Art Dealers—Wealth Transfer Considerations

By Michael Duffy

Michael Duffy is Managing Director at Merrill Lynch Private Wealth Management. He may be reached at mduffy2@ml.com.

ART DEALERS— Wealth Transfer Considerations

I have read dozens of excellent treatises and articles on the tax and wealth planning considerations that trust and estate lawyers should keep in mind when working with artists, art collectors, and art investors. But I don’t recall any articles that focus exclusively on planning for art, antiques, and collectibles dealers. Although this article will focus on fine art dealers and fine art gallery owners (hereinafter described for convenience as “dealers”), the general concepts highlighted below are generally applicable to antiques and collectibles dealers as well.

A dealer’s plan should address what to do with the fine art business assets:

• transfer some or all of the business to heirs during the dealer’s lifetime

• sell the business during the dealer’s lifetime

• transfer the business to heirs at death

• sell the business at the dealer’s death

• liquidate the business at the dealer’s death

Perhaps the dearth of written materials is a natural result of so few dealers having taxable estates. Despite what a casual observer might assume by reading stories of dealers selling works of art for prices that end in seven zeros, the fine art dealer space is mostly made up of businesses that have relatively modest sales volumes. When Dr. Clare McAndrew, Founder of Art Economics and Dr. Taylor Whitten-Brown (PhD Sociology, Duke University) polled thousands of dealers (795 of whom responded) for The Art Market ]2021, An Art and UBS Report (2021) (available at https://bit.ly/3G3xLsC), they found that 64 percent of the respondents had annual sales of less than $1 million, which included 38 percent with annual sales of less than $250,000. Only 6 percent of the dealers reported having annual sales of greater than $10 million.

The entire dealer ecosystem and the ability to compete have been severely disrupted in recent years due to the proliferation of art fairs, auction houses serving as art dealers, and the explosion of online fine-art sales platforms. Now comes a global pandemic, which has crimped sales for the majority of dealers around the world, according to the 2021 report.

The Art Dealers Association of America (ADAA) currently has nearly 190 member galleries in over 30 cities. See generally artdealers.org. Even if the actual number of dealers in the United States was 20 or 30 times the ADAA’s membership roster, because of the current estate tax exemption and the availability of certain advanced estate planning solutions, the vast majority of these dealers’ estates will not owe any estate tax. According to the IRS, in 2019 there were over 2.8 million deaths in the United States, but only 6,409 estates were large enough to file an IRS Form 706, Federal Estate (and Generation Skipping Transfer) Tax Return. And of those returns, only 2,570 remitted any estate tax. Said another way, only .09 percent of adult deaths in 2019 triggered estate tax. There is no reason to think that annual deaths among dealers in the United States would trigger a substantially different amount of estate tax returns.

Taste in Art Changes—So Too Tax Laws

Note, however, that if the current 2021 estate tax exclusion amount of $11.7 million is reduced to $5 million (adjusted for inflation) in 2026 under the so-called sunset provisions of the 2017 Tax Cuts and Jobs Act (TCJA), or lowered sooner by Congress as proposed in the September 13, 2021 tax plan issued by the House Ways and Means Committee (the “2021 Tax Proposal”), the number of art dealers with taxable estates would increase—and perhaps substantially. Thus, even modestly successful dealers should consider advanced estate planning that can reduce or eliminate estate taxes under most scenarios.

Whether a dealer anticipates having a taxable estate or not, as a closely held business owner, a dealer is welladvised to be thoughtful and deliberate with his planning. If the goal is to pass his business to heirs, then in addition to tax and trust planning, it is advisable to also incorporate management succession planning solutions into the mix.

At a minimum, all dealers should have a basic suite of estate planning documents in place that speak at their incapacity or death. These documents usually include a last will and testament, revocable trust, durable powers of attorney, and health care directives. Although these documents are crucial in disposing of one’s person or assets, they do not reduce estate tax. The best that a last will and testament or a revocable trust can do is postpone an estate tax event until the last to die of the dealer and the dealer’s spouse. For dealers who anticipate having a taxable estate (now or in the future), there are only three strategies that can reduce an estate below whatever estate tax exemption exits at an estate tax event: personal consumption, charitable donations or bequests, and lifetime transfers to heirs.

If the dealership is co-owned with other stakeholders, then additional factors must be considered, like stakeholder agreements, bylaws (or similar governance documents), and buy-sell agreements.

If the goal is to pass the operating business to heirs, there are a number of lifetime gift strategies that should be considered. The sooner, the better in order to transfer appreciation out of the dealer’s gross estate.

