Owning artwork is not only a cultural indulgence, but the sophisticated (and the lucky) possess artwork as an investment that can provide a handsome return. Auction houses, most recently Christie’s, have seen record-setting bids as fine art wrestles to take its position as an asset class equal to equities, commodities, and other hard assets. In light of the increase in capital gains tax combined with the collector’s desire to reduce the imposition of income tax and estate tax, the field is ripe for sophisticated planning.
As part of it Educational Conference Call series, John O. McManus this month discussed strategies to addresses the hard and soft issues surrounding the ownership and transfer of art. We invite you to listen to the recording to find detailed information on the Top 10 issues with owning and gifting artwork that follows, whether you’re an artist, dealer, investor or collector.
1. Putting a Price on the Priceless. Original works of art may be an investment in the owner’s quality of life without ever addressing its monetary value but, before a transfer plan can be consummated, a fair market value of the artwork must be established.
a. Because art is considered an unmarketable asset, a qualified appraisal must be conducted in order to take advantage of an income tax deduction.
b. According to the Internal Revenue Code, fair market value is defined as the amount that an informed, willing buyer will pay a similarly informed, willing seller in an arms-length transaction and in a market in which such items are commonly sold, with neither party under any undue pressure to either buy or sell.
c. When valuing art, keep in mind that auction values, as opposed to retail gallery values, may be more indicative of fair market value.
d. The IRS requires an appraisal for donated artwork with a value over $5,000 and has the right to challenge such valuations for a period of four years.
2. Business – Not Beauty – Is in the Eyes of the IRS. Whether you are in the “business” of the art world versus being a private collector can have a significant impact on income tax deductions.
a. Costs associated with conserving, restoring, maintaining and transporting art may be deductible for an artist, dealer or investor if they are incurred as normal and ordinary business expenses or if they are incurred in the production of income. Art collectors are limited in the deductions they can take for these typical expenses.
b. The IRS uses facts and circumstances tests with regard to classifying the owner’s status. If you want to be classified as an investor, you must be able to show the sale of art for a profit.
c. Most individual owners are collectors who appreciate art and accumulate it for personal enjoyment. Collectors can enjoy favorable tax treatment when selling or giving artwork.
3. The Broad Strokes of Gifting Artwork. Collectors can enjoy the benefit of avoiding capital gains tax on a low-basis asset by donating artwork.
a. Here are some general guidelines:
i. The work must be contributed to a public charity that was formed within the U.S.;
ii. The work must be considered long-term capital property;
iii. The work must satisfy the “related use” test (according to the Pension Protection Act of 2006, charities must generally retain gifts of tangible personal property valued at more than $5,000 for at least three years if the donor is to receive an income tax deduction for the fair market value); and
iv. The donor must obtain an appraisal by a qualified appraiser.
b. A Form 709 Gift Tax Return must be filed with the IRS for gifts made within the calendar year over the annual gift exclusion amount of $14,000 per individual or charity.
4. Till Death Do Us Part…with Our Art. Artwork can be enjoyed during the owner’s lifetime, delaying the transfer until after death to a charity.
a. A tax that would otherwise be due upon a sale may be minimized through the use of the Charitable Remainder Trust (CRT).
b. CRTs are irrevocable trusts that provide for two classes of beneficiaries: (i) the income beneficiary or grantor who receives a fixed percentage of income for the CRT term (which could be a specified number of years up to 20 years, or the remainder of the grantor’s lifetime), and (ii) a charity, which receives the remaining assets of the CRT after the trust term is completed.
c. Due to the fact that a gift of the remainder interest in the CRT is given to a tax-exempt not-for-profit organization, the grantor would qualify for an income tax deduction for the initial contribution to the CRT.
d. The amount of the current income tax deduction is based on the present value of the remainder interest to the charity and is limited to the lesser of the cost basis of the art or 20% of the grantor’s adjusted gross income.
e. Any part of the deduction not utilized in the year of the gift to the CRT (for example, if the grantor’s income is less than the deduction) may be carried forward as an income tax deduction in the succeeding four years.
