Modern estate plans in the United States, especially among the very wealthy, often involve the creation of long-term irrevocable trusts to hold assets for current and future beneficiaries. Among their many benefits, such trusts can keep trust assets out of the beneficiaries’ taxable estates and also protect them from their judgment creditors.
In the United States, wealth transfer planning using trusts has become so ubiquitous among wealthy families that heirs face the reality of not inheriting assets directly anymore, but rather inheriting trust structures that hold assets for them. Occasionally, such trusts are funded with tangible personal property like fine art and collectibles. These assets present unique challenges for trustees to manage, especially in light of a trustee’s duties to exercise prudence and loyalty.
This article will highlight key administrative provisions that might be appropriate to include when designing irrevocable trusts to hold and manage art and collectibles over multiple generations.
Before the introduction of the Prudent Investor Rule in 1992, if a trust document was silent as to a particular investment, trustees were essentially limited to holding and making investment decisions under the concept of the Prudent Person Rule, which looked at each distinct investment on its own, without regard to its relationship with other trust investments. The rule favored income-producing stocks and bonds. The rule banned certain investments entirely. Under the Prudent Person Rule, trustees were essentially limited to blue-chip stocks, investment-grade municipal bonds, government bonds, commercial trust funds, and certificates of deposit. Alternative investments such as private equity, hedge funds, and fine art holdings would have violated the rule and exposed a trustee to personal liability from actions brought by that trust’s beneficiaries.
Today, most states have adopted some version of the Uniform Prudent Investor Act (the Act), which permits trustees to hold, invest, and sell any type of asset, as long as that asset’s potential investment return, income, liquidity, and volatility profiles make sense from an overall modern portfolio management viewpoint. See Uniform Prudent Investor Act, available at https://tinyurl.com/mr232zd8.
Even under the Act, however, trustees are generally required to diversify concentrated investments and resist investing in and holding illiquid assets. That creates an inherent conundrum for any trustee who is being asked to administer a trust that holds art and collectibles, which by their very nature are extremely illiquid, volatile, non-income-producing, hard to value, expensive to maintain, and subject to fraud (e.g., fakes), and have exceptionally high transactional costs when compared to listed stocks and bonds.
Because trustees are often sued by trust beneficiaries for failing to fulfill their duty to invest prudently, it may be impossible to find a qualified person or professional trust company that is willing to serve as trustee if you do not provide the trustee with clear written authority to acquire, hold, or exchange art assets.
In order to allay a trustee’s reservations about serving, consider including the following provisions in your trust:
To exacerbate the illiquidity problem, extracting money another way, through an art loan, can be even more challenging. Most lenders consider making loans only against “blue-chip” works that have recently sold at auction. Good luck finding a bank to lend you money against a painting that you purchased in a local gallery. Lenders want to know that if the loan has to be foreclosed, there is a clear path to liquidity … which means the auction markets.
Because of art’s illiquid nature from both the sale and the loan perspectives, trustees normally want to see language in the document that recognizes these issues and allows the trustee to explicitly hold and invest in illiquid investments like art and collectibles.
Permit Trustee to Retain All Tangible Personal Property with No Duty to Monitor Such Property’s Investment Performance. There are no listed art exchanges, and it is estimated that one-half of art sales worldwide happen in private transactions that go unrecorded. This makes it impossible to monitor the fair market value of a work of art, and thus reporting a trust’s investment performance to beneficiaries is a challenge. In recognition of the poor and inaccurate pricing inherent in the art market ecosystem, most prudent investors would refrain from making an investment in something with a value that cannot be monitored. Thus, you should consider adding language that allows the trustee to hold art and collectibles and relieves the trustee from the duty to regularly obtain pricing information.
Add “Art and Collectibles” to the Nonexclusive List of Permissible Trust Investments. Some trusts merely state that the trustee has the power to invest in “any” asset. Other trusts will refer the trustee to the applicable state statute and the trustee powers set forth therein, while others offer readers a nonexclusive list of permissible investments.
In order to allay any concerns that art and collectibles are not an appropriate holding, your document might include a nonexclusive list that specifically identifies art and collectibles as potentially suitable investments. Corporate trustees in particular prefer to have specific references in the document as to permissible investments rather than a general power to invest in anything. And because it is reasonable to expect that most long-term trusts might need a corporate trustee sometime in the future, you should consider adding art and collectibles to the investment list.
Include So-Called Directed Trust Language That Could Give an Art Investment Advisor the Right to Direct the Trust to Acquire or Sell a Work of Art. This provision is particularly important if you anticipate that a corporate trustee might ever be asked to serve in the future. Corporate trustees are generally ill-prepared to hold and manage art. They regularly refuse to take on trusts that hold unique assets, unless the trusts are formed in states that permit a third party to direct them to hold, buy, and sell the unique asset, thereby eliminating the trustee’s potential personal liability for doing so. These trusts are called “directed trusts” and generally require that the trust document specifically mention the state’s directed trust statute and the trust director or advisor’s powers, compensation, and successors.
