It’s often said that “Buying art is easy, selling art is hard, and donating art is next to impossible.” This adage reflects a fundamental reality of the museum world’s ecosystem: Regardless of artistic merit or acquisition cost, collectors may struggle to find museums or charitable institutions that are willing to accept donations into their permanent collections. This challenge becomes significantly more acute when donors seek “charitable homes” for multiple works of art or their entire collection.

Occasionally, out of frustration, collectors will donate works of art to their family’s private foundation. Unfortunately, donating art and collectibles to a traditional private foundation (aka “non-operating foundation” and/or “grantmaking foundation”) is usually tax-inefficient, administratively complex, and financially burdensome for both the donor and the foundation.

Assembling a collection of fine art, including works by well-known artists, is no guarantee that collectors will be able to find a museum that’s willing to accept any of their pieces into the museum’s permanent collection.

Collectors need to be sensitive to the many reasons why a museum could reject their donation, some of which might include:

• The artwork may not be considered “museum quality” by the donee-museum.
• The artwork may not fit within the museum’s collection strategy.
• The artwork may be redundant to other pieces in the museum’s permanent collection.
• The art may be considered a “lesser work” from an artist who’s already in the museum’s permanent collection.
• In addition to the artwork, the museum may require a cash gift that the donor is unwilling or unable to make.
• The museum may not agree to the donor’s restrictions (for example, display requirements, naming rights, installation instructions, and restrictions on selling or lending the artwork).
• The museum may determine that there are certain issues and risks associated with the artwork’s condition, cultural patrimony, authentication, attribution or title that the museum wishes to avoid.

Because donating or bequeathing works of art to a museum can be so challenging, donors are generally encouraged to approach multiple museums with potential donations to get an indication of each organization’s interest in various pieces before attempting any type of donation.

In many cases, a museum will also require a gift of cash or marketable securities to help offset the administration expenses that are inherent when adding a work of art to its permanent collections. This reflects the financial realities of the museum world, where operating budgets tend to be razor thin. In most instances, a newly donated work of art will have little or no effect on ticket sales or revenue, but the donee-museum must still incur significant expenses for legal and accounting services, property and casualty insurance, moving and storage, exhibition/display, restoration, research, and appraisals.

When donating tangible personal property like works of art to a private foundation, the donor’s income tax deduction will be limited to the lower of the work’s fair market value or the donor’s adjusted tax basis in the artwork. This stands in stark contrast to a donor’s ability to claim a charitable income tax deduction based upon the donated asset’s fair market value when that asset is a publicly traded security.

To make matters worse, when donating works of art to a private foundation, the donor’s available charitable income tax deduction (as described above) will generally be limited to 30% of the donor’s adjusted gross income (AGI) when donating works of art to an operating foundation, and only 20% of the donor’s AGI when donating works of art to a private foundation. Usually, these adjusted tax basis and AGI limitations are sufficient to dissuade collectors from donating appreciated works of art to their private foundation during their lifetime.

Also keep in mind that, among the many requirements to claim a charitable contribution income tax deduction when donating works of art, the donor must obtain a qualified appraisal from a qualified appraiser within 60 days of the donation. The IRS has issued guidance as to what satisfies the definition of qualified appraisal and qualified appraiser in IRS Publication 561, which is available online. If a donor fails to obtain a qualified appraisal, the IRS can deny the donor’s income tax deduction in full, even though the donor’s charitable deduction was based upon the donor’s adjusted basis. Unfortunately, the donor’s cost to obtain a qualified appraisal has the effect of reducing the opportunity cost savings of the donor’s charitable income tax deduction.

When works of art are bequeathed to a private foundation, the art will be removed from the donor’s gross estate for estate tax purposes. However, the private foundation can be strapped with unforeseen administrative burdens, expenses and excise taxes as discussed below.

