No Deduction For African Sculpture

 

You can anticipate the final decision when you read the following sentence:

One does not need to be a tax expert to open his eyes and read plain English.”

This time we are talking about art. Expensive art. And donations of said expensive art.

I am not a fan of the minutiae in this area. It strikes me as a deliberate gambit to blow-up an otherwise laudable donation for what one could consider ministerial oversight, but such is the state of tax law.

Then again, the taxpayer side of these transactions tends to have access to high-powered professional advice, so perhaps the IRS is not being intractable.

Still, one likes to see reasonable application of the rules, with acknowledgement that not everyone has advanced degrees and decades of experience in tax practice. Even if one does, there can be disagreement in reading a sentence, the interpretation of a comma, the precedence of a prior case, or the interplay - or weighting - of related tax provisions. Or maybe someone is overworked, exhausted, running the kids to activities, attending to aging parents and simply made - excuse a human foible - a mistake. 

It used to be known as reasonable cause and can be grounds for penalty abatement. I remember it existing when I was a younger tax practitioner. Today? Not so much.

One way to (almost certainly) blow reasonable cause?

Be an expert. I doubt the IRS would ever allow reasonable cause on my personal return, for example.

Let’s look at the Schweizer case.

Heinrich Schweizer was a high-powered art advisor.

He better not get into it with the IRS about art donations, then.

Schweizer received a law degree in Germany. He then worked an internship with Sotheby’s in New York City. When the internship ended, he returned to Germany to pursue a PhD, a goal interrupted when Sotheby’s recruited him for a position in their African art department. He there served as Director of African and Oceanic Art from 2006 to 2015. He increased the value of the annual auctions and provided price estimates at which customers might sell their art at auction. He also worked closely with Sotheby’s appraisal department in providing customers with formal appraisals.

Schweizer filed his first US tax return in 2007. He hired a CPA firm to help with the tax return. He continued this relationship to our year in question.

In 2011 Schweizer made a substantial donation to the Minneapolis Institute of Art (MIA). He donated a Dogon sculpture that he had acquired in Paris in 2003. The deduction was $600 grand.

The accountants filed for an extension and contacted the IRS Art Appraisal Services (AAS) unit.

COMMENT: One can spend a career in tax and never do this. AAS provides advice and assistance to the IRS and taxpayers on valuation questions. A reason to contact AAS is to obtain a statement of value (SOV) after donating but before filing a tax return. The donor can rely on the SOV as support for the value deducted on the tax return. It is – by the way – not easy to get into AAS. The minimum ticket is a $50 grand donation as well as a filing fee for time and attention.

Schweizer obtained his SOV. All he had to do now was file his return and include the magic forms (Form 8283 with all the required signatures and secret handshakes, a copy of the appraisal, yada yada).

Guess what he did not do?

No properly completed Form 8283, no copy of the appraisal, nothing.

Remember: form is everything in this area of the tax law.

Off to Tax Court they went.

His argument?

His failure to meet the documentation requirements was due to reasonable cause and not willful neglect.

 Move me with a story.

He received and reasonably relied on advice from the accounting firm that it was unnecessary to include either a qualified appraisal or a fully completed Form 8283 with his 2011 return.

Why would I believe this?

Because the IRS already had these documents through the SOV process.

I know the conclusion is wrong, but it gives me pause.

OK, reliance on tax advice can be grounds for reasonable cause. He will of course need the firm to back up his story ….

The spokesman for the firm testified but did not corroborate, in any respect, Schweizer’s testimony about the alleged advice.”

Well, that seems to be prompting a malpractice suit.

Schweizer’s attorney will have to cross-examine aggressively.

And petitioner’s counsel asked no questions of […] squarely directed to this point.”

Huh? Why not?

The fact that petitioner did not seek corroborative testimony from the person who might have supplied it weighs against him.”

Well, yeah. If someone can bail you out and they fail to do so, the Court will double-down on its skepticism.

Now it became a matter of whom the Court believed.

To tighten the screws even further, the Court noted that – even if the firm had told Schweizer that he need not include a phonebook with his tax return - the Court did not believe that Schweizer would have relied on such advice in good faith.

Why not, pray tell?

Schweizer was a high-powered art advisor. He was also trained in law. He had done this - or something very similar - for clients at Sotheby’s over the years. The Court said: he knew. He may not have been an expert in tax, but he had been up and down this stretch of road enough to know the rules.

