STEP ONE: Appraising the Art and Determining a Value
One of the very first steps that should take place when working through an estate administration containing art is to have the piece(s) appraised. However, a mistake that many people make is to hire an appraiser for the entirety of the estate. While a general appraisal of the estate is helpful for one’s personal knowledge it is crucial that when trying to determine the value of “hard to value” assets such as artwork, an appraiser with deep knowledge of that category, be it art, music collections, artifacts, etc., be included in the process.
In fact, these assets require professional appraisals to be done using a methodology that meets the IRS’s standards, known as a “qualified appraisal.” Even when a qualified appraisal is done, there is often significant room to differ as to the valuation assigned to the asset. Fair market value as defined by Internal Revenue Service Publication 561 is “the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts." This is just one factor out of many in how valuation can be assigned. Additionally, discounts can often be taken on certain assets for lack of marketability and lack of control. The use of these valuation methodologies and discounts is an art form, and qualified appraisals done by a qualified appraiser are an absolute “MUST” for any estate that may require an estate tax return.
STEP TWO - Determining Where Necessary to Report Value
When a US taxpayer passes away, everything they owed and owed at the time of their death becomes their “estate” for tax purposes. Pursuant to federal law, they are allowed to transfer a certain dollar amount from their estate to other people or entities free of estate tax1. This dollar amount that can pass estate tax-free is known as the “federal estate tax exemption” and is currently set at $12.06mm for 2022. This amount changes nearly every year, and is intertwined with the federal gift tax exemption. A deceased person’s federal estate tax exemption amount is the amount set for the year they died, reduced by any taxable gifts made by that deceased US taxpayer during their lifetime (their “exemption amount”).2
If an estate is over the threshold and federal estate tax is due, it is assessed on the value of the estate over the exemption. (For instance, if the estate is valued at $14.06mm, then the federal estate tax would be assessed on the $2mm difference at a rate of 40%, which is a whopping $800K in taxes!) Interestingly, some states also assess their own state estate tax, set their own exemption amounts (often a much lower bar than the federal exemption amount), and have their own methods of applying the tax. Learn more about this here.
As you can imagine, when estates are over or near the federal estate tax exemption threshold, valuations of illiquid assets like artwork become critical for determining if the estate is subject to estate tax, and, where applicable, the amount of that tax. This is why the selection of a qualified appraiser, as well as ensuring that the appraiser uses a widely accepted valuation methodology, is so critically important. If not done properly, there could be hundreds of thousands of dollars (in some cases, millions of dollars) or more at stake.
STEP THREE - Reporting the Value
So you may be asking yourself, but how on earth does the IRS even know if I own artwork? Where do they check and how does this work? The American Tax system relies heavily on on “self reporting,” however, do not mistake this reliance for the “honor system.” If you do not report accurately and on time, and a tax liability is subsequently uncovered, the consequences are dire for all involved.
So let’s get into how to report it.
Who should report?
When someone passes away, if their estate is over the deceased’s available federal estate tax exemption amount, they are required to file an IRS Form 706, also known as a federal “estate tax return.” In addition, when an estate is near the federal estate tax exemption amount but not over it, it is usually still a good idea to file Form 706 for informational purposes because it closes the time window that the IRS has to audit the particular estate. (If you do not ever file, presumably the IRS can, at any time, even 50+ years later, audit the estate to ensure that the value was actually below the estate tax exemptiuon amount and there was actually no estate tax due.) If an estate is well below the deceased’s available federal estate tax exemption amount, it may still make sense to file a Form 706 for the estate if there is an affluent surviving spouse and a portability election is needed to transfer the deceased’s unused estate tax exemption amount to him or her.
What is an IRS Form 706?
An IRS Form 706 or “estate tax return” is a form that shows the values of all the assets and liabilities that the deceased person had on the date of his or her death, tallies them up, and calculates the estate tax due, if any. The methods used to value each asset and liability are attached to the return on as schedules, so that the IRS can review how you came up with the particular value you reported. This is why the appraisal report is so critical, as that is what the IRS will spend the majority of their time reviewing.