5. The Beauty of a Private Foundation. Not only a charity, but a Private Foundation may receive the remainder interest of the Charitable Remainder Trust and/or other donations that a collector may wish to make during their lifetime and in their estate plan.
a. In making a charitable gift directly to the Foundation, the grantor receives a charitable tax deduction (up to 33% of adjusted gross income for cash gifts and 20% for gifts of appreciated stock or art).
b. Each year, the Foundation is only required to distribute 5% of its principal amount to the public charities of the grantor’s choice.
c. The grantor’s estate would take a deduction equal to the fair market value of any assets passing to the Foundation after death.
d. At all times, the principal of the private Foundation compounds free of income tax each year and, if managed successfully, the annual income generated would be sufficient to meet the 5% distribution requirement.
e. If the artwork is owned by a private operating Foundation, public viewing is not a necessity and can be replaced by lending out works of art, making grants, or making the artwork available to researchers.
6. The Artistic Genius of a Family Trust. A Family Trust that is created can purchase the artwork in exchange for a promissory note for 100% of the current value of the art, effectively removing it (and its appreciation in value) from the grantor’s estate for estate tax purposes.
a. The Trust will pay off the interest of the note to the grantor in annual installments from the liquid assets that the Trust owns, which, if needed, provides the grantor with revenue to supplement his or her standard of living or aid in covering the cost of unforeseen expenses.
b. At the time that the Trust sells the art, the entire amount of the original principal could be prepaid without penalty.
c. Any amount of the proceeds remaining in the Trust would remain outside of the grantor’s estate.
d. Due to the fact that a sale is considered an arms-length transaction, it would not be subject to gift tax or use of the grantor’s lifetime gift tax exemption amount (unified with the estate tax exemption amount), allowing the grantor to dramatically reduce the estate’s tax burden.
7. Look Out, Louvre! Opening a private museum opens doors to tax deductions, allows the donor to regularly view the pieces of art and allows their friends to attend viewings as well.
a. Creating a tax-exempt exhibition space allows the founder a deduction of the full market value of any art, cash and stocks donated to the private museum.
b. The IRS has issued rulings that the private museum may be located in close proximity to the founder’s home, but must have adequate signs and advertise so that the public good is served.
8. Yes, van Gogh…We Can Transfer Just a Piece of the Art! Recent court decisions allow joint owners with a fractional ownership interest in a piece of art to give that fraction away at a reduced value for gift tax purposes.
a. The IRS has consistently held that fractional interest discounts on artwork are not appropriate. However, a recent court decision allows over a 40% discount on a fractional interest in art for estate tax purposes.
b. Expert valuations will come under even more IRS scrutiny to counter the recent court ruling. It is important to retain well-qualified experts to determine the value and support the valuation discounts.
c. Discounting for gift or estate tax purposes must be weighed against increased capital gains upon a future sale.
9. Portray Your Family Mission. Donating art to a Family Foundation, and thereafter selling pieces to charities and collectors, allows the Foundation to be funded with financial assets (including equities) to support the family’s mission of altruism and philanthropy long beyond the collector’s lifetime.
a. The grantor’s children may be named to the Board of Trustees of a Foundation to participate in the family’s present philanthropic goals each year.
b. Children and grandchildren may also be compensated for any role they may serve as a program officer to coordinate grants to charities and for their time spent serving the Foundation (i.e. meetings of Board of Trustees).
c. Through their efforts and the efforts of other future descendants, the family may continue the original collector’s donative pattern and legacy of charitable giving.
d. A Foundation requires annual meetings, which can become a time for the family to meet and strengthen its bonds.
10. Share the Wealth of Cultural Enrichment. When a sale is not needed to fund the Foundation, consider spreading the love of fine art by donating artwork directly to a museum or university.
a. The Association of Art Museum Directors estimates that more than 90% of art collections held in public trust by American museums were donated by private individuals.
b. Personal collections, which started in the private residences that showcased the masterpieces of their wealthy owners, add new opportunities to the public through educational programs, research and exhibitions.
“If we actually love what we’re doing and we go and do what we love, and every day we get up because we’re really happy to get up and go and do what we do, you can’t actually do that without expression, and art forms part of that mix of expression that makes the whole package of life so enjoyable to be in.”
Australian media mogul and renowned art collector