It’s important to note that, if a decedent’s estate filed a Federal Estate Tax Return: IRS Form 706, the executor must still obtain qualified appraisals for each discrete work of art despite the fact that the artwork is passing to charity and is not subject to estate tax.

Unlike private foundations, which primarily make grants to other qualified charities, private operating foundations must allocate most of their earnings and assets toward pursuing their own charitable programs, like operating a soup kitchen, running foster care programs or offering educational scholarships to low-income families. In the art world context, private operating foundations have been formed for a whole host of purposes, like creating not-for-profit art museums, art lending libraries and art research centers, to name a few.

When conducting personal charity through a private foundation, the vast majority of wealthy families in the United States use traditional private foundations rather than operating foundations. A 2022 IRS study on domestic private foundations and charitable trusts found that, of the 109,351 private foundations then in existence, only 9,658 were operating foundations — a little over 11.3%. As explained above, private operating foundations are treated as public charities and offer donors larger income tax deductions than private foundations based upon the donor’s AGI.

Another key difference between the two types of foundations is that a private foundation must distribute 5% of its assets every year, while an operating foundation has no such distribution requirements and isn’t subject to the private foundation excise tax for failing to make minimum annual distributions.

All private (non-operating) foundations are required to distribute at least 5% of their noncharitable-use assets each year on either charitable grants or qualifying charitable operating expenses. As a result, most family foundations are funded with cash or marketable securities so they can meet their distribution and expenditure requirements. This 5% distribution rule presents a potential liquidity trap for private foundations holding art.

Works of art held by a private foundation are generally considered “non-charitable use” assets, meaning that they’re unrelated to the charity’s mission and therefore need to be appraised each year so that the foundation’s manager can calculate the required annual 5% distribution requirement set forth above. This rule is much harsher than the private foundation rules for real estate, which only require the foundation manager to have real estate appraised every five years. Failure to distribute the proper annual amount will subject the foundation to a 30% excise tax on the undistributed required amount. An additional 100% tax can apply if a corrective distribution isn’t made within a certain amount of time.

It should also be noted that annual appraisals introduce ongoing IRS audit risks. The IRS can always contest the annual appraisals. If the IRS were to determine that a work of art was undervalued, the finding would result in the private foundation failing to distribute its 5% annual requirement, thereby triggering unwanted excise tax, interest and penalties on the undistributed amount. Finally, it should be noted that obtaining annual appraisals is inherently expensive. Those expenses create a drag on a foundation’s overall investment returns and available cash. To exacerbate matters, all carrying costs related to a private foundation holding non-charitable use works of art — such as property and casualty insurance, storage, and conservation — most likely won’t qualify as grant-related expenses under the 5% distribution rule, thus creating an additional drag on investment results and available cash.

All foundations are subject to the IRS self-dealing rules, which are intended to prohibit financial transactions between a foundation and so-called “disqualified persons.” The federal tax code defines disqualified persons as:

• Foundation officers, trustees and directors
• Foundation managers with similar powers to officers, trustees and directors
• Substantial contributors (donors who contributed more than 2% of the foundation’s total contributions, if the amount contributed by the donor exceeds $5,000)
• Certain family members of the preceding disqualified persons (spouse, ancestors, children, grandchildren, great grandchildren, and spouses of children, grandchildren and great grandchildren)
• Corporations, partnerships, trusts, estates or unincorporated enterprises where more than 35% of the voting power (for corporations), profits interest (for partnerships) or beneficial interest (for trusts, estates and unincorporated enterprises) is owned by a disqualified person described above
• The Code and Treasury Regulations also provide the following basic guidance as to which activities between a private foundation and a disqualified person would be considered self-dealing:
  • Sale, exchange or leasing of property — even if done at commercially reasonable rates
  • Loaning money, property or extending credit
  • Providing goods, services or facilities
  • Paying compensation or reimbursing expenses to a disqualified person
  • Transferring foundation income or assets to, or for the benefit of, a disqualified person

With these basic definitions and guidelines, let’s take a look at how these rules apply to collectors and their private foundations.

