Pennsylvania Trust

The Importance of Valuation in Estate Planning for Art

What is the value of a piece of art?

Statements of value are often based on sentiment or folklore. Many items have considerable emotional value, such as family heirlooms, but a minimal market value. Other items may have risen in value, or have an unknown value. For federal estate, gift and income tax purposes, transferred property must be reported at fair market value. In the context of estate planning, a proper valuation, based on both facts and the law, is essential.

Consider the following scenarios:

  • Grandma bought a set of small oil paintings fifty years ago at a gallery in Nantucket and they have hung in her living room ever since. Should she have the paintings appraised? What if the paintings are now worth $1.5 million and Grandma has other assets such as securities and real estate that will cause her to have a taxable estate?
  • John is a collector of modern art. He reads an article about one of the artists he has supported and the rising values of the pieces in his collection. Should John think about estate planning?

Art collectors have three basic options: sale, gift or donate, during lifetime or at death. In the case of Grandma, the first step is to obtain an appraisal from a qualified, independent appraiser. It is better to learn the value now and avoid a surprise, such as estate tax liability, later. If Grandma is very attached to the paintings, selling might not be the right choice. Additionally, lifetime sales of art can be expensive due to the 28% capital gains rate for collectibles, plus the additional costs of sales commissions, insurance, and sales tax.

Grandma’s second option is to give the paintings to family members or to charity. However, what if her children and grandchildren are not interested in owning the paintings, and would prefer to get liquid assets at her death? Grandma considers donating the paintings to a museum. She realizes that she could get an income tax deduction of up to 30% of her adjusted gross income (AGI) based on the value of the paintings at the time of the gift, but she doesn’t really need the income tax deduction based on her current AGI. Ultimately, she determines that she really does not want to part with the paintings during her lifetime and the best course is for the paintings to be sold after her death. Her estate will get a step up in basis to the date of death value of the paintings, thus avoiding the large capital gain of a lifetime sale, and she has determined that her estate is sufficiently liquid to pay any estate tax associated with inclusion of the paintings in her estate. She will specifically provide for the sale in her Will, along with payment of sale, storage and delivery costs, to ensure that her estate gets a deduction for these items as administrative expenses. In the end, because Grandma and her advisers knew the value of the paintings, she was able to make an informed decision about their disposition.

In John’s case, he has a sizeable estate, a spouse and three adult children. He should consider his lifetime gifting options to remove the artwork, and any appreciation of the artwork, from his estate. It is important that he acts quickly due to the rising values. The first step is to obtain an appraisal. With the appraisal in hand, he could use his annual exclusion (currently $14,000) or the lifetime exclusion of $5,490,000 to make gifts. He could make gifts outright to his children or to an irrevocable trust, including full or fractional interests. Because the minority and lack of marketability discounts typically associated with FLPs or LLCs are not available for gifts of fractional interests in artwork, an “Art LLC” may be the solution. John can transfer the collection into an LLC at the appraised value, and then make gifts of LLC interests to his children using valuation discounts. If John believes that the artwork has the potential to substantially increase in value, he might transfer the LLC interests into a Grantor Retained Annuity Trust (GRAT), take back an annuity payment each year during the term of the trust and pass the appreciation on to his children, the remaindermen of the trust, free of gift tax. If the collection is very valuable, i.e. in excess of John’s lifetime exclusion amount of $5,490,000, he could sell the collection to an intentionally defective grantor trust (IDGT) in return for a note bearing interest at the federal rate (currently 1.22% – 2.6% depending on the loan term). If the assets sold to the trust appreciate at a rate greater than the interest rate of the promissory note, he can transfer value to the trust beneficiaries free of gift tax. Additionally, if the trust is set up as a grantor trust, a sale of the artwork should not cause John to recognize capital gain. John could also make a charitable gift of some or all of his collection. In order to obtain a charitable income tax deduction, John must substantiate the gift with an appraisal. If John is interested in selling some of the artwork, but wants to avoid the capital gains tax, he could fund a charitable remainder trust (CRT) with the artwork. He would receive distributions during the term of the trust and at the end of the term the remaining assets would be distributed to the selected charities.

John could receive an income tax charitable deduction equal to the present value of the charity’s remainder interest. Additionally, because the CRT is a tax-exempt entity, if a contributed asset is sold, no capital gains tax is payable at the time of sale.

As demonstrated above, there are numerous techniques for transferring artwork during lifetime or at death. The rules and tax consequences are complex. It is important to develop a comprehensive plan with your advisors for the disposition of such assets. The centerpiece of any such plan is a solid valuation.

by Leslie Gillin Bohner, Esq.
Ms. Bohner is Senior Vice President and Chief Fiduciary Officer at Pennsylvania Trust.