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Friday December 2, 2016

Case of the Week

Wild Bill Russell's "Artistic" Unitrust

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 his artistic pursuits. He traveled throughout America and Europe and studied all of the great modern and classical artists. In France he was greatly impressed 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 and paintings of cowboys and 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 finally selling his paintings for $75,000 or more, and now had another new experience — paying large income taxes. Bill called his CPA Helen Swenson and said that he thought there must be a better way. Could she find a way for Wild Bill to sell his paintings tax-free? After talking to her friend the gift planner at the Cowboy Western Museum, Helen called Wild Bill and exclaimed, "I found the answer. We can indeed sell tax-free!"

Solution:

Helen explained to Wild Bill the benefits of giving his paintings to a charitable remainder unitrust. Generally, the unitrust will use either a net income plus makeup or a FLIP formula payout. If a FLIP unitrust is selected, the trigger event for the FLIP would be the sale of the art. The FLIP trust will be a net income trust until the art is sold. On the following January 1, the FLIP trust may then become a straight unitrust.

When art is transferred to a charitable remainder trust, there are two 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 received by the trust, the intervening interest in the tangible personal property has expired. Reg. 1.170A-5(a)(1).

The second rule also operates to reduce the charitable deduction from fair market value to cost basis, assuming that FMV exceeds cost basis. Even after the art is sold and the intervening interest has terminated, there still has been a transfer of tangible personal property for unrelated use. Therefore, the charitable deduction is the cost basis of the property times the remainder factor. Reg. 1.170A-5(b)(7).

In order to calculate the charitable deduction, both of the above rules, plus the rules for selecting the Applicable Federal Rate (AFR), 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 a gift of art to a unitrust, the value is first reduced from fair market value to cost basis under the unrelated use rule. 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.

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

Because Bill has only the cost of the paint and canvas in his paintings, he will receive only 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 now have 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. In time, Wild Bill had over $1 million in value in his unitrust.

Published November 25, 2016
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