Collectibles such as art, antiques, jewelry, stamps, coins and automobiles can constitute a significant portion of the estate of a wealthy individual.
Often — and unfortunately — advisors fail to focus adequate attention on planning for these important assets.
There are a number of hurdles to giving collectibles their due, including their status as a hobby for many people. Other obstacles include the difficulties of finding credible valuations and of incorporating them into charitable giving and inheritance plans.
Still, any advisor who works with high-net-worth clients needs to understand the ins and outs of collecting. Collectors are passionate, and helping them protect their treasures can significantly strengthen the client/advisor bond.
One of the most important considerations in planning for the disposition of collectibles is how the items are to be valued. If the collectibles are incorrectly valued for tax purposes, additional tax, plus penalties and interest can be imposed. The general rule for federal estate, gift and income taxes is that the transferred items are to be valued at their fair market value. Sometimes, the tax authorities will accept the buyer's cost or a recent sale as evidence of fair market value. Most often, however, fair market value will need to be determined by an appraisal of the transferred property. Note that if the client is making a gift of art worth more than $5,000 to charity and wants an income tax charitable deduction, then for the transfer, the property must be appraised by a qualified appraiser and the client should be sure to attach Treasury Department Form 8283 to her income tax return reporting the transfer.
There are four noncharitable planning techniques for art and collectibles:
Annual Exclusion Gifts
A donor is permitted to make gifts of up to $11,000 per beneficiary annually free of federal gift tax, $22,000 per year for married couples. Any property gifted in this manner is entirely removed from the donor's estate, even if death occurs immediately after the gift. For works of relatively modest value, use of the $11,000 annual exclusion can be a simple and effective means of removing the value of art and collectibles from the client's taxable estate.
For larger collections of greater value, if the donor has a large number of children and grandchildren, he could consider making gifts to an irrevocable trust containing Crummey withdrawal powers for each child and grandchild. For example, suppose a married individual has three children and six grandchildren. He could establish an irrevocable trust for the benefit of all nine descendants, granting each one a Crummey withdrawal power. Gifts of up to $198,000 per year could be made to such a trust without the imposition of federal gift tax.
Unified Credit Gifts
In addition to the annual exclusion, each individual has a lifetime exemption from federal gift tax of $1 million. Note, however, that gifts made using the $1 million lifetime exemption are effective only to remove any appreciation in value of the gifted property from the taxable estate; they do not remove the property itself.
Art LLC or Art Partnership
A more aggressive approach would be for the donor to place the art or collectibles in a family limited partnership or family limited liability company (an “Art LLC”). The Art LLC would serve the following purposes. First, it would provide a convenient vehicle through which to manage and control the collection, regardless of who the owners of interests in the LLC might be from time to time. Second, if interests in the Art LLC are gifted to family members or trusts, it should be possible for an appraiser to apply discounts to the value of the gifted property to reflect the fact that the gifted LLC interest is not readily marketable and does not permit the recipient to control the affairs of the entity.
Charitable Gifts of Art and Collectibles
Some of the most exciting opportunities for planning for art and collectibles are charitable techniques. Structured properly, charitable gifts and bequests of art and collectibles can be a tax-efficient way of keeping a collection intact.
Unfortunately, along with the planning opportunities, there are a number of tax traps regarding transfers of collectibles to charity. The income tax charitable deduction for a gift of appreciated art work or collectibles to a public charity depends on whether the charity's use of the gift is deemed “related” or “unrelated” to the charity's charitable purpose.
If the gift's use is related, the client is entitled to a deduction for the property's fair market value — up to 30 percent of the client's adjusted gross income. If the gift's use is unrelated to the charity's charitable purpose, the client is only entitled to a deduction equal to her cost basis in the property — up to 50 percent of the donor's adjusted gross income. For example, if a painting contributed to a university is used for educational purposes by being placed in its library for display and study by art students, the use is related to the university's charitable purpose (and, therefore, a fair market value deduction is available). Some examples of charitable planning for art and collectibles are the following:
A bargain sale is a sale of appreciated property to charity at a price lower than its present fair market value. A charitable deduction is allowed for the difference between the sale price and the property's fair market value. The donor must allocate the property's cost basis between the gift element and the sale element, based on the fair market value of each part. The donor has a taxable gain on the difference between the sale price and the cost basis allocated to the sale element, but it is not taxed on the gain allocated to the gift element.
