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PaperclipPerfector  7mo ago (text post)   4718 thread views

Small-Scale Question Sunday for September 24, 2023

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I have heard, but don't have the know-how to confirm, that the following tax loophole exists:

  1. Commission a famous artist to create an art piece, for $50,000

  2. Get it appraised to be worth $5 million

  3. Donate it, getting a full $5 million tax writeoff

  4. Profit income_tax_rate * valuation - commission_cost

Is this more or less correct? If so, I have the following harebrained idea to take advantage of it / force the IRS to address it:

  1. Create an accredited 501c "NFT art museum"

  2. NFTs are already naturally WAY overvalued relative to their cost-to-produce, but just to encourage things to remain that way, create a custom NFT collection with a few accredited artists who are the only ones allowed to add to that collection. Make the transfer fee super high so that these NFTs are disincentivized from remaining in the market.

  3. Design this whole thing to be totally sincere. Call it the "Artist and Artist Appreciation DAO" or something. Nominally, the point is to fund the creation of new artwork. New NFTs are regularly commissioned and donated to the art museum, and whoever paid for the commission eats the tax benefits.

  4. Possibly tokenize the whole process so that it's easy to buy a $1 tax deduction for only $0.10. Honestly doubt this would work with the current tax code though even if the rest of the process does work. I think there would need to be some kind of organization filing copyrights on all created pieces of artwork, then legally filing somewhere that the ERC20 represents legal ownership of the artwork. Even then, it probably wouldn't work.

  5. Profit? Either infinite tax write-offs, or the IRS closes a loophole that should never have existed anyways.

Anyways, can anyone tell me why this definitely wouldn't work?

The special sauce is the inflated appraisal value. this is done with real estate too or insurance fraud.

The short version is the IRS knows about this trick and has a very successful record of prosecuting people who try to use it.

That looks very different to me since the appraisal was faked.

It seems like it would be hard to pull off this trick without faking the appraisal; if the artist's paintings are for-real worth $5,000,000, then he could just paint them and sell them for that price rather than accepting literally 0.01x that payment from you.

Elsewhere I said:

Just like with regular art, I think the process of donating it to charity actually increases its fair market value. Also, the fact that it was commissioned (rather than being sold directly by the artist) increases its fair market value. Yes, that isn't how these things should work, but art is mostly signaling anyways so in this case you literally get what you pay for; the more you pay the more valuable it is.

So, I think it is evident that there exist situations where I could create, then donate, an art piece worth $5MM, without being able to create and sell the piece for anywhere near as much.

And you need to put at least three people's heads on the block to make this scheme work - your own, someone to sign receipts on behalf of the charity (you only get to deduct the appraised value if the charity uses the donated object as part of its charitable activities, so someone needs to confirm this), and the appraiser.

501(c)s also have to have a non-profit board, with a minimum of three people. The exact rules for how many must be 'independent' and what that means are complicated as hell, but it adds to the issue.

Well the charity would be a real charity, there already exist online "NFT museums." The appraiser would also be real. NFTs already get utterly absurd valuations, and have gotten multi-million dollar legit appraisals. Generally I'm not planning on actually running a scam, just genuinely taking advantage of a loophole in a way somewhat more blatant than is the norm.

No, the standard is not a "legit appraisal." An appraisal can help establish what you believed to be the fair value the contribution to charity is, but in most cases you would need to show that the item could have been sold by the charity in an open market transaction for the amount deducted. The fact that there would be a recent transaction where an artist was willing to produce the piece for $50,000 would set the baseline case not the $5MM appraisal. The burden of proof would be on you and the appraisers to show otherwise. You would have to make an affirmative case the valuation is justified, the fact that the market is illiquid, so like no one knows the real price man, is not a defense. This is not a new idea, and appraisers and tax filers lose cases regularly where an inaccurate appraisal is used to claim an unjustified deduction.

I'm on the same page as you about all of that except the part about the market being illiquid. I think it would be doable to have a liquid enough market, where 90% of a given NFT collection is owned by the museum, but the remaining pieces are swapped around with some frequency. This is already how normal NFTs work much of the time--their "market cap" is sky high but this is because most of the supply is not circulating.

