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Income Tax Planning for Visual Artists, Their Dealers, Investors, and Collectors

Posted on Feb. 8, 2021
[Editor's Note:

This article originally appeared in the February 8, 2021, issue of Tax Notes Federal.

]
Herbert I. Lazerow
Herbert I. Lazerow

Herbert I. Lazerow is a professor of law at the University of San Diego. He thanks the University of San Diego Law School for providing a research grant to help complete this report. He also thanks Ed Brennan, Roy Brooks, Derrick Cartwright, Ken Coveney, Paul Dostart, Miranda Perry Fleischer, Paul Frimmer, Liam Gaarder-Feingold, Iris Jones, Alvin Katz, Lori Kirk, Jane Lazerow, Dennis Lilly, John Palley, Paul Roy, Christine Steiner, and Diana Wierbicki for their advice and assistance.

In this report, Lazerow examines deductions and other tax benefits available to artists, art dealers, art investors, and art collectors.

Copyright 2021 Herbert I. Lazerow.
All rights reserved.

I. Introduction

The tax issues of visual artists, art dealers, art investors, and art collectors all revolve around the same type of property: artwork. Be it a painting, drawing, print, sculpture, photograph, fabric, or glass art, that property raises tax issues for which advance planning can be useful. Some tax problems are shared by artists, dealers, investors, and collectors alike, such as the necessity to prove a profit motive in order to deduct expenses.1 However, those four categories of taxpayers face different tax results for the same activity in some cases, such as when artwork is sold or donated.2 This report explores those similarities and differences and suggests steps advisers can take to maximize tax benefits for their clients. It occasionally questions whether the similarities and differences — or the rules applied by the IRS — make sense.3

Clients from the art world come in a variety of packages. A few artists are wildly successful, and some have trouble making enough money to pay the rent. To survive financially, many artists follow the adage “Don’t give up your day job.” Their economic status may change from year to year — an artist who earns a living solely by selling artwork may have years of plentiful sales followed by years in which nothing sells, and vice versa. Art collectors and investors are usually prosperous, with income from investments or other endeavors. Art dealers run the gamut from well-to-do to “Why did I ever commit myself to running an art gallery?” The tax planner needs to consider many different possibilities.

II. Business Expense Deductions

A. Activity Engaged in for Profit

Artists, dealers, investors, and collectors alike would prefer to deduct their business expenses in the year in which those expenses are incurred. Whether they are able to do so depends initially on whether their artistic activities are “engaged in for profit.”4 This intensely fact-based question is designed to separate for-profit activities, whose expenses are generally deductible, from personal activities, whose expenses are not deductible. Because people often pursue the production or collection of art as a hobby, with little intention of making a profit, a line must be drawn between artists and collectors who are seeking a profit and those who are not. This is an old problem, but recent restrictions on some deductions make the distinction between profit-seeking activities and hobbies less crucial.

Few people object to their hobbies producing a bit of extra cash. For that reason, many people have some hope of turning a profit. The profit-seeking requirement aims to distinguish taxpayers whose motivation is profit from those whose motivation is pleasure.5 Trying to divine the taxpayer’s subjective intent is extraordinarily difficult. Before 1969, courts spent inordinate amounts of time trying to determine whether taxpayers who engaged in activities that most people considered pleasurable were in fact engaged in that activity hoping to make a profit, even though it produced losses.6

In 1969, to reduce the volume of cases that were litigated to determine whether pleasurable activities were profit-seeking, Congress enacted section 183.7 Some people view section 183 as a provision that restricts deductions,8 which is understandable given the way the statute reads. However, a closer reading reveals that subsections (a) and (b) simply restate the existing rule that one is not entitled to deduct expenses unless they are in a profit-seeking activity or Congress has specifically granted the deduction.9 (As of 1969, Congress had specifically granted deductions for interest10 and taxes11 if the taxpayer itemized deductions.) Subsection (c) of section 183 clarifies that an activity that is not engaged in for profit is an activity for which deductions are not allowed under section 162 (trade or business expenses) or section 212(1) or (2) (expenses incurred to produce income or to maintain income-producing property). Again, nothing new.

However, subsection (d) adds a rebuttable presumption that a taxpayer is considered to be engaged in an activity for profit if the activity shows a profit in three of the preceding five years. Any time an artist can show that income has exceeded expenses for three of the previous five years, she has the benefit of this presumption of intent to make a profit. Although the IRS can always challenge that result because the presumption is rebuttable, I have not found a case in which the IRS succeeded in proving that a person who met the three-of-five-years test was not profit seeking.12

Therefore, if an artist-client manages to turn a profit in three of the five previous years, she has all the factors on her side toward establishing that she is engaged in the artistic activity for profit. Whether she can accomplish that with a bit of accounting sleight of hand is another question. One route is to keep expenses low in three years in which artwork is sold. Producing or dealing in artwork that is more salable for disposal in the selected years, bunching the delivery of commissioned work in those years, or discounting work more heavily in those years might be other ways. Purchases by friends or relatives count, as long as they are genuine sales.

What if your client is unable to meet the three-of-five-years profit rule? She retains the right to argue that she was nonetheless engaged in a profit-seeking activity. The volumes of published court opinions are littered with taxpayers who failed in that attempt,13 but others have succeeded. What is the secret of success?

The regulations place weight on objective facts in determining whether a person is engaged in an activity for profit. It is difficult to see how subjective matters, other than the taxpayer’s self-interested statements, could be introduced into evidence.14 Statements about the taxpayer’s past intent would be deeply discounted because of their self-serving nature. But statements of intent made by the taxpayer to third parties before the tax controversy arose seem to stand on different footing.15

The regulations specify that a reasonable expectation of profit is not required. A small chance of a large profit is sufficient.16 What is required is a genuine intent to seek a profit.

The regulations set forth nine factors, listed below, that should normally be considered, but they also clarify that all facts and circumstances regarding the activity are to be taken into account and that other relevant factors may enter the calculus. No one factor is determinative, and a result is not to be reached by simply counting factors.17 Presumably, one weighs the significance of each of the following factors:

  1. the businesslike manner in which the activity is carried on;18

  2. the expertise of the taxpayer or his advisers;

  3. the time and effort of the taxpayer (or his employees) devoted to the activities;

  4. the expectation that assets used in the activity will increase in value;

  5. the taxpayer’s past success in similar or dissimilar activities;

  6. the taxpayer’s history of income or losses in the activity;

  7. the relation of profits to losses, and the relation of both to the investment and value of assets;

  8. the paucity of the taxpayer’s income from other sources; and

  9. the elements of personal pleasure or recreation.19

Like most multifactor tests, this test is not particularly helpful in predicting results in actual cases. Many cases have been decided under these regulations. In the following sections, I analyze noteworthy cases and try to determine the importance of different factors to the final decisions.

1. Artists.

First, let’s look at taxpayers who actually claimed to be artists, such as Gloria Churchman.20

Churchman and her husband, a professor at the University of California at Berkeley, claimed losses from her art activities on their joint returns for 1970-1972 — principally depreciation on Churchman’s in-home studio. In a 1977 opinion, the Tax Court found as fact that Churchman had an undergraduate degree (although it did not mention her major) and two and a half years of graduate work in both psychology and art. Her media included painting, sculpting, designing, drawing, building, writing, performing, and filmmaking. Over the 20 years preceding the trial, Churchman taught at San Francisco State College, the University of California Extension, and the Mendocino Art Center, and gave numerous independent workshops (presumably all on art). In 1969 she designed and ran a gallery where the work of many artists, as well as her own work, was shown and sold. During the 1970-1972 period, Churchman exhibited her work at least once a year at commercial galleries and at her home studio. In the year before trial, she was in three gallery shows. Churchman had also had two one-woman shows.

Although Churchman sold numerous works, she had no artistic income in 1970-1971 and had only $250 of artistic income in 1972. In none of the 20 years during which she pursued her artistic activities did Churchman’s artistic income exceed her artistic expenses. When some of her works did not sell, she made lower-priced work such as posters.

At the time of trial, Churchman had an inventory of 46 paintings, numerous drawings, and a film. She maintained a mailing list of 200 people, consisting of students, friends, customers of her art gallery, and members of organizations to which she belonged. Churchman kept a notebook in which she recorded what she sold and to whom, and she kept receipts for her expenses. She did not keep records of gifts of her art to friends or relatives, and she did not have a separate business bank account.

The court began by observing that in some respects, Churchman’s artistic activities looked like a hobby. She had a history of financial losses, and the court noted that artwork is commonly regarded as a recreational activity. The court then emphasized that being an artist involves two different types of activity: production, which the hobbyist and the business artist share, and marketing, which has little appeal for the hobbyist. Churchman devoted substantial time to marketing her artwork.

In general, the court was impressed by Churchman’s expertise and the businesslike way in which she approached the art world. Although her recordkeeping was not CPA caliber, it seemed reasonably adequate for the volume of business Churchman was doing, according to the court. It was impressed by her art studies, her ability to snag gallery shows and a grant to make a movie, and her shift to production of less expensive work to make sales. The court was also impressed, albeit mistakenly, by Churchman’s inventory of unsold works and mailing list. (In my opinion, neither an inventory of 46 unsold paintings, a film, and drawings nor a 200-person mailing list are particularly large for someone who has devoted herself to art for 20 years.)

Churchman testified that she sought personal recognition as a skilled artist and believed that financial profit was a key marker of that recognition. The court commented that whether she wished to make a profit because of love of lucre or because it symbolized fame was irrelevant as long as she wanted to make a profit.21 This should be the majority approach. Determining intent is difficult enough as it is; nothing in section 183 or the regulations requires distinguishing between wanting to make a profit because it symbolizes recognition and wanting to make a profit for any other reason.22

There are litigation lessons to be learned from Churchman. The case concerned only three years, 1970-1972, but the evidence presented covered a 20-year period (presumably 1957-1977). Why was anything that occurred before 1970 or after 1972 relevant to Churchman’s state of mind during the three years in question? It is a clear tenet of tax law that things that occur before or after the tax year in question do not change the amount of tax due,23 and that is true here. If Churchman had sold $1 million of art in 1977, that would not change the numbers on her 1972 return. But the question in this case related to intent, not numbers. To determine intent in current years, actions in past years are certainly relevant.24 In Arrowsmith,25 the Supreme Court recognized that a transaction in a prior year that was connected to a payment in the current year could be considered to determine whether the loss was ordinary or capital.

The regulations recognize this. Most of the factors to be considered in determining whether the taxpayer has profit-making intent inevitably require evidence about things that occurred in previous years, such as businesslike performance, expertise in the field, the expectation that assets will increase in value, the taxpayer’s previous successes, the history of income and losses, and the availability of other resources for support. So once the taxpayer’s profit-seeking intent is put into question, all her activities from childhood26 to the date of trial may be introduced into evidence.

While it is clear why evidence of a taxpayer’s activities in years that preceded the years at issue is admissible, it is not so clear why things that occurred after the years at issue are relevant. The argument must be that sales and values of art are so unpredictable that evidence of changes should not be excluded just because they happened to occur after the years at issue. This consideration of years not at issue presents an opportunity for counsel to make clients appear more businesslike in the remaining years before the litigation, which might help in a close case.

Even art professors are not immune from this profit-motive scrutiny, although the IRS usually has other reasons for challenging the taxpayer’s return. Take, for example, Susan Crile, a tenured art professor at Hunter College who, over 40 years, made more than 2,000 pieces of art.27 Her work hangs in at least 25 museums and has been purchased by 14 Fortune 500 corporations and six major law firms, as well as the U.S. government. Crile has been represented by five New York galleries and been reviewed by major art critics. She kept extensive records of sales, receipts, and expenses. Crile also promoted her work through her galleries and a mailing list with 3,000 names. She sold more than $1 million of art, subject to the usual gallery commission of 50 percent, and sometimes received nothing when a gallery went bankrupt before paying her.

The Tax Court said the test was whether Crile “conducted her art business with a predominant, primary, or principal objective of earning a profit.”28 That test is internally inconsistent because the terms “predominant,” “primary,” and “principal” all require that the thing be more important than anything else, whereas the indefinite article “a” admits that there are other factors of equal standing. This was the pre-section-183 test.29 The court easily found that four factors strongly favored Crile, that three factors weakly favored her or were neutral, and that two factors weakly favored the IRS. It concluded that Crile was engaged in an activity for profit.30 My reaction is that if this taxpayer was not engaged in being an artist for profit, no one whose expenses exceed her income should be considered engaged in an activity for profit.31

Not all artists have fared as well under the regulations. In fact, the list of persons held not to be engaged in art for profit is long.32 A good example is Richard Stasewich, who lost two cases in the Tax Court.33 Stasewich was a CPA and a painter of nudes. He kept a journal of receipts from sales of his artwork and a shoe box full of credit card statements for expenses. He took out an Illinois retail sales license, tried to sell his work, advertised, was mentioned in newspaper articles, and employed art students as assistants. Stasewich operated both his art and CPA businesses from his home. As of the trial in the first case, he had no budget or financial projections; his books were not designed to help him cut expenses or increase income; and despite years of losses, he made no change in his method of doing business or the kind of art produced.

As of the trial in the second case, Stasewich had shifted from nudes to portraits and installations, but his marketing was minimal, as were his sales, although his books were kept more professionally. The court discounted his shift from nudes to portraits and installations because that shift did not result in more income. The court noted Stasewich’s outside CPA income, but it was modest from 1985-1998 (less than $10,000 in five of those years, around $27,000 in two years, and $15,000-$21,000 in the other seven years). This was enough to pay the rent, but hardly enough to finance a lavish lifestyle. Militating against Stasewich were the size of the losses, which significantly dwarfed his artistic income for all years. In two years, his losses equaled his accounting income.

It is not unusual for artists to be unable to earn enough from the sale of their work to support themselves. The classic answer is to find a patron. Perhaps the most famous was Lorenzo de’ Medici (1449-1492), known as “Lorenzo the Magnificent” for his spending on culture. Today patrons are more often close relatives, such as spouses. Alternatively, artists keep their day jobs. Many artists have day jobs related to their art, such as teaching studio art in colleges or high schools, as Crile and Churchman did. Others, like Stasewich and serious artists who nonetheless are lawyers or medical professionals, have day jobs unrelated to their art. In every case in which the artist has an alternate source of income (or presumably wealth, if the artist is living from accumulated capital), he must go out of his way to prove a profit motive. This is true even though it is textbook law that a person may have more than one enterprise in which he is seeking profit.

What helpful advice for artists can practitioners glean from the regulations and cases?

One piece of advice is that the artist’s efforts should be geared toward the goal of avoiding controversy with the IRS, rather than successfully litigating a case. Winning in court means simply losing less than if one lost in court. The artists who successfully litigated their cases were represented by counsel,34 and some of them were aided by the testimony of expert witnesses.35 Lawyers seldom work tax cases pro bono, nor do expert witnesses. Thus, the artists’ tax savings were offset by the costs of achieving them.

