Structuring the Joint of Ownership of Art in New York

Q: My friend and I want to buy art together and share ownership. What is the best way to do it?

A: There are three basic ways to structure the ownership of art by two or more parties:

• an informal tenancy-in-common (TIC);
• a written TIC agreement; or
• ownership through an entity.

They each have advantages and disadvantages, which are discussed below. In general, we recommend holding jointly owned art through an entity, instead of through an unwritten “partnership”.

Please note that the discussion below is of a general nature only and does not constitute specific legal advice. Structuring and documenting the joint ownership of art can involve the analysis of applicable corporate, tax and commercial factors as they apply to the specific facts and circumstances. This requires the advice of experienced legal and tax advisers.

Tenants-in-common

Q: My friend and I think of ourselves as “partners”. What does that mean?

A: If there is no written partnership agreement between you, it probably means that you are tenants-in-common. In general, if two or more parties want to buy and hold art together but fail or neglect to agree on the terms and conditions of joint ownership, under New York law the parties will by default own the work as tenants-in-common. This is the result when dealers or collectors co-purchase the work and hold it as informal “partners”.

Q: We would prefer to keep things simple. What are the risks of holding art through an unwritten “partnership” or co-investment in a work of art?

A: This will result in a TIC and is bound to end in dispute if you and your friend disagree about the disposition of the work or of your separate TIC interests in the art that you buy together.

In an example, the executor of the estate of a recently deceased artist discovered that the artist had funded 50% of the repurchase of two of his own paintings that had been bought at auction by his dealer, who was the buyer of record. The estate needed the money and wished to separate from the dealer, so it demanded that the dealer consent to the marketing and sale of the co-owned paintings. The dealer refused to do so, presumably in the hope that the market for the artist’s work would rise in the future. The only documentation was the invoices showing that the dealer had bought the co-owned paintings in the dealer’s name, and financial records showing that the artist had funded 50% of the purchase price.

In light of the impasse, the estate’s counsel advised that, under New York law, the co-owned works were held by the estate and the dealer as tenants-in-common. Thus, either party could sell its own 50% interest; either party could block the sale of the paintings as a whole; and either party could sue for dissolution. Neither co-owner was the other’s agent and neither had actual or apparent authority to market and sell the paintings. In essence, each party had a blocking position and veto over the disposition of the paintings. This was a bad outcome for the estate and a good one for the dealer (although the dealer lacked clients for the painting and could only hope that the auction market would eventually rise).

The impasse was only resolved when the estate purchased the dealer’s TIC interests in the context of an overall settlement and separation, after threatening litigation that would have alleged various contract and tort claims common to disputes between artists and dealers.

In sum, although an unwritten partnership in paintings is a common approach in the art market, its flaws become apparent if and when the parties disagree on the marketing and disposition of the jointly held artwork or their separate TIC interests in the art. Thus, the legal consequences of being a tenant-in-common can be advantageous or disadvantageous depending on your posture and goals. In the case of the artist’s estate, it was the worst outcome because the estate had no alternative but to threaten litigation to force a settlement.

Q: The TIC discussion above assumes that New York State law governs the relationship between the parties. How do I know whether New York law will govern the relationship between me and my partner?

A: “Conflicts of Law” or “Choice of Law” is the body of law under which courts determine whether the laws of a particular jurisdiction (such as New York State or England & Wales) govern the relationship between different parties or a transaction or dispute between them. Conflicts of law is a complex field that is beyond the scope of this discussion; for these purposes, it is enough to say that courts generally test the weight or balance of the “contacts” that the parties and the transaction have to a particular jurisdiction and the interest that the jurisdiction has in applying its law to the matter.

For example, if two parties and a jointly owned painting are all located in New York State, New York law will probably govern a dispute between the parties over the painting. On the other hand, some years ago a London dealer described a series of informal but related arrangements between various dealers and collectors in the US and UK. That would have required a complicated conflicts of law analysis to determine the law(s) governing any dispute if a conflict arose at some link in the chain.

