With little fanfare, the recently enacted Pension Protection Act has drastically changed the rules that apply to gifts of fractional interests in artworks. Unless the law is changed, the likely effect will be the end of fractional gifts of art to museums.
Bear with me here.
Gifts of fractional interests in art have been standard practice for years. Here’s how it worked. A collector would give a museum, say, a one-fourth interest in a painting and retain for herself the other three-fourths interest. The museum had to be given the right to possession of the painting for a quarter of each year (though, under the Winokur rule, it didn’t have to exercise that right). The collector got a current income tax deduction equal to 25% of the value of the painting, and she (or her estate) could get further deductions for additional contributions in the future, based on the then-current value of the painting (which the collector of course hoped would be higher than at the time of the initial contribution). Everybody was happy – both the museum and the collector.
Not any more. First, under the new law, Section 1218 of the Pension Protection Act of 2006, no deduction will be allowed unless all interests in the artwork were owned by the donor and the donee immediately before the contribution (unless everyone who holds an interest in the work makes a proportional contribution).
Second, if the collector fails to contribute her entire interest to the same museum before the earlier of (i) 10 years from the initial contribution or (ii) the collector’s death, then all previous tax benefits are recaptured -- with interest, as well as a 10 percent penalty.
Third, recapture also applies if during the 10-year period (or the period ending on the collector’s death if sooner) the museum fails to take “substantial physical possession” of the artwork – reversing the Winokur rule that the “legal right” to possession is sufficient – and “used the property in a use which is related to” its charitable purpose. It’s not clear whether keeping a work in storage would satisfy the latter requirement, or if a collector will instead have to extract a promise from the museum to actually display it to the public from time to time. (More on this so-called “related use” rule below.)
Fourth, and worst of all, the new law provides that the fair market value of any additional contributions shall be determined by using the lesser of (a) the fair market value of the work at the time of the initial contribution or (b) the fair market value of the work at the time of the additional contribution. This creates two problems for collectors. One, they’re deprived of the benefit of any increase in the value of the artwork over time. Say I donate 25% of an artwork to a museum at a time when the work is worth $8 million and, several years later, when the work is now worth, say, $20 million, donate the remaining 75%. Under the new law, my deduction for the latter contribution will be limited to $6 million (75% of the value at the time of the initial contribution), even though what I have donated is an asset worth $15 million (75% of $20 million, the value at the time of the later contribution).
Even worse – and this is the part that will likely mean the end of fractional giving to museums unless changed – the law sets up a potential mismatch between the work’s taxable value and its deductible value. To see this, suppose that tomorrow a collector gives a museum a one-half interest in a painting valued at $5 million. Her current deduction will thus be $2.5 million (putting aside the usual percentage limitations on charitable deductions). Suppose further that she dies several years from now, leaving the remaining one-half interest to the museum in her Will – but imagine that now the value of the painting has gone up to $6 million. Now the estate tax charitable deduction will be limited to $2.5 million (one-half of the value of the painting at the time of the initial contribution), but the full $3 million (one-half the painting’s current value) will be includible in the collector’s estate, leaving estate tax due on the $500,000 “spread.” Ouch.
The same problem applies to gifts as well. Using the same example, if rather than leaving the remaining one-half interest to the museum in her Will, the collector decides to complete the gift during her lifetime, she will have to pay gift tax on – but will get no income tax deduction for – the same $500,000 spread.
The new law applies to contributions made after August 17, 2006. The legislative history indicates that a contribution of a fractional interest before that date is not treated as the initial contribution for purposes of these rules, but the first additional contribution after the effective date will be (and so starts the 10-year clock ticking, for example).
If you’re so inclined, you can view the Joint Committee on Taxation’s 396-page "technical explanation" of the Act here.
In one other related provision, Section 1215 of the Act provides for recapture of any tax benefits claimed for donated property that does not get put to a “related use” (that is, a use related to the recipient charitable organization’s tax-exempt purposes). This provision automatically applies if the donee organization disposes of the property within three years of the date of contribution (with an exception if the organization certifies that the property was put to a related use or that it became impossible to do so). A $10,000 penalty applies to anyone who identifies property as having a related use knowing it is not so intended.
The Association of Art Museum Directors has been very active in pushing for a restoration of the income tax deduction for charitable contributions by artists of their own work -- without much success. By contrast, here's a change, with a potentially catastrophic impact on gift-giving to museums, that seems to have flown in completely under the radar. It will be interesting to see what happens once the meaning of these changes becomes widely understood. Here’s a start, from the Chicago Tribune last week.