Selling out Without Selling out: The Art of Tax Exempt Commerce
Can a museum or gallery engage in commerce and remain a non-profit? It depends!
An organization may engage in a trade or business as long as its operation furthers an exempt purpose and its primary objective is not the production of profits. see Goldsboro Art League, Inc. v. Commissioner, 75 T.C. 337, 343 (1980). In Goldsboro Art League, Inc., the league sold artwork (in addition to holding educational classes and exhibiting work) and retained a portion of the sale as a commission but maintain non-profit status because the court found incidental to its other activities and serve the same overall objective of art education. This is not a case where the other activities are adjunct to petitioner's sales, but, rather, where petitioner's sales activities are secondary and incidental to furthering its exempt purpose. Id.
Treasury Regulation § 1.501(c)(3)-1(e). It states “An organization may meet the requirements of section 501(c)(3) although it operates a trade or business as a substantial part of its activities, if the operation of such trade or business is in furtherance of the organization’s exempt purpose or purposes and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business, as defined in section 513” The Regulation goes on to explain that when evaluating what constitutes the “primary purpose”, “all the circumstances must be considered, including the size and extent of the trade or business and the size and extent of the activities which are in furtherance of one or more exempt purposes” 26 CFR § 1.501(c)(3)-1(c)(1) states “An organization will not be so regarded [as a non-profit] if more than an insubstantial part of its activities is not in furtherance of an exempt purpose”
IRS Rev. Rul. 71-395 held that that a cooperative art gallery formed and operated by a group of artists to exhibit and sell their own works does not qualify for tax-exempt status under IRC Section 501(c)(3)
Rev. Rul. 76-152 held that a nonprofit which exhibited and sold art for local artists and retained a ten percent commission did not qualify for exemption because the direct benefit to the artists could not be considered incidental.
What should you do if you are a non-profit and municipality (or the federal government) is trying to revoke your status based on the trade or businesses your organization is carrying on ? You should marshal the facts on how the trade or business is incidental to furthering your exempt purpose.
Search if your work is in datasets that could have been used to train an LLM
The Atlantic has published a tool which allows artists and writers to search if their work is in datasets. They clarify that just because a work is in a dataset doesn’t necessarily mean that it was used to train an LLM . They also clarify that they don’t have every single dataset used to train AI and thus if you don’t see your work listed it doesn’t mean that it wasn’t used to train an LLM.
A-Corp OK for you?
Colorado recently passed the Colorado Artist Company Act which created a new type of corporation for artists to organize themselves into a business. They are referred to as A-Corp and if it finds success in Colorado other states may adopt similar forms to help their own artists in the same way.
Key aspects of the law are as follows:
Artists must own 51% of voting shares. This is set by statue and cannot be contracted away.
Intellectual Property transferred to the corporation cannot be transferred to a non-artist investor or 3rd party. If the corporation is dissolved, the Intellectual Property reverts back to the artist who created it. In Waite v. UMG Recordings, Inc. (2020) a group of musicians tried file termination claims (demanding their intellectual property back) under 203 of the copyright act and UMG denied those claims under the reasoning that the artists had assign those intellectual property rights to carve out corporations. If those corporations had this protection afford to A-Corporations, this would not have happened.
Economic governance can be separated from artistic control. Artists can give non-artist investors rights of economic distribution or royalties while retaining complete creative control over the creation of their art.
Members and Managers have fiduciary duty to preserve the artists mission while balancing it with financial interests.
Gain Today, Gone Tomorrow: Installment Sales and Other Ways to Avoid Gains
At various points collectors or gallery owners will want to turn over their art work or collectibles and acquire new pieces. If a piece is sold, it may subject a tax payer to paying taxes on capital gains (or claiming a loss). IRS Revenue Code section 1031 used to allow for the deferral of paying taxes on a capital gain (or loss) at the disposal of property if it is exchanged for a “like-kind'“ property. This used to apply to personal property, which would include artwork. However, the Tax Cuts and Jobs Act (TCJA) of 2017 eliminated this avenue for collectors and gallery owners.