Tenancy-in-common agreement

Q:My friend and I don’t want to form an entity to hold our jointly owned art, but we are willing to document our TIC relationship. What will this involve?

A: A TIC agreement must address the issues and contingencies arising between two investors to govern the ownership and disposition of jointly owned art assets. In particular, the TIC agreement will govern the mechanics of the acquisition, holding, marketing and sale of the work, and state the parties’ respective rights and responsibilities.

A related investment memorandum can govern the fundamental economic relationship between the co-owners in terms of initial and subsequent investments, funding, capital calls, dilution, economic and tax allocations and distributions, in a manner analogous to the capital contributions and distributions and returns of capital governed by a limited partnership or LLC agreement.

One advantage of this structure is that it may allow the joint owners to borrow separately against their respective TIC interests in the artwork, although that may require their respective lenders to negotiate an intercreditor agreement stating the lenders’ rights to the TIC interests if either borrower defaults.

The TIC agreement is the opposite of an unwritten TIC, as described above. It requires time and effort to craft what may initially be a custom-tailored arrangement. It substitutes a bespoke, bilateral contractual relationship for the structure that is largely available at law if the art is held through an entity.

Ownership through an entity

Q: What kind of entities are commonly used to hold art?

A: Six types of entity can be used to acquire, hold and dispose of art assets. Note that an entity can be as small as a corporation with a single shareholder or a limited liability company with a single member, or as large as a quasi-public limited partnership with dozens of members. The following is a thumbnail summary of entities commonly used in the United States.

C and S corporations

The shareholders own the shares of stock in the corporation and elect the directors, who have overall responsibility for managing the business and affairs of the corporation and electing the officers. The officers manage the day-to-day operations of the corporation in accordance with the responsibilities of their office stated in the by-laws.

The governing documents include a certificate of incorporation and the by-laws. If the corporation has multiple shareholders, a shareholders' agreement often addresses voting agreements for the election of directors, requirements for supermajority approval of fundamental corporate transactions, restrictions on transfers of stock, puts/calls, dissolution on deadlock, etc.

General partnerships

Unlike a TIC, a general partnership is a legal entity that owns the art assets itself, and the economics and tax attributes are passed through to the general partners.Unless varied by agreement, each general partner has the actual authority to bind the partnership with third parties. This can be a dangerous feature unless the partners specifically agree on who can bind the partnership.

Limited partnerships

Under the limited partnership agreement, a general partner manages the business and affairs of the partnership, and the limited partners are essentially passive investors with reporting and accounting rights.

Limited liability companies

The operating agreementfunctions as a combination of the certificate of incorporation, the by-laws and the shareholders' agreement.The members hold the equity (membership interests) and the managers function as the directors or general partners in charge of the LLC’s overall management and day-to-day operations.

Trusts

Trusts have their own pros and cons compared to the company structures discussed above. Two issues arise.

• First, the relationship between the estate of an artist or collector and a trust created to hold, administer and dispose of the art assets, and the dynamics and tensions between the executor of the estate and the trustees of the trust, need to be considered as part of an overall plan.
• Second, consider whether the trustees are suited by age, temperament and skill set to carry forward the artist’s or collector’s legacy for decades after death. Were they appointed out of a sense of personal loyalty, friendship or obligation or because they are well suited to advance the goals of the trust?

Family-owned entities

Limited partnerships, LLCs and trusts are all often used as a vehicle for family ownership because they permit fractional ownership, serial transfers of fractional ownership and inter-generational transfers and sophisticated tax planning.

Concerns common to all entities

State law governs

An entity is governed by the laws of the state under which it is formed.As a consequence, the governing statute will often provide a resolution for issues that are not expressly or clearly addressed in the governing documents.Delaware is often the jurisdiction of choice for formation among sophisticated parties because of its well-developed body of corporate law and sophisticated courts that handle a high volume of complex business litigation.

