Tuesday, October 02, 2007

Art and Kids

Still catching up on things I missed over the last couple of weeks, Kelly Crow had an interesting article in the Wall Street Journal on kids who are collecting Warhols instead of Beanie Babies. This paragraph caught my eye:

"But there are upsides to mixing kids and fine art. Families can reap potential tax benefits by putting art in a trust set up for their children. The move can side step a federal estate tax of up to 45% of the art's value if children had instead inherited it after their parents die. There are several disadvantages to trusts: If a piece of art is valued at $1 million or more, parents may be taxed when they move the work into the trust. The strategy also could hinder parents from selling or loaning a work."

So I asked Tara Kaplan of our firm's trusts and estates department what she thought. She wrote the following:

"Although, to a great extent, the paragraph is accurate, it's also a little misleading. As you will see from my discussion below, you just can't accurately describe the real tax consequences of putting art into a trust for your children in one paragraph.

"To put the discussion in context, let's start with some basics about our federal estate and gift tax regime. Under current law, $2 million of an individual's estate passes free of estate tax, regardless of the beneficiary. If an individual has made taxable gifts during his or her lifetime, the amount shielded from federal estate tax is reduced by the amount of lifetime taxable gifts up to $1 million. Currently, any amount subject to federal estate tax (beyond the $2 million exemption) is subject to estate tax at a flat rate of 45%. The exemption is set to increase to $3.5 million in 2009. In 2010, the estate tax is scheduled to be repealed. Under the current legislation, however, the estate tax repeal ends in 2011, unless Congress enacts new legislation. This means that, without further legislation, in 2011 (and thereafter) the estate tax exemption and tax rates will return to their pre-2001 levels ($1 million exemption per individual with a top estate rate of 50%). Although no one can predict what Congress will do, most estate tax practitioners believe that new legislation in some form will be enacted, which leaves us with a very uncertain environment for any gift and estate tax planning at this time.

"In contrast to the federal estate tax, the lifetime gift tax exemption is not set to change. Rather, the lifetime gift tax exemption is frozen at $1 million for individuals and $2 million for married couples who split gifts. This amount is cumulative over an individual's lifetime. (If certain requirements are met, an individual also may make tax-free annual gifts of $12,000 -- or $24,00 if married and the gift is split -- indexed for inflation. These 'annual exclusion' gifts are in addition to, and do not use up any part of, the lifetime gift tax exemption amount.)

"With those basics in place, let's turn back to the Journal article:

Families can reap potential tax benefits from putting art in a trust set up for their children. The move can side step a federal estate tax of up to 45% of the art's value if children had instead inherited it after their parents die.

"Although such a lifetime transfer to a trust, if properly structured, would effectively sidestep a 45% estate tax, we must also consider the potential gift tax consequences. If a gift tax were assessed on the transfer to the trust, we'd end up prepaying transfer taxes (albeit, because of the difference in the way gift taxes and estate taxes are applied, the effective gift tax rate would be lower than the estate tax rate). While it is true that a gift removes subsequent appreciation from the donor's estate, given the uncertainty of the future of the estate tax, there may be no estate tax liability to be paid at the individual's death at all. In that case, a completely unnecessary gift tax would have been incurred.

"This also leaves out income tax considerations. The income tax implications could be significant if the trust (or the child beneficiary) ultimately determines to sell the art. One consequence of transferring property to a trust is that the child (or the trust created for the child's benefit) will receive the property with a 'carry-over' basis. Generally speaking, 'carry-over' basis means that the donee of the gifted property has the same cost basis as the donor; it simply 'carries over' when the gift is made. If the art has appreciated in the hands of the donor/parent and if a gift tax is paid with respect to the gift, this carry-over basis is adjusted upward by the portion of the gift tax attributable to the appreciation element of the gift. If the artwork has appreciated above the basis of the work in the hands of the donee/child (or trust), if and when the child (or the trust) sells the artwork, a 28% federal capital gains tax liability (plus any state taxes) would be incurred on the gain. By comparison, under the current estate tax regime, if the child inherits the property at the parent's death, the basis would be 'stepped-up' to the fair market value at the time of the parent's death and the capital gains taxes on any subsequent sale would thus be lower or even eliminated.

"Continuing with the article:

If a piece of art is valued at $1 million or more, parents may be taxed when they move the work into the trust.

"Again, that statement is true, but it gives an incomplete picture of the relevant tax consequences. It seems to suggest that the $1 million exemption is applied on a 'piece' by 'piece' basis. In fact, however, since the lifetime gift tax exemption is cumulative, if multiple works of art are gifted during an individual's lifetime, a tax may be assessed on a transferred item even though, taken by itself, it is worth less than $1 million. It is not the value of the particular work of art being transferred, but rather the cumulative value of the lifetime gifts made by the transferor. It is also worth remembering that married couples who elect to split gifts may transfer artwork valued up to $2 million (in the aggregate) without incurring gift tax.

"And finally:

The strategy could also hinder parents from selling or loaning the artwork.

"Not only could the transfer of the artwork 'hinder' the parents from selling or loaning the artwork once it has been transferred to a trust, in order to remove the artwork from the parents' estate, the trust instrument would have to prohibit the parent (though not the trust) from selling or loaning the artwork. The Internal Revenue Code provides that if the transferor retains the right to determine who may enjoy the trust property, the trust assets will be taxed in the transferor's estate. Accordingly, if a parent transfers a work of art to a trust for his or her child, but still has the ability to direct the distribution of the property or indicate who may use the property, the trust asset will be includible in the transferor parent's estate at the date of death value, which would eliminate all the tax-planning benefits of having made the gift.

"So, all in all, it's a little more complicated than that paragraph in the Journal suggests. In addition to the above, let me leave you with three final thoughts:
  • Art cannot take care of itself and rarely throws off income. Therefore, when setting up these types of trusts it is not only the artwork that needs to be transferred, but cash as well. One needs to consider whether funds need to be placed in the trust to cover storage, conservation and insurance costs.
  • Unless the trust is pre-funded with a large amount of cash to cover expenses for the duration of the trust (which of course also increases the value of the initial gift), it is important that the trust is structured in such a way that future gifts of cash or other liquid assets to cover expenses will qualify for the annual gift tax exclusion (currently $12,000/individual and $24,000/married couple, indexed for inflation).
  • Finally, a common misconception is that a parent can transfer the art to a trust and continue to hang the art in the family living room. To remove a work of art from the parent's estate, the parent must relinquish dominion and control over the art and give up all beneficial enjoyment of the artwork. The art should be treated separate and apart from any art which remains within the parent's estate, including for example having it insured under a separate policy in the name of the actual owner, not under the parent's policy. This may be especially difficult while the child is a minor, living under the same roof as the parent. In that case, the safest route would be to hold the art in storage (and not in the parent's storage) until the child is living out on his or her own."