According to many who knew her, Brooke Astor had one very favorite painting, Childe Hassam’s “Flags, Fifth Avenue.” This great American impressionist painting hung in a prominent place in her apartment since the early 1970s. Her son, Anthony Marshall, sold the painting while she was alive (and not competent) for ten million dollars and paid himself a two million dollar commission. A short time after the sale, the dealer resold the painting for twenty million dollars.
The sale of this prized painting was the beginning of a long, unpleasant road for Mr. Marshall. By all accounts, Brooke Astor really enjoyed looking at that piece of art every day and she intended to leave it at her death to the Metropolitan Museum so that others could enjoy it. Instead her son convinced her she needed to sell the painting to support herself (or that was his testimony). It was sold. He got the commission, an IRS audit and a court battle. She was no longer able to view the art and it was kept in private hands—it never got to a Museum.
For many individuals and families, what to do and whom to trust with art is a thorny issue. For estate planning purposes, it is important to consider the legacy of the work itself and to understand the choices involved: who shall receive it, who can afford to pay any estate taxes on it, who can afford to maintain it, who will use it and who will appreciate it. For many families, these are not simple decisions. The right solution lies at the intersection of many complex and sometimes competing considerations.
Since the monetary value of art is an inexact science—no one can ever be sure what the market will bring—the first step to measuring its value is to obtain a qualified appraisal and valuation. The appraiser should be a member of the American Society of Appraisers, the Appraisers Association of America or the International Society of Appraisers.
The Impact of Taxation
It is important that the family understand the impact of taxation on the art. For estate tax purposes, the gross estate of a U.S. citizen or resident at the time of his/her death includes “the value of all property, real or personal, tangible or intangible, wherever situated” which is owned by the decedent at the time of his death. (Internal Revenue Code Section 2031 (a). The Internal Revenue Service has established an Art Advisory Panel whose task is to assist the IRS in reviewing and evaluating appraisals of artwork in conjunction with federal income and gift and estate tax returns (IRS Audit Manual, MT 42(16)4 (11-19-82). The Panel consists of twenty-five art experts who serve without compensation.
If a tax return containing an item of art with a claimed value of at least $50,000 is selected for audit, the case must be referred to the Art Advisory Panel. If the artwork exceeds $50,000, Revenue Procedure 96-15 (modified by Ann. 2001-22, 2001 CB, 2-15-2001) provides that there can be a request made for an IRS expedited review of the art valuation. If the art is forwarded to the Art Advisory Panel then there are very specific requirements about how it is photographed. If a family member will be filing an income, gift or estate tax return which involves an item of art in excess of $50,000 it is prudent to review the IRS requirements and obtain the appropriate photographic evidence at the outset.
Each year the Internal Revenue Service Art Advisory Panel publishes its report on its activity, including a listing who the panel members were and a summary of their findings. The fiscal year 2013 report indicates that the Panel reviewed 291 items with an aggregate taxpayer valuation of $444,288,500 on 31 taxpayer cases under examination. The average claimed value of a charitable contribution item was $2,361,154; the average claimed value for an estate and gift item was $1,167,118.
The Panel recommended accepting 44% and adjustments to 56% of the appraisals it reviewed. On the adjusted items, the Panel recommended total net adjustments of $54,556,123 on estate and gifts tax appraisals, a 33% increase. Net adjustments for charitable contribution appraisals totaled $51,065,000, a 32% reduction.
It is also important to note that each state has jurisdiction over the real property and tangible property that his physically located in it. Therefore if a family owns a vacation home and art in a state that has an estate tax (such as Massachusetts) then even if the decedent is domiciled in a state that does not have a state estate tax (such as California) the state that does have the estate tax will have the ability to assess the estate tax on the real property and tangible personal property that is physically located there. And, if the family member is spending significant time in multiple states and the issue of which is the state of domicile is not factually clear then this issue can create even more significant problems. At the family member’s death when a non-resident estate tax return is filed and includes the real property and artwork located there the taxing authority also has an “invitation to the party” and can review the issue of domicile. The domicile test in most states for estate tax is not the same as the test for income tax purposes. The state estate tax domicile test is for the most part not a mechanical application of days in residence. Instead more emphasis is put on the intent of the decedent – where did the decedent intend his domicile to be. This can be factually (and subjectively) determined by reviewing where he voted, how much time was spent there, organizations belonged to and where he requested be buried. The stakes are very high for a high net worth decedent because the state in which he is domiciled will have the authority to tax all of the decedent’s assets (other than real property and tangible personal property that is physically located in other states). As some state estate taxes reach 20% the assessed tax can be significant. Therefore if the family member has multi- jurisdiction properties and art he should consider planning to avoid these issues by owning the art (and real estate) in vehicles that would be taxed in the jurisdiction of domicile, not the state jurisdiction that has the vacation home and the artwork. This is done by converting the ownership of the art (and vacation property) from an interest in real or tangible personal property to one of intangible personal property as intangible personal property is taxed in the domicile jurisdiction.
