WEALTH PL ANNING WITH ART

WEALTH PLANNING WITH ART Art. It inspires us. It intrigues us. We celebrate art and artists globally — from EXPO Chicago to Art Basel Miami and Hong Kong. Whether you view art as a passion or an investment, or perhaps a bit of each, today’s vibrant art market and the surge in private gifts of art touches many of our lives. In this Insights on Wealth Planning we explore considerations of interest to those with an affinity for art. Wealth planning and management related to art offers many opportunities, but it is also quite nuanced. The art environment is diverse and constantly changing; acquiring, managing, valuing and ultimately disposing of works of art requires thoughtful planning and the advice of trusted experts and advisors in order to realize the full value of an individual work or collection. We encourage you to confer with your art, legal and tax advisors as to matters pertaining to your particular circumstances.

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ART MARKET TODAY

In 2014, the global art market reached its highest-ever recorded level, with transactions totaling nearly $60 billion worldwide, up 7% from 2013.1 The substantial growth in sales of art has been facilitated by the globalization of the art market, and has been propelled by an exceptional increase in wealth, especially in emerging art markets such as China, India, Russia, the Middle East and Latin America.2 The increase in the number of ultra-high net worth individuals globally has substantially contributed to the demand for buying and investing in artwork. The art market is heavily polarized, with the trophy works by well-known modern, postwar and contemporary artists comprising the bulk of transactions by dollar value. During the first half of 2015, the top ten artists at auction earned over $2 billion, and comprised 23.3% of the total market by value. The top earners for the first half of 2015 include:3 ARTIST

Sales at Auction

Pablo Picasso

$441 million

Claude Monet

$289 million

Andy Warhol

$288 million

Alberto Giacometti

$204 million

Mark Rothko

$181 million

Gerhard Richter

$152 million

Francis Bacon

$150 million

Cy Twombly

$113 million

Joan Miró

$97 million

Jean-Michel Basquiat

$94 million

In 2015, a striking 90% of the top two hundred collectors are collecting contemporary and postwar art (typically defined as art created during one’s lifetime), up from 58% in 1990.7 Contemporary and postwar works made up the largest segment of auction sales worldwide, reaching approximately $6.58 billion, comprising 48% of all sales by value.8 Sales in this segment made up 72% of the value of all auction sales at New York City auction houses in 2014, up 11% from 2013. THE ART RELATIONSHIP

Artists, investors, hobbyists, business collectors and dealers each have slightly different relationships with art and those relationships have wealth planning and management implications. There are some common understandings of the various categories of holders of art. ■■ Investors buy, sell and collect art as an investment with the hope the art will appreciate enabling a profitable sale. ■■ Hobbyists collect art for personal pleasure, rather than focusing on whether the art will ever become a profitable investment. ■■ Dealers buy and sell art as a trade or business. ■■ Business collectors buy art, not for resale, but for business use, such as for display in a workplace. An individual may have different relationships with various artworks and may have a blended relationship with a single piece or collection. Increasingly, high-net-worth individuals acquire art, not only for personal satisfaction, but also with an investment outlook. It is estimated that the individual art investor currently allocates approximately 10% of his or her portfolio assets to art and collectibles.9 It is not particularly surprising therefore, that 76% of art collectors view their art acquisitions and collections as both a passion and as an investment, up from 53% in 2012.10 Although many may view their art partly as an investment, only 3% of collectors surveyed said their acquisitions were purely investment-motivated, with 61% responding that the social value of buying art was a key motivation for collecting.11

Art transactions rest on a limited cadre of participants. Specifically, 8% of the art sold at auction worldwide accounted for 82% of the market by value. Concentrated interest in the works of a relatively small number of artists and those high-priced sales skew the data toward those artists.4 Picasso’s Les Femmes D’Algers (Version “O”) (1955) sold at Christie’s in May 2015 for $179 million, becoming the most expensive work ever sold at auction.5 During the same sale, Giacometti’s L’Homme au Dougt (Pointing Man) (1947) fetched $141.2 million, claiming the top spot for the most expensive sculpture ever sold at auction. Another notable sale was Richter’s Abstraktes Bild (1986), which sold for $46.3 million at Sotheby’s London in February 2015 and took the record for most expensive painting by a living European artist.6 The same Richter work previously sold for $607,500 in 1999.