Yes, I understand none of this is necessarily an ironclad defense of the NFT's value, but aside from the internal IRS appraisers, I'm not sure how much more ironclad you can get than fair market value. I'm quite confident that, given NFT's properties (especially the ability to set extremely high transfer fees) you could set a "fair market value" extremely high without necessarily leading to a situation where people sell their NFTs without donating to them. That said, the IRS does include the stipulation that the market must not be artificially inflated, which sounds like a pretty central description of this whole scheme. Maybe.

In the end, I agree there's still a piece missing, but if it's possible for standard art then it's probably possible for NFTs too.

To me, the part that doesn't work is the idea you can "set" the fair market value. The fair market value is the price a knowledgeable buyer would actually pay for the entire quantity donated. The appraisal value must be for the entire collection donated. If you can today produce NFT's people will actually pay $5MM for a cost to you of $50k. You should, and will make a profit of $4.95M and have to pay taxes on the gains. This is always strictly better than just collecting the tax savings. If the NFT market is not actually deep enough to clear $5MM from selling all the NFT's in an open market the fair market value is not $5MM.

If all you have done is manipulate the market cap up by adding transaction costs, limiting the free float, or trading with yourself or co-conspirators you have not set the fair market value higher. You have just committed more crimes by manipulating the price of unregistered securities.

You have to make an affirmative case for your valuation if the IRS challenges it, which is going to be pretty hard when 79% of all NFT collections ... remained unsold.

Edit: Always strictly better under the current system, Andrew Granato and Tyler Cowen pointed out this would not be the case under the proposed 40% capital gains rate back in 2021.

If you can today produce NFT's people will actually pay $5MM for a cost to you of $50k. You should, and will make a profit of $4.95M and have to pay taxes on the gains. This is always strictly better than just collecting the tax savings.

Just like with regular art, I think the process of donating it to charity actually increases its fair market value. Also, the fact that it was commissioned (rather than being sold directly by the artist) increases its fair market value. Yes, that isn't how these things should work, but art is mostly signaling anyways so in this case you literally get what you pay for; the more you pay the more valuable it is.

So, I think it is evident that there exist situations where I could create, then donate, an art piece worth $5MM, without being able to create and sell the piece for anywhere near as much.

To me, the part that doesn't work is the idea you can "set" the fair market value. The fair market value is the price a knowledgeable buyer would actually pay for the entire quantity donated. The appraisal value must be for the entire collection donated.

Well, what I have in mind is that these pieces are created and donated a few at a time. I once again agree that it should work this way, but in practice this just isn't how art, or really anything, is valued. Is oil's fair market value determined by what someone would pay for all the oil in the world? Generally, no matter the asset, selling the entire supply at once would mean selling at a steep discount. The market doesn't need to be deep enough to absorb the entire supply at once for that to be the fair market value.

If all you have done is manipulate the market cap up by adding transaction costs, limiting the free float, or trading with yourself or co-conspirators you have not set the fair market value higher. You have just committed more crimes by manipulating the price of unregistered securities.

They're certainly not securities, no matter how much the SEC wants them to be. However the rest is valid. Like I said, I do think there's a piece missing before this scheme makes sense at all, but right now it's looking like the piece might exist.

You have to make an affirmative case for your valuation if the IRS challenges it, which is going to be pretty hard when 79% of all NFT collections ... remained unsold.

Meh, they analyzed 73,000 collections. I can programmatically create that many for like $1 and now 90% of collections remain unsold. The "blue chip" NFTs, let's say the top 10, are like 80% of the total NFT market cap.

I'm not trying to 100% disagree with you, I think your objections are reasonable and generally it's the exact sort of thing the IRS would come down on hard, but I do disagree with some of the specifics and think that through that process of debate we can arrive somewhere closer to the truth.

So, I think it is evident that there exist situations where I could create, then donate, an art piece worth $5MM, without being able to create and sell the piece for anywhere near as much.

If it is ever challenged by the IRS, you will need to make an affirmative case that the value has been increased, not only that there exist situations where it is possible. The price you would be able to sell for is literally the definition of fair value the IRS uses.

Is oil's fair market value determined by what someone would pay for all the oil in the world?

