When Jim Wallace died, he left $600,000 of his estate tax-free to his children, and the balance of his property to his wife, Sarah. This estate was valued at $7 million, including $2 million worth of stock in the small company he owned, a house valued at $1 million, artwork valued at $2 million, and other personal property.
At Sarah's death 12 years later, her estate must pay estate taxes at graduated rates peaking at 55 percent of the estate's valuation. To raise this cash, her executor determines that the artwork must be sold. But a soft art market brings in only $1.5 million. Even the sale of the house may not provide enough to pay the total tax bill, leaving the company stock vulnerable to a forced sale and the Wallace heirs' ownership of the family business in jeopardy.
This is another case of inadequate estate planning—fictional but highly possible. All too often a family business owner's assets never reach his or her heirs as intended. Yet there are creative treatments of certain estate elements—particularly tangible assets—that can mitigate the tax impact. These assets can include artwork, antiques, jewelry, or other collectibles.
What could the Wallace family have done differently? Several things.
Either Jim or Sarah could have placed the artwork in a Grantor Retained Income Trust (GRIT) and continued to enjoy its esthetic value. A GRIT is a special kind of irrevocable trust in which tangible assets may be placed as a completed gift. If Sarah created a GRIT for a certain duration, say 10 years, and transferred ownership of the artwork to it, she would be able to keep them on her wall and enjoy them for that length of time.
When Sarah dies 12 years later, the heirs will pay tax on the remainder of her estate. Ownership of the paintings will have passed to her children at the end of the 10-year trust term, however, so they are not part of her estate and her estate tax bill is proportionately reduced.
A gift tax is due at the time the paintings are transferred to the trust, but the tax is on the value of the paintings less the value of 10 years of Sarah's continued use. The value of the paintings has been discounted by putting it in the trust. In this case, the $2 million of artwork would be worth approximately $550,000 for gift tax purposes. Applying Sarah's $600,000 unified credit to the transaction eliminates the gift tax libility. The result is the transfer of $2 million in artwork free of any Federal gift tax.
Another strategy that can be used to moderate taxes on tangible assets is to give the property away now and remove its appreciation from your estate. If you give a $200,000 painting to your child, the value for gift tax purposes will be $200,000. Under the federal transfer-tax structure, when you die, say, 20 years from now, everything you have gifted and what you have in your estate will be gathered back for a final tally. And what will come back into that tally is the historical value of the gift, $200,000 of artwork back in 1994, 20 years before your death.
What never comes back into this computation is the appreciation on that painting which at your death may be worth two, three or more times its original value. So for valuable assets you hope to keep in your family, consider giving them away now.
One final example of creative planning for the transfer of tangible objects is the CRUT, the Charitable Remainder Unitrust. This is an intriguing concept for people who have valuable assets with which they can part and who have charitable intent either now or through their estates.
In this case, an asset such as a painting is put into the Charitable Remainder Unitrust for your favorite charity. An independent trustee, like Bankers Trust, may then sell the asset if it deems a sale necessary and proper in order to meet the objectives of the trust. If you sell the painting yourself, you will get hit with a capital gains tax. However, the sale has occurred in the Charitable Remainder Unitrust, a type of trust that benefits from a unique tax treatment.The capital gains that are realized at the painting's sale are not taxed.
The Charitable Remainder Unitrust is designed to pay the donor a percentage of the trust value each year. When you create this trust, you might elect to be paid 5 percent of its value annually. In order to meet this objective, your trustee decides to sell the artwork, diversifies its investment, and creates a balanced portfolio producing enough income to meet the 5 percent payout obligation. Every year you will get 5 percent of the trust value.
The trust you have established for the charity is much bigger than if you had sold the assets on your own, because the capital gains tax has not been paid. Plus, your assets are now income-producing. The art work is no longer around for you to enjoy, but you have additional income.
As an added advantage, there is an income tax charitable deduction because, ultimately, the assets in the Charitable Remainder Unitrust are going to charity. The concept is the same as the Grantor Retained Income Trust. The fact that you have retained an interest for a number of years has an actuarial value, and that value is subtracted from the value of the asset. The IRS looks at that discounted amount and then, based on your age, calculates the present value of the gift that will eventually go to your charity. And then, in an unusual display of generosity, the IRS grants you an income tax charitable deduction for that present value eventually passing to charity.
One final piece of advice in planning your estate is to consider appointing a family member or trusted friend to be co-trustee with your fiduciary institution. Some institutions charge extra for co-trusteeship, so inquire at your bank. Co-trusteeship assures that the heirs are represented by both a knowledgeable, professional organization and someone close to family matters and concerns. When required, this person can make discretionary decisions affecting the heirs, giving the corporate trustee a single point of contact in the family and freeing the corporate trustee to concentrate on professional sevices such as money management and investmentment.
Remember that wealth in the form of tangible items is often accumulated over a number of years, masking its value. Your paintings, antiques, or other collectibles should be considered as carefully as the other elements of your estate. With proper planning, these objects can work for your enjoyment now and for your heirs in the future.
Michael J.A. Smith is a certified trust and financial advisor with 23 years of experience in estate and trust administration. He is vice-president for private advisory services at Bankers Trust Company, New York.