Valuing Artwork for Federal Taxation Purposes: Income, Estate & Gift Tax Issues1
Introduction
Valuing artwork is inherently subjective. Appraisers can
rely on objective factors to value artwork, such as comparable
sales of similar pieces, but, clearly, two different appraisers can
arrive at different values. There may also be a variety
of subjective factors that affect the value an owner ascribes to a
particular work of art, whether it is because the work is a family
heirloom or because the work was recovered from the Nazis. On
top of all this, the tax rules often motivate owners to overvalue
or undervalue property, including artwork.
The Internal Revenue Code of 1986, as amended (the
"Code"), and the Treasury Regulations thereunder,
establish a labyrinth of rules and requirements regarding the
taxpayer's burden to substantiate the value of property stated
on a tax return. For federal tax purposes, the importance of
valuing property is apparent in three common scenarios: (1) when an
owner donates property to a charitable organization and wishes to
claim a charitable contribution deduction under Section 170, (2)
when a decedent's gross estate is valued for the purpose of
calculating the estate tax, and (3) when a donor is subject to the
gift tax under Section 2501.
The Code incentivizes taxpayers to choose a higher valuation for
artwork in the case of a charitable contribution and a lower
valuation in the case of the estate or gift tax. What is an
owner to do if one appraiser values a work at $25 million, while
another values it at $30 million? Considering that the
highest individual income tax rate is currently 39.6% and the
highest estate and gift tax rate is 40%, a taxpayer's
preference for a low-side or high-side valuation of artwork may
affect his tax liability by millions of dollars.
The tax law makes clear that the taxpayer has the burden of
substantiating the value of the property. To this end, a
taxpayer must not only comply with the procedural requirements for
valuation, but must also persuade the trier of fact that his
claimed valuation is correct.
What Is "Fair-Market Value" for Federal Tax Purposes?
The Treasury Regulations define "fair market value" as
"the price at which the property would change hands between a
willing buyer and a willing seller, neither being under any
compulsion to buy or sell and both having reasonable knowledge of
relevant facts."2 Although this "willing
buyer" and "willing seller" approach appears
workable, the parties involved in a donation or gift, for example,
are not forced to agree on a negotiated value the way an actual
buyer and seller are. Accordingly, the only obstacle to using
a particular valuation for artwork is often the Internal Revenue
Service (the "IRS"), combined with the potential for
penalties and interest in the case of a misstatement of
value.
In an effort to assist taxpayers in valuing artwork, the IRS
established the Art Appraisal Services division (the
"AAS"). Prior to submitting an income, gift, or
estate tax return, a taxpayer can request that the AAS provide a
Statement of Value in which the IRS values the artwork for the
taxpayer. A taxpayer must submit such a request to the AAS
prior to filing the tax return that first reports the transfer of
the item.3
After receiving a Statement of Value from the IRS, the taxpayer
must attach a copy of it to his income, gift, or estate tax
return. A taxpayer who disagrees with the IRS's Statement
of Value may submit with the tax return additional information in
support of a different value. A taxpayer who submits a return
prior to receiving the Statement of Value must indicate on the
return that a Statement of Value has been requested and attach a
copy of the request to the return. In such a case, upon receipt of
the Statement of Value, the taxpayer must file an amended income or
gift tax return, or a supplemental estate tax return, with the
Statement of Value attached.
Pursuant to the Federal Advisory Committee Act, the Art Advisory
Panel (the "Panel") was created in 1968 to assist the AAS
in appraising works of art valued at $50,000 or more. The
Panel's members are museum directors and curators, art dealers,
and auction representatives so that differing views as to fair
market value are provided. When a tax return selected for
audit includes an art appraisal valued at $50,000 or more, the
local IRS office refers the case to the AAS and orders a subsequent
referral to the Panel when applicable. The Panel's
recommendations are advisory. The AAS staff reviews all of the
Panel's recommendations, which become the position of the IRS
only with the AAS's concurrence. For Fiscal Year
("FY") 2012, the AAS adopted, in full, 96.5% of the
Panel's recommendations, and adopted the rest in part.
The Panel also reviews and evaluates the acceptability of property
appraisals submitted by taxpayers in support of the fair market
value claimed on works of art involved in federal income, estate,
or gift taxes. In March 2014, the IRS renewed the Panel's
charter for two years, explaining that the Panel serves the
public's interest.
