By: Greta Staat

Art collections are typically driven by personal and emotional connections developed between the art collector and a particular period of art, a specific artist, or an individual work of art. Collections can also be driven by the significant financial gain that can accrue to the collector or the collector’s estate. Whether an art collection was created for love or for money, the collector must decide the fate of his or her collection.

This decision encompasses several different factors that must be analyzed from an estate planning perspective in order to accomplish, in the most tax effective way, the collector’s intentions for ownership and disposition. These factors include:

What does the art collector own, both generally and in the collection?
How does the collector own the individual pieces that comprise the collection?
Who are the intended beneficiaries of the collection?
When does the collector wish to transfer the collection to the intended beneficiaries?

The starting point for any estate plan is an analysis and assessment of the fair market value of the collector’s gross estate. This helps to drive the structure of the plan for the purpose of minimizing or eliminating any estate taxes that may otherwise be due. The estate, gift, and income tax regulations define fair market value of all assets as:

“the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”[1]

While this definition is easily applied to most traditional financial assets, art presents unique valuation issues.

“Art” is a word used to define a wide spectrum of objects and acts. Art is subjective, emotional, and in a state of constant evolution, both aesthetically and economically. The deep connections, whether personal, financial, or both, between the work of art and a collector increase the difficulty of conclusively valuing this illiquid and unregulated asset.

Due to these uncertainties, it is essential that art collectors inventory and professionally appraise their art collections periodically in order to monitor how the collection may impact the collector’s estate. For collectors with significant collections, the collection may result in unfavorable estate tax consequences upon the collector’s death.

However, such consequences can be deferred, avoided, or minimized through the implementation of proper estate planning techniques during the collector’s lifetime.

Determining whether the proper beneficiaries of the collection should be individuals or charitable organizations may be challenging. The collector should talk with the intended beneficiaries to determine whether the nature and extent of the beneficiaries’ interests in the collection match the collector’s intentions for the collection.

There are several established and some recently developing methods for transferring art collections. The methods may involve any combination of sales or gifts (including charitable donations) during the collector’s lifetime, or upon the collector’s death. The method with the most favorable tax outcome will depend on the collector’s individual facts and circumstances.

Giving a collection that has appreciated in value to individual beneficiaries during the collector’s life will remove future appreciation from the collector’s gross estate but will also pass on to the beneficiaries the collector’s basis in the collection[2] and the related potential income tax liability on the pre-gift appreciation. For income tax purposes, a work of art is a capital asset (unless the collector is an art dealer)[3]and a “collectible.”[4] Any gain on the sale of a work of art held for more than one year, would be classified as long-term collectibles gain taxed at the rate of 28%. For gift tax purposes, the gift will not result in gift taxes if the value of the gift is less than the federal transfer tax exclusion ($5.43 million in 2015) and any available federal annual exclusions ($14,000 in 2015).

Giving an appreciated collection to individual beneficiaries upon the collector’s death will eliminate pre-death gain and related potential income taxes because the basis of the collection will be its fair market value at the collector’s death.[5]

In either case, the value of the collection, to some extent, will be included in the calculation of the collector’s estate taxes at the time of his or her death. If the gift occurs during the collector’s lifetime, the gift will be included as part of the decedent’s adjusted taxable gifts, and the amount includible will be the fair market value of the collection at the date of gift.[6] If the gift occurs at death, the gift will be included as part of the collector’s gross estate, and the amount includible will be the fair market value of the collection at the date of death. To the extent that an Illinois collector’s taxable estate exceeds the federal transfer tax exclusion, the collector’s estate will be liable for US and Illinois estate taxes at a combined effective rate of approximately 50%.

To obtain more favorable income and estate tax consequences, a collector could create an intentionally defective grantor trust (“IDGT”) for the benefit of an intended beneficiary and sell the collection to the IDGT in exchange for a note bearing interest at the appropriate applicable federal rate.[7] The sale of the collection to the IDGT would not be recognized for income tax purposes because the collector would be deemed to own the IDGT’s assets under the grantor trust rules.[8] Accordingly, the collector would have no income tax liability on the sale. Additionally, any future appreciation of the collection which exceeds the interest rate on the note would be excluded from the collector’s gross estate and would be transferred to the trust beneficiaries free of gift or estate taxes. However, in creating the IDGT, the collector would have to transfer to the IDGT cash or other property in an aggregate amount adequate for the IDGT to make payments on the note. This aggregate amount would be a gift to the IDGT beneficiaries and would use the collector’s federal transfer tax exclusion to the extent that the amount exceeded any available federal annual exclusions.

Another transfer method involves giving minority interests in an entity owning the collection to the intended beneficiaries. This method minimizes estate taxes by shrinking and freezing the value of the collection for federal estate tax purposes. This is traditionally achieved by the collector transferring the collection to an entity, such as a family limited partnership or a limited liability company, taking back all interests in the entity, and assigning fractional interests in the entity as gifts to the intended beneficiaries (or to IDGTs or other irrevocable trusts for the beneficiaries). The value of a fractional interest is generally the value of the share of the entity’s assets corresponding to the fractional interest discounted by 30% to 50% to take into consideration the lack of marketability and lack of control associated with such interest. Gift tax is avoided by utilizing the any available federal annual exclusions and federal transfer tax exclusion.

