A valuable art collection presents an opportunity to craft a cultural and personal legacy that can last for generations. At some point along the path to achieving a collector’s vision, however, he should consider some of the unique tools and nuances of art ownership.
Managing Capital Gains
Art collectors face special income and transfer tax hurdles. One such challenge is managing the 28 percent long-term capital gains tax that collectors and investors must pay when they sell a work held longer than one year for a profit. For most other capital assets, the long-term capital gains rate is only 15 percent.1 Unfortunately, when the rate was decreased in the Taxpayer Relief Act of 1997, the law specifically excluded collectibles (for example, art).
One strategy that taxpayers use to manage their capital gains exposure is to engage in like-kind exchanges. Internal Revenue Code Section 1031 allows tax deferral on art exchanges, as long as the transaction is done by an art investor, the artist, or a dealer—but not by a “collector,” as those terms have been defined by the Internal Revenue Service and case law.
It’s fairly common for art patrons to swap works with other patrons, dealers and auction houses with the intent to improve and curate their collections. It’s, therefore, critical to understand the distinction between a collector and an investor.
The Court of Claims in Wrightsman v. United States,2 provided the initial guidelines as to what constituted sufficient “investment intent” to delineate between a collector (when a pursuit would be a mere hobby) and an investor (when a pursuit would be a for-profit endeavor).
Although the court dealt with whether the taxpayers could deduct expenses associated with their art collection, the objective factors used to examine investment intent are also used to determine collector versus investor status for like-kind exchanges.3
The factors the court noted include: (1) the frequency and degree to which owners obtain advice from art experts; (2) the expertise of the taxpayers; (3) the frequency and degree of time the taxpayers devote to their collection; (4) the degree of personal use; (5) whether adequate records are maintained; (6) whether the taxpayers participate in collection-related activities; and (7) whether the taxpayers have a reputation as being in an art “trade or business” or as being an “investor” in art. The IRS and the courts have further provided that lack of profits, personal use and personal pleasure don’t necessarily preclude a person from being classified as an investor, but such factors will be weighed in making a determination.
Paintings, sculptures, prints, collector coins, rugs or textiles, precious gems, antiques, antique firearms and classic automobiles may qualify for like-kind exchange treatment. There’s little guidance on what constitutes like-kind when it comes to art. Generally, the “nature or character” of the works in question should be similar. Thus, exchanging an oil painting for another oil painting probably satisfies the like-kind requirements of IRC Section 1031, while exchanging an oil painting for a sculpture may not.
The exchange documentation is typically prepared before the swap. These documents generally include an exchange agreement, an assignment agreement and a notice of exchange. There are special timing rules for when an exchange isn’t simultaneous.4 These rules typically provide that an investor has 45 calendar days (beginning on the date the investor transfers the relinquished property and ending on the 45th day post-transmission) to identify the artwork that he intends to acquire and must exchange the relinquished property within 180 days or by the due date of the investor’s tax return, including extensions.
If the art market presents a purchase opportunity, a reverse exchange may be performed, whereby an investor can purchase the replacement work first and later exchange the relinquished work within the requisite 180 days.5 It may be prudent to use a qualified intermediary, so that the exchange can qualify under the safe harbor rules and not trigger a constructive sale.
Before engaging in any like-kind exchange, investors, artists and dealers should consult with legal and tax counsel to determine their tax status and what legal documents and logistical arrangements will be necessary.6 (For more information on like-kind exchanges, see K. Eli Akhavan, “Brushstrokes of Art Planning,” Trusts & Estates (August 2012), p. 23.)
Between 2000 and 2007, the art markets, in particular the contemporary art market, reached breathtaking heights. Back then, auction houses were willing to guarantee a minimum hammer price for works put up for sale, essentially pre-selling works, to coax market-shy sellers into providing the scarce inventory needed to satisfy the market’s insatiable demand.
In the wake of Lehman Brothers’ failure and the ensuing credit crisis, the major auction houses reportedly lost millions on these guarantees.7 Their woes were exacerbated by being forced to acquire non-performing physical assets when most firms were struggling to raise liquidity and survive the tumultuous markets. The need to raise cash and reduce balance sheet risk led auction houses to engage in the practice of third-party guarantees, whereby the risks associated with such guarantees could be transferred to a discrete pool of investors and not borne by the auction houses.