Note that a large number of these cases are litigated because many of the claimed expenses do not appear to be justifiable as costs of the artist’s profit-seeking activity. The judge attributed to Crile the theory of claiming deductions because “most experiences an artist has may contribute to her art and . . . most people with whom an artist socializes may become customers or otherwise advance her career.” While this may be true as a matter of fact in the art world as in other occupations,36 it proves too much, making many ordinary living expenses deductible. Crile claimed phone and cable bills; newspaper and magazine subscriptions; doorman tips; taxis to the opera, museums, and social events; restaurant meals with friends and acquaintances; and international travel to gain inspiration from paintings in European museums.37 The lesson is that the client should claim only expenses that can be related to the production and sale of art and that do not present themselves as personal living expenses.

Another lesson is to conduct affairs in a businesslike manner. Few artists prepare a detailed business plan before they begin making art for a living. A business plan is helpful but not indispensable. An annual review can substitute for or supplement an initial business plan. Each year the client should review the financials from the previous year and decide what she can do to improve them in the coming year. Then do it. In the popular conception, the fun part of the art world is in creating the art, not in marketing it. However, it is the marketing part of the plan that needs both intention and implementation.38

Further, marketing one’s art requires contemporaneous recordkeeping. Most artists are aware that they should record the works they produce and, when a work is sold, record the name of the buyer or the buyer’s agent, the price, and the amount of the gallery’s commission. (Not all artists are good about recording those details.) When the artist visits a gallery to try to persuade it to carry his work, he should record the date and time of the visit, the name of the person spoken to, the length of the interview, and the response. The same is true for other marketing attempts.

Although time spent creating the art may be pleasurable, it should not be discounted as “fun time.” The artist should keep contemporaneous records of time spent producing art, as well as time spent marketing it. This sounds like punching a time clock. It is. We also know that even when not in the studio, artists frequently think about ways in which they can improve the art they are working on. Nonetheless, the artist can no more persuasively credit time shaving and thinking about art or exercising and thinking about art than I can credit similar time thinking about this report. An artist who has contemporaneous records of the amount of time spent producing art when that is the sole activity is in better shape for settlement than one who estimates, three years after the tax year has ended, how much time was usually spent on the activity.

The contemporaneous recordkeeping that needs to be done is the recordkeeping appropriate to the enterprise. Several judges have commented that the artist-taxpayer lacked a separate bank account for the art business. It is hard to generalize without conducting a survey, but I suspect that some artists have separate business bank accounts and some do not. An artist who has few sales during the year and no employees, or an artist who freelances for two magazines, is paid quarterly, and has few expenses other than his apartment rent, which includes a studio, probably does not need a separate bank account. An artist who has many sales (even if each is for a small amount), employees, or numerous expense items probably needs a business bank account. If representing an artist whose profit-seeking motive was questioned, I would come to the audit with a survey of whether profit-making artists in the community with businesses similar to my client’s have separate bank accounts for their art businesses. In no case has the existence or lack of a separate bank account seemed determinative.

Probably the most important criterion is conducting the art business in a businesslike manner.39

Another seemingly important criterion is the persistence and size of the claimed losses from art, especially compared with the gross revenue from that activity. In many cases the loss years in question do not stand alone; they follow several other years in which the expenses of the art business dwarfed its income.40 Courts have reacted favorably to attempts to change the business to reduce or eliminate those losses, even if the attempts were unsuccessful.41 Even if losses are not eliminated, a record of increasing receipts tends to be persuasive,42 as is an explanation for any unusual circumstances creating continued losses.43

Most of these cases did not address the question of defining the precise contours of the taxpayer’s profit-seeking enterprise. For instance, one could well have divided Churchman’s profit-seeking activity into three separate activities based on her roles as artist, art teacher, and gallery operator. That was not done; her profit-seeking activity was quite broad. Contrast that with Douglas Chandor,44 who conceived the idea of painting a triple portrait of Franklin D. Roosevelt, Winston Churchill, and Joseph Stalin as they met at Yalta. He painted artist’s studies of Roosevelt and Churchill, but Stalin refused to sit for him. When Chandor sold the Churchill portrait, he claimed a capital gain on the sale. He proved that his regular artistic activity was painting portraits on commission and that this was the only portrait that he had ever completed on speculation. Because the portrait was not property held “primarily for sale to customers in the ordinary course of his trade or business” of painting portraits on commission, the sales income was capital gain.45

The scope of the artist’s profit-seeking activity was an issue in Crile. The IRS argued that Crile was engaged in the trade or business of being an employee of Hunter College. A duty of her employment, beyond teaching, was to create and market art, so the activities that she cited to try to prove that she was in an independent, profit-seeking activity were in fact part of her work as an art teacher and thus should limit her deduction, according to the IRS. The court compared Crile’s art-producing activity with the minimum that would be required by her tenured position and decided that because her activity exceeded that minimum, she was engaged in a separate business.46 Had the IRS succeeded in its argument, Crile would have been entitled to a deduction only if she itemized, and then only to the extent that the expenses exceeded 2 percent of her adjusted gross income.47

The IRS has had similar problems persuading courts that different activities outside the art world should be considered separate profit-seeking activities rather than a single activity. Courts have considered whether the same employees work on different activities, whether there are synergies among the activities, and whether it is common to combine the activities in a single enterprise.48

2. Dealers.

I would not expect dealers to have trouble convincing the IRS that they are engaged in a profit-seeking enterprise. Few people consider dealing in art a hobby, and a dealer is likely to have many sales.

Dealers can be divided into three rough categories: auctioneers, gallerists, and brokers.

Auctioneers hold public sales of artwork. The assumption is that an auctioneer is selling work as an agent for the owner, but that is not necessarily the case. Nothing prohibits an auctioneer from selling works that the auctioneer owns, and there is no requirement that an auctioneer disclose whether he is the principal or the agent on a particular sale. Auctioneers are usually involved only in selling works that have already passed from the artist to a collector — the secondary market. Note that some auctioneers are also brokers, although they like to call these sales “private treaties.”

The gallerist will have an inventory of artwork in her possession on consignment.49 She will have a physical facility in which those works may be displayed. She normally deals in both works that an artist is trying to sell (the primary market) and works that have already passed from the hands of the artist into the waiting arms of a collector or investor, who now wishes to convert them into money (the secondary market).

A broker, often known as a private dealer, will normally not have an inventory. Brokers work to put buyers and sellers together (although often without disclosing the identity of either party to the other). The broker’s “inventory” is a deep knowledge of who owns what art, who would like to buy what art, and the ability to finalize a deal between a buyer and seller. The broker normally deals only in the secondary market.

The classification of online art sites is not clear. Some are run by brick-and-mortar galleries and should be classified as gallerists. Others partner the seller with a normal gallery. Some sites allow a seller to post a photo of the artwork for sale. And some sites run online auctions. Some combine two or more of those activities. Classification will depend on the methods of doing business.

This report does not address art consultants. An art consultant is a person who advises someone about potential purchases or sales of art but is neither a party nor an agent in the sale. The classification breaks down because the same person can function as an auctioneer, gallerist, broker, and consultant on different transactions.50

Most dealers are involved only in the marketing end of art, which, as noted, people do not usually regard as a pleasurable activity. Dealers do not produce the art (although one should remember that during the year in which she ran a gallery, Churchman tried to sell her own art as well as the work of others).

One would expect auctioneers and gallerists to have far more extensive records than brokers because they possess art belonging to others and normally have a venue for displaying that art.

It is doubtful that any of the dealers discussed in this section would have difficulty establishing that they are profit-seeking enterprises. The exception is when the person incurs sizable losses year after year while operating in a way that does not seem businesslike and that appears to be designed as a vehicle for the deduction of travel and other living expenses.

3. Collectors and investors.

I define an art investor as a person who buys and sells art with the intention of making a profit based on the supposition that the sale price will exceed the purchase price, as increased by the costs of the sale and holding the art.51 By contrast, a collector buys art to put together and enjoy a collection. A collector may also be a person who uses art as wallpaper. Some collectors are also investors. Tax law draws a line between investors, who under normal circumstances can deduct some of their costs (but not in tax years ending before 2026), and collectors, who can use their costs only to reduce the amount of gain they report on a sale. No reported case has yet held that anyone who claims to be an investor invests in art with a profit-seeking motive, but there is one such case involving a stamp collector.52

The classic art case involved Charles and Jane Wrightsman, whose names now grace 13 galleries of French decorative arts at the Metropolitan Museum of Art in New York.53 In that pre-section-183 case, the trial commissioner recommended that the couple be found to be engaged in a profit-seeking activity, but that view secured the vote of only one Court of Claims judge. The six-judge majority held that the Wrightsmans were not investing in art with a profit-seeking motive.

The Wrightsmans began collecting 18th century objets d’art in 1947, admittedly as a hobby. They acquired expertise on their art period, published books on the subject, and consulted at the Met. The couple kept 80 percent of their collection in their New York City apartment, which they occupied only 30 days a year. The remainder was either kept in their Palm Beach apartment, where they resided for roughly 150 days each year, or was on loan to the Met. The Wrightsmans maintained both a detailed inventory and a catalog of their collection. They distrusted the stock market, so all their assets were invested in oil interests, which they then diversified into art.

The Wrightsmans bought many works of art over the next 15 years (including the 1960 and 1961 tax years at issue), spending about $5.5 million. That sum rose to almost $9 million by the time their case came to trial, at which point the works were valued at almost $17 million for insurance purposes. As of the trial date, the couple had sold only a few items from their collection. They had deducted costs of maintaining their collection — such as insurance premiums, maintenance, subscriptions, and shipping — as well as their hotel, travel, and entertainment costs in looking for art in Europe.54 The couple kept detailed records for their art activity, just as they did for the investments in their oil businesses.

The claims court rejected the IRS’s attempt to establish per se rules under which personal use of the property would disqualify an investment intent and taxpayers would have to show some action inconsistent with personal use. It instead required that the Wrightsmans prove that investment was their primary purpose. The court acknowledged that investment was a purpose for the couple, but it found that their primary purpose was personal pleasure. There was no discussion of the substantial tax benefits that must have resulted from donating some of the items to museums.55

The one dissenting judge believed the “pleasure” factors cited by the majority were just as applicable to investment intent. To him, the plan to invest in art as a way to diversify the risk of investing in oil — plus the fact that the trial commissioner, who heard the witnesses, found that the Wrightsmans were engaged in the collection of art primarily for investment purposes — tipped the scales in the couple’s favor.

Another pre-section-183 case involved the Barcuses, who collected and sold antiques.56 Some of the antiques were used as their home furnishings, while others were stored in the basement. Many of the stored antiques were later promoted to home use. There were no contemporaneous records showing which antiques were bought for personal use and which were part of the business. The couple generally sold pieces at far below the markup typical for antique dealers, and they sometimes sold at a loss. The Barcuses did not advertise, and they had not turned a profit in the dozen years before the years at issue. Their purchases far outnumbered their sales.

The court said the test was whether profit making was the taxpayers’ purpose for undertaking the activity. In response to the Barcuses’ argument that they had hoped their antiques would appreciate in value, the court said that “speculative hope of a profit at some time in the future” was not persuasive of profit-making intent in this case.

Results did not improve much for loss-deducting collector-investors after section 183 was enacted. One example is Mary Stanley, who collected and sold antique glass novelties.57 After 10 years, she had a collection of about 2,500 items. During the same period, she sold or traded 295 items that were duplicates or upgrades of items in her collection. Stanley published a book on glass toys, which she sold at her cost, for an overall loss. She kept careful records of acquisitions but did not keep financial records on the purchase and sale of glass. The novelties were stored at various places in her home, which she showed by prearrangement to dealers and others. Stanley did not turn a profit in any of eight years, and she deducted automobile expenses, travel expenses, subscriptions to general interest magazines, and depreciation on parts of her residence.

The court imposed a primary purpose test. Stanley’s main claim was that she anticipated that the objects would appreciate in value, to which the court responded:

A potential for appreciation is inherent in many, if not most, of the items which have traditionally been collected as a hobby, e.g., stamps, coins, works of art for the pleasure afforded by the acquisition and possession of the collection itself. The mere fact that a collector is aware that the value of his collection may increase does not mean that he is primarily motivated by an expectation of profit rather than the personal satisfaction derived from pursuing a hobby.58

Stanley never had the collection appraised. The court held that her glass activities were not primarily motivated by profit.

Courts have reached the same result in other cases.59

However, in Tyler,60 a pre-section-183 case, a stamp collector succeeded in convincing the court that he was a stamp investor. Before George Tyler began collecting, he consulted with friends who were stamp collectors and with a professional philatelist. They advised him that stamps were a sound investment and referred him to people who had profited from rising stamp prices. He compared prices in the Scott stamp catalogue over the years and confirmed the price increases. Tyler retained a professional philatelist (Philip Ward) as an adviser, who suggested that the most likely candidates for appreciation were U.S. stamps and those of British colonies. Tyler put most of his collection in those areas. Ward testified that Tyler picked up the typical hobbyist’s enthusiasm but did not engage in typical hobbyist activities like showing his collection or discussing stamps with other hobbyists. Tyler bought only stamps recommended by Ward, although not all the stamps that Ward had recommended.

When Ward offered Tyler the opportunity to sell a block of stamps at a profit, Tyler sold them. During the Depression, when Tyler needed money for a new house, he sold stamps. He decided to liquidate his stamps in 1936 because of worry about the European situation and the desire to be more liquid, but he put off the sale several times because the market had deteriorated. Tyler eventually liquidated part of the collection at a substantial loss. Meanwhile, he had kept extensive records of his purchases and sales, and of the changes in market value of individual stamps over time. Although the court found that there was some element of pleasure, the investment element was predominant.

Faced with that array of unfavorable precedents and only a single success, how can counsel advise a client who wishes to be considered an investor rather than a collector?

Again, most of the cases involve taxpayers who have claimed deductions for what look like ordinary living expenses, such as travel and meals, rather than expenses that are more closely related to art, like securing the opinions of art historians. The first lesson should be that a collector claiming to be an investor in art should have an otherwise clean return and claim only expenses clearly related to the investment. This may be less of a problem in the future, given the substantial restrictions placed on the deductibility of travel, meals, and entertainment enacted in the Tax Cuts and Jobs Act.61

In many cases, the taxpayer was using the property in everyday living. Investors should avoid this. Although it may be expensive, taxpayers might consider having their art professionally stored. If the art is of museum quality, a less costly alternative is to find a museum willing to exhibit it and relieve the investor of the cost of insuring the art.

It is important to keep careful records, although one probably need not keep records as extensive as those kept by Tyler’s staff. The problem is that keeping extensive records does not distinguish a collector from an investor if the records pertain only to the physical properties, creation, and provenance of the work. An investor will keep careful records of prices achieved at auction by other works by his artists, or by comparable works of comparable artists.

Most important if investor status is to be achieved, the investor should have a business plan indicating the rate at which she anticipates that the art will appreciate and roughly when she plans to sell it. That plan should be firmly based on experience. If comparable Picassos appreciated 100 percent in the past 20 years, it is not unreasonable to anticipate a doubling in the next 20 years. If you have a plan for each acquisition and most of them are based on experience, a few hunches can also be played. When the investor deviates from the plan, it is important to make a contemporaneous note of the financial reasons for doing so, such as a change in the market.62 The clincher for Tyler was that most of his interactions with his adviser Ward seem to have been about the financial side of philately and were by letter or contemporaneously put in writing, so convincing evidence was available at the time of trial.

