CGNA: Chapter 7 - Tangible Property, Quick Take-Aways and Intermediate

• Related use and future interest rules limit the availability of fair market value deductions.
• Gift annuities, pooled-income funds, charitable remainder trusts, and charitable lead trusts all require significant evaluation for possible tax issues, marketability and general suitability.
• Tangible property is often difficult to value, and frequently requires a specialist to appraise and evaluate for proper tax substantiation.
• Donors may have an emotional attachment to their collections which may impede the charity’s related use or prudent liquidation process.
• For donated artwork, factors such as blockage, buyer’s premiums, and independent IRS valuation are relevant to the gift transaction and liquidation, if any.
• Donors may not have basis evidence for inherited property or pieces purchased long ago.

Wrinkles in the process to consider include:

• Payment obligations may require the charity to sell the gift, which is an unrelated use (as would be a charitable auction).
• Bequests may be a more effective way to make the gift, either to retain a lifetime interest or as an alternative bequest should an heir disclaim the gift. However, many planners also suggest donating during life to capture a current charitable income tax deduction (even at basis) which would be lost through the estate. This also eliminates life-time donor expenses like insurance, storage and other holding costs.
• Future interest deduction restrictions do not apply to undivided gifts of fractional interests.

Discovery Questions

Donor Questions

1. What is the donor trying to accomplish with the gift?
2. What is the tangible asset’s value and how was that determined (i.e., appraisal or recent transactions)?
3. Legally, who or what owns the asset?

Advisor Questions

1. What is the current tax basis and is it ordinary income or long term gain?
2. What is the likely exit plan for the charity (e.g., auction or private sale)?
3. Does the advisor have an estimate of what a qualified appraisal will cost?
4. Is the asset inventory?

Charity Questions

1. Is the effort worth the expected benefits (i.e., is the juice worth the squeeze)?
2. Has the screening and due diligence process identified any potential problems and can the risks be mitigated (donor restrictions or excessive holding costs—like boat slip fees)?
3. Is there the necessary expertise to accept and manage tangible assets in a timely way?
4. Should indirect gift acceptance be considered, like using external third party foundations or supporting organizations to receive the asset?
5. Is there a clear liquidation plan to maximize the sales proceeds as soon as possible?
6. Can the charity use the assets as part of its charitable mission?
7. How will the charity manage or administer the assets until sale (insurance, transportation, maintenance, storage, etc.)?

Tangible Property Intermediate

by Ryan Raffin

Below is a review on gifts of tangible property. Tangible property topics are based on Armen Vartian’s “Charitable Donations of Art and Collectibles.” For quick take-aways on gifts of tangible property, see Tangible Property Quick Take-Aways. For a review based on that article, see Tangible Property Intermediate. For an in-depth examination adapted and excerpted from the article, see Tangible Property Advanced. For further details, see Tangible Property Additional Resources.

This review of charitable gifts of tangible property has five parts, beginning with a definition of tangible personal property. It then discusses income tax issues, followed by income-producing gifts. The fourth part analyzes nontax issues, before concluding with practical gift considerations.

Unlike many other types of asset, owners and collectors of tangible personal property often have no idea as to the fair market value of their assets. Correspondingly, they are also commonly unaware of the philanthropic opportunities that such property presents.

Review Part 1: Tangible Personal Property Defined

Tangible personal property comes in many shapes and forms (including vehicles, addressed separately in chapter 9). Jewelry, gems, coins, and artwork such as paintings, prints, sculpture, or photography are all common examples. The general definition is any property you can both touch and move.

It is also a complex area of law that changes slightly with every tax code revision. There are some natural tensions between the players involved, given their different goals. Taxpayers hope to avoid taxes on highly appreciated property, but the IRS wants its share, and nonprofits actively pursuing these donations simply want the gift to be completed.

With these broad motivations as guidance, nonprofits should consider specific assets on a case-by-case basis, paying particular attention to related-use regulations. Those regulations play an important role in determining the size of the deduction, and as a result heavily factor into the donor’s plans, and the nonprofit’s ability to accept and liquidate the donation.

Review Part 2: Income Tax Considerations

Tangible assets present special issues for income tax charitable deduction purposes. Relevant questions are:

1. Is the property capital gain property?
2. How will the charity use the donated property?
3. Is the charitable organization a public charity or private charity?
4. Is the donation of a fractional interest only?
5. Is the gift of a present or future interest?

If the property is a capital asset which 1) has been held for over a year, and 2) has appreciated in value, it may be deducted at fair market value. If it does not meet these requirements, the donor’s deduction is limited to actual basis in the property. Collectible items generally meet these requirements. However, items which are “inventory” do not—items held as part of a trade or business, including creator-owned items. Artwork often falls into this exception: art dealers and artists themselves are both limited to cost basis in artwork they donate.

Additionally, donors may receive a fair market value deduction on gifts of tangible personal property only if the property’s use is related to the nonprofit’s tax-exempt purpose. What does this requirement mean? The IRS states that an unrelated use is one without connection to the purpose or function constituting the basis of the charitable organization’s tax exemption under Section 501. Further, the donor must prove that the use is not unrelated, or must show that it is reasonable to anticipate there will not be an unrelated use. If the use is unrelated, the deduction is limited to the donor’s cost basis.

The amount of the deduction also depends on the nature of the charity. A gift to a public charity (receiving over a third of its support from the public) means that the deduction can be up to 50 percent of adjusted gross income—although important caveats usually end up capping the deduction at 30 percent. Similarly, a gift to a private foundation (receiving less than a third of its funding from the public) means that the deduction will be capped at either 20 percent or 30 percent. In any case, the donor will carry over any undeducted amounts for an additional five years beyond the donation year, so long as the charity puts the property to related use.

