The CPA Journal

Valuation of Art Objects for Estate Tax Purposes

By Ted D. Englebrecht

In Brief

The Importance of Homework in Valuing Art

Probably more than any other objects of appraisal, artworks and collectibles challenge the appraiser’s craft. Volatile market forces make precise appraisals difficult, and the expertise of the appraiser can be difficult to weigh. IRS revenue procedures, regulations, and other guidance, as well as abundant court cases, provide sufficient guidance to assist anyone who feels uncertain about a field that often relies on obscure connoisseurship at the same time it thrives on media attention and emotion, all of which are important in estate tax situations.

The courts and the IRS do not always agree about the end result, but both expect art valuations to be done by unbiased experts with accepted credentials and documented experience. Research and preparation are no less important in establishing a valuation foundation based on relevant facts.

The valuation of art for estate tax purposes presents unique problems and challenges. The unpredictable nature of the art market, with changing tastes and styles, makes art prices volatile. The art world boomed during the 1970s and 1980s, when contemporary works as well as Impressionists were in favor. Today, record-setting prices may be set for anything from a Van Gogh painting to Jacqueline Onassis’s collection.

Despite fluctuation in the retail art market, the responsibility for placing a fair market value on artworks for estate tax purposes remains with the taxpayer and the IRS. The process may be somewhat subjective, but the end result must be an equitable value.

Background

Property in general—real or personal, tangible or intangible—should be valued at its fair market value at the date of death, or at the alternate valuation date of six months after the decedent’s death as provided by the IRC. Additionally, any interest such as joint or community property must be valued and included in the gross estate. The regulations define fair market value as the price at which “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.”

Because the definitional guidelines provide little assistance in arriving at actual dollar determinations, the IRS has issued additional guidance to assist in the valuation of art for estate tax purposes.

Administrative Stance on Art Objects

Even though art objects, including paintings, sculptures, tapestries, silverware, and other artifacts, are subject to the general valuation rules for estate tax purposes, the valuation process and documentation required depend upon the value of the articles. Specifically, an art object valued at no more than $100 may be grouped with other articles on a room-by-room appraisal, with a separate value given for each item named. An executor is also allowed to submit an aggregate value as appraised by a competent appraiser or dealer.

For articles with artistic or intrinsic value of more than $3,000 or a collection of similar articles valued at more than $10,000, the appraisal must be made under oath by an expert who must also attach a statement of qualifications.

When an art object has a value in excess of $20,000, the valuation is automatically reviewed by the Art Valuation Group (National Office) of the Engineering and Valuation Branch of the IRS for possible audit. When the value is greater than $50,000 and substantiated valuation is desired, the IRS provides a procedure for obtaining this secure art value.

Pursuant to Revenue Procedure 66-49, the IRS would not approve valuations or appraisals prior to the actual filing of the associated tax return and would not otherwise issue any advance rulings approving or disapproving appraisals. Naturally, this led to uncertainty and rendered impossible a taxpayer’s prior determination of the valuation of art property. To address these concerns, and in response to legislation enacted in 1993, the IRS promulgated Revenue Procedure 96-15, which modified Revenue Procedure 66-49 by establishing a procedure for the issuance of a Statement of Value. A taxpayer could rely upon this to substantiate the value of art for income, estate, or gift tax purposes.

Revenue Procedure 96-15 applies only to items of art valued at $50,000 or more that were or will be transferred as charitable contributions, by reason of a decedent’s death or inter vivos gift. In addition, under limited circumstances, the IRS may issue the Statement of Value for items appraised at less than $50,000 if the request includes at least one item appraised at $50,000 or more and the IRS determines that such a statement would be in the best interest of efficient tax administration. The IRS may also decline to issue a Statement of Value if it is in the interest of efficient tax administration not to do so. In such event the IRS must refund the required $2,500 filing fee.

Under section 7 of the Revenue Procedure, the request for a Statement of Value must include the following:

In addition, the appraiser’s taxpayer identification number and that of the appraiser’s employer, if other than the taxpayer, must be provided.

Even though valuation is subjective, this revenue procedure sets forth the IRS’s expectation as to what a proper valuation should address. Regardless of whether the taxpayer will seek a statement of value or accept the IRS’s decision as to its valuation, the appraisal should address and meet all of the IRS’s requirements. By doing so, the credibility of the appraiser and reasonableness of the opinion will be strengthened in the eyes of the IRS and the courts.

