Tax Policy Regarding Fractional

Giving
Michael Rushton
(with the research assistance of Sarah Morris)
Indiana University
16th ACEI Conference, Copenhagen, June 2010
The Problem
Most tax systems encourage charitable gifts by allowing a
reduction in income tax (or, in the case of bequests, estate tax)
owing.
If an individual has a large amount of liquid wealth relative to
annual income, and wishes to support a charitable organization, the
tax incentives encourage donating some amount each year rather
than donating one large lump sum in a single year.
But what if the wealth is an indivisible object, such as a valuable
painting? How can the tax system:
Encourage donations of art to nonprofit and public museums, and
Treat donations of art relative to donations of cash (to all
charitable causes, not just museums) in an equitable way?
Fractional Gifts
A potential solution to the tax policy problem is fractional
giving: the donor gives the museum (for example) 5% of the
painting each year for 20 years, at the end of which the
museum is the sole owner. In her income tax filings, the
donor claims a donation of 5% of the painting’s value in each
of the next 20 years. But practical problems arise:
Where does the physical object reside during these years,
and who controls this?
What happens if the painting’s value rises or falls during
the 20 year period?
Suppose the owner/donor dies before the 20 years are over?
Re-stating the Problem: 1
Donors and Recipients prefer tax systems that treat their sorts of
transactions generously. When rules are tightened regarding the tax
expenditures made through donations of art from private owners to
museums, we expect advocates for that sector to say “this is bad for
the arts and museums”.
But as economists we must look for something more systematic in
policy evaluation.
Let us assume for the sake of argument the following:
The government wants to encourage charitable donations through
tax expenditures;
The government does not wish to distinguish between charitable
donations to different sectors, or between gifts of cash or tangible
property.
Re-stating the Problem: 2
There are different ways the government might achieve this, for
example:
A taxable income deduction (as in the US);
A income tax credit (as in Canada).
The method balances the problem of efficient subsidy of charitable
donation while maintaining equity in how the income tax is applied.
Donations of art add extra factors to the problem of the optimal tax
treatment of charitable donations:
The donation is an indivisible object that cannot be in two places
at one time (it must reside with the donor or the recipient); and
It is non-trivially costly to move the object from one location to
another.
Recent policy in the United States
An instructive way to study the problem is to consider
recent policy changes in the US towards fractional gifts.
There have been three eras:
A policy relatively generous towards fractional giving, up
to 2006;
Policy changes that made the system much less friendly to
fractional giving, since 2006 ;
A proposal made in 2009, still in process, that attains
something of a synthesis between the previous two systems.
I will describe these in turn, omitting the finer details of the
legislation.
US Policy Before 2006: 1
Donors could give “fractions” of tangible works of art to museums
in order to best benefit from the charitable deductions in the
personal income tax.
The amount of deduction was the fair market value of the share at
the time of the donation. For example:
In year 1 the painting is worth $1 million, I donate 10%, and can
claim a $100,000 income tax deduction.
In year 2 the painting has appreciated in value to $2 million, I
donate a further 10%, and claim a $200,000 deduction in this year.
The donation must be for the “entire interest”. So, for example, I
cannot donate a tangible work of art but retain the reproduction
rights.
US Policy Before 2006: 2
The recipient is given the right of possession and control
of the work for a fraction of the year according to how
much has been donated.
But, in a key tax case from 1988, known as Winokur, it
was held that the recipient does not need to take physical
possession for the fractional donation to have taken
place. So, for example, the museum might have received
30% of a painting from a donor, yet the painting spends
the entire year in the donor’s home, and the donor still
receives the tax deduction for the donation.
US Policy Before 2006: 3
The tax rules set no time limit on the completion of the
fractional donation – this would be set in a contract with
the donee.
If the donor died before the completion of the donation,
the remaining fraction would then be donated at death,
and valued at fair market value, and would be deducted
from the net value of the estate for estate tax purposes.
US Policy Since 2006: 1
“In Iowa, where I live, it’s pretty simple. Giving is not
keeping.”
Senator Charles Grassley
Changes to the rules governing fractional gifts were in
the Pension Protection Act of 2006, Section 1218.
In a nutshell: Senator Grassley saw fractional giving as
an unjustified and inequitable tax benefit to the art
world, a “loophole” exploited by wealthy collectors and
museums for mutual benefit at a cost to the majority of
taxpayers.
US Policy Since 2006: 2
The amended provisions:
All interest in the property must be fully transferred within 10 years of
the initial donation;
The recipient museum must be in full physical possession of the work of
art by that time and using it in the way that is its principal mission (as
defined by its own application for tax exemption).
Note the donor will pay a price to the tax authorities if this provision is not
met by the museum.
The value of the fractional donation in years beyond the first donation
would be the lesser of the fair market value of the initial donation and the
fair market value at the time of the subsequent donation.