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THE VALUE OF ART

Looking beyond the headline auction sales, there are a number of important challenges in determining the value of art apart from aesthetics. There is no public, regulated, transparent, real-time marketplace for art as there is for publicly traded securities. The factors that impact the value of art are varied, accompanied by a degree of associated risk and uncertainty. Determining a work’s value may be difficult, especially if the piece is unique, rare or does not have an established retail market. Valuation may be especially difficult if a work is part of a larger collection, was commissioned or is by a lesser known artist. Supply and demand are determinants of price in markets generally. However, a number of other forces unique to the art market will have a material influence on both the value of a particular work or collection and the price obtainable in the market, including authenticity, provenance, title, rarity, condition and government restrictions on trade. Authenticity Authentication is the starting point for determining the value of your art collection. In most cases, the authenticity of goods that trade on a secondary market can be readily verified and permanently relied upon. The authenticity of a work of art, however, is not a permanent condition; rather, it is a consensus opinion at a point in time, and can and does change.12 Scenarios giving rise to authenticity concerns are typically forgery, misattribution and modification. A forgery is an intentional deception. Misattribution is the mistaken opinion of the seller that the artwork is by the artist in question. Modification generally occurs when the owner seeks to restore the artwork and in so doing, modifies it.13 A major risk associated with investing in art is that a work could turn out to be fake, forged, stolen or questionably obtained. For a collector, it is critical to establish the authenticity of a particular piece. Authentication by a reputable and unbiased independent expert is often desirable and serves as a verification of authenticity for the buyer who wants confidence that the item he or she is bidding on at auction or at private sale is authentic.14 Because of the risk that a major acquisition could actually be worthless, buyers should conduct their own due diligence whenever possible before purchasing a piece, and should be wary of accepting a piece as authentic simply because of its supporting documentation. Remember, documents can be forged too. Provenance Provenance is a clear and definitive indicator for determining value. Provenance is the origin or source from which a particular work has come to the market, and refers to the work’s ownership history, various auction records, conservation records, certificates and bills of sale. A record of provenance gives buyers reassurance regarding the work’s value and provides a verifiable public certification of authenticity.15 The ownership history can have a marked effect on the valuation of a piece. For example, a Cartier ruby and diamond necklace given to Elizabeth Taylor by Richard Burton was appraised at $200,000-300,000, but sold at auction for almost $3.8 million based on the special circumstances of its provenance.16

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Good Title In transferring a piece of artwork, whether by sale or gift, you must be able to defend its title. A piece of artwork might be subject to various liens, serve as security for a loan or be subject to a legal claim. Additionally, stolen art creates difficult legal issues for the unsuspecting collector. Artwork that crosses international borders may have more than one legal system at play as countries have different laws as they pertain to purchasing stolen artwork. A war-looted work not only impairs good title, but could also be subject to future legal controversies. When dealing with artwork with WWII-era provenance, for example, you should be sure to collect as much information as possible to avoid purchasing war-looted art. Title issues involving war-looted art arise more frequently than one might expect. For example, a Picasso painting, Portrait of Angel Fernandez de Soto, then owned by the Andrew Lloyd Webber Foundation, was estimated to fetch between $40 million and $60 million at auction, was withdrawn from a 2006 Christie’s auction sale because of a claim that it had been transferred under duress by a Jewish owner in Germany to an art dealer in Switzerland in 1935.17 The legal challenge was subsequently resolved, and in 2010, Christie’s presented the piece at auction, selling for over $51 million.

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Rarity Rare art objects often translate into higher values. For example, if an artist has created a relatively small number of works, and the artist is considered of major importance, each individual work will likely be highly sought after and consequently expensive. However, this is not always the case. Rarity can negatively impact value if the work does not reflect the current market taste, making the piece less desirable. Condition Maintaining a work’s good condition is crucial to maintaining its value and is simply effective asset management. Collectors should take care to properly store artwork in order to facilitate its preservation. Musty rooms, direct sunlight and displaying paintings over fireplaces are examples of ways in which the work’s condition can be compromised over time, even though the work appears flawless to an untrained eye. Government Restrictions A number of countries, including the United States, impose restrictions on the trade in certain items that may adversely affect U.S. collectors. The Convention on International Trade in Endangered Species of Wild Fauna and Flora (CITES), for example, is an international agreement between 181 countries, including the United States. The CITES governs the international trade in certain wild animals and plants so that their survival is not threatened. The United States is also subject to stricter restrictions enacted under its Endangered Species Act of 1973 (ESA). The ESA restricts or prohibits the movement of endangered or otherwise protected plants or animals and related items such as feathers, corals, ivories, tortoiseshell, walrus, seal and certain types of woods. APPRAISING ART

One may assume they know the value of the works in their collection or are able to gauge value based on prices they observe in the art market, but that is seldom the case. Knowing the value of your artwork is of utmost importance for a host of reasons, including: ■■ Determining and maintaining appropriate types and levels of insurance coverage; ■■ Making gifts to charity and substantiating any associated income tax deduction; ■■ Making gifts to family and others and complying with any applicable gift tax requirements; ■■ Settling the estate, including making distributions and determining estate taxes; ■■ Engaging in art-based lending transactions; and ■■ Engaging in sales and exchanges and the related tax reporting. The purpose of an appraisal will guide the selection of the appraiser and the requirements of the appraisal itself. It is important to work with a qualified appraiser who understands the purpose of the requested appraisal and who regularly deals with the type of property being appraised. Working with a qualified appraiser will help ensure that certain required information is included in the appraisal as the requirements may vary depending on its use.

