When investment banker Frank Klotz gave 250 pieces of art to Florida State University in 1999, he forever altered the charitable landscape for wealthy Canadians and their advisors.

CRA disputed the credit Klotz claimed on his tax return. The resulting court battle, which ended with millions of dollars in denied donation credits, set the precedent for future art-flip cases.

It took until 2004 for the Tax Court of Canada to rule Klotz and other donors had been participating in an illegal tax shelter, often with encouragement from their advisors.

It all began in 1997, when promoters for a program called Art for Education approached advisors and accountants, searching for clients who wanted to pay less tax by making large art donations to schools. The promoters hired art dealers to buy prints for between $5 and $75. These were bundled into lots, and sold to Klotz and others at about $300 per print. Then the promoters arranged for the lots to be donated. The donors never saw the art.

Between 1997 and 1999, more than 63,000 prints were donated, netting organizers more than $8 million. Klotz’s 250 prints cost $75,000, but appraisers hired by the program valued them at between $1,000 and $2,000 each, for a total market value of $264,900. Klotz decided to claim a conservative $258,400 on his tax return to offset his income.

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The court called the claims inflated, adding other participants received nearly identical appraisals. The promoters argued the market value exceeded the purchase price because donors bought in large lots. The court said Klotz could, at most, have claimed the $75,000 he paid, and added he should have done his own due diligence. Klotz appealed to the Supreme Court, but lost.

That scheme also exposed the donors’ advisors, who earned commission on each purchase their clients made. One couple sued their accountant for recommending the scheme and won because the court ruled he hadn’t lived up to his fiduciary duty. He had to pay the couple $45,000, an amount that included his $7,500 commission.

Ten years later, the Canadian art world is still feeling the effects, says Joel Secter, a lawyer for arts organizations and charities at Drache Aptowitzer in Ottawa.

“As a result of the art flips, we have new laws,” he says. Now, collectors have to hold art for three years before CRA allows a tax benefit greater than the purchase cost.

But there are still substantial tax advantages to donating art the right way.

Deciding to donate

Start by asking clients with art collections if they’ve ever considered donating some of their pieces. And, discuss how those collections fit with their legacies. While some may plan on leaving art to their children, you should warn them art is treated as capital property. Any change of hands could trigger huge tax bills. Other clients may want to see their collections in museums for the public to enjoy. Tell them it’s best to plan the donations now.

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Before going ahead with a donation, ask: how did you acquire this piece? The answer affects taxes. If the donor is the spouse or child of the artist, an art dealer, or the artist himself, CRA will treat him differently than a general collector. For instance, when an artist decides to donate a piece, it’s considered inventory and he can choose to deduct the expenses he incurred to make the art, rather than its market value.

The two most common donation scenarios are: collectors giving art to institutions (like a museum), or gifting works to charities.

From attic to museum

Regardless of a donor’s circumstances, the most tax-effective strategy is to give an item of cultural importance to a gallery.

Art is usually subject to capital gains when it changes hands, but culturally significant donations are exempt. A donor can also claim a charitable tax credit equal to the fair market value of the work, and use it to offset up to 100% of her net income. By contrast, other charitable donation credits are capped at 75% of net income.

These advantages come with strict rules. The Canadian Cultural Property Export Review Board must certify the piece as culturally important. To pass, the object must have a close association with Canadian history, be potentially useful in the study of arts and sciences, or contribute to national heritage. But, before the review board can assess the piece, the donor and her advisor must find an interested gallery that’s on the list of nearly 300 federally designated cultural institutions.

To make the list, a museum must be able to preserve the art and display it to the public. The piece should also fit the museum’s mandate. The McMichael Canadian Art Collection in Kleinburg, Ont. won’t accept non-Canadian works, says Linda Clemow, the gallery’s associate director of individual giving.

Once the museum accepts, the donor must sign over ownership to qualify for a tax credit. To qualify for a particular tax year, the donation must be made by Dec. 31, says the Art Dealers Association of Canada. In her book Crimes Against Art, lawyer Bonnie Czegledi suggests creating a deed of gift to notarize the transfer.

From this point, the institution handles the donation, says Secter. It works with the donor to get the piece valued. CRA requires a professional and independent appraisal for any piece worth more than $1,000. If it could be worth more than $20,000, two appraisers should weigh in, says Jim Stokoe, senior principal at KPMG in Edmonton. While the institution arranges the appraisal, the donor is usually expected to pay, says Toronto-based professional appraiser Sharon Berlin. Clients need to provide as much documentation as possible, including original tax or purchase receipts, prior appraisals and other paperwork. “It saves time and effort on the part of the appraiser,” she says.

Others note it also saves your client money. Appraisals for the cultural review board are more detailed, and can be more costly.

Stephen Sweeting, a chartered surveyor and president of Appraisal Associates in Toronto, says he typically charges $250 an hour for an appraisal. He gives the museum a cost estimate before beginning work.

The institution then assembles the rest of the cultural board application, including an explanation of why the art is of national importance.

