23 September 2021 - Article
Trusts are being used with increasing frequency by both collectors and dealers for a variety of purposes including tax savings, assets protection, estate planning and charitable gifts. The following are typical client questions concerning the transfer of artwork into a trust in the USA.
What is a trust?
Like a corporation, partnership or LLC, a trust is a distinct legal entity with a unique set of legal characteristics. The creator of a trust, that is, the person transferring asset to a trust, is typically referred to as a “grantor” or “settlor”. The grantor makes a legal transfer of property to a trustee who is the fiduciary charged with administering the trust property in accordance with the terms of the trust. The trust terms are almost always set forth in writing in an instrument referred to as a trust indenture or deed of trust. The trustee is given legal title to the trust property but must hold the trust property exclusively for the benefit of the trust beneficiaries. The beneficiaries are most typically individuals or charities.
I am considering transferring my collection of paintings to my children. Should I use a trust?
Trusts can play an important role in transferring wealth to younger generations. By transferring artwork to a trust for your children's benefit, rather than transferring the artwork outright, the artwork can be used and enjoyed by your children, but would not be reachable by creditors or divorcing spouses as would assets your children own personally. The art would also not be included in your children's taxable estates at their deaths. You could make the transfer of the artwork to the trust during your lifetime or upon your death.
Will I pay tax when I transfer art to a trust?
If your will bequeaths art to a trust on your death, the estate tax will be due based on the fair market value of the property at the time of your death. If you make a transfer of artwork to a trust during your lifetime, you will be responsible for a gift tax on the value of the artwork unless the trust is revocable by you. In such a case, an estate tax is applied (in lieu of the gift tax) on the value in trust on your death. The maximum federal estate tax and gift tax rates are currently both set at 46%. The first $1million of gifts is exempt from the gift tax. The first $2 million in bequests currently escapes the estate tax.
Do trusts pay income tax?
Certain charitable trusts are exempt from US income and capital gains tax. However, most trusts fall into the category of “complex” trusts or “grantor” trusts.
Complex trusts have a tax identity which is separate from the grantor. So, the trust, not the grantor, is generally responsible for the payment of tax on trust income and gains. However, if a complex trust distributes income or gains to a beneficiary in the year earned, it is the beneficiary receiving the distribution, not the trust, who is responsible for the tax. The federal and state tax rates for trusts are generally the same as those for individuals. For example, if the trust realizes a gain on the sale of artwork, the capital gains tax is chargeable at 28%.
If a trust is a grantor trust then the grantor is charged with all income and gains of the trust as if the grantor were the owner of all assets for tax purposes. There are advantages and disadvantages to both types of trusts which are discussed more fully below.
I am interested in donating some of my collection to charity. Should I use a charitable trust?
The simplest way to make a charitable gift of your artwork is a direct gift to a museum or other charitable organization. The documentation of such a gift is straightforward and an income tax deduction is normally available. A charitable trust may be a better option, however, if you want to maintain some control over your charitable gift either during your lifetime or after your death. For example, you may wish a charitable contribution deduction now but you are undecided as to the ultimate beneficiary of your collection. In such a case, your collection might be donated to a trust with a variety of museums as beneficiaries. Such a trust could be qualified with the IRS as a private operating foundation which would allow you the same tax deduction as a direct gift to a museum. In that way, the artwork can be loaned perhaps on a rotating basis to several museums during your lifetime. Upon your death or other specified time, the distribution of your artwork can be made to the desired charitable organizations.
Can I transfer art to a charitable remainder trust?
If you are thinking about selling certain artworks and have at least some charitable inclination, a charitable remainder trust (“CRT”) can be helpful in reducing the overall tax burden on the sales. You would transfer the artwork into the trust and then the trust would seek to sell the artwork. Since the trust is a tax-exempt entity you would save the 28% federal tax which now applies on sales of artwork as well as applicable state tax on the gain. During your lifetime, or for a period of years, the trust would pay an annual amount to you which would be taxable. However, because the tax is deferred over your lifetime the trust will have the entire proceeds from the sale to reinvest on your behalf rather than the after tax amount. In addition, the remainder of trust assets at the end of the trust term would be payable to the charity of your choice.
What is an Intentionally Defective Trust? Should I be considering one?
An intentionally defective trust or IDIT is another name for a grantor trust described above. The trust is intentionally defective in the sense that it is drafted to allow the grantor certain retained powers over trust property. As such the grantor is considered the owner of all trust property for federal income tax purposes. This is often useful since the Grantor's payment of the tax liability of the trust is not considered a taxable gift to the trust. In that case, the grantor can enhance the value of trust assets eventually going to his heirs without increasing the gift or estate tax cost. In addition owners of artwork who have previously created IDITs should consider whether to swap the artwork for assets of the trust, including cash. Under the grantor trust rules, such a swap can be made tax-free as long as the value received from the trust is equal to the art going in. If the art is expected to increase in value more rapidly than the assets taken in the exchange, the value of transfers to heirs can again be enhanced at no tax cost. Art can also be purchased from the trust by the grantor, either for cash or a note.
I recently created a qualified personal residence trust (QPRT) for my residence. Can I create a similar type of trust with my artwork?
It is possible to use a similar type of trust for artwork called a grantor retained interest trust or GRIT; however, such a trust is useable only in narrow circumstances. With a QPRT you retain an interest in your personal residence for a term of years while giving the remainder value to your children or trusts for your children. You would pay gift tax on the remainder value of the residence (determined under IRS actuarial tables) only at the time the trust is created. The value of your retained life interest and all future appreciation of your residence would then pass eventually to your children free of estate tax.
A GRIT with features similar to a QPRT can be funded with artwork but under the Internal Revenue Code, the remainder beneficiaries can not be descendants of the grantor. So the standard GRIT technique can only be used in cases for example, where the grantor is looking to benefit relatives other than direct descendants.
A special type of GRIT called a Tangible Personal Property GRIT (TPP GRIT) can be used for family members. However the difficult requirement of a TPP GRIT is that the remainder value cannot be determined using the favorable IRS tables. Rather, the remainder value must be determined by an appraisal which takes into account the “market” for term of years and remainder interests in art. Since, at least historically, term and remainder interests in art works have not been bought and sold, there may not be sufficient information in the market place from which to make such an appraisal.