There was no deduction for Schweizer.

Our case this time was Schweizer v Commissioner, T.C. Memo 2022-102.

Setting Up A Museum

Have you ever wondered why and how there are so many private art museums in the United States: The Brant Foundation, The Broad, The Warehouse?

Let’s posit the obvious immediately: wealthy people with philanthropic objectives.

This however is a tax blog, meaning there is a tax hook to the discussion.

Let’s go through it.

We already know that the tax Code allows a deduction for charitable contributions made to a domestic corporation or trust that is organized and operated exclusively for charitable purposes.  There are additional restrictions: no part of the earnings can inure to the benefit of a private individual, for example.

Got it: charitable and no sneak-arounds on the need to be charitable.

How much is the deduction?

Ah, here is where the magic happens. If you give cash, then the deduction is easy: it is the amount of cash given, less benefits received in return (if any).

What if you give noncash? Like a baseball card collection, for example.

Now we have to look at the type of charity.

How many types of charities are there?

Charities are also known as 501(c)(3)s, but there several types of (c)(3)s:

·      Those that are publicly supported

·      Those that are supported by gifts, dues, and fees

·      The supporting organization

·      The nonoperating private foundation

·      The operating private foundation

What happens is that the certain noncash contributions do not mix will with certain types of (c)(3)s. The combination that we are concerned with is:

 

·      Capital gain property (other than qualified stock), and

·      The nonoperating private foundation

 Let’s talk definitions for a moment.

 

·      What is capital gain property?

 

Property that would have generated a long-term capital gain had it been sold for fair market value. Say that you bought $25,000 of Apple stock in 1997, for example, when it traded at 25 cents per share.

 

By the way, that Apple stock would also be an example of “qualified stock.”

 

·      What is not capital gain property?

The easiest example would be inventory to a business: think Krogers and groceries. A sneaky one would be property that would otherwise be capital gain property except that you have not owned it long enough to qualify for long-term capital gains treatment.

 

·      What is a nonoperating private foundation?

 

The classic is a family foundation. Say that CTG sells this blog for a fortune, and I set up the CTG Family Trust. Every year around Thanksgiving and through Christmas the CTG family reviews and decides how much to contribute to various and sundry charitable causes.  Mind you, we do not operate any programs or activities ourselves. No sir, all we do is write checks to charities that do operate programs and activities.

Why do noncash contributions not mix well with nonoperating foundations?

Because the contribution deduction will be limited (except for qualified stock) to one’s cost (referred to as “basis”) in the noncash property.

So?

Say that I own art. I own a lot of art. The art has appreciated ridiculously since I bought it because the artist has been “discovered.” My cost (or “basis”) in the art is pennies on the dollar.

My kids are not interested in the art. Even if they were interested, let’s say that I am way over the combined estate and gift tax exemption amount. I would owe gift tax (if I transfer while I am alive) or estate tax (if I transfer upon my death). The estate & gift tax rate is 40% and is not to be ignored.

I am instead thinking about donating the art. It would be sweet if I could also keep “some” control over the art once I am gone. 

I talk to my tax advisor. He/she tells me about that unfortunate rule about art and nonoperating foundations.

I ask my tax advisor for an alternate strategy.

Enter the operating foundation.

Take a private foundation. Slap an operating program into it.

Can you guess an example of an operating program?

Yep, an art museum.

I set-up the Galactic Command Family Museum, donate the art and score a major charitable contribution deduction.

What is the museum’s operating program?

You got it: displaying the art.

Let’s be frank: we are talking about an extremely high-end tax technique. Some consider this to be a tax loophole, albeit a loophole with discernable societal benefits.

Can it be abused? Of course.

How? What if the Galactic Command Family Museum’s public hours are between 3:30 and 5 p.m. on the last Wednesday of April in leap years? What if the entrance is behind a fake door on an unnumbered floor in a building without obvious ingress or egress? What if a third of the art collection is hanging on the walls of the CTG family business offices?

That is a bit extreme, but you get the drift.

One last point about the deduction if this technique is done correctly. Let’s use the flowing example:

                  The art is worth             $10,000,000

                  I paid                            $          1,000

We already know that I get a $10,000,000 charitable deduction.

However, what becomes of the appreciation in the art – that is, the $9,999,000 over what I paid for it? Does that get taxed to me, to the museum, to anybody?