Appraisals for Insurance Purposes Insurance appraisals are prepared as a risk-management measure to protect art assets in case the collection should fall victim to theft, accidental damage, fire, flood or any other unfortunate situation. Insurance appraisals are generally based on retail replacement value (RRV). The RRV is the amount of money it would cost to place an item with a like item of similar quality, in a retail venue and within a relatively short period of time. The RRV will likely be higher than the fair market value used for tax-related purposes, discussed below, because RRV reflects the price one would have to pay to replace the item at retail, such as at a high-end gallery. Appraisals for Tax Purposes If an appraisal is for tax-related purposes, Treasury regulations are generally consistent in their approaches to the valuation of artwork for income, gift and estate tax purposes.18 Unlike the retail replacement value used for insurance purposes, the value for tax purposes is the work’s fair market value at the time of the contribution or transfer, either during life or at death.19 Fair market value for tax purposes is “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”20 This value is based on a hypothetical sale in the market in which the artwork is most commonly sold to the public – at auction. However, if the artwork is unique, rare or part of a larger collection, the regulations’ contemplated “retail market” may not exist. Not surprisingly, taxpayers and the Internal Revenue Service (IRS) at times have differing views of the value of a work of art. The Art Advisory Panel of the Commissioner of Internal Revenue (the Panel) provides advice to the Art Appraisal Service unit in the Office of Appeal of the IRS. The Panel’s charge is to help the IRS review and evaluate the tangible personal property appraisals submitted to the IRS to support the values reported for tax purposes. Objectivity and taxpayer privacy are priorities. Although the Panel’s recommendations are advisory, the IRS adopted 90% of the Panel’s recommendations in full in Fiscal Year 2014.21 ART ADVISORY PANEL FISCAL YEAR 2014 COMPREHENSIVE RECOMMENDATIONS REPORT Taxpayer Claimed Value

Panel Recommendation

$246,996,500

$302,702,500

$55,706,000

$3,804,000

$1,727,000

($2,077,000)

Totals 315

$250,800,500

$304,429,500

$53,629,000

Items Adjusted 194

Not applicable

Not applicable

$53,629,000

Type of Tax

Number of Items

Net Change

309 total Gift and Estate Tax 188 adjusted 6 total Income Tax – Charitable Contribution 6 adjusted

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Charitable Gifts – Appraisal requirements of art for income tax deduction purposes are somewhat more involved than for gift or estate tax purposes. The income tax regulations articulate clear requirements for an appraisal to be a “qualified appraisal.” For any contributed work of art valued in excess of $5,000, you, as the donor, must obtain a qualified appraisal from a “qualified appraiser” within 60 days of the contribution date.22 A qualified appraiser must be an individual who holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis and is qualified to make appraisals of the type of property being valued.23 Thus, an appraiser who specializes in Chinese pottery from the thirteenth century may not be qualified to appraise a Monet watercolor under the guidance provided by the regulations.24 Further, a qualified appraiser must be fully independent, meaning the appraiser cannot be you (the donor), a party to the transaction in which you acquired the artwork (e.g., an employee of the gallery that sold the artwork to you) or anyone “related to” you, as defined by the regulations. Further, if you have any information that would lead you to believe that the appraiser would falsely state the value of the contributed work, then that appraiser is not qualified. Additionally, a qualified appraiser must have a designation from a recognized appraiser organization, such as the Appraisers Association of America, and must not have been banned from practicing before the IRS at any time during the three-year period ending on the appraisal date.25 The appraisal itself must contain certain information in order for it to be a qualified appraisal. Some, but not all, of the required information includes: ■■ A description of the artwork; ■■ The expected donation date; ■■ Identifying information about the appraiser (including name and address); ■■ The date on which the artwork was appraised; and ■■ The appraised fair market value of the artwork.26 Donors of artwork must conduct their due diligence to select a legitimate, qualified appraiser, as the consequences for failing to do so can be severe, including loss of the entire charitable deduction and/or fines.27

Although the blockage discount in O’Keeffe was applied for estate tax valuation purposes, the discount would also be appropriate for valuing for gift tax purposes a lifetime gift of a collection of art. Other valuation discounts, such as the discounts for lack of marketability or control, may be applied in order to determine the fair market value of a transfer of art for gift and estate tax purposes in cases where, for example, the transfer is of an interest in an entity owning the artwork or where a collection is transferred subject to various restrictions on partition, alienation or possession.30 Although the income tax rules require a “qualified appraisal” by a “qualified appraiser,” the estate tax rules require only an appraisal accompanied by a sworn statement made by the executor of the estate containing an itemized list of the appraised works of art and a declaration as to the appraiser’s disinterested character and his or her qualifications.31 No similar regulation applies to gifts of art under the Federal gift tax. Nonetheless, if you make a charitable gift of art and want to begin the running of the statute of limitations on the gift in order to prevent a revaluation by the IRS at a later date, the gift must be “adequately disclosed.” Adequate disclosure may be made either by providing a detailed description of the method used to determine the fair market value of property transferred or by submitting an appraisal of the gifted property that meets the detailed requirements set forth in the regulations.32 These requirements are similar in scope and extent to the qualified appraisal requirements that apply for charitable income tax deduction purposes.