B. Deductible Expenses

If you are successful in persuading the IRS that your client is engaged in a profit-seeking activity, what can your client deduct? She can deduct much less than she could have half a century ago, and only after running a gauntlet unimaginable in the days of Churchman.

1. Portions of the home.

Churchman’s principal deduction was for the studio that she maintained in her home. Once she established that she was profit seeking, the deduction followed immediately. That is no longer the case. In 1976 Congress enacted section 280A to address two largely unrelated problems with a common theme — the taxpayer’s home. One issue was the extent to which a taxpayer could deduct the cost of a vacation home that was sometimes rented to third parties. This report examines the other issue: the taxpayer’s deduction for using part of her home in her business, primarily as a home office.

Section 280A imposes several conditions on securing the deduction, most of which an artist or broker can satisfy with careful planning. But this will be difficult for a gallerist or investor.

Section 280A is structured much like section 183. It begins with a subsection that sweepingly disallows deductions for the use of taxpayer’s dwelling unit except as specifically allowed in other subsections, and then it exempts itemized deductions otherwise allowed regardless of profit-seeking motive.63 Business deductions are allowable if the space is exclusively used in the taxpayer’s trade or business and is either (1) the taxpayer’s principal place of business, (2) a place where customers deal with the taxpayer in the normal course of business, (3) a structure not attached to the dwelling unit, or (4) for day care use.64

a. Artists.

For most artists with home studios, the principal place of business requirement is easy to meet because the studio is their main (and only) place of business. Although many cases have espoused a “focal point” test under which the principal place of business is where the person delivered the service,65 that seems unreasonable for surgeons or trial lawyers, for whom it is difficult to say that the person’s principal place of business is the hospital or courthouse, respectively, where neither has an office. The better view is that the principal place of business is usually where the person spends most of her working time, although other factors, such as the importance of the business functions performed at various locations, may be considered.66

Even for an artist who has gallery representation, the gallery is not the artist’s principal place of business; it is the gallerist’s place of business, and the artist is not expected to spend significant time doing business there.67 The fact that the place of business belongs to someone else does not disqualify it from being the artist’s principal place of business. In cases involving employees when the employer provides an office or workplace, the employee’s principal place of business will usually be the one provided by the employer.68 When the place provided by the employer is inadequate to do the job for which the employee was hired and the home space is where the employee spends most of his working time, the home space is the principal place of business for the convenience of the employer.69

The artist has a more difficult time if the home studio is not her principal place of business and it is not in a structure detached from the dwelling unit.70 Although many artists may speak to prospective gallerists and purchasers by phone or email from their studios, that does not qualify as use by customers; customers must be physically present there, and the use must be substantial.71

The second criterion for deductibility is the “exclusive use” condition. For anything to be deductible, the space must be used exclusively for the qualifying business.72 However, the portion exclusively used does not need to be a separate room, as long as it is identifiable.73

Some artists may give art lessons to children, the elderly, or those who are unable to care for themselves. Use of the residence in the trade or business of operating such day care centers is a fourth use that qualifies the part of the home used for deductibility. The artist must be licensed for day care use of the property if the state in which the day care center operates requires licensure.74

Contrary to the rules applying to the principal place of business, places used by clients, and separate structures, the day care use of the home need not be the exclusive use. If the use is not exclusive, the deduction attributable to it cannot exceed the ratio of the number of hours of day care business use to the total hours available.75

However, the use of a space for a second or third trade or business need not be the exclusive use as long as all uses meet either the principal place of business, meeting with clients, separate structure, or day care tests, and it must cumulatively be the space’s only use so that the space is exclusively used for businesses that comply with section 280A(c)(1).76

A second exception to the exclusive use test is for storage of inventory. Most artists have substantial inventories of unsold work. If a space is regularly used to store that inventory, that need not be the exclusive use of that space during the tax year. However, the dwelling unit must be the only place of business the taxpayer has for that trade or business.77

Having satisfied the above tests for tentative deductibility, the question might be asked, “How much is really deductible?” When an artist who rents or owns a home uses part of the dwelling for business, only the cost of the business part can be deducted. The cost of the part used for business may be determined in any reasonable way, but it is most commonly determined on the basis of square footage.78

In lieu of making that calculation, the taxpayer may use the simplified method by deducting $5 per square foot, up to 300 square feet ($1,500). This method has some advantages other than simplification. If the taxpayer itemizes, he can also take the full deduction for mortgage interest and real property taxes instead of allocating it between business and nonbusiness use. A second advantage is that the taxpayer is not deemed to have taken depreciation, so there is no depreciation recapture on the sale of the unit.79 The downside is that $1,500 is not much and buys less space each year because of inflation.

The third and most devastating hurdle is the gross income limit. Deductions are limited to the amount by which gross income from the business use of the home exceeds the sum of the other business deductions plus itemized deductions allowed for the area. In other words, gross income does not really mean gross income. There is instead a specialized definition of gross income, which is gross income less otherwise allowable deductions (such as mortgage interest and real property taxes) less other deductions allocable to the home use (such as labor and supplies).80 Allocations are to be made by any reasonable means.

An amount disallowed can be deducted in the next tax year if there is enough gross income in that year to support it.81

As a result of the enactment of section 280A, neither Churchman nor Criles could deduct the cost of their home studios today, because they had no gross income allocable to their art activities in the same tax year.82

b. Dealers.

Most auctioneers and gallerists will have a commercial space in which they hold auctions and display artwork. Because that is both the focal point for meeting the public and the place the taxpayers spend most of their working time, it is likely to be their principal place of business. Unless they have home offices that are physically separate from their dwelling units, these taxpayers will need to rely on the home office being a place where they frequently meet with clients. The IRS is likely to be suspicious of this, so it is important for the dealer to keep careful records of when and for what length of time he met with clients there. The records should include the name of the client and the nature of the business discussed.

A broker may have no other place of business and thus be able to qualify under either the principal place of business test or the meeting with clients test. Again, careful records are required; without them, the IRS may assume that client meetings were by phone or email or at the client’s home or business.

The limitation to gross income less otherwise allowable deductions applies here also, but most dealers will have sufficient income to support the deduction.

c. Collectors/investors.

Even if an individual proves that he is an investor rather than a collector, he cannot deduct expenses of a home office because each of the three possible conditions for a home office deduction — principal place of business, place where the taxpayer meets regularly with clients, and a separate structure — requires that the space be used in connection with a trade or business. The Supreme Court held long ago that an investor for his own account, no matter how active, was not engaged in a trade or business.83 Lacking a trade or business, there is no deduction for a home office.

Even in the absence of this requirement, an investor who sold no work during the tax year would be stymied by the limit on the deduction to gross income from the endeavor.

2. Inventory.

a. Artists.

The general rule for inventory is that it is an asset. Like other assets, its cost must be capitalized. This is, the cost of buying or producing the piece of inventory is not deductible but is attached to the asset and recouped for tax purposes when the asset is sold.84 For most businesses, this is not a problem because the majority of inventory is sold soon after it is produced. Artists are different, however; most of them maintain substantial inventories. For a typical business, if an item does not sell, the business stops making it. By contrast, an artist continues to create work, hoping to strike a potential purchaser’s fancy. Thus, it can be years between the production of the work and its eventual sale. Under the general rule, the artist would be unable to recover her costs during all that time.

Congress came to the rescue, exempting qualified creative expenses of freelance writers, photographers, and artists from the need to capitalize rather than expense their costs of producing work.85 An artist is defined as an individual whose personal efforts create “a picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design, or original print edition.”86 In determining whether an expense is a qualified creative expense, one should evaluate the originality and uniqueness of the object and the predominance of aesthetic value over utilitarian value.87

Thus, artists can deduct all the costs of producing work as they are spent.

b. Dealers, collectors, and investors.

Dealers, collectors, and investors — unlike artists — must capitalize the expenses of acquiring and storing artwork. They can recover that cost for tax purposes only when they sell the work.

3. Education.

A person who is engaged in a trade or business can deduct some education costs as ordinary and necessary business expenses if the education meets one positive requirement and two negative ones. The positive requirement is that the education must maintain or improve skills required in the business.88 The negative requirements are that the education cannot be the minimum required to enter the taxpayer’s business and cannot qualify the taxpayer for a new business.89

Under these rules, a person who is in the business of being a painter could certainly deduct the tuition and other expenses of a painting course to improve her painting skills. An oil painter could deduct the costs of learning to paint with watercolor or gouache without running afoul of the “new trade” restriction. The same would be true of a wood sculptor learning the techniques of working clay, metal, or stone. Given the many artists who produce work in multiple media, perfecting a given art form does not qualify the artist for a new trade90 — she is still an artist.

There are no cases specifically addressing when an artist seeking education is maintaining and improving her skills.91 The closest analogy is probably to teachers who claim the expenses of travel because it better educates them to teach. Courts have granted deductions when the primary activities of the travel appear to improve teaching92 and denied it when the travel seemed more like tourism.93 The cases most likely to result in deductibility were situations in which the teacher proved the later classroom use of the trip.94

Education is not disqualified just because it leads to a degree, as long as it does not qualify the taxpayer for a new business.95 On the other hand, despite Crile’s admittedly correct belief that all experience prepares you to be a better artist, not all education is deductible. An artist getting a liberal arts degree can deduct the cost of the art courses, but not the history or math courses, absent a much stronger tie to her art.

An artist who obtains an MFA or a PhD in art history may stand in a different place. The MFA is regarded as a terminal degree qualifying one to teach studio art at a university, and the PhD is a terminal degree qualifying one to teach college-level art history. What is not clear is whether those businesses are different from being an artist. Going from classroom teacher to guidance counselor or principal is not a new trade, nor is moving from psychiatrist to psychoanalyst96 or from dentist to orthodontist.97 A lawyer receiving an LLM in tax does not enter a new business.98 On the other hand, going from being an accountant to being a CPA qualifies as a new business,99 as does gaining admission to practice law in another state.100 The same is true for moving from being an Air Force pilot to being a flight engineer certified by the Federal Aviation Administration,101 and from being an actuarial analyst to a certified actuary.102 Being a registered nurse is a new profession for a licensed practical nurse.103

In most of the litigated cases, the losing taxpayer either received a degree or prepared for a qualifying test, but the opinions addressing new business qualification have focused on duties and responsibilities. It is perhaps fair to say that absent the blessing of the regulations, courts have seized on any significant change in activities or responsibilities to find that a person is qualifying for a new profession. For this reason, although the artist taking an occasional course may deduct its cost, the artist in a formal MFA or PhD program deducts the cost at her peril. The question is not whether you enter a new occupation, but whether you qualify for it.

The same comments apply to a dealer’s educational expenses. As with the artist, I have found no cases on educational expenses of businesspersons. In general, a dealer is likely to find that various courses are helpful in his business, whether they be studio art, art history, economics, or marketing. If the dealer is admitted as a candidate for an MBA or other degree, a court may find that he has qualified for a new business and deny the deduction. It should not. The businessperson may be advantaged by the fact that there are few licenses to which an art dealer might aspire. However, the gallerist whose education qualifies him to be a regulated auctioneer may find that he has qualified for a new business.

The same applies to an investor.

4. Travel.

a. Travel to business.

An artist, dealer, or investor can deduct her expenses of business travel. Artists will typically be asked to be artists in residence, giving master classes or advising students on their work. The cost of travel (if not reimbursed) from the artist’s principal place of business to this secondary business is deductible. If it is away from home, unreimbursed meals and lodging are also deductible.104 Artists may have shows to which they need to travel or transport their art. They may travel to try to secure gallery representation or otherwise promote their work.

The same is true of dealers, now that a substantial part of art marketing takes place through art fairs, although the continued existence of those fairs during a coronavirus pandemic seems doubtful.105

b. Travel as education.

Travel, as a form of education, is a vital part of the history of the visual arts. Some old master painters did not travel as part of their early education,106 but most of them traveled to other countries where they had the opportunity to see a variety of art, landscapes, and societies, and immerse themselves in other cultures. One of the prime exercises of learning to paint was to try to reproduce the great work of previous masters.

Contemporary artists can continue this tradition of travel, but they can no longer use a reduction in taxes to help finance it. There is no longer a deduction for travel as a form of education.107

That does not mean that artists can no longer travel to foreign locations to benefit from great art and deduct the cost. If the traveling artist is enrolled in an educational institution, she may be able to classify a claimed deduction as education rather than travel as education.108 However, enrolling may not be enough. Prudent artists secure a statement from the educational institution recording their presence in class and in outside activities, in case of later audit.109 It is also useful for artists to detail in writing, in advance, how the educational program will help their artistic career.

The same rules on travel apply to dealers and investors, although those taxpayers are less likely to claim travel as education. Dealers and investors may spend considerable time traveling to see the work of emerging artists or to inspect possible purchase or representation of works alleged to be by established artists. When the travel leads to an immediate business deal, the dealer should have no problem deducting it. The investor always, and the dealer sometimes, faces the question whether the expense should be capitalized. When a purchase is made, the cost should certainly be capitalized as a cost of acquiring the asset. But what about “dry holes” — situations in which expenses are incurred but no purchase is made because the investor’s or dealer’s perception is that the purchase price demanded is too high to support any eventual profit? Those costs are deductible.

5. Other ordinary and necessary business expenses.

Artists, dealers, and investors may have other expenses that can be deducted, most of which can be placed under the heading of marketing expenses.

Investors will have ordinary maintenance expenses — such as insurance, security, framing, restoration, climate control, cleaning, storage, and lighting — that can be deducted after 2025.110

Artists are often asked by universities to participate in the education of current art students. The arrangement usually entails reimbursement of travel expenses and a small honorarium. These invitations are coveted as reputation-enhancing. To the extent that the cost incurred is not reimbursed, it should be deductible, and usually is.

However, the IRS challenged the deductibility of Sam Gilliam’s unreimbursed expenses.111 A Washington color-school artist, Gilliam was invited to teach for a week at the Memphis Academy of Art. He had a history of hospitalization for mental illness. Before getting on the plane, Gilliam took a new medicine to control his anxiety. During the flight, he acted irrationally and eventually assaulted another passenger. He was arrested on arrival in Memphis. At trial, Gilliam was found not guilty by reason of temporary insanity. He deducted the attorney fees for his defense, which the IRS disallowed. The Tax Court, in a strange opinion, agreed. I say “strange” because the court was confronted by two seemingly controlling precedents favoring Gilliam — Dancer and Clark112 — which it proceeded to distinguish in a fashion that made no sense.

Dancer stands for the proposition that the cost of accidents that occur while the taxpayer is traveling from one place of business to another is an ordinary and necessary business expense. In Clark, the taxpayer was able to deduct as an ordinary and necessary business expense the cost of settling civil and criminal charges of attempted rape while interviewing a job candidate. The Gilliam court’s attempted distinction was that it is ordinary to commit an intentional criminal offense while performing business duties, but not ordinary to commit one while traveling on business.113 Given the ridiculousness of the distinction, one should probably not regard Gilliam as a significant impediment to future deductions by artists.

Again, it is wise to remember that deducting items that look like vacation or living expenses is likely to tickle IRS audit antennae, so one should be prepared to link the specific item to specific business done. Gilliam did that. The trip to Memphis was not a scouting expedition; he was invited to do a job for which he was paid. The trip was directly from his tax home (Washington, D.C.) to his secondary employment (Memphis) and back. Taxpayers should be prepared with similar justifications in travel cases.

