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Rather than selling a work of art and reinvesting the after-tax proceeds into investments that will generate income, philanthropically motivated collectors can instead transfer a work of art to a charitable remainder trust (CRT). By donating artwork to a CRT (and having the CRT trustee sell the artwork), the donor usually retains an income stream, incrementally pays capital gains tax over the term of the CRT (28% long-term rate for collectibles), generates an up-front income tax deduction and benefits their favorite charity at the CRT’s termination.
CRT Basics
A CRT is a form of split-interest trust, wherein the taxpayer transfers an asset to a CRT, retains an income stream for a set term (up to 20 years or for life) and gives the remainder of the trust’s assets (that is, after donor’s income stream expires) to one or more qualified charities.
The two basic types of CRTs are: (1) charitable remainder annuity trusts (CRATs); and (2) charitable remainder unitrusts (CRUTs). A CRAT must pay the donor a specific amount each year, called the “annuity amount,” either as a stated sum or a percentage of the initial value of the trust’s assets. A CRUT pays a specific percentage to the donor based on the annual fair market value (FMV) of the CRUT’s asset(s), which can fluctuate year-to-year. If the underlying assets increase in value, so too do the annual payments to the donor. The opposite is also true: If the CRUT’s assets decline in following years, so will the annual income stream to the donor.
There’s only one type of CRAT, but there are actually four different types of CRUTs: (1) a standard CRUT; (2) a flip-CRUT; (3) a net-income CRUT (NICRUT); and (4) a net-income with make-up CRUT (NIMCRUT). While the differences among these CRUTs are beyond the scope of this paper, donors are generally advised to choose a flip-CRUT, NICRUT or NIMCRUT when art is used to fund the trust, because these CRUTs aren’t required to pay the donor a unitrust payment until the CRT actually sells the donated artwork.
CRTs Funded With Art
Unlike most other charitable donations for $250 or more, there’s no requirement that CRT donors receive a contemporaneous written acknowledgment of their gift from either the CRT trustee or the qualified charity remainderman. That’s because in many cases, CRT donors reserve the right in their last will and testament to change the charitable remainder beneficiary. In recognition that any named charity in a CRT document might be changed by the donor’s last will, the Internal Revenue Service has exempted the substantiation requirements for donations to CRTs.
What’s crucial to understand is that you must address special considerations if you intend to donate (tangible) art to a CRT, which aren’t relevant when donating appreciated publicly traded stock to a CRT. First, as set forth in IRS Publication 561, the donor must receive a qualified appraisal of the artwork within 60 days of the donation, or the IRS can deny the donor’s deduction (despite being based on tax basis). In this same publication, the IRS has laid out rules as to who can serve as a “qualified appraiser” and what the valuation report must show to be considered a “qualified appraisal.”
Remember that the CRT trustee must sell the donated art to raise the cash necessary to make the required annual income payments to the donor. This means that there should be a reasonable expectation that the trustee will be able to monetize the art once it’s been transferred to the CRT. It would therefore be prudent to explore market conditions before transferring art to a CRT, because a CRT holding art that can’t be sold would be of no benefit.
If a potential buyer can be identified before funding, the owner must make sure that the purchaser is under no legal obligation to purchase the artwork from the CRT before funding to avoid the CRT’s capital gains from being assigned back to the owner under Palmer v Commissioner.1
Works by artists who’ve traded at a fine art auction within the last five years would generally make excellent candidates for a CRT strategy. Works by emerging artists with no auction history or who don’t have works that are actively traded on an online art marketplace would be poor candidates because the CRT trustee may not be able to locate a buyer.
A contemporaneous donation of cash or marketable securities is well advised whenever donating illiquid fine art to a CRT, because the trust may have to hold the art for a period of time before being able to sell it. After the transfer, the CRT trustee will take possession of the art. As owner of the artwork, the CRT trustee will be responsible for paying ongoing carrying costs until the artwork can be sold (for example, restoration, storage, property and casualty insurance). Therefore, practitioners often suggest also transferring cash to the CRT to cover these ongoing expenses.
It’s currently the IRS’ position that a donor may only claim a charitable deduction based on the tangible personal property’s tax basis rather than its FMV. In Private Letter Ruling 9452026 (Sept. 29, 1994), the IRS was asked to make several rulings on the tax treatment of funding a CRAT with a musical instrument. Regarding the timing of the donor’s deduction, the IRS maintained:
Because the musical instrument is tangible personal property, section 170(a)(3) of the Code prevents any deduction for the remainder interest so long as Taxpayer retains an income interest in the musical instrument. However, an income tax deduction would be allowed under section 170(a)(3) when the trustee sells the musical instrument. When the musical instrument is sold, Taxpayer no longer retains an intervening interest in the tangible personal property as contemplated under section 170(a)(3), that is, Taxpayer is only holding an income interest in the sale proceeds from the musical instrument.