Non-charitable Gifts and Bequests – Obtaining a current valuation is also important for gift tax purposes if you gift works during your life and for estate tax purposes if the works are owned at death. The difficulty of valuing art for gift and estate tax purposes is often complicated by the fact that a work of art is often held as part of a larger collection.28 For example, renowned artist Georgia O’Keeffe died owning a collection of approximately 400 works of art. The IRS agreed with the estate that at the time of O’Keeffe’s death in 1986, the individual fair market values of the works totaled $72 million. Subject to dispute, however, was the estate’s claimed “blockage discount” attributable to the fact that so many of the works of art in the collection could not be sold in bulk for the price that individual pieces would sell for if sold over an extended period of time.29 The blockage discount, therefore, recognizes for transfer tax purposes the realities of a huge number of works of art coming on the market for sale at the same time, disrupting the normal economics of supply and demand. The Tax Court settled the dispute between the O’Keeffe estate, with the IRS applying a 37% blockage discount.

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Advance Valuation Ruling Procedure – In an attempt to avoid the time and expense involved in disputing art valuations, a procedure exists enabling a taxpayer to obtain an advance ruling from the IRS as to the value of art for income, gift or estate tax purposes.33 For a transfer of a work of art that has been appraised at $50,000 or more, a Statement of Value may be obtained from the IRS for the item prior to filing the appropriate tax return that first reports the transfer.34 Working with a reputable appraiser will ensure that all of the advance ruling procedure requirements are met prior to submitting the request. Once the IRS issues a determination of value under this procedure, it must be attached to the applicable tax return and it is binding on the IRS. If the taxpayer disagrees with the determination, he or she may submit additional information with the appropriate return to support an alternate valuation. This procedure would be advantageous to a taxpayer who desires certainty when filing his or her return. THE GIFT OF ART

A Matter of Life or Death? You may desire to pass on your passion for art by gift, to charity, family or friends, but are uncertain as to when you would like to make your gift. There are a number of advantages associated with both lifetime and testamentary gifts. Advantages of Lifetime Gifts – A transfer made during life will remove the art from your estate, which may be advantageous for a few reasons. First, the value of the art is no longer part of the estate, reducing the value of the estate and thus the amount of estate taxes that may be due upon your death. Second, any further appreciation in the value of the art occurs outside of your estate. If you wish to transfer art to a spouse, a lifetime gift may make more sense than a testamentary gift in some instances. A spouse can make unlimited transfers of assets (including art) during life to a U.S. citizen spouse without triggering Federal gift taxes. If one spouse has significantly more wealth, transferring art during life can reduce the value of the taxable estate of the first-to-die and help equalize wealth between the two spouses. Advantages of Gifting at Death – One of the most important benefits of transferring appreciated art to family or friends at death is the possibility of a step-up in basis to fair market value. Generally speaking, when property transfers at death, the recipient’s basis in the property is equal to the value of the property on the date of the decedent-owner’s death. If you transfer art that has appreciated in value at death, the recipient may then sell the art without realizing some or all of the built-in gain as a result of the step-up in basis. However, it is important to remember that the value of the appreciated art will still be included in the value of your gross estate. Another benefit to transferring art at death is that you will be able to own and enjoy the art until your final day. For many collectors, art is a passion asset that brings a great amount of joy. Waiting until death to transfer the art allows you to continue to enjoy your art in the comfort of your home. Transferring art at death may also allow you to more effectively achieve your charitable giving goals, depending on those goals and the organizations you wish to support. The related use rule, discussed below, does not usually apply to transfers of art from a decedent-collector’s estate. For example, a collector may wait until death to transfer a prized painting to a local soup kitchen or homeless shelter so that the estate can take a charitable deduction for the full fair market value of the painting. It is worth noting, however, that this technique may not be available for artists who wish to transfer their own self-created art to charitable organizations at death due to complexities with copyright interests. Therefore, it is important that artists consult with experienced attorneys and tax advisors on charitable planning with art.

