Many are unaware that the assets of a private foundation (PF) can be categorized as held for either investment or charitable purposes. However, the classification as one or the other can be of crucial importance to a PF. A PF’s investment assets are included in its asset base in calculating its 5% annual minimum distribution requirement (MDR), whereas assets used—or held for use—in carrying out a PF’s charitable purposes are excluded from such asset base.
Some may be under the impression that the assets of a PF are automatically deemed to be held for charitable purposes because, after all, the PF is an Internal Revenue Code Section 501(c)(3) charitable organization. However, while the income from investment assets, such as stocks or bonds, may be used to make charitable expenditures, such underlying assets aren’t deemed to be held for charitable purposes.1 By default, a PF asset generally is considered held for investment unless it’s used (or held for use) directly in carrying out the PF’s charitable purposes.2 Therefore, a PF must be prepared to demonstrate that the asset is actually being used to carry out charitable purposes; merely establishing that an asset isn’t held as an investment or to produce income is insufficient to classify it as a charitable-use asset.
A Longer Term View
A significant short-term benefit to charitable-use classification is that the amount paid to purchase a charitable-use asset is treated as a qualifying distribution in satisfaction of the MDR.3 Similarly, the value of an investment asset that’s converted to charitable use is treated as a qualifying distribution on the conversion date.4 Further, amounts expended in improving or maintaining a charitable-use asset will also count as qualifying distributions.
Depending on the circumstances, an asset’s classification as investment or charitable use can significantly impact a PF’s long-term viability. For example, if the bulk of a PF’s investment assets are illiquid and don’t produce income, but nevertheless generate a payout requirement, the PF may find it increasingly difficult or impossible to satisfy its current and future MDR with its limited liquid assets. In one case, we encountered a PF that received a contribution of a large and valuable tract of partially forested land containing wild bee colonies. Had the PF rented the property at market rates, the rental income wouldn’t have been sufficient to cover the portion of the MDR attributable to the value of such land.
For instance, suppose that the land was worth $1 million and the PF could have generated $20,000 per year in rental income at market rates. Because the portion of the PF’s MDR attributable to the land was approximately $50,000 ($1 million x 5%), the PF may have struggled to make up the $30,000 MDR gap each year ($50,000 MDR – $20,000 rental income). The PF’s managers realized that the PF would be better off classifying the land as a charitable-use asset, if possible. Even though this would result in foregoing5 the rental income, the benefit of excluding the value of the land from the asset base used to calculate its MDR would outweigh the benefit of the rental income. The annual $50,000 reduction in MDR and the
one-time $1 million qualifying distribution resulting from converting the land to a charitable-use asset would be more advantageous than maintaining the land as an investment asset and receiving only $20,000 of rental income, as this could lead to an annual $30,000 MDR gap.
Ultimately, whether a PF asset is used (or held for use) for charitable purposes is a question of fact. The regulations provide several examples6 of assets deemed held for charitable purposes, including:
- Any portion of real estate directly used by a PF in carrying out its exempt activities. For example, if a PF owns a building that it uses for its own office space7 or as a venue for its own direct charitable programs, the building may be classified as a charitable-use asset.
- Any property leased by a PF in carrying out its charitable activities at no cost (or at only nominal rent) to the lessee, such as the leasing of apartments to low income tenants at low rent as part of the lessor’s program for rehabilitating a blighted portion of a community. In the above example involving wild bee colonies, the PF leased the land to a nearby university for nominal rent so that its students could study the colonies in their natural habitat. Accordingly, the PF determined that the land could be classified as a charitable-use asset.
- Artwork that’s publicly displayed,8 such as in a gallery or museum.9 The public display of artwork is considered to further a charitable purpose because doing so educates the public “on subjects useful to the individual and beneficial to the community.”10 In Revenue Ruling 74-498, the Internal Revenue Service ruled that a collection of paintings owned by a PF formed to further the arts was considered a charitable-use asset because the PF loaned the paintings under an active loan program for exhibition in museums, universities and similar institutions.
In some cases, it’s manifestly obvious that an asset is being used for charitable purposes and should be classified as a charitable-use asset. In other cases, such as with certain artwork or other collectibles, it may be unclear whether an asset is sufficiently being publicly displayed to warrant classification as a charitable-use asset because the PF may be able to display the asset only infrequently.
