I recently had a conversation with Irina Tarsis, the founder and managing director of the Center for Art Law, an independent public charity that is dedicated to writing, gathering and sharing legal and visual arts information for the benefit of artists, students, lawyers and academics. During our conversation, I inquired as to how the Center was assisting their members and donors to reduce their income or estate tax on the sale or inheritance of artwork. There are several ways that a donor can use the tax-exempt status of a charity to reduce and defer taxes on transactions. These techniques are especially relevant to artists and their family when it comes to artwork.
Currently, the capital gains rate on artwork is 31.8% (28% plus 3.8% for the Investment tax) rather than the current maximum for the sale of real estate, stocks and bonds, which is 23.8% (20%, plus the 3.8% Investment tax). The non-tax costs of selling art can also be daunting—there is the seller’s commission (as high as 25%), plus state capital gains tax as well. Sale at auction could result in half of the hammer price going to taxes and fees.
There are no tax-free exchanges of artwork, unlike real estate investments, but there are some alternatives to defer the payment of the capital gains tax:
Charitable Remainder Trusts are the best way to defer paying capital gains tax on appreciated assets, if you can transfer those assets into the trust before they are sold, to generate an income over time.
A Charitable Remainder Annuity Trust (CRAT) is established with a gift of cash or property made to an Irrevocable Trust. The donor (or another non-charitable beneficiary) retains an annuity (fixed payments of principal and interest) from the Trust for a specified period (up to 20 years), or for the life or lives of the non-charitable beneficiaries. At the end of the term, a specified qualified charity receives the balance of the Trust Property.
Gifts made to a CRAT qualify for income and gift tax charitable deductions; and, in some cases an estate tax charitable deduction for the remainder interest gift, if the Trust meets the legislative criteria. The annuity paid must be either a specified amount expressed in terms of a dollar amount (e.g., each non-charitable beneficiary receives $500 a month), a fraction or a percentage of the initial fair market value of the property contributed to the Trust (e.g., beneficiary receives 5% each year for the rest of his/her life).
The Grantor will receive an income tax deduction for the present value of the remainder interest that will ultimately pass to the qualified charity. Government regulations determine this amount, which is essentially calculated by subtracting the present value of the annuity from the fair market value of the property and/or cash placed in the Trust. The balance is the amount that the Grantor can deduct when the Grantor contributes the property to the Trust.
A Charitable Remainder Unitrust (CRUT) is similar to a Charitable Remainder Annuity Trust except that instead of a fixed dollar amount or percentage of the original gift amount, the annuity is a specific percentage of the balance of the Trust assets as of the beginning of the year the payments are to be paid.
Here is an example of the tax savings using a Charitable Remainder Trust:
Value of artwork: $1,000,000
Term of annuity: 10 years
Current AFR rate: 5%
Tax savings in the year of the sale: $318,000
Annual payment: $116,554.63
Immediate charitable deduction: $100,000.11
Charitable Lead Trusts
A Charitable Lead Trust is the best way to accelerate charitable deductions to both reduce the negative effects of the new limitations on itemized deductions and to offset up to 50% of the Grantor's Adjusted Gross Income in any tax year. It can also be used as a way to eliminate gift or estate taxes on transfers to children or other beneficiaries.
Creating a CLAT requires transferring cash or other assets to an Irrevocable Trust. A charity receives fixed annuity (principal and interest) payments from the Trust for the number of years you specify. At the end of that term, assets in the Trust are transferred to a non-charitable remainder person (or persons) specified at the Trust's creation. This person can be anyone: the Grantor, a spouse, a child or grandchild, even a completely unrelated party.
You can set up a CLAT during lifetime or at death. Both corporations and individuals may establish Lead Trusts, which is useful when you need to take appreciated assets out of a business tax-free.
If you are the beneficiary, then you will receive an immediate and sizable income tax deduction. In the second and following years, you must report the income earned by the Trust, less the amounts actually paid to the charity in the form of an annuity.
One advantage of the CLAT is the acceleration of the charitable deduction in the year you make the gift, even though the payout is spread out over the term of the CLAT. For example, if you have sold a very highly appreciated asset this year, but you can reasonably expect that in future years, your income will drop considerably, you can have a very high deduction in a high bracket year, even if you have to report that income in lower bracket years. You are able to spread out the income (and the tax) over many years.
Another advantage of the CLAT is that it allows a "discounted" gift to family members. Under present law, the value of a gift is determined at the time the gift is made. The family member remainder man must wait for the charity's term to expire; therefore, the value of that remainder man’s interest is discounted for the "time cost" of waiting. In other words, the cost of making a gift is lowered because the value of the gift is decreased by the value of the annuity interest donated to charity.
When the assets in the Trust are transferred to the remainder man, any appreciation on the value of the assets is free of either gift or estate taxation in your estate.
A Charitable Lead Unitrust (CLUT) is similar to a Charitable Lead Annuity Trust except that the payout to charity is a percentage of the Trust assets at the beginning of the year in which the annuity payments are to be made.
Here is an example of a CLT for estate taxes:
Donation to the CLAT: $1,000,000
Term of CLAT: 10 years
Growth of assets in CLAT: 8%
Annual payout to charity: $72,999.47
Remainder passing to your heirs tax free: $1,016,813.00
Estate tax savings: $400,000
So, if your client is an artist, collector or inheritor of art, when it comes time to plan to sell or gift the art, consider using the charitable status of organizations like the Center for Art Law to help defer or avoid the tax.
Matthew Erskine is managing partner at Erskine & Erskine.