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Gifts to Charity Many philanthropists are motivated to make charitable gifts because they have a desire to make a positive impact in their communities or support specific organizations. In addition to having an interest in making a positive impact, many donors are also interested in obtaining a deduction on their personal Federal income taxes. In order for a donor to optimize, there are many factors to consider. Type of Property Contributed – In order for you to obtain an income tax charitable deduction equal to the full fair market value of contributed art, the art must be considered capital gain property. Generally speaking, you must have owned and held the art for more than one year, the work of art must qualify as a capital asset, the art must have appreciated in value and the art must be a “collectible” as defined by the Internal Revenue Code (Code).35 If the art is considered ordinary income property, your deduction will limited to the basis in the art, which generally means the cost of the materials used to create the art. The art may be considered ordinary income property if it was: (1) created by you, the donor; (2) received by you as a gift from the creator; (3) held as inventory by an art dealer; or (4) owned for one year or less at the time it is donated.36 Thus, artists and those who receive gifts of art directly from an artist should take note of the fact their pieces will likely be categorized as ordinary income property. Type of Organization Receiving the Gift – In order for you to obtain an income tax deduction equal to the full fair market value of the art, the art must be contributed to an organization that will use the art in a way that relates to the organization’s charitable mission. This requirement is often referred to as the “related use” test. A classic example of a donation of art satisfying the related use test would be a gift of a painting to a fine art museum. If a donation of art fails to meet the related use test, the deduction will be limited to the cost basis. In some instances, a contribution of art will never satisfy the related use test. For example, if you contribute your art during life to a private foundation or a charitable remainder trust the related use test will not be satisfied because those tax-exempt entities do not have charitable purposes related to art. Therefore, it is important for you and your advisors to consider the type of organization receiving a donation of art before making such a gift. Appraisal of the Contributed Art – While the old adage that “beauty is in the eye of the beholder” reflects the subjective nature of art, we may need a new adage that “value is in the eye of the appraiser” to reflect the importance of an objective, qualified appraisal when discussing charitable gifts of art. The requirements for art appraisals for charitable income tax deduction purposes are discussed at length above. As a reminder, donors of art looking to maximize their current income tax charitable deduction must follow the complex IRS rules carefully. Working with trusted advisors can make the process easier, and help ensure your tax goals are aligned with your philanthropic goals. Communication with the Donee – While an income tax charitable deduction may be an important consideration for you in contemplating a charitable gift of art, it is by no means the only consideration. Donors often have strong motivations for making a charitable gift of art, such as a desire to safeguard art and preserve it for subsequent generations to see and enjoy. But before making such a gift, you should work with potential donees to ensure goals and expectations are realistic and aligned for both parties.

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CHECK LIST FOR NON-CHARITABLE TRANSFERS OF ART ■■

■■

■■ ■■

Obtain a qualified appraisal prior to making the transfer. Provide all documentation pertaining to provenance (if applicable). Transfer title to new owner. File gift tax return and pay any applicable gift taxes.

If you are thinking of leaving art to one or more nonprofit organizations in your will or estate plan, it is a good idea to let those organizations know of your intentions while you are still alive. First and foremost, it is important to know whether or not a museum or other nonprofit organization is interested in receiving your art as a gift. If a cherished work of art does not fit within a museum’s curatorial or accession plan, the organization may pass on the gift. That may not only thwart your philanthropic goals, but it may leave the executor of your estate with the task of figuring out a “Plan B.” Work with an Advisor on a Gift Agreement – Communicating in advance with an intended donee allows you to express your wishes for how you would like the organization to manage your gift. For example, you may want a donated piece of art displayed for a certain period of time by the recipient. Assuming you and the donee can come to an understanding around accepting a donation of art, it is a good idea to have a written gift agreement in place to document the details of the transaction. Gift agreement templates may be easily accessible online, but it is worth the time and expense to work with an experienced attorney or philanthropic advisor to develop an agreement that accurately represents the goals and expectations of all parties. Consider Making a Gift of Cash or Securities Along with Gifts of Art – Along with your art, you may also want to consider making an additional gift of cash or marketable securities as a way to help the recipient organization manage the donated art. There are a number of expenses that may be associated with properly caring for and protecting art, including insurance, storage, restoration and transportation. It would be wise for you to discuss these associated costs with potential donees. In certain circumstances, you may wish to make an additional gift of cash or appreciated securities to help offset some of the associated costs.

Gifts in Trust It may make sense for you to transfer art out of your estate during life in order to reduce the size of the taxable estate. But what if you do not have any individuals or charitable organizations identified to receive the art? Or, what happens if you want to transfer art to a family member or friend, but you have certain conditions that you want to place on the transfer? Transferring art to a trust may be a solution in these circumstances. If you want to safeguard multiple pieces of art for future generations, but are not yet ready for your children or grandchildren to take possession of your collection, making an irrevocable gift of the art collection to a trust may be an effective transfer technique. But before making the transfer, you should carefully consider the terms of the trust, decide who will act as the trustee of the trust and consider the responsibilities the trustee will have to undertake. For example, a trustee of a trust owning art may have to consider where to store the art, appropriate insurance levels, if and/or when the art can be loaned or sold and how often to have the art appraised. Further, the trust may need additional liquid assets to pay insurance premiums, storage costs and other related expenses.

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Once the art is held in trust, the trust document will dictate how the art is managed and ultimately transferred. In the trust provisions you can name specific individuals to receive specific trust assets (such as specific works of art or sculpture), or the trust may direct the trustee to choose which beneficiaries receive the pieces of art held in trust. If you intend to transfer your art into trust, you should work with an experienced attorney to draft the trust document, and be very thoughtful about selecting a trustee with experience in managing art. In some instances, it may be a wise choice to select a corporate or institutional trustee to manage art transferred to trust. Regardless of whether you make a direct transfer of art to a family member, or if you use a trust to transfer art to subsequent generations, it is vitally important to work with advisors who have experience in estate planning with art. The rules can be complex, and it is easy to get tripped up in the planning. As you have already spent a lifetime obtaining cherished works of art, it is usually worth the time and expense to work with professional advisors who can help you achieve your ultimate planning goals.

MONETIZING ART

A number of options are available to you in planning to monetize part or all of your art collection, using the art as collateral for a loan or sale at public or private auctions, by private sales or at art galleries.

