and promotion, photography and shipping fees. That makes defining who is and isn’t an artist important.
“The IRS has guidelines about hobbyists versus professionals,” New York City accountant Steven Zelin told Observer. “Basically, the IRS wants to know if the taxpayer intends to make a profit.” In other words, it’s not just high-earning artists who have to think about this stuff. Artists are technically in business as soon as they have the intention to earn money from their work, whether in the form of sales, grants or fees if they give public demonstrations.
There are nine criteria that the IRS applies to separate professionals from hobbyists:
- Is the activity carried on in a businesslike manner?
- Does the artist intend to make the artistic activity profitable?
- Does the individual depend in full or in part on income generated by the artistic work?
- Are business losses to be expected, or are they due to circumstances beyond the artist’s control?
- Are business plans changed to improve profitability?
- Does the artist have the knowledge to make the activity profitable?
- Has the artist been successful in previous professional activities?
- Does the activity generate a profit in some years and if so, how much of one?
- Will the artist make a profit in the future?
The artist need not answer “yes” to every question to legitimately deduct business-related expenses, and spending more money than one takes in does not disqualify someone from claiming to be profit-oriented. “In many businesses, one might expect to have losses in the first few years,” said New York City tax preparer Todd Thurston. While the IRS does expect an artist in business to have a profit motive, demonstrating intent is less tricky than it sounds. Unprofitable artists can continue to claim losses after three years if they can show they’re operating as a business by opening a business bank account, acquiring a business credit card, advertising for the business and/or having a business website, keeping good books and records. Some artists even incorporate their practices. “In the rare case of an audit, losses that an artist has already taken generally won’t be challenged, only losses claimed going forward.”
Zelin noted that creating a business plan, which a company or sole proprietor would need when applying for a bank loan, is useful if the IRS needs proof of an artist’s profit-making intent. This document might feature an executive summary (the nature of the business and the expectation of earnings), a description of the business operations (the studio, how much time is spent in the studio every day or every week, how artwork is transported to one site or another, the website, exhibition venues, how payment is accepted), staffing and management (a studio assistant, a business manager), revenue forecasts, marketing plan (how the artwork produced will be made known to prospective buyers), expected expenses and expected milestones (exhibitions, grant awards, prizes).
The IRS does not define what makes an artist a professional, but certain elements help in the determination of whether or not there is a serious intent to earn a profit. “Having a BFA is something, having an MFA is better,” said New York accountant Susan Lee. “Having a website helps, especially if the website is set up for making sales, as does having a separate business credit card and business bank account. Using the services of a lawyer or an accountant in setting up or running your business shows you are serious. Belonging to an artists’ organization, subscribing to an industry-related magazine or going to professional conferences is also helpful because it builds a picture of you doing everything you can do to be on top of the market.”
If an artist believes that the IRS has denied business-related expense tax deductions unfairly, they may challenge the auditor’s decision in Tax Court, which requires petitioning the Court and paying a $60 filing fee within 90 days of receiving the IRS’ Notice of Deficiency. Tax Court generally operates in the manner of a small claims court—there is no jury; taxpayers tell the judge their story directly. However, many who go to Tax Court hire lawyers to represent them.
Artists have gone to Tax Court with claims that they are not just hobbyists and won. Back in 1977, a precedent-setting decision was handed down with regard to a painter, Gloria Churchman, who had claimed losses of several hundred dollars in her tax filings in 1970 and 1971. For all of her 20-year career, Churchman’s income from art sales never exceeded her losses, and the IRS also claimed that the artist was supported by her husband, a college professor. As a result, IRS auditors labeled Churchman a hobbyist and her deductions for art-related expenses were denied. However, when the artist took her case to Tax Court, it was ruled that Churchman pursued her art career “with a bona fide intention and expectation of making a profit” and the fact that she did not rely on sales of her artwork for her livelihood was irrelevant. Lack of income, the Court ruled, and “a history of losses is less persuasive in the art field than it might be in other fields because the archetypal ‘struggling artist’ must first achieve public acclaim before her serious work will command a price sufficient to provide her with a profit.”
SEE ALSO: What Art Collectors Should Know About the Changing Lifetime Gift Tax Exemptions
More recently, Cambridge, New York, painter and Hunter College art professor Susan Crile successfully challenged an IRS auditor’s rejection of her claimed deductions on her tax returns for art-related expenses on the basis that her work as an artist was “an activity not engaged in for profit.” Noting that she had received fellowships from the National Endowment for the Arts in 1982 and 1989 and that more than two dozen museums had her work in their collections, including the Metropolitan Museum of Art, the Hirshhorn Museum and Sculpture Garden and the Phillips Collection, the Tax Court ruled that “[i]n a qualitative as well as a quantitative sense, we conclude that the balance of factors favors [Crile] and that she has met her burden of proving that in carrying on her activity as an artist, she had an actual and honest objective of making a profit. We therefore hold that she was…in the ‘trade or business’ of being an artist.”
Home office deductions
Many artists work out of their homes instead of keeping separate studios, but the IRS permits tax deductions for business use of one’s house or home office. Expenses may be deducted if the space in the home or apartment is used “exclusively and regularly” for income-producing business activity; that is, an artist’s studio, for the purposes of tax filing, cannot also be the den where family members watch football on Sundays, and the work performed in the room has to be the sort for which one gets paid or hopes to get paid. Deductible expenses include rent, repairs, utilities, mortgage interest, security systems, insurance, real estate taxes and losses from damage to the home (from fire, trash removal, theft, hurricane, tornado, lightning, hail and other events). These expenses are deductible proportionate to the amount of space in the house that the office represents: If the home office adds up to 15 percent of the overall square footage of the house, 15 percent of the total expenses may be deducted.