Another transfer method involves giving to individual beneficiaries fractional interests in each work of art in the collection and entering into a co-ownership agreement with the beneficiaries. Similar to minority interests in an entity, the value of a fractional interest in a work of art would generally be the value of the share of the piece corresponding to the fractional interest discounted by 30% to 50% to take into consideration the lack of marketability and lack of control associated with such interest. However, IRS has repeatedly asserted its belief that fractional interests in art do not qualify for any valuation discounts as there is no established market for undivided fractional interests in works of art by which to determine an appropriate discount.

The United States Tax Court as well as the 9th Circuit Court of Appeals has disagreed with this conclusion on several occasions. In particular, both courts upheld a nominal discount of 5% to be applied to fractional interests in works of art.[9] However, in 2014, in Elkins v. Commissioner[10] awarded to a decedent’s estate fractional-interest discounts for each piece ranging from 50-80%. In this case, fractional interests in 64 works of art were established by means of inter vivos grantor retained interest trusts and co-tenancy agreements. The ruling was supported by testimony of three independent expert appraisers, the methods used to create the fractional interests, and complete lack of evidence in support of the IRS’ argument.

A collector may be interested in donating the collection to a charitable organization. Depending on the collector’s philanthropic goals and tax needs, there are several techniques that can be used to facilitate the charitable donation (many of which are beyond the scope of this article such as, charitable lead trusts, charitable remainder trusts, and private operating foundations).

If the collector donates the collection during his or her lifetime to a charity, the collector in entitled to an income tax deduction equal to the full fair market value of the property as of the date of the contribution[11] subject to some limitations[12] and elections[13], if the following criteria are met: (1) the collection is deemed long-term capital gain property[14], (2) the charity is a public charity[15], (3) the charity’s intended use for the collection is related to the charity’s tax-exempt purpose [16], and (4) a qualified appraisal was obtained from a qualified appraiser.[17]

Similarly, a collector can donate the art collection upon his or her death and be entitled to an estate tax deduction equal to the full fair market value of the property as of the date of the collector’s death[18] but without the limitations imposed for income tax purposes identified above.[19]

A problem is created when the collector wishes to retain an interest (whether a present interest for a period of time or a remainder interest) in the collection, resulting in a gift of a partial interest in the collection to charity. As a rule of thumb, such a gift will not qualify for an income, gift, or estate tax charitable deduction because the interest will not meet all of the requirements for an annuity trust or unitrust.[20]

One of those requirements is that the trust must pay a guaranteed amount, at least annually, to the holder of the present interest. Since a collection does not produce income from which the requisite annual payment can be made, it is not a suitable asset to fund an annuity trust or unitrust. Further, a charitable deduction for income tax purposes is not allowed for a remainder interest until the collector or the collector’s family terminates any present interest (right of possession, enjoyment, etc.) in the collection for which a remainder interest has been transferred to a charity.[21]

On the whole, whether an art collector built his or her collection as a personal expression of his or her love of art or as a financial investment, the collector has several decisions to make with respect to who should inherit the collection and when. An analysis of several factors, such as the collector’s intentions for the collection, the estimated value of the collector’s gross estate, the collector’s individual tax needs, and the income, gift, or estate tax consequences of the potential transfer methods, will help drive the structure of the transfer of the collection to the intended beneficiaries with the most tax favorable outcome.

[1] Treas. Reg. § 20.2031-1(b); Treas. Reg. § 25.2512-1; Treas. Reg. §1.170A-1(c)(2)
[2] IRC 1015
[3] I.R.C. § 1221
[4] I.R.C. § 408(m)
[5] IRC 1014
[6] IRC 2001(b)
[7] I.R.C. §1274(d)
[8] Rev. Rul. 85-13 1985-1 C.B. 184
[9] Estate of Scull v. Commissioner, 67 T.C.M. 2953 (1994) and Stone v. United States, 103 A.F.T.R.2d 2009-1379 (9th Cir. 2009) (unpublished opinion)
[10] Elkins v. Commissioner, 767 f.3d 443 (5th Cir. 2014), the 5th Circuit Court of Appeals
[11] I.R.C. § 170(a)(1)
[12] IRC 170(b)(1)(C)(i)
[13] IRC 170(b)(1)(C)(iii)
[14] I.R.C. 170(b)(1)(A)(iv)
[15] I.R.C. §§ 170(b)(1)(A)(i)-(viii), (E)(i)-(iii); 509(a); Treas. Reg. § 1.170A-9
[16] I.R.C. § 170(e)(7)(B)
[17] Treas. Reg. § 1.170A-13(c)(3)
[18] I.R.C. § 2055(a)
[19] I.R.C. § 170(e)(1)(B)(i); Treas. Reg. § 20.2055-1(a)(4)
[20] I.R.C. § 170(f)(3)(A); I.R.C. §2522(c)(2); Treas. Reg. § 25.2522(c)-3(c)(1); I.R.C. §§ 2055(e)(2)(A), 664(d); Treas. Reg. § 20.2055-2(e)(i)
[21] I.R.C. § 170(a)(3)

The DuPage County Bar Association grants permission to reprint all or part of the article entitled, ” For Love or For Money: The Art Collector’s Introduction to Estate Planning”, by Greta R. Staat, Volume 27 Issue 9, the June, 2015 edition of the DCBA Brief magazine, with appropriate attribution to the author and DCBA Brief. Copyright 2015, DCBA Brief, All Rights Reserved.