In a third-party guarantee bid, the third-party guarantor provides insurance to both the consignor and the auction house that a piece won’t be sold below a predetermined bid price.8 Thus, the third-party guarantor agrees to purchase a work at the guaranteed price if it fails to achieve a hammer price above the guaranteed bid. If a winning bid is above the guaranteed minimum bid, however, the guarantor typically shares in the upside, along with the seller and the auction house.
There are different ways to structure third-party guarantees. Some auction houses, like Christie’s, currently offer the third-party guarantor a separate guarantee fee that’s paid regardless of who’s the successful bidder. Some argue that this net price system gives guarantors a sales discount, which isn’t fair to bidders who don’t guarantee lots. Other institutions, like Sotheby’s, currently structure third-party guarantee sales by awarding guarantee fees (in the form of a share of the auction commission earned on the sale and/or a share of any overage) only to guarantors who don’t acquire the artwork.
Art lawyers and other experts warn that being a third-party guarantor isn’t necessarily a huge money-making proposition and should only be considered if the guarantor is willing to actually buy the work at the guarantee price.
Selling works of art, even through a reputable auction house or dealer, presents risks that must be addressed to avoid losing the consigned work and/or sales proceeds to the auction house’s or dealer’s judgment creditors.
In its most basic form, a consignment occurs when an individual contracts with a gallery or dealer to find buyers. The owner/consignor, as principal, delivers the work to the dealer or auction house, but retains legal ownership. The owner can always withdraw the work from being offered and sets the agreed upon sales price and commission.
The gallery or dealer acts as agent for the seller. Accordingly, general fiduciary principles apply, which protect the consignor and, generally, are governed by the consignor contract, Article 9 of the Uniform Commercial Code and common law.
Issues relating to dealers’ creditors have become particularly important in the wake of the recent financial crisis, because many dealers have filed for bankruptcy protection or have gone out of business. As creditors lined up to be paid, the owner/consignor often learned that he was subordinate to other senior creditors. The result was usually a full loss of the consigned work or its value.
For example, some unscrupulous art dealers have used consigned art as collateral for personal and business loans, unbeknownst to the individuals who consigned the works. When the bank called these loans, the art dealers sold the posted collateral (that is, the consigned works) and used the proceeds to pay off the loan. The only legal action available to most of the consignors was to go after the dealer, but they had no legal claim as to the banks. Ultimately, many of these individuals had to rely on their personal insurance to try to recoup their losses.
Although over 30 states now have enacted statutes protecting artists who place artwork on consignment with galleries, collectors and investors generally can’t point to a state statute that grants them superior priority on artwork or its proceeds over the agent.9
Individuals seeking to consign their art have a simple inexpensive solution to avoid a deleterious outcome. They need to file a UCC-1 financing statement.
This statement should protect the consignor by placing the world on notice as to the consignor’s superior title. While a UCC-1 financing statement doesn’t guarantee clear title, excluding claims from rightful owners, it does give the consignor protection from the art dealer’s creditors.
Why do so few consignors file UCC-1 financing statements? One major reason is confidentiality. To be effective, the statement must be filed with the Clerk of the Court. The property covered by the filing must be sufficiently described, so that it can be clearly identified. The filing, therefore, creates a public record of ownership. Many collectors would rather not go on record as possessing valuable fine art for fear of, among other things, alerting criminals about the collectors’ personal possessions.
Private Operating Foundation
Collectors wishing to make charitable donations often consider creating private foundations. However, many collectors don’t pursue this route, because they can only deduct their cost basis for income tax purposes.
A private operating foundation (POF) may be an acceptable alternative, because it can qualify for the same charitable income tax deduction rules that are applicable to a public charity. In brief, these rules permit donors to claim a fair market value charitable income tax deduction for donations of tangible personal property (that is, art) up to 30 percent of their adjusted gross income.
The Broad Art Foundation (BAF) is an interesting example. Eli Broad established the BAF in 1984 for his (then) 2,000 piece collection of contemporary art. The BAF’s purpose is to advance public appreciation for contemporary art by lending artwork to institutions throughout the world for public exhibition. Since its inception, the BAF has actively lent over 8,000 works to more than 500 institutions, which has allowed parts of the collection to be viewed by over 100 million people.
The major benefit of starting a POF, as opposed to donating a collection outright to an established charity, is control. With a POF, the donor, along with the POF’s board, can continue to acquire and curate the collection. They set loan policy and decide which institutions qualify for loans.