Practical Difficulties
There are several reasons why it may not be feasible to display artwork as often as desired, including:
- The collection is too vast. For example, the Smithsonian Institute’s collections are so extensive that less than 1% are estimated to be on display in the museums at any given time, presumably because it lacks the facilities to display its entire collection simultaneously.11
- The item is fragile. Certain artwork is fragile, doesn’t travel well and may be damaged in transit, so it may be lent out for display only occasionally and in a limited geographical area. For instance, watercolor paintings tend to be light-sensitive and may be displayed only on a limited basis to protect them. Similarly, showing an antique car too often at roadshows increases the risk of damage and deterioration.
- There’s a lack of demand. The artwork may be of a high quality, but the artist may be unknown or not broadly recognized, in which case museums may not be interested in borrowing a PF’s collection, as they may have a policy of exhibiting the artwork of only recognized artists.
- The item isn’t in mint condition. By contrast, the collectible may be that of a recognized artist, but it may not be in pristine condition. Museums may have policies against borrowing artwork that doesn’t meet certain curatorial standards. In this case, only a limited audience, such as scholars or researchers, may be interested in viewing the collectible.
If the collectible is rarely (or never) displayed publicly, arguably the PF may not be justified in classifying the collectible as a charitable-use asset because it’s not furthering an educational purpose. Therefore, PFs with assets that can’t be displayed frequently often struggle to determine exactly how often the collectible must be displayed—whether at roadshows, museums, parks or other public venues—to justify its classification as a charitable-use asset.
Practical Solutions
Unfortunately, there’s no magic number when it comes to how many days, weeks or months per year that a collectible must be on display. However, there are tangible steps a PF can take to help an asset merit classification as a charitable-use asset, including:
- Loan the collectible to organizations other than museums. For instance, artwork could also be loaned to a hospital, library, community center or school for public display. Other venues might include shopping malls, office parks, lobbies or courtyards of buildings open to the public. The more frequently the artwork is lent out for display, and the longer the duration of the displays, the stronger the argument is that it’s being put to a charitable use.
- Publicly display the collectible on a PF-owned or rented property. For example, the PF could periodically rent a gallery to exhibit a collection. However, this approach may not be practicable because it’s likely to be prohibitively costly. Aside from rent, other significant expenses may include packing, shipping, mounting, insurance, publicizing and staffing the viewing events.
- Digitize the collectible. Publicly display the collectible online by posting high resolution images of it, together with educational content about the item, as with a digital catalog.12 This way, the asset is being actively used13 to advance an educational objective.
- Make the collectible available for private viewing. For instance, in Private Letter
Ruling 9411009 (Dec. 10, 1993), an artist bequeathed unfinished works and other works that were only of study quality to a PF, which were made available to art scholars for private viewing by appointment.14
In any event, the PF should broadly publicize the fact that the collectible is on display for public viewing, along with the viewing schedule and location, as applicable.15 Rightly so, it’s doubtful that an item would be considered publicly displayed if the public was never made aware that it was on display in the first place.
Although the regulations provide that the actual use of an asset is key in determining whether it’s used or held for a charitable or an investment purpose, the regulations also indicate that such determination is a question of fact. To that end, showcasing the PF’s ongoing commitment to publicly displaying the item may be helpful, as demonstrated by a log of all efforts to display the collectible at various venues, including any declinations. The log could be included in board minutes, which might also reflect any vote affirming the PF’s ongoing commitment to publicly display the collectible.
Further, such commitment might be reinforced when an asset is donated to the PF pursuant to a restricted gift agreement requiring the PF to publicly display the asset. Some practitioners put teeth in the gift agreement by requiring the PF, in the event of a sale, to remit any sale proceeds of the item to a designated museum or other public charity. Some agreements even go as far as including a “gift-over” provision, which would result in the forfeiture of the asset in favor of a designated public charity in the event that the PF fails to publicly display the collectible for the specified period of time. If the gift-over provision is triggered, the public charity would have standing to enforce the terms of the gift.
Actual Use is Key
Stacking up helpful facts to justify an asset’s classification as a charitable-use asset may buy the PF more time to use the asset for charitable purposes. However, the more time that elapses without sufficient public display of the asset, the higher the risk that the classification of the asset as charitable is open to challenge. For instance, an asset’s classification may be called into question when it’s never publicly displayed in any venue over an extended period of time despite numerous attempts, or if the asset is available to scholars for private viewing but no one ever schedules an appointment to see it.
