Vagaries of Valuation for Collections of Artwork

By Elizabeth Summers*

Screen Shot 2017-10-12 at 4.57.56 PMFor better or for worse, the world cares how much collectors pay for art. A record price realized at auction or in a “private” sale can create headlines in both art world publications and the national press. The final value of a collection, however, is determined only upon the collector’s death, when the personal representative of the estate assigns a value to the art for purposes of the federal estate tax. Issues surrounding the valuation of art have generated extensive and energetic litigation in the U.S. Tax Court and, by extension, considerable interest among estate planning attorneys.

General Rules of Estate Tax Valuation

The value of a decedent’s gross estate is determined by calculating the value of all property the decedent owned at the time of his or her death, wherever such property is situated. (IRC Section 2031) Under IRS regulations regarding valuation for estate tax purposes, the value of every item of property includible in a decedent’s gross estate is its fair market value at the time of the decedent’s death. (T.R. Section 20.2031-1(b)) The IRS defines “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 to sell and both having reasonable knowledge of the relevant facts. With unique objects like individual works of art, the determination of a “fair market value” may be difficult. Fortunately, the IRS has provided additional guidance. Special rules apply to tangible personal property “having marked artistic or intrinsic value” of a value in excess of $3,000. Items that fall into this category must be formally appraised, and the appraiser must be competent in the specific subject matter of the appraisal. The appraisal of a painting of “artistic value” must include a description of the size and subject of the painting and the name of the artist. The appraisal must be filed with the estate tax return, along with a written statement by the executor containing a declaration that, under penalty of perjury, the appraisal is complete and accurate, and the appraiser both qualified and disinterested.

Valuation of Works of Art

While relatively minimal guidance exists in the Internal Revenue Code and Treasury Regulations specific to the valuation of art, subsequent IRS publications have created further special requirements for works of art that have been appraised at $50,000 or more and are transferred at death. The IRS now provides a procedure through which the executor of an estate may request a “Statement of Value.” The Statement of Value is effectively a pre-approved appraised value, issued by the IRS, that the executor may rely on to substantiate the value of a work of art for purposes of the estate tax. 

For the purpose of the Statement of Value requirements, the IRS defines “art” as “paintings, sculpture, watercolors, prints, drawings, ceramics, antique furniture, decorative arts, textiles, carpets, silver, rare manuscripts, historical memorabilia, and other similar objects.” The executor must request a Statement of Value for an item prior to filing the federal estate tax return that first reports the transfer of the art work. The request must include the following: a copy of the appraisal; a description of the work; the appraised fair market value; the cost, date and manner of acquisition; the date of death; and the location of the IRS District Office with jurisdiction over the estate tax return. The current fee for a Statement of Value is $5,700 for one to three items, and $290 for each additional item.

An appraisal submitted for purposes of securing a Statement of Value must contain, among other information, a detailed description of the work, a professional photograph, the specific basis for the valuation, and a statement that the appraisal was prepared for estate tax purposes. The appraiser must prepare, sign and date the appraisal and sign a statement attesting to his or her competency and expertise. The appraisal must be prepared within 60 days of the valuation date, and the executor must sign the request for the Statement of Value under penalty of perjury. While the Statement of Value procedure constitutes a kind of insurance against challenge for the valuation of an asset that might otherwise be subject to significant scrutiny, it can be time-consuming and expensive.

All returns selected for evaluation or requests for a Statement of Value that include an artwork with a claimed value in excess of $50,000 will be submitted to the IRS’s Art Appraisal Services department for possible review by the Commissioner’s Art Advisory Panel. The IRS established the Art Advisory Panel in 1968 for the purpose of assisting the IRS in evaluating appraisals of art. The Panel is composed of renowned curators, dealers and art historians from across the United States. In 2015, the most recent year for which a report is available, the Art Advisory Panel reviewed 446 appraisals of artworks, representing a total value of almost $650 million. Of these appraisals, the Panel recommended adjustments to the appraised value of the property approximately 65% of the time. While the IRS is not technically bound by the Panel’s recommendation, in practice, its opinion is generally decisive.

Because the outcome of an appraisal can dramatically affect the amount of estate tax the collector’s estate owes, it should come as no surprise that art appraisal issues have been extensively litigated in the Tax Court over the past decade. Following are some recent cases of interest.

Effect of Economic Forces in the Estate of Bernice Newberger v. Comm’r, T.C. Memo. 2015-246 (2015).

In some cases, the appraised value of a work may not be the best indicator of value and in such instances the Tax Court may also consider relevant sales and the effects of larger economic forces upon the art market. The variations in market and appraised value are well illustrated by the ruling by the Tax Court reached in regards to the Estate of Bernice Newberger . Upon Bernice Newberger’s death in July of 2009, her art collection included Pablo Picasso’s Tete de Femme (Jacqueline), an untitled work by Robert Motherwell, and Jean Dubuffet’s Element Bleu XV. In early 2010, Christie’s appraised the Picasso at $5 million. Sotheby’s appraised the Motherwell at $450,000 and the Dubuffet at $500,000. The Picasso sold in an auction at Christie’s on February 2, 2010, for over $12 million. The estate listed the appraised values on the estate tax return that it filed in October of 2010. The return made no reference to the 2010 February sales price of the Picasso. The estate continued to hold the Motherwell and Dubuffet.

