This second half of a two-part article examines ways of transferring art without actually selling it, in order to reduce tax liabilities and retain art within a family or some kind of structure enduring beyond the owner's death. The article is part of a series on fine art being published this month.

The first half of this article, published here, discusses the options available to a collector or artist in disposing of collectibles: The collector can (i) monetize the collection by selling it; (ii) gift it to family or friends during one’s lifetime or as an inheritance at death; or (iii) donate it to charity.

If the donor decides that setting up his or her own charitable organization is the way to go, there are two distinct categories of private foundations to consider: (i) non-operating foundations and (ii) operating foundations. We explore these options here in the second part of this essay.

Operating Or non-operating foundation?
At the most basic level, the primary difference between non-operating foundations and operating foundations is the extent to which resources and operations are dedicated directly to charitable activities and services, and whether such operations are carried on continuously or merely sporadically.

Non-operating foundation
These foundations typically make grants to public charities, and they make up the vast majority of the private foundation community. They can conduct their own direct charitable activities but running their own programs is not their primary focus. In addition, these foundations can make grants to individuals, award scholarships, make international gifts, and follow special procedures to make grants to organizations that aren’t recognized as 501(c)(3) organizations. These foundations are the kind that Foundation Source establishes and supports.

Operating foundation
An operating foundation directly operates its own charitable activities (rather than making grants to nonprofits) and must be significantly involved in its own projects in a continuing and sustaining fashion. (Examples might include the operation of a museum, zoo, library, or research facility.)

The case for an operating foundation
For collectors, the primary appeal of donating to an operating foundation is that it confers the same tax benefit as gifting to a museum or other public charity while allowing the donor to retain complete control over the collection. Moreover, the donor can determine how the foundation uses the collection to fulfill its exempt purpose.

The foundation can then lend the art to a museum or university (as opposed to gifting it outright), which ensures that it won’t be sold or warehoused. And when art is exhibited at a prestigious museum or institution, it benefits from that institution’s reputation and cachet, which may have the effect of increasing the perceived quality and monetary value of the collection should the foundation one day decide to sell it. If the donor wants to exert even more control over the art (or if prestigious institutions aren’t clamoring to borrow it), the foundation itself can choose to display the art—either in a by-appointment private gallery or in a privately funded museum that is open to the general public. Art owned by the foundation cannot, however, be displayed privately in the home or on the property of a disqualified person (2) as this is a disallowed personal benefit (“self-dealing”). Instead, the foundation’s art must be housed in a space that’s allocated specifically for that purpose.

Considerations
An operating foundation can be used to run a private gallery or museum, enabling the donor to retain full control over how the collection is displayed and presented. However, to ensure that operating foundations are adequately engaged in directly carrying out their charitable activities, each year, they are required to spend the major portion of their net investment income (85 per cent) directly on the active conduct of their charitable operations (direct charitable expenditures).

If the foundation’s charitable purpose is to share its collection with the public, and the donor puts it in a private gallery or museum, the public must have ready access. The foundation’s tax status can be imperiled by restrictive limitations, such as “by appointment” viewing, that severely limit that access. There can also be considerable costs associated with this approach. Every expense, whether it’s related to maintaining a clean, safe, insured, and climate-controlled building, or hiring staff to care for the art, manage public relations, or admit museum-goers, must be borne by the operating foundation.

But perhaps the biggest drawback of an operating foundation established to house a collection is that it doesn’t give the donor flexibility to do much else. To maintain its status, an operating foundation is required to prove on a periodic basis that it is using most of its assets to conduct its pledged charitable purpose. (3) Although an operating foundation can make grants to organizations that are not directly relevant to its charitable purpose, those grants will not count as qualifying distribution. In practice, this means that an operating foundation may be confined to the narrowly restricted purpose for which it was established.

The Case for a non-operating foundation
If the collector doesn’t want the pressure or ongoing obligation of running an operating foundation, he or she might want to contribute the collection to a private non-operating foundation. Because the annual charitable contribution deduction is limited to 20 per cent of AGI, and the deduction will be limited to cost basis, (or fair market value if it is less than the price the donor originally paid), donating the art to a private, non-operating foundation may be less tax-efficient than donating to a public charity or operating foundation.

