By Emily M. Lanza*
In 2017, the estate of Lisa de Kooning filed a petition in the U.S. Tax Court after the Internal Revenue Service (IRS) increased the value of the de Kooning estate by $231 million, resulting in a $92 million tax bill. The estate of Lisa de Kooning consisted of a large collection of artwork, including fifty-seven paintings, eighty-three sculptures, and fifty-one drawings, by her father, Willem de Kooning, the famous Dutch-American abstract expressionist, who died in 1997. Originally, the estate of Lisa de Kooning had appraised the collection at $231.4 million; but when determining the total estate tax owed, the estate discounted the value of the collection by nearly sixty percent for the paintings and eighty-five percent for most of the sculptures. The estate intended these discounts to accommodate the “block” of artwork that could be introduced into the market. By increasing the estate’s tax liability, the IRS determined that the estate could not apply “blockage discounts” to the value of the artwork.
According to regulations and case law, when determining the tax liability of an artist’s estate, the estate must not only value the individual pieces of art, but also consider whether the aggregate value of the art should be reduced, in order to adjust for the potential effect on the art market of a large collection of art by a single artist becoming available at one time. “Blockage discounts” reflect the economic concept that introducing a large “supply” of art by the same artist onto the market would instantly (albeit temporarily) decrease the price of the individual works. In order to determine the appropriate value of the estate for the purposes of tax liability, appraisers apply a “blockage discount” to reflect the realities of the marketplace economics.
Unfortunately for appraisers, estate executors, and artists, estate tax statutes and regulations do not clearly outline when and how an estate can apply a blockage discount to a large collection of art held by an estate. The following discussion will examine the legal foundation for blockage discounts and the application of these concepts by the Tax Court to artists’ estates.
Legal Basis for Blockage Discounts
The concept of blockage discounts is rooted in the basic standard for determining the value of an estate: “fair market value.” According to estate tax regulations (26 C.F.R. § 20.2031-1), the fair market value of property held by the estate is “the price at which the property would change hands between a willing buyer and a willing seller.” A “willing buyer” or a “willing seller” means that neither party are compelled to buy or sell, forcing the price to be artificially high or low. Under the regulations, both parties participating in this sale would have reasonable knowledge of the relevant facts, and the market in which the sale would occur is the market where the item at issue is most commonly sold to the public. When determining the value of a large collection of art belonging to a single artist, the estate must consider the potential buyer and market for the collection as a whole, as well as the individual works of art.
In order to determine when to apply a blockage discount, estate appraisers and executors rely on the estate tax regulation for valuing a large number of stock shares (26 C.F.R. § 20.2031-2). Known as the “blockage rule,” the regulation permits an executor of an estate to apply a blockage discount if he or she “can show that the block of stock to be valued is so large in relation to the actual sales on the existing market that it could not be liquidated in a reasonable time without depressing the market.” The concept of supply and demand, that a large supply would naturally diminish the value unless the demand rises to meet the supply, underlies this rule.
Application of the Blockage Discount by the Tax Court
The courts have applied the principles and concepts outlined by this securities valuation regulation to determine the value of a large block of art held by an estate. The U.S. Tax Court first applied the concept of blockage discounts to art in 1972 in the case Estate of David Smith v. Commissioner of Internal Revenue.
Estate of David Smith v. Commissioner of Internal Revenue
David Smith (1906-1965), an American artist known for abstract metal sculpture, had possessed 425 pieces of his sculpture at the time of his death. He received mixed critical acclaim during his lifetime for his work, which typically consisted of very large pieces of metal sculpture, but gained national recognition after his death.
The executors of Smith’s estate estimated its value by calculating the individual price of each work at the time of Smith’s death, and then totaled these values for a sum of $4,284,000. The estate then discounted this figure by seventy-five percent, claiming that the works could only be sold at the time of death to a bulk purchaser acquiring the art for resale. Such a purchaser, according to the estate, would only pay twenty-five percent of the art’s aggregate value with the understanding that an acceptable profit could be recovered only over an extended period of time. The IRS dismissed the estate’s block discount and valued the works at $4,284,000, the full fair market value. According to the IRS, selling all of the sculptures simultaneously would not have had an adverse impact on the fair market value of each item. The Smith estate then petitioned the Tax Court for further review.
The Tax Court agreed with the Smith estate that the “blockage rule,” previously used in the securities context and outlined in the estate tax regulations, should apply to collections of art. The Tax Court explained that the IRS should have considered that a willing buyer of one piece of art would take into account that 424 other similar items were being offered for sale at the same time, and the buyer would lower his or her price accordingly. The court emphasized that a large number of similar works would significantly impact the auction market, the typical market for this type of property, and any valuation analysis should account for this material factor. In applying the blockage discount, the Tax Court also considered Smith’s reputation, the size and quality of the 425 sculptures, and the location of the bulk of these sculptures, as well as other material factors.