At first (quickly amended) the full value of the art work would be used to
value a deceased donor’s estate, but the allowable deduction would only be for
the value at the initial donation – this provision practically killed the practice.
US Policy Proposal 2009 : 1
The proposed new policy (currently in Senate Committee, Bill s. 1605,
sponsored by Senator Schumer of New York):
All donations to be valued at fair market value at the time of the
donation (including through the estate tax on gifts completed on the death
of the donor), applied to the remaining share of ownership. Recall in the
pre-2006 regime, the value would apply to the whole value of the work.
For example, suppose a work is valued at $1 million at initial donation
of 10%. In year 2 the painting has appreciated in value to $2 million, and
a further donation of 10% is made. What is the value of this second
donation?
Pre-2006: $200,000
2006-2009: $100,000 (10% of initial value)
Proposal 2009: $190,000 (10% of initial value + 10% of 90% of
appreciation = $100,000 + $90,000)
US Policy Proposal 2009: 2
A time limit of 20 years or death of donor (whichever is less),
with at least 10% of the total interest in the initial gift and at
least 20% donated by year 11.
Museums must over a five-year period take possession of the
art and use it for a proportion of time equal to its share of
ownership:
For example, if the donor has given 20% of the work, then the
museum must have and display the work for 1 full year out of five.
These five-year periods start at the first donation.
It remains that the donor will pay the penalty if the donee doesn’t
take possession as it should – we imagine this will be contracted at
the initial donation.
Analysis: 1: The Time Limit
For how long should the donor be able to stretch the full donation? Even
for a one-time cash donation to any charity a carry-forward is available
for 5 years.
This is not just a problem facing fractional gifts of art – it is an artifact of
the choice to tax personal income on an annual rather than a life-time
basis. Assuming that is a given, the problem of charitable gifts that are
large relative to annual income is a second-best problem.
If we have the goal of non-discrimination between types of gifts, then as
long a period as feasible is best, since someone with liquid wealth has
the option of giving a small amount every year until death. The rationale
for having to complete a gift of art over a short time period is unclear,
especially if accompanied by a requirement that the museum have
physical possession of the object for the proportion of time they own it.
Analysis: 2: Location and Use
As stated earlier, our problem is that transport is risky and costly.
Gifts of land and buildings are not as complicated, since there are
well-established rules on joint ownership.
We want:
To avoid the problem of false gifts that so upset senator
Grassley;
To avoid the opposite: a donor having to move a work right
away while only receiving credit for a fractional donation;
Multiple moves with all the transaction costs.
The new proposal seems to strike a reasonable balance – requiring
location based on share, but allowing that to be realized over a 5-
year period.
Analysis: 3: Valuation
To be equitable with respect to charitable gifts of cash,
the new proposal seems to best fit the bill: base the
charitable deduction on the owner’s remaining share
(pre-2006 used 100% of the value of the work even
though some had already been donated) of the current
fair market value (2006-2009 used the lesser of the value
at the time of the first fractional donation and the current
fair market value).
Summing Up
Equity in the treatment of charitable donations would say to treat gifts
of work of art as closely as possible to gifts of liquid or divisible
assets.
Efficiency would dictate likewise unless a claim could be made that
gifts of art are worthy of greater incentives for giving that other types
of gift, and we have not seen that case yet being made.
In that light the current proposals, not yet law, score two out of three:
Value the fractional donation at current market value of remaining
donor’s share (+)
Strike a balance on where the work must be located during the
transition period (+)
Limit the time from the first fractional donation to the last (-).
Which ain’t bad.
References from Legal Scholarship
Samuel G. Wieczorek “Winokur, Lose, or Draw: Art Collectors Lose
an Important Tax Break” Houston Business and Law Tax Journal 8
(2008): 90-112.
Mary Varson Cromer “Don’t Give Me That!: Tax Valuation of Gifts
to Art Museums” Washington and Lee Law Review 63 (2006) 777-
808.
Elizabeth Dillinger “A Not So Starry Night” University of Missouri
Kansas City Law Review (Summer 2008): 1045.
Emily J. Follas “Appropriate Donor Incentives for Fractional Gifts of
Art” Notre Dame Law Review 83 (2008): 1779.
Sean Conley “Legislative Update: Paint a New Picture” DePaul
Journal of Art, Technology and Intellectual Property Law 20 (2009):
89.
References in the Press
Jeremy Kahn “Museums fear tax law changes on some
donations” New York Times September 13, 2006.
Pablo Eisenberg “Congress should end special tax breaks
for art gifts” Chronicle of Philanthropy October 12, 2006.
Stephanie Strom “The man museums love to hate” New
York Times December 10, 2006.
Shelly Banjo “Restoration work on gifts of art” Wall
Street Journal August 8, 2009.
The Art Law Blog:
http://theartlawblog.blogspot.com/2009/08/fractional-gift-
news.html