Artists, Tax Collectors, and Private Foundation Status

Artists, Tax Collectors, and Private Foundation Status

Article posted in Tangible Personal Property on 8 April 2004| comments
audience: National Publication | last updated: 18 May 2011


When it comes to estate planning, the estates of successful artists have a problem: Flooding the market with originals to raise money to pay estate taxes can have a depressing effect on not only the prices of the artwork being sold, but more importantly on the perception of value of those who already own work by that artist. In this article, Burgess J.W. Raby, Esq., and William L. Raby, CPA, both associated with the Raby Law Office, Tempe, Ariz., examine how one artist solved this problem with a bonfire and another with a foundation.
by Burgess J.W. Raby, Esq. and William L. Raby, PhD, CPA

Full Text:

One artist solved his federal tax problems with a bonfire. Another created a foundation and then had to go to court to get tax exemption for it. The first artist was Ettore (Ted) De Grazia (1909- 1982), who achieved national renown for his 1960 UNICEF Christmas card illustration, "Los Niños." He also later achieved a sort of notoriety among tax planners of the late 1970s.

De Grazia's Federal Tax Complaints

De Grazia had two federal tax complaints:

(1) that his heirs might have to "dump" on the market his inventory of original paintings, which he seldom sold, to pay the estate taxes that would be imposed on them; and

(2) that he could not obtain lifetime income tax benefits from charitable contribution of that original art.1

De Grazia's tax notoriety resulted from a well-publicized 1976 burning of over 100 of his oil paintings at Angel Springs in the Superstition Mountains east of Phoenix.2 His discontent over the tax treatment of successful artists had been heightened by reports of the tax troubles that emerged when noted sculptor David Smith died. It seemed to De Grazia that Smith's family had had to buy back from the IRS the inventory of enormous metal sculptures that Smith still held when he died, both paying what cash the estate could raise and agreeing to a royalty to the government on the sale of the pieces that were in his estate inventory. The actual burning of artwork was triggered by De Grazia's fury when he read of the plight of the heirs of Walt Kelly, creator of "Pogo," whose family literally faced bankruptcy as a result of the estate tax.

Following the publicity over the mountain bonfire, there ensued discussions at tax seminars, conferences, and institutes of the tax provisions that led to De Grazia's dramatic tax protest. The tax gurus of the day explored whether there were tax-planning stratagems that might have solved De Grazia's problems without depressing the market for his paintings or impoverishing his heirs. We are not aware that any perfect answers emerged.

Art Market Economics

Buyers of original art, it has been suggested, have an advantage over other investors. They reap their return on investment from being surrounded by good or great art and also from their perception that the value of their investment is growing. Neither intangible is subject to income tax. When and if they do sell the art, they receive capital gain treatment but, as is often the case, if they donate the art to museums, schools, or other tax-exempts that use the art in carrying out the donee's exempt function, the collectors get a full deduction for the appraised value of the art.

Artists are not unaware of why people buy and hold art. It is hardly true that the value of an artist's work never starts to rise until after his death, but there is a supply-and-demand aspect to the price the market puts on art. As a result, artists' deaths do, over time, enhance the value of their work because there is then no more of their work being created. Flooding the market with originals to raise money to pay estate taxes can have a depressing effect on not only the prices of the paintings being sold, but more importantly on the perception of value of those who already own work by that artist. Even the expectation of such an increase in supply can depress perceived values. The cynical have suggested that avoiding those perceptions may have helped spur De Grazia's well-publicized "bonfire of the paintings."

Kinkade Foundation Charitable Trust

Not only did De Grazia feel that the tax law discriminated against him, but he also felt that in many ways he was rejected by an art establishment that seldom took seriously artists whose reproductions were mass-produced, such as on greeting cards or magazine covers. Even his alma mater, the university in his home city of Tucson, took no interest in his work in his earlier years, so De Grazia opened his own gallery.

