Introduction
They say that art is in the eye of the beholder.
It might be more accurate to say that art, at least when it comes to its value, is in the eye of the Internal Revenue Service (“IRS”). Cognizant of transactions supposedly involving charitable art donations and inflated appraisals, the IRS has sounded the proverbial alarm bell. In the context of tax enforcement, this generally means making public announcements and then initiating a compliance campaign. This sounds simple enough, but, as this article explores, the IRS might encounter several problems in the realm of art donations if it does nothing more than roll out its standard procedures.
Observations about Art Donations
A key issue with all charitable donations is value. Always a difficult question, things can get downright complex when it comes to gifts of art. This is because art, by its very nature, is unique. IRS Publication 5497 explains that a credible art valuation includes lots of information, including, a comprehensive description of the work, details about when, how, and for what price the work was acquired, a history of the work sufficient to authenticate it, a high-quality image, and the basis for the appraisal.
The IRS often does not take the donor at his or her word with respect to valuation; it has its own specialized groups to handle this. For instance, the IRS has an internal team of appraisers that responds to anticipatory valuation requests by taxpayers and supports the IRS during tax audits, appeals, and litigation. It is called Art Appraiser Services. The IRS also relies on outside help, Art Advisory Panel. That is a group of up to 25 experts who, according to IRS Publication 5392, meet regularly, discuss pending valuation issues, and supply “information, advice and insight into the world of art which cannot be obtained effectively from within the IRS.”
Warnings of New Art Abuse
The IRS announced in late 2023 in Information Release 2003-185 that “unscrupulous promoters” were marketing transactions involving “exaggerated art donation deductions,” “inflated values,” “questionable appraisals,” and outcomes that are “too good to be true.” After exhausting all its standard buzzwords in an effort to grab headlines, the IRS got down to business. It explained that the promotion contained the following elements:
Promoters encourage taxpayers to buy various types of art at “discounted” prices, offer additional services for which they can charge fees (such as shipping, storing, or appraising the art), find charities willing to accept the art donations, tell the taxpayers to hold the art for more than one year so that it is characterized as long-term capital gain property, and help the taxpayers claim tax deductions based on the fair market value of the art, instead of the discounted price at which they obtained it approximately one year earlier.
The IRS did not limit itself to threatening to fully disallow excessive charitable deductions and impose penalties. In fact, with the apparent goal of toughening its stance, the IRS also stated in Information Release 2003-185 that it might not accept the “reasonable reliance” defense to penalties because taxpayers “are always responsible for the information reported on their tax returns.”
The IRS further warned charities that they should implement measures to avoid “enabling these schemes.” Finally, ending on a predictable note, the IRS professed to have already initiated dozens of taxpayer audits and promoter investigations.
Possible Application of Routine Procedures
The language in Information Release 2003-185 is very similar to that employed by the IRS in the context of its ongoing battles against “syndicated conservation easement transactions.” The IRS typically uses a four-step process when attacking such easements. First, the IRS attempts to invalidate a transaction based solely on some supposed problem with one of the vast number of documents donors must file with the IRS.
Second, the IRS raises several judicial theories for criticizing the donation, such as it lacked economic substance.
Third, the IRS claims that the donation should be worth $0, based on a technical issue, judicial notion, or internal valuation. Finally, the IRS asserts that the donor should be hit with the highest possible penalty. The IRS appears poised to use easement-like arguments in attacking art donations. Doing so could create at least two significant problems for the IRS, as explained below.
First Problem – Economic Substance and Charitable Donations
Section 7701(o) of the Internal Revenue Code states that in situations where the economic substance doctrine applies, a transaction is acceptable only if it meets two criteria. First, the transaction must change the economic position of the taxpayer “in a meaningful way,” not taking into account federal income tax effects.
Second, the taxpayer must have a “substantial purpose” for participating in the transactions, aside from getting federal income tax benefits. Things do not stop there, though. Section 7701(o) expressly says that this two-part test does not even come into play unless the case involves “a transaction to which the economic substance doctrine is relevant” in the first place. In what seems troublesome for the IRS in connection with its current focus on art donations, several cases, including one issued as recently as November 2023, have held that the economic substance doctrine is not relevant to charitable donations. A few key cases are summarized below.
The taxpayers in Skripak v. Commissioner, a Tax Court case from 1985, participated in a program whereby they bought scholarly books for one-third of their retail price, held them for more than one year, donated the books to rural public libraries, and claimed charitable donation deductions based on their full retail price. The IRS fully disallowed the deductions and imposed penalties. Its primary theory was that the transactions in question lacked economic substance and, therefore, should be ignored for tax purposes. The Tax Court rejected the IRS’s argument, stating the following:
“[The IRS] spent a great deal of time attempting to show that [the taxpayers] were completely inexperienced in every aspect of the book business and that [they] had virtually no chance of realizing an economic profit from their alleged acquisition and disposition of the reprint books. The record abundantly established that to be the case. Although we accept the truth of these matters, we have made no express findings on these facts because they are not pertinent to our inquiry. The deduction for charitable contributions provided by Section 170 is a legislative subsidy for purely personal (as opposed to business) expenses of a taxpayer. Accordingly, doctrines such as business purpose and an objective of economic profit are of little, if any, significance in determining whether [the taxpayers] have made charitable gifts . . . [T]he deduction for charitable contributions was intended to provide a tax incentive for taxpayers to support charities. Consequently, a taxpayer’s desire to avoid or eliminate taxes by contributing cash or property to charities cannot be used as a basis for disallowing the deduction for that charitable contribution.”