Although there are significant benefits to classifying an asset as charitable use, it’s important to remember that such classification isn’t merely a matter of preference. Actual use is key. What’s considered sufficient use will vary depending on the nature of the asset. While it may be relatively easy to demonstrate sufficient charitable use for some assets, a PF may have difficulty identifying various avenues to put other types of assets to a charitable use. Ultimately, the strongest support for classifying an item as a charitable-use asset is the PF’s actual success in actually using it for a charitable purpose.
Endnotes
1. See Treasury Regulations Section 53.4942(a)-2(c)(3)(i).
2. Ibid. Even if the private foundation (PF) isn’t currently using an asset for a charitable purpose, the regulations provide that it may be considered a charitable-use asset nonetheless, provided that the PF can establish that its immediate use of the asset for a charitable purpose is impractical and that definite plans exist to begin using the asset within a reasonable period of time.
3. See Internal Revenue Code Section 4942(g)(1)(B).
4. See Treas. Regs. Section 53.4942(a)-3(a)(5). However, if a PF counts the acquisition of (or conversion of an investment asset) to a charitable-use asset as a qualifying distribution, it may be required to “recover” the amount previously counted as such on a sale (or conversion of the asset to investment use) by effectively increasing its minimum distribution requirement in the PF’s next taxable year. See IRC Sections 4942(d) and 4942(f)(2)(C).
5. Note that a PF needn’t necessarily forego all rental income to treat a given property as a charitable-use asset. Treas. Regs. Section 53.4942(a)-2(c)(3)(ii)(f) lists property that’s leased at no cost—or at a nominal rent—to carry out the PF’s charitable purpose as an example of an asset deemed used (or held for use) directly in carrying out the PF’s charitable purposes.
6. See Treas. Regs. Section 53.4942(a)-2(c)(3)(ii).
7. Note, however, that it may be appropriate to classify a portion of the building as held for investment use if more than 5% of the space is used to manage the PF’s investments. See Treas. Regs. Section 53.4942(a)-2(c)(3)(i), which indicates that an asset shall be considered used exclusively for charitable purposes if 95% or more of such asset’s use is dedicated to exempt purposes; otherwise, a reasonable allocation, such as one based on square footage, between exempt and non-exempt use is required.
8. Note that artwork or any other item owned by a PF may not be used or displayed on a disqualified person’s (DP’s) property, as doing so likely will result in self-dealing and compromise the asset’s classification as a charitable-use asset. See, e.g., Revenue Ruling 74-600 (placement of paintings owned by a PF in the residence of a DP resulted in self-dealing) and Technical Advice Memorandum 8824001 (placement of PF’s sculptures on the grounds of a DP’s residence resulted in self-dealing).
9. Paradoxically, although lending artwork or other collectibles to museums of high repute typically makes the item more valuable, it shouldn’t undermine its classification as a charitable-use asset because lending it out for public display constitutes the charitable purpose.
10. Treas. Regs. Section 1.501(c)(3)-1(d)(3)(i)(b). See alsoGoldsboro Art League, Inc. v. Commissioner, 75 T.C. 337, 343 (1980), acknowledging that “[t]he promotion of the arts has consistently been recognized as both charitable and educational.”
11. See Smithsonian/Smithsonian Collections “Media Fact Sheet,” www.si.edu/newsdesk/factsheets/smithsonian-collections#: ~:text=Only%20a%20small%20portion%20of,from%20all%20over%20the%20world (Aug. 1, 2018).
12. See, e.g., Private Letter Ruling 200001048 (Oct. 14, 1999) (making a numismatic collection publicly available through an informative website and extensive catalogs posted on such site constituted a charitable use of such collection).
13. However, once the asset has been digitized, one might argue that the physical artwork itself isn’t being deployed for a charitable use. Indeed, the PF could retain the right to digitally display and reproduce physical copies of the artwork but sell the physical artwork itself. Further, if no one visits the site, this could undermine the position that the item is in fact being publicly displayed.
14. Although making it available for viewing by scholars may look good on paper, bolstering its initial classification as a charitable-use asset, doing so may backfire if no scholars actually come to view the collectible for several years (or come only infrequently).
15. See, e.g., TAM 8824001 (criticizing the lack of effort to advise the general public of the display of sculptures through publicity).