by Callie Mobley, Associate Member, University of Cincinnati Law Review Vol. 93
I. Introduction
Section 501(c)(3) of the Internal Revenue Code (“IRC”) allows organizations that are organized and operate exclusively for certain public benefit purposes to receive tax exemption.[1] Increasingly, extremely wealthy art collectors are taking advantage of IRC Section 501(c)(3) by creating tax-exempt private operating organizations in the form of art museums.[2] Some private art museums are cherished public amenities that promote art and art education.[3] In contrast, others seem to offer very little public value, as they are rarely advertised or available to members of the general public.[4]
In some cases, ultra-wealthy art collectors can use their private museums to avoid paying taxes on their art collections while maintaining control of and limiting access to their museums.[5] In 2013, a billionaire donated his historic mansion to his private foundation and was granted tax-exempt status by the Internal Revenue Service (“IRS”).[6] The foundation assured the IRS that the estate would be open to the public every weekday from 9:00 a.m. to 5:00 p.m.[7] In 2023, a journalist discovered that the estate was open only two hours a week and that a limited number of tickets were given away by a lottery, which the journalist entered unsuccessfully three times.[8] Despite this lack of public access, ProPublica obtained tax records showing that over five years the billionaire had saved more than $38 million in taxes.[9]
Private museums maintain their tax-exempt status with minimal oversight of the public or private benefits they provide.[10] Part II of this article will discuss private operating foundations and why they appeal to wealthy art collectors. Part III will discuss the public benefits of private art museums and how they can produce sufficient public benefits to earn tax-exempt status. Part IV will conclude by arguing that there must be greater oversight for private museums granted tax-exempt status.
II. Background
Section 501(c)(3) grants federal income tax exemption to certain nonprofit organizations (“501(c)(3) organizations”).[11] This tax exemption means that these nonprofit organizations do not have to pay federal income tax on income gained from activities that are substantially related to the purpose for which the organization was formed.[12] Section 501(c)(3) states that a qualifying organization must be organized and operated for at least one exempt purpose.[13] The exempt purposes recognized are charitable, religious, educational, scientific, literary, testing for public safety, fostering amateur sports competition, and preventing cruelty to children or animals.[14] Qualifying activities for art museums include exhibiting art, lending it to other museums, or making art available to researchers.[15]
A. What is a Private Operating Foundation?
501(c)(3) organizations are classified as either a public charity or a private foundation. Private foundations are typically created by one or a small number of donor founders.[16] There are two types of private foundations: non-operating and operating. Operating foundations directly conduct their charitable purposes, while non-operating foundations only make grants to other organizations.[17] Private foundations in the United States hold over $1 trillion in assets.[18]
Most private art museums are organized as private operating foundations.[19] A private operating foundation must demonstrate that it spends at least 85% of its adjusted net income or minimum investment return, whichever is less, on the conduct of its exempt activities.[20] An operating foundation must also meet one of the endowment, support, or assets tests for three out of the last four years.[21] The endowment test requires that the foundation distributes at least two-thirds of its minimum investment return directly for the conduct of its exempt activities.[22] The support test requires three things. First, that at least 85% of the foundation’s support is received from the general public and five or more unrelated exempt organizations.[23] Second, not more than 25% percent of its support comes from more than one exempt organization.[24] Lastly, not more than half of its support comes from gross investment income.[25] The assets test requires that sixty-five percent of the foundation’s assets are devoted directly to the conduct of its exempt activity or a related business or consist of stock of a corporation controlled by the foundation.[26] Most private museums satisfy the assets test.[27]
In addition to providing a public benefit, private foundations should not create substantial private benefit.[28] The United States Tax Court has defined private benefits as nonincidental benefits conferred on disinterested persons who serve private interests.[29] The IRS has said that some private benefits are permissible if the benefits from the organization’s activities flow principally to the general public.[30] However, the exact balance of a permissible incidental private benefit and a substantial one that would disqualify an organization from 501(c)(3) status is not well-defined.[31]
B. Why Private Operating Foundations are a Common Choice for Wealthy Art Collectors
