There are numerous tax issues related to the ownership and transfer of art that, with proper tax planning, collectors can enhance the financial benefits of their collection.
Following is a discussion of some of the more relevant tax issues and related tax planning strategies:
Estate and gift tax concerns
Under present law, an individual may make $1 million in total gifts during his or her lifetime without paying gift tax. Any lifetime gifts exceeding this total are taxed at rates starting at 41 percent. In addition, transfers exceeding $3.5 million at death to heirs other than one’s spouse are subject to estate tax at a 45 percent rate. An individual may currently make $13,000 worth of gifts to another person each year without having to pay gift tax or use up any of the $1 million lifetime “exemption.”
Because wise art deals can be the most highly appreciating assets in a collector’s estate, wealthy collectors who wish to minimize their gift and estate tax liabilities should consider developing and executing a gifting strategy during their lives. One effective strategy is to use the $13,000 annual exemption in conjunction with valuation discounts by gifting fractional interests in art.
For example, if a husband and wife have two children, they may gift a total of $52,000 in cash or property to their children (each parent gifts each child $13,000) without any gift tax implications. When gifting fractional interests in property, discounts for lack of control of the property and lack of marketability of the partial interest can be taken. Assuming a 30 percent total valuation discount, the husband and wife in this example could gift fractional interests in art with a pre-discounted value of $74,286 a year without gift tax implications. Not only does this remove the gifted art from the parents’ estate tax free, it also removes future appreciation of the art from their estate.
It is also important for wealthy collectors to consider the financial and tax ramifications of holding a significant art collection with the hope of passing it on largely intact to their heirs. A large estate that does not have enough liquid assets to sufficiently pay its estate taxes might put the heirs in the position of having to sell valuable works of art on short notice for a fraction of their value.
Reducing taxes related to unreported transfers
Collectors may find themselves in possession of art was transferred to them from a previous generation without being disclosed properly on the appropriate gift or estate tax returns. Here is a typical scenario: John Smith purchased a painting several decades ago. When John died, his son simply took the painting off the wall and put it in his home. The painting was worth $100,000 when John died. Since John had a large estate, this painting would have been subject to estate tax. The transfer was not reported either because the son wasn’t aware of the reporting requirement or because he felt the transfer would go unnoticed by the taxing authorities (i.e. it would pass “below the radar screen”). Several years after John’s death, the son would like to sell the painting which is now valued at more than a million dollars.
A sale of this magnitude to an unrelated party would no longer fall “below the radar screen.” The sale almost certainly would be reported to the IRS, which would most likely scrutinize the transaction. If the IRS were to find the son acquired the property by inheritance from his father and the father’s estate should have paid estate tax on this painting, the unpaid estate tax would have to be paid by the son, along with interest and substantial penalties. No matter how many years passed between John’s death and the sale by the son, if the omission is determined to be due to fraud (intentional omission), the statute of limitations would not have run out since there is no statute of limitations with respect to fraud.
Depending on the specific circumstances, there are various strategies a collector may utilize to help mitigate their tax exposure in this situation.
Some popular strategies for charitable giving include:
• Outright donation to a qualified charity — Collectors who are not dealers can receive a tax deduction equal to the fair market value of art donated to a qualified charity. In addition, the excess of the fair market value of the art over its cost to the collector does not have to be reported as income by the collector when the art is donated.
If a collector donates art with a fair market value which is significantly higher than his or her cost, the decrease in income taxes resulting from the tax deduction for the donation may be greater than the amount of net cash realized from selling the art, after deducting selling expenses and income tax on the gain recognized. In this instance, it is more profitable for the collector to donate the art than to sell it.
This is also a good strategy for collectors who have incomplete records of the cost basis of art since the deduction is based on the fair value of the art and the cost basis becomes irrelevant.
• Donation of an undivided portion of an interest — A popular way of executing this type of strategy is for a collector to donate to a museum the right to take possession of a work of art for a specified period each year. This works particularly well for a collector who spends a certain part of each year away from a residence which houses art. For example, a collector who spends winters in Florida and lives in New York the rest of the year could donate to a museum the right to take possession of a work of art from his New York residence during the winter. This commitment to the museum must be permanent. The collector would benefit from this arrangement as follows:
• The collector establishes goodwill and philanthropic capital with the museum and within the community
• The collector retains the art during the period he lives in his New York residence
• The collector receives an income tax deduction in the initial year of the donation equal to the fair market value of the art multiplied by the percentage of the year the art is given to the museum.
• The collector doesn’t have to worry about the maintenance of the art during his time away from the New York residence.
There are strict requirements need to be met in order for a donation of an undivided portion of an interest in a work of art to be held valid under Federal law. Collectors should consult with a tax professional experienced in this area when entering into this type of arrangement.
I have outlined a few relevant tax issues and related tax planning strategies collectors should consider in developing a tax/ financial plan for their collections.
Collectors should work closely with an experienced financial and tax advisor to develop a plan that meets all of their needs. ?
Kevin Yardumian is a certified public accountant and a partner at Gumbiner Savett Inc., gscpa.com, a full-service accounting, tax and business advisory firm located in Santa Monica, Calif. He has more than 20 years of experience in public accounting and is a collector of 19th century art. He can be reached at email@example.com or 800-989-9798.
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