Case of the Week

Case:

Bill Russell grew up on the Great Plains. During his youth, he was a rodeo bull rider and gained fame as "Wild Bill" for his daring exploits. But Wild Bill was an artist at heart and soon decided to move on to artistic pursuits. He traveled throughout America and Europe and studied all of the great modern and classical artists. In France, he was greatly moved by the delicate works of Impressionist painters Monet and Manet and the bold colors and brush strokes of Van Gogh. Upon his return to his beloved Great Plains of the west, Wild Bill combined the subtlety of the Impressionists, the colors of Van Gogh and his own unique skills. His Impressionist western landscapes, paintings of cowboys and depictions of life on the ranch became treasured by art collectors nationwide.

Question:

Wild Bill was rapidly gaining a national reputation. His western Impressionist art exhibits would draw art lovers from America and the world. He was selling his paintings for $75,000 or more and, as a result, was facing a much higher income tax bill. Wild Bill called his CPA Helen Swenson and said that he thought there must be a better way. Could Helen find a way for Wild Bill to sell his paintings tax free? After talking to the gift planner at the Cowboy Western Museum, Helen called Wild Bill and exclaimed, "I found the answer. We can sell your paintings tax free!"

Solution:

Helen explained the benefits of giving Wild Bill's paintings to a charitable remainder unitrust. Generally, the unitrust will use either a net income plus makeup or a FLIP structured payout. If a FLIP unitrust is selected, the trigger event for the FLIP would be the sale of the art. The FLIP trust would operate as a net income plus makeup unitrust until the art is sold. On January 1, following the sale, the FLIP trust would then become a standard unitrust and begin making the stated trust percentage payouts to Wild Bill.

When art is transferred to a charitable remainder trust, there are specific rules that limit the deduction. First, there is no charitable deduction for a future interest in tangible personal property. The deduction applies only after all "intervening interests" have expired. Sec. 170(a)(3). Therefore, when art is transferred to a charitable remainder unitrust, there is no charitable deduction at that time. However, if the art is then sold by the trust, the charitable deduction is available in the year of the sale. After the art has been sold and cash has been received by the trust, the intervening interest in the tangible personal property expires. Reg. 1.170A-5(a)(1).

Wild Bill Russell will not generate a substantial charitable deduction with a gift of his own art. When Wild Bill creates a work of art, that property is considered work created in "the ordinary course of trade or business." Therefore, his artwork would be deemed ordinary income property. Reg. 1.170A-4(b)(1). If an ordinary income asset is placed into a FLIP trust, there is a proportionate deduction only for the gifted portion of the artist's cost basis. Sec. 170(e)(1).

In order to calculate the charitable deduction, both of the above rules must be applied. This calculation will be different from that of a unitrust funded with cash or public stock, since the valuation date is deferred under the "intervening interest" rule. Each transfer to a charitable trust must be valued on a "valuation date." Sec. 7520(d). For Bill's gift of art to the unitrust, the value is first reduced from fair market value to cost basis. However, there still must be a valuation, since a charitable deduction is permitted at cost basis only if the fair market value is equal to or greater than cost basis.

When the asset is sold, the intervening interest has terminated and the valuation date is set. The charitable deduction will be the appropriate factor times the lesser of cost basis or fair market value. The required Applicable Federal Rate (AFR) will be the rate for the month of that valuation date or either of the prior two months. Sec. 7520(a)(2). The highest rate will produce the largest deduction.

Because Bill's cost basis consists of only the cost of the paint and canvas in his paintings, he will receive a small deduction. But his primary goal is to sell the paintings tax free. Bill decided to use the unitrust to sell half of the paintings he creates each year. "Wow," he thought. "I cut my income in half and saved enough taxes to feed my horse Trigger for years. This is the best deal around!"

Bill was able to fund the unitrust with a painting. As each painting sold, he continued to add new paintings to his unitrust. In time, Wild Bill had over $1 million in value in his unitrust.