As of the writing of this article, the current transfer planning environment and tax laws are extremely favorable. To wit, the lifetime gift exemption and estate tax exemption amounts are at all-time highs; applicable federal rates (AFRs) are near all-time lows; valuation discounts for closely held businesses are currently permitted; short-term grantor retained annuity trusts (GRATs) can be designed with little or no gift tax; a properly funded dynasty trust is not subject to an automatic transfer tax every 20, 25, or 90 years; appreciated assets receive a step-up tax basis at death; and it is possible to structure completed gift trusts wherein the settlor is treated as the taxpayer for income tax purposes (i.e., intentionally defective grantor trusts (IDGTs)). The most recent draft of the revised framework for the Build Back Better Act would not disrupt or limit any of the aforementioned wealth transfer solutions.

Before 2018, it was common for practitioners to engage in lifetime freeze transactions but refrain from using a taxpayer’s available gift tax exemption in order to preserve the exemption for the client’s estate. But the TCJA changed the basic calculus of estate planning for larger estates by giving taxpayers until December 31, 2025, to use the newly expanded exemption amount. The case for using the exemptions before 2026 was arguably strengthened in 2019 when Treasury issued its “anti” claw-back regulation, which clarified that if a donor took advantage of the increased exemption amount and the exemption was later lowered in 2026, there would be no claw-back.

Paint-by-Numbers: Estate Planning for Taxable Estates

Because of the favorable planning factors mentioned above, many estate planning pundits have referred to this moment in time as the “use it or lose it estate planning opportunity of a lifetime” for persons with a net worth as low as $5 million ($10 million if they are married) (indexed for inflation). They are flipping the 2017 script by recommending that clients soak up their unused remaining lifetime gift exemption before engaging in freezes. In 2021 the “order of things” for larger estates might be summarized as follows:

• First, soak up the temporarily increased lifetime gift tax exemption with completed (discounted) gifts and IDGTs [e.g., dynasty trusts, spousal lifetime access trusts (SLATs), irrevocable life insurance trusts (ILITs), qualified personal residence trusts (QRPTs), etc.].

• Next, consider “freezing” some or all of the taxpayer’s remaining taxable estate by having IDGTs purchase additional assets from the taxpayer in return for promissory notes.

• Next, consider freezing some or all of the taxpayer’s estate with GRAT solutions.

• Next, consider making taxable gifts in 2021 at an effective gift tax rate of 28.875 percent versus an effective estate tax of 40 percent (or higher if Congress increases the estate tax rate in the future). Yes, the donee will take a carryover basis on the gifted assets, but if the donee intends to keep the business, having a low tax basis becomes perhaps moot from a transfer tax perspective. Paying gift tax versus estate tax basically saves one-third on transfer taxes.

• Finally, consider acquiring life insurance within an ILIT that could provide the estate with liquidity to pay whatever estate taxes might be triggered despite the dealer using some or all of the advanced strategies mentioned above.

Dealer—IRS Classification

The IRS classifies people in the art world into four categories: artists, collectors, investors, and dealers, based upon that person’s conduct as it relates to a work of art. Each IRS category has its own unique set of tax rules. It is possible for an individual to wear all four hats and experience different tax results based upon that taxpayer’s particular conduct with respect to a piece of art. But each art-related endeavor must fall under one discrete set of tax rules, so it’s crucial that dealers keep accurate and complete business as well as personal records. If a dealer is ever challenged by the IRS, remember that the dealer has the burden of proof to demonstrate that he was not a collector or an investor. A lack of thorough records might lead to unwanted tax results. The IRS’s 2012 Art Galleries—Audit Technique Guide (https://www.irs.gov/pub/irs-utl/ artgalleries.pdf) lays out a roadmap for dealers as to what the IRS considers when examining the activities of dealers.

Federal Tax Rules for Art Dealers

Chart available in the publication. that highlights some of the important federal tax rules for art dealers:

Dealer—Functional Definition

Art dealers essentially come in two forms: those with “bricks and mortar” and those with no physical presence. Some dealers own the works that they are attempting to resell, but the vast majority of dealers simply sell works of art as an agent under a consignment agreement. Only a small fraction of dealers offer so-called blue-chip material, which generally means that they offer works from artists who are highly recognizable or by artists who have had works recently sell at fine art auctions. The vast majority of these blue-chip dealers are reselling works. Only a small number of these art dealers function as so-called primary dealers, in which case they sell art that is coming to the market for the first time, directly from the artist’s studio.