While the Tax Court agreed with the Smith estate about the application of the blockage discount, it ultimately concluded that a seventy-five percent discount was too large and held that the fair market value of the 425 sculptures at the moment of Smith’s death was $2,700,000, with a blockage discount of thirty-seven percent. The Tax Court did not provide any specific analysis about how it reached this thirty-seven percent discount. The executors of the estate appealed the Tax Court decision to the U.S. Court of Appeals for the Second Circuit in regard to a separate issue related to the deduction of administration expenses.
Estate of Georgia O’Keeffe v. Commissioner of Internal Revenue
About twenty years later, the Tax Court considered another blockage discount issue for the estate of Georgia O’Keeffe (1887-1986), an American painter who died at the age of ninety-eight, and whose career spanned most of her life. At the time of her death, O’Keeffe’s estate comprised approximately 400 works or series that she had created. In her will, O’Keeffe had bequeathed forty-two works to eight museums. The total value of these bequeathed works was $22,575,000. As calculated by the estate, the total sum of the individual fair market values of O’Keeffe’s works on the date of her death exceeded $72,759,000.
When determining the tax liability of the estate, experts of the estate applied a seventy-five percent blockage discount. The estate assumed, when conducting the fair market value analysis, that all of the works in the estate could be hypothetically “sold” at the date of death only to a single buyer as a bulk purchase. The IRS did not follow this analysis, but divided the works in the estate into two categories: bequeathed art and remaining art. The bequeathed works were not available for sale, according to the IRS, and thus did not require a blockage discount. The agency then applied a discount of thirty-seven percent to the remaining art, finding that the estate owed $6,014,493 in taxes. The estate petitioned the Tax Court for review of this deficiency.
The Tax Court in Estate of Georgia O’Keeffe disagreed in some part with the analyses of both the estate and the IRS. First, the Tax Court objected to the IRS not applying the discount to the bequeathed art, as the fair market value analysis assumes that all works held by the estate are available for sale, regardless of the final disposition of the property. However, the Tax Court also rejected the estate’s assumptions of a single buyer and that the property must change hands at the date of death, because this approach ignores the regulatory condition that the “willing buyer and willing seller” would act without compulsion.
The Tax Court ultimately held that a blockage discount should apply. Acknowledging that different works within the estate would be of interest to different segments of the market, the court determined that there would not be one buyer, like the estate’s proposed single bulk purchaser, but several buyers with multiple sales transpiring over a period of time. The court proposed that O’Keeffe’s work should be divided into two categories for these potential sales: works salable within a relatively short period at approximately their individual values; and works that could be marketed over a longer period of several years. The quality, uniqueness, and salability of each respective work would determine placement in a particular category. The court further proposed that the latter group should be discounted at seventy-five percent, and the former group should be discounted at twenty-five percent. According to the court, the fair market value of the entire estate–with the discount–was $36,400,000, leaving the IRS to determine the final tax liability for the estate.
Calder v. Commissioner of Internal Revenue
Unlike the Smith and O’Keeffe cases, the case Calder v. Commissioner of Internal Revenue addressed the blockage discount issue in the context of gift taxes. The federal gift tax is a tax imposed on an annual basis on all gratuitous transfers of property. Gift taxes are typically associated with estate taxes, since both share the same rate structure and certain credits. Thus, it is appropriate and illustrative to discuss the Calder case in the context of blockage discounts applied to estates.
The petitioner in this case is the widow of Alexander Calder (1898-1976), the American artist known for large abstract sculpture. Alexander Calder died in 1976, and his widow, Louisa Calder, inherited from the estate 1,226 gouaches. The 1,226 gouaches were listed as part of a collection of 1,292 gouaches on the estate tax return filed by the Calder estate. The total fair market value of the 1,292 gouaches listed on the tax return was $949,750, which accounted for a blockage discount of sixty percent. The IRS did not dispute this value at the time the estate tax return was filed. After the death of Alexander Calder, his widow created four irrevocable trusts for her children and grandchildren (six beneficiaries in total: two daughters, four grandchildren). Louisa Calder then gifted the gouaches to the trusts: 306 gouaches to each of the trusts of the daughters and 307 gouaches to each of the trusts of the grandchildren. 369 of the gouaches were sold between 1977 and 1984 on behalf of the trusts.
