What to Do with the Art?

FACTS:

John and Jane Eastwood are 69 and 67 years old respectively. They have four grown and married children and eleven grandchildren. John has been a professor of art history at the same university for most of his career and is now wishing to retire. During that time, he and Jane have acquired a very unique and rare art collection, which the university would love to receive as a donation. Because John is so knowledgeable about art, he knows the collection has a value of about $12 million, while their entire estate is only valued at $14.5 million. While the Eastwoods would like to see the collection kept together, they also don’t want to disinherit their children or grandchildren. Further, they also recognize that none of their children are really passionate about the collection.

SOLUTIONS:

There are several solutions that will enable the Eastwoods to achieve the results they desire:

Bargain Sale

Collectibles are considered tangible personal property. They must first be organized, catalogued, and then valued. Many collectors fail to do these critical steps. However, to accomplish any significant planning results, these initial steps are vitally important.

Once the first step is accomplished, the Eastwoods will negotiate with the university to sell it a portion of the collection at a substantial discount from its current fair market value (FMV). The University agrees to purchase of portion of the collection with a FMV of $6 million for $4 million. This transaction is known as a “bargain sale”.

Because they will sell the art for much more than they paid for it, John and Jane will realize a capital gain on the transaction. Unlike other types of assets that are subject to capital gains at a top federal rate of 15%, gains on tangible personal property are taxed at 28% (plus state capital capital gains tax). Therefore, there will be significant tax on the gain. However, because the Eastwoods are selling the property for less than its FMV, they will also receive an income tax charitable deduction for the difference between the sale price and the FMV. In this case, their deduction will be $2 million, which will help offset some of the tax. The amount of the deduction they can use is limited to 30% of their adjusted gross income. However, any unused deduction can be carried over and claimed subject to this same percentage limitation for up to five tax years or until it is used up, whichever comes first.

Family Limited Partnership and Grantor Deemed Owner Trusts

Next the Eastwoods will establish a Family Limited Partnership (FLP). John and Jane will retain both the General (GP) and Limited Partner (LP) interests at the outset. In fact, the GP interests will be held by a new Limited Liability company (LLC) that John and Jane will establish. They will then transfer $2 million of marketable securities that they purchased using the funds from the bargain sale and $2 million of their remaining art collection to the FLP. They will then have the LP interests appraised by a qualified appraiser to determine the value of each unit. Because of a lack of liquidity and lack of marketability, we presume a downward valuation adjustment from FMV of around 35%.

John and Jane will then establish Grantor Deemed Owner Trusts (GDOTs). These are irrevocable trusts that offer very distinct benefits: Assets in GDOTs are outside of the Eastwoods’ estates for estate taxes purposes while all income remains taxable to the grantors (in this case John and Jane). This has the added benefit of John and Jane paying the income taxes on their beneficiaries’ assets, essentially an additional method for making gifts. John and Jane will gift a small amount of their assets to their individual trusts (in this case $130,000 each). This is to give the trusts economic substance and is commonly called a “seed gift”.

John and Jane will now sell their FLP interests to the GDOTs in exchange for a note. The note will be an interest only note and will pay them annually. We estimate the payment to be $90,000 per year, which is almost the annual income requirement that John and Jane desire. The payment does not consume all of the GDOT cash flow so we will have the GDOT purchase $5 million of survivorship life insurance on John and Jane utilizing the assets in the GDOT to fund the purchase. The GDOT will also have tremendous flexibility regarding its assets and the beneficiaries may decide to sell, lend or gift some of the art holdings at a later date.

Charitable Remainder Unitrust

The Eastwoods will next establish a Charitable Remainder Unitrust with what is known as a “flip” provision (FlipCRT) and transfer $4 million of their remaining art collection to it. The trust will be designed to pay the Eastwoods an annual amount equal to 6% of its value determined at the beginning of each year.1 However, these payments will not commence until the year after the artwork is sold from the trust.  In this case, the university will purchase the artwork from the trust for cash.

Because CRTs are tax-exempt, there is no capital gains tax due on the sale to either the Eastwoods or the trust. John and Jane will begin receiving an income stream based on the entire $4 million of proceeds from the sale. Utilizing a 6% payout rate, they will receive $240,000 in the first year. If in future years the trust grows in value, the Eastwoods will receive 6% of that increasing value. Only the income distributed to the Eastwoods will be subject to income tax. Any undistributed income and gains will compound tax-deferred.

In addition to deferring the capital gain on the sale of the art, the Eastwoods will also receive an income tax charitable deduction for a portion of the value transferred to the trust. Because the charity will not receive the proceeds of the trust until after the Eastwoods die, the deduction is limited to the present value of their future gift and will be calculated based on their cost basis of the art.2

The Eastwoods will also gladly name the university as the beneficiary of the CRT, effectively assuring it will receive most of the purchase price for the art back when John and Jane die.

Irrevocable Life Insurance Trust

John and Jane will have more cash flow than they dreamed of or anticipated. They utilize some of it to purchase another $5 million of survivorship insurance in a newly established Irrevocable Life Insurance Trust (ILIT). Because they have enough beneficiaries and will take advantage of the annual gift tax exclusion, they will not have to worry about making any taxable gifts.

Retirement Plan Gifts

Further calculations indicate that the Eastwoods will transfer the current value of their entire estate to their children and grandchildren while still allowing the university to receive or purchase a large portion of the collection. Because of this, John is able to name the university as the secondary beneficiary of his retirement plan. If he pre-deceases Jane she will still have full use of the funds. However whatever is left will go to support and maintain their collection in perpetuity. Retirement plans are excellent charitable giving candidates because not only are they otherwise subject to estate tax, they are also taxable income to those who inherit them. Naming a charity as the beneficiary of a retirement plan eliminates both of these taxes.

Charitable Lead Trusts

Feeling comfortable their heirs will receive ample funds very shortly after their deaths, John and Jane are able to establish Testamentary Charitable Lead Annuity Trusts (TCLATs) that will “zero out” their estates for estate tax purposes. This special type of trust takes any assets remaining in the estate that would be subject to estate tax and utilizes those assets to give a fixed income stream to charity (in this case the university) for a fixed term of years and then gives whatever is left at the end of the term to the heirs. Depending on the term of the trust, the amount it pays, and interest rates at the time the trust is created, the TCLAT can produce an estate tax charitable deduction that equals its value thereby eliminating all estate taxes on amounts transferred to it.

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Footnotes

• 1. A Flip CRT operates as Net Income with Makeup provision CRT (NIMCRUT) until the occurrence of a triggering event, in this case the sale of the art. Because a NIMCRUT is required to distribute only “income” that it earns and since the art produces no income, this feature will protect the trust from having to make any distributions. When the trust sells the art, it will convert to a Standard CRT (SCRUT) and will make distributions of 6% of its annual value from income (and principal, if necessary) beginning in the following year.
• 2. Because the transfer consists of tangible personal property and is being given to a trust that cannot put it to a use related to its tax-exempt purpose, the tax rules require the deduction to be based on the lesser of the donors’ adjusted cost basis in the property or its fair market value. Furthermore, the donors’ income tax charitable deduction will not take effect until the trust sells the property.