Donating Artwork: The Artful Dodger and the Dirty Dozen

Author: JOHN BARRIE, LAUREN B. CRAMER, AND JULIA KAI LEE

JOHN BARRIE is a partner and chair of the Tax Practice at McLaughlin & Stern; LAUREN CRAMER is a partner, chair of the Tax-Exempt Organizations Practice, and co-chair of the Art Law Practice at McLaughlin & Stern; and JULIA LEE is an associate with McLaughlin & Stern.

This article explores the key considerations and pressing tax issues that must be addressed after you or your client’s decision to make the gift and to ensure it is accepted by the IRS, or a court, under the Internal Revenue Code.

So, a client or potential client wishes to donate a work of art – a photograph, oil painting, sculpture, music – or perhaps an entire archive. How hard can it be? Unfortunately, the decision to make a gift is not a straight line from contacting a museum to filing your federal tax return with the charitable deduction the following April.

What to do? What is the work? Is it a single piece or an archive? What is the provenance? How did you come by it? Inheritance? Purchased at a discount? What is the fair market value (“FMV”) of the work?

Do you have a qualified appraisal? How long has it been in your possession? And what is your intent? Where would you like to see the work or collection? And how do you ensure that your deduction is legitimate? And what happens if the client receives a letter from the IRS commencing an examination?

This article will explore the key considerations and pressing tax issues that must be addressed after you or your client’s decision to make the gift and to ensure it is accepted by the IRS, or a court, under the IRC, if it is challenged by the IRS.

The Dirty Dozen Campaign

IRS and Traps for the Unwary.

The IRS warns taxpayers and their advisors that when it comes to a donation of artwork, beauty is not always in the eye of the beholder when it comes to tax deductions of art. In Section IR-2024-104, issued April 10, 2024, as part of the IRS annual so-called “Dirty Dozen” campaign, the IRS warns wealthy individuals and their tax advisors about various “tax traps designed for them by dishonest promoters and shady tax practitioners.”¹

Section IR-2024-104 reminds readers that the so-called “Dirty Dozen” list “is not a legal document nor a formal enforcement priority … [but rather an] education effort … designed to raise awareness and protect taxpayers and tax pros from common tax scams and schemes.”² Nonetheless, while an education effort in the art donation world, the Dirty Dozen list reflects the power of the IRS Commissioner’s Art Advisory Panel (the “Panel”), which advises and makes recommendations to the IRS Art Appraisal Services unit in the valuation of major artwork. In 2023, the last publicly available summary of Panel recommendations reviewed 195 items with an aggregate taxpayer valuation of almost $800 million on 37 taxpayer cases. The average claimed value for an item was just over $4 million. The Panel recommended accepting the value of only 103 items – 53 percent of the items reviewed.³

The Artful Dodger

Step One: Taking on the Client.

Say a client, or potential client, has taken a large charitable deduction for artwork donated to a charitable organization, and they receive a letter from the IRS commencing an examination of the client’s federal income tax return. The letter identifies the claimed charitable deduction of the artwork as one of the items under examination. With the real threat of a potential negative review by the IRS … what do you do?

First, if you were involved as the tax advisor at any level of the donation determination and documentation, you should first determine whether you are the appropriate tax advisor to handle the IRS examination, or whether there are potential conflicts that might run afoul of IRS Circular 230, which relates to practice before the IRS. Assuming you are qualified to take on the engagement, you should next gather from the client all possibly relevant information and documentation regarding the donation before you respond to the initial IRS correspondence (which will likely be a request for the same documentation). It is very important to understand the risk and exposure to the client before there are any substantive discussions with the examining IRS agent. Until you have made an initial review of that documentation, you should not respond to the IRS examining agent. That is not always possible, in which case you may consider sending the agent an IRS Power of Attorney (Form 2848) to provide an introduction and a request for additional time to gather the requested documentation before arranging an initial substantive meeting.

