Estate planning for valuable art (Part Two)

Lessons Brooke Astor could have used.

To continue our discussion from May 22.  Here are several additional options and considerations you may find appealing.

CRATs and CRUTs

The donor may determine how the income interest will be calculated with a CRT. 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 the other persons the donor designates) are fixed when 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, and 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 client makes a final decision.

A disadvantage of using a CRT for art is that because art is personal property, the income tax deduction may be limited significantly. In addition, when a charitable contribution consists of a future interest in tangible personal property, no deduction may be taken until all interests and rights to possession or enjoyment of the property have expired or are held by a person other than the donor (Sec. 170(a)(3)).

The tax benefits of transferring art to a CRT 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 CRT with what is known as an irrevocable life insurance trust. When used together, these tools replace the art’s value and keep that value out of the donor’s taxable estate.

Trusts

The client may also choose to make a gift (lifetime or at death) of the art to family members in trust. If the client wishes the art or collection to stay with intended beneficiaries, he or she can establish an irrevocable trust 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 client’s estate. If doing so, it is advisable to add enough funds to that trust to insure and maintain the art. Choosing a trustee must be carefully considered as the trustee or trustees will have the continuing ability to manage the trust assets, including the art.

Fractional Interests

A gift of a fractional interest in art should also be considered. However, the Pension Protection Act of 2006 (PPA) greatly limited the value of this strategy. Until passage of the PPA, a collector could donate a fractional interest in a work of art to a museum that qualifies as a charitable institution. Collectors did so for many 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, he or she could write off half the value as a charitable deduction. The painting would spend half the year in the donor’s possession and half the year in the museum’s. Unfortunately, this led Congress to be concerned that collectors may have been abusing the write-off by enjoying more than their rightful share of the art. For example, if a collector donated 50% of the art but kept it for more than six months a year, the public would be losing out on the painting’s availability during the excess period.

To address this perceived abuse, Congress changed the law to make donations of partial interests in artwork much less attractive for donors. Generally, before the PPA, 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 fair market value at the time of the collector’s death. But the PPA changed the law to require that the write-off be based on the art’s value 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 art’s value has appreciated in that period, as it typically does, the law will reward the collector by reducing the amount his or her estate could take as a deduction for the donation and thus increasing the estate tax liability.

Consider the example of a painting worth $1 million when the collector first donated 50% to the museum. The collector bequeaths the remaining 50% of the painting when she dies, at which time it is worth $10 million. Under the old rule, the painting would pass to the museum and the estate would take a $5 million charitable contribution deduction. Under the new law, her estate may only deduct $500,000 and the estate would have to pay taxes on $4.5 million more than it would have under the old law.

The PPA also introduced recapture rules (deductions turned back into taxable income) that further reduce the desirability of contributing a partial interest in art. If the collector fails to donate the balance of the art to the museum on or before the earlier of 10 years of the original gift or the collector’s death, the collector will be forced to recapture the deduction. In addition to paying income tax and interest on the recaptured amount, the collector must pay an additional 10% tax on it. This essentially requires the collector to donate or bequeath the remaining fractional interest or lose the tax benefit of the original gift.

Conclusion

If the client has valuable art, it is important that he or she assemble a team of advisers that understands how to deal with it. The team may include an attorney, financial adviser, tax specialist, and an art succession planner. It is wise to make sure that the team members know the extent and value of the art and how the client intends to dispose of it so that it can properly be 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 client, the intended beneficiaries, the charitable organization, and the team of advisers.

Patricia Annino is a sought after speaker and nationally recognized authority on women and estate planning.  She educates and empowers women to value themselves and their contributions in order to ACCOMPLISH GREAT THINGS in the world – and in so doing PROTECT THEMSELVES, those they love, and the organizations they care about.  Annino recently released an updated version of her successful book, Women and Money: A Practical Guide to Estate Planning to include recent changes in the laws that govern how we protect our assets during and beyond our lifetime.  To download Annino’s FREE eBook, Estate Planning 101 visit, http://www.patriciaannino.com.

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