It is always preferable to receive a smaller honorarium plus travel expenses than a larger honorarium, so there is no argument about whether the travel expenses are deductible.

6. Start-up costs.

Business expenses are deductible “in carrying on any trade or business.”114 Expenses of preparing to carry on that business are generally not deductible.115 Start-up expenses are allowed on a limited basis.116 In the year in which the business begins, the taxpayer can deduct up to $5,000 in start-up expenses unless he elects to capitalize them.117 The remainder of the start-up expenses may be amortized over 180 months beginning with the month in which the business begins.118

The fundamental question is when a business begins. That question is easily answered for an auctioneer, who must secure a state or local license to operate his business. The business does not begin before the license is secured and the taxpayer begins to do what he is licensed to do.119 But no license is required for an auctioneer in some states, or for a dealer, an art investor, or an artist. For situations in which no license is required, the classic definition is that one is engaged in carrying on a trade or business when one holds oneself out to the public as being willing to sell (or presumably buy) goods or services.120 It is a matter of when you begin to do the business of your business, and the classic definition puts the emphasis on the realization requirement that runs through U.S. tax law.121

As a result, an artist may not be in business while creating her first canvas. She probably needs to take some step to try to sell it before she is engaged in a trade or business. The dealer should either solicit artists or buyers. The auctioneer needs to not only have a license but also begin moving toward holding a sale. The investor might take steps toward identifying suitable investment artwork.

Once entered into the business or investment, not all investigations of opportunities will move forward. Being in a business, explorations of other ways in which to operate the business are deductible until they become part of the cost of acquiring a new asset. At that point, they must be capitalized.

However, the art investor is not in a business. The cost of acquiring art must be capitalized to the particular artwork. The cost of investigating art that is not acquired might need to be capitalized ratably to all the art that the investor acquires, or it might be deductible currently as a loss. If each artwork represents a separate transaction, the taxpayer should be able to deduct the loss represented by the expenses incurred in failing to make the purchase.122 When an investor tries to acquire a group of paintings from a single individual and succeeds with some but not with others, he must probably capitalize all those costs to the works he purchased.

7. Qualified business income deduction.

Since 2018, a deduction has been available under section 199A to taxpayers in specific businesses. That deduction equals 20 percent of the amount by which that business’s qualified business income exceeds the taxpayer’s net capital gain, but it cannot exceed 50 percent of the Form W-2 wages paid to employees in that business.123 This obviously excludes both collectors and investors because neither is engaged in a trade or business.124

a. Artists.

The first problem that confronts an artist who wishes to take advantage of the section 199A deduction is qualifying for it. The deduction is not available to every trade or business, and it is never available to an employee.125

A second no-no is a person in a specialized service trade or business, which includes services in healthcare, law, accounting, performing arts, consulting, athletics, “or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”126 One might wonder whether that includes visual artists. The reputation and skill of the artist are certainly the main assets of the artist’s business. On the other hand, unlike the other service providers listed, the artist actually delivers a physical product — artwork — which might take her out of the category of service provider altogether.

For most artists, there is a low-income safe harbor. No independent service provider is disqualified from the deduction if her income is below a specified amount. That threshold amount was $157,500 in 2018,127 plus $50,000, with each figure doubled for a taxpayer filing a joint return.128 Thus, an artist filing a joint return can take advantage of the section 199A deduction if taxable income does not exceed $415,000. However, there are several catches.

If the artist’s income exceeds the threshold amount, the deduction is reduced by the percentage that the excess income over the threshold amount bears to $50,000. So if an artist who does not file a joint return has taxable income of $182,500 ($25,000 more than the threshold amount), her deduction is reduced by 50 percent.129

Most artists will have no trouble keeping their taxable income below the threshold amount. Highly successful artists will greatly exceed it.

However, the largest problem facing the successful artist is the fact that if the artist’s income exceeds the threshold amount, the deduction is limited by the size of the artist’s payroll. Most artists probably have no employees. Some may have a few employees, often part time, to do preparatory tasks like preparing and stretching canvases. A successful artist might employ a bookkeeper, although that job is more likely to be given to an independent contractor. In short, the section 199A deduction for most highly successful artists will be minimal because the Form W-2 wages they pay in a tax year will likely be small.

Artists whose taxable incomes do not exceed the threshold amount (probably the great majority of artists) are not subject to the wage limitation and can deduct the full 20 percent.130

b. Dealers.

The dealer is likely to be in a different situation, for several reasons.

First, the dealer is not engaged in the sort of service business that would disqualify him from being a qualified trade or business. This is true even although the success of any business, especially that of an art dealer, is probably attributable in substantial part to the skill of the owner.

Whether a dealer will have significant employee expenses depends on the kind of dealer he is. Gallerists must pay the salaries of gallery sitters, auction houses must have substantial crews to make their auctions run smoothly, and private brokers may act alone. If the dealer’s taxable income does not exceed the threshold amount, the 20 percent deduction is available regardless of the level of employment that the dealer provides.

8. Passive activity losses.

a. Artists.

Having survived the above obstacles, artists who have a loss for the tax year that they wish to use to offset other income must escape the prohibition on deducting passive activity losses. A passive activity is a business or investment activity in which the taxpayer does not materially participate.131 The code defines material participation as being regularly, continuously, and substantially involved in the operation of the activity.132 That sounds formidable, but it is not; most artists can easily meet that standard.

The regulations provide several safe harbor tests, followed by a general facts and circumstances test:

An individual shall be treated . . . as materially participating in an activity for the taxable year if and only if —

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals . . . for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual . . . for such year; [or]

. . . .

(7) Based on all of the facts and circumstances . . . the individual participates in the activity on a regular, continuous, and substantial basis during such year.133

Most artists will meet all of the first three safe harbors. They will be active artists for over 500 hours in a year. Based on a 40-hour work week, that is less than 13 weeks full time, or roughly a quarter of the year. They will often be the only persons engaged in the activity. There is no definition of the term “substantially all.” Clearly, it is less than 100 percent. Employees’ activities in the business do count, so an artist who employs gofers and people to make canvas stretchers may find that she has not contributed substantially all the activity to the enterprise. Normally artists will put in at least 100 hours (only two and a half weeks full time), and no other person will exercise more hours. Further, any participation in the activity by the taxpayer’s spouse is considered participation by the taxpayer and not by a third party.134

Note that any disallowed passive activity loss or credit can be carried over to “the succeeding year.”135 Despite that language, the carryover is indefinite,136 and absent sufficient profit, can be taken (subject to conditions) when the taxpayer discontinues the passive activity.137

b. Dealers.

In most cases, dealers — whether auctioneers, gallerists, or brokers — will easily meet the material participation test, usually by putting in over 500 hours of work. Brokers will sometimes be the only ones engaged in the activity; auctioneers and gallerists will rarely be the sole providers of labor. If an auctioneer or gallerist devotes under 500 hours of labor, he is unlikely to be the person who provides most of the work. He will need to make a facts and circumstances argument, presumably based on the essential quality of the services he provides.

However, problems may arise when a dealer in need of cash has sold participation in the enterprise to others, who in essence become co-owners. This will usually involve a passthrough entity, such as a partnership, limited liability company, or subchapter S corporation. In that case, when there is a loss, each of the co-venturists will need to qualify as material participants to currently deduct the loss. When their sole participation is the money used to buy the share, they do not materially participate. Even when the associates have responsibility for making important management decisions collectively, that does not constitute material participation.138

c. Investors.

Art investors are also subject to the passive activity rules. It is unclear how an investor can materially participate in an art investment. The regulations suggest that an investor’s material participation can involve studying financial statements or operating reports, preparing financial summaries, or monitoring finances or operations.139 In most cases the investor qualifies because he is the only person providing services in the investment.

III. Charitable Gift Deduction

A. General Rules

A person who is ready to dispose of appreciated artwork might well ask whether she wants that artwork to benefit a nonprofit organization. If she does not and simply wants to maximize her net gain, she should skip this section of the report and go directly to Section IV.

A person who wishes to benefit a charity has three basic choices. She can sell the artwork, pay 28 percent federal capital gains tax on the gain (plus state income tax and federal investment income tax, if applicable), and give the proceeds or some part of them to the nonprofit. She receives (subject to other limitations) a charitable deduction equal to the amount of cash donated. Alternatively, she can give the artwork to the nonprofit. The tax results are described below. A third option is to place the artwork in a charitable remainder trust (CRT), which gives someone an income interest, with the remainder going to the nonprofit.

The rules for claiming a deduction for charitable contributions differ sharply between artists and dealers on one hand and collectors and investors on the other. In rules applicable to everyone, the charitable deduction is available only to taxpayers who itemize their deductions, a much smaller group since 2018 when the standard deduction was increased and the deduction for state and local taxes was limited to $10,000.140 There are limits on the percentage of AGI that one can take as a charitable deduction.141

A charitable deduction requires a gift under both property law and tax law. A valid gift under property law requires that the donor be competent and not acting under duress. In one case,142 two sisters made four gifts to a museum run by their brother. After the brother’s death, they sought to invalidate the gifts in part on grounds that the brother exercised undue influence over them. The court affirmed one gift, revoked a second, and remanded for a trial to determine whether undue influence was in fact exercised for the other two gifts. Substantial assets were expended to litigate this case to the Texas Supreme Court, funds that might otherwise have been used either by the museum or the donors. Also, had the donors claimed an income tax deduction for any gift that was later invalidated, the tax benefit rule would require that they include that amount in their gross income for the year in which the gift was recouped.143

Property law also requires donative intent, delivery, and acceptance. Acceptance is usually not a problem because it is presumed in the absence of evidence to the contrary. There is also usually plenty of evidence of donative intent from statements made by the donor. Intent is often buttressed when the donor has established a pattern of gifts and the gift in question fits that pattern. Owners of art, however, are often loath to part with possession of their art, so there is sometimes a question raised whether the purported donor has delivered the artwork to the donee. Aside from pure love of the art, donors often delay physical delivery because moving art can damage it. That job is best left to professional art movers, and they charge.144 Under common law, delivery of a document of gift is a valid substitute for actual delivery law if the item is impossible (or in some jurisdictions, difficult) to deliver. A New York court held that delivery of a 1,100-pound bronze sculpture that was in storage was successfully effected by the donor’s writing a memo of gift on the back of a photo of the work.145

Some jurisdictions have dispensed with the requirement that delivery be impossible or difficult. Delivery of a deed of gift, sometimes called either symbolic or constructive delivery, satisfies both the evidentiary reason for requiring delivery (to protect against the fraudulent assertion of a gift) and the function of delivery in impressing in the donor’s mind that he is giving up the property.146 A gift of a Gustav Klimt painting was held validly delivered, even although delivery was by letter rather than a formal deed, and the donor retained both possession and the right to possession for his life.147 Occasionally, a gift is found without actual or constructive delivery, such as when a donor has marked the donated property with the donee’s name and has made statements under oath that the gift had been given, even although the donor retained practical control of the property.148 Those cases are not to be relied on by careful attorneys. Nor does the fact that both donor and donee have access to the artwork, or co-own the property in which it is located, establish proper delivery.

A valid delivery requires the donor’s intent that it be a delivery. Sometimes, what appears to be a delivery is not. Two Texas sisters delivered a deed of gift to a museum. The sisters established that the museum represented that it needed to prove that it had title to the work to secure a loan, and that they continued to treat the art as although it were their own. The court held that delivery of the deed was not intended to transfer title.149

Having complied with applicable property rules, the transfer must also be a gift for federal income tax purposes. The gift must be motivated by detached and disinterested generosity,150 which is sometimes interpreted to mean that the donor has not received anything significant in exchange for the transfer.151 The deductibility of gifts of less than the entire interest in tangible personal property is subject to substantial limitations.152

The starting place for measuring the deduction is always the retail fair market value of the property given to the charity at the time and place given. From that should be deducted the FMV of any benefit received in money or money’s worth, such as when the charity buys the item at a bargain price or gives the donor significant benefits.153 A charitable deduction of any property worth more than $500 requires that a detailed description be attached to the return, and a deduction worth more than $5,000 requires submitting a qualified appraisal with the return.154

B. Outright Gifts to Nonprofits

1. Artists and dealers.

Usually, artists and dealers will be contributing property that, had they sold it, would have produced ordinary income. The issue of what property produces long-term capital gain, short-term capital gain, and ordinary income is discussed later.155 The deduction for the gift of ordinary income property is limited to the taxpayer’s basis.156 Because the artist has probably already deducted her cost of producing the work, as discussed earlier in connection with section 263A, the artist’s basis in work she created is usually nothing. In that case, there is no charitable deduction.

The dealer usually has a basis in the property because he has purchased it. Because this is property held primarily for sale to customers in the ordinary course of his business, it would produce ordinary income if sold, so the dealer’s charitable deduction is limited to his basis.

If, however, the artist or the dealer can qualify the property as a capital asset held for longer than a year, she joins the status of the collector or investor.

2. Collector or investor.

In the hands of a collector or investor who has held the art for at least a year, sale of the art would produce long-term capital gain. The charitable deduction for long-term capital gain tangible personal property is limited to basis if (1) the property is given to a private foundation157 or (2) the use of the property by the donee is unrelated to the donee’s exempt function within three years of the gift.158 By giving to a public charity and ensuring that the donee uses the property in its exempt function for at least three years, the donor who itemizes his deductions may deduct the full FMV of the donated property. The deduction itself is valuable. Also valuable is that the deduction is realized without ever paying income tax on the artwork’s increase in value between the time it was purchased and the time it was donated.

It is easy to ensure that one is giving to a public charity rather than a private foundation.159 It may not be so easy to determine whether the use by a public charity is within its exempt function. For a charity such as a university or a museum whose exempt function is education, placing the artwork on permanent display for students or the general public for study clearly comports with the organization’s exempt function; however, selling the work and using the proceeds for education does not.160 The reality usually lies in between. While museums often have their finest works on permanent display, a substantial part of their collections lies in storage. Universities tend to have even less display space. It is surely a use in their educational function if the work can be studied on demand, even although it is not on permanent display.161 It might also be a satisfactory use if the work is accessible on the organization’s website. There is a suggestion that the use must be substantial,162 but there is no hint of what substantial means in this context.

If the donee’s exempt function is religious, charitable, scientific, to test for public safety, literary, to foster national or international amateur sports competition, or to prevent cruelty to children or animals, it is not clear what needs to be done to use the artwork in its exempt function. How does a hospital use a painting in its exempt function? The regulations suggest that when furnishings donated to a charitable organization are used in the administrative offices, that is a use related to the organization’s charitable function.163 That would suggest that artwork hung in the administrative offices of any exempt organization would be used in the organization’s exempt function. Religious art given to a church and hung in a place where it could be used for devotional purposes would clearly qualify.

In advising a donor, counsel should secure a statement from the donee setting forth that the donee is not a private foundation and describing the related use to which it plans to put the donated artwork.164 The statement should also indicate the length of time, not less than three years, of that use.