If De Grazia can be described as an artist who was a commercial success but was rejected by the art establishment of his day, Thomas Kinkade must be thought of as the combination Henry Ford and Billy Graham of such artists. In an interview in Christianity Today, published on December 4, 2000, the self-styled "Painter of Light" was quoted as saying "The critics may not endorse me, but I own the hearts of the people." He went on to add, "I'm on a crusade to turn the tide in the arts, to restore dignity to the arts and, by extension, to the culture." Not surprisingly, Norman Rockwell was a major and formative influence on Kinkade. The Kinkade game plan? First, he established himself as the most commercially successful artist in the culture, "the first mainstream superstar." Next, he built a highly successful corporation devoted to exploiting his work, with licensing relationships with scores of affiliates and with its own "manufacturing plant" that produced what Kinkade called "semi-originals" for distribution throughout the world. The third step was to establish the Thomas Kinkade Foundation as a way to resist "the art culture that is so inbred." That third step would include erecting a series of museums that would be an alternative to existing art museums and that would feature traditional artists.

The Thomas Kinkade Foundation Charitable Trust was created on December 29, 1999, and applied for tax exemption via a Form 1023 filed on October 4, 2000. The Form 1023 sought classification both as an exempt organization under section 501(c)(3) and as a supporting organization under section 509(a)(3) and not as a private foundation. After a great deal of correspondence and telephone conversation between various people in the IRS and the foundation's attorneys, including early assurances that a favorable determination letter would be issued, the IRS finally released a negative determination letter on August 2, 2002. The Service had concluded that the primary purpose of the foundation was "to provide substantial and direct personal benefit to the Foundation's settlors." Its concern was reportedly that the foundation would be buying copies of Kinkade's art from Kinkade's corporation, Media Arts Group. The IRS ruling also concluded that even if the foundation were exempt, it would be a private foundation under section 509 and not a supporting organization. The foundation immediately filed a protest and also brought a suit seeking a declaratory judgment under section 7428.3

The Thomas Kinkade Foundation Charitable Trust v. United States, No. 02CV01973, disposed of that suit by entering an order granting the foundation both its exempt status and its freedom from private foundation restrictions as a support organization. That apparently occurred after District Judge Rosemary M. Collyer had criticized the IRS delay in reaching a decision on the exemption request. Section 7428 allows the applicant to file for declaratory relief if the IRS has not acted within 270 days. The IRS had taken almost two years to decide the Kinkade Foundation's status. The IRS attorneys, having reviewed the administrative file on the basis of which the case would be decided, concluded that the government had no case and filed a motion agreeing to Judge Collyer's order. Presumably the Foundation was then free to help support the market for Kinkade's work and the crusade to replace modernism in art with beauty, sentiment, the memory of Eden, and the promise of paradise.

[PGDC Editor's Note: For further background, see "Thomas Kinkade Foundation Seeks Charitable Status" and "Court to Shed Light on Jurisdiction Over Thomas Kinkade Foundation."]

Nonprofits and Private Inurement

Nonprofits can benefit for-profit activities of artists or of anyone else. Some of that type of benefit is unplanned. For example, not having to deal with a trade-in may facilitate the sale of a new or newer auto. The donation of an old clunker to a charitable organization may result in a tax benefit that exceeds the real trade-in allowance that a dealer might give. See "When Charity Begins at Home," Tax Notes, Jan. 5, 2004, p. 95, and VEHICLE DONATIONS: Benefits to Charities and Donors, but Limited Program Oversight, General Accounting Office, GAO-04-73. Auto dealers may not be responsible for the abuses that the GAO has chronicled, but they nevertheless benefit from them.

For another example, consider that a school teaching social dancing might encourage or even participate in creating an exempt nonprofit that would accept untaught dance lessons from the school's customers to be used to provide dance education in schools unable to otherwise finance dance programs. No direct benefit would inure to the school, but the ability of its customers to dispose of untaught units in a socially beneficial way, and with some tax benefit, would salve one of the chronic irritations of dance studio customers who file complaints and suits charging that they were high-pressured into buying excessive numbers of lessons. Sports teams, both professional and collegiate, often make it possible for season ticket holders to make charitable contributions of tickets that are not going to be used, with the tickets going to underprivileged children, an arrangement that lessens the sales resistance to buying season tickets.