Prior to 2006, an art collector could gift partial interest in a work of art to a museum and deduct from their taxes the full value of the art multiplied by the percentage donated.[32] In this manner, donors could escape capital gains taxes on their art and continue to display and enjoy it for decades before completing its physical transfer to a museum.[33] Congress eventually closed this loophole with the Pension Protection Act of 2006, which limited the circumstances under which a charitable donation was available, the size of the deduction for each subsequent fraction donated, the time of the fractional donation process, and introduced a physical transfer of possession requirement. [34]
To continue receiving tax benefits while maintaining substantial control over their art collection, extremely wealthy donors began forming private operating foundations under Section 501(c)(3) instead.[35] The three main tax benefits associated with private foundations are: “(1) a charitable contribution deduction each year a donation is made, (2) relief from capital gains tax on donated property, and (3) a lesser amount or elimination of estate taxes.”[36] Contributions to private operating foundations are also deductible up to 50% of the donor’s adjusted gross income, while contributions to most other private foundations are generally limited to 30% of the donor’s adjusted gross income.[37] In addition to giving up physical possession of their collection, donors who choose to sell their collection and donate the proceeds would miss out on a deduction for the fair market value of the art as well as be responsible for paying taxes on any gains from the sale.[38]
C. Weighing Private and Public Benefit
A 2015 New York Times article revealed the limited public access to many private museums and created uproar regarding the lack of standards for private operating foundations receiving such generous tax breaks.[39] In response, Senate Finance Committee Chairman Orrin Hatch sent a letter to the IRS Commissioner summarizing the findings of an inquiry conducted to assess whether the public benefit provided by private museums outweighs the substantial tax benefits the organization’s founder receives.[40] Hatch questioned eleven tax-exempt private museums to determine how each museum made its art available to the public and what privileges its founder and donors enjoyed.[41] Hatch expressed concern that some of the museums were barely advertised, open as little as 20 hours a week, and required reservations made weeks or months in advance. He also noted that some founding donors maintained an active role in managing the museums and how many museums were located adjacent to the donor’s private residence.[42]
In 2017, Republicans in the House of Representatives proposed a tax plan including a clause that would close the loopholes allowing collectors to gain tax benefits while retaining significant control of their collections.[43] The clause required art museums to be open during normal business hours for at least 1,000 hours each year, which is the number of hours required for accreditation through the American Alliance of Museums. [44] However, this clause was ultimately struck from the tax plan.
When a private foundation is found to have engaged in a prohibited act, the foundation and its managers are subject to an excise tax.[45] Prohibited acts include self-dealing between foundations and their substantial contributors, failing to distribute income for charitable purposes, and “behavior detracting from a foundation’s ability to further charitable purposes”.[46] However, such sanctions are rare as the IRS examines an average of only 225 of the 100,000 tax returns filed by private organizations each year.[47]
There are a few cases by which private foundations can gauge maximum private and minimum public benefit. In 2021, the IRS revoked the tax-exempt status of a foundation created to exhibit its founder’s collection of African art.[48] The IRS found that the collection had never been properly transferred from the founder to the foundation and that pieces from the collection were displayed for only two to three of the twenty-plus years of the foundation’s existence.[49] The foundation claimed that its expenditures on having the collection authenticated were in the execution of its exempt purpose.[50] However, the Tax Court found that authentication increased the value of the collection and was a private benefit to the founder.[51] The IRS also disqualified a private museum from 501(c)(3) status when there were no signs advertising the museum’s location, the majority of the art was clustered near the donor’s home, and no efforts were made to inform the general public of the opportunity to tour the grounds. [52]
III. Discussion
Public and private museums can both benefit society through preserving, displaying, interpreting, and otherwise promoting and making art available. However, public and private tax-exempt museums must find a way to complement each other rather than compete if both are to receive tax benefits for their public service. Furthermore, the government must strengthen the enforcement of private operating foundations and must enact consequences for abusing the tax benefits available to private operating foundations.[53]
A. Providing Public Benefit
Concerns such as those in Senator Hatch’s letter are valid, but they also neglect an important part of the public benefit analysis. Most charitable organizations are created to serve a need in their community. Museums in the form of private operating foundations are often created first and find public benefits to provide second.[54] As a result, these museums tend to cater to the same demographic of people who already have access to public museums.[55] They fail to fill a void that is not already largely satisfied by existing public museums.[56]