Nope.

A Rough Rider’s Eagle And The Estate Tax

What is the value of something that you cannot sell?

Someone walked face-first into this issue with the IRS.

We are talking about Ileana Sonnabend, an avid art collector and a very wealthy woman. She died in 2007, leaving an art collection that included works by Andy Warhol, Jasper Johns and Robert Rauschenberg. Her estate was in the billion-dollar range, prompting her executors to sell pieces from the collection to pay federal and New York estate taxes. Those taxes approached $500 million.

There was a troublesome piece in the collection – Rauschenberg’s “Canyon.” Rauschenberg was a post – World War II American artist, and some of his work is described as “combine.” This means that the work includes different materials, such as Picasso mixing sand into his paints. The issue with “Canyon” is that it includes a stuffed bald eagle.

There are federal laws – the 1918 Migratory Bird Treaty Act and the 1940 Bald and Golden Eagle Protection Act – that says that one cannot traffic in bald eagles, even a stuffed one.

Ms Sonnabend purchased “Canyon” in 1959, well after the 1940 law. In 1981 (yes, 22 years later) the Department of Fish and Wildlife contacted her to inform her that her ownership violated federal laws. She was able to obtain a permit to retain “Canyon” and loan it to museums, but she was forbidden to sell it. She got the permit because Rauschenberg – who made the piece – provided a written statement that the bald eagle had been killed and stuffed by one of Teddy Roosevelt’s Rough Riders, well before 1940.

The government decreed that it must be informed of “Canyon’s” location at all times. If the artwork left the country for an exhibition, it would have to apply for a visa.

Seriously?

Ms Sonnabend died. The executors had to put a value on “Canyon” for the estate tax return.

How do you value art for an estate? You get an appraisal. The estate got an appraisal on “Canyon” from Christie’s, the auction house. Their appraisal? It was worth zero – nada, zippo, subtract one from one. One cannot sell “Canyon” without going to jail, with greatly cuts into its marketability. Two other auction houses gave the same appraisal, so the estate filed an estate tax return showing a zero value for “Canyon.”

The IRS of course saw otherwise. In 2011 the IRS sent the estate a report proposing a value of $15 million for “Canyon.” The estate disagreed and refused to pay. The IRS – in an example of why people hate the IRS – issued a formal Notice of Deficiency upping the value to $65 million.

NOTE: It is not as though your local IRS revenue agent came up with this value. This is specialized work. The IRS has an Art Advisory Panel that helps with these cases. The most that a Rauschenberg has ever received at auction however is $14.6 million, which seriously calls their $65 million figure into question.

Just to put sand in the paint, the IRS levied a special “understatement” penalty of 40%.

So how did the bright bulbs on the Art Advisory Panel come up with the $65 million figure? One of them, Joseph Bothwell, said that there:

... could be a market for the work. For example, a reclusive billionaire in China might want to buy it and hide it.”

Huh? An illegal sale to a “reclusive billionaire in China” is not considered an accepted valuation technique.

Another bulb, Stephanie Barron, further explained that the Panel evaluated “Canyon” without reference to any restrictive laws.

“The ruling about the eagle is not something the Art Advisory Panel considered,”’ she explained.

What? The most important factor in “Canyon’s” valuation and you did not consider it?

We all just cringed at the idea that this had zero value. It just didn’t make any sense,” she continued.   

Good grief.

Let’s have a brief review of the facts for Stephanie Barron. Ms Sonnabend owned an item. The government did not approve of her owning the item. This item could be anything. Let’s say – for example - that it is a Big Gulp in Times Square. The government does not want you to have it and wants to take it from you. The government could call in a drone, I suppose, but it instead shows restraint. The government cleverly takes the item from Ms Sonnabend without actually taking it from her possession. Is that a fair summary of what happened here?

OBSERVATION: One could argue that Ms Sonnabend suffered a theft loss.

The executors had a decision to make. If they didn’t pay the taxes, they would face IRS collections action. If they sold “Canyon” to raise the money to pay the taxes, they would go to prison for violating federal law.

How did this turn out? This month the IRS dropped its claim against the estate of Ileana Sonnabend over “Canyon.” The estate donated the work to the New York Museum of Modern Art. The estate agreed not to claim a tax deduction for the donation, as it previously argued that the work had no value.

This was not the IRS’ finest effort.