The IRS issued a notice of deficiency stating that the Picasso, the Motherwell and the Dubuffet had values of $13 million, $1.5 million and $750,000, respectively. The IRS based its adjusted valuation on the February 2010 sales price of the Picasso, the sale of a comparable work by Motherwell for $1.4 million in November of 2010, and the sale of a comparable work by Dubuffet for $825,000 in November of 2007. The estate promptly appealed, asking the Tax Court to honor the original $5 million valuation because the Christie’s sale was “a fluke,” and arguing that the comparable sales prices for the Motherwell and the DuBuffet failed to take into account the effects of the global recession of 2008-2009.

In a remarkably nuanced decision, the Court held for the IRS in valuing the Picasso at $10 million, which the IRS expert had arrived at by adjusting the sales price to account for July 2009 market conditions. However, the Court held for the estate regarding the Motherwell and Dubuffet works, finding that the estate’s experts had properly taken into account the depressing effects of the global recession on the art market at the time of Ms. Newberger’s death. The Court made specific reference to the IRS expert’s “inexplicable” valuation of the estate’s Motherwell at a price above the sales price for the comparable work, which was sold in November of 2010, after the art market recovered.

Fractional Interests in the Estate of Elkins v. Comm’r, 767 F.3d 445 (5th Cir. 2014)

The ownership of a work of art can be divided into a number of fractional interests. While fractional interests allow the owner to discount the value of his or her property for lack of marketability and control, they can create significant hurdles for the appraiser.   

James Elkins built an impressive art collection over his lifetime, including works by Pablo Picasso, Jackson Pollock, Jasper Johns, Cy Twombly, and David Hockney. By the time of his death, James Elkins owned fractional interests in 64 pieces of artwork. Specifically, Elkins owned a 73.055% interest in 61 of the works, subject to a restrictive co-tenant’s agreement with his children (the holders of the remaining fractional interests), and a 50% interest in a grantor-retained income trust (“GRIT”) that owned 3 works. Following Elkins’ death in February of 2006, his executor valued his 73.055% interest in the 61 works owned in conjunction with his children at approximately $9.5 million, and his 50% interest in the GRIT at approximately $2.6 million. To reach this value, the executor commissioned an appraisal from Sotheby’s, determined Elkins’ pro-rata share of the value of the appraised works, and applied a 44% discount to the pro-rated appraised value for lack of marketability and control. The IRS issued a notice of deficiency valuing the estate’s 73.055% interest at approximately $18.4 million and the 50% interest in the GRIT at $5.3 million. See Estate of Elkins v. Comm’r, 140 T.C. 86 (2013). 

The Tax Court disregarded the restrictions in the co-tenancy agreement between Elkins and his children and, with it, the estate’s 40% discount. The discount was reduced to 10% to account for the uncertainties a hypothetical buyer would face in determining a resale value in light of Elkins’ children’s continuing interests in the works. Understandably, the estate appealed.

On appeal, the Fifth Circuit Court of Appeals reversed the Tax Court ruling and held that indeed the estate was entitled to a higher discount for the fractional ownership.

Conflicts of Interest in Estate of Kollsman v. Comm’r, T.C. Memo. 2017-40.

In evaluating an appraisal, the IRS will also scrutinize the motivations of the appraiser as it did in the review of the valuations submitted for the Estate of Kollsman. Upon her death, Eva Franzen Kollsman owned two old master paintings: Maypole by Pieter Brueghel the Younger, and Orpheus attributed to Jan Brueghel the Elder, Jan Brueghel the Younger, or a Brueghel studio. A Sotheby’s specialist sent a brief letter to the executor of Kollsman’s estate appraising Maypole at $500,000 and Orpheus at $100,000, which values the estate included on Kollsman’s federal estate tax return. The same specialist also sent another letter proposing that the estate grant Sotheby’s an exclusive right to auction both works, and stated an estimated value at auction of $600,000-800,000 for Maypole and $100,000-150,000 for Orpheus. The estate accepted Sotheby’s proposal. The IRS issued a notice of deficiency, finally asserting a value of $2.1 million for Maypole and $500,000 for Orpheus.

At trial, the Court essentially disregarded the Sotheby’s appraisal, believing the appraiser gave a low estimate in order to reduce the estate’s tax burden and “curry favor” with the executor for the purpose of securing the right to auction the works. The Court accepted the IRS’s valuations, applying only a 5% discount for the risks associated with cleaning the paintings and an additional 20% discount for Orpheus due to the work’s generally poor condition and the uncertainty of its attribution.

The manner of disposition of the collection may also be relevant for purposes of valuation. Some estates include a “blockage discount” in the calculation of the value of a collection. A blockage discount accounts for the difference in the overall value realized if a number of works by a single artist are liquidated at once, as opposed to being sold off one by one. Selling a large “block” of works risks flooding the market and devaluing all of the artist’s work. Blockage discounts have been utilized in a number of collectors’ and artists’ estates, including those of Georgia O’Keeffe and Andy Warhol.

The IRS contested the application of a blockage discount to the appraisal of certain works of art owned by the estate of Lisa de Kooning, the daughter and sole heir of the abstract expressionist Willem de Kooning. Upon de Kooning’s death in 2013, Christie’s valued her collection of her father’s paintings and sculptures at $231 million. The estate commissioned two experts to calculate the amount for a blockage discount for the collection. The experts determined that the appropriate discount would be 60% for the paintings and 85% for the sculptures, and consequently valued the entire collection at a total of approximately $100 million. The estate submitted a request for a Statement of Value reflecting this amount. 