Private institutions suffer from a lack of guidance on desirable public benefits.[57] Donors and founders of private art museums have nearly complete control over what and how they present to the public.[58] They are not required to consider what their community needs or desires or what is accessible to their community.[59] For example, the Getty Center in Los Angeles has free admission and an extensive collection of art on display at any given time. However, the expense of on-site parking, the lack of public transportation to the center, and the museum’s operating hours create barriers that limit the audience the center can serve.[60] The Getty Center also competes directly with the nearby Los Angeles County Museum of Art.[61]
Private museums are often capable of pushing the limits of art in ways that public museums are not.[62] Instead of competing against public museums, private museums should only be granted tax-exempt status if they provide a public benefit that is otherwise missing. For example, field trips to an art museum are already feasible for most public schools given the availability of public art museums, so private operating foundations citing art education as a charitable purpose could fund and provide materials for art educators in schools that otherwise could not afford the materials.[63]
There are also less traditional areas where private museums could innovate. Patients in hospitals and nursing homes are a demographic largely neglected by public art museums. Private museums could fill this gap by creating rotating exhibitions for these locations or even by making their museum physically accessible to those with a wide array of physical disabilities and special needs.[64] Courthouses and similar public buildings are also potential beneficiaries of private art museum efforts.[65] These kinds of public displays would reach a wide audience, including many unlikely to visit public art museums. Private museums could also use their resources to explore the growing reality of virtual museum spaces and experiences.[66]
B. Deterring Private Benefit
One of the major criticisms of United States tax law is that it reinforces inequality.[67] This criticism is validated when the IRS implements rules that allow wealthy individuals to create, control, and benefit from their own tax-exempt museums.[68] The Getty Trust again provides an example. In 2006, the Attorney General issued a report exposing the Trust’s president for using Trust employees for his personal errands, misappropriating funds to gift art to retiring board members, and billing the trust for luxury travel.[69] Ultimately, the former trust president was able to return some cash, forfeit some tax benefits, and completely avoid criminal prosecution.[70]
The government must vigorously enforce the requirements of Section 501(c)(3) tax-exempt status to ensure fairness in the enforcement of the tax code. This will require publishing more concrete guidance on how much and what type of public benefit is required and how little incidental private benefit will be tolerated. It will also require oversight into the workings of private foundations and a willingness to significantly punish offenders, both monetarily and criminally.
IV. Conclusion
The existing requirements for Section 501(c)(3) should be more closely monitored and enforced. The IRS should also more carefully define what qualifies as public and private benefit and how much private benefit is acceptable. More importantly, the IRS should require private tax-exempt museums to fulfill a benefit that the public desires, not simply one of the founder’s choosing. This would include regulations for how much advertising and how many hours the private museums must be open to the public. But it must also include an analysis of gaps in public access to art and require private museums to fill those gaps in exchange for generous tax breaks.
[1] I.R.C. § 501(c)(3).
[2] Private Art Museum Report 2023, Larry’s List, https://www.larryslist.com/report.php?report=report-5 (last visited Oct. 15, 2024).
[3] See Jeff Ernsthausen, How the Ultrawealthy Use Private Foundations to Bank Millions in Tax Deductions While Giving the Public Little in Return, ProPublica (July 26, 2023), https://www.propublica.org/article/how-private-nonprofits-ultrawealthy-tax-deductions-museums-foundation-art; Julie Belcove, The Secluded World of Private Museums, Robb Report (Nov. 18, 2018), https://robbreport.com/shelter/art-collectibles/secluded-world-of-private-museums-2829055/.
[4] Belcove, supra note 3.
[5] Jason Kleinman, Tax Benefits and Pitfalls of Private Museums, Mondaq (July 3, 2015), https://www.mondaq.com/unitedstates/music-and-the-arts/409456/tax-benefits-and-pitfalls-of-private-museums.
[6] Ernsthausen, supra note 3.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] I.R.C § 501(c)(3).
[12] Id.
[13] Id.
[14] Id.
[15] E. Alex Kirk, The Billionaire’s Treasure Trove: A Call to Reform Private Art Museums and the Private Benefit Doctrine, 27 Fordham Intell. Prop. Media & Ent. L.J. 869, 884 (2017).
[16] Katherine Pollard, What’s the Difference Between Private and Public Museums?, Headway News (Sept. 18, 2024), https://headwaynews.org/whats-the-difference-between-private-and-public-museums/.
[17] Types of Foundations, Internal Revenue Service, https://www.irs.gov/charities-non-profits/private-foundations/types-of-foundations (last visited Oct. 16, 2024).
[18] Nonprofit Organizations: Total Financial Assets Held by Private Foundations, Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/BOGZ1FL164090015Q (last visited Oct. 24, 2024).