The value if you donate $5MM, marked to last trade or mid, worth of oil futures is very close to $5MM, close enough that you can probably claim the full $5MM. The true market value is close to but less than $5MM. This is because the oil futures are fungible and the market is very liquid, with literally trillions of dollars of notional value changing hands regularly. If you think you can regularly move $5MM of oil futures with literally zero transaction cost to arrival you should go become the worlds best market maker, you have discovered an infinite money glitch. What you are proposing is moving millions of dollars of notional value in market with a few tens of millions of dollars average daily notional volume where each product is non-fungible. Your price impact will be greater.

They're certainly not securities, no matter how much the SEC wants them to be.

Surprisingly the SEC hasn't taken a strong stance on if NFT's are securities, but certainly is way to strong of a statment though since the existing case law contradicts you. It also doesn't change the criminality because of the fact that any artifice to manipulate a price done by computer is still wire fraud even if it is not securities fraud.

The "blue chip" NFTs, let's say the top 10, are like 80% of the total NFT market cap.

There is literally a section titled "The Current State of the Top NFT Assets." If you have the ability to consistently create some of the top valued NFTs you have a very valuable skill, running a tax scheme is arguably a very high risk way of monetizing that skill, but it shouldn't be surprising that there is some way to extract value from that ability.

There's a limit of 30% of your AGI and it can't be things you created (those are ordinary income properties with a different treatment).

The authority of the IRS is so absolute, and the tax code so complex and yet also vague, that they can and will fuck you for anything they decide they don’t like. That essentially translates to “the spirit of the rules”.

Knowing very little about tax code, I think this shouldn't work because the jump from $50k -> $5million would be counted as profit in some sense, similar to if you buy $50k of stock and then sell it for $5 million. I think it's called an "asset appreciation tax"? So your taxable income would go up by 4.95 million from having an asset you paid $50k for go up in valuation, and then down by $5 million for the donation, giving you a net -$50k (because you spent $50k that you then donated). But I'm not certain this is how it actually works.

You can donate appreciated stock at it's stepped up value and avoid capital gains taxes. It's a very good way to make charitable donations. It is however limited to 30% of your AGI though.

From IRS Pub 526

However, the reduced deduction doesn't apply to contributions of qualified appreciated stock. Qualified appreciated stock is any stock in a corporation that is capital gain property and for which market quotations are readily available on an established securities market on the day of the contribution.

That's definitely how it should work, but I believe is not how it actually works if you donate it. I'm in the same boat as you though and am not exactly an authority on this.

First off: There's no way this would work. I mean, it might work in the sense that you can write whatever numbers you want on a document and hope the IRS doesn't look into it, but there's no way it would hold up in tax court.

Second off: Jesus Christ the tax code is impenetrable. I'm not a lawyer, but I'm usually pretty good at finding relevant citations whenever I need them. I've never seen anything like Title 26. It's obscene.

I think this only works because those involved have enough prestige to make it look legit. They can find somebody with letters after their name to back up their claims to artistic integrity. They have friends at museums with respectable names. They have money and by implication lawyers standing behind them.

IRS auditors are required to refer all gifts of art valued at $20,000 or more to the IRS Art Advisory Panel. The panel’s findings are the IRS’s official position on the art’s value, so it’s critical to provide a solid appraisal to support your valuation.

Can you bamboozle the government artist auditors? That's the real test.

IRS auditors are required to refer all gifts of art valued at $20,000 or more to the IRS Art Advisory Panel. The panel’s findings are the IRS’s official position on the art’s value, so it’s critical to provide a solid appraisal to support your valuation.

Interesting, I wonder what the guidelines are for art valued below $20,000. It's really easy for crypto to find loopholes and bust them open; it would be child's play to just create 100 pieces valued at $15,000 or something rather than one piece valued at $1.5M. The whole point is to put this loophole into the Common Man's hands anyways, so a $15,000 tax writeoff is reasonably close to the sweet spot.

I think this only works because those involved have enough prestige to make it look legit. They can find somebody with letters after their name to back up their claims to artistic integrity. They have friends at museums with respectable names. They have money and by implication lawyers standing behind them.

I absolutely agree, but that at least sounds like a somewhat tractable problem. There are some legit museums displaying NFTs, and some other legit museums minting NFTs from their artwork. If legit museums can display NFTs then presumably there is at least a little wiggle room there.

I am rooting for you...but suspect that Uncle Sam is going to be very much not amused and that this stunt could potentially land you in prison. Good luck. Consult a tax lawyer first - the very best you can find.

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