C. Charitable Remainder Trusts

A CRT is a trust in which an income interest is in someone not a charity, and the remainder goes to a nonprofit organization. When artwork is the corpus of the trust, the artwork must be sold to produce the income stream required to qualify as a CRT. Because I think that a CRT will be appropriate for few clients, I present summary treatment here.165

For those who are not charitably inclined, a CRT may be preferable to an outright sale of the artwork under some circumstances. An outright sale incurs federal capital gains tax of 28 percent on the gain, plus the net investment income tax of 3.8 percent for high-income individuals.166 There will also be state income tax on the gain, which in high-tax states may be as much as 12 percent. Thus, a high-income taxpayer in California or New York City who sells a work of art with no basis for $1 million receives roughly only $560,000 that he can invest after paying taxes. A CRT allows the taxpayer’s trust to invest the entire $1 million proceeds because tax on the gain is deferred until the taxpayer receives a payout from the trust, which must be at least 5 percent per year but may be as much as 50 percent (although it will be a rare trust that can earn 50 percent). When a taxpayer receives the payout, he is subject to the same rate of tax unless his income is sufficiently low to escape the NII tax or lower his rate of state taxation. It is a matter of running the numbers to see whether the taxpayer is better off with an outright sale or with a CRT.167 The taxpayer also can take a charitable deduction equal to a percentage of his basis in the year in which the artwork is sold. In most cases, that deduction will be minimal.

Another alternative for those who are not charitably inclined is to combine an outright sale with an investment in Opportunity Zone property, as detailed later.

For those who are charitably inclined, a CRT of art may be preferable to the outright gift of the art to a charity only under limited circumstances. A CRT and an outright gift share some characteristics. For example, each removes the value of the asset from the owner’s gross estate for estate tax purposes, and each provides a charitable deduction from the income tax.

However, there are significant differences between the two ways of gifting art to a charity.

The amount of the income tax charitable deduction is different for collectors and investors. For an outright gift, a deduction is available for the FMV of the artwork if the nonprofit will use it in the organization’s charitable function for at least three years. For a CRT, the deduction is a percentage of the owner’s basis in the artwork. That percentage is determined by subtracting the value of the income interests from the value of the artwork.

LTR 9452026 rules that the income tax charitable deduction is not available to the grantor of tangible personal property to a CRT until the property is sold, because the taxpayer retains an intervening interest. It further rules that once the tangible personal property is sold, the taxpayer is entitled to a deduction because his interest is in the proceeds of the sale — money — but the taxpayer’s deduction is limited to basis because the taxpayer has given tangible personal property. The two statements are inconsistent; if taxpayer’s interest is in the proceeds, what is being given to the charity is also the proceeds — cash.168 A CRT thus lacks a major benefit of an outright gift: the ability to deduct the FMV while not paying income tax on gain that has accrued since the purchase of the artwork.

With a CRT, the charity will never use the artwork in its exempt function because the artwork must be sold to fund the income interest. Thus, a CRT is not an option for an art collector who wishes that his artwork be added to the collection of a specific museum or university rather than disappear into the collection of a private person.

The effect on the combined gift and estate tax exemption is different. For an outright gift to charity, there is no effect on the exemption and no effect with a CRT if the income interest is reserved to the donor or the donor’s spouse. If the CRT income interest is given to a third party, it will use up the exemption to the extent that the income interest’s FMV exceeds the annual exclusion.169

A CRT would be more attractive to an artist or dealer if it could turn what would have been ordinary income into capital gain. A CRT pays no income tax.170 The income of the CRT is taxed to the holder of the income interest as the holder receives the income. The income is first considered ordinary income to the extent any is received by the trust. If more of the trust’s income is distributed than the trust’s ordinary income, the excess is long-term capital gain to the extent received by the trust.171 The argument is that the income derives its character from the nature that it would have had in the hands of the trust had the trust been taxable, disregarding the fact that if sold by the donor, the gain would have been ordinary income.

One’s first thought is that this is possible because any “property” can be the subject of a CRT.172 The trust corpus need not be confined to property whose sale would produce capital gain.173 Further reflection makes that result unlikely. The Supreme Court has decided a series of cases preventing property that would usually produce ordinary income from being turned into capital gain.174 It is likely that those cases would be applied as an antiavoidance measure if someone placed property producing ordinary income into a CRT.

An outright gift reserves no economic interest in the donor. A CRT allows the donor to reserve an income interest in the trust for up to 20 years or life, at a rate between 5 and 50 percent of the initial corpus or of its value each year.175 That interest can be in the donor, third parties, or a combination of the two. For a donor who wishes to sell his artwork, defer income tax on the capital gain created by the sale, obtain a current income tax charitable deduction, and reserve an income interest, a CRT is the only way to achieve all those ends. However, unless the proceeds of the sale are invested in property that produces nothing but income taxed at capital gain rates, more of the income that the income recipient receives will be taxed at ordinary income rates than would have been the case had the donor himself sold the artwork.176

A final disadvantage of a CRT is that it is complicated. One false step disqualifies the trust as a CRT, making all its tax benefits disappear.177 As a result, considerably more money is likely to be spent on attorney fees and administration than would be incurred for an outright gift. Therefore, a CRT should not be considered unless the value of the artwork is great and the percentage of that value that constitutes gain is significant.

IV. Characterization of Income

When the taxpayer sells artwork, she has a realization event. If the amount realized exceeds basis, the taxpayer has a gain. If basis exceeds the amount realized, the taxpayer has a loss.178

Whether the gain or loss is ordinary or capital could dictate a significant difference in tax consequences, assuming that the asset has been held for at least a year. Normally, one wants gain to be long-term capital gain because the maximum rate of tax is 20 percent.179 However, the rate of tax on collectibles, including art, is 28 percent.180 One wants losses to be ordinary so that they will offset income that is taxable at the higher rate for ordinary income.

The general policy is that income from personal services or from normal business operations generates ordinary income or loss, and that income from selling investments generates capital gain. But as Le Corbusier said, “Le bon Dieu est dans les détails.”181

The question is how income or loss from the sale of visual art will properly be characterized.

A. Artists

Most of the art sold by an artist produces ordinary income. A capital asset is property, but there are some statutory and common law exceptions under which something that is property is not considered a capital asset. The first statutory exception is “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”182 Art produced by the taxpayer-artist is normally held primarily for sale to customers in the ordinary course of the artist’s business.

Another reason that art created by the artist is not a capital asset is because it is a copyright held by the person whose personal efforts created it.183 But wait. A painting may be subject to copyright, but it is not a copyright. In fact, the copyright law is quite clear that the transfer of a work of art is not the transfer of the copyright to that work, and vice versa.184 However, a copyright includes “any other property eligible for copyright protection,”185 which would certainly include artwork produced by the taxpayer.

Thus, the artist who sells his own work realizes ordinary income on the sale.

Artists frequently collect the work of other artists. As a result, the artist may be both a producer and a collector of or an investor in art. As a collector or investor, the artist should be entitled to capital gain treatment on the sale of the artwork. However, the collection of art made by the artist is often the product of trades of artwork — an artist frequently trades a work she produced for a work produced by another artist. A work is not a capital asset if its basis in the hands of the taxpayer is determined in whole or in part by the basis it had in the hands of the artist who produced it.186

For exchanges before 2018, the IRS’s argument was that the two artists had engaged in a like-kind exchange, art for art, as a result of which the basis of the acquiring artist was the same as the basis he had in the art he gave up.187 Beginning in 2018, tax-free like-kind exchanges are confined to realty.188 That means that the artist’s basis in the artwork received in the exchange is what he paid for it. Because he paid in property, it is the FMV of the property he transferred to receive it.189 (The fact that both artists probably forgot to include the gain on the exchange in their incomes does not change the computation of basis.)

Assuming that the artist is entitled to long-term capital gain treatment on art she has sold, how do you prove it? Not easily.

The IRS will argue that your artist is in the trade or business of selling art. The piece that was just sold is art. Therefore, it is ordinary income property because it is held primarily for sale to customers in the ordinary course of a trade or business.

Your artist needs to be able to argue that his trade or business is selling his own art,190 and that the art of others is part of his collection or investment. To be in a position to make that argument, the artist should keep a separate inventory of her own work and her art investments. It helps if she keeps her investments in a separate place from her own work. The sale of the work of others cannot be so frequent that it is regular, because that may cause her investment to become a trade or business, resulting in ordinary income. The artist may further differentiate her own work from the work of others by heavily marketing her own work and not marketing the work of others in which she invests.

B. Dealers

Dealers experience the same problems. Many dealers amass private art collections over the years that are distinct from the works that they regularly sell.191

In addition to the techniques for distinguishing the private collection from inventory for the artist, some works can be identified as not part of the inventory based on their personal nature or the personal manner in which they were acquired. One of the works that the dealer Daniel-Henry Kahnweiler (1884-1979) kept in his country home at Saint-Hilaire in France was André Derain’s portrait of Kahnweiler’s wife, painted in 1921.192 When Leo Castelli (1907-1999) asked the 17-year-old Ileana Sonnabend to marry him, she asked for, and received, a Matisse painting instead of an engagement ring.193 Sonnabend kept her inventory at her gallery, and her collection either in storage, at home, or in a museum.

The dealer may also differentiate his collection from his inventory by use. The inventory is likely to be displayed and advertised to the public; the collection may grace the dealer’s private office but should not be advertised or mingled with displayed works.194

C. Collectors and Investors

Neither collectors nor investors should have difficulty qualifying their sales as capital gain, because neither has a trade or business in which the works could be primarily held for sale to customers.

V. Exchanges

As indicated earlier, artwork cannot be the subject of a tax-free exchange beginning in 2018 because those exchanges are now limited to realty.195 Nonetheless, the provision may be important, in part because the years in which one could have carried out a tax-free exchange are not quite closed. More important, a work of art that was in a previous tax-free like-kind exchange requires special computation for its basis, which would be relevant in the year in which the work that was received in the like-kind exchange is sold.

Before 2018, a person owning art could exchange it solely for “property of like kind” without paying tax on any gain that had occurred while the taxpayer held it.196 That person could continue exchanging the art received solely for like-kind property until the owner’s death brought a stepped-up basis, meaning that no income tax would ever be assessed on the accumulated gain.197 However, a tax-free exchange of inventory property was not tax free,198 so artists and dealers could avail themselves of these provisions only if they could establish that the relinquished property was not inventory.199

A second limitation was that the property had to be held for productive use in a trade or business or for investment.200 This requires at least that the taxpayer be engaged in a profit-seeking activity. What the phrase “productive use” means is anyone’s guess. Property held for productive use in a trade or business can be exchanged for property to be held for investment, and vice versa,201 so it appears that a dealer could have exchanged a painting that he held for investment for a painting that permanently decorated his office.202

The third limitation was that the artwork needed to be exchanged for property of like kind.203 Again, there is little clarity about what the term “like kind” means. All the regulations tell us is that all realty is like kind with all other realty,204 so city real estate is like kind with a ranch or a farm, as are improved and unimproved realty and even long-term leases in realty. Depreciable personal property requires much more similarity. Whether it is property of like kind depends on whether it falls within the same product classification established for other purposes.205 Intangible and non-depreciable personal property such as art march to a different drummer. Whether they are like kind depends on the nature of the interest and the underlying property in which the interest is held. A copyright of a novel is like kind with a copyright of another novel, but not with a copyright of a song.206 We are also told that “like kind” depends on the nature and character of the property rather than its grade or quality.207

Following the copyright distinction, we might like to know about an intermediate case. Is the copyright of a novel like kind with a copyright of other kinds of writings, such as poetry, history, or biography? What about memoirs, which often seem to have substantial fictional elements? We have no clue. On one hand, they all have the character of writings, but is that the relevant character? Perhaps the relevant character is fiction, but if so, does a novel have the same nature as a short story? No guidance is provided.

Moving to the art world, one might argue that all paintings are of like nature with all other paintings. But is a Rembrandt self-portrait208 like kind with Andy Warhol’s portraits of Campbell’s soup cans? What about a totally abstract painting by Mark Rothko?209

It is not just within paintings that the question must be asked. While many interested in the arts possess only specific media, it is not unusual for a person to be “omnimedia” and amass paintings, drawings, photographs, sculpture, and prints.210 Are they like kind with each other? One can argue that they are all included in the definition of “work of visual art” for purposes of moral rights.211 They are also all included (except photographs) in chapter 97 of the harmonized tariff schedule and entitled to duty-free entry into the United States. This argument is weakened by the fact that chapter 97 also includes antiques, postage stamps, and natural and ethnographic collections.212 Or perhaps like kind is dictated by the individual sections of that chapter, which group paintings; drawings and collage;213 engravings, prints, and lithographs;214 and sculptures separately.215 No one knows.

If the above is insufficiently indeterminate, more confusion has been added by the IRS’s failure to clearly separate the like-kind requirement of section 1031 from the “similar or related in service or use” requirement for involuntary conversions under section 1033. When property is destroyed or damaged, no tax is due on the gain (usually from insurance, but sometimes from the wrongdoer) if the taxpayer elects to replace that property with property similar or related in use or service within the replacement period.216

One immediately notices differences between involuntary conversions and like-kind exchanges. Involuntary conversions are elective; like-kind exchanges are automatic. Involuntary conversions require a calamity; like-kind exchanges can be planned. Like-kind exchanges require that the property be used either for investment purposes or for productive use in a trade or business; with involuntary conversions, any property is eligible.

The IRS has taken a position on whether different forms of art qualify as similar or related in service or use. LTR 8127089 considered a taxpayer whose art collection was damaged by fire and smoke. Ninety-nine percent of the value loss was attributable to damage to lithographs. The taxpayer proposed to purchase a group of artworks consisting of 63 percent lithographs and 37 percent oil paintings, watercolors, sculptures, or other graphic works, although the ruling is not clear on whether those are percentages of value or number of works to be bought. The ruling concluded that the IRS “will not consider as property similar or related in service or use, artwork in one medium, destroyed in whole or in part, replaced with art work in another medium.” There is no discussion of what the use of any of these items might be, or why lithographs are not similar or related in service or use to other prints, such as etchings, serigraphs, silk screens, or even photographs.217

Uncertainty increased with the release of a 1979 revenue ruling in which the IRS concluded that gold-bullion-type coins and gold numismatic coins are not like kind because the former are held for appreciation in the price of gold while the latter are held for appreciation because of their collectibility. The justification given was the enactment a decade earlier of section 1031(e) declaring that livestock of different sexes are not like kind because they are used for different purposes, one for breeding and the other for slaughter.218

One might point out that different forms of art are all used for the same purpose: art appreciation, in both senses of “appreciation.” One might also point out that this distinction is entirely inconsistent with the rules for both real and personal property, neither of which considers the use of property rather than its nature.219

In short, in these two rulings, the IRS used the “similar or related in service or use” standard of section 1033 to determine whether property was like kind under section 1031, and used the like-kind standard to determine whether property was similar or related in service or use. In addition to using the wrong standard, the agency in both rulings reached the wrong result under any sensible interpretation of the statutory language. Nonetheless, the prudent tax planner will note the IRS’s extreme hostility to the use of either provision and act accordingly.