There are some alternative strategies that can be used to avoid realizing a gain (or loss) all at once. First, a collector or gallery owner can use an installment sale under Internal Revenue Code 453. Instead of receiving complete payments all at once, you receive payments over time. The IRS requires a taxpayer to characterize portions of each payment as return of basis (tax free), capital gain (capital gains tax) , and interest (ordinary income tax) on the remaining balance. It is best to consult a licensed professional in order to construct and report the installment sale correctly. This cannot be used for inventory. Thus, gallery owners can use this to dispose of works that they display, but not sell.
The obvious downside to using this strategy is is that collector or gallery owner is not paid all at once. The benefit to using it is that it will allow them to stay in a lower bracket while earning even more money over time. The Net Investment Income Tax applies to individuals that earn more than $200,000. Utilizing an installment sale might allow some collectors and gallery owners to avoid this. Obviously, this strategy should only be used with buyers that collectors and gallery owners trust to follow through on all the payments.
Second, for very large capital gains collectors or gallery owners it might make sense to place the proceeds from a sale into a quailed opportunity fund. Under the TCJA qualified opportunity funds are specific funds which invest in specifically economically distressed areas in the country. Profits invested in these funds become completely tax free after 10 years (if the funds invested are withdrawn earlier a percentage of capital gains tax will be due).
Can you Trust your Art Trust?
When artists (or collectors) are planning their estate the issue of whether artwork should be placed in a trust should be considered. Like any strategy, art trusts have costs and benefits and it is ultimately up to the client to determine if they are worth it. I like to focus on what the client’s goal is. Do you just not want the artwork to be thrown away? Donating it to a hospice or non-profit which will put artwork on display may be a more economical solution to having a trust pay to have it stored and never be seen.
If an artist (or collector) has determined that the benefits of an art trust outweigh the costs, there are several things that need to be considered in order to ensure an art trust will actually serve its intended purpose.
Waiver of Trustee’s Duty to Diversify Investments
Most states have adopted some form of the Uniform Prudent Investor Act. This act requires trustees (absent a waiver in the trust) to diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.
While it is possible for a trustee of an art trust to argue holding the work better serves the purpose of the trust, not having a waiver of the requirement to diversify investments certainly puts them on the back foot. Presumably, the artist (or collector) chose the trustee because they trust them and want them to succeed. Waiving the requirement that investments are diversified and specify exactly what they want the trustee to do with their work (hold, sell, license, loan) will help them succeed.
Waiver of Trustee’s Duty to Monitor Investment Performance of Personal Property or Illiquid Assets
The Uniform Prudent Investor Act requires trustees to manage trust assets as a prudent investor would and requires them to consider, general economic conditions, and take reasonable steps to verify facts relevant to the investment and management of trust assets. Trustees can arguably violate these provisions if artwork is held in trust and they cannot substantiate how they monitored investment performance of the artwork. Artwork is not like a stock traded on an open exchange. It is close to impossible to substantiate its economic performance over a short length of time. Thus, it is important to excuse a trustee from any obligation of trying to monitor. investment performance of something that they will not be able to do.Allow the Trust to hold artwork and real property in an LLC
Most states have some form of the rule against perpetuities which limits the amount of time a trust can administer real or personal property. In some states the rule is the trust property must vest or the trust will terminate 90 years after its creation or within 21 years of the death of the youngest beneficiary alive when the trust was created. If an artist (or collector) wishes for the trust to control the artwork for the longest period of time, it might be in their interest to setup and LLC to hold the artwork and have the trust own shares in the LLC. Allowing the LLC to hold the property fits an exception to the rule against perpetuities most states have for non-donative transfers which essentially characterizes it as a business transaction.
Some states even have specific drafting requirements for these types of trusts which are referred to as “dynasty trusts”.