Intro to Taxation of Art Galleries with Top 13 Audit Pitfalls

The business of art is fertile grounds for the tax professional. Depending on the unique facts, a piece of art can never sell—or sell for millions of dollars. It can change hands once—or multiple times over.

Below is a brief overview of how art galleries do business, followed by classification of art-related taxpayers, and then followed by 13 tax-audit pitfalls for the unwary art connoisseur.

The Business of Art Galleries

An art gallery is a medium through which art is marketed and shown to the world. Art displayed within it can be as varied as the artists’ vision. We often think of art galleries as displaying paintings only, but they may also display sculptures, pottery, architecture, jewelry, rugs, and more.

A gallery may operate via retail or wholesale. The gallery may be used to acquire ownership of art for business or for personal use and enjoyment. According to IRS publications, it appears that many audits need to wade through this distinction.

The differences in economic success amongst galleries are vast. Some may fail to turn a profit while others may have gross receipts of $50 million or more. Some galleries maintain inventories worth tens of millions, while others take art on consignment only (artists retain ownership until sold at which point the gallery earns a commission). Some galleries sell lots of low-priced art while others sell only select high-priced works.

Successful galleries find a way to connect with the most popular and skilled artists, while other galleries amass are large inventory of consigned pieces hoping for sales.

Gallery owners are integral to success of the gallery. Some are artists; Others are collectors or entrepreneurs trying to turn a profit. Like any other business, the owner will have a leg up if she has knowledge of the art, clientele, and marketplace. The IRS acknowledges that success, even amongst similarly situated galleries, hinges on the owner’s expertise and savvy.

The Four Basic Categories of Art-Related Taxpayers

Categorization of taxpayers engaged in art purchases an d exchanges is paramount to determine tax consequences.

Once a piece of art leaves an artist’s hands, it is picked up by one of four categories of persons—all with differing tax consequences. Some categories may even merge. For example, an art dealer may hold one piece of art for business, but hold another piece as an individual investor. Income rates and deductibility of expenses hinge on the accurate delineation of these categories. Accurate categorization of taxpayers and transactions at issue are governed by the oft-heard “facts and circumstances” test.

Here at four basic types of Art-Related Taxpayers:

1. Hobbyist: A hobbyist buys art without intent to make a profit. A hobbyist rarely sells work. But if it is, the gain is recognized as capital while the losses are disallowed. (IRC § 1221 and § 165(c)). Expenses attributed to maintaining the collection are generally not deductible per IRC § 262 but IRC § 183 allows deductions up to the amount of gross income generated by the activity. Because of these tax disadvantages, hobbyists may try to claim that they’re investors.
2. Investor: An investor buys, sells and collects art as an investment with the hope that the art will appreciate and result in a profit when sold. That gain will be capital unless the art falls outside of the definition of a capital asset under IRC § 1221.[1]  A capital loss is available to an investor under IRC § 165(c) if the investor can prove an intent to enter into the transaction for profit. A critical factor weighing against investor status is the extent to which the investor personally used and enjoyed the artwork.  As to expenses, an investor may deduct them under IRC § 212 if the investor’s primary intent was to hold the art for the production of income. As to that intent to hold the, the “facts and circumstances” are weighed to include the investor’s personal use and enjoyment of the art. Expenses to extend the life of the art are not deductible but would instead need to be capitalized. Limited expense deductions and capital losses make the dealer classification look enticing to the investor. For these reasons, investors often attempt to switch hats and argue that they are dealers.
3. Business Collector: A business collector buys art not for resale or profit, but for office display or decoration during the ordinary course of trade or business. Art is generally not depreciable because it lacks a determinable useful life. But such businesses can still buy art for investment purposes, and if enough art is bought (and sold) those businesses could claim art-dealer status. Collectors are probably hobbyists if an investment motive is lacking.
4. Art Dealer: An art dealer buys and sells art as a trade or business. An art gallery may be a type of dealer. Art dealers are taxed like retailers with their income from sales taxed as ordinary income. Expenses may be deducted under § 162 if they are “ordinary and necessary.” Dealers may claim investor status in order to benefit from lower capital gains rates on the sales of art. Some dealers buy some art for business, and some art for investment. These activities should be kept separate.

13 Potential Tax-Audit Triggers Involving Art Galleries

1. Mischaracterizing inventory as investments in order to receive favorable capital-gains treatment;
2. Not capitalizing the costs of framing art. Said another way, not adding framing costs to an art’s basis but instead deducting them as current expenses;
3. Artists cashing checks paid by galleries leading to unreported income, which may trigger the audit of the gallery’s “related return”;
4. Barter transactions (trading one product or service for another) between artists and galleries; Barter transactions are taxable transactions. The fair market value of the item received is reportable income. Here are some helpful IRS resources on bartering;
5. Avoiding state sales taxes using schemes involving marketing and shipping of art to other states. Understanding the states’ various sales and use taxes is complicated. This article in MarketWatch may help: States are targeting art collectors who don’t pay taxes;
6. Inventory valuation issues, including those related to trades amongst gallery owners and artists; Here are some helpful tips on conducting a year-end inventory accounting of art. Also, here are 10 Tips to Manage your Art Inventory;
7. Taking frequent losses with low gross receipts, which leans toward Activity Not Engaged in for Profit pursuant to I.R.C. § 183;
8. Overusing travel or entertainment, especially with low gross receipts, which leans toward Activity Not Engaged in for Profit pursuant to I.R.C. § 183;
9. Disguising sales as collateralized loans raising issues of money laundering;
10. Living lavishly in while reporting low gallery income;
11. For the charitable-contribution deduction, using fair market value instead of adjusted cost basis; and
12. Improperly taking deductions for business use of the home under IRC § 280(A)(c).
13. For the inside scoop of what auditors consider with audits of art galleries, here is the IRS Audit Technique Guide for Art Galleries.

Contact me if you’d like to discuss these issues further.