In terms of due diligence for initial information, regardless of whether it was requested by the IRS examining agent, you should usually start by speaking with the client regarding the donation(s). This discussion should include when, how, and why the artwork was acquired; the general decision-making process in regard to donating the artwork; the selection and diligence in engaging an appraiser to value the artwork; and if any diligence was done on the recipient charitable organization(s) as qualified under IRS regulations. This would make the organization eligible to receive artwork that would entitle the client to a full FMV charitable deduction.

Step Two: Going Through the Documentation Checklist.

In terms of documentation, your request should include at least the following documentation relating to the artwork:

the acquisition of the artwork (including the purchase price/invoice and the provenance of the artwork);
any correspondence identifying the art dealers or art promoters and their relationship to the purchase of the artwork;
any promotional materials relating to the purchase or contribution of the artwork
correspondence specific to the proposed or actual donation to the charitable organization, and for a completed gift, the Contemporaneous Written Acknowledgment (“CWA”) from the charitable organization (Publication 1771 (Rev. 11-2023));
a copy of the income tax return(s) filed with the IRS;
a complete copy of the Appraisal Report(s) (and any drafts relating to same);
the engagement letter with the appraiser; and
a copy of the fully executed IRS Form 8283 (relating to noncash charitable contributions).

The last three items are most important.

Choosing the Institution: Museum or Charity?

When donating artwork to a museum or charity, a donor must consider several factors. The first is whether the institution is qualified as an exempt 501(c)(3) organization under IRC. If a museum: Does the work align and further its collection policies and standards so that the use relates to the organization’s exempt status? If a charity: Is its mission related to cultural or educational goals, and are there deduction limitations for the donor if there is a very real prospect of its likely sale?

Agreements and Acknowledgements: IRC Section 170(e)(8).

Prior to making the gift, it is prudent for the donor and institution to memorialize the conditions of the donation. Finally, after the gift is made, the donor must receive a CWA to confirm receipt of the artwork and its related use. Such acknowledgment is crucial for substantiating the charitable contribution deduction.

Timing: IRC Section 170 (b)(1)(C).

The holding period and determination of the FMV of a piece of artwork can also hold significant importance to determine the allowable amount of tax deductions. Specifically, if the artwork is donated shortly after it is acquired by the donor, the one-year holding period will not be satisfied and the IRS may also scrutinize the donation to ensure the artwork’s value is not inflated.

In Orth v. Commissioner, 813 F.2d 837 (7th Cir. 1987), the court emphasized that the purchase price of the artwork was a reliable indicator of its value at the time of donation, especially when there was only a brief interval (15 months) between purchase and donation, and no significant appreciation in value was evident. Similarly, in Epic Assocs. 84-Iii v. Comm’r, T.C. Memo 2001-64, the court found that the appropriate market for valuing the property was the market in which the taxpayers purchased the property, particularly when the purchase and donation occurred within a short period.

As the holding period of the artwork also affects the tax treatment of the donation, it is best to donate only artwork that is treated as a long-term capital asset. Artwork must be held for more than one year for the donor to deduct the FMV of the donation. If the artwork is held for less than a year, the deduction is limited to the donor’s basis in the artwork.⁴ This distinction is crucial for maximizing the tax benefits of the donation.

Note: Under IRC Section 1221(a)(3)(A) an artist cannot receive a deduction for the donation of their artwork as a capital asset and the deduction will be treated as the artist’s cost basis, which is customarily restricted to the cost of the supplies used to create the art. The artist donor cannot avoid this rule by gifting the artwork to a friend or family member to make the donation.

FMV: IRC Section 170 (b)(1)(C).

Any potential donation of artwork is traditionally limited to the art’s FMV at the time of the contribution. The FMV is only pertinent where such artwork is used by the museum in alignment with their charitable purpose; otherwise, a deduction may be limited to the donor’s tax basis or original purchase price. Further, the deduction for donated artwork may be subject to limitations based on the adjusted gross income of the donor.