A collection can also be kept complete, unlike giving it to a public museum that may be unable or unwilling to maintain an entire collection. Thus, creating a POF can prevent a collection from being divested over time or placed in a museum’s archives and left unseen. The lack of exhibition space is a big factor in the rise of private museums. At many major public museums, about 5 percent of a collection is on view at any time.10
More recently, Alice Walton founded the Crystal Brides Museum, a POF to be run as a private museum. Walton wanted to be intricately involved with the curation of the institution that showcases her family’s collection of American art. Other POFs that operate as museums include: The Irvine Museum in Irvine, Calif., The Neue Galerie in New York, the Walt Disney Family Museum in San Francisco and the Zelma Basha Salmeri Gallery of Western American and Native American Art in Sun Lakes, Ariz.
Title insurance is a new concept in the art world. Until recently, the only insurance a collector could procure was legal defense cost insurance for title challenges. Under such arrangements, if a claimant prevailed against the insured, the insured would have to forfeit the work. Receiving insurance proceeds for legal fees was of little comfort.
The benefit of title insurance extends beyond theft disputes. In fact, the large majority of disagreements regarding title arise from divorce or inheritance challenges.11 More recently, disputes in title are a result of a consignee shuttering its doors with creditors in hot pursuit. To grapple with title risk, title insurance companies like Hiscox (a syndicate at Lloyd’s of London) and ARIS Title Insurance of New York now offer protection that was once unavailable.
Collectors and investors, generally, know that even when purchased from top-drawer dealers or at auction, there’s no guarantee that a work is authentic or even free of all encumbrances. Even when highly regarded dealers draft sales agreements in which they commit to return the full purchase price in the event a piece’s title is successfully contested, that commitment is only as good as the dealer’s balance sheet.
Art patrons often confuse provenance with clear title, but the two are clearly distinguishable. Provenance is simply the history of a work’s possession. It doesn’t address legal ownership. If one person in the chain of ownership didn’t have clear title, then, in theory, all possessors that follow also hold imperfect title, and they’re at risk of the true owners making a claim for the property.
The cost of title insurance varies. ARIS typically charges a one-time premium between 1.75 percent and 6 percent of the art’s value, while Hiscox prices on a case-by-case basis with premiums in the 0.5 percent to 2.5 percent range. Generally, older works carry higher premiums.
Title insurance is likely to take on greater prominence as collectors look for ways to monetize their collections. Lenders who use art as collateral are starting to require title insurance to prevent a true owner from materializing and making a claim on their collateral.
—Goldman Sachs does not provide legal, tax or accounting advice. We encourage you to discuss these strategies with your tax and legal advisors. Tax results may differ depending on your individual positions, elections or other circumstances.
1. The Tax Relief Act of 2010 temporarily extended the 15 percent rate to 2011 and 2012, after which the long-term rate is scheduled to increase to 20 percent.
2. Wrightsman v. United States, 482 F.2d 1316 (1970).
3. Under the Hobby-Loss rule found in Internal Revenue Code Section 183, “collectors” may only deduct expenses associated with their collections if they have income associated with said collections.
4. Non-simultaneous exchanges are sometimes referred to as “Starker exchanges.” See Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979).
5. Revenue Procedure 2000-37.
6. For example, like-kind exchanges must be reported on Internal Revenue Service Form 8824.
7. Judd Tully, “Assurance Policies: Third-Party Guarantees May Reduce Risk and Yield Rewards,” Art & Auction (Sept. 22, 2011); Lindsay Pollock, “Rise of the Outside Guarantor,” The Art Newspaper (Issue 209, January 2010).
8. A third-party guarantee provides the seller with a guaranteed minimum price that will be procured at auction. This differs from the reserve, which is the minimum price at which a seller will let a piece go. Unlike the guaranteed minimum sales price, if the auctioneer can’t solicit bids in excess of the reserve, the seller must take back the work of art.
9. N.Y. Arts & Cult. Aff. Law Section 12.01; Conn. Gen. Stat. Ann. Section 42-116; Fla. Stat. Ann. Section 686.503; and Mass. Ann. Laws ch. 104a, Sections 1-6.
10. Lauren A.E. Schuker, “The Firestorm Over Private Museums,” Wall Street Journal (April 4, 2008).
11. See generally www.aris-corporation.com.