Non–Tax Planning Considerations

As with any closely held business, art dealers need to consider whether the business should be sold or liquidated before their death, sold or liquidated at their death, or passed on to heirs. If a dealer’s heirs are not interested in the business or don’t know much about it or the art market ecosystem, it might make sense for the dealer to monetize the business before the dealer passes away, the assumption being that the dealer should be able to find a bona fide buyer more easily, and negotiate better terms for the sale, than an uninformed or uninterested heir might be able to.

There are two key competing income tax concepts that must be weighed when monetizing a closely-held business during a dealer’s lifetime. First, under current law, an entity sale would generate federal LTCG tax at a rate of only 20 percent (plus 3.8 percent surtax under the Affordable Care Act). Second, under current law, if the dealer holds the entity until death, the entity is entitled to a step-up in tax basis under IRC § 1014. If a dealer’s entity is a partnership, or an LLC treated as a partnership, the partnership might be eligible to make an IRC § 754 election to step up the inside basis of the entity’s assets to match the entity’s outside basis.

If the goal is to pass the operating business down to their heirs, dealers are advised to consider a number of factors that focus on management succession considerations, like:

• Has the dealer asked the heirs if they actually want the business?

• Are the heirs familiar with the artists that the dealer sells, the dealer’s inventory, and the business’s consignment model?

• Do the heirs understand the art market industry?

• Does the business have a written mission statement?

• Has the dealer trained the heirs to run the business?

• Are there any key employees or nonfamily advisors who are critical to the future success of the business?

• Will the heirs have to relocate in order to run the business?

• Will some heirs hold voting interests yet others hold nonvoting interests?

• Should a dealer give away some or all of the dealer’s interests in the business during the dealer’s life?

After the Paints Have Been Put Away—Post-Mortem Planning

Even after engaging in advanced lifetime transfer tax planning to reduce their taxable estates, if a dealer still ends up with a taxable estate and his art dealer businesses constitute at least 35 percent of the decedent’s gross estate, the dealer’s executor can make an IRC § 6166 election to defer some or all of the estate tax for up to 14 years. Under IRC § 6166, interest only can be paid to the IRS during the first four years of the loan, and then the estate must go on a 10-year repayment plan with equal principal payments plus interest. If the deceased dealer owned several art-related businesses with at least a 20 percent ownership stake, the executor can combine the value of those endeavors to meet the 35 percent threshold for IRC § 6166 relief.

In addition to considering IRC § 6166 relief for a dealer’s taxable estate, the executor might also be able to reduce the gross taxable estate due by borrowing some or all of the money needed to pay estate tax to avoid a forced liquidation of assets. IRC § 2053(a)(2) permits an estate to deduct the costs actually and necessarily incurred that are associated with the collection of assets, payment of debts (e.g., estate tax), and distribution of property. This section of the Code allows an executor to reduce the value of the estate by deducting the future interest payments of the loan without first having to discount such interest payments to reflect their present value based on the AFRs in effect at the time of the loan. Such lending solutions, which are intended to provide liquidity and lower estate taxes, have become known as “Graegin loans,” after the 1988 Tax Court case that has become the seminal IRC § 2053 case that subsequent courts continue to consider (Estate of Graegin v. Comm’r, 56 T.C.M. (CCH) 387 (1988)).

The lender of a Graegin-type loan can be a commercial bank, friend, family member, or family entity. Loans from commercial banks can be somewhat difficult to obtain because the premise for asking for the loan is that the business is already strapped for cash, given the estate tax liability. Commercial lenders will want a clear path to repayment. Most will require the executor to demonstrate that the business will have sufficient future cash flow to retire the debt. Commercial lenders will require the estate, and sometimes the heirs, to post collateral in which the bank has a priority interest. Most commercial lenders will only consider short-term loan solutions for Graegin loans that will have to be renegotiated every couple of years.

In the rare event that a dealer has a taxable estate, it may be possible to claim a blockage discount on some or all of the dealer’s inventory when appraising the dealer’s business for estate tax purposes.

Finally, it should be noted that an art dealer’s executor may face unique tail-risks when it comes to closing an estate. Dealers’ estates can be subject to a whole host of future claims by artists and patrons who might assert that the artist never got paid by the dealer, the work that was sold was not authentic (i.e., it was forged), the work had clouded title, the work was never delivered, the work that was delivered was not the item that purchasers agreed to purchase, etc. So, even if no estate taxes are due, an executor may wish to hold back a certain amount of assets in reserve for several years until the statute of limitations has run on potential claims.

Published in Probate & Property, Volume 36, No 1 © 2022 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.