The Panel reviews appraisals without knowledge of whether the
taxpayer is better served by a high valuation for a charitable
contribution or a low valuation for estate or gift tax
purposes. In its Annual Summary Report for FY 2012, released
on January 23, 2013, the Panel reported that it recommended
accepting 51% of all art appraisals it reviewed for FY 2012 and
proposed adjustments to the remaining 49%. During FY 2012, the
Panel completed its review of 444 items with an aggregate taxpayer
valuation of $281,859,200 on 43 taxpayer cases under audit. The
average claimed value of a charitable contribution was $613,684,
and the average claimed value of an estate and gift tax item was
$628,890. The Panel recommended total net adjustments of
$66,066,800, a net 52% reduction on the charitable contribution
appraisals and a net 47% increase on items in estate and gift tax
appraisals.
Charitable Contributions Pursuant to Section 170
There are several rules that a taxpayer must be aware of when
claiming a charitable contribution deduction for a donation of art
to a charity. Section 170(a)(1) generally allows taxpayers to
claim as a deduction any charitable contribution made during the
taxable year. Generally, the amount of the deduction is equal
to the amount of money or the fair market value of the property
contributed, determined at the time of the donation. However,
the deduction must be reduced by the amount of gain that would not
have been long-term capital gain if the property contributed had
been sold by the taxpayer at its fair market value. For
example, if a taxpayer purchases artwork for $100,000 on January 1,
2001, then donates the artwork to a charity on December 31, 2001,
when the property is valued at $300,000, the charitable
contribution is limited to $100,000, determined as follows:
$300,000 fair market value minus $200,000 non-long-term
capital gain. Alternatively, if the taxpayer waits until January 2,
2002 to donate the artwork, the "non-long-term capital
gain" limitation would not apply and the deduction would be
$300,000, the artwork's fair market value.
The provisions of Section 170(f)(11) impose reporting obligations
on taxpayers who claim charitable contribution deductions valued at
more than $500. When the claimed donation is valued over $500
but under $5,000, the taxpayer needs to complete Section A of Form
8283 in order to provide the IRS with a description of the donated
property and certain other required information. When the
claimed donation is over $5,000, the taxpayer needs to attach a
"qualified appraisal" to his tax return and complete
Section B of Form 8283, known as the "Appraisal Summary."
The Treasury Regulations contain numerous requirements for a
"qualified appraisal" and for the definition of a
"qualified appraiser."4 The donee has no
obligation to confirm or otherwise validate the donor's claimed
valuation. For example, in 2004, the Smithsonian had no
obligation to value the musical instruments it received from
Herbert Axelrod, who claimed a tax deduction for $50 million on the
donation. In 2005, Axelrod was sentenced to 18 months in jail
for unrelated tax fraud.
Selected Valuation and Donation Cases
One of the most fascinating valuation disputes in recent memory
involved the Estate of Ileana Sonnabend and Robert
Rauschenberg's "Canyon." For estate tax
purposes, the taxpayer valued "Canyon" at $0 because the
collage contained a stuffed bald eagle, which meant the sale of the
work would have been illegal under federal law and could have
resulted in imprisonment for the seller.5 The IRS,
however, following the advice of the Panel, valued
"Canyon" at $65 million and assessed a $29.2 million
estate tax, plus $11.7 million in penalties. The IRS reasoned
that someone may have wanted to purchase "Canyon" on the
black market. In late November 2012,
the parties settled the tax dispute. The heirs agreed to
donate the work to the Museum of Modern Art in exchange for the IRS
dropping its deficiency claim. The heirs also agreed not to claim a
charitable contribution deduction with respect to the
donation.
A 2011 decision by the 11th Circuit highlights the problem when
courts must decide between two different "reasonable"
valuations. In U.S. v. Reinhard, 107 A.F.T.R.2d
2011-355, (11th Cir. 2011), the defendant failed to include certain
sculptures in his bankruptcy estate in 2006. To measure the
estate's loss as a result of such failure, the government
argued that the sculptures should be valued at $40,000 each, based
on a 2004 appraisal. The defendant, however, argued
that a 2007 auction price of $24,000 more accurately reflected the
value of the sculptures in 2006. Although the court
acknowledged that "there is something to be said for" the
defendant's argument, it determined that the lower court's
acceptance of the higher 2004 appraisal was not clear error and was
therefore affirmed.