After consulting the Art Advisory Panel, who advised that the value of de Kooning’s works would only increase over time, the IRS rejected the blockage discount and issued a Statement of Value of approximately $255 million. This figure included a 50% discount for sculptures valued at over $100,000. Undeterred, the estate challenged the Statement of Value in its return and submitted additional information regarding the blockage discount. The IRS promptly disallowed the sculpture discount and, without making any adjustment to the Statement of Value, increased its value of the collection by $60 million to approximately $315 million. In February of 2017, the estate filed a case with the Tax Court to contest the IRS’s new position and the resulting $92 million tax bill. As of the date of this article, the case remains pending and the result shall be of keen interest to both estate planners and art law enthusiasts.

Conclusion

Despite the guidance provided by the IRS and relevant case law, the appraisal of art for estate tax purposes remains more of an art than a science. The valuation of artwork is intensely fact-specific, subject to a short time horizon, and dependent on the state of the art market. For those in New York City on November 10, 2017, the upcoming Art Law Day organized by the Appraisers Association of America might be of some interest.

Select Sources:

*About the Author: Elizabeth A. Summers is a Trusts and Estates Associate with a firm in Minneapolis, Minnesota, where she specializes in wealth transfer planning for high net worth individuals and families. 

Disclaimer: This article is intended for educational purposes only and is not meant to provide legal advice. Any views or opinions made in the linked article belong to the author alone. Readers are not meant to act or rely upon the information in this article and should consult a licensed attorney regarding their specific situation.

In the Eye of the Beholder: Appraisals of Art for Estate Tax Liability

by Emily Lanza*

Form 706 Estate Tax

Estate tax, death tax or inheritance tax? Pick one and pay up to 40% with first $5.4 mill exempt.

In February 2017, the U.S. Tax Court ruled that the estate of a deceased New York woman, Eva Franzen Kollsman, undervalued $2.4 million worth of art on the estate tax return. The assets at issue before the Tax Court were two Old Master paintings by Pieter and Jan Brueghel held by the decedent at her death. The IRS claimed before the Tax Court that the Kollsman estate underreported the values of the two Old Master paintings resulting in a $781,488 federal estate tax deficiency.

In reaching this decision, the Tax Court not only rejected but also criticized the appraisals made for the estate of the two Old Masters by George Wachter, Vice President of Sotheby’s North America and South America. The Tax Court dismissed Estate’s declaration and the valuations made by Wachter, finding that his valuations were “unreliable and unpersuasive” due to his direct conflict of interest and misconstrued analysis of the Old Master paintings. 

The opinion of the Tax Court in the Estate of Eva Franzen Kollsman v. Commissioner of Internal Revenue demonstrates the importance of having a justifiable and objective appraisal when determining the tax liability of an estate. The valuation of art is not an exact science and may change depending on the “eye of the beholder.” However, in order to determine the precise tax liability of an estate, appraisers and estate executors must adhere to Internal Revenue Service (IRS) guidelines, professional codes of ethics, and the legal requirements within the Tax Code to ensure some level of objectivity and consistency. What were the shortcomings of the appraisal conducted for the Kollsman estate and what are the lessons to be learned from this case?

Estate Tax

The federal estate tax is a tax levied against the estate of a decedent, which must be paid by the estate upon the transfer of the property. The top tax rate is statutorily set at 40%. A series of adjustments and modifications of a tax base known as the “gross estate” determines federal estate tax liability. The gross estate includes the value of all property, including real or personal property such as artwork, that the decedent owned on the date of his or her death. The value of the property included in the decedent’s gross estate is the “fair market  value” on the date of the decedent’s death. According to estate tax regulations, the “fair market value” of the property is the price at which the estate property would hypothetically change hands between a willing buyer and willing seller. In such a sale, the buyer and seller would not be compelled to buy or sell the property as such a compulsion would disproportionately raise or lower the price. Additionally, both parties would be expected to have reasonable knowledge of the relevant facts, such as the condition or history of the relevant property. The impact of subsequent events after the death of death on the fair market value depends on the particular facts of the case and whether the parties would be expected to have knowledge of the relevant facts surrounding the subsequent event. The fair market value tends to reflect the hypothetical sale price in a market in which the item is most commonly sold to the public, such as the auction market for art assets.

Next, certain allowable deductions reduce the gross estate to the taxable estate. These allowable deductions include estate administration expenses, certain debts and losses, charitable bequests, and state death taxes. Then, the tax rates are applied to the taxable estate after the total of all lifetime taxable gifts made by the decedent is added to the taxable estate. Any available credits, such as the “unified credit,” are subsequently taken to obtain the actual estate tax liability, the amount of tax paid by the estate. For estates belonging to decedents who died in 2017, they must pay tax on estates valued greater than $5.49 million, the basic exclusion amount under the unified credit for 2017 (the unified credit in 2016 was $5.45 million). The IRS adjusts the unified credit amount every year to account for inflation. The Trump administration has recently proposed to eliminate the estate tax.

Estate of Eva Franzen Kollsman v. Commissioner of Internal Revenue

As explained above, the fair market value of property held by the estate is an important factor in determining the tax liability of the estate. This was the primary issue before the Tax Court in this case. Upon her death in 2005, the decedent, Eva Franzen Kollsman, owned two 17th-century Old Master paintings at issue in this case: Village Kermesse, Dance Around the Maypole (“Maypole”) by Pieter Brueghel the Younger and Orpheus Charming the Animals (“Orpheus”) by Jan Brueghel the Elder or the Younger. Pieter Brueghel’s work was later sold by Sotheby’s for the hammer price of $2,100,000.

