I recently had a conversation with Irena Tarsis, the founder and managing director of the Center for Art Law, an independent public charity that is dedicated to writing, gathering, and sharing legal and visual arts information for the benefit of artists, students, lawyers and academics. During our conversation, I inquired as to how the Center was assisting their members and donors, to reduce their income or estate tax on the sale or inheritance of artwork. There are several ways that a donor can use the tax-exempt status of a charity to reduce and defer taxes on transactions. This is especially relevant to artists and their family when it comes to artwork.

The capital gains on artwork is 31.8 per cent rather than the maximum for the sale of real estate, stocks and bonds which is 23.8 per cent . The non-tax costs of selling art can also be daunting – there is the seller’s commission , plus state capital gains tax. This means that sale at auction could result in half of the hammer price going to taxes and fees. 

There are no tax-free exchanges of artwork, unlike real estate investments, but there are some alternatives to defer the payment of the capital gains tax:   

Charitable remainder trusts are the best way to defer paying capital gains tax on appreciated assets, if you can transfer those assets into the trust before they are sold, to generate an income over time.  
 
 When a charitable remainder annuity trust is established, your gift of cash or property is made to an irrevocable trust. The donor retains an annuity from the trust for a specified number of years , or for the life or lives of the non-charitable beneficiaries. At the end of the term, a qualified charity you specify receives the balance of the trust property. 

Gifts made to a CRAT qualify for income and gift tax charitable deductions and, in some cases, an estate tax charitable deduction for the remainder interest gift, if the trust meets the legislative criteria. The annuity paid must either be a specified amount expressed in terms of a dollar amount a fraction, or a percentage of the initial fair market value of the property contributed to the trust . 

You will receive an income tax deduction for the present value of the remainder interest that will ultimately pass to the qualified charity. Government regulations determine this amount, which is essentially calculated by subtracting the present value of the annuity from the fair market value of the property and/or cash placed in the trust. The balance is the amount that the grantor can deduct when the grantor contributes the property to the trust. 
 
A charitable remainder unitrust is similar to a charitable remainder annuity trust except that instead of a fixed dollar amount or percentage of the original gift amount, the annuity is a specific percentage of the balance of the trust assets as of the beginning of the year the payments are to be paid. 

Here is an example of the tax savings using a charitable remainder trust: 

Type of trust: charitable remainder annuity trust
Value of artwork: $1,000,000
Term of annuity: 10 years
Current AFR rate: 5 per cent
Tax savings in the year of the sale: $318,000
Annual payment: $116,554.63
Immediate charitable deduction: $100,000.11

A charitable lead trust is the best way to accelerate charitable deductions to both reduce the negative effects of the new limitations on itemized deductions and to offset up to 50 per cent of your adjusted gross income in any tax year. It can also be used as a way to eliminate gift or estate taxes on transfers to children or other beneficiaries. 
 
Creating a CLAT requires transferring cash or other assets to an irrevocable trust. A charity receives fixed annuity payments from the trust for the number of years you specify. At the end of that term, assets in the trust are transferred to the non-charitable remainder person you specified, when you set up the trust. This person can be anyone, yourself, a spouse, a child or grandchild, even someone who is not related to you. 

You can set up a CLAT during your lifetime or at your death. Both corporations and individuals may establish lead trusts, which is useful when you need to take appreciated assets out of a business tax free. 

If you are the beneficiary, then you will receive an immediate and sizeable income tax deduction. In the second and following years, you must report the income earned by the trust, less the amounts actually paid to the charity in the form of an annuity.

One advantage of the CLAT is the acceleration of the charitable deduction in the year you make the gift, even though the payout is spread out over the term of the CLAT. For example, if you have sold a very highly appreciated asset this year, but you can reasonably expect that in future years, your income will drop considerably, you can have a very high deduction in a high bracket year, even if you have to report that income in lower bracket years. You are able to spread out the income over many years. 

Another advantage of the CLAT is that it allows a "discounted" gift to family members. Under present law, the value of a gift is determined at the time the gift is made. The family member remainder man must wait for the charity's term to expire; therefore, the value of that remainder man’s interest is discounted for the "time cost" of waiting. In other words, the cost of making a gift is lowered because the value of the gift is decreased by the value of the annuity interest donated to charity. 

When the assets in the trust are transferred to the remainder man, any appreciation on the value of the assets is free of either gift or estate taxation in your estate. 

 A charitable lead unitrust trust is similar to a charitable lead annuity trust except that the payout to charity is a percentage of the trust assets at the beginning of the year in which the annuity payments are to be made.    

Here is an example of a CLT for estate taxes

    Donation to the CLAT: $1,000,000
    Term of CLAT: 10 years
    Growth of assets in CLAT: 8 per cent
    Annual payout to charity: $72,999.47
    Remainder passing to your heirs tax free: $1,016,813.00
    Estate tax savings: $400,000

So, if you are an artist, collector or inheritor of art, when it comes time to plan to sell or gift the art, consider using the charitable status of an organization like the Center for Art Law to help defer or avoid the tax.