In addition to there being a potential timing issue with the deduction, it’s been the IRS’ long-standing position under Internal Revenue Code Section 170(e)(1)(B)(i) that a CRT can never meet the related-use rule for contributions of tangible personal property because the CRT must sell the artwork to make the annual payments to the donor, and the sale would violate the doctrine of related use. The IRS applied this rationale in PLR 9452026 to reduce the taxpayer’s deduction accordingly.
There are some practitioners who’ve suggested that if the income tax deduction must be postponed under IRC Section 170(a)(3), the determination of the “type” of property that’s donated (that is, tangible property versus cash) to the CRT should also be suspended and determined in the year the trustee sells the artwork, so the donor is said to have contributed cash and can claim a deduction based on the cash amount.
The only case to discuss funding a CRT with tangible personal property is Furrer v. Comm’r.2In Furrer, the donors contributed ordinary income property to a CRT, which the trustee then sold in the year of contribution. The IRS denied the donors’ claim that they were eligible to deduct FMV because they didn’t contribute a long-term capital asset. The IRS didn’t have to rely on the related-use rule to conclude the taxpayers’ deduction was limited to tax basis. Also, because the trustee sold the contributed property in the year of donation, the IRS wasn’t asked to re-examine the delayed deduction issues under Section 170(a)(3).
Example: Carla, age 70, purchased a work of art from a dealer 10 years ago for $200,000. Since that time, the artist’s works have soared at auctions and now fetch $1 million or more per piece. Carla is slowly culling down her collection in hopes of bequeathing her most important works, as a group, to her favorite museum. As part of the culling process, she intends to sell some pieces outright, but she intends to use this piece of art to fund a flip-CRUT.
If she funded a flip-CRUT in January 2023 with a work of art that had an FMV of $1 million, her up-front tax deduction would be based on a portion of her $200,000 tax basis, and she’ll only be able to deduct up to $105,764 on her 2023 federal income tax return. By contrast, had she funded with cash or marketable securities worth $1 million, her up-front charitable income tax deduction would have been as much as $528,820. It’s for this reason collectors tend to fund CRUTs with works or art that have a relatively high tax basis.
Taxation of Income Stream
The trustee of a CRT must report distributions of trust income to the beneficiaries on Schedule K-1 (Form 1041). Distributions from a CRT to the donor are taxable in the following order:
- Ordinary income: Payments are considered ordinary income first to the extent the trust had ordinary income for the year and undistributed ordinary income from prior years. If the trust has enough ordinary income to cover all payments, the entire payments are taxed as ordinary income.
- Capital gains: Once the trust’s ordinary income is exhausted, payments are taxed as capital gains based on the sale or disposition to the extent of the capital gains of the trust for the current year and any undistributed capital gains income from prior years.
- Other income: Once all ordinary income and capital gains in the trust are fully distributed, payments are characterized as other income to the extent of the trust’s current year and accumulated other income. This includes tax-exempt income.
- Corpus: After all current year and accumulated income and gains are fully distributed, payments would be considered corpus or principal of the trust not subject to tax.
With each CRT distribution, the four-tier system would cause distributions to first flush out 35% ordinary income, then 15% qualified dividends, then 35% short-term capital gains, then 28% capital gains from sale of art/collectibles, then other taxable income, then tax-free income and finally a return of principal.
Other Strategies
Finally, there are other strategies to monetize your art collection if a CRT exit strategy doesn’t appeal to you. For example, collectors often use their collections to obtain so-called “art loans” and then use the proceeds for whatever purposes they want. An art loan allows the appreciated art to remain in the collector’s estate and should qualify the artwork for a stepped-up tax basis at the collector’s death. Heirs could then immediately sell the collection without incurring capital gains, or they might transfer a work of art to a CRT, be able to claim an income tax deduction based on estate tax FMVs (that is, such value will be the work’s new tax basis) and generate an income stream.
Endnotes
1. Palmer v. Commissioner, 62 T.C. 684 (1974), aff’d on other grounds, 523 F.2d 1308 (8th Cir. 1975).
2. Furrer v. Comm’r, T.C. Memo. 2022-100 (Sept. 28, 2022).