In September 2005, a month following the decedent’s death, the estate’s expert, George Wachter, Vice President of Sotheby’s North America and South America, valued the paintings at $500,000 for the Maypole and $100,000 for Orpheus. In reaching these values, Wachter considered the composition and subject matter of the paintings but focused much of his analysis, according to his testimony before the Tax Court, on the extreme yellow discoloration and the dirt and grime on the paintings that accumulated during years of the decedent’s smoking. Wachter’s valuation was included in the estate’s 2005 tax return. After the valuation, the paintings were cleaned by a fine art services firm, Julius Lowry Frame and Restoring Company, at the request of the estate.

 

In 2009, Maypole sold at Sotheby’s for the hammer price of $2,100,000. The executor of the estate, Jeffrey Hyland, retained Orpheus. While the estate tax return listed the fair market value of Maypole and Orpheus at $500,000 and $100,000 respectively, the IRS asserted in a notice of deficiency that the estate had underreported the value of the two paintings and the actual fair market value of Maypole was $2,100,00 and of Orpheus was $500,000, resulting in a $781,488 tax deficiency. The estate petitioned the Tax Court for a redetermination of the paintings’ fair market values.

Before the Tax Court about ten years after the initial evaluation, the estate and the IRS presented the testimony of their respective experts and their valuations of the two paintings at issue. Paul Cardile, Ph.D., an art historian with twenty-five years of experience as a fine art appraiser, served as the expert for the IRS before the Tax Court. After analyzing the testimonies of the two experts, the court rejected Wachter’s valuation, and found the value of the Maypole at $1,995,000 and of Orpheus at $375,000. The estate was found liable for the resulting tax deficiency, the amount of which to be determined later by the IRS.  

Analysis of the Estate’s Appraisal

While the Tax Court routinely weighs in on the valuation of paintings for the purpose of determining estate tax liability, the court in the case of Estate of Eva Franzen Kollsman v. Commissioner of Internal Revenue not only agreed with the analysis of the IRS’s expert but strongly objected to and criticized Wachter’s testimony referring to his valuations as unreliable and unpersuasive. Why did the estate’s appraiser incur such criticism by the Tax Court?

1. Lack of Objectivity

First, the Tax Court found that Wachter held a significant conflict of interest “that could cause a reasonable person to question his objectivity” by adjusting the valuation for his own benefit. Determining the appropriate estate tax liability greatly depends on the objectivity of an appraiser, especially in the context of assessing the fair market value of art. Such calculations demand “insider-knowledge” of the art market, and objectivity must accompany this skill and expertise in order to maintain the integrity of the estate tax framework.

IRS Revenue Procedure 96-15 outlines various conflicts of interest that an appraiser must avoid when crafting his appraisal for tax liability purposes. These prohibitions include the appraiser not inheriting property from the estate as a beneficiary or not being any part of the estate. The appraiser also cannot have been employed by the decedent, because such a relationship may color the motivations of either party. The IRS also requires the appraiser to “hold himself or herself out to the public as an appraiser,” as potentially demonstrated through membership in professional appraisal organizations. These organizations, such as the American Society of Appraisers (ASA) and the Appraisers Association of America (AAA), require their members to follow a code of ethics in order to avoid such conflicts of interest as identified by the IRS. For example, the AAA requires that its members must appraise property objectively, “independent of outside influences and without any other motive or purpose than stated in said appraisal.” The AAA offers a list of certified appraisers, who possess an extensive level of expertise, education, and experience.

In addition to the IRS procedures and ethical “carrots,” appraisers may face potential “sticks” to ensure objective and accurate work. Implemented by the Pension Protection Act of 2006, section 6695A of the Tax Code imposes a penalty on the appraiser who prepared an appraisal used for an estate tax return and the appraisal results in a substantial valuation understatement. An understatement has occurred if the reported value of the property is 65% or less of the amount determined to be the correct value. The penalty imposed is the lesser of 10% of the underpayment (or $1,000 if greater than the 10%) or 125% of the gross income received from the preparation of the appraisal. For example, if an appraisal resulted in an underpayment of $50,000 and the appraiser received $2,000 for the appraisal, the penalty imposed under section 6695A would be $2,500 as the lesser value of 10% of the $50,000 underpayment ($5,000) and 125% of the gross income of $2,000 ($2,500) for the appraisal.

The court held that Wachter’s relationship and correspondence with the estate’s executor, Hyland, during the valuation process impaired his objectivity and, correspondingly, his credibility. While Wachter was determining the fair market value estimates for the estate paintings, Wachter and Hyland apparently corresponded about the fate of the paintings. During this correspondence, Wachter, as a Vice President of Sotheby’s, solicited Hyland for the exclusive rights for Sotheby’s to auction the Maypole and Orpheus, if Hyland ever chose to sell the paintings. The Tax Court did not reveal whether or how much Wachter received for this appraisal or whether he differentiated between his two roles as an appraiser or potential seller of the paintings in this correspondence.  Under Sotheby’s terms of service according to the Tax Court, an auction sale would entitle Sotheby’s to a 20% commission on the first $200,000 of the hammer price. Presumably, the employee who would bring in property would also collect a certain fraction of the hammer price as an incentive for bringing business. It appears, according to the Tax Court, that Wachter “had a direct financial incentive to curry favor with Mr. Hyland by providing fair market value statements that benefited his interests as the estate’s residual beneficiary” and that Wachter thus “lowballed” the estimates of the paintings to reduce the estate’s tax liability. The Tax Court further found that the simultaneous timing of the valuations and Wachter’s pitch for exclusive auction rights seemed to imply that the latter influenced the former, demonstrating Wachter’s lack of objectivity.