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It should take four months for the board to make a decision. If the application is approved, it issues an income tax certificate for what it deems fair market value. It’s good for two years; if the donation isn’t made by then, the donor will have to restart the process. If there’s disagreement about the board’s assessment, it can be appealed in tax court. When it’s time to claim the donation on a return, fill out line 342 of Schedule 9, Donations and Gifts. Since it’s a non-refundable tax credit, CRA limits the amount claimable to the tax still payable after using credits from any other donations.

Donation debacles: Avoid these mistakes

  1. Giving to unqualified recipients. There are 11 types of qualified recipients under the Income Tax Act, from registered charities to the United Nations. If a client wants to donate art to the law firm where she was partner, she won’t qualify for any tax benefit, says Joel Secter, a lawyer at Drache Aptowitzer who specializes in art donations. In fact, CRA will consider the transfer a sale at fair market value, and your client may have to pay capital gains tax.
  2. Getting armchair appraisals. Don’t go into an appraisal with a preconceived notion of what the piece is worth, says Sharon Berlin, a professional appraiser. Sometimes, a piece may have actually lost value, she notes.
  3. Including too many strings. To qualify for the donation tax credit, CRA says the gift must be irrevocable. Plus, museums may turn down gifts if the donor wants too much control, says Jim Stokoe of KPMG.
  4. Donating fake or stolen art. The Art Loss Registry is the world’s largest database on stolen art. INTERPOL also keeps a registry of stolen art. Resources like these can help donors determine a piece’s provenance. If a donated piece turns out to be forged, the cultural review board could change its certified value and CRA could re-assess your client’s return.
  5. Omitting information. CRA is strict about what must be included on a tax receipt for a charitable gift, says Secter. The receipt must include items such as: the names and addresses of the organization and the donor; the organization’s registration number; a receipt serial number; and the address of the appraiser.

Donating to public organizations

Your client may have a beneficiary other than a museum in mind. Donors can give to registered charities, all levels of government, and even amateur athletic associations (see “Qualified donees” sidebar below).

These donations are subject to capital gains tax if the piece in question is worth more than $1,000, says Joel Secter. In that case, CRA also requires an appraisal. After accepting the piece, the organization issues a receipt. It can be for as much as the piece’s fair market value, or for as low as the adjusted cost base of the art, he says. “If I’m giving a work of art to an eligible recipient and I don’t want the capital gains, I can elect to have it valued at a lower amount,” he explains.

When determining capital gains, deduct any expenses incurred to donate, such as appraisal fees, from the adjusted cost base, says Secter. The claim goes on line 339 of Schedule 9 of the return. The credit can be used to offset up to 75% of her income, and any unused amounts can be used to offset taxes in the next five years.

Donations made the year the donor dies have different rules. On a final return, the donor is eligible to claim the lesser of 100% of either her net income that year or the donations she made in the last five years. Any extra amounts can be carried back one year.

When the time is right

“You want to match the timing of a significant donation with a significant amount of income,” Stokoe says.

Ten years ago, he helped a businesswoman plan her estate, which included a substantial art collection. She faced significant tax on her annual earnings and, upon her death, there would be a deemed disposition of the art at fair market value.

On Stokoe’s advice, she donated a Group of Seven painting worth $2 million to a museum. She used that $2-million credit, and the CRA rule allowing unused donation amounts to be carried forward, to offset her annual income. It reduced her tax bill for four years, and then the client died. The remaining credit reduced her estate’s tax bill. Had she survived the maximum five-year carry forward, she would have had to sell other property to realize more tax benefits.

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“If you make a large donation like that, you want to make sure that you’re going to be able to use it all, and it’s not going to expire,” says Stokoe.

When to make a donation depends on the donor’s circumstances, he says. “Often, the big liability is on death. If that’s the case, you may want to make the donation through your will.”

Currently, the credit for a donation made in a bequest can be carried back one year, but changes in the 2014 budget will give future donors more flexibility. Right now, CRA deems donations in a will to have been made immediately before the individual’s death. Starting in 2016, it will use the actual date of donation, as long as it’s within 36 months of the donor’s death. The estate can then choose to allocate the donation to its return the year the donation is made, an earlier tax year of the estate or the individual’s last two tax years.

But giving during someone’s lifetime can be useful, too. For example, if a person’s annual income is similar to the value of a donation, the resulting credit could be used immediately or within the carry-forward time limit.

Whether a donation will be made while alive or through the estate, Secter says to plan now to ensure tax benefits are used efficiently.

“Collectors can make the decisions themselves during their lifetimes,” he says. “Even if it is to see that things happen after they’re gone, they have control now.”

Qualified donees

  • Registered charities
  • Registered Canadian amateur athletic associations
  • Registered national arts service organizations
  • Listed housing corporations in Canada set up only to provide low-cost housing for the aged
  • Listed municipalities in Canada
  • Listed municipal or public bodies performing a function of government in Canada
  • The United Nations
  • Universities outside Canada listed in Schedule VIII of the Income Tax Regulations that ordinarily include students from Canada
  • The Government of Canada, a province, or a territory

Source: CRA