We believe it can be argued that charitable contributions of unused tickets, untaught lessons, used cars, or anything else should be deductible in those situations under current law. Those arrangements need to be distinguished from the type of thing involved in such cases as Ralph Pierce Graves, et ux. v. Commissioner, T.C. Memo. 1994-616, which clearly falls on the other side of the line for both the contributor and the nonprofit. Graves involved contributions to the Owl Foundation, which at the time had a section 501(c)(3) determination letter from the IRS and was listed as a publicly supported exempt organization in IRS Publication 78. The foundation obtained its funds from parents. They paid Owl the amount of their children's tuition plus 15 percent, and Owl furnished them with receipts for their contributions. The foundation then awarded full-tuition scholarships to the children.

This "too good to be true" way of getting a tax deduction for the children's tuition by paying a (deductible) 15 percent fee was, of course, too good to be true. The IRS retroactively revoked the Owl Foundation's exemption letter. It issued deficiency notices, including fraud penalties, to the Graveses and other contributors. The foundation's director was indicted for subscribing to a false income tax return and for aiding and assisting in the preparation of false returns. The Tax Court shrugged off the arguments that the Graveses were entitled to rely on the determination letter issued to the foundation and should be entitled to at least deduct the 15 percent they paid over and above the tuition benefit they received. It also disagreed with their contention that there should not, in any event, be penalties, because they relied on their accountant as to the actual preparation of the return. The Graveses were not innocent victims, concluded the Tax Court, but were part of the situation that resulted in revocation of the foundation's exemption. As to the penalties, the court reasoned that a reasonably prudent person would have investigated whether an indirect payment of tuition could provide a tax deduction. The Graveses had never told their tax preparer that the contribution paid the tuition, so they obtained no penalty insurance from the mere fact that the return was prepared by a professional. However, the court did reduce the penalty from fraud to negligence.

Tax-Exempt but Private Foundation

The most frequent problem we encounter when section 501(c)(3) is being used to provide a tax umbrella for legitimate ways of doing well by doing good is not the section 501(c)(3) status itself but the private foundation complication. Being a private foundation under section 509 puts severe limitations on a section 501(c)(3) organization. Gifts of capital gain property to such a private foundation, other than publicly traded stock, may be deductible only to the extent of the property's tax basis. Its activities are restricted, and it cannot accumulate income or engage in any financial dealings with substantial contributors. Its annual Form 990-PF information return requires more information than does the normal Form 990. A 2 percent excise tax is imposed on net investment income, while a tax of 15 percent of undistributed income is imposed if the foundation fails to distribute 5 percent of its net investment assets each year.4

Those limitations are why the Lapham Foundation, which had nothing to do with art or artists, objected when the IRS agreed that it qualified under section 501(c)(3) but ruled it subject to the private foundation limitations. We are discussing the Lapham Foundation here because the IRS contended that even if the Kinkade Foundation was exempt, it should, in any event, be treated as a private foundation. To understand what is involved in those cases, and in planning in analogous situations, practitioners need to understand the difference between a supporting organization and a private foundation. Also, practitioners who are filing Form 1023s for entities the IRS may want to classify as private foundations need to understand the nature of a declaratory judgment proceeding under section 7428.

Lapham Foundation

The opinion in Lapham Foundation, Inc. v. Commissioner, T. C. Memo. 2002-293, on appeal (6th Cir.), started with Senior Tax Court Judge Arthur L. Nims III saying that "the facts recited in the administrative record . . . are assumed to be true for purposes of this opinion." That is, in a section 7428 proceeding, there is no opportunity to submit evidence. The message for practitioners is that if a declaratory judgment proceeding is a possibility, the material submitted to the IRS at the earlier stages should be focused not only on responding to and persuading the Service but also on building an administrative record that provides maximum support for the petitioner's later arguments in court. The Kinkade Foundation apparently did an excellent job of that.