Wachter’s actions suggest if not directly implicate the various conflicts of interest outlined in the IRS policy about appraisal procedures. While Wachter was not a direct beneficiary inheriting the paintings from the estate, his employer certainly benefited from the sale of the Maypole and the explicit or inexplicit arrangement between Wachter and Hyland. Thus, Wachter violated professional ethics requirements for objectivity with this “quid pro quo” arrangement. However, according to the Tax Court opinion and Wachter’s biography on the Sotheby’s website, he is not a member of any professional organizations that demand some sort of accountability. If Wachter’s valuation had occurred after 2006 (and not the year before), Wachter would likely have been penalized under section 6695A for the gross understatement of the painting’s value. Given the hammer price that was more than four times the value he ascribed to Maypole, Wachter valued that work well under the threshold set in the Tax Code at a quarter of the value determined by the Tax Court. While Wachter seemed to avoid any legal repercussions for his lack of objectivity, at least according to the Tax Court ruling, the estate was settled with the consequences and the adjusted estate tax liability. In order to avoid such scenarios, estates should investigate the objectivity of their appraisers and ensure some type of oversight or accountability when hiring them for this important task.

2. Exaggerating the Poor Condition of the Paintings

Second, the Tax Court objected to Wachter’s emphasis on the poor condition of the paintings when forming his valuations. In his report, Wachter described the condition of both paintings as covered in dirt and grime with extreme yellow discoloration, due to the decedent being a heavy smoker. According to Wachter, one could not be certain of the inherent value of the paintings in this condition, and he concluded that the value of the paintings should reflect the high level of risk involved in cleaning. However, the Tax Court found that such a risk was exaggerated, highlighting testimony of the conservator that the risks involved with cleaning were low. Moreover, the Tax Court pointed out that the cleaning process only took two to three hours, indicating that such a procedure was “comparatively easy and problem free.” Contrary to Wachter’s report, Cardile, the IRS expert, did not adjust for the dirty condition of the paintings as “surface dirt do[es] not affect the intrinsic value of an Old Master painting.”

Upon first consideration, accounting for the state of the painting, as Wachter did when calculating the value, appears to be a logical step in a fair market value analysis. According to IRS policies, an appraisal must include a description of the art item that states the physical condition of the work in addition to the subject, medium, size, visible marks, and provenance. In the past, the Tax Court has acknowledged the physical condition of the work and has adjusted the value accordingly. For example, in the Estate of James J. Mitchell v. Commissioner of Internal Revenue, the Tax Court placed less weight on the testimony of the IRS experts because they did not adjust their valuation of an early twentieth-century watercolor by American artist Charles Marion Russell to account for “its inferior status and for its poor paper quality and back boarding.”

While an appraiser may and should consider the physical condition of a work, Wachter’s assessment of Maypole and Orpheus was inappropriate due to the emphasis on the level of dirt – a condition that could be and was easily remedied. The cleaning and framing of Maypole and Orpheus, which occurred after Wachter’s valuations, cost the estate $4,500 and $4,350 respectively. Unlike the Russell watercolor which was painted with inherently volatile and poor materials, the dirt covering the Maypole and Orpheus was not intrinsic to the painting itself. Wachter’s emphasis on the dirt of the paintings ignores the guiding principle when determining fair market value that the hypothetical buyer and seller have “reasonable knowledge of relevant facts” affecting the potential sale. “Reasonable knowledge” includes facts acquired during the background investigation and negotiations for the sale, and in this particular case would likely involve consulting a conservator about the risks of cleaning a dirty painting. Wachter’s deep deduction in the value of the paintings to account for their dirtiness was misplaced and too substantial, for information about the actual cleaning process, which only took a few hours, was “readily discoverable.” The Tax Court did acknowledge that cleaning carries some risk but calculated only a 5% discount for the Maypole and a 25% discount for Orpheus to account for bowing, a more critical aspect of its condition. But Wachter’s inappropriate consideration of surface dirt demonstrates the importance of taking a holistic approach towards the analysis of a painting and fully accounting for all the facts that a likely buyer or seller would recognize when approaching a sale.

3. Need to Use Comparable Sales

Perhaps the most significant criticism of Wachter’s valuation by the Tax Court is the absence of comparable sales to support his analysis. “Comparables”  (or “comps”) are the recent selling prices of similar pieces of art that are used to help determine the fair market value of a piece of art, with the assumption that it will sell at a similar price of other similar works. The Tax Court referred to this omission as “remarkable” and with the absence of any comparables, “Wachter’s report lacks any objective support for his valuation figures.” According to the Tax Court, comparables of paintings by Pieter Brueghel sold between $1,040,000 and $3,331,000, and paintings by Jan Brueghel sold between $400,000 and $700,000.

The use of comparable sales provides the basic foundation for the valuation of art by offering an objective analysis of the likely market value. Cardile, the expert for the IRS, identified several comparable paintings for both the Maypole and Orpheus. Comparing the subject matter, medium, size, and the provenance (record of ownership) of similar paintings that sold prior to the date of the Kollsman estate was being appraised, Cardile could calculate the likely market price of the Maypole and Orpheus more accurately and confidently. Generally, courts, in their analysis of appraiser testimony, are likely to weigh more favorably comps that were sold closer in time to the date of valuation and are more similar in subject matter to the estate’s property than comparables that are too dissimilar to the painting at issue to provide an objective benchmark. For example, the court in Estate of Murphy v. United States found the testimony of the IRS expert to be particularly problematic and thus gave his testimony less weight than the testimony of other experts. The valuation of the IRS expert was based upon sales too remote in time, from six to nineteen years before the valuation date, while the testimony of the other experts relied upon sales only a few months before the valuation date.