On her 1976 gift tax return, Louisa Calder estimated that the fair market value of the gouaches did not vary between the date of death and the date of the gift and applied the same sixty percent blockage discount on the gift tax return, reporting a value of $949,750. The IRS calculated the value of the gifts to be $2,300,000, opposing the application of the blockage discount for the gift tax. According to the IRS, blockage discounts were inappropriate in this context, because gifts, unlike deaths, are contemplated events and can accommodate the market accordingly. Louisa Calder petitioned the Tax Court for review.
While Louisa Calder, the IRS, and the Tax Court agreed on the fair market value of the individual gouaches, the legal issue before the Tax Court in Calder v. Commissioner of Internal Revenue was whether a blockage discount should be applied when valuing gifts, and if so, whether the discount should be applied to each gift separately or applied on an aggregate basis to all the gifts as a block. The Tax Court ultimately held that blockage discounts may apply to gifts, and that the blockage discount should be applied separately to each gift that Calder made to the beneficiaries, citing the Treasury regulations that outline the same treatment for the valuation of a block of stocks distributed as multiple, separate gifts.
To determine the precise discount, the court used the same approach for valuing annuities by considering the rate of liquidation at a uniform rate over a period of time. Relying on the actual average sales figures of the gouaches already sold during the 1977-1984 period, the court found that sixty gouaches could be sold each year, and that it would take twenty-two years to liquidate all 1,226 gouaches. Using an annuity framework, the court applied a ten percent discount rate over the twenty-two-year liquidation period to the per-item fair market value of the gouaches, resulting in a total valuation of $1,210,000. The Tax Court then handed over the final tax liability calculation to IRS with this relatively minor adjustment in value.
Block Discounts for the de Kooning Estate?
Determining the fair market value for a single painting can require a complicated investigation into the art market and the work itself. Calculating the value of a collection of tens or hundreds of similar pieces only further complicates the analysis. While the estate tax regulations do not explicitly provide a framework for valuing a block of artwork, the Tax Court has applied the principles outlined in the regulation for valuing securities (26 C.F.R. § 20.2031-2) to the estates and gifts of artists. This case history, as exemplified by the Estate of David Smith, Estate of Georgia O’Keeffe, and Calder, reveals multiple factors that a court may consider when calculating a blockage discount including the potential buyer, the salability of the type of works, the artist’s reputation, and the potential rate of sale. The evolution of the blockage discount for art–from the earliest application in the Estate of David Smith to the later Estate of Georgia O’Keeffe and Calder cases–reveals an increasing emphasis on the sale of the block of artwork over a period of time. To make such a calculation, the Tax Court and practitioners must continue to rely on securities regulations and valuation practices, demanding specialized knowledge and resources from the estates of artists.
No precise calculation exists in this extremely fact-based analysis. Further case law to provide insight in the reasoning of the Tax Court would be helpful to both tax practitioners and estate executors. The ongoing case about the de Kooning estate presents slightly different facts from the Estate of David Smith and Estate of Georgia O’Keeffe cases, as it is not the estate of the artist at issue but that of the artist’s daughter. The Tax Court’s opinion will hopefully address whether this fact is of material significance, and clarify current law regarding the application of blockage discounts to art held by an estate. The case, Estate of de Kooning v. Commissioner of Internal Revenue, is still pending before the U.S. Tax Court as of the date of this article.
- Estate of de Kooning et al. v. Commissioner of Internal Revenue, 4860-17.
- Estate of David Smith v. Commissioner of Internal Revenue, 57 T.C. 650 (1972).
- Estate of Georgia O’Keeffe v. Commissioner of Internal Revenue, 63 T.C.M. (CCH) 2699 (1992).
- Calder v. Commissioner of Internal Revenue, 85 T.C. 713 (1985).
- Treas. Regs. (26 C.F.R.) § 20.2031-1.
- Treas. Regs. (26 C.F.R.) § 20.2031-2.
- Treas. Regs. (26 C.F.R.) § 25.2512-2.
- Treas. Regs. (26 C.F.R.) § 25.2512-5.
- Jimmy Hoover, De Kooning Estate Battles $92M Tax Bill Over His Artwork, LAW360 (Mar. 6, 2017, 8:52 PM), https://www.law360.com/articles/898666.
- John G. Steinkamp, Fair Market Value, Blockage, and the Valuation of Art, 71 Denv. U. L. Rev. 335 (1994).
*About the Author: Emily Lanza is currently Counsel for Policy and International Affairs at the U.S. Copyright Office and had worked previously as a legislative attorney for the Congressional Research Service, advising Congress on intellectual property and estate tax issues. She received her J.D. in 2013 from the Georgetown University Law Center. Before her law career, she studied archaeology and worked for museums in various capacities. She writes on the intersection of art history and the law at The Legal Palette. She can be reached at firstname.lastname@example.org.
Disclaimer: The opinions expressed here are solely of the author and do not express the views and opinions of the U.S. Copyright Office.