Transferring High-Value Collectibles to the Next Generation

Fine art collectors and estate taxes

Tax and estate planning is complex and constantly evolving. Choosing the appropriate strategy depends on the specific circumstances involved. It is critical for tax professionals, estate planning attorneys, and valuation analysts to understand the client’s precise needs and work collaboratively to achieve their stated goals.

Fine art collectors and estate taxes

Collectibles such as fine art, precious metals, and antiques represent a significant portion of net worth for some families.  Transferring this type of wealth to the next generation presents unique challenges. While these challenges are often complex, proper planning can help reduce estate taxes, family disputes over ownership, and liquidity challenges upon death of the owner. 

It is important to note that collectibles are currently taxed at a federal long-term capital gains rate of 28 percent.  When compared to the highest long-term capital gain rate for securities of 20 percent, the resulting tax from the sale of a collectible can be staggering.  Take, for example, someone who sold McDonald’s stock in 2013 for $500,000.  If that person had purchased the stock years ago for $10,000, the resulting long-term capital gains tax would be $98,000 ($490,000 x 20 percent).  A Mark Rothko painting, however, purchased and sold in the same situation, would result in a $137,200 capital gains tax ($490,000 x 28 percent).

For families with substantial wealth, including collectibles, tax and estate planning offers strategies that allow the removal of items from the estate on a tax-advantaged basis.  One strategy that is particularly attractive for fine art collectors is the use of assets which may have already been transferred in prior estate planning techniques.

Let’s consider the instance of parents—Mr. and Mrs. Smith—who want to transfer assets of fine art to the next generation, while retaining the right to enjoy the art during their lifetime and maintaining an income stream during their retirement.  Let’s assume in prior years that they have already done some estate planning by creating three intentionally defective grantor trusts (IDGTs), one for the benefit of each of their three children, and transferred substantial assets into these trusts.  Over the years, these trusts have grown income tax free due to the unique income tax benefit of having all of the income from the trusts taxed to them (the parents) during their lifetime.

This strategy begins with the Smiths creating a new limited liability company (LLC), which is funded by them transferring their personally-owned artwork into the LLC in exchange for LLC interests.  Since these assets often have low basis, the LLC will have carryover basis in the assets transferred (resulting in a built in gain to the LLC).  The Smiths then hire a professional to independently value the LLC interests (which most likely will require an independent appraisal of the artwork transferred).  As a result of the valuation, each LLC interest is valued at an amount less than the value of the underlying artwork (due to discounts for lack of control and lack of marketability).

The LLC interests are then sold (one-third to each IDGT) for promissory notes payable to the Smiths over several years, plus interest at the current Applicable Federal Rate (AFR) of interest in effect for the month of sale.  Since the LLC is owned by the Smiths, and the IDGTs are deemed to be owned by the Smiths, this sale does not result in any income tax.  In addition, all payments under the note (including the interest portion) are also disregarded for income taxes.

Now that the IDGTs own the LLC interests, if the Smiths continue personal use of the LLC-owned artwork, it must rent the artwork from the LLC.  An independent appraisal of rental value is determined each year setting the amount of annual rent the Smiths must pay the LLC for continued use of the property.  This annual rent should be pursuant to a written rental agreement between the LLC and the Smiths.  Since the LLC is now owned by the IDGTs, the annual rental payments are disregarded for income tax purposes.

In addition, the Smiths are managing the property.   This would include determining when and at what price artwork is bought and/or sold, negotiating tax-free exchanges with potential replacement property, and which gallery might borrow the artwork for display (thus enhancing its value).  This management agreement should be outlined in a written contract.  Again, since the LLC is owned by the IDGTs, the management fees are disregarded for income tax purposes. 

From a cash flow perspective, the annual management fees paid by the LLC to the Smiths should be offset by rental fees it receives from them for the continued personal use of the property.

Assuming the Smiths have sufficient other assets remaining in their estate, they could continue to pay taxes on the income generated within the IDGTs (including taxable sales of low basis artwork).   In addition, with adequate rental and management fees paid by both sides, the Smiths can continue the personal enjoyment of the artwork, and they can continue to manage the use of the property for the benefit of their future generations, all without any income tax ramifications.  The discounted value of the LLC interest at the inception results in significant up front wealth transfer to the next generation.  Also, upon the death of the Smiths, the artwork is no longer in their estate, and the need for quick sale to provide liquidity is eliminated.  Finally, this strategy can provide significant tax-free cash flow to the Smiths during their retirement years in the form of loan repayments from the sale of the LLC interests.   

Tax and estate planning is complex and constantly evolving, and choosing the appropriate strategy depends on the specific circumstances involved.  It is critical for tax professionals, estate planning attorneys, and valuation analysts to understand the client’s precise needs, and work collaboratively to achieve the client’s stated goals.  If collectibles, such as fine art, are part of the equation, perhaps the strategy outlined above would be a good fit within a comprehensive tax and estate plan.

Lawrence Horwich, managing partner of Horwich Coleman Levin, LLC, has over 30 years of experience in public accounting and is also a Certified Valuation Analyst (CVA).  He is an authority in federal taxation, specializing in estate planning matters, specifically for high net-worth individuals. He has extensive experience with partnerships;  gift, estate, and generation skipping taxes; trust, foundation, and income taxation of fiduciaries and beneficiaries; along with business consulting, auditing, and accounting.  In addition, he is currently trustee and previously executor for several client relationships. 

Mr. Horwich performs valuations of private, closely held businesses and emerging companies for sale, merger and acquisition, financing (debt and/or equity), estate and gift tax purposes, shareholder disputes, buy-sell agreements, insurance claims, marital situations, and other business matters. His additional experiences include litigation support work, mediation/arbitration disputes and providing expert testimony. Lawrence can be reached at lah@horwich.com.

David Elyashar, CVA, CPA, has expertise dealing with income tax matters in the financial services industry, specifically with private equity firms and hedge funds.  He also specializes in tax and estate planning, auditing and accounting and financial/investment services.  Mr. Elyashar is a Certified Valuation Analyst (CVA) and is well-versed in business valuation and litigation support.  He performs valuations of private, closely held businesses and emerging companies for sale, mergers, and acquisitions, financing (debt and or/equity), estate and gift tax purposes, shareholder disputes, buy-sell agreements, insurance claims, marital situations and other business matters.  David can be reached at dje@horwich.com