The Tax Court came to a similar conclusion in Hunter v. Commissioner, a case from 1986. There, the promoter bought large amounts of prints from a gallery at low prices because the gallery had owned them for a long time and failed to sell them to visitors. Specifically, the promoter bought the prints for one-sixth of their retail price, sold them to the taxpayers for one-third of their retail price, and then assisted the taxpayers in donating the prints and claiming charitable deductions for their full retail price. The IRS took the position that the charitable deduction should be $0 because, among other things, the series of transactions arranged by the promoter lacked economic substance and the taxpayers “merely purchased a tax deduction which promised a three-to-one write-off on their investment.” The Tax Court disagreed. Referencing Skripak v. Commissioner, the Tax Court explained that the IRS cannot use a taxpayer’s desire to reduce taxes as grounds for disallowing a deduction under Section 170 because Congress enacted that provision to incentivize supporting charities.
The next case, Weitz v. Commissioner, was released in 1989. It featured taxpayers who participated in a program pursuant to which they pooled funds with other investors, had their agent purchase medical equipment in their names at bankruptcy auctions for low prices, stored the equipment for more than one year, donated the equipment to hospitals, and claimed charitable deductions based on the retail value of the equipment. The taxpayers expected a four-to-one return on their investment.
The IRS claimed that the donation should be worth $0 for several reasons, most of which concerned economic substance in some manner. The Tax Court, as it did in the two earlier cases described above, discussed the inapplicability of the economic substance doctrine to charitable donations. It explained the following:
“Section 170 allows a deduction from tax with respect to donations to charitable institutions even when the donation is carefully contrived to comply with the requirements of the applicable rules and regulations. [The taxpayers’] actions have been planned and executed to assure that their donation of medical equipment to [the hospital] would come within the definition of a deductible charitable contribution and all of the steps necessary to accomplish that goal have been effectuated. [The taxpayers] cannot be penalized for being careful.”
The most recent case, which involved a conservation easement donation under Section 170, is Mill Road 36 Henry, LLC v. Commissioner. It was released in late October 2023. The IRS argued that the taxpayer lacked the necessary donative intent because “it was primarily motivated to monetize the federal income tax deductions for its investors” and “it was subjectively motivated not by disinterested generosity but by tax avoidance.” The Tax Court rejected this argument, noting that the existence of tax benefits is not problematic in the charitable donation context:
“That federal income tax benefits are a consideration in determining whether to make a contribution does not undermine the validity of the contribution. It may be that the ideal donor does not let his left hand know what his right hand is doing . . . but Section 170 does not insist on that ideal. Rather, a donor motivated by guilt, or by the hope of being admired, or by the desire for a tax benefit, may still deduct his contribution. Congress long ago decided to incentivize charitable contributions by allowing a deduction for those contributions, and it would be perverse indeed to deny a deduction to a donor simply because he had responded to the incentive. The Government may not “take away with the executive hand what it gives with the legislative.”
Second Problem – Extreme Valuation Position
The IRS has traditionally adopted an extreme position when it comes to the valuation of conservation easements. As explained above, the IRS invariably claims, at least initially, that the tax deduction should be $0. It appears that the IRS is heading down this same path when it comes to certain art donations. This type of unreasonableness might backfire on the IRS, as it has in other situations.
The Tax Court has exhibited its frustration in several art donation cases over the years, indicating that radical valuation stances by the IRS, followed by an unwillingness to reconsider its positions before trial, are not helpful to the tax dispute process and force judges to make decisions beyond their expertise.
The Tax Court has also rejected the idea, often advanced by the IRS, that the amount a taxpayer paid for a particular piece of art is the only proper measure of its value when later donated.
For example, in Rhoades v. Commissioner, a case from 1988, the Tax Court dismissed the suggestion that the “purchase price is the only reliable basis for determining the fair market value at the time of the contribution.”
The Tax Court took the concept a step further the following year, in Mast v. Commissioner. The taxpayers donated to a university the largest collection ever assembled of stereoscopic plates, prints, and related materials. The IRS urged a valuation of $0, but the Tax Court found that the taxpayers were entitled to about 90 percent of what they claimed. It suggested that the unreasonable valuation position by the IRS in its Notice of Deficiency, combined with a lack of evidence to clearly support such a position at trial, should have consequences. Indeed, the Tax Court concluded that “[u]nder such circumstances, any presumption of correctness that might attach to [the IRS’s] determination in the Notice of Deficiency loses its conviction.”
Conclusion
The IRS is searching for abusive art donations. History shows that, notwithstanding the potential problems described in this article, the IRS might insist on challenging donations using the economic substance doctrine and adopt a starting point that all donations are worth $0 for one reason or another. Experience also dictates that when the IRS implements this type of compliance campaign, it often catches not only bad actors but also some taxpayers who are making genuine, properly-valued contributions to charities. All taxpayers making art donations, therefore, should be aware of the issues and potential defenses explored in this article.