For those attending the 2013 National Conference of the Appraisers Association of America in New York last week (Nov. 8-10), the announcement that Basquiat surviving sisters are suing the IRS rings familiar. After all, the conference organizers built in a lot of IRS material into the program, including “Current Issues at the IRS”, “De-mystifying the IRS:Preparing a Successful Report for Tax Purposes,” “Recent Complex Art and Tax Law Cases,” and “Blockage Discount: A Primer.” To recap, for tax purposes, value of art may or may not depend on the Fair Market Value of the object depending on whether the valuation is being done for the artist or the collector, for charitable contribution purposes or estate appraisal. For example, if a living artist decided to donate his art, he may only deduct the cost of paints, brushes and canvas regardless of the fact that his or her works sell for significantly larger sums in the primary and secondary market. Works appraised in excess of $3,000 need to have comparables included in the valuation. Depending on the appraisal, the pieces of art work may be referred to the IRS Art Appraisal Services team for audit of the evaluation. Depending on their findings, the appraisal is accepted, adjusted in part or rejected. Taxpayers may appeal the determination, in which case the same team, but a different appraiser on the IRS payroll, advises the IRS Appeals Officer on the case and the weaknesses of both sides to determine the hazards of litigating or settling a particular appeal. Taxpayers dissatisfied with the appeal process may proceed to litigation in the Unite States Tax Court. Incidentally, pursuant to IRS Internal Revenue Manual, the Service may penalize appraisers for promoting abusive tax shelters or aiding and abetting understatement of tax liability. See Sec. 18.104.22.168.
In April 2014, the US Tax Court will hear the case brought by Lisane and Jeanine Basquiat, sisters of the famous artist Jean-Michel Basquiat, on the grounds that the Service overvalued the artist’s estate. Jean-Michel died in 1988 at the age of 28. For decades the his estate was administered by his father, Gerard Basquiat. Gerard, who died in July 2013, brought the initial complaint. As reported elsewhere, Basquiat’s mother died in 2008 and her portion of the estate was divided between the sisters and the father of the artist. At that time, the estate was appraised by Sotheby’s at $36 million. Gerard paid $8.5 million in estate taxes. Independently, the Service audited the Sotheby’s appraisal and estimated the basis to be $138 million. Half of the total was subject to tax and the family owed the IRS another $7.30 million in taxes. Gerard challenged the audit arguing that the Service did not adjust for a blockage discount — after all, selling the entire collection at once would overwhelm the market and result in lower prices realized.
The idea to apply the blockage discount appeals to taxpayers because they seek to reduce estate taxes. However, the heirs should be aware that there is a possibility of paying more in taxes if the collection sells above the discounted valuation.
The Service is well familiar with the concept of the “blockage discount” and it recognizes that “a [blockage] discount may be allowed where a large quantity of any one type of art is offered on the market at one time, and would substantially depress its value.” IRS Valuation Guide (Oct 1995). “Blockage is triggered by a determination that an item’s value in the marketplace does not accurately reflect its fair market value because it is part of a bloke which cannot be sold within a reasonable time without adversely affected price.” Janis v. C.I.R., 469 F.3d 256 (2nd Cir. 2006). In fact, the amount of the discount is based on the costs of holding the inventory such as storing, insuring and otherwise maintaining the collection. There are different methodologies for calculating the discount: hypothetical, see In Estate of O’Keeffe v. C.I.R., 1992 RIA TC Memo 92,210 (1992) and the present value of the stream of sale, see Calder v. C.I.R, 85 T.C. 713, 717 (1985). Both O’Keeffee and Calder estate contained hundreds of artworks.
Another case, In Estate of Smith v. C.I.R. 57 T.C. 650 (1972), where the executors advocated for a 75% blockage discount, decided by the United States Tax Court allowed a 37% discount. The Basquiat estate contains over 1,300 works of art, including some by other artists, such as Andy Warhol, and the time will tell whether there is a deficiency in the estate tax paid. However, if the collection is estimated far below the fair market value and the Basquiat’s sisters start selling the works they will be have to pay income tax on their profit (amount earned above the value used for estate tax purposes), which is higher than the estate tax
This article is intended as general information, not legal advice, and is no substitute for seeking representation.