Loans of artwork to charity are a popular technique. Under a special provision of the Internal Revenue Code, a loan of art work to charity will not generate an income tax deduction and will not be treated as a taxable gift. This avoids the need for the client to obtain an appraisal of the loaned artwork. Clients looking to loan artwork to museums and other institutions should be sure to have their advisor review the loan agreement regarding such items as the length of the loan term, insurance and other issues.
Charitable Remainder Trust
Tangible personal property — such as paintings, sculpture and jewelry — can sometimes be an appropriate asset with which to fund a charitable remainder trust (“CRT”). A CRT is an irrevocable trust that provides distributions to individuals during their lives (or for a term of not more than 20 years), with the remainder passing to charity. Because a CRT is a tax-exempt entity, it is ideal for the tax-efficient diversification of highly appreciated assets. When a contributed asset is sold, no capital gains tax is payable at the time of the sale — making the full proceeds of the sale available for reinvestment by the trust. When an individual funds a CRT, he or she is entitled to receive an income tax charitable deduction equal to the present value of the charity's remainder interest. There are a number of tax traps associated with gifts of artwork to CRTs. Three are of particular importance. First, the grantor's income tax deduction is delayed until the property is actually sold by trustee. Second, the grantor should be informed that his or her income tax deduction for the remainder interest will be based on the lesser of the property's fair market value or its cost basis. Third, if the property has been subject to accelerated depreciation (e.g., farm equipment) then the charitable deduction may be further reduced.
Charitable Lead Trust
A charitable lead trust (“CLT”) is sometimes referred to as a charitable remainder trust “in reverse.” In a typical CLT, a donor transfers assets to an irrevocable trust, either during life or at death, providing that charity shall receive a qualified annuity or unitrust interest for a set term. The term may be a term of years or the life or lives of certain individuals. The donor to the CLT is entitled to a gift or estate tax deduction for the actuarial value of charity's interest in the trust. If the CLT is established as a grantor trust for income tax purposes, the donor is also entitled to an income tax deduction for the value of charity's interest in the trust. The most commonly used CLT for art and collectibles is the testamentary CLT. The testamentary CLT can be structured to provide the donor's estate with an immediate estate tax charitable deduction for the full value of the collection transferred to the trust. If the trustee sells the collection shortly after it is transferred to the CLT and reinvests the proceeds in a manner which produces investment returns greater than the discount rate mandated by the IRS in valuing the charitable interest in the trust, the donor's family will receive any excess appreciation estate tax free.
Private Operating Foundation
There are circumstances in which a donor might not want to transfer his collection to a museum but would rather establish his own museum for the collection. This can be accomplished through the creation of an entity known as a private operating foundation (“POF”). The donor is entitled to a fair market value deduction, offsetting up to 30 percent of adjusted gross income, for the gift but gets to retain control as a member of the Board of Directors of the POF. Note that a POF is very different from the usual private foundation, which typically exists only to write checks to other charities. To be classified as a POF, a private foundation must directly operate an active charitable program (e.g., a museum) and expend or dedicate a sufficient amount of its resources to that program.
Clients looking to remove art or collectibles from their taxable estate should also be advised to respect all of the formalities of transferring such property. The transfer should be documented with a written deed of gift, the item should be removed from the donor's insurance policy and added to the donee's policy, and the transfer should be reported on a gift tax return. It is critical that there be actual delivery of the gifted item from the client to the donee. The most beautifully drafted deed of gift will not be worth the cost of the paper if the donor retains physical possession of the gifted item.