In Williams, III v. Comm'r, 110 A.F.T.R. 2d 2012-6904
(4th Cir. 2012), aff'g, T.C.M. 2011-89 (Apr. 21,
2011), the tax court had to determine the date on which the
taxpayer acquired artwork for the purposes of determining whether
he owned the work for more than one year. The taxpayer had
executed an "Art Purchase Agreement" that required him to
pay 5% at signing, with the balance due at the time of the
charitable contribution. The total amount payable by the
taxpayer to the seller was limited to 24% of the artwork's fair
market value at the time of the donation. The Tax Court
found, and the 4th Circuit affirmed, that the "Art Purchase
Agreement" did not grant taxpayer ownership of the artwork
because, in substance, the agreement provided only an option to
purchase artwork in the future. The Court determined that the
taxpayer did not acquire the artwork until the time of the
deduction. Accordingly, under Section 170(e)(1)(A), the
taxpayer's deduction was limited to his basis because he did
not own the work for more than a year. The Williams
decision indicates that courts will consider the substance of the
transaction before allowing a taxpayer's charitable
contribution deduction. Id. at 2012-6912 (quoting U.S.
v. Heller, 866 F.2d 1336, 1341 (11th Cir. 1989) "Federal
tax law disregards transactions lacking an economic purpose which
are undertaken only to generate a tax savings. Federal
tax law is concerned with the economic substance of the
transaction under scrutiny and not the form by which it is
masked.").
Conclusion
The value of a particular work of art depends on various
objective and subjective factors, which often lead to varying
opinions as to the work's fair market value. The AAS and
the Panel serve important roles in the administration of the tax
laws by reducing some of the uncertainty and subjectivity of
valuations, particularly in cases where a taxpayer may be
stretching the boundaries of reasonableness.
Combining the difficulty of valuing artwork with the Code's
incentives and complexity is a recipe for constant tax
litigation. As highlighted in the discussion of recent case
law, applying the tax law to art valuation issues is often
extremely difficult. For example, although the IRS may have
been unreasonable to value "Canyon" at $65 million, the
IRS was not unreasonable to argue that the work had some
value. In cases where a particular work of art may have a
reasonable range of value, the taxpayer is likely to claim the
value that is most tax favorable to him. The IRS is then
forced to challenge the claimed valuations in an effort to protect
tax revenues and prevent abuses, such as in
Williams.
In deciding how to value a work of art for U.S. tax purposes, a
taxpayer must consider all the various rules and procedural
requirements. Appraisers and other experts may assist
taxpayers in arriving at a reasonable valuation to use on tax
returns; however, taxpayers may not blindly rely on such
experts. As a guiding principle, taxpayers should always
consider the price that a "willing buyer" would pay for
the property reported on a tax return. ?
Footnotes
1 IRS Circular 230 Disclosure: To ensure
compliance with Treasury Department regulations, we inform you that
any U.S. federal tax advice contained in this document (including
any attachments) was not intended or written to be used, and cannot
be used, for the purpose of (i) avoiding penalties that may be
imposed under the U.S. Internal Revenue Code or (ii) promoting,
marketing, or recommending to another party any transaction or
matter addressed herein.
2 E.g., Treas. Reg. 1.170A-1(c)(2) (for
charitable contributions); Treas. Reg. 20.2031-1(b) (for estate tax
purposes); Treas. Reg. 25.2512-1 (for gift tax purposes).
3 The request must include the following: (1) a copy
of an appraisal of the item of art; (2) a check or money order
payable to the IRS in the amount of $2,500 for a request for a
Statement of Value for one, two, or three items of art, plus $250
for each additional item of art for which a Statement of Value is
requested; (3) a completed appraisal summary (Section B of Form
8283, Noncash Charitable Contributions); and (4) the location of
the District Office that has or will have examination jurisdiction
over the return. See Rev. Proc. 96-15, 1996-1 CB 627,
12/28/1995.
4 See Treas. Reg. 1.170A-13(c)(3) and
(5).
5 The Estate reportedly paid $471 million in state and
federal estate taxes even with a $0 valuation for
"Canyon."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.