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The IRS recognizes five distinct types of taxpayer: the Artist, the Collector, the Investor, the Business Investor, and the Dealer. IF, you are not the creator, the IRS will assume you are a Collector (thus imposing the highest capital gains tax and allowing the fewest deductions). In actuality, you may qualify for the more advantageous tax status of Investor, where more deductions are allowed, as well as the use of techniques such as like kind exchanges. Qualifying as an Investor is not as simple as a declaration, and requires a well-documented pattern of behavior by your client; but, a qualified expert can help your client position himself to obtain the most desirable tax status.
An artist’s work, during their life and later, may sell numerous times and be seen in galleries more than once. The sales value can vary from a small sum to millions of dollars such as with the work of Picasso, Van Gogh, etc. An artist may achieve notoriety during their life or may never achieve it; however, their works are of no less importanc. An artist may conduct their craft as their occupation, as a for-profit trade or business or as a not-for-profit activity. Income would be taxed as ordinary income, and generally, expenses would fall under IRC § 162. However, for the activity deemed not-for-profit under IRC § 183, expense deductibility is limited to gross income.
Beyond the Artist: Investor, Hobbyist, Business Collector and Dealer
Once the artwork leaves the hands of the artist, it generally goes to one of four categories of persons, each of which have different tax considerations. They are the investor, hobbyist, business collector and dealer. Which category a taxpayer falls into would depend on the facts and circumstances of that taxpayer’s case. The line between these categories of art owners, for tax purposes, is not always clear; therefore, there has been much litigation in the courts such as the distinction between investor and dealer or between an investor and a hobbyist.
In addition, a taxpayer might hold art in different categories. For example, a dealer might hold specific pieces of art in their trade or business and other pieces of art as an individual investor. Various expenses and losses in each category may or may not be deductible and depends on facts and circumstances. Any private taxable collector should have a customized plan based on a piece-by-piece consideration of the determination of the category they fall into, on the purchase, holding or sale of an item. If, any expense or loss is deductible, and if needed, they should consult with their subject matter expert. Following is a brief introduction to the four categories.
An investor is a person who buys sells and collects art solely as an investment with the hope the asset will appreciate to enable sale at a profit. For an investor, generally the art investment when sold is taxable as a capital gain, unless it falls outside the definition of capital asset. IRC § 1221 defines capital asset to include all assets except:
(1) Stock in trade or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business
(2) Property used in a taxpayer’s trade or business that is subject to the allowance for depreciation or
(3) An artistic composition held by the creator or a person in whose hands the basis of such artistic composition is determined by reference to the basis of the creator. A gift from an artist to an individual, would fall under category (3) and be taxable as ordinary income property.
A capital loss is available to an investor under IRC § 165(c)(2), if the intent test of entering into the transaction for profit can be proved. The taxpayer must prove the purchase and the sale of the artwork was a transaction entered into for profit. Many factors are looked at based on the facts and circumstances of the taxpayer’s case. However, the taxpayer’s personal use and enjoyment of the artwork will generally be a critical factor showing the intent was not entered into for profit.
An investor can be classified as a dealer or a hobbyist, instead of an investor, based on the facts and circumstances in their case. Sometimes, investors want to be classified as dealers when they have losses in order to be able to deduct the loss as ordinary income, rather than as a capital loss.
A hobbyist is a collector who buys art or other collectibles, without considering whether it will ever be a profitable investment. The hobbyist rarely sells a work, which if sold generally is a capital asset in which gains are recognized, but losses are not allowed (IRC §§ 1221 and 165(c) respectively). Expenses attributed to maintaining the collection are generally not deductible per IRC § 262; however, IRC § 183 may allow some deductions up to the amount of gross income generated by the activity following the ordering rules of the IRC § 183. The disadvantage of being a Hobbist is that, though you pay 28% on the gains on the sale of a collectible, you are not able to take the losses on the sale of collectibles. Therefore, Hobbyist try to be classified as an investor.
The Business Collector
A business collector does not buy the art for resale, but rather for purposes such as office display or decoration in the ordinary course of trade or business. Art, because the useful life is not determinable, is generally not subject to depreciation. In addition, many businesses buy art for investment that can place them in the category of investor or hobbyist. The art investment can be of such a nature that they cross the line into being a dealer. Again, facts and circumstances need to be reviewed in each individual case to determine the categorization of the activity.
The dealer is one who buys and sells art as a trade or business. An art gallery is one such type of dealer. Art dealers are taxed in the same way as any other retail operation. As such, all income including income from the sale of art is taxed as ordinary income (IRC §§ 61, 64). Expenses, if ordinary and necessary, are deductible under IRC § 162. Dealers sometimes want to be classified as investors because of the favorable capital gains rates versus being taxed on said gains as ordinary income. Additionally, dealers including gallery owners often wear the hat of investor in art as well as dealer in art keeping the two as separate activities. There are many court cases dealing with this issue such as Williford v. Commissioner, T.C. Memo. 1992-450.
So, when you find the collectible trading card of LaBron James you spent $300,000 on is now worth $7 million, congratulate yourself on your investment, but think about doing some tax planning before you sell it!
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