Limited liability

All entities other than a general partnership generally provide equity holders with limited liability from claims against the entity (unless there is confusion between the individual investors and the corporate shell, and the formalities distinguishing them are not observed and the corporate “veil is pierced”, thereby exposing the investors to claims directly). Owning art through an entity rather than individually is safer if a claim arises from a defect in the art asset, such as title, import/export, authenticity, attribution, condition, etc. If the artwork is “wrong”, the investors are better off if an entity holds the art because the entity will be sued and not the individual equity holders, and the equity holders will generally have no personal exposure beyond their committed capital.

Double taxation v pass-through tax

C corporations are taxable at the entity level, and shareholders pay a second tax on dividends. By contrast, S corporations, partnerships and LLCs are “pass-through” entities where the equity holders but not the company are taxed and so avoid the penalty of double taxation.

Art investment entities are commonly structured as LLCs or LPs

Most art investment entities are structured as a limited partnership or a limited liability company. The investors will generally invest as limited partners or as a class of members in an LLC with limited voting and management rights. The general partner or manager will be a separate entity controlled by the sponsors and will make a small capital contribution to the company.

The limited partnership or LLC agreement will provide for the management and operation of the fund vehicle and the rights, preferences, powers and priorities of the various classes of investors, including:

• the payment of fees and expenses to the general partner or manager; and
• a waterfall of operating and liquidating distributions of net profits first to the partners as a return of capital (with the limited partners having a priority return over the general partner) and then a split of residual net profits – often 80% to the limited partners and 20% to the general partners (subject to negotiated exceptions in respect of priority and preferences and potential claw-backs of amounts previously distributed).

A separate management company, managed by the specialists or art advisers to the company, will make the investment decisions by which the company will buy and sell art.The management company may charge the company a management fee, which is in addition to the general partner’s or manager’s returns under the limited partnership or LLC agreement.

Securities law concerns

Limited partnerships and LLCs can be appropriate vehicles for larger investments with numerous investors. However, that raises federal and state securities law issues governing the offering of the LP or membership interests, disclosure issues regarding the business plan, and risk factors relating to the portfolio assets and features of the company, which are beyond the scope of this discussion. Consensual agreements among a limited number of investors – essentially family and friends with a pre-existing relationship – do not generally constitute a private offering of securities and do not trigger securities law concerns, such as offering documents and filings such as Form D and State Blue Sky filings. An entity with more than ten investors or wide solicitations to third parties triggers those concerns.

Estate and gift tax concerns

Estate and gift tax considerations, or other tax concerns, may determine the choice of entity or structure of holding. For example, the ownership of an LLC by multiple members of the same family may raise concerns under charitable contribution rules governing gifts by the LLC.

Pros and cons of joint ownership through an unwritten TIC, a TIC agreement or an entity

Q: Which form of joint ownership is best for me?

A: Depending on your goals, the value of the art and your tolerance for legal fees, we would generally advise against an unwritten TIC, as the potential for dispute and the consequences of a dispute between the owners are too great. Between forming an entity and crafting a TIC agreement, our preference is generally for holding the art through a jointly owned entity.

In an example, an individual wanted to form a de facto partnership with two other investors to bid on a seven-figure object at auction and, if successful, to hold and dispose of the object. The investors were recommended to invest through an LLC for purposes of simplicity and limited liability, but the individual refused, so a contract addressing all the phases of bidding, owning, holding and selling had to be drawn up – essentially a TIC agreement. The exercise would have been much easier if the investors had simply created an LLC with three managers with majority voting and proportionate allocations and distributions for economic and tax purposes.

In sum, entity ownership can be less complicated than creating a TIC structure with a bespoke document package because the rights and responsibilities of equity owners and management are already defined by the applicable state law governing domestic corporations, general and limited partnerships and limited liability companies.