LEASE BACK ARRANGEMENTS

Some collectors may wish to transfer works of art to children or grandchildren, but they hesitate to transfer the art outright to subsequent generations. The hesitation may be out of concern that the potential recipients are not able to properly care for the art, or the hesitation may be due to a desire to still enjoy and display the art. For collectors facing this dilemma, a potential solution may be to transfer the art to an irrevocable trust for the benefit of children or grandchildren, and then lease the art back from the trust. The basic structure of the lease-back arrangement can be rather straightforward. The collector transfers art to an irrevocable trust. The trust beneficiaries may be family members, such as children or grandchildren, or friends and other loved ones. The collector executes a lease agreement with the trustees to lease the art for the fair market rental value, as determined by an independent, qualified appraiser. The collector makes fair market value lease payments to the trust, which can be used for distributions to beneficiaries per the terms of the trust, or for necessary expenses (insurance,

tax payments, etc.). The trust can be structured so that the collector is responsible for paying the trust’s taxes, thereby allowing the income generated by the leased art to be used for the benefit of named trust beneficiaries. This technique has many potential benefits, including: ■■ Removing the value of the art from a collector’s estate (and any subsequent appreciation); ■■ Ensuring the art is safeguarded for future generations; ■■ Generating a rental income stream to the trust to help maintain the art and benefit future generations; and ■■ Allowing the art to remain in the home of the grantor to enjoy and display. In order to take advantage of this planning technique, it is critically important that collectors work with experienced attorneys and qualified appraisers. There are many pitfalls, such as failing to pay fair market value for the leased art, which can jeopardize the transaction. Having a team of advisors to help structure the transaction can avoid these pitfalls.

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Leveraging Value from Art – Using Art as Collateral Obtaining credit with art as collateral may be a convenient way to leverage an illiquid asset to fulfill a borrowing need while still being able to keep possession of the art. The purpose of the loan itself can range from a multitude of business purposes to more personal trust and estate and wealth diversification reasons. Lines of credit and term loans can be structured with the art as collateral and there is typically a high degree of customization associated with these loans. A rule of thumb loan-to-value is 50% and you should be prepared to demonstrate the ability to comfortably repay the loans without the need to sell the art. Loans of this nature are typically dedicated to borrowers who are art collectors, rather than investors. Selling Art In considering sale options, it is important for you to realize that the art market is comprised of a number of unique submarkets defined by artists and genres, which operate relatively independently. The upside of this is that a motivated seller will usually be able to locate a willing buyer. The downside, however, is that many submarkets lack transparency, valuations are highly subjective and the price obtainable for a particular work depends in part on the collector or investor’s taste or aesthetic. If you wish to sell some or all of your art collection, there are important considerations and steps to follow to avoid jeopardizing the transaction. First, potential sellers of art must understand the tax consequences of selling works of art. If the sale is of long-term capital gain artwork, any gain realized on the sale of the art will be subject to the 28% capital gain Federal income tax rate.37 Second, if you choose to sell your works at a major auction house, you will be subject to a variety of selling costs and fees, which will be deducted from the final sale price. The fees can include commissions, insurance coverage, authentication changes, as well as the costs associated with marketing the works as part of a larger sale. In deciding to sell works of art, there are important steps that you, as either the seller or the buyer, should follow to properly execute the transfer. For example, completing a final bill of sale, transferring title, changing applicable insurance policies and arranging for physically transferring the art can all be part of the sale process. You should work with qualified art advisors, who can assist in determining the appropriate sale venue in order to maximize sale proceeds and fulfill your intentions. Auction – Auction is a transparent process that exposes the art work to a bidding audience. The location of the market place is critical to a successful sale at the auction. Works sold at auction receive a free “auction estimate,” which is a range of values provided to give the seller a sense of the value for the art object. Auction estimates can be an important marketing tool in presenting a work at auction. Most works also carry a “reserve price,” which is the confidential minimum price below which the work will not be sold. The reserve price is known only to the seller and auction house.

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An appropriate time to start considering an auction is three to four months ahead of the scheduled sale season. During that period of time you should have the artwork inspected by a qualified expert, obtain auction estimates, engage the auction house, pack and ship the artwork to the auction house, catalogue the artwork, create marketing materials and schedule a pre-sale exhibition a week before the sale.38 Should you, as the seller, need funds in advance of the sale, there are a number of options available for raising that cash. The auction house may advance some of the projected sale proceeds to you. The auction house may guarantee a sale, offering you a minimum price regardless of the outcome of the sale. Or, you may obtain a loan from a financial institution secured by the artwork.39 In order to protect the confidentiality of the parties to an auction sale, auction houses will sometimes engage in a private treaty sale, and the information regarding the sale is not made publically available. Private or Gallery Sale – In some cases, a private sale will be preferable, either because the parties would prefer to remain anonymous, they want to avoid publicity, the timing of the auction cycle does not match their required timeline or the artist’s work has yet to reach high prices at auction and can realize stronger prices through private transactions. The latter example is particularly relevant for an artist with a strong regional following. Most of the data on art values comes from public auctions. Gallery sales and private auction sales are unreported. Therefore, it is very difficult to obtain information on these transactions. Whether you are a buyer or a seller, parties to an art transaction are well advised to conduct their due diligence and to carefully negotiate purchase and sale agreements of artwork, with advice of counsel, to protect themselves. Movement of Art – Each country has its own rules for the movement of artwork either into or out of the country. There are taxes to be considered, as well as customs duties, treaties, and international agreements on transfer of cultural goods to observe. Freeports, which are warehouses holding art in certain tax havens like Switzerland, have the potential to become important hubs for collectors and their advisors. With the increasingly global nature of the art market the demand for storage facilities and duty-free zones is likely to increase.40