The family member should also understand that regarding valuable art, more may be included in his gross estate than the art itself. Art may have to be sold and substantial commissions paid on the sales. If that is the case, it may be desirable to mandate in estate planning documents that a sale be made by the executor so that the commissions are deductible as administrative expenses. The only other way that commissions paid on the sale of the art after death are deductible from the estate is if the sale is necessary to pay the estate taxes. In other words, if the art is sold by the estate (for any reason other than it was essential to pay estate taxes) and the estate planning documents do not mandate that the art be sold, then the expenses of the sale which can be significant will not be deductible. Therefore, in essence, the heirs will be paying an estate tax on the lost deduction.
Before bequeathing art, it is essential to have a frank discussion with family, beneficiaries and any intended charity If a piece of art has always been in the family, and the owner believes that his children wish to receive it, it is wise to have a conversation with the children or heirs to see if that is true and if they want the art or if they are more interested in converting it to cash. In reality, even if the children do want the art, they may not be able to afford the taxes on it and/or the cost of maintaining it. In these uncertain economic times, they may just want or need the value it represents. For example, in a recent (2/25/2012) New York Times article, Bert Cohen discussed the plan for his antique marble collection. Cohen had given one $500,000 marble collection to his son in 1986, thinking he wanted to add to it. However, his son sold it. Based on that experience, Cohen came to the conclusion that his multi-million dollar collection had to be sold.
The possible lack of deduction from the taxable estate for expenses attributable to the sale of art further underscores how critical it is to discuss the legacy of the art with heirs and with any charitable organization in the planning process. If the family member desires to leave the art to a charitable organization, and that organization is willing to accept it, then the value of the art is included in the family member’s taxable estate, and the estate receives a charitable deduction for the gift. If the charitable organization, for whatever reason, does not accept it, and there is no alternative provision, and the art is sold and added to the residue or passes to individual heirs, the expenses attributable to the sale are not deductible.
If in the discussion about art, one family member does wish to receive the art, then in the planning process one must carefully address how the estate taxes on that art are to be paid. Who is to bear the burden of that tax? Is the tax the recipient’s burden, or will the tax be paid from the decedent’s remaining assets? In other words, if a mother bequeaths a million dollar painting to a son and directs that that son pay the estate taxes on it, then it is the son’s problem. If, on the other hand, the mother bequeathes the million dollar painting to her son and directs that the mother’s estate pay the taxes, then in essence the payment of those taxes comes out of what others are receiving, assuming others are also beneficiaries of the mother’s estate.
Another option may be to consider what is known as a disclaimer, i.e., the mother leaves the art to the charitable organization or to the son, and if the son disclaims it (or choose not to take it) within nine months of the date of the mother’s death, then the charitable organization will receive the art and her estate will receive the charitable deduction. Setting an estate up so that the ability to disclaim is ‘on the table’ allows the son to have a second look- in the cold hard nine month time frame and decide if he wants the painting, what its value is and how the estate taxes are to be paid. If he does not want it then by disclaiming he steps aside, the art passes to the charitable organization as if he had never been mentioned and the estate tax charitable deduction is preserved. It may also be prudent to have what are known as cascading disclaimers- meaning a series of charitable organizations so that if one museum does not wish to receive it on the terms the mother mandates then that museum can step aside and it would fall to the next charitable recipient. If the mother is convinced that the art must be sold at death then it is important from an estate tax point of view that she mandate the sale of that asset to insure that the estate will receive the requisite administrative deduction.
If the family member is considering gifting it to a charitable organization, it is best to find out now whether or not it is realistic for that organization to accept the gift and to discuss any terms of the gift. Will there be any restrictions on it? Are those restrictions realistic? Are there endowment funds that will accompany the donation? It can be a burden to maintain and store art for a significant period of time. In my experience, donating funds to assist with maintenance and storage is prudent.
Charitable Remainder Trusts
Lifetime gifting options should be explored. There can be income tax benefits to making the gift of art – whether outright, in trust or by fraction now. To assess the benefit, you must determine the income tax basis in the asset and quantify any capital gains tax that will be due on the sale. To avoid that gain, some individuals consider transferring the art to a charitable remainder trust. A charitable remainder trust (known as a split interest gift) is an irrevocable trust. The donor can gift the assets to the trust and retain the right to receive income for a predetermined period of time. When the income period ends, the charitable remainder trust ends; and the remaining assets are distributed to the charitable organizations which the donor has selected.
When the donor contributes assets to the CRT, the donor will (in most cases) receive a current income tax deduction equal to the present value of the gift the charity will eventually receive when the CRT ends. Because CRTs are generally tax exempt, appreciated assets can be gifted to a CRT and later sold without the donor or the trust owing capital gains tax. An exception to this is unrelated business taxable income.
