Now that tax season is upon us, it is vital to know how the IRS will characterize your art-related activities when you try to (1) deduct expenses associated with those activities against income or (2) claim operating or capital losses. The manner in, and the extent to which you are taxed depends upon which of the following five categories of art-related activities apply to you.
HOBBYIST:
If you create art primarily for your aesthetic satisfaction, the IRS will treat you as a "hobbyist.”[1] This is so, even if you earnestly hope one day to sell your work and earn some income.[2] In the absence of a steady income flow, the IRS is likely to treat your artistic activities as a hobby, and you will NOT be permitted to deduct such expenses as studio rent, art, insurance, travel expenses, promotion, club and association fees, advertising, postage, shipping, office supplies and the like. Additionally, if you end up selling a piece for less than the cost of the materials of which it is composed, you may NOT deduct that loss from your tax obligation.[3] Determining whether or not you are a hobbyist largely depends upon how professional your activities are, not on whether or not you make a lot of money from your actions. As an informal rule, the IRS is more likely to designate you as a hobbyist if you fail to make a profit from your activities in three years out of five, although this is a presumption that can be overcome by evidence showing that your artistic endeavors have been primarily profit-motivated.
Even if you are just a hobbyist, Uncle Sam will still take a bite from the apple when you sell your artwork. The good news is that the sale proceeds will not be taxed at the maximum 37% tax rate for ordinary income,[4] but rather, they will be taxed at the special capital gains rate for collectibles, i.e., 28%. of your net sales proceeds[5]. Net sales proceeds for the sale of a hobbyist’s artwork is its sales price less basis (i.e., the gross sales proceeds less the cost of materials of which it is composed).[6]
ARTIST:
If you create art primarily to make income or earn a profit, the IRS will regard you as an “artist”[7] and treat you more favorably than it would a mere "hobbyist." When determining as to whether or not you are profit-motivated, the IRS will want answers to the following:
Have you consulted with experts, such as an art consultant, who are engaged in the trade or business of creating art and who regularly advise professional artists?[8]
Do you reasonably expect to make a profit from your artistic endeavors and do you merely have a vague hope that someday someone might buy your work?
Are you an art dabbler or seasoned and/or educated artist?
Do you keep detailed, accurate records as would a reasonable business person?
Do you carry on your artistic activity in a businesslike manner?
Do you depend in full or in part on the income derived from your artistic endeavors?
Have you educated yourself sufficiently to know how to make your business profitable?
Have you been financially successful in previous professional art-related activities?
Have you made a profit from your artistic endeavors in at least three of the last five years?
Do you reasonably expect to make a profit from your art?
Do you belong to a professional artist’s association?
Do you have protocols as to how your art is to be transferred?
Do you have a venue such as a gallery where your art can be seen by the public and purchased?
Do you have a written market plan?
Do you have revenue forecasts?
Do you have a list of places where your art is exhibited?
It is important to note that you do not have to answer favorably to every question for the IRS or tax court to consider you an "artist" and not a "hobbyist," but the more you can answer affirmatively the better.
If the IRS accepts you as a professional artist, the sale of your art will be taxed as ordinary income up to 37% of adjusted gross income (AGI), depending upon your tax bracket. Your sales proceeds will not be treated as either a short or long-term capital gain. However, you will be able to deduct against yearly current income rent or depreciation for studio expenses, insurance, shipping, postage, and office overhead as well as the cost of materials.[9] Most importantly, net operating losses may be deducted against income in the amount that exceeds 2% of your AGI,[10] and the excess loss may be carried over to be deducted against subsequent years’ income.[11]
Art Dealer:
An art dealer is one who regularly buys and sells art[12] as a trade or business to ultimate consumers and occasionally to other dealers.[13] Art galleries are the prototypical art dealers. All income from the sale of art by a dealer is considered “ordinary income” taxable up to the maximum rate of 37% of AGI.[14] Expenses incurred by the art dealer in the ordinary and necessary course of his business are deductible against gross income.[15] Net operating losses may be deducted up to 80% of taxable income, and that portion of the loss above this threshold may be carried forward and against subsequent year’s income.[16]
One note about art dealers and sales taxes should be noted. To be a legitimate "art dealer," you must regularly and consistently buy and sell art for profit. Some art collectors and investors have falsely presented themselves to state taxing authorities as "art dealers" to claim an exemption from paying sales tax on purchased artwork for their enjoyment. State and federal taxing authorities consider this scheme to be a serious, criminal tax fraud. IRS regulations provide that, to hold yourself out legitimately as an art dealer, you must contribute a major or substantial part of your time to pursue a livelihood or obtaining a profit.[17]
Art Collector:
An “art collector” is someone who buys and sells art primarily for her pleasure and is neither a dealer nor an investor. The IRS, as well as the tax courts, have traditionally presumed that purchases of are art "collectors" and not "investors" [See "Art Investors" below]. Art collectors may NOT deduct expenses related to insuring, displaying, preserving, shipping or other costs associated to his collection because they are incidental to the collector's pleasure in engaging in a hobby and not in furtherance of a serious profit motive.[18] Although net sale proceeds of art sold by collectors are taxed at the capital gains rate for collectibles (i.e., 28% for art held for more than one year),[19] the collector may NOT deduct a loss on the sale of his art against income. Collectors are treated as “hobbyists” under the Internal Revenue Code.