However, a non-operating foundation may be the best choice if the collector wants to maintain control over the collection while engaging in other philanthropic interests. Here are some advantages of a non-operating foundation:

Control: Like an operating foundation, a non-operating foundation gives the donor complete control over the disposition of the collection.

Philanthropic flexibility: Non-operating foundations aren’t limited to a narrowly restricted purpose. This means that in addition to sharing a collection with the public, the foundation could support nonprofits relevant to its mission or fund unrelated charitable objectives. The foundation could make grants to nonprofits providing relief to hurricane victims, providing support to a community hospital, fund a pioneering STEM education program, build housing for the homeless, etc. The possibilities are almost limitless.

The donor can display the collection: Just like an operating foundation, a non-operating foundation can be used to share a collection with the public. A non-operating foundation can lend its collections to museums and other institutions or choose to display it in a dedicated space. That’s because, in addition to making grants (the primary way that non-operating foundations further their missions), these entities are also permitted to use their assets to run programs. However, unlike an operating foundation, a non-operating foundation can run programs that are outside its stated operating purpose.

Considerations
If art is held strictly as an investment, there are some considerations to keep in mind. All non-operating foundations are required to distribute a minimum of 5 per cent of the previous year’s net average investment assets annually. (This is colloquially known as the “minimum distribution requirement” or “MDR.”). Therefore, if a non-operating foundation is funded primarily with collectibles held as investments, the collection will need to have sufficient liquidity to meet the foundation’s annual payout requirement and maintain its operations.

And because the market for collectibles and individual pieces can fluctuate considerably, the foundation will need to conduct regular annual appraisals to determine its 5 per cent payout requirement for the next year.

Once donated, tangible assets held as an investment need not be held forever. It is possible for the foundation to dispose of works over time by gifting them to a museum or other institution. Alternatively, the foundation can liquidate the collection, in part or in whole, and use the funds to meet its annual payout requirement. If and when the foundation does sell these assets, the sale will only be subject to a 1.39 per cent excise tax on the foundation’s net capital gains.

Whether the foundation sells the collectibles slowly over time or the entire collection all at once, it should make sure that there’s a ready market for these assets. Note that family members cannot buy back the collection because they are disqualified persons (i.e., foundation “insiders”). Should a sudden need for cash arise, the foundation would not be able to sell it to a disqualified person. If the foundation were to do so, a self-dealing violation would result.

If holding collectibles as an investment becomes problematic at any point, the foundation could always convert the collectibles held as investments into charitable-use assets by lending them to other charities, putting the items on public display, etc. Once converted, such charitable use assets are excluded from the 5 per cent payout calculations.

Because holding collectibles as an investment requires additional planning to ensure sufficient liquidity, holding them as charitable use assets may be a preferable option. If the collection will be publicly displayed or actively used by the foundation in carrying out its mission (for example, by lending it to a public museum), the value of the assets may be excluded from the calculation of the foundation’s MDR.

As outlined above, the private foundation offers numerous benefits to donors. And with advances in technology, the cost and complexity in starting and administering a private foundation have dropped precipitously. Given that nearly all high net worth individuals embrace a commitment to philanthropy, and the often–overlooked opportunity of donating tangible personal property, ranging from artwork to a baseball card collection, this topic should be a part of many estate planning discussions.

Footnotes:
2. Generally, a disqualified person (“insider”) is any and all of the following: foundation managers (directors, officers, trustees, and those with similar powers or responsibilities); substantial contributors and individuals or entities with a 20 per cent or greater interest in an entity that is a substantial contributor; the family members of all such individuals; certain entities partially or wholly owned, directly or indirectly, by disqualified persons.
3. There is an income test that must be passed, having to do with ensuring that a sufficient percentage of the foundation’s distributions relate to its stated operating purpose (e.g., running a museum). Additionally, an operating foundation must pass one of three other tests, one of which concerns distributions, a second of which concerns assets used in furtherance of the foundation’s stated operating purpose, and a third of which concerns contributions.

Jeffrey Haskell, J.D., LL.M., is chief legal officer for Foundation Source, which provides comprehensive support services for private foundations. Contact him at jhaskell@foundationsource.com. Stephen Pappaterra, attorney at law, serves as Counsel for the law firm of Earp Cohn, P.C.