Authorize Trustee to Lend Artworks to Museums. When a work of art is not being personally enjoyed by a trust beneficiary, the trustee may have an opportunity to lend it to a museum exhibition rather than place it in storage. All of the carrying costs associated with maintaining a work on loan are normally paid for by the museum; furthermore, having a work appear in an exhibit that is well-received by the public can help drive up the price if the work is later sold.
Authorize Trustee to Pledge Art to Borrow Money. Trusts that hold art will incur ongoing expenses that are unique to this type of asset. Annual expenses generally range from 1percent to 3 percent of the fair market value of the entire collection and can include property and casualty insurance, storage, moving and handling, appraisals, art advisors, and conservators. If a trustee does not have sufficient resources to pay the trust’s ongoing expenses, it might be helpful to explicitly allow the trustee to engage in art loan transactions to obtain the needed liquidity.
Authorize Trustee to Sell Art. In order to pay for ongoing administration expenses, and to account for unforeseen circumstances in the future, your trustee might be given the sole and absolute discretion to liquidate a work of art, or the entire trust’s collection, in the best interests of the beneficiaries. For example, a trust that is established for a beneficiary will not serve its intended purposes if that beneficiary dies because they could not afford medical treatment. In a situation where a beneficiary is gravely ill and in need of money to pay for treatment, many settlors would make it clear in the trust agreement that the trustee can sell works to raise the needed capital and can exhaust all of it on behalf of the ill beneficiary.
Authorize Trustee to Lend Art to Beneficiaries. There should be express language in the trust document that allows the trustee to temporarily part with the art’s possession and allow it to be held by a beneficiary without the loan violating the trustee’s duty to preserve trust assets.
You might also include protective language that provides that the trustee has no duty to inspect the art when it is being used by a beneficiary and that the trustee is not liable for damages or destruction while in possession of the beneficiary.
Authorize Trustee to Donate Works to Charity. If the irrevocable trust document is silent as to charitable donations of cash or property (e.g., art), the trustee will not be able to make such donations, even if requested to do so by the trust’s beneficiaries. Since nobody can know the future and whether it might make sense in the future for the trust to donate a work, many settlors will authorize the trustee to make such donations in the trustee’s sole discretion.
It is worth noting that trust beneficiaries (usually by majority vote) are often given the right, through a special power of appointment, to appoint some or all of the art and collectibles to charity during their lifetime or at their death.
Authorize Trustee to Hire Art Agents. If the purpose of a trust is to hold, preserve, and manage fine art for beneficiaries, we suggest that you consider adding discrete language in the trust document that specifically allows the trustee to hire art-world agents, including but not limited to art advisors, curators, archivists, auction house specialists, dealers, art historians, forensic art specialists, conservation experts, provenance experts, gallerists, and appraisers.
Authorize Trustee to File UCC Statement. To protect a consignor’s interest in a work of art from a successful judgment creditor of a dealer, gallery, or auction house, consignors are encouraged to file a UCC Financing Statement at the appropriate courthouse before they consign. These filings become part of the public record and are generally easy to search. Because trustees also have a duty to keep the trust’s business private, some trustees may not want to make a public filing of this type without express permission set forth in your trust document.
Authorize Trustee to Form Separate Limited Liability Companies in which to Hold Art. Trusts that are designed to be long-term multigenerational trusts often split into separate shares for beneficiaries at designated trigger points, such as when the donor’s youngest child attains the age of 21 or when a beneficiary passes away. The purpose of dividing a multigenerational trust is to allow a trust to be managed and administered differently for each branch of the settlor’s family. However, this common and ubiquitous way of splitting up trusts for future generations presents a problem for art and collectibles since these assets are usually heterogeneous and not fungible and cannot be divided. One solution might be to allow the trustee to hold art through an LLC. When the trust is divided into further trusts at trigger dates, those resulting new trusts can hold pro-rata fractional interests in the underlying art by owning a pro-rata portion of the LLC.
Holding tangible personal property, like art and collectibles, inside multigenerational trusts presents unique challenges for any trustee. As set forth above, many of these challenges can be addressed in the administrative and investment provisions of the trust document. Art assets are inherently “clunky” assets for a trustee to hold for any length of time because such assets produce no income, have substantial overhead costs, and are not fungible.
As to this last point, consideration should be given as to how the underlying art can be shared among beneficiaries when multiple generations are expected. For example, if parents have three children and they each have three children, there could be a time when there are 12 living adult beneficiaries who might qualify to borrow a work of art. It would be impractical and expensive and may expose the art to damage if it were transferred to each beneficiary for one month. It might also be seen as unfair by some beneficiaries to rotate possession among them every 12 months if there are not enough pieces to be lent to every beneficiary on day one. This “sharing” problem will only get worse in multigenerational trusts as each new generation of trust beneficiaries comes into being. For this reason, it is always advisable to give your art advisors the sole and absolute discretion to sell the underlying art if it becomes impractical to administer the trust to the number of beneficiaries.