The IRS will most likely find acts of self-dealing if a collector's foundation purchases works of art from the collector:

• For fair market value
• At a bargain (that is, part-gift/part-sale)
• Acts of self-dealing may also be found if disqualified persons:
• Lease works of art from their foundation
• Display the foundation’s art in their personal residence
• Store the foundation’s artwork in their personal storage facility
• Store their personal art in the foundation’s storage facility
• Hang the foundation’s works of art in their business office
• Use the foundation’s art as décor for a wedding, private party or their business office
• Use the foundation’s art as collateral to obtain a personal loan
• Purchase a work of art at a public auction where their private foundation was the consignor

The initial excise tax on disqualified persons who selfdeal is 10%. Foundation managers can also be subject to a 5% excise tax if they knowingly allowed the self-dealing transaction. And if self-dealing isn’t corrected within the taxable period, an additional 200% excise tax can be imposed on the disqualified person. The term “taxable period” is defined under tax laws to mean the period beginning on the date of the act of self-dealing and ending the earliest of when the IRS mails a notice of deficiency, the IRS assesses the initial 10% excise tax, or the act is actually corrected. The correction period begins on the date of the act and ends 90 days after the IRS mails a notice of deficiency.

If a private foundation makes an investment that would financially jeopardize the carrying out of its exempt purposes, both the foundation and the individual foundation managers may become liable for excise taxes. Because works of art are highly illiquid and don’t pay dividends or interest, if a private foundation were to purchase fine art, that acquisition might be considered a jeopardy investment and subject both the foundation and the foundation manager(s) to an excise tax of 10% of the fair market value of the art. If the IRS assesses jeopardy investment excise tax, and if the offending asset isn’t sold within a certain time period, the excise tax can increase to 25%. Since art is extremely illiquid, a foundation may not be able to sell the offending piece in time to avoid a 25% excise tax.

While the jeopardy investment tax shouldn’t apply to donations of art, any private foundation that receives a donation of art should consider selling it immediately to avoid the annual carrying expense and to defuse the risk that the IRS could dispute the foundation’s annual valuation and its 5% distribution amounts.

Unfortunately, collectors have very few options if they’re unable to find a qualified charity that will accept their works of art. Typical options that don’t include donating to their family foundation include:

• Passing their collection to their heirs so the heirs can enjoy, donate, sell or discard.
• Finding another type of nonprofit institution that will accept the donation into its permanent collection, like a hospital or university.
• Selling some or all of their art while they’re alive and donating the net proceeds to their private foundation.
• Donating works of art to a charitable remainder unitrust (CRUT) so that the charitable remainder trust (CRT) trustee can sell the art and redeploy the gross sales proceeds into a diversified stock and bond portfolio that will pay the donor an income stream for a prescribed period of time, with the remainder passing to the donor’s private foundation after the donor’s income stream has ended. The IRS generally takes the position that a donor’s charitable income tax deduction will be limited to the lower of a donor’s adjusted basis in the donated work or the work’s fair market value because when the donor-advised fund sells the donated work, the so-called “related use” rules won’t have been satisfied. It’s also the position of the IRS that when donating tangible personal property like works of art to a CRT, the donor won’t be able to claim a charitable income tax deduction until the CRT trustee actually sells the artwork, which could be in a year other than the year of donation. Funding CRTs with fine art only may be attractive to someone who recently inherited a blue-chip work of art, since the art would have received a stepped-up tax basis at the previous owner’s death, and the artwork has a high probability of being sold since it’s blue-chip.
• Instructing their executor to sell the artwork and distribute the proceeds to their private foundation. Note that there should be a backup plan if the executor is unable to sell the art within a certain period of time. 
• Donating their collection to their own private art museum (that is, operating foundation). Unfortunately, this option is generally reserved for very wealthy mega-collectors who can afford to lay out tens of millions of dollars building, running and endowing an art museum.