This two-part article examines the ways of transferring art without actually selling it, in order to reduce issues around tax and also to retain art within a family or some kind of structure enduring beyond the owner”s death. The article is part of a series around fine art being published this month.
Many people take pleasure in “collectibles,” perhaps even
amassing sizable and valuable collections of art, stamps and
coins, jewelry, antiques, and other forms of tangible personal
property.(1) However, despite the pervasiveness and often high
value of collectibles, owners of these items often fail to plan
adequately for their disposal. This two-part article outlines, in
part one, the options available to a collector or artist for
disposing collectibles and, in part two, highlights the benefits
of donating such items to either an operating or non-operating
private foundation. The author is Jeffrey D Haskell, with
contributions from Stephen Pappaterra.
Available Options
The first consideration is determining whether to divest oneself
of the collection during one’s lifetime or upon death. In either
case, the collector can (i) monetize the collection by selling
it; (ii) gift it to family or friends during one’s lifetime or as
an inheritance at death; or (iii) donate it, either to a publicly
supported charity or to one’s own private foundation.
Selling a collection
There may be some initial uncertainty as to the selling price of
a collection because market values fluctuate with demand, an item
or collection may be extremely rare, etc. However, once an
offering price is determined, a second key factor in selling a
collection involves tax considerations, and specifically, the
collection’s cost basis. The cost basis will depend on how the
collection was acquired:
* If the items in the collection were created by the owner, the
cost basis is the cost of the materials.
* If the collection was acquired by purchase, the cost basis is
the price paid for the collection plus subsequent capital
investments, such as restoration.
* If the collection was received by way of gift, the cost basis
is the prior owner’s cost plus subsequent capital
investments.
* If inherited, the cost basis is stepped-up to the fair market
value as of the deceased owner’s death. Any appreciation from the
date of death to date of sale is a capital gain.
A creator of the collection, or a dealer who held the collection
as inventory, will report the sale price minus the seller’s cost
basis as ordinary income (usually taxable at the highest tax
rates). If the seller did not create the work and is not a
dealer, the seller will report the sale price minus cost basis as
capital gains (usually taxable at a lower tax rate than ordinary
income). A seller who can demonstrate that he or she is a
professional collectibles investor or dealer will be able to take
a deductible loss if the sale is for less than cost basis. For
most collectors, a collection is held “for personal use,” such as
display in their homes, and no loss on a below-basis sale is
allowed. The current federal tax rates for different types of
sales of collectibles are as follows: (a) up to 37 per cent if
ordinary income or capital gain on assets held for less than one
year; (b) a flat 28 per cent on all other collectible sales plus
a 3.8 per cent Medicare surtax for certain high-income sellers.
In addition, some states may have their own tax rates on sales of
collectibles.
If the sale of the collection can be delayed until the collector
dies, and then sold soon thereafter, there will be little or no
capital gain due to the stepped-up basis at death.
Correspondingly, if the collection has depreciated prior to the
owner’s death, the collection will receive a step-down basis.
For a large estate (one that exceeds the applicable federal gift
and estate tax exemption), selling a rapidly appreciating
collection during life—even at a 28 per cent capital gain
rate—and making gift-tax–free annual exclusion gifts over time
may be preferable to paying federal estate tax at a 40 per cent
rate. Artists and collectors with illiquid estates should aim to
avoid a potential “fire sale” of a collection in order to pay
estate taxes.
Moreover, large sales from a single artist within a short time
period can reduce the value of the collection (2) and therefore
should also be avoided.
Transferring a collection
An artist or collector who wants to pass on their collection to
heirs must weigh the loss of possessing and enjoying the
collection themself with reducing their future estate tax
exposure. One solution would be to form a separate entity, such
as a limited partnership or limited liability company, with the
artist or collector owning 100 per cent of the entity and then
selling or gifting fractionalized interests in the entity to his
or her heirs. The value of the ownership interests in the
partnership or LLC that were not gifted would be included in the
artist’s or collector’s estate but would potentially be
discounted on account of their now minority interest and lack of
marketability. (After all, buyers may not line up to become
partial owners of a collection shared with strangers and/or
relatives of the collector.)
The collection could be transferred to a spouse outright or with
the direction to sell the collection without gift tax
implications. Another option would be to transfer the collection
to a trust that, if properly structured, could provide an income
stream and eliminate future appreciation from the estate.
Alternatively, a trust could be established for a surviving
spouse who can, if desired, authorize the sale of the collection.
Such a trust can ensure that the artist’s or collector’s intended
beneficiaries receive the collection itself or the proceeds from
the collection’s sale.
Donating a collection to a public charity
By donating the collection to charity, the collector could
receive both a tax benefit and leave a legacy, thereby showcasing
the collection for future generations. For income, gift, and
estate tax purposes, the charity must be a “qualified” charitable
organization.(3) In addition, to maximize the amount of a
charitable deduction for income tax purposes, the collection must
be used in a manner related to the charity’s tax-exempt purpose
(rather than sold upon receipt of the donation). For example, if
a donor donates a painting to an art museum to add to its
holdings, unless the donor knows otherwise, it may be reasonable
for the donor to assume that the painting will be put to a
related use (e.g., mounted in an exhibition, used to teach
restoration techniques, etc.).