IRS Art Advisory Panel

In 1968, the IRS created the Art Advisory Panel to assist in the valuation of major art objects for income, gift, and estate tax purposes. The Art Valuation Group of the Engineering and Valuation Branch of the IRS provides support for the panel.

The Internal Revenue Manual provides that art objects valued by taxpayers at $20,000 or more are to be directed to the National Office for review by the panel. However, due to the large number of cases meeting the criterion, the Art Valuation Group has been forced to select cases for the panel’s consideration and to handle the rest itself.

The Art Advisory Panel is composed of 25 prominent members of the art community, typically museum directors, curators, art directors, art scholars, and art dealers. The IRS appoints the panel members annually, and they are subject to the same confidentiality and disclosure regulations as IRS employees. Except for food and lodging expenses during panel meetings, the IRS does not compensate panel members. Typically, the panel meets semi-annually to discuss and review cases prepared and slated by the Art Valuation Group.

In 1996, the panel reevaluated 171 works that taxpayers had appraised at a total of $15.2 million. The panel found that the collections were worth much more, however: $31.1 million. In 1996, the top estate tax rate was 55%, making the increased taxes on the art works more than $8 million. According to a 1997 Boston Globe story, the IRS had noted that “some families have tried to reduce estates by disparaging their own collections—claiming, for instance, that an authentic Old Master was painted by his ‘school’ or followers.” This drastic reevaluation of the appraisal is not uncommon for the panel: in 1992, the panel’s recommendations resulted in a 56% appraisal increase.

Exhibit 1 summarizes the procedures related to valuing art objects for estate tax purposes.

Judicial Interpretations: Expert Testimony Methods

Estate of Scull. Robert Scull was an avid, long-time collector of pop and minimalist art. At the time of his death, his collection was worth approximately $7 million. However, his estate was entitled to only 65% of the ownership because of a divorce order with his former spouse. It had not been decided who got which pieces of the collection. After Scull’s death, the executor determined the value of the art collection by using several different appraisals of the artwork done in various years by Sotheby’s, the respected and renowned auctioneer of art and other collectibles. The executor used both Sotheby’s appraisals and the median of the high and low values and multiplied them by 65% to reach an estate tax value. Eleven months after the date of death (the chosen valuation date), a number of works were auctioned at Sotheby’s. The amount realized was closer to the high end of the appraisals, and consequently the IRS petitioned that the collection should be valued at the higher value.

During the trial, the judge was required to inspect the volumes of evidence from each side and decide which had the most credible argument and witnesses. The decision (67 TCM 2953-2959) was in favor of the IRS, and the estate was liable for more than $700,000 in additional estate taxes as well as penalties of more than $151,000.

Estate of Lemann. Mildred Lemann left a large amount of jewelry in her estate. The court determined that fair market value of jewelry includable in a decedent’s gross estate was the price at which the items or comparable items would be sold at retail. The judiciary sided with the appraisals by the government’s expert witness because they were based upon comparable auction sales and the appraiser’s experience. The court rejected the estate’s appraisals because they were based on the price a jeweler would pay for the subject jewelry, not comparable sales or retail value. The decision [Mildred Lemann, et al. v. U.S., 94-1 USTC par. 60,159 (E.D. La. 1994)] was therefore in accordance with fair market value as defined in Treasury Regulations section 20.2031-1(b).

Estate of Leslie E. Roberts. Leslie Evan Roberts died testate in New York City on August 27, 1961. The estate reported the total fair market value of several oil paintings, watercolors, and porcelain pieces at $4,775, but the IRS determined these items were worth $8,275.

The estate and the IRS each offered testimony in support of their respective valuations. The executor presented testimony of a professional appraiser with over 30 years of experience. On the other hand, the testimony and opinions of the IRS witness did not establish that the valuations of the estate witness were incorrect or not entitled to due weight. Consequently, the estate’s valuation was sustained (L.E. Roberts, 28 TCM 40).

Estate of E. Trompeter. Emanuel Trompeter, a wealthy entrepreneur and owner of Trompeter Electronics, Inc., died on March 18, 1992. He was a nationally recognized collector of rare coins and had other precious collections of art, artifacts, firearms, gems, jewelry, and music recordings.

In this estate, considerable disagreement occurred over the valuation of preferred stock, art objects, and art objects that were omitted from the estate tax return.

The Tax Court determined that Trompeter’s collection of 191 rare gold coins was worth $7.6 million, not the $3.2 million as listed on the estate tax return or the IRS’s $8.5 million valuation. The court pointed out numerous flaws in the paradigms used in the appraisals by both the estate’s and the IRS’s experts. Consequently, the court valued the coins at the decedent’s pre-death valuation reserve price, which differed from the pre-death auction price by less than 2%.

The Tax Court ruled that the estate had failed to report $4.5 million of assets (art objects, artifacts, etc.) and had undervalued other assets in the estate by $2.7 million. As a result, the court felt that the estate’s conduct was fraudulent and imposed a $14.8 million penalty pursuant to IRC section 6663(a).

When the estate appealed to the U.S. Court of Appeals for the Ninth Circuit, the appellate court determined that the Tax Court had failed to follow the specificity required by the Ninth Circuit in its holding of Leonard Pipeline Contractors (CA-9, 142 F3d 1133). That is, the Tax Court had failed to specify how it arrived at the $4.5 million figure for omitted art objects or to provide a list of such items. On remand, the Tax Court was instructed to provide detailed findings pertaining to the omitted assets and to clarify its valuation methods with respect to the preferred stock.

Judicial Interpretations: Blockage Discounts

Estate of David Smith. When David Smith, a noted sculptor, died in an automobile accident on May 23, 1965, he possessed 425 pieces of sculpture of his creation. This is the first estate case to consider that the collection should not be valued as if it were to be sold in isolation. That is, the Tax Court stated that the retail art market would certainly take into consideration that a large number of the works were being sold at the same time. Specifically, the Tax Court, not wanting to make Smith’s estate endure the consequences of a “forced” sale, allowed a 37% blockage discount, which, essentially, ensured that the estate would not suffer from being forced into the position of an “unwilling” seller.

Many contributing factors enter into this blockage discount, based somewhat on a sense of supply and demand. In the case of Smith [Estate of David Smith v. Comm’r, 57 TC 650 (1972), aff’d 510 F.2d 479 (2nd Cir. 1975)], the court considered the artist’s reputation and whether there was an available and timely market for the works.

Estate of O’Keeffe. At her death, renowned painter Georgia O’Keeffe owned approximately 400 works or groups of art, which her executors valued at $18 million in her estate. This value was derived by applying a 75% blockage discount to the individual appraised values, which totaled nearly $73 million.

The individual values of each of O’Keeffe’s works were derived by agreement between the experts for the IRS and the estate; however, the estate and the IRS went before the Tax Court to determine what the appropriate block discount percentage should be. The expert for the estate recommended a discount of 75%. The IRS argued that the works should be divided into two categories, one category receiving a 10% discount and the other receiving a 37% discount.

The estate, in its testimony, noted the artist’s handling of her works prior to her death. O’Keeffe was very particular about the manner in which her works were sold. She would use only certain dealers and typically imposed contingency conditions on each sale that frequently stipulated that her works could be resold only to her. Despite the wide market for her pieces, these self-imposed restrictions made each sale unique. The estate testified that this technique increased the market value of the works that the decedent handled herself and would therefore decrease the value of works sold by the estate.

The IRS argued instead that these strict conditions served to limit sales of O’Keeffe’s art. Because such a large market existed for her works, it argued that sales without the artist’s restrictions could actually increase both sales and sale proceeds.

The Tax Court’s final opinion rested on several issues. First, the court noted that the experts ignored pertinent facts in the matter of applying a block discount. The judge chose to ignore the flawed expert opinions of both sides, stating that neither had given valid proof of its position.

The Tax Court determined that the collection should be divided into two specialized categories, those works that could be sold in a relatively short period of time and those that could not. The final opinion (Estate of Georgia T. O’Keeffe v. Comm’r, 63 TCM 2699) was that half the approximately $72 million collection would be granted a 75% discount, and the other half was discounted only 25% because of its immediate salability. The collection was subsequently determined to be worth $36.4 million for estate tax purposes.

Estate of Warhol At the time of his death on February 22, 1987, Andy Warhol owned more than 28,000 paintings, drawings, and prints and more than 66,000 photographs that were considered part of his artistic oeuvre.

The largest impact on the valuation of Warhol’s art came from a legal dispute over fees. The valuation proceeding took place in New York County Surrogate’s Court as part of a case brought by Edward Hayes, for counsel fees based on 2% of the gross estate. Hayes’ experts estimated the value of Warhol’s artworks at $708 million to $800 million. Hayes claimed a fee of approximately $16 million, which was opposed by the Andy Warhol Foundation for the Visual Arts as the sole residuary beneficiary of the estate.

The foundation agreed that the artwork should be subjected to a blockage discount of 60% to 75%. The foundation retained Christie Appraisals, Inc., which derived a value of $265 million for the collection.