When evaluating suitable comparables, courts focus on the details, such as the date of the sale and similarity in composition to the painting at issue. When an expert such as Wachter completely ignores such evidence, the court has very little information to rely upon when assessing the credibility and accuracy of a valuation and corresponding testimony. There is no reason to believe that Wachter did not know who painted Maypole and Orpheus and even those less familiar with leading artists are likely to recognize the surname Brueghel to find suitable comparables. The practice of using comparable sales in this context is so essential and commonplace that it is unclear why Wachter’s valuation was missing such a critical component. The lesson from this omission is that the strength and credibility of future appraisals depends upon finding pertinent and appropriate comps so that a court may properly analyze the proposed valuation.

Conclusion

The evasive “fair market value” is the cornerstone of determining estate tax liability. Calculating the value of a unique piece of property based upon the price of a hypothetical market transaction is an inherently difficult task. Appraisers rely upon past sales of comparable art pieces in order to predict the future activity of this market. They consider the whole piece of art, including the subject matter, condition, and provenance, from the point of view of a hypothetical buyer and seller for the fair market value analysis. Because such precise analysis requires great skill, knowledge, and years of specialized experience that members of the courts generally do not possess, the courts and accompanying legal system depend upon the objectivity of the appraisers. If such professionalism is absent, the courts and the IRS cannot administer the tax law fairly. Unfortunately for the estate of Eva Franzen Kollsman, its appraiser did not follow these principles, and the estate had to pay penalties for the omissions of its appraiser.

Selected Sources:

  1. Estate of Eva Franzen Kollsman v. Comm’r of Internal Revenue, 2017 T.C.M. (RIA) 2017-040 (2017).
  2. 26 U.S.C. § 2001.
  3. 26 U.S.C. § 2031.
  4. Treas. Reg. § 20.2031-1(b).
  5. 26 U.S.C. §§ 2053, 2054, 2056.
  6. Rev. Proc. 96-15, 1996-3 I.R.B. 41, § 8.04.
  7. Appraisers Association of America, Code of Ethics, https://www.appraisersassociation.org/index.cfm;jsessionid=15426E3A1A9207384153A96906B788A6.cfusion?fuseaction=document.viewDocument&documentid=720&documentFormatId=1353&CFID=3969729&CFTOKEN=a08c8da32b839881-B1374B0E-1C23-C8EB-805AFDB50E7E6B2D.
  8. 26 U.S.C. § 6695A.
  9. 26 U.S.C. § 6662(g).
  10. Sotheby’s, Bio of George Wachter, ttp://www.sothebys.com/en/specialists/george-wachter/bio.html.
  11. Estate of James J. Mitchell v. Comm’r of Internal Revenue, 101 T.C.M. 1435, at *14 (2011).
  12. U.S. v. Simmons, 346 F.2d 213, 217-18 (5th Cir. 1965)(finding that facts revealed during a background investigation of the decedent’s records constituted “reasonable knowledge” for purposes of determining the fair market value of property).
  13. Mary Anderson et al., Art Advisory Panel Helps Courts Sculpt Estate Valuations, 42 Est. Plan. 20, 11 (2015).
  14. Estate of Charles H. Murphy, Jr. v. U.S., No. 07-CV-1013, 2009 WL 3366099, at *18 (W.D. Ark. Oct. 2, 2009).

*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 can be reached at emilyla8@gmail.com.

Disclaimer: The opinions expressed here are solely of the author and do not express the views and opinions of the U.S. Copyright Office.

Case Review: Crile v. Commission of Internal Revenue

By Chris Michaels, Esq.*

“All children are artists. The problem is how to remain an artist once he grows up.” – Pablo Picasso

For many artists, the financial instability that accompanies an artistic profession forces the artist to seek employment with a more consistent paycheck. A “day job” often provides the income for rent and bills while the artist continues to pursue their artistic endeavors. In this situation, tax deductions for expenses related to creating art may help the artist stay afloat financially. It seems like a fairly straightforward situation until April 15 rolls around and it is time to pay taxes. In a ruling filed by the United States Tax Court on October 2, 2014, the Court resolved a question of whether individuals who pursue their art while otherwise employed can deduct art-related expenses. The decision the Court reached helps artists to remain artists, even if they are not making a profit from their work.

Susan Crile Website

Susan Crile Website

The petitioner in this case, Susan Crile, has worked as an artist for over four decades. She has created more than 2,000 works using oil, acrylic, charcoal, pastels, and many other mediums. Her art is in the permanent collections of several museums including the Metropolitan Museum of Art, the Guggenheim Museum, the Brooklyn Museum of Art, the Phillips Collection, and several colleges and universities. In addition, her work has been purchased by corporations including Bank of America, General Mills, Charles Schwab, and several major New York City law firms. She has been represented by at least five New York City art galleries, most recently in 2009 by the Michael Steinberg Fine Art gallery. She has received awards from the National Endowment for the Arts and her works have been reviewed in almost every major art publication. Crile is also a full-time tenured professor of studio art at Hunter College in New York City, where she has worked in some capacity since 1983.

