Valuing Artwork for Federal Taxation Purposes: Income, Estate & Gift Tax Issues¹May 2014 – Art & Advocacy, Volume 17
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.").
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.
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."