Who handles it/is responsible for filing IRS Form 706?
The legal representative of the estate (i.e., the Executor, Administrator, or Personal Representative) is responsible for signing and filing the form, and can be held personally liable for failing to file. However, they should not attempt to prepare and file Form 706 on their own, as a lawyer who specializes in estate tax return preparation is needed to handle this part of the process.
What is the deadline for filing an estate tax return?
The IRS Form 706 is due within 9 months of the date of death of the deceased. On or before the 9-month deadline, a 6-month extension to the deadline can requested and granted, as long as the estimated taxes are paid when the extension request paperwork (Form 4768) is filed.
What does the IRS do once they get the estate tax return?
From the IRS’s perspective, once the 706 is filed, they review, in great detail, the reported values of all of the assets and liabilities, ensure that such values make sense and are correct, compare the values with the deceased’s available federal estate tax exemption, and apply the tax, if there is one. If the estate taxes you reported that you owed match the IRS’s calculations, then they will not assess anything additional. If not, you will owe the balance, and in most cases, interest and penalties will apply for the “underreporting.”
What does this have to do with artwork appraisals?
As you can imagine, where illiquid and hard-to-value assets like artwork are concerned, the IRS will look very closely at the asset, valuations, and appraisal reports. They will review and independently research the appraisal methodology, the qualifications of the appraiser, as well as a slew of other information. They may even hire their own appraisal experts to re-appraise the asset to challenge the value reported on Form 706.
This is where estate tax litigation can occur, if the IRS assesses additional estate tax because they have assigned a higher value to an asset or a lower value to a deduction that you disagree with. You can challenge this in tax court, as big dollars are frequently at stake.
This is why it is so important to have a qualified appraiser that accurately can report the value. Though underreporting an asset’s value or overreporting a liability/deduction can seem tempting, the interest and penalties are extremely stiff and simply not worth the risk. Below are some tax court cases that deal with IRS disputes with respect to valuations of works of art specifically.
In George O. Doherty and Emelia A. Doherty v. Commissioner, 16 F.3d 338 (9th Cir., 1994), the taxpayer’s expert and IRS’s expert could not resolve the question of the authenticity of a donated painting. In 1969, the Dohertys bought a painting for $10,000 and subsequently donated an undivided 40% interest in 1982 and the remaining 60% in 1983. In those two years, they claimed charitable deductions in the amounts of $140,000 and $210,000. The IRS asserted that the painting was a forgery and worth only $100. The Ninth Circuit noted that the credentials of both experts were beyond question but had reached different conclusions, and thereby the Court could not rule on authentication and concluded that the painting had a value of $30,000, recognizing the fact that even if the painting were authentic, the dispute had affected its fair market value. Furthermore, the Court rejected taxpayers' argument that because the doubt as to the painting's authenticity did not arise until IRS had evaluated the validity of their deduction, the question of authenticity should not have been considered when determining the painting's fair market value at the time of the donation. If that was the case, taxpayers in general would be entitled to undisputed acceptance of their (or their chosen appraiser's) valuation of artwork merely by avoiding the scrutiny of independent appraisers before the work is donated. Therefore, it would be sufficient that the facts that later form the basis of the doubt existed at the time of the contribution, and would have affected the bid of a willing buyer.
ESTATE OF KOLLSMAN
More recently, in 2017, in the Estate of Eva F. Kollsman, et al. v. Commissioner, TC Memo 2017-40, the Tax Court allowed discounting with respect to two “Old Masters” paintings, (1) a painting of Orpheus by Jan Brueghel the Elder or Jan Brueghel the Younger or a Brueghel studio (“Orpheus”) and (2) a painting of a maypole scene by Pieter Brueghel the Younger which was valued at $500,000 on the decedent’s estate tax return and subsequently sold, four years after her death, for $2,434,500 (“Maypole”).
In this case, the Court rejected the appraisals of the paintings done by the estate’s expert and instead accepted the appraisal offered by the IