For all the good that a beautiful work of art can do for our minds and souls, it remains a tangible object that costs money to purchase and generates no income while it is owned. Artworks can be sold, but the former owner will then have to pay a hefty capital gains tax: 28 percent to the IRS, plus a 12 percent capital gains tax for New York State residents, plus a 3.8 percent federal surcharge for high-income individuals and couples, minus the state income tax deduction on the taxpayer’s federal return, for a net combined tax rate of about 41 percent. One way a growing number of art and collectibles owners can earn income from their art while deferring capital gains taxes is through charitable support.
A charitable remainder unit, somewhat inelegantly called a CRUT, allows collectors to transfer tangible objects such as art to a trust and authorize a trustee to sell the artwork when the market appears to be at a peak. Proceeds from the sale are tax deferred, and the money can be reinvested to grow within the trust over time. If Collector However, if collector
Once a sale occurs, a portion of the proceeds – ranging from five to fifty percent, but typically five to eight percent – is distributed annually to the beneficiaries, usually the donor and their spouse. Although some CRUTs are designed to last a certain number of years, most charitable remainder trusts terminate upon the death of the last individual beneficiary, and the remaining funds become donations to designated charities.
“This is a tax deferral strategy,” Lawton Leung, a trust and estate partner at law firm Withers, told Observer. The charitable trust is considered a tax-exempt entity. “Say you finance that CRUT with works of art, whatever kind of appreciated real estate, the trust can sell it without a tax bill. The tax would apply if there is a distribution from the annuity or the unitrust payment. So then the grantor or grantor of the trust will have to pay tax on that piece – what he or she gets from the trust each year. The payments from the trust can be made quarterly, annually, semi-annually or monthly. It depends on the type frequency you want, but at least once a year.”
The trust functions much like a 401(k) or IRA in that the assets can be reinvested and grow on a tax-deferred basis. “We especially like to use charitable funds when there is an opportunity to defer a large capital gain,” Leung said.
He noted that CRUTs provide collectors with a way to benefit from contemporary art prices, generate income for retirement and fulfill philanthropic goals in a tax-efficient manner. “The charity must receive a minimum of 10 percent actuarial value at the time the trust is established. The amount that goes to the charity at the end of the term can vary. There is some unpredictability to what the charity actually gets, but at least at the start of the trust the intention is for the charity to receive at least 10 percent of what is put into it.”
Collectors can reduce their capital gains and estate taxes, but it’s not entirely win-win. Once they place works of art in a CRUT, they can no longer keep them in their homes or offices – the rules for residual trusts are similar to those for individuals setting up private foundations – so most keep the art elsewhere. That could be a bank, a law firm or an art gallery willing to keep it; many collectors choose storage facilities for fine art. Once a work of art is donated to the charity, it remains there; the collector cannot change his mind and take it back.
Charitable remainder trusts are not typically established in isolation, but rather as part of a broader estate planning strategy for individuals with a range of valuable assets. Still, Leung said, the typical cost to set up a CRUT is $10,000. The first step is for the donor to irrevocably transfer art or other personal property to the trustee, usually a lawyer or banker. An IRS actuarial table calculates, based on the beneficiaries’ age, the payout rate and an interest rate, both the amount the beneficiaries are expected to receive over the term of the CRUT and the amount that will go to one or more designated charities. The donor then deducts the calculated percentage of the gift to the charity at the time the trust is established, based on the original cost of the items rather than their current fair market value. This deduction may be spread over five years. For example, if the IRS actuarial table indicates that 70 percent of the trust’s assets go to the beneficiaries and the remaining 30 percent to charity, the donor is entitled to deduct 30 percent of the cost of the assets. A painting purchased for $100,000 and transferred to a CRUT entitles the donor to a $30,000 deduction.
Each year after the trustee sells the art, the individual beneficiaries typically receive a fixed percentage of the annual value of the trust assets. If a painting in a CRUT generates net proceeds of $1,000,000 and the payout rate is set at five percent, the beneficiary will receive $50,000 in the first year of the trust. These distributions, known as unitrust payments, are taxable to the beneficiary in the year they are made, based on the beneficiary’s total income and how the trust income is invested. Meanwhile, the assets remaining in the CRUT continue to generate income and realize capital gains without immediate tax costs to the trust or beneficiary. As a result, annual unitrust payments can increase by five percent over time as trust assets increase in value on a tax-deferred basis. The collector receives a tax deduction up front and pays taxes as he receives annuity payments.
There is more than one type of charitable trust. A charitable remainder annuity trust provides the collector with a predetermined payment each year, while a unitrust can pay out varying amounts annually depending on the trust’s performance.
Often those considering a CRUT are planning for retirement, a time in life when they want to maximize income and minimize expenses. Old art collectors may own highly prized assets that incur high costs for storage, security and insurance and would generate large capital gains taxes if sold. People in that situation often want to simplify their lives by getting rid of part of their art assets, but prefer not to incur a large tax bill in the process. A charitable residual unit trust provides them with an income stream and a lower tax burden than they would experience if they sold the assets outright, meaning more of their money would be kept for one or more charities of their choice.
Although trust assets must go to a charity, there is no requirement that the charity be designated when the trust is created. People change their minds about which charities they want to support, and that’s fine. The trustee can also name the charity.
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