Donations of artworks
Unfortunately, artists may not claim full deductions when they donate their own artworks to a nonprofit institution such as a museum or to a charitable auction. Federal law allows creators to write off the cost of the materials but not the expected fair-market value. Collectors of art, on the other hand, have continued to receive a full fair-market-value deduction on their tax returns for their gifts of that same art. Whether or not the current tax law actually is unfair is debatable—bills that would allow artists to take a full fair-market-value deduction on their tax returns for their gifts regularly appear before Congress but never pass.
Tax deductions for art collectors
Art collectors also need to follow rules established for charitable donations set by the IRS. When gifting an object to a nonprofit organization, the piece to be donated must be in line with the institution’s mission. A soup kitchen, for instance, might be close to the heart of an art collector, and it might even welcome the decoration of a Rembrandt, but the purpose of the soup kitchen is not the display of art, so a donation of that kind would not be fully deductible under IRS rules. Even closer, a museum devoted to postwar and contemporary art might not be the appropriate recipient for the Rembrandt, regardless of the work’s inherent quality and importance.
For a donor to receive a full fair-market-value income tax deduction for a gift, the recipient organization must show that its use of the artwork is related to its tax-exempt purpose, referred to by the Internal Revenue Service as a “related use.” If there is no related use, the donor’s charitable deduction will be limited to his or her cost basis in the artwork, what they paid for the item. A painting originally purchased for $50,000 that is now worth $500,000 would only allow the donor to take a $50,000 deduction.
Additionally, if a nonprofit—art museum or otherwise—sells the donated artwork within three years of receiving it, that sale must be reported to the IRS and the donor’s fair-market value deduction will be retroactively lowered to that taxpayer’s original buying price. This would be particularly relevant to donors to charities holding benefit auctions, soliciting artworks and other items that can be sold to generate money for an organization’s operations expenses.
Many collectors sit on the boards of museums or may know museum curators who hint at particular artworks that the institutions would like to acquire, and it is not uncommon that collectors purchase from galleries pieces that museums want for their permanent collections. However, under current IRS rules, collectors are not permitted to purchase and then immediately donate artworks to these institutions but must wait at least a year and a day to transfer ownership of artwork if they expect to claim an income tax deduction based on a piece’s fair-market value as determined by a qualified appraiser. Less than a year and a day, the IRS will only allow a deduction of the cost value of the item—what the donor actually paid.
Calculating deducations
Those who become members of public broadcasting stations, museums or other nonprofits often have lots of options: They can give one big payment or spread their donation over a period of months and at different payment amounts. Depending upon how much they donate, they are eligible to receive a gift: a choice of CDs, tee-shirt, water bottle or tote bag, and sometimes they can click the “No Gift” button on the station’s website. Most donors opt to receive a gift, demonstrating their support for the organization, but those people need to be aware that their donation is not fully tax-deductible.
Those water bottles, tee shirts, tote bags and whatever else have a listed fair-market value, which the IRS requires taxpayers to subtract from their charitable donation. A $15 per month gift (or $180 over the course of a year) that includes the gift of a $20 water bottle results in a net tax deduction of $160. Water bottles are not such a big deal, but they are a benefit that takes away from the purely charitable nature of one’s gift, requiring that a donation be reduced by the bottle’s value.
Another example: there are three membership levels at the Museum of Modern Art—Access, Explore and Supporting—that each provide different benefits. The $110 Access level offers individuals exhibition previews, free admission and reduced admissions for plus ones, but those benefits reduce the tax deductibility to only $100, while the $200 Explore membership has more benefits that lower the tax-deductible element to $125 and the $600 Supporting membership works out to a tax-deductible $390.
And another: New York City’s Metropolitan Opera held its annual gala dinner dance on New Year’s Eve with single ticket prices ranging from $1,000 to $7,500 and benefactor tables for between eight and ten guests priced between $40,000 and $75,000. The organization’s website notes that the tax-deductible portion of the gift is reduced by the cost of the dinner, which for a $1,000 dollar gift is $632 and for the $75,000 table for eight comes to $68,320.
Charities are required to inform donors of the value of any goods and services that donors receive for their gifts—many post descriptions of the fair-market value of gifts on their websites, as well as the tax implications on the gift acknowledgment letters and tax substantiation forms sent to donors, as required by the IRS—but operations staff at nonprofit organizations aren’t usually experts in the tax code and may give donors incorrect information.
“There is an assumption that if you buy a ticket to an event but don’t attend, you don’t have to subtract the cost of the event,” said Michael Wyland, partner in the Sioux Falls, South Dakota nonprofit consulting firm Sumption & Wyland. That sounds reasonable, but you can still only deduct the net value of the gift “because you had the opportunity to go, even if you didn’t take it.” Another question that arises is whether or not one needs to deduct the cost of a benefit dinner if the caterer provides the food for free. The answer there is also yes because the issue is the fair-market value of the food and not who bore the cost of buying and preparing it.
Charity auctions offer other potential complications. Someone who bids $1,000 for a two-night stay at a hotel where rooms go for $400 per night can only deduct $200 as a charitable gift. Someone who bids $3,500 for a vacation to Cancun, Mexico, that actually costs $5,000 would not be able to take any tax deduction, as IRS rules require that the charitable gift can only be the amount above the face value of the goods or services received.
You may also be wondering whether collectors can write off the costs of conservation, storage and insurance of artworks under any circumstances. The answer, according to New York City lawyer Ralph Lerner, is probably not unless a taxpayer can prove they are actually an investor who is buying and selling for the purpose of earning a profit. “A collector who buys works of art primarily for personal pleasure may not write off” these expenses, although “the collector may be able to add the cost of conservation to the cost basis of the artwork for the future sale of the artwork.”