In the future, arguments about whether the artist has engaged in a tax-free like-kind exchange will take on a somewhat surreal aspect. Normally, the artist would be arguing for the tax-free exchange. However, by the time this report is published, the statute of limitations for the year 2017 will be close to expiring.220 Taxpayers will be arguing that the transaction was not a tax-free exchange so they can have a higher basis in the artwork when it is eventually sold. A taxpayer’s basis in property received in a tax-free exchange is his basis in the property relinquished to acquire it,221 whereas a taxpayer’s basis in property otherwise acquired is his cost. In an exchange, cost is the FMV of the relinquished property given up.222

VI. Opportunity Zone Investments

As Congress closed one deferral possibility for disposition of art, it opened another. A taxpayer can elect to defer (and possibly eliminate) tax on gain if it is invested in a qualified opportunity fund within six months of its realization.223 The gain is deferred until disposition of the investment, or the end of 2026, whichever occurs first. If the Opportunity Zone investment is held for five years, 10 percent of the gain is forgiven; if held for seven years, 15 percent is forgiven; and if held for 10 years, the taxpayer may elect to have the entire gain forgiven.

One notes immediately some differences between like-kind exchanges and Opportunity Zone investments. In the former, everything received must be rolled over into the new property or else some tax will be due; in the latter, one need only invest the gain, and one can pocket an amount equal to the basis without paying tax. In a like-kind exchange, one must wait until death to be freed from tax on the gain, whereas under the Opportunity Zone provisions, 10 years provides complete exemption and five years provides partial exemption.224

Note that under the Opportunity Zone provisions, the investment must be made through either a corporation or a partnership that invests at least 90 percent of its capital in designated Opportunity Zones. Whether such an entity will provide sufficient return combined with the tax benefits will depend on the return on investment, which in turn depends on both the success of the investment and the size of the bite taken by those who manage it. The fact that there will be many Opportunity Zones throughout the country and many corporations and partnerships trying to attract investments is probably sufficient to reduce the agency costs to a reasonable amount.

The Opportunity Zone provisions add yet another option for the owner of appreciated art. As an alternative to either selling the art and taking the money or placing the art in a CRT, one can now sell the art and invest in a QOF.

VII. Conclusion

It should be clear from this report that the tax treatment of visual artists and their dealers, collectors, and investors is much more complicated than it was a generation ago. The good news is that there are many ways tax planners can help their clients achieve the best results.

FOOTNOTES

1 Section 186.

2 Sections 170(e)(1)(A) and (B) and 1221(a)(1) and (3).

3 The seminal article on income tax comparisons between artists and collectors is Alan L. Feld, “Artists, Art Collectors and Income Tax,” 60 B.U. L. Rev. 625 (1980). The ensuing 41 years have brought some changes.

4 Sections 183(a), 162(a), and 212(1) and (2).

5 Reg. section 1.183-2(a) slips in a requirement that the test for disallowance is the primary intent (“Deductions are not allowable . . . for activities which are carried on primarily as a sport, hobby, or recreation.”), but it forgets to include the word “primarily” in the rest of the regulations, including the following sentence, where one would expect to find it. Indeed, reg. section 1.183-2(b) refers to “lack of profit objective,” the correct question, in its introductory paragraph. The “primary” test is criticized in Johnson v. United States, 11 Cl. Ct. 17, 26 (1986), but generally adopted. A “primary” test is necessary because in most cases, taxpayers want to both enjoy the activity and make a profit.

6 E.g., Crymes v. Commissioner, T.C. Memo. 1972-3; Estate of Hailman v. Commissioner, T.C. Memo. 1958-165; Adams v. Commissioner, T.C. Memo. 1966-242; Porter v. Commissioner, T.C. Memo. 1969-288, aff’d per curiam, 437 F.2d 39 (2d Cir. 1970); Rood v. United States, 184 F. Supp. 791 (D. Minn. 1960); and De Grazia v. Commissioner, T.C. Memo. 1962-296.

7 For the history, see Joseph H. Marxer, “Note: Section 183 of the Internal Revenue Code: The Need for Statutory Reform,” 62 Ind. L.J. 425 (2002).

8 Daniel O. Posin and Donald T. Tobin, Principles of Federal Income Taxation section 6.02(9) (2005).

9 Reg. section 1.183-2(a) makes this clear: “Deductions are not allowable under section 162 or 212 for activities which are carried on primarily as a sport, hobby, or for recreation.”

10 Section 163.

11 Section 164.

12 Faulconer v. Commissioner, 748 F.2d 890 (4th Cir. 1984) (the taxpayer, a horse breeder, had moderate gains in the requisite years and big losses in the other years, but the 3:1 ratio of annual losses to annual gains was irrelevant in shifting the burden of proof to the IRS, which burden it failed to carry).

13 See, e.g., Ruben v. Commissioner, 852 F.2d 1290 (9th Cir. 1988) (breeding harness racing horses); Remuzzi v. Commissioner, T.C. Memo. 1988-8 (practicing orthopedic surgeon living on cattle breeding farm); Westbrook v. Commissioner, 68 F.3d 868 (5th Cir. 1995) (practicing veterinarian raising cattle and miniature horses); Magassy v. Commissioner, T.C. Memo. 2004-4 (plastic surgeon running a yacht-chartering operation); and Stasewich v. Commissioner, T.C. Memo. 1996-302 and T.C. Memo. 2001-30 (accountant who painted motorcycles and nudes).

14 For an interesting contrast between objective facts and a taxpayer’s statements, see Tyler v. Commissioner, No. 5508 (1947). Read in isolation, the section labeled “Opinion” gives the impression that the only reason the judge found that the taxpayer was engaged in stamp collecting for profit was the taxpayer’s declaration of “the requisite greed” at trial. By contrast, the lengthy “Findings of Fact” section details the taxpayer’s investigation of whether stamps would be a suitably profitable investment; the substantial correspondence between the taxpayer and his agent, which centered on which stamps would be most likely to increase in value and purely financial discussions about when and how to sell parts of the collection; incredible recordkeeping; and the fact that the taxpayer participated in few of the activities that hobby philatelists usually love, such as meeting with other philatelists and displaying their collections.

15 Reg. section 1.183-2(a) specifies that “greater weight is given to objective facts than to the taxpayer’s mere statement of his intent,” but it does not distinguish between a taxpayer’s statement after the tax controversy has arisen and a taxpayer’s statement at the time he was contemplating entry into the arrangement. If the taxpayer had prepared a business plan before entering the arrangement, would that constitute a “mere statement,” a “statement,” or an “objective fact”?

16 Reg section 1.183-2(b) (introductory paragraph).

17 Reg. section 1.183-2(b).

18 Lee Caplin, The Business of Art (1998).

19 Sometimes one wonders at the slavish adherence to these criteria. See Matter of Steve and Linda Horn, DTA No. 825333 (N.Y. Tax Appeals) (taxpayer with commercial outlets and employees was in antiques and realty for profit). On the general question, see Leo Previti, Warren Kleinsmith, and Michele Previti, “Hobbies Versus Business Activities: The Tax Court’s Analysis,” 33 J. Tax’n Inv. 65 (Spring 2016).

20 Churchman v. Commissioner, 68 T.C. 696 (1977).

21 Note that Churchman and her husband were represented by counsel. Churchman died August 2, 2009, at age 81, in Mill Valley, California. She was still having shows in her senior years. I do not know if she was ever financially successful with her art.

22 This is yet another version of the conflict between requiring that profit be the dominant motive and requiring only that it be a motive. It seems bizarre for a tax system to discount a person’s profit motive because they prefer fame to riches but are nonetheless seeking riches.

23 Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931) (a company recovering a contract judgment for work done in a prior year cannot amend the prior year’s return but must include the judgment in income for the year received).

24 For a case in which the court refused to consider activities in later years to determine intent in the tax years at issue, see Feistman v. Commissioner, T.C. Memo. 1981-105, at 10-11 (stamp collector who also sold stamps). But in a litigation of the taxpayer’s next two tax years (1976 and 1977), the court considered the fact that he turned a profit in 1980 and expected one in 1981 (the trial year), and it found a profit-seeking motive based on increased activity, increased inventory, and multiple purchases of the same item, which purchases would not be made by a collector. Feistman v. Commissioner, T.C. Memo. 1982-306.

25 Arrowsmith v. Commissioner, 344 U.S. 6 (1952) (payment of a judgment in a later year due because of liquidation of a corporation in an earlier year must be linked to the earlier liquidation to characterize the loss).

26 De Grazia, T.C. Memo. 1962-296 (the taxpayer won art prizes as a child).

27 Crile v. Commissioner, T.C. Memo. 2014-202.

28 Id. The primary-purpose test may or may not be in effect in the Ninth Circuit. Without discussion, it was imposed in Storey v. Commissioner, T.C. Memo. 2012-115, whereas Churchman, 68 T.C. 696, likewise without discussion, simply required profit seeking to be a purpose. The primary-purpose test seems to arise from reg. section 1.212-1(c), where it is made specifically applicable only to years before 1970.

29 See Marxer, supra note 7, at 432 (complaining that the courts do not actually weigh the strengths of taxpayers’ motivations and instead simply announce their conclusions; it is not clear how one would measure the relative strengths of different intents).

30 Crile, T.C. Memo. 2014-202. For a pre-section-183 case in which the IRS unsuccessfully contended that an art professor was not engaged in a profit-seeking activity, see Rood, 184 F. Supp. 791.

31 Churchman and Crile are both discussed in Julia L.M. Bogdanovich, “Devising an Artful Tax: An Appraisal of Payment-in-Kind Income Taxes in Mexico and the United Kingdom,” 164 U. Pa. L. Rev. 983, 1014-1017 (2016). For another taxpayer success, see Waitzkin v. Commissioner, T.C. Memo. 1992-216 (taxpayer worked full time on her art and supported herself by it until an inheritance permitted her to discontinue teaching art; she had many sales, was in numerous gallery and museum shows, and kept good records).

32 E.g., Harmon v. Commissioner, T.C. Memo. 1986-305 (taxpayer who sold her ceramics at their estimated cost); Paxton v. Commissioner, T.C. Memo. 1991-217 (teachers who sold their crafts for direct costs without considering overhead or sales costs, had no plan to reverse losses, and used shoddy recordkeeping); Windisch v. Commissioner, T.C. Memo. 1996-369 (government clerk who kept meticulous records but did not operate her photography in a businesslike manner); Dreicer v. Commissioner, 78 T.C. 642 (1982), on remand from 665 F.2d 1292 (D.C. Cir. 1981) (lecturer and writer who incurred enormous traveling expenses and did not operate in a businesslike manner; test did not require that profit seeking be the primary motive); and Drummond v. Commissioner, T.C. Memo. 1997-71 (taxpayer who bought six drawings and more than a decade later sold one of them).

33 Stasewich, T.C. Memo. 1996-302 and T.C. Memo. 2001-30.

34 Storey, T.C. Memo. 2012-115 (film); Crile, T.C. Memo. 2014-202; Churchman, 68 T.C. 696; Waitzkin, T.C. Memo. 1992-216; and Tyler, No. 5508 (stamp collector).

35 Crile, T.C. Memo. 2014-202 at 15-20, 40-41, and 47; and Waitzkin, T.C. Memo. 1992-216 at 18.

36 Henry v. Commissioner, 36 T.C. 879 (1961) (Robert L. Henry, a tax lawyer, owned a yacht from whose mast he flew a flag containing the numerals “1040.” When asked about the unusual ensign, he explained that he was a tax lawyer, and established that he was able to secure several well-heeled clients in that fashion. The court denied a deduction for depreciation on the yacht on grounds that it was not an ordinary and necessary business expense.).

37 Crile, T.C. Memo. 2014-202 at 22. For other cases in which the reason for claiming to be pursuing profit seemed to be more a desire to deduct otherwise personal living expenses, see Windisch, T.C. Memo. 1996-369; and Porter, T.C. Memo. 1969-288.

38 Storey, T.C. Memo. 2012-115 at 9-13 and 26-29.

39 Compare several horse-breeding cases, Metz v. Commissioner, T.C. Memo. 2015-54 (profit seeking); Welch v. Commissioner, T.C. Memo. 2017-229 (profit seeking); Blackwell v. Commissioner, T.C. Memo 2011-188 (profit seeking), with Craig v. Commissioner, T.C. Summ. Op. 2013-58 (not profit seeking).

40 E.g., Windisch, T.C. Memo. 1996-369 (revenue was no more than 11 percent of expenses in the years in question, which were preceded by three loss years).

41 Churchman, 68 T.C. 696 (production of lower-cost art); Blackwell, T.C. Memo. 2011-188 (discontinued business after several years of losses); and Welch, T.C. Memo. 2017-229 (changed type of cattle bred twice; hired veterinarian cheaper than fees for outside veterinarians; and reduced shipping costs).

42 Welch, T.C. Memo. 2017-229.

43 Metz, T.C. Memo. 2015-54 (various unanticipated problems, including the Great Recession).

44 Estate of Chandor v. Commissioner, 28 T.C. 721 (1957).

45 Section 1221(a)(1). A different result would obtain today because of the addition of section 1221(a)(3), which denies capital treatment on the sale of a copyright by its creator. While that statement does not seem to include Chandor because he sold the painting, not the copyright, that code section has been interpreted to include the sale of property that is subject to copyright. Reg. section 1.1221-1(c)(1). Estate of Chandor, 28 T.C. 721. In fact, it has been very broadly applied. See Jones v. Commissioner, 560 F.3d 1196 (10th Cir. 2009) (photocopying FBI investigative reports was preparing documents for the taxpayer).

46 Crile, T.C. Memo. 2014-202 at 25-27.

47 Sections 212 and 67(a). In tax years 2018-2025, employee business deductions are not allowed at all. Section 67(g). In Renner v. Commissioner, T.C. Memo. 1984-303 at 7-9, the court doubted that the taxpayer, an art teacher, was in the separate trade or business of being an artist, but even if she was, no deduction would be allowed for the expenses of a home studio because she derived no gross income from her artistic activities.

48 Reg. section 1.183-1(d)(1); Metz, T.C. Memo. 2015-54 (breeding, operation of ranch, and ownership of the ranch land were a single activity); and Welch, T.C. Memo. 2017-229 (use of hay growing to provide feed for cattle- and horse-breeding activities, using same employees for all three enterprises, and similar integrated activities at other neighborhood ranches indicated single activity).

49 In the old days, gallerists actually bought works from artists to support them and took the risk that the works would not sell. Paul Durand-Ruel (1831-1922) bought about 1,000 Monets and similar amounts from other impressionists. He was one of Monet’s major dealers. He barely averted bankruptcy but promoted the work of his stable of impressionist artists by carefully controlling the amount of it to hit the market at any time and by ensuring (sometimes by doing the buying himself) that each auction of his artists’ works set a record. He staged lavish shows of their work, used artist biographies to stir interest, and went abroad (most spectacularly to the United States) to promote their work. Ken Johnson, “A Portrait, Freely Brushed, of a Shrewd Dealer,” The New York Times, July 24, 2015. More recently, Picasso and his principal gallerist, Daniel-Henri Kahnweiler (1884-1979) and other gallerists, were on a buy-sell relationship. Pierre Assouline, An Artful Life 327-331(1990).

50 A fuller description of the commercial side of visual art can be found in Alexandra Darraby, Art, Artifact, Architecture and Museum Law, ch. 2 (2017).

51 Holding property for appreciation is one of the ways one can seek profit, but the anticipated appreciation needs to exceed the purchase price plus maintenance plus costs of the sale. Reg. section 1.183-2(b)(4) and Craig, T.C. Summ. Op. 2013-58 (unlikely that possible appreciation would exceed prior expenses).