[19] Kirk, supra note 15 at 893.
[20] Definition of a Private Operating Foundation, Internal Revenue Service, https://www.irs.gov/charities-non-profits/private-foundations/definition-of-private-operating-foundation (last visited Oct. 23, 2024).
[21] Id.
[22] Private Operating Foundation: Endowment Test, Internal Revenue Service, https://www.irs.gov/charities-non-profits/private-foundations/private-operating-foundation-endowment-test (last visited Oct. 16, 2024).
[23] Id.
[24] Id.
[25] Id.
[26] Private Operating Foundation: Assets Test, Internal Revenue Service, https://www.irs.gov/charities-non-profits/private-foundations/private-operating-foundation-assets-test (last visited Oct.22, 2024).
[27] Kirk, supra note 15 at 886.
[28] Id. at 897.
[29] Am. Campaign Acad. v. Comm’r, 92 T.C. 1053, 1069 (1989).
[30] Kirk, supra note 15 at 900.
[31] Id. at 900-3.
[32] Id. at 911.
[33] Id.
[34] Pension Protection Act of 2006 § 1218(a), I.R.C. § 170(o)
[35] Kirk, supra note 15 at 912.
[36] Khrista McCarden, Private Operating Foundation Reform and J. Paul Getty, 17 Pitt Tax Rev. 387, 398 (2020).
[37] Private Operating Foundations, Internal Revenue Service, https://www.irs.gov/charities-non-profits/private-foundations/private-operating-foundations (last visited Oct. 16, 2024).
[38] McCarden, supra note 36, at 397.
[39] Patricia Cohen, Writing off the Warhol Next Door, N.Y. Times (Jan. 10, 2015), https://www.nytimes.com/2015/01/11/business/art-collectors-gain-tax-benefits-from-private-museums.html.
[40] Aaron Fobes & Julia Lawless, Hatch Concludes Review into Tax-Exempt Private Museums, Notes Concerning Findings, U.S. Senate Comm. On Finance (June 2, 2016), https://www.finance.senate.gov/chairmans-news/hatch-concludes-review-into-tax-exempt-private-museums-notes-concerning-findings#:~:text=WASHINGTON%20%E2%80%93%20Senate%20Finance%20Committee%20Chairman%20Orrin%20Hatch,John%20Koskinen%20summarizing%20the%20findings%20of%20the%20inquiry.
[41] Id.
[42] Id.
[43] Tucker Higgins, The GOP Tax Plan Cracks Down on Fishy ‘Private Museums’ of the Ultra-Rich, CNBC (Nov. 2, 2017), https://www.cnbc.com/2017/11/02/the-gop-tax-plan-cracks-down-on-fishy-private-museums-of-the-ultra-rich.html
[44] Accreditation and Excellence Programs, Am. All. Of Museums, https://www.aam-us.org/programs/accreditation-excellence-programs/eligibility-to-participate-in-the-accreditation-program/ (last visited Oct. 16, 2024).
[45] Private Foundation Excise Tax, Internal Revenue Service, https://www.irs.gov/charities-non-profits/private-foundations/private-foundation-excise-taxes (last visited Oct. 23, 2024).
[46] Id.
[47] Ernsthausen, supra note 3.
[48] Tikar, Inc. v. Comm’r, T.C. Memo 2021-53 (2021).
[49] Id.
[50] Id.
[51] Id.
[52] Kleinman, supra note 5.
[53] McCarden, supra note 36, at 403.
[54] Id. at 402, 406.
[55] Id. at 393
[56] Id.
[57] Id. at 390.
[58] Id. at 396.
[59] Id.
[60] Id. at 393.
[61]Id. at 404.
[62] Private Museums: Serving the Public Good, N. Tr. Inst., https://www.northerntrust.com/united-states/institute/articles/serving-the-public-good (last visited Oct. 16, 2024).
[63] See McCarden, supra note 36, at 405.
[64] Id.
[65] Id.
[66] See Matthew Erskine, Going Beyond Preserving a Collection- The Private Operating Foundation, Erskine & Erskine, https://www.erskineanderskine.com/publications/preserving-art-collections-the-private-operating-foundation (last accessed Oct. 23, 2024).
[67] McCarden, supra note 36, at 407.
[68] Id.
[69] Id. at 408.
[70] Id.
Cover Photo by Adrianna Geo on Unsplash.