The respondent in this case, the Commissioner of Internal Revenue, determined that Crile had deficiencies in her Federal income tax returns for the years 2004, 2005 and 2007–2009. Specifically, respondent argued, among other things, that Crile was not entitled to claim deductions for expenses related to her artwork because she did not intend to profit from her art. The Court, therefore, was faced with determining the issue of whether Crile was engaged in a trade or business with the intent of making a profit from her activity as an artist. Crile’s artwork during the tax years in dispute included a series of works based on the life of Saint Francis in the Basilica di San Francesco in Assisi, Italy, works based on the events at the Abu Ghraib prison in Iraq, silkscreen printings, a series of small abstract paintings, and a project based on the prisoners in Guantanamo Bay.

Since her art career began in 1971, Ms. Crile sold over 300 works with gross proceeds of $1,197,150 and an earned income of $667,902. From 1971 to 2013, however, she never reported a net profit from her art business due, in large part, to the deductions she took for expenses relating to the sale of her art.

To determine whether Crile was entitled to the deductions she had taken, the Court considered two sections of the Internal Revenue Code, sections 162(a) and 183(b). Under section 162(a), deductions are allowed for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” To be entitled to deductions under section 162(a), the taxpayer must show that he or she engaged in the activity with the intent of making a profit. Further, under section 183(b), if the activity is not engaged in for profit, deductions are not allowed except to the extent of gross income derived therefrom. Essentially, in order to take the deductions, Crile had to prove that she was in the art business to make a profit.

A threshold issue that had to be decided before the Court reached the issue of Crile’s intent to earn a profit concerned the scope of her activity as an artist. Under section 183(b), the activity to be considered can either be a “single undertaking” or “multiple undertakings.” The Commissioner argued that Crile’s art activity was not separate from her activity as an art professor and was thus a “single activity.” As a single activity, the Commissioner posited that Crile had to claim her art-related expenses as unreimbursed employee business expenses and not as deductible business expenses. The Court ultimately reasoned, however, that she had practiced as an artist for a decade before she had started teaching and that many activities she undertook as an artist were unrelated to her teaching career. As such, the Court held that Crile’s artist activities and professor activities were multiple undertakings that had to be analyzed separately under section 183(b).

The bulk of the Opinion handed down by the Court dealt with whether the artist conducted her art activity with an intent to earn a profit such that she could take deductions for expenses attributable to that activity. The Court analyzed the following nine factors and used a balancing test to determine whether Crile engaged in the activity for profit:

  1. The manner in which the taxpayer conducts the activity;
  2. The expertise of the taxpayer or her advisers;
  3. The time and effort spent by the taxpayer in carrying on the activity;
  4. The expectation of the taxpayer that assets used in the activity may appreciate in value;
  5. The success of the taxpayer in carrying on other similar or dissimilar activities;
  6. The taxpayer’s history of income or losses with respect to the activity;
  7. The amount of occasional profits, if any;
  8. The financial status of the taxpayer; and
  9. Elements of personal pleasure or recreation.

An analysis by the Court concluded that factors number one through five and nine were in favor of Crile and factors six and seven were in favor of the Commissioner. Factor number eight was neutral. As such, the Court held that Crile acted with the requisite intent to make a profit and, therefore, could take deductions for “ordinary and necessary expenses.” The Court reserved deciding on whether the deductions that Crile took were actually “ordinary and necessary.”

The Court’s decision in this case is a win for struggling artists everywhere. In finding that Crile engaged in her art activity as a distinct activity from her employment as a professor, the Court gave artists the opportunity to take deductions for expenses relating to their artwork as long as they are engaged in that activity for profit. While it certainly is not a windfall for anyone, the Court’s decision makes it a little easier for grown ups to remain artists.

Petitioner, Susan Crile, was represented by Robert H. Baron, Micaela McMurrough, and Megan Y. Lew, all of Cravath Swaine & Moore LLP. Respondent, Commissioner of Internal Revenue, was represented by Jane J. Kim and Michael J. De Matos of the Internal Revenue Service.

Sources:

About: Chris Michaels is a litigation attorney in the Philadelphia office of the Atlanta, GA-based law firm, Cruser & Mitchell, LLP, where he actively pursues his interest in the field of art law. He may be reached at (518) 421-7238, chriswmichaels@gmail.com, or on Twitter @CMichaelsartlaw.

Disclaimer: This article is intended as general information, not legal advice, and is no substitute for seeking representation.

Basquiat sightings, or Case Review: Heriveaux v. Christies, Inc.

By Chris Michaels, Esq.

Born in Brooklyn, NY in 1960, Jean-Michel Basquiat was a contemporary American artist, who started his career as a graffiti artist in the mid-1970s working in and around the Lower East Side of Manhattan. He gained popularity in the art world in the early 80s when his first solo art show opened in 1981. It was also in 1981 that Artforum magazine published a feature on Basquiat, effectively bringing his work into the mainstream. Basquiat’s art received widespread critical acclaim and in 1985 The New York Times Magazine featured the artist on their cover. Three years later, Basquiat died of a heroin overdose in 1988 at the age of 27. His popularity continued and grew after his death; today Basquiat’s work continues to bring in huge sums at auction. For example, in May of 2013 his painting, Dustheads, sold for $48.8 million at auction.

Basquiat’s “Dustheads,” which recently sold at auction on May 15, 2013 for $48.8 million:

Basquiat’s “Dustheads,” which recently sold at auction on May 15, 2013 for $48.8 million.

After the artist’s death, his estate established a committee to review and determine authenticity of works thought to be Basquiat. The authentication work was directed by the artist’s father, Gerard Basquiat, with assistance from a former curator of American Art at the Whitney Museum. As of September 2012, the authentication committee disbanded. (Read our report on the phenomenon of closing authentication committees here.)

