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.
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.