The court was not swayed by the experts from either side, and determined [In re Warhol Estate, No. 824/87, unpub. opin. (N.Y. County Surrogate’s Court 4/14/94)] a total value of $391 million for the artwork based on different blockage discounts than the opposing experts had used.

Good accounting records of average pre-death sales may prove invaluable in justifying a sizable block discount. Exhibit 2 shows a summary of instructive judicial decisions.

The Role of Appraisers

Although the IRS has adopted standards and requirements for appraisals, the valuation of art remains very subjective and depends largely upon the persuasive opinions of experts. As such, this area is prone to litigation. There is often a wide disparity between the values asserted by the taxpayer and the IRS, and a review of the cases above demonstrates that this is frequently attributable to the taxpayer taking poorly researched positions, failing to carefully select a qualified appraiser, or submitting appraisals that do not satisfy administrative requirements. In such circumstances, the court may disregard the appraisal or afford it little weight. The result can be a waste of the appraisal, accounting, and legal fees, and a disappointing result.

The best-known appraisal societies are the American Society of Appraisers (www.appraisers.org), founded in 1905, and the Appraisers Association of America, Inc. (www.appraisersassoc.org), founded in 1949. Both organizations train, test, and certify appraisers, and mandate compliance with ethical rules and standards.

The following issues are important when selecting or recommending a particular appraiser:

Bias. Bias or interest can destroy an appraiser’s objectivity and undercut her credibility and the weight that the IRS or the courts give to an appraisal. Courts are particularly sensitive to “hired guns” and will punish a litigant accordingly. In Peters v. Comm’r (36 TCM 552), the taxpayer valued a painting at $78,000 and the IRS valued the same painting at between $5,800 to $8,000. The court adopted the upper end of the IRS’s range ($8,000), and in so doing rejected the testimony of the taxpayer’s witnesses because they were business or personal associates of the taxpayer. In Furstenberg and Sheridan v. U.S. (595 F2d 603), the U.S. Court of Claims gave little weight to the expert testimony of an appraiser who had been a long-time friend and business associate of the taxpayer.

Similarly, in Wiltshire v. Comm’r (40 TCM 493), the Tax Court rejected the opinions of experts who had extensive dealings with the taxpayer and who had a year earlier sold the donated property to the taxpayer for the value asserted by the IRS.

Specialty and experience. The best appraiser for a particular engagement is a specialist with experience in the item or collection being appraised. In Isbell v. Comm’r (44 TCM 1143), the court discounted the testimony of the taxpayer’s appraiser because, although he was an expert with regard to interior furnishings, he did not specialize in Chinese art. The court placed little weight upon the taxpayer’s opinion. On the other hand, the IRS’s experts were specialists in Chinese art and so persuasive that the court adopted the IRS’s position of value.

An example of a taxpayer’s appropriate selection of an appraiser is found in Biagiotti v. Comm’r (52 TCM 588). The court accepted the taxpayer’s specialist in pre-Columbian art, who worked in a gallery and relied upon comparable sales from his and other galleries. Another illustration of selecting the appropriate appraiser is seen in Roberts, above. In this case, the taxpayer’s appraiser was experienced at buying and selling various works of art. He used valid methods of appraisal that were found to be more reliable than the IRS’s methods. The court also noted that the IRS appraiser’s valuation was based mainly on hearsay and could not be considered valid.

Undervaluation Penalties

When a court determines the value assigned by a taxpayer to art objects in an estate to be too low, the court may impose a penalty in addition to the regular penalty for the late payment of estate tax. As provided for by IRC sections 6662(a) and (g), this penalty is applied only if the value assigned by the estate is less than or equal to 50% of the correct value determined by the court. The penalty will not apply when the misstated value is less than or equal to $5,000.

The rate of the penalty applied to the deficient tax value is normally 20%, but IRC section 6662(g)(2)(C) provides that the rate may be doubled where only 25% or less of the correct value of the art is shown on the estate or gift tax return.

In addition to the penalty for understatement of art objects in the gross estate, the court may assess a fraud penalty if it determines that the taxpayer intentionally misvalued the property. In these situations, IRC section 6663 states the burden of proof is on the taxpayer to show the portion of the value not attributable to fraud. Because these penalties can be quite punitive (see Trumpeter), they should act as sobering influences.

Ted D. Englebrecht, PhD, is Smolin-ski Eminent Scholar Chair at the School of Professional Accountancy, College of Administration & Business, at Louisiana Tech University, Ruston, La.