Section 509(a) defines a private foundation as any organization described in section 501(c)(3) except for those organizations excluded under sections 509(a)(1)-(4). The most common exceptions in our experience are schools, churches, hospitals, and other 501(c)(3)s that normally receive more than one-third of their support each year from persons other than "substantial contributors" (as defined in section 507(b)(2), which is essentially a "more than $5,000" test). The Lapham Foundation argued, however, as did the Kinkade Foundation, that it should be excluded from private foundation treatment under section 509(a)(3) as a supporting organization. Such an organization:

(A) is organized and operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified organizations that are exempt as a church, educational institution, hospital or related medical research organization, publicly-supported charity, or a state or the political subdivision of a state;

(B) is operated, supervised, or controlled by or in connection with one or more such organizations; and

(C) is not controlled directly or indirectly by one or more disqualified persons (as defined in section 4946) other than foundation managers and other than the organization(s) referred to in (A).

Supporting Organization

The Lapham Foundation argued that it was a supporting organization for the American Endowment Foundation (AEF), a donor-advised publicly supported organization recognized by the IRS as exempt under section 501(c)(3). The final submission by the foundation to the IRS in its quest for a tax determination letter was a proposal to amend its articles to include the First Presbyterian Church of Northville, Michigan, and the Northville, Michigan, troops of the Boy Scouts of America Detroit Area Council as two additional supported organizations, with AEF remaining as a third. However, before any action was ever taken on finalizing that amendment or other amendments to the foundation bylaws to address IRS concerns regarding disqualified person control, the IRS issued its final adverse ruling on the supporting organization status. The foundation failed the "operated, supervised or controlled" test, the IRS ruling concluded, and also failed the disqualified person control test.

In the Tax Court proceeding, the foundation asserted that it had made the proposed changes to both its articles and its bylaws and that Judge Nims should take the changes into account, even though the IRS had not. Judge Nims concluded, however, that "we are constrained to reach our disposition on the basis of the administrative record as constituted without taking any such changes into account. Accordingly, we base our ruling herein solely on the materials exchanged by the parties during the administrative process."

[PGDC Editor's Note: See also "Attorney Says Court's Analysis of Supporting Organization Test Missed Bigger Picture."]

Responsiveness and Integral Part Subtests

Judge Nims never did deal with the disqualified person control test in his opinion, saying only that it was moot because he decided the "operated, supervised or controlled" question against the foundation. The regulations impose two specific tests that must be satisfied if any organization is to be held to be operated in connection with a publicly supported entity, such as AEF in this case. Those are referred to in the opinion as the "responsiveness test" and the "integral part" test. "The responsiveness test," said Judge Nims, "is designed to ensure that the supporting organization is responsive to the needs of the publicly supported organization by requiring the supported organization have the ability to influence the activities of the supporting organization." Reg. section 1.509(a)-4(i)(2) sets out several ways in which this can be done. He added that, in turn, "[t]he integral part test seeks to ensure that the supporting organization maintains a significant involvement in the operations of one or more publicly supported organizations and such publicly supported organizations are in turn dependent upon the supporting organization for the type of support which it provides." While the responsiveness test requires that the supported organization be able to influence the activities of the supporting organization, the integral part test seems designed to make sure that it will be motivated to do so.

Judge Nims concluded that the foundation met the responsiveness test. That left the integral part test, and there Judge Nims disagreed with a key element of the foundation argument. The foundation viewed itself as playing a pivotal role in terms of AEF activities in the Northville, Michigan, area. Said Judge Nims:

We reject petitioner's argument on the ground that it is based upon a faulty factual premise; namely, that petitioner's support to AEF is dedicated to activities in Northville, Michigan, or southeastern Michigan. This premise is based upon the fact that petitioner intends to recommend to AEF that petitioner's contributions to the donor-advised fund be used to support charities in Northville, Michigan, or southeastern Michigan. However, as found above, AEF is not bound by such recommendations and can use the support received from petitioner to fund charitable activities anywhere in the United States.