Donations of fractional interests in artwork—typically to museums—are allowed with certain stipulations:

1. The donor (or donor and museum together) must own 100 percent of the artwork prior to making the gift.
2. The donor must agree to donate the remaining interest she holds within ten years or on death, and
3. The charity must take physical possession of the work and put it to a related use within that time-frame.
4. Additionally, the deduction is limited to the lesser of originally appraised fair market value or current value—meaning no increased deduction for appreciations in value.

Gifts of a future interest impact the donor’s tax deductions as well. The IRS considers the contribution to be made only when earlier or intervening interests in the asset have expired. For tangible property, this usually comes up in a context where the donor reserves a lifetime right to use and possession, and also in the context of charitable remainder trusts. For example, if a lifetime right to possess donated artwork is retained, the contribution will not occur until that interest expires—whether due to the donor’s death or relinquishment of the interest.

Review Part 3: Income-Producing Gifts

How do planned giving vehicles which produce income for the donor impact the tangible property gift analysis? Both related use and future interest rules affect planned giving vehicles. Charitable gift annuities, remainder trusts, and pooled-income funds all merit consideration.

When tangible personal property is exchanged for a charitable gift annuity, there is no gift of future interest. This is because the transfer gets part-gift, part-sale treatment. Hence, the donor will not receive a full deduction, but will be able to deduct the gift portion due to the transfer of his present interest, if the charity puts the property to a related use.

Pooled-income funds and charitable remainder trusts satisfy related use requirements when the trust’s use would qualify if the nonprofit organization itself was using the property. Since the trust will likely sell the property to meet its obligations, that use is not normally within the tax-exempt purpose of most nonprofits. As a result, related use rules are not met, and the full charitable deduction is not allowable. Further, these gifts to a pooled-income fund or charitable remainder trust are considered gifts of a future interest. But, since the trust is likely to sell the asset in relatively short order, the donor’s interest does terminate.

Finally, note one significant exception to the future interest rule. It does not apply to contributions of an undivided fractional interest. This means that when a charity is donated a one-quarter interest in a painting, it has an immediate right to use and possess the painting for the corresponding time period (three months per year, in this case). Since the interest is immediate, the donor gets a corresponding proportionate deduction.

Review Part 4: Nontax Issues

Of course, tax considerations are not the only relevant ones. The tax effects of various planned giving vehicles were discussed above, but there are other factors to discuss when evaluating which charitable vehicle is best for both the nonprofit and the donor.

Charities should carefully evaluate the marketability of the offered property when considering a charitable gift annuity or pooled-income fund. This is because the nonprofit is obligated to make annuity payments regardless of income the asset generates— even if it cannot be sold. As a result, the charity may conservatively value the property to compensate for market risk.

Charitable remainder trusts, meanwhile, are well suited to tangible gifts of property. A flip unitrust in particular is a good structural fit, since the payments can be set to begin only on sale of the asset (with net income before sale—likely zero dollars). A net income unitrust or standard unitrust may also work due to more limited distribution obligations. However, the nonprofit will still need to produce cash at some point to meet its payment obligations. A charitable remainder annuity trust is an unappealing option since they have fixed payment obligations, and cannot receive additional contributions.

A gift of a future interest is not deductible, as discussed above. Further, such a gift will also be taxable for gift and estate purposes. As an alternative, donors should consider donating by bequest, which would preserve the asset for the donor’s lifetime use.

Donors can fund charitable lead trusts with tangible property in some cases. However, non-income-producing property will incur a capital gains tax for either the grantor or trust itself. Further, since tangible personal property is difficult to value (and therefore difficult to estimate the income the charity will receive), careful analysis is required before using this particular vehicle.

Finally, even if tangible personal property is left to family members or friends, this does not mean the property will be accepted. Estate tax, insurance, or simple upkeep concerns may result in a refusal. For this reason, the will should include a right to disclaim, with the property going to a specified charity in that case.

Review Part 5: Practical Gift Considerations

Tangible property often involves more emotional attachment than say, interests in LLCs or mineral royalties. If the charity displays the gift, this can be a very gratifying public acknowledgment. Donors and charities alike should be aware that these personal connections can greatly influence the gift for better or for worse, and often in unpredictable ways. For this reason, charities should work with donors and their advisors to plan the gift out as clearly as possible.

These advisors should usually include financial and legal professionals, but should also include an advisor who can help with the valuation and potential sale of the asset. The advisor should be independent (not affiliated with a museum or dealer), and work alongside existing financial or legal planners to structure the transaction plan in a way that best satisfies all interested parties. Two factors that impact the value are the “buy- er’s premium” which auction houses will charge, and “blockage” reducing the price of collections sold as a unit. The charity’s advisor may be the same professional appraiser who values the asset for taxpayer deduction purposes.

Moreover, the nonprofit and donor should work together to ensure compliance with regulations. This includes verifying the nonprofit's tax status, the property’s gain character, and planned use, among others. As the value of the donated asset increases, so do IRS valuation and appraisal requirements. Donated art over $20,000 in value must include a copy of the appraisal with the tax return. If it is both over $50,000 and selected for audit, the IRS’s Art Advisory Panel must review and make recommendations on the claimed value. The IRS generally defers to the Panel for its official position on value, and rarely alters its initial conclusion.