52 Tyler, No. 5508.

53 Wrightsman v. United States, 428 F.2d 1316 (Ct. Cl. 1970). The couple also gave generously to the Morgan Library. On her death in April 2019, Jayne left more than 375 works to the Met, including paintings by Johannes Vermeer (fewer than 40 paintings are now attributed to him), Peter Paul Rubens, Anthony van Dyck, Jacques Louis David, and Eugène Delacroix, bringing the total number of artworks the Wrightsmans donated to 1,275. Robin Pogrebin, “A Trustee Leaves Trove of Old Masters Works to the Met,” The New York Times, Nov. 13, 2019.

54 Had the Wrightsmans been engaged in a profit-seeking activity, it is likely that they still could not have deducted the major expenses of travel, hotels, and food in search of art to buy. The best they could have hoped for was that those costs would have been part of the cost of acquisition of the art that would need to be capitalized under section 263. More likely, those expenses would have been disallowed as personal, living, or family expenses. Section 262.

55 The fact that there are tax benefits does not disqualify a person from being engaged in a profit-seeking activity. Engdahl v. Commissioner, 72 T.C. 659, 670 (1979) (dictum) (horse breeder entitled to deduct losses).

56 Barcus v. Commissioner, T.C. Memo. 1973-138, aff’d per curiam, 492 F.2d 1237 (2d Cir. 1974).

57 Stanley v. Commissioner, T.C. Memo. 1980-217.

58 Id. at 221.

59 Holowinski v. Commissioner, T.C. Memo. 1997-168 (antique glass sellers who kept careful records but did no financial projections and whose sale of their entire inventory at projected prices would not have turned a profit were not profit seeking); Dailey v. Commissioner, T.C. Memo. 1982-591 (art and antique collectors who never offered an item for sale and did not compile an inventory before litigation were not profit seeking); Griesmer v. Commissioner, T.C. Memo. 1999-147 (meteorite and pyrite collector who never offered an item for sale and had no gross receipts or records was not profit seeking).

60 Tyler, No. 5508.

61 Section 274(a), (c), (d), (g), (h), (k), (m), and (n).

62 The appropriate Latin motto is tempora mutantur. Heraclitus of Ephesus said, “There is nothing permanent except change.” More recently, Robert Burns proclaimed: “But, Mousie, thou art no thy lane/In proving foresight may be vain,/ The best-laid schemes o’ mice an’ men,/Gang aft agley,/An’ lea’e us nought but grief an’ pain, For promis’d joy!” Burns, “To a Mouse” (1785).

63 Section 280A(a) and (b).

64 Section 280A(c)(1) and (4).

65 E.g., Renner, T.C. Memo. 1984-303 (college art teacher’s principal place of business was the classroom).

66 The leading case on principal place of business is Drucker v. Commissioner, 715 F.2d 67 (2d Cir. 1983) (Metropolitan Opera musician’s principal place of business was the practice room in his apartment when the opera did not provide practice space). See also Meiers v. Commissioner, 782 F.2d 75 (7th Cir. 1986) (laundromat owner spent twice as much business time in her home office as at the laundromat); Weissman v. Commissioner, 751 F.2d 512 (2d Cir. 1984) (professor spent four times more working hours in his home office than at the school); and Popov v. Commissioner, 246 F.3d 1190 (9th Cir. 2001) (violinist spent more time practicing at home than performing or recording, and the relative importance of the home and away activities was about equal).

67 In the year in which Churchman ran a gallery in which her own work was displayed, the gallery was probably her principal place of business.

68 Loughlin v. United States, 50 A.F.T.R. 2d 5827 (D. Minn. 1982) (home was not an airline pilot’s principal place of business).

69 E.g., Weissman, 751 F.2d 512 (professor spent four times the working hours in home office as at school because the school-provided office was shared and not suitable for research expected of a professor).

70 There is no indication that the separate structure must also be served by separate utility lines in order to be “not attached to the dwelling.”

71 Prop. reg. section 1.280A-2(c) (“Occasional meetings are insufficient.”).

72 Section 280A(c)(1). “A taxpayer who uses a den in his dwelling unit to write legal briefs, prepare tax returns, or engage in similar activities as well for personal purposes, will be denied a deduction.” S. Rep. 94-938, 186 (1976). See, e.g., Tilman v. United States, 644 F. Supp. 2d 391 (S.D.N.Y. 2009) (rooms in which the taxpayer gave music lessons were also used as guest rooms and to entertain friends); Naggar v. Commissioner, T.C. Memo. 1983-559 (deduction denied because the areas used for business during weekdays were used for personal purposes nights and weekends); and Waitzkin, T.C. Memo. 1992-216 (the taxpayer proved exclusive use of 50 percent of her apartment for her art business).

73 Weightman v. Commissioner, T.C. Memo. 1981-301 (dictum).

74 Section 280A(c)(4).

75 Section 280A(c)(4)(C); the denominator of the daily fraction must always be 24, the number of hours in the day that the portion of the dwelling is available for use, although it is often expressed as 168 hours in a week. Prop. reg. section 1.280A-2(g)(4); Rev. Rul. 92-3, 1992-1 C.B. 141; and Neilson v. Commissioner, 94 T.C. 1 (1990). In an ideal world, the formula should be hours of business use/(hours of business use + hours of nonbusiness use). There is no policy reason to count nonuse as either business or nonbusiness use, but that is the precise way the code is worded.

76 Prop. reg. section 1.280A-2(g) states that it “may apply to a portion of a unit used for more than one business purpose.” In that case, the use for neither purpose would be exclusive. For an extreme counterexample, see Hamacher v. Commissioner, 94 T.C. 348 (1990) (the taxpayer, who used his home office exclusively for two businesses that was the principal place of business of only one of them, could deduct nothing). The proposed regulations indicate that Hamacher may exceed the regulation’s intention, because they give the example of a teacher who runs a retail business and uses an area of the home for both purposes. They suggest that a deduction is available for the retail business use, even though it is not exclusive, but in computing the gross income limitation, the taxpayer cannot use his income from teaching. Prop. reg. section 1.280A-2(i)(2).

77 Section 280A(c)(2); and prop. reg. section 1.280A-2(c) and (h).

78 Prop. reg. section 1.280A-2(i)(3).

79 Rev. Proc. 2013-13, 2013-6 IRB 478.

80 Section 280A(c)(5); and prop. reg. section 1.280A-2(i).

81 Section 280A(c)(5). The proposed regulations do not comment on whether a disallowed deduction may be carried forward for only one year or instead may be continuously carried forward until there is sufficient income to absorb it.

82 The same is true for Sheila Waitzkin. Waitzkin, T.C. Memo. 1992-216.

83 Higgins v. Commissioner, 312 U.S. 212 (1941). From this it was deduced that a trade or business involved offering goods or services to the public. That definition of a trade or business was called into question by Commissioner v. Groetzinger, 480 U.S. 23 (1987), in which the taxpayer spent up to 80 hours a week gambling on his own account. Since then, most taxpayers who acted on their own accounts have not been held to be in a trade or business. E.g., Kanofsky v. Commissioner, 271 F. App’x 146 (3d Cir. 2008); and Magassy v. Commissioner, 140 F. App’x 450 (4th Cir. 2005). But there is the strange case of Bagley v. United States, 963 F. Supp. 2d 982 (C.D. Cal. 2013), in which the taxpayer’s 10-year pursuit of a qui tam action under the False Claims Act on behalf of the United States was held to be a trade or business.

84 Section 263A. The analogy here is to Idaho Power Co. v. United States, 418 U.S. 1 (1974), in which the taxpayer bought trucks that were used entirely to construct a dam and depreciated them over their short useful life. The Supreme Court held that the purchase price of the trucks was part of the cost of the dam, so depreciation had to be over the (much longer) useful life of the dam than that of the trucks.

85 Section 263A(h).

86 Section 263A(h)(3)(C)(i).

87 Section 263A(h)(3)(C)(ii).

88 Reg. section 1.162-5(a). Alternately, education is deductible if it meets the requirements of an employer or law to retain the job, but that avenue is not relevant because if the artist is self-employed, as most are, there is no employer and there are no educational prerequisites to becoming or continuing to be an artist. If the artist is employed, no employee business deductions are allowed through 2025. Section 67(g).

89 Reg. section 1.162-5(b).

90 Most artists who paint also do prints. Many painters also do sculpture, such as Edgar Degas and Paul Gauguin. Fewer artists may venture into ceramics, as Pablo Picasso did, or stained glass, like Marc Chagall.

91 In the one case involving an artist, the focus was on whether she intended to make a profit. When the court held that she did, it allowed, without discussion, a deduction for the cost of a monthlong summer art academy in Salzburg, Austria. De Grazia, T.C. Memo. 1962-296.

92 E.g., Smith v. Commissioner, T.C. Memo. 1967-246 (teacher of Latin and French was primarily improving her skills on a Mediterranean cruise (for which the school granted her paid released time) visiting sites of the Roman Empire and on which French was the commonly used language, and she brought back materials later used in class).

93 E.g., Schrimpf v. Commissioner, T.C. Memo. 1977-315 (art teacher who did not visit artists or museums or listen to art lectures was not primarily improving his skills; he brought back a scrapbook of souvenirs that he shared with his class, but he mostly pursued normal tourist activities).

94 E.g., Marlin v. Commissioner, 54 T.C. 560 (1970) (the wife, a world history teacher, was primarily improving her skills on trips to important historical sites from which she collected books, slides, and photos later used in class; the husband, a Latin teacher, made occasional visits to Roman ruins in France, but they were not a predominant part of the trip and probably did not improve his language teaching); Gibbons v. Commissioner, T.C. Memo. 1978-75 (school librarian who spent hundreds of hours researching the trip and consulting with colleagues and brought back hundreds of slides to aid her resource person position was primarily improving her skills, but the trip did not improve the skills of her husband, a reading specialist).

95 Reg. section 1.162-5(a).

96 Reg. section 1.162-5(b)(3). There are old cases holding that psychoanalysis is a new business for a psychiatrist. E.g., Namrow v. Commissioner, 288 F.2d 648 (4th Cir. 1961).

97 Rev. Rul. 74-78, 1974-1 C.B. 44.

98 Ruehmann v. Commissioner, T.C. Memo. 1971-157 (dictum).

99 E.g., Glenn v. Commissioner, 62 T.C. 270 (1974).

100 Levine v. Commissioner, T.C. Memo. 1987-413.

101 Brandt v. Commissioner, T.C. Memo. 1982-180.

102 Radin v. Commissioner, T.C. Memo. 1987-348.

103 Robinson v. Commissioner, 78 T.C. 550 (1982).

104 Section 162(a)(2), but until the end of 2025, not if the artist is an employee. Section 67(g).

105 Art Basel canceled its 2020 fairs in Hong Kong and Miami Beach. The Miami location is serving as a reserve COVID hospital. Brett Sokol, “Pandemic Prompts Cancellation of Miami Beach Art Fair,” The New York Times, Sept. 5, 2020. Clare McAndrew, The Art Market 2020, reported that in 2019, sales at fairs accounted for 47 percent of total sales for galleries with turnover above $10 million and 30 percent of sales for galleries with turnover less than $500,000. Benjamin Sutton, “What You Need to Know From the Art Market 2020 Report,” Art Market and News, Mar. 5, 2020.

106 Rembrandt and Vermeer come to mind. By contrast, Rubens spent eight years traveling around Italy, where he was much influenced by renaissance masters and witnessed the proxy marriage of Henri IV of France and Marie de Medici, for whom he later worked, in Florence’s Duomo. Others whose education included travel were Joshua Reynolds, David, Jean-Auguste-Dominique Ingres, Delacroix, John Singleton Copley, Thomas Eakins, and John Singer Sargent. For some, such as Nicolas Poussin and Claude Lorrain, the scene of their travel education became their longtime professional home.

107 Section 274(m)(2). This provision followed many attempts, usually unsuccessful, to deduct rather large travel expenses when the gross income generated was minimal or nonexistent. E.g., Dreicer, 78 T.C. 642 (motive not profit seeking when, over 10 years, the expenses of writing two failed travel books and consulting on it — mostly costs for dining; hotels; travel; and a secretary, who traveled with the taxpayer — exceeded average annual revenue of $1,600 by a yearly average of $25,000).

108 This rule also applies to lawyers. For example, one might prefer to enroll in our law school’s summer international law programs in London or Paris rather than simply travel there. One advantage of enrolling in a formal educational program is that the program can expose the lawyer to institutions that he could not visit on his own or could visit only at a greatly increased cost.

109 My “specialized graduate diploma” from the University of Paris I Panthéon-Sorbonne warns me to guard my diploma carefully because a duplicate will not be delivered.

110 Sections 212 and 67(a).

111 Gilliam v. Commissioner, T.C. Memo. 1986-81.

112 Dancer v. Commissioner, 73 T.C. 1103 (1980); and Clark v. Commissioner, 30 T.C. 1330 (1958).

113 Gilliam (b. 1933) is Black. One may question whether this was significant in the respective decisions to arrest and prosecute him (rather than seek out mental health assistance for him), determine a deficiency, and oddly distinguish his tax case from Dancer and Clark.

114 Section 162(a).

115 E.g., Frank v. Commissioner, 20 T.C. 511 (1953) (travel and legal expenses of investigating whether to enter newspaper or radio business not deductible). A finer distinction would be between expenses of investigating whether to enter a business, which always must be capitalized, and pre-operating expenses incurred once it has been decided to enter the business. See Arthur Fleischer Jr., “The Tax Treatment of Expenses Incurred in Investigation for a Business or Capital Investment,” 14 Tax L. Rev. 567 (1959).

116 Section 195.

117 If the start-up expenses exceed $50,000, the amount deductible in the first year is reduced dollar for dollar by the excess. Section 195(b)(1)(ii). The code is phrased in terms of electing in, but the regulations make the election automatic unless taxpayer opts out. Reg. section 1.195-1(b). The reason for the automatic opt-in is probably that most businesses will choose to elect unless they think they will be unable to ever use the deductions because of an anticipated long period of tax losses.

118 Reg. section 1.195-1(b).

119 Richmond Television Corp. v. United States, 345 F.2d 410 (4th Cir. 1965) (taxpayer not in the television business until FCC issued a license and broadcasting began).

120 Deputy v. DuPont, 308 U.S. 488, 499 (1940) (Frankfurter, J., concurring) (payments made were not in the taxpayer’s business but in those of a corporation in which he held stock). Whether that definition is still good law in requiring interface with clients may be questioned as a result of Groetzinger, 480 U.S. 23 (a gambler full time for his own account was in a trade or business).

121 For instance, I have no income as a result of making an advantageous purchase.

122 Larsen v. Commissioner, 66 T.C. 478 (1976) (cost of unsuccessfully seeking oil and gas leases is a deductible loss when the property is separate from the leases acquired).

123 The full requirements are much more complicated. This is a simplified summary based on section 199A(a)-(c). For instance, a taxpayer whose taxable income does not exceed the threshold amount plus $50,000 is not entirely limited by the Form W-2 wages paid. Section 199A(b)(3).