By contrast, if the painting is sold within three years of the
contribution, part of the donor’s charitable contribution
deduction could be recaptured.(4) This can be avoided, however,
if the charity “certifies” that the property donated was intended
for a related use, but that such use is now impossible or
unfeasible. If counsel drafts the gift agreement, the donor
should ask about including a term in the agreement requiring the
charity to use the donated item(s) for an exempt purpose related
to its mission for a stated minimum period of time.
If the collection is donated to the charity upon death, there is
no capital gains tax liability (as with any gift) and no estate
tax due to the estate tax charitable deduction. If donated during
his or her lifetime, the donor avoids capital gains taxes,
removes the value of the collectibles from his or her estate, and
also receives an income tax deduction (limited to certain
percentages of adjusted gross income). The income tax deduction
for donations of art, collectibles, and other forms of tangible
personal property is limited to 30 per cent of the donor’s
adjusted gross income if the charity is a public charity or a
private operating foundation (20 per cent if a private
non-operating foundation). Any excess contributions generally can
be carried forward for five years.
A crucial aspect in donating tangible personal property is
determining its value. As with any sale, timing, demand, shifting
tastes, condition, and provenance are all contributing factors to
the collection’s stated value. The charity, as the recipient of
the gift, cannot be involved in its valuation.
For deductions greater than $5,000, the donor must file Form 8283
and include a “qualified appraisal” from a “qualified appraiser.”
Tax returns selected for audit where donated artwork is valued
greater than $20,000 or more should follow guidelines by the IRS
Art Advisory Panel. This panel will automatically scrutinize
donated artwork valued in excess of $50,000.
Donating to one’s own private foundation
For an artist or collector who wishes to transfer ownership of a
collection, a private foundation (either operating or
non-operating) offers yet another option. Unlike a publicly
supported charity, such as an art museum that depends on
fundraising for its operations, a private foundation is funded
and controlled by an individual, family, or corporation. It
therefore offers some of the benefits associated with donating to
a publicly supported charity, but with a greater level of
control. There are many reasons why an artist or collector might
want to create a private foundation:
* The donor can retain a level of control over the foundation,
including holding the collection within it. He or she can make
sure the pieces stay together, determine where, how often, and
how they are displayed, and ensure that they’re on exhibit
instead of languishing in storage.
* The art can remain a permanent holding of the foundation:
Because a private foundation can own and hold any type of asset
(unlike donor-advised funds, which typically require the donor to
sell the asset first and then donate the proceeds), the
collection can remain in the permanent possession of the
foundation.
* A foundation may hold collectibles and other tangible property
strictly as an investment (with no intention to display it
publicly). Alternatively, if the tangible property is publicly
displayed or actively used by the foundation in carrying out its
mission, the donation may be classified as a charitable use
asset. As we will explain, there are a number of advantages to
designating the contribution as a charitable use asset.
* If created during his or her or lifetime, the donor can
personally experience the joy of directly sharing the collection
with the public.
* Unlike donor-advised funds and other charitable vehicles that
typically liquidate donations of tangible property immediately
upon receipt, a private foundation can accept and hold them
indefinitely. The artist or collector therefore avoids having to
sell the collection quickly and, potentially, at distressed
prices.
* If contributed during the collector’s lifetime, the collector
receives an income tax deduction for the donation’s fair market
value, provided the foundation is an operating foundation and
that the donated tangible property is put to a related use. For a
non-operating (or grantmaking) foundation, or where the donor is
also the creator of the donated collection, the deduction is
limited to cost basis (or the lower of fair market value and
basis if the property is depreciated at the time of
donation).
* The donor can involve his or her family members in the
foundation. Not only will family members have hands-on experience
of philanthropy, but if their work is helpful and appropriate,
they can also be paid a salary that is commensurate with the
foundation’s size and the individual’s experience, time,
commitment, and responsibilities.
* Whereas a museum might want to sell off lesser examples of a
collection or even part with the collection altogether if its
curatorial priorities change, a private foundation can preserve
all options for the donor and future foundation directors. The
collection can be sustained in perpetuity, grow over time, or be
sold in part or in whole.
* Private foundations can employ a wide variety of IRS-sanctioned
philanthropic capabilities related to its mission. These might
include awarding music school scholarships to talented street
buskers, making loans to cash-strapped museums to mount new
exhibitions, or running programs that help artists inspire and
beautify their communities with public murals.
If the donor decides that setting up his or her own charitable
organization is the way to go, there are two distinct categories
of private foundations to consider: (1) non-operating foundations
and (2) operating foundations. Stay tuned for Part Two in which
we discuss these options and highlight the benefits of donating
to a private foundation.
Footnotes:
1. For a definition of tangible personal property for charitable
purposes, see IRS Pub. 526.
2. The IRS recognizes this fact and provides a “blockage
discount” in valuing collections for estate tax purposes.
3. Consult a tax advisor prior to making a donation of art or
other valuable collectible.
4. The donor would include in his or her income the deduction
originally claimed minus the basis in the property when the
contribution was made.
Jeffrey Haskell, J.D., LL.M., is chief legal officer for
Foundation Source, which provides comprehensive support services
for private foundations. Contact him at
jhaskell@foundationsource.com. Stephen Pappaterra, attorney at
law, serves as Counsel for the law firm of Earp Cohn, P.C.
