Quite often an art collection forms a substantial portion of a collector’s assets. Sometimes, a collector is ready to part with a particular work of art or perhaps might be in need of income. A collector might sell the artwork to generate cash. However, if the artwork has substantially appreciated in value in the hands of the collector, this appreciation will generate tax upon the sale. The tax impact can be substantial at 28% capital gain rate or the ordinary income tax rates, depending on how the artwork is classified in the hands of the collector.
If You Must Sell, Make the Most of It
An alternative to a direct sale is to contribute the artwork to a Charitable Remainder Trust (“CRT”) and for the CRT to sell the artwork. A CRT is an irrevocable split-interest trust that is tax-exempt. When the trustees of the CRT sell the artwork, the CRT will not pay the tax on the sale of the artwork. Provided there is no prearranged contract of sale, the collector will also not pay the tax attributable to the appreciation, except to the extent the collector is receiving payments from the trust. Since the cash realized from the sale of the artwork is not reduced by tax, the CRT will have more assets to generate income than if the collector just sold the artwork directly and invested the proceeds after the payment of taxes.
The basic idea of a CRT is that an individual receives income during his or her life or during a specific term of years, and then the remainder of the trust assets is distributed to charitable organizations. A CRT can be a charitable remainder annuity trust (“CRAT”) or a charitable remainder uni-trust (“CRUT”). A CRAT annually pays to a non-charitable beneficiary a fixed percentage based on the value of the assets in the trust at the time the trust is initially funded. A CRUT annually pays to a noncharitable beneficiary a fixed percentage based on the annual value of the assets in the trust.
A CRT which will be funded with artwork requires careful consideration because art is not an income producing property. This characteristic often makes artwork a poor choice for funding a CRT because funding a CRT with a property that is not capable of producing income can disqualify a trust from being a CRT from its inception.
If the timing of the sale of the artwork by a trust is uncertain, other alternatives to a traditional CRT should be considered. Some flexibility is available by using a variation of a CRUT, called a “net income with make up charitable remainder unitrust” (“NIMCRUT”). A NIMCRUT permits the trustee to pay out only the trust’s income if the income is less than the stated payout percentage and then make up any deficiency in a future year when the trust’s actual income exceeds the stated payout percentage. Another alternative is a Flip CRUT, which is a NIMCRUT that “flips” to a traditional CRUT upon a triggering event specified in the trust instrument, permitting the non-charitable beneficiary to receive a fixed percentage rather than only the trust’s income.
There are various limits on charitable deductions for transfer of artwork to a charitable donee which generally determine how much the donee can deduct. One limitation depends on whether the artwork is a capital gain property (subject to 28% tax rate) or an ordinary income property (subject to ordinary income tax rates). Another limitation is whether the charitable donee is a private charity or a public charity. Finally, another limitation — particularly applicable to a CRT funded with the artwork — is how the artwork will be used by the charitable donee.
Under the “related use” rule, the donor cannot deduct the full fair market value of tangible property donated to charity unless the property is used by the charitable organization in a way that is related to its charitable purposes. Since a CRT will be selling the artwork, the contribution of artwork to the CRT will not satisfy the related use rule. As a consequence, the donor’s charitable deduction will be limited to the donor’s basis in the artwork. Additionally, under yet another rule, the donor can receive the charitable deduction only when the CRT actually sells the artwork rather than at the time of the funding of the CRT. This last rule by itself may make a collector skeptical about using a CRUT if the art is hard to sell.
When to Consider Using Charitable Remainder Trust for Planning with Artwork
In the right circumstances, a charitable remainder trust can be a useful planning vehicle for artwork. It can be appropriate when the collector holds artwork that has substantially appreciated, the collector needs to create a source of income and has charitable inclinations.