Basquiat’s estate is currently administered by his sisters, Jeanine Basquiat Heriveaux and Lisane Basquiat, who in their roles as administrators are currently suing the Internal Revenue Service, alleging that their brother’s estate was overvalued. (Read: Untitled but Taxable.) The sisters took over the suit, which was originally filed by their father Gerard, after Gerard died. The origins of the IRS suit began when Sotheby’s originally valued Basquiat’s mother’s half of the estate at $36 million. Death taxes were paid by Gerard using the Sotheby’s valuation of the estate. The IRS, however, later valued the estate at $138 million, significantly increasing the amount of death taxes owed by the estate, and imposing nearly $2 million in penalties. The IRS suit is on the docket for a hearing by the United States Tax Court in April of 2014.

With April only weeks away, on 4 March 2014, Basquiat’s sisters filed a claim against the auction house Christie’s, Inc. (“Christie’s”), alleging it was attempting to sell inauthentic Basquiat items. The Complaint concerns publication Christie’s 148-page sales catalogue entitled “Jean-Michel Basquiat: Works From The Collection of Alexis Adler.” The catalogue was published in mid-February 2014 and was created to publicize the auction house’s March 2014 sale of approximately 50 items that Christie’s attributed to/listed as created by Basquiat.

UNTITLED (FLAG), one of the works attributed to Basquiat which was to be sold by Christie's before the case.

UNTITLED (FLAG), one of the works attributed to Basquiat which was to be sold by Christie’s before the case.

The source of the collection featured in the catalogue purportedly comes from Alexis Adler, a woman with whom Basquiat had a relationship and lived with for time between 1979 and 1980 in New York. The collection that Christie’s accepted on consignment for sale was allegedly left behind by Basquiat in the apartment he shared with Adler.

Prior to the catalogue being published, in 2007, Adler attempted to have seven items in her possession authenticated by the Estate’s Authentication Committee. At the time, six out of the seven items were, in fact, determined to be authentic Basquiat works. Nevertheless, according to the Complaint, at no time did Adler or Christie’s attempt to authenticate the rest of the items in her collection.

If, by way of example, Christie’s had in fact submitted the collection to the Estate for authentication and it declined to authenticate some of the items, a proposed New York State bill, if passed, would afford the Estate greater protection if Christie’s then decided to sue for improper/negligent denial of authenticity. Proposed New York State legislation, §13.04 of the New York Arts and Cultural Affairs Law, outlines specific protection for people or entities that qualify and are sued as “authenticators.” Under the bill, an “authenticator” is defined in two ways: 1) “a person or entity recognized in the visual arts community has having expertise on the artist or work of fine art with respect to whom such person or entity renders an opinion in good faith as to the authenticity, attribution or authorship of a work of fine art”; or 2) “a person or entity recognized in the visual arts community or scientific community as having expertise in uncovering facts that serve as a direct basis, in whole or in part, for an opinion as to the authenticity, attribution or authorship of a work of fine art.”

Notably, under the proposed bill, an authenticator shall not include “a person or entity that has a financial interest in the work of fine art for which such opinion is rendered. . . .” The proposed bill does, however, allow for an authenticator to be compensated for their efforts relating to their authenticating a work.

Untitled (We'll Get You Next Time), work attributed to Basquiat, listed in the Christie's catalog.

Untitled (We’ll Get You Next Time), work attributed to Basquiat, listed in the Christie’s catalogue.

Under the proposed bill, if a suit is brought against an authenticator that relates to the authenticator’s opinion concerning a work of art, the claimant must: 1) specify with particularity in the complaint facts sufficient to support each element of the claim or claims asserted; and 2) prove the elements of the claim or claims by clear and convincing evidence. As further protection for authenticators in civil claims, if the authenticator prevails in the action, he, she, or it may recover reasonable attorney’s fees, costs and expenses.

When the catalogue for the online auction was published, however, a notice on the last page was included which read, “All artwork by Jean-Michel Basquiat: © 2014 the Estate of Jean-Michel Basquiat/ADAGP, Paris/ARS, New York.”

In the Complaint, Basquiat’s sisters allege that Christie’s included the above-mentioned notice to deceive potential bidders into thinking that all of the items for sale were authenticated by the committee. In addition, plaintiffs/or their first names allege that Christie’s included the notice to increase the auction prices in order to maximize its revenue from the sale. At the time, the Complaint noted that allowing the sale to continue would serve to damage the Basquiat Estate by putting into the marketplace items of questionable authenticity, which will in turn decrease the value of works actually created by Basquiat.

The plaintiffs in this case are seeking, among other things, a minimum of $1 million in damages and injunctive relief restraining Christie’s from using the Estate’s name in any credits without the Estate’s prior written consent. Plaintiffs’ claims for relief include, but are not limited to, false endorsement, false advertising, deceptive trade practices, and unfair competition.

Plaintiffs are represented by Cinque & Cinque, P.C. law firm in New York. Christie’s has yet to enter its appearance. However, on March 9, 2014, Christie’s postponed the Basquiat auction pending the outcome of this case. No amended complaint was filed as of March 24, 2014. An Initial Pre-Trial Conference is scheduled for May 2, 2014.

Sources: 

About the Author: Chris Michaels is a litigation attorney in the Philadelphia office of the Atlanta, GA-based law firm, Cruser & Mitchell, LLP, where he actively pursues his interest in the field of art law. He may be reached at 518-421-7238, chriswmichaels@gmail.com, or on Twitter @CMichaels88.

Disclaimer: This article is intended as general information, not legal advice, and is no substitute for seeking representation.