124 For a general view, see, e.g., Craig W. Benson, “Section 199A: A Magic Dance Through the Labyrinth,” 58 Wash. L.J. 187 (2019); and Daniel Shaviro, “Evaluating the New U.S. Pass-Through Rules,” 2018 Brit. Tax Rev. 49.

125 Section 199A(d)(1)(B).

126 Sections 199A(d)(1)(A) and 1202(e)(3)(A).

127 Adjustable each year for inflation. Section 199A(e)(2)(B).

128 Section 199A(d)(3)(A) and (e)(2)(A).

129 Section 199A(d)(3)(B).

130 Section 199A(b)(3)(A). Nor are artists whose taxable income does not exceed the threshold amount by more than $50,000, but they suffer percentage reductions in the deduction. Section 199A(b)(3)(B).

131 Section 469(a)(1), (c)(1), and (6)(B).

132 Section 469(h)(1).

133 Reg. section 1.469-5T(a).

134 Reg. section 1.469-5T(f)(3). Back to the 19th century theory that husband and wife are one person! The spouse’s work may be treated as work of the taxpayer only if it is owner-type work. It is unclear whether the type of work done is the disqualifying factor in reg. section 1.469-5T(k), Example 7, or whether it is the fact that the spouse’s work is done specifically to qualify as the taxpayer’s material participation, but reg. section 1.469-5T(f)(2) says that both conditions are required.

135 Section 469(b).

136 Section 469(f)(1).

137 Section 469(g). There are special rules for limited partners. Reg. section 1.469-5T(e).

138 Reg. section 1.469-5T(k), Example 8.

139 Reg. section 1.469-5T(f)(2)(ii).

140 Beginning in 2020, those who take the standard deduction can now also deduct cash charitable contributions up to $300 per year ($600 for married persons filing jointly), as enacted in section 2204 of the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136). Sections 63, 63(c)(7), and 164(b)(6).

141 Section 170(b). The CARES Act also loosened the percentage limits on charitable deductions for gifts to public charities.

142 Stephens County Museum Inc. v. Swenson, 517 S.W.2d 257.

143 Alice Phelan Sullivan Corp. v. United States, 180 Ct. Cl. 659 (1967) (tax must be paid at the rate prevailing in the year of recovery, which might be more, less, or the same as the tax saved by the initial deduction).

144 The cost of moving the art to the charitable donee is also deductible. Archbold v. United States, 444 F.2d 1120 (Ct. Cl. 1971) (legal fees spent to prevent the destruction of previously donated parkland was for the benefit of a charity and thus deductible); and Rockefeller v. Commissioner, 676 F.2d 35 (2d Cir. 1982) (unreimbursed expenses for providing services to a charity are deductible).

145 Mirvish v. Mott, 968 N.E.2d 906 (N.Y. 2012).

146 Estate of Genecin v. Genecin, 363 F. Supp. 2d 306 (D. Conn. 2005).

147 Gruen v. Gruen, 496 N.E.2d 869 (N.Y. 1986).

148 Edinburg v. Edinburg, 492 N.E.2d 1164 (Mass. App. 1986).

149 Stephens County Museum, 517 S.W.2d 257.

150 Commissioner v. Duberstein, 363 U.S. 278 (1960) (gift is given from disinterested generosity as determined by the trier of fact); and Foster v. Commissioner, 80 T.C. 34 (1983) (land donated to obtain favorable zoning is not a deductible charitable gift).

151 Hernandez v. Commissioner, 490 U.S. 680 (1989) (a payment made in exchange for religious training is not a deductible charitable gift).

152 Section 170(a)(3) and (o).

153 Rev. Rul. 67-246, 1967-2 C.B. 104 (donor who receives an event ticket for gift must reduce charitable deduction by the FMV of the ticket).

154 Section 170(f)(11).

155 For good discussions of the policy distinguishing the deductibility of charitable contributions of ordinary income property from those of capital assets, see Joel S. Newman, “Sales and Donations of Self-Created Art, Literature, and Music,” 12 Pitt. Tax Rev. 57 (2015); and Feld, supra note 3.

156 The code phrases it as reducing the FMV by “the amount of gain which would not have been long-term capital gain . . . had the property been sold by the taxpayer at its fair market value,” thereby including in a single sentence ordinary income property and short-term capital gain. Section 170(e)(1)(A). Its constitutionality was affirmed in Maniscalco v. Commissioner, 632 F.2d 6 (6th Cir. 1980).

157 Section 170(e)(1)(B)(ii).

158 Section 170(e)(1)(B)(i), (e)(7).

159 Section 509 defines a private foundation; all other organizations specified in section 501(c)(3) are public charities.

160 Reg. section 1.170A-4(b)(3)(i).

161 The regulations suggest that it is sufficient that artwork donated to a museum be “of a general type retained by such museum or other museums for museum purposes.” Reg. section 1.170A-4(b)(3)(ii)(b).

162 Section 170(e)(7)(D)(i)(I).

163 Reg. section 1.170A-4(b)(3). However, it would be wise for the organization to consult with its insurance carrier about the placement of the work. Insurance might not cover artwork hung in places accessible to the general public.

164 A suitable statement of use is set forth at section 170(e)(7)(D)(i).

165 For more details, see Paul N. Frimmer and Jessica Vail, “A Primer on Tax and Other Issues Relevant to Art Collectors and Their Advisors,” 77-19 N.Y.U. Ann. Inst. on Fed. Tax’n section 19 (2020); and Ralph E. Lerner, Judith Bresler, and Diana Wierbicki, Art Law, vol. 2, sections 15:2.2[B], 15:2.3, 15:2.6, and 16:2.2[B][3] (2020).

166 Sections 1(h)(4)-(5) and 1411.

167 One advantage of deferral is the hope that when the tax is due, it will be taxed at a lower rate, either because taxpayer’s income has changed, such as after retirement, or because the applicable tax rates have been reduced. (They might have been increased in the alternative.) A second advantage of deferral is that it provides more capital to invest, which will in turn produce more income. For example, a person who defers $100,000 in taxes can borrow $900,000 from lenders and buy a property for $1 million. To the extent that the return on the property exceeds the interest paid on the loan, the taxpayer is benefiting from income earned on much more than the $100,000 invested.

168 Given the IRS’s stated position, it is unlikely anyone will choose to litigate that question, even though the ruling is directed only to the taxpayer who requested it and cannot be cited as precedent. Sections 170(e)(1)B)(I) and 6110(j)(3).

169 Section 2503(b)(1). The income interest in a trust is not disqualified as a future interest, as long as it cannot be diverted to another person. Reg. section 25.2503-3(b) and (c), Example 4.

170 Section 664(c)(1).

171 Section 664(b).

172 Section 664(d)(1)(A).

173 Cf. section 1400Z-3, requiring “capital gains.”

174 See, e.g., Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955) (corn futures bought by a corn product manufacturer are an inventory substitute and thus not a capital asset); Commissioner v. P.G. Lake Inc., 356 U.S. 260 (1958) (the assignment of ordinary income from a working interest in an oil well is not a capital asset); United States v. Midland-Ross Corp., 381 U.S. 54 (1965) (a discount on bonds bought from the issuer is an interest substitute, not a capital asset); and Hort v. Commissioner, 313 U.S. 28 (1941) (payment to a landlord to release the tenant from a lease is a substitute for rent, not the sale of a capital asset).

175 A charitable remainder annuity trust requires paying a percentage of the initial value, while a charitable remainder unitrust calls for payout of a fixed percentage of the trust’s annual value. Section 664(d).

176 When the trust sells the artwork, it pays no tax on the gain. When the trust distributes funds to the income beneficiaries, those funds are deemed to come first from the trust’s ordinary income, then from its long-term capital gains, then from other income, and finally from the return of capital. Section 664(b). Tax on the gain from the sale of the artwork is thus deferred from the year of sale to the year in which the person who has the income interest receives the distribution.

177 See, e.g., Estate of Atkinson v. Commissioner, 115 T.C. 26 (2000) (a trust whose document conformed to CRT rules but never made the required distributions was not a CRT); and LTR 200122045 (not a CRT for technical reasons related to the income interest, and not a CRT because the power to change income and remainder beneficiaries meant that there was no completed gift of either interest). If the gain is 100 percent of the value of the art and the income payout is 5 percent, a part of the tax on the gain could be deferred for as long as 20 years while it earns additional income in the hands of the trust.

178 Section 1001(a). The basis for determining gain may differ from basis for determining loss if the artwork has been gifted and, when gifted, is worth less than its basis. Section 1015(a).

179 Section 1(h)(1) and (j)(5). For married taxpayers filing joint returns in calendar year 2020, capital gains are not taxed if other taxable income does not exceed $80,000. The capital gains tax rate is 15 percent for income between $80,001 and $496,600 on joint returns.

180 Section 1(h)(4)-(5). For the history of this special capital gains rate, see Anne-Marie E. Rhodes, “Big Picture, Fine Print: The Intersection of Art and Tax,” 26 Colum. J.L. & Arts 179, 185-187 (2003).

181 “The good God is in the details” — a nice pun for an architect to make, and it was also used by Mies van der Rohe. Its original use is often attributed to Gustave Flaubert (1821-1880) and is thought to mean either “things are a lot more complicated than they seem” or “pay attention to the little things.”

182 Section 1221(a)(1). It was this provision that Chandor evaded by establishing that his trade or business was painting portraits on commission, so the one portrait that he painted on speculation was not in the ordinary course of his trade or business. See supra notes 44-45 and accompanying text.

183 Section 1221(a)(3).

184 17 U.S.C. section 202.

185 Reg. section 1.1221-1(c)(1).

186 Section 1221(a)(3)(C).

187 Section 1031(a) and (d). The argument does not fit smoothly, because the code says “to the basis of such property in the hands of a taxpayer” whose personal efforts created such property. (Emphasis added.)

188 Section 1031(a)(1).

189 Section 1012(a).

190 See the discussion of Chandor, supra notes 44-45 and accompanying text.

191 E.g., the private dealer Gustave Kahnweiler (1895-1989) amassed a private collection featuring Picasso, Juan Gris, Fernand Léger, Paul Klee, and Henry Moore. When he went on vacation, Kahnweiler “stored” the collection at London’s Tate Gallery, except for one massive Moore sculpture that he judged too heavy for even the most daring thieves to steal. Assouline, supra note 49, at 349. The Romanian-born Paris then New York gallerist Ileana Sonnabend (1914-2007) put together a private collection that included Robert Rauschenberg’s Combine Canyon (1959), a work that included the body of an eagle. Patricia Cohen, “Art’s Sale Value? Zero. The Tax Bill? $29 Million,” The New York Times, July 22, 2012.

192 Assouline, supra note 49, at 348. In his inventory of works, French gallerist René Gimpel (1881-1945) marked works held for sale with an “S” for stock; works in his private collection went unmarked. Gimpel c. l’Etat, 30 Sept. 2020 Cour d’Appel de Paris RG 19/18087, Portalis 35L7-V-B7D-CAWMR 6, 9.

193 Roberta Smith, “Ileana Sonnabend, Art World Figure, Dies at 92,” The New York Times, Oct. 24, 2007.

194 Bradley T. Borden, “Tax-Free Exchanges of Art and Other Collectibles,” 29 J. Tax’n Invs. 3 (Spring 2012).

195 Section 1031(a). There are always exceptions. Some artworks are realty, like Robert Smithson’s “Spiral Jetty.” Others are realty because they have been permanently affixed to realty. The law of fixtures deems them to be realty. One suspects that the number of artworks exchanged that are realty is relatively small, probably smaller than the percentage of artworks that are classified as realty.

196 It could also be exchanged for like-kind and non-like-kind property, in which case the taxable gain would be the lesser of the realized gain or the amount of non-like-kind property received. Section 1031(b).

197 Section 1014(a) and (b).

198 Former section 1031(a)(2)(A) excludes an exchange of “stock in trade or other property held primarily for sale,” the latter an ambiguous phrase unaccompanied by “to customers in the ordinary course of a trade or business.”

199 It appears that the property received could not be inventory, either, because the code says that “this subsection shall not apply to any exchange of” stock in trade. Id.

200 Section 1031(a)(1).

201 Reg. section 1.1031(a)-1(a)(1).

202 But an investor who relinquishes an investment painting to receive a painting he intends to flip does not get tax-free treatment because he is not going to use the received painting for productive use in his trade or business or for investment. Feld, supra note 3, at 649.

203 Section 1031(a)(1).

204 Reg. section 1.1031(a)-(c). But the statement is overbroad. It would perhaps be more accurate to say that all long-term interests in realty are like kind with all other long-term interests in realty.

205 Reg. section 1.1031(a)-2(b).

206 Reg. section 1.1031(a)-2(c).

207 Reg. section 1.1031(a)-1(b).

208 My favorite is “The Prodigal Son in the Brothel” in the Gemaldegalerie Alte Meister, Dresden, painted in the 1630s, showing the young Rembrandt raising a tall beer flagon, with his new wife Saskia on his knee. Less happy times were ahead of them.

209 The problem is discussed more extensively, but no more definitively, at Borden, supra note 194.

210 In LTR 8127089, taxpayer’s collection of lithographs, oil paintings, pencil drawings, sculptures, masks, wood carvings, and block prints were damaged.

211 17 U.S.C. section 101 (“work of visual art”).

212 Harmonized Tariff Schedule section 9704-9706.

213 Id. at section 9701.

214 Id. at section 9702.

215 Id. at section 9703.

216 Section 1033(a)(2)(A). For an artist or a dealer who is not also a collector or investor, section 1033 is unlikely to be significant. The artwork she holds is inventory. If it is stolen or destroyed, the taxpayer probably has no desire to purchase other artists’ work to replace it in the inventory and thereby diversify what she is selling. The dealer will not wish to because of the assumption that inventory is likely to be sold quickly, so the amount of deferral is probably minimal. It is also unclear that section 1033 can be used for property whose sale would result in ordinary income. A person for whom the involuntarily converted art was part of a collection or investment may well wish to take advantage of section 1033 to defer tax on the insurance proceeds received. The replacement must occur within two years of the end of the tax year in which any part of the gain is realized. Section 1033(a)(2)(B).

218 Rev. Rul. 79-143, 1979-1 C.B. 264.

219 A prudent tax counselor might be excused for believing that this ruling might preview a similar view about like-kind property under section 1031. See Richard M. Horwood, “The Art Collector Meets the Tax Collector,” 29 J. Tax’n Inv. 33 n.26 (Summer 2012).

220 The statute of limitations is normally three years from the filing of the return, but it is extended to six years if the taxpayer omits to report at least 25 percent of his gross income. Section 6501(a) and (e)(1)(A). There is no statute of limitations on tax fraud. Section 6501(c)(1)-(3).

221 Section 1031(d); and reg. section 1.1031(d)-1(a).

222 Reg. section 1.1012-1(a).

223 Section 1400Z-2. The provision has been much criticized. E.g., Calvin H. Johnson, “Repeal Opportunity Zones,” Tax Notes Federal, Oct. 26, 2020, p. 625.

224 A cynic might note that the promise of complete exemption from tax on the gain is illusory. Under current law, it is impossible to hold the investment for 10 years because the provision became effective in 2018 and expires with the arrival of 2026, at which point the gain will be measured if the Opportunity Zone interest has not previously been disposed of. The drafters of the provision must have contemplated that the Opportunity Zone provisions would be made permanent before 2026.

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