Art Investor:
An “art investor” is someone who buys and sells art primarily for making a profit and not for personal pleasure as would a collector/hobbyist and not for earning ordinary income as would an art dealer.[20] To qualify as an "art investor," the profit objective must be of "first importance"[21]. Unlike collectors, art investors may add to the basis of a purchased work of art their expenses such as insurance, shipping, expert consultations, art subscriptions, travel to exhibitions and galleries.[22] Instead of being required to pay tax at the ordinary income rate up to 37% of AGI, the investor pays just 28% on the net gain as long as the work of art was held for at least one year.[23] Unlike a collector, an investor may deduct losses on the sale of his art against ordinary income.
Both art dealers and art investors are primarily motivated to make a profit, but they are taxed differently. So, one might ask, “How does the IRS differentiate them?” Factors considered in determining whether the purchase and sale of art is done pursuant to a trade or business in the pursuit of ordinary income include:
For what purpose was the art acquired? In other words, was it for a quick resale to an end consumer (dealer's purpose) or to hold over a period of time and reap the harvest of appreciated value (as would and investor)?
The frequency of sales. Dealers try to turn over inventory quickly, unlike investors who hold artwork over long periods to benefit from appreciation.
The immediate use of the sale proceeds. Dealers are more likely to reinvest sale proceeds immediately in new inventory for sale, whereas investors are more likely to be more patient and wait a more extended period required to find the right work in which to invest.
The business of the taxpayer. Investors tend to be engaged primarily in other businesses or professions, whereas art dealers are primarily engaged in the purchase and sale of art.
The time and effort spent by the tax collector to solicit purchasers and advertise. Dealers spend a substantial time in these pursuits while investors typically do not.
Obviously, “art collectors” prefer to be treated as “investors” by the IRS since investors may deduct expenses by adding them to the basis of their artwork and may deduct losses on the sale of their art against ordinary income. However, the IRS has been traditionally loath to uphold a taxpayer’s claim that he is an investor and not just a collector. Time and time again, the IRS and tax courts have found that the taxpayer’s true, primary objective in collecting art is to derive personal pleasure and satisfaction from his collection and that making a profit is not of “first importance”[24]. We have devoted an entire article to the subject of how to persuade the IRS that you are an investor entitled to favorable tax treatment (and not just a collector/hobbyist), and we encourage you to read our article, How to Affirm Your Art Investor Status with the IRS.
[1]" I.R.C. § 183.
[2] Barcus v. Commissioner, 32 T.C.M (CCH) 559, 673, aff’d per curium 492 F2d 1257 (2nd Cir. 1974).
[3] I.R.C. § 183(b).
[4] I.R.C. § 1(a).
[5] I.R.C. § 1(h)(5)(A).
[6] I.R.C. § 263(A).
[7] An “artist” for the purposes of the tax laws is defined as any individual whose personal efforts create or may reasonably be expected to create a picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design, or original print edition. I.R.C § 263 A (h)(3)(C).
[8] Professional art consultants such as Arcadia Art Consultancy can assist artists with understanding market trends, and popular styles and subject matter most sought after by art collectors and investors in the current market.
[9] I.R.C § 163 & 212(1) & (2); § 263 A(h)
[10] I.R.C. § 165 (subject to limitations of § 68).
[11] I.R.C. § 461(1) & (2).
[12] Sporadic investment activities do not qualify an activity as being a “trade or business” under the Code. Whipple v. Commissioner, 373 U.S. 23 (1987).
[13] See generally IRS Publication 334 (1981), see also Boyle, What Determines that an Activity is a Trade or Business?, 50 Tax’n for Accountants 346 (1993).
[14] I.R.C. §§ 61 & 64.
[15] I.R.C. § 162.
[16] I.R.C. § 172(a).
[17] Treasury Reg. §§ 1.170A-1(a)(2)(ii), 1.170A-23.
[18] See generally, Wrightsman v. United States, 428 F2nd. 1316 (Ct. Cl. 1970).
[19] I.R.C. § 1(h)(2)(4)(A)(i).
[20] See generally cases distinguishing securities dealers with investors. Wood v. Commissioner, 16 T.C.13 (1951); Seeley v. Helvering, 77 F2d 321 (2nd Cir 1953).
[21] Treas. Reg § 1.212-1(c).
[22] Presumably, many of such deductible expenses would have to be pro-rated among inventory.
[23] I.R.C. § 1(h)(2)(4)(A)(i).
[24] Malat v. Riddell, 383 U.S. 569, 572 (1168); Treas. Reg. § 1.212-1(c).
This article is written for informational purposes only. Please consult your agents (accountants, attorneys, wealth managers, etc.).