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IRS Art Donation Audits Are the Start of a Tax Pro’s Paper Chase

Fri 3 May 2024 News & Press

In its latest message to wealthy taxpayers, the IRS says it plans to target improper art donation tax deductions, focusing on promoters who “encourage taxpayers to buy various types of art, often at a ‘discounted’ price” but with built-in fees for additional services.

An IRS examination may end up supporting the claimed full fair market value of the charitable deduction—or find the deduction was improperly given. Whatever the outcome, tax advisers should consider the following steps if the agency contacts an existing or potential client who has taken a large tax deduction for artwork donated to a charitable organization.

First, you should determine whether you’re the appropriate adviser to handle the IRS examination, regardless of the level of the donation determination and documentation. Tax or legal advisers may jeopardize the donor’s benefit because of:

Lack of tax knowledge. An adviser without a solid understanding of tax laws and regulations may provide inaccurate guidance regarding art donations.

Unfamiliarity with related-use rules. Art donations must align with the donee organization’s purpose. Advisers who overlook this related-use concept could lead donors astray.

Failure to consider AGI limitations. Charitable contribution deductions are subject to limits based on adjusted gross income. An uninformed adviser might not account for these restrictions.

Inadequate appraisal expertise. For artwork valued at $50,000 or more, obtaining an IRS Statement of Value is crucial.

Conflict of interest. Perhaps that adviser is the actual promoter or is related to the promoter. It’s important to determine potential conflict issues that might run afoul of IRS Circular 230 regarding practice before the IRS.

If you’re satisfied with your qualifications, you should gather all possibly relevant information and documentation about the donation before responding to the initial IRS correspondence—which likely will request the same documentation. Understand the risk and exposure to your client before having any substantive discussion with the IRS examining agent. Don’t respond to the agent until you’ve made an initial review of that documentation.

If that isn’t possible, consider providing the examining agent with an IRS Power of Attorney (Form 2848) to make an introduction. You also can ask for additional time before arranging an initial substantive meeting.

In terms of due diligence for initial information, start by speaking with the client about the donation(s) regardless of whether the IRS examining agent requests it. This discussion should include an understanding as to when, how, and why the artwork was acquired.

It also should discuss the general decision-making process for donating the artwork, the selection and diligence in engaging an appraiser to value the artwork, and what if any diligence was done on the recipient charitable organization(s) as qualified under IRS regulations. This is important to determine whether the client is entitled to a full fair-market-value charitable deduction.

Your documentation request should include at least the following:

  • The origin of how the artwork was acquired, including purchase price and invoice
  • 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 where a completed gift, the contemporaneous written acknowledgment from the donee charitable organization
  • A copy of the income tax return or returns filed with the IRS
  • A complete copy of the artwork’s appraisal report(s) plus any related drafts
  • The engagement letter with the appraiser IRS Form 8283, relating to noncash charitable contributions

It’s critical during this examination to confirm that the qualified appraisal report has been fully attached to the client’s federal income tax return. Then, confirm that IRS Form 8283 was properly completed and signed by both the donee organization and the appraiser, and was attached to the client’s federal income tax return for the year the deduction was claimed. Finally, confirm the same for the contemporaneous written acknowledgment.

After reviewing these documents, it’s usually easy to spot any “low hanging fruit” that can lead to a full disallowance—such as unqualified appraisers, incomplete or improperly completed Form 8283, and missed deadlines—despite what might otherwise be a full deduction if the proper documentation was timely provided. At this point, you should be able to make a preliminary determination if any “dirty dozen” issues are present.

You also may want to consider engaging a second appraiser, on a Kovel basis, to help analyze the qualified appraisal attached to the return. This analysis normally would be protected by the attorney client or work product privileges. You also should consider any penalty exposure, primarily whether the 20% or 40% valuation overstatement penalty might apply.

Depending on where you end up in your 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 US Tax Court (or pay the tax and penalties and timely file a refund claim).

If the case is a clear loser, you can bite the bullet and recommend conceding the case or filing an amended return eliminating or showing the adjustment to the claimed deduction.