by Gary Schuster

People who have amassed collections of paintings, sculpture, or other valuable collectibles eventually get around to wondering what is to become of that collection, either before or after their deaths. This article will introduce some of the issues involved and the range of possibilities that exist.

Unfortunately this issue requires you to consider your estate plan. Generally, $2 million in assets is exempt from federal estate taxation. However the New York State exemption is only $1 million. If you have a home, investments, a retirement account and a few cars, you may be closer than you imagine to $1 million. Add in the fair market value of your collection and you may be subjecting your heirs to an estate tax that they may be unprepared to pay.

First you must determine the value of your collection. For tax purposes, the value of a work of art is its fair market value. Given the inherently subjective nature of artistic goods, and the possibility of abuse in claiming deductions, the Internal Revenue Service maintains an Art Advisory Panel composed of museum curators, gallery directors, art dealers and the like. Disputes as to the value of artwork are referred to the Panel, and the IRS adopts their conclusions concerning fair market value. Individuals trying to determine their net worth, or considering bequests or lifetime gifts of artwork, should engage a professional appraiser to prepare a written appraisal that will be deemed a “qualified appraisal” by the Art Advisory Panel. For even more certainty, the IRS will provide its own advance ruling on the value of almost any kind of personal property if you (i) transfer at least one item having a value of $50,000 or more, (ii) transfer the property before requesting the ruling, (iii) include a “qualified appraisal” when requesting the ruling, (iv) file IRS Form 8283, and (v) pay $2,500 for the first 3 items and $250 for each additional item.

Having determined fair market value of an item, you can then determine your unrealized gain on that item. The unrealized gain is the difference between the price you paid (your “basis”) and the current fair market value. You “realize” the gain when you actually sell and receive money or other value. When you sell, you become liable for tax on the gain. Your gain would be taxed at the relatively low long-term capital gains rate, rather than the higher ordinary income rate, if (i) you owned the item for more than one year, and (ii) you are not a regular dealer in items of that kind (because then the item would be considered to be part of your inventory and not a capital asset held as an investment). Unfortunately, there is a special capital gains tax rate for artwork and other collectibles of 28%, which is higher than the 15% rate for more typical capital assets such as corporate stock. Once you know your probable after-tax profit on selling an item, you can compare that to the results you might achieve using other means of disposing of the asset.

If you enjoy owning the asset and want to keep it during your lifetime, you can bequeath it to your heirs in your Will. There are a number of practical issues to consider:

  • Does the item or collection require costly maintenance, storage, conservation, moving or insurance? Will a bequest be more of a burden than a benefit?
  • Do you want all of your heirs to receive roughly equal value?
  • Do several heirs want the same items? If you leave an item or a collection to the heirs jointly, no one has a right to a particular item. Arguments over possession may ensue. In such a case the only solution may be liquidation of the collection, possibly at relatively low estate or bulk sale prices, and distribution of the cash proceeds. You might avoid disputes by bequeathing specific items to specific heirs.
  • There is a tax benefit in disposing of items by specific bequests as opposed to a more general residuary bequest (“…all the rest and residue of my estate I leave in equal shares to my children…”). Under the residuary bequest scenario each heir may have liability to the estate for their share of any estate tax which may be attributable to the items received.
  • Perhaps none of the heirs have an interest in maintaining or enhancing the collection. The collection may fare better in the hands of a museum or not-for-profit.

An heir receiving an asset by specific bequest will benefit from a “step-up” in basis to the fair market value of the asset as of the date of death. The concept and benefit can be readily demonstrated in an absurd example: Suppose great-great-grandfather paid $50 for a Van Gogh painting in 1880. The painting is handed down through the generations until you receive it by bequest in 2004. You sell it in 2006 for $20 million. Is your gain $19,999,950, based on the $50 basis of great-great-grandfather? No. Your gain is $20 million minus your “stepped-up basis”, which is the fair market value of the painting when you received it in 2004. The IRS Art Advisory Panel would likely be called upon to determine that fair market value. If the 2004 fair market value is determined to be $17 million, your gain is $3 million and you are taxed accordingly. Since this was a capital asset that you held for more than one year and you are not an art dealer, you will be taxed at the relatively favorable capital gains rate for artwork.

An alternative to selling or bequeathing your collection is to give it away during your lifetime. There may be significant advantages to such gifting, particularly if the artwork has appreciated greatly in value.

First, by avoiding selling, you avoid the 28% capital gains tax.

If you give to a family member or friend, you should be aware of gift tax “annual exclusion amounts”. In one tax year you are permitted to gift up to $12,000 in value to any individual without tax consequence to either donor or donee. For married coupled gifting jointly, the annual exclusion amount is $24,000 per donee. The $12,000 exclusion amount applies through 2008, and will rise thereafter.

In addition to the annual exclusion amount, there is a lifetime gift tax exclusion amount of $1 million. If you have assets or net worth in that range you should carefully plan your lifetime gifts and bequests with a qualified accounting or legal professional.

If you give to a tax-exempt charity, for a purpose related to its tax-exemption, you are entitled to an income tax deduction equal to the fair market value of the artwork, not to exceed 30% of your adjusted gross income. An example of a related purpose would be an art museum displaying a donated painting. An unrelated use would be if the museum immediately sold the painting in order to pay for operations. In the latter case your deduction would be limited to your cost basis in the artwork, further limited to 50% of your adjusted gross income.

There are several other vehicles for disposing of valuable artwork. A formerly popular technique known as “fractional giving” was loaded down with so many restrictions and qualifications by the Pension Protection Act of 2006 that is now essentially prohibited. The remaining vehicles, which range from simple to complex and costly, include trusts, family limited partnerships, bargain sales and loans. If your collection is valuable, a careful analysis of your assets and estate plans is essential before you give it all away.

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