Inherent Market Risks May Frustrate Monetization Approaching the task of monetizing an art collection is made more challenging by the fact that there is no fundamental pricing model for art. Aside from the psychic pleasure art produces, there is no clear income stream that flows from it. Each piece of artwork is unique, and even different measuring standards for the same artist can depend on the medium or at what point in the artist’s career the work was created. The lack of a fundamental pricing model for art means that art is subject to fads, fashions and potential bubbles. Is the current intense interest in contemporary art, for instance, one of those market bubbles? Without an established pricing model, it is difficult to answer this question.41 Working in collaboration with expert and independent appraisers, reputable auction houses, dealers, art advisors, galleries, insurers and wealth advisors, you can better identify the goals for your art assets and be better prepared to navigate the nuanced art market to achieve your goals.

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EXCHANGING ART

For the art investor who is sensitive to the tax impact on their art transactions, a tax-deferred exchange may be a strategy to consider. Code § 1031 provides for the tax-deferred exchange of like-kind property held for investment. Tax-deferred exchanges of art may be of particular interest given the higher 28% tax rate on the sale or exchange of collectibles, including art, as compared to 20% tax rate for long-term capital gain property generally. A Code § 1031 exchange may be accomplished by a simple simultaneous “swap” between two parties. More often the exchange is more complex, involving an intermediary to broker a gap in time in the transaction. In a forward exchange, you sell your relinquished asset to a second investor and the intermediary holds your cash. Within 45 days of the sale of the relinquished asset, you identify the replacement property in writing and you complete the purchase within 180 days of the initial sale. Be aware that the IRS admonishes its examiners to be on the alert for Code § 1031 exchange issues involving art exchanges. Code § 1031 exchange treatment is not available for inventory42 or for exchanges of property differing materially either in kind or extent.43 The Service has stated an unofficial view that: “The owner of a work of art enjoys different legal entitlement that the owner of another work of art. Each owner has a pecuniary interest in and is entitled to sell a unique piece of property. Therefore, trading artwork for other artwork is an exchange of materially different property.”44

TAXING ART Artist and Donee of Artist

Type of property

Ordinary income property

Hobbyist

Investor

Dealer

When assessing whether Code § 1031 like-kind exchange treatment may be available for a disposition of art, there are a number of specific requirements to satisfy: ■■ The original property must be held for investment. ■■ The acquired replacement property must be of a like-kind. ■■ The replacement property must be identified within 45 days after the original property is sold. ■■ The replacement property must be received within the earlier of 180 days of the initial sale and the due date of the tax return (without extensions) for the tax year — this is what is known as the “replacement period.” First and foremost, in order to qualify for like-kind exchange treatment, the art must be held for investment and, at the time of the exchange, you must intend to hold the replacement art for investment. This is a question of fact and there is no authoritative guidance to rely upon.45 Personal use of more than a limited degree will preclude like-kind exchange treatment. As to the qualitative like-kind question, we have very little guidance in the art realm. For tangible personal property generally, the like-kind standard has traditionally been interpreted more narrowly than for real property exchanges. As to antiques, we know – because the IRS has provided examples in regulations – that an exchange of a particular model of antique car for another model of antique car is considered a like-kind exchange, but the exchange of an antique car for antique furniture is not considered like-kind. As to coins, bullion-type coins and numismatictype coins are not like-kind, nor are silver bullion and gold bullion.46 Recent U.S. budgets have proposed to limit tax-deferred exchanges under Code § 1031 to $1 million per-investor per-year. Repeal has been proposed in recent years by both Senate and House committees. Where these various proposals will lead is yet to be determined. This is yet one more complex area requiring careful navigation.

Business Collector

CONCLUSION Generally, capital asset

Generally, capital asset

Ordinary income property (inventory)

Generally, capital asset

We conclude where we began: in appreciation for art and for artists, and with a further appreciation for the many associated considerations to be contemplated by those with an affinity for art, whether for passion or for profit, who are incorporating art into their overall wealth planning and management. FOR MORE INFORMATION

Sale

Ordinary income

Capital gain, but no capital loss

Capital gain or capital loss

Ordinary income

Capital gain or capital loss

Code § 1031 Exchange

Not available for artist or donee of artist

Not available for hobbyist collectors

Conditions for exchange treatment must be satisfied

Not available for inventory

Conditions for exchange treatment must be satisfied

Charitable Contribution

Deduction limited to basis of property contributed

Deduction for the fair market value of property contributed

Rules vary based on organizational structure

Deduction limited to basis of property contributed

Rules vary based on organizational structure

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As a premier financial firm, Northern Trust specializes in life-driven wealth management backed by robust technology and a strong fiduciary heritage. For more than 125 years we have remained true to the same key principles – service, expertise and integrity – that continue to guide us today. Our Wealth Planning Advisory Services team leverages our collective experience to provide financial planning, family education and governance, philanthropic advisory services, business owner services, tax strategy and wealth transfer services to our clients. It is our privilege to put our expertise and resources to work for you. If you would like to learn more, contact a Northern Trust professional at a location near you or visit us at northerntrust.com.