Appraisal: IRC Section 170(f)(11) .

To determine the FMV of the artwork, a qualified appraisal must be attached to the donor’s income tax return. The appraisal must be conducted no earlier than 60 days prior to the donation or no later than the filing of the due date of the federal tax return.⁵ Further, the appraiser must be independent, in that the appraisal cannot be performed by the taxpayer, the donative institution, or any related person.

Final Steps: Evaluation.

The next step is to review these documents – in particular, the Qualified Appraisal Report by a qualified appraiser (all terms of art in the Treasury Regulations), the CWA, and the IRS Form 8283. Specifically, you must confirm that the Qualified Appraisal Report has been fully attached to the client’s federal income tax return and that IRS Form 8283 was properly completed and signed by both the receiving organization and the appraiser and attached to the client’s federal income tax return for the year the deduction was claimed.

After these required documents have been reviewed and provided in a timely manner, it is usually easy to spot any low-hanging fruit that may result in a full disallowance by the IRS, despite what might have otherwise been recognized as a full charitable deduction.

Purchased at a Discount and Timing Considerations.

In IR-2024-104, the IRS targeted improper art donation deductions and focused on promotors who “encourage taxpayers to buy various types of art, often at a ‘discounted’ price. This price may also include additional services from the promoter, such as storage, shipping, and arranging the appraisal and donation of the art.”⁶ The claimed tax benefit is a charitable tax deduction significantly higher than the actual purchase price of the art. Absent additional special planning, the artwork must be held for at least one year before donations are made to one or more qualified charitable organizations.

Notwithstanding the IRS concerns, there remain legitimate ways to make valid charitable contributions of artwork to qualified charitable organizations. Should the IRS proceed with an examination of these alleged improper art donation deductions, these recommendations may serve as protections to support the claimed full FMV of the charitable deduction and avoid the audit in the first place.

Conclusion

At this point, you should be able to make a preliminary determination whether there are any “Dirty Dozen” issues. You may also want to consider engaging a second appraiser, initially on a Kovel basis, to assist in analyzing the qualified appraisal attached to the return (this analysis would normally be initially protected by the attorney-client or work-product privileges). You should also consider any penalty exposure, primarily whether the 20 percent or 40 percent valuation overstatement penalty might apply.

Depending where you end up in the above analysis, you should be able to advise the client of the exposure issues and how best to proceed with the IRS examination. If the examination goes south, remember you almost always have the right to seek review by the IRS Office of Independent Appeals and the United States Tax Court (or pay the tax and penalties and timely file a refund claim). Or, if the case is a clear loser, recommend conceding the case, or perhaps, filing an amended return eliminating or showing the adjustment to the claimed deduction.

As in the musical “Oliver,” the Artful Dodger is clever, but his activities eventually catch up with him. By noting all the key considerations and addressing these tax issues you can be a powerful ally for your client’s decision to make the gift of artwork and help ensure that it is accepted by the IRS or deal with any challenges that come your way.

“Dirty Dozen: High-income filers vulnerable to illegal tax schemes; face risk from improper art donation deductions, charitable remainder annuity trusts, monetized installment sales,” Internal Revenue Service (Apr 10, 2024) (news release). Available at: https://www.irs.gov/newsroom/dirty-dozen-high-income-filers-vulnerable-to-illegal-tax-schemes-face-risk-from-improper
Ibid.
“The Art Advisory Panel of the Commissioner of Internal Revenue,” Department of the Treasury Internal Revenue Service (2023). Publication 5392 (Rev. 6-2024). Available at: https://www.irs.gov/pub/irs-pdf/p5392.pdf.
Williams v. Comm’r, T.C. Memo 2011-89. (T.C.M. Apr 21, 2011).
Internal Revenue Service, Treasury. Reg. § 1.170A-13(c)(ii)(3).
cit. note 1.