The foundation also argued that its donations to AEF were and would be earmarked for use in Northville, Mich., and that that was the only support AEF would receive for activities in that area. But Judge Nims did not accept that variation on the argument, either:

On the present facts, there exist at least two barriers to petitioner's ability to satisfy the integral part test through the alleged earmarking. The first is the requirement that either petitioner or AEF earmark the funds for a particular program or activity. Because the contributions are made to a donor-advised fund, petitioner cannot definitively earmark the moneys for any specific project. Rather, petitioner is limited to making recommendations which AEF is not bound to, and will not necessarily, implement. Moreover, petitioner has not established that AEF has in fact earmarked petitioner's contributions for a particular venture.

Second, the regulations mandate that the payments be earmarked for a substantial program or activity of the supported organization. Again, the administrative record belies that supporting Northville, Michigan, is a substantial activity of AEF. Even benefiting Michigan as a whole has not been shown to be a substantial focus of AEF, and there is no evidence that the rather minimal expenditures made in that state by AEF ($5,500 in 1998) would be interrupted absent petitioner's support. Petitioner therefore has failed to prove that its operations will ensure AEF's attentiveness.


Assume that an artist created a section 501(c)(3) entity (the foundation) for the purpose of providing funds to section 501(c)(3) art museums for their acquisition and display of a certain type of art. That would benefit the artist indirectly in that it would help increase the market for the type of art of which his or her work was a part. Such a step would be a more positive approach to the inability to get a tax deduction for donations of the art than would a bonfire of paintings. Cash donated to the foundation would provide a charitable contribution deduction while a healthier market would allow mitigation of the estate tax problem by facilitating the reduction of inventory during the artist's life without depressing the individual collector market.

The tax practitioner asked to assist in such an endeavor, or in any creation of a charitable organization to accomplish donor objectives that a critical IRS might view as self-serving, will find that the complexities of the private foundation rules, in addition to the normal IRS suspicion of possible private inurement, will make the whole process far more difficult and time-consuming than might originally be anticipated. The Kinkade Foundation seems to have succeeded for now in getting its vehicle on the road. Perhaps it is blazing a trail that others will be able to follow. Taxpayers should be able to achieve charitable objectives of their choosing through creation of or contributions to legitimate exempt organizations. Inevitably, however, the IRS will challenge those tax-exempts and their donors in situations in which the Service concludes that something is occurring that goes beyond the Service's view of what Congress intended. Prudent practitioners will forewarn their clients of that possibility -- and prepare them for the possibility (and costs) of controversy. When enough is at stake, either in terms of the goal to be achieved or the dollars involved, the effort will probably be worth the cost.


1 De Grazia was quoted as saying, "If anyone else buys my painting for $2, he can then give it to a museum and deduct $10,000 from his taxes, if that is the market value of the piece. If I myself donate it, I get $2 tax credit, because that is what the paint and the canvas cost." Harry Redl, The World of De Grazia, Chrysalis Publishing Co., 1981, p. 56. Of course, De Grazia did not worry about the difference between a deduction and a credit, nor would his fury over the injustice of this treatment have been lessened if he had.

2 The Superstition Mountains are also the fabled location of the legendary Lost Dutchman's Mine as well as being a location often pictured in De Grazia's work.

3 Suits seeking declaratory judgments under section 7428 may be brought in the Tax Court, the Court of Federal Claims, or the U.S. District Court for the District of Columbia. The Kinkade Foundation chose the District of Columbia district court.

4 Private foundation status is not always fatal to achieving objectives. For example, Rev. Rul. 74-498, 1974-2 C.B. 387, concluded that a collection of paintings, owned by a private foundation formed to further the arts, that are loaned under an active loan program for exhibition in museums, universities, and similar institutions, are being used directly in carrying out the foundation's exempt purpose within the meaning of section 4942(e)(1)(A), and the value of the paintings is excludible in computing the foundation's minimum investment return. In the same way, Rev. Rul. 75-207, 1975-1 C.B. 361, concluded that the value of an island owned by a private foundation dedicated to preserving the natural ecosystems and historical and archaeological remains of the island may be excluded from a private foundation's minimum investment return under section 4942(e).


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