The Challenges for Art Donation (Part 2 of 3): Economic Substance

As discussed in part one of this series on art donations, a taxpayer who wishes to receive a tax deduction for their charitable donation of a work of art should take several steps in anticipation of the Internal Revenue Service’s (IRS’s) refusal to allow the deduction. In recent years, especially, the IRS has undertaken a significant effort to crack down on illegitimate deductions, which has meant that some legitimate deductions have been caught in the same net.

Typically, when the IRS challenges a charitable donation, whether through conservation easement or through an art donation, it tends to follow a similar set of tactics. Often, the IRS begins by raising technical issues in a taxpayer’s documentation to substantiate a donation. Then, the IRS points to judicial rulings to claim that the transaction lacks economic substance because the taxpayer was motivated by the tax deduction. Finally, if at all, the IRS will claim that the donation has an inflated value or a questionable appraisal. If the donated item were actually worth $0 and the taxpayer claimed otherwise, they would be liable for significant penalties. Those are the taxpayers that the IRS is rightfully pursuing as those taxpayers are abusing the system for their own selfish gain.

Economic Substance

The economic substance doctrine has two criteria to determine whether the transaction is treated as having economic substance. See Internal Revenue Code (IRC) § 7701(o). The first, sometimes called the objective profit potential test, looks to see whether the transaction “changes in a meaningful way…the taxpayer’s economic position.” The second, sometimes called the subjective non-federal-income-tax-purpose test, looks to see whether “the taxpayer has a substantial purpose…for entering such a transaction.” These two criteria of the economic substance doctrine do not apply, however, unless the situation at issue involves “a transaction to which the economic substance doctrine is relevant.” In other words, there is a prior test to determine whether economic substance is relevant at all.

The economic substance doctrine is defined as “the common law doctrine under which tax benefits…with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.” See IRC § 7701(o)(5). But, as the case law has determined and further defined over the years, the economic substance doctrine is not typically relevant to transactions which were intended to qualify for tax incentives. If tax deductions are obtained in exchange for charitable donations, the courts have determined that usually the economic substance doctrine is not relevant.

Donated Books

The taxpayers in Skripak v. Commissioner, 84 T.C. 285 (1985) participated in a charitable contributions tax shelter program involving scholarly reprint books. The taxpayers executed a series of documents purporting to evidence the purchase of these reprint books at a cost of one-third of the publisher’s catalog retail list prices. Approximately 6 months later, once there had been a significant capital gain on the property, the taxpayers donated the books to small rural public libraries and qualified to receive deductible contributions. See IRC § 170(c). The taxpayers claimed deductions for these “charitable contributions” in the amount of the publisher’s catalog retail list prices. In other words, they claimed three times what they had paid for their “subscriptions” to the book contribution program.

After an IRS audit, the IRS disallowed the claimed deductions in full and imposed penalties on the taxpayers. The IRS claimed that the transactions lacked economic substance and thus should be ignored for tax purposes. The Tax Court, however, rejected this argument. The Tax Court found that Section 170 deductions for charitable contributions were provided by legislative subsidy for personal (as opposed to business) expenses of a taxpayer. As a result, the business purpose and an objective of economic profit bear little, if any, significance in determining whether a taxpayer made a charitable gift. Because the Section 170 deduction for charitable contributions was intended to provide a tax incentive for taxpayers to support charities, “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.”

Donated Artwork

Another Tax Court case involved taxpayers purchasing “limited edition prints” and later donating those prints to museums. See Hunter v. Commissioner, T.C. Memo. 1986-308. In this case, Martin S. Ackerman was able to purchase the limited edition prints from a gallery that had possessed the prints for a long time, but had been unable to sell. Mr. Ackerman purchased the prints at one-sixth of their price. He then sold the prints to the taxpayers at issue for one-third their retail price, and assisted the taxpayers in donating the prints and claiming the charitable deductions for their full price. In this case, Mr. Ackerman handled much of the paperwork from the point of acquiring the prints through the donations of the prints.

When the IRS audited the taxpayers, they claimed that the taxpayers should get a charitable deduction of $0. The IRS claimed that the taxpayers had “merely purchased a tax deduction which promised a three-to-one write-off on their investment.” The Tax Court, however, rejected the IRS’s argument, holding that the taxpayers’ tax avoidance motive did not preclude allowance of a deduction, similar to Skripak.

Donated Medical Equipment

A third Tax Court case, similar to Hunter, involved taxpayers pooling their money to purchase medical equipment at bankruptcy auctions. The taxpayers then donated the purchased medical equipment to hospitals, after storing it for more than a year, and claimed charitable deductions based on the retail value of the equipment. See Weitz v. Commissioner, T.C. Memo. 1989-99. In this case, like Hunter, the taxpayers relied on an agent, Barry Adler, to purchase the medical equipment. Even after paying Mr. Adler for his work, the taxpayers expected a 4-to-1 return on their investment.

The IRS once again claimed that the taxpayers’ deduction should be $0, due in part to economic substance of the donations. The Tax Court rejected this argument again, finding that “petitioners actions complied in every respect with statutory requirements. As we recently noted in Skripak v. Commissioner, supra, 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] cannot be penalized for being careful.”

The IRS has warned against improper art donation deduction promotions, but as far as the Tax Court is concerned, taxpayers have a right to pursue art donation for the explicit purpose of getting the charitable donation tax deduction. That being said, as outlined in part one of this series, taxpayers can anticipate some of the moves the IRS will make in disallowing charitable donation tax deductions. The IRS’s increasingly common position that donated property is worth less than the taxpayer’s donated value will continue to get challenged in Tax Court, as will be addressed in part three of this series.

It is important to point out that the taxpayers who prevailed in the above cases took steps to reasonably value and appraise their donated items. Those fair market values tended to be three to five times their acquisition cost. Taxpayers who have lost in Tax Court tend to be significantly more aggressive with their appraised values, in some cases, those values can be fifteen or twenty times their acquisition cost. While that sort of appreciation is certainly possible, especially in the art world, taking such a position on a tax return should require that the taxpayer be certain to properly substantiate their audit file.