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1 Dr. Clare McAndrew, TEFAF Maastricht, The TEFAF Art Market Report 2015 (2015); Katya Kazakina, Global Art Sales Hit Record $54 Billion, Led by U.S. Buyers, Bloomberg Business, Mar. 11, 2015, http://bloom. bg/1GF03bm (last visited Aug. 12, 2015).

22 Treas. Reg. § 1.170A-13(c).

2

25 IRC § 170(f)(11)(E)(ii)-(iii).

C lare McAndrew, Fine Art and High Finance: Expert Advice on the Economics of Ownership loc. 393 (2010).

3 Press Release, artnet, artnet Releases Six-Month Auction Results (July 22, 2015) (on file with author).

23 Treas. Reg. § 1.170A-13(c)(5)(i). 24 Treas. Reg. § 1.170A-13(c)(5)(iv)(F).

26 Treas. Reg. § 1.170A-13(c)(3). 27 IRC § 6662(e), (h).

4

D r. Clare McAndrew, TEFAF Maastricht, The TEFAF Art Market Report 2015 (2015).

28 Estate of O’Keeffe v. Commissioner, T.C. Memo. 1992-210.

5

P ress Release, artnet, artnet Releases Six-Month Auction Results (July 22, 2015) (on file with author).

30 See, e.g., Estate of Elkins v. Commissioner, 767 F. 3d 443 (5th Cir. 2014).

6

Id.

7 The ARTnews 200 Top Collectors: 25th Anniversary Edition, ARTnews, (Summer 2015). 8

Katya Kazakina, Global Art Sales Hit Record $54 Billion, Led by U.S. Buyers, Bloomberg Business, Mar. 11, 2015, http://bloom.bg/1GF03bm (last visited Aug. 12, 2015).

9 Dr. Clare McAndrew, TEFAF Maastricht, The Global Art Market, with a focus on the US and China 49 (2014); See also Alexander Forbes, What is Behind the Art Investment Boom?, artnet news, Sept. 26, 2014. 10 Id. 11 Id.

29 Id.

31 Treas. Reg. § 20.2031-6(b). 32 Treas. Reg. § 301.6501-1(f)(3). 33 Rev. Proc. 96-15. 34 Id. 35 IRS Publication 526. 36 IRC § 170(e)(1)(A); Treas. Reg. §§ 1.170A-8(d)(3), 1.170A-4(b)(2) 37 IRC § 1(h)(4). 38 The Am. Coll. of Trust and Estate Counsel, What Your Client Really Cares About: Planning for and dealing with their treasured art and collectibles 17 (2015).

12 The Am. Coll. of Trust and Estate Counsel, What Your Client Really Cares About: Planning for and dealing with their treasured art and collectibles 5 (2015).

39 Id.

13 Id. at 7.

41 Nouriel Unplugged, EconoMonitor.com, 2/11/2015.

14 Id. at 13.

42 IRC § 1031(a)(2)(A) (exception for stock in trade held primarily for resale).

15 Clare McAndrew, Fine Art and High Finance: Expert Advice on the Economics of Ownership loc.1306 (2010) (ebook). 16 The Am. Coll. of Trust and Estate Counsel, What Your Client Really Cares About: Planning for and dealing with their treasured art and collectibles 12 (2015). 17 nemona Hartocollis, Despite Court Ruling, Christie’s Pulls Painting From Auction, N.Y. Times, Nov. 8, 2006. 18 Treas. Reg. §§ 1.170A-1(c)(2), 20.2031-6, 25.2512-1. 19 Treas. Reg. § 1.170A-1(c)(1).

40 Dr. Clare McAndrew, TEFAF Maastricht, The Global Art Market, with a focus on the US and China 71 (2014).

43 Treas. Reg. § 1.001-1(a) (gain or loss is realized when property is exchanged for other property differing materially in either kind or extent). See also, Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991). 44 Internal Revenue Service, Artists and Art Galleries Audit Technique Guide, 2012 ARD 03303 (Feb. 15, 2012). This document is not an official pronouncement of the law and cannot be used, cited, or relied upon as such. 45 Northern Trust, Art as an Investment, Wealth Magazine (2013). 46 Rev. Rul. 79-143 (coins); Rev. Rul. 82-166 (bouillon).

20 Treas. Reg. § 25.2512-1. 21 C ommissioner of Internal Revenue, Art Advisory Panel, Ann. Summary Rep. for Fiscal Year 2014 (2015).

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LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their owsn research or for obtaining specific legal or tax advice from their own counsel.

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