When the CRT is being established, the donor must decide the length of the income interest. In many cases it is a lifetime payment stream (and/or for the lifetimes of one or more other persons whom the donor designates). As an alternative, the donor may choose to direct that the income interest be paid for a specified period of time not to exceed 20 years. Once the specified income interest has concluded, the CRT terminates; and the remaining assets are distributed to the charities that the donor has chosen. The donor also has the choice of determining how the income interest will be calculated. There are two types of CRTs: the Charitable Remainder Annuity Trust (CRAT) and the Charitable Remainder Unitrust (CRUT). The CRAT is designed so that the actual dollar amount distributed to the donor (and/or other persons that the donor designates) is fixed at the time the trust is created and funded. Generally, the predetermined annuity amount will not change no matter how the trust assets fluctuate in value. A CRAT can be appealing to the donor who needs a specific amount of income and who is concerned about a change in income payments.
A CRUT is designed so that the amount distributed to the donor is recalculated each year based on a fixed percentage of the trust’s fair market value for that year. Unlike the CRAT, the CRUT is not a fixed annuity payment. The fixed percentage will not change. However, the amount that the donor receives can fluctuate. If the CRT performs well and the trust assets increase in value, so will the income interest payment which is calculated as a fixed percentage of the increased trust value. However, the reverse is also true: If the trust decreases in value, the income interest will also be affected. A CRUT is appealing for the investment minded donor who wants to benefit from increased income payments resulting from the long term appreciation of the trust assets. There are various types of CRUTS which should be explored in greater detail before the family member makes a final decision.
A disadvantage to using a Charitable Remainder Trust for art is that because art is personal property, the income tax deduction may be limited significantly. In addition, however, no deduction may be taken until all interests and rights, possession or enjoyment of the property has expired or held by a person other than the donor. The tax benefits to transferring art to a charitable remainder trust and later selling it include avoiding the capital gains tax on the sale of the asset and removing the underlying value of the asset from the donor’s taxable estate. Of course, the reason that the art is removed from the taxable estate is that it is no longer owned by the donor. For that reason, some donors couple the use of a Charitable Remainder Trust with what is known as an irrevocable life insurance trust. When used together, these tools replace the value of the art and keep that value out of the donor’s taxable estate.
The family member may also choose to make a gift (lifetime or death time) of the art to family members, but in trust. If the family member wishes the art or collection to stay with intended beneficiaries, another choice may be to establish an irrevocable trust (lifetime or death time) and transfer the collection to it. That will protect the assets from the creditors of the beneficiaries and preclude its value from being taxed in the family member’s estate and then again in the beneficiaries’ estates. If doing so, it is advisable to add enough funds to that trust to insure and maintain the art. The choice of Trustee must be carefully considered as the Trustee or Trustees will have the continuing ability to manage the trust assets, including the art—that could mean selling it.
Gifting a Fractional Interest
A gift of a fractional interest in art should also be considered. For the most part, the Pension Protection Act of 2006 (PPA) closed the door on a technique. Until then a collector would donate a fractional interest in a work of art to a museum that qualifies as a charitable institution. Collectors did so for a variety of reasons, one of which was that they could take a tax deduction for the value of the fractional interest. For example, if a collector donated a 50% interest in a painting to a museum, she could write off half the value of the painting as a charitable deduction and the painting would spend half the year in the donor’s possession and half the year in the museum. Congress was concerned that collectors may have been abusing the write off by enjoying more than their rightful share of the art; e.g., if a collector donated 50% of the art but kept it on the wall for more than six months a year, the public was losing out on the availability of the painting during the excess period it was held by the collector. To address this perceived abuse, Congress threw out the baby with the bathwater. Generally the collector would bequeath the remainder of the fractional interest to the museum so the collector’s estate would take a charitable contribution deduction for the remaining current value of the art at the time of the collector’s death. But the PPA requires that the write off be based on the value of the art at the time the original fractional interest was donated if the art appreciated in value, rather than on its value at the time of the collector’s death. If the value of the art has appreciated in that period of time, as it is wont to do, the new law will reward the collector by increasing her estate tax liability.
As an example, suppose the painting is worth one million dollars when the collector first donated 50% to the museum, and the collector bequeaths the remaining 50% of the painting when she dies and the painting is worth 10 million. Under the old rule, the painting would pass to the museum; and the estate would take a 5million dollar charitable contribution deduction. But under the new law, her estate may only deduct $500,000; and the estate would have to pay taxes on 4.5million more than it would have under the old law. There are also recapture rules (deductions turned back into taxable income). If the collector fails to donate the balance of the art to the museum within ten years of the original gift (or before the collector dies)—whichever comes first—the government will send the collector a bill recapturing the original deduction. This essentially requires the collector to donate or bequeath the remaining fractional interest or lose the tax benefit of the original gift.
If a family member has valuable art, it is important that she assemble a team of advisors that understands how to deal with it. The team may include an attorney, financial advisor, tax specialist and an art succession planner. It is wise to make sure that all the team members know the extent and value of the art and how the family member intends to dispose of it so that it can be properly taken into account when establishing a financial and estate plan.
The decisions and choices as to how to preserve the legacy of artwork should be thought through with care and involve a discussion with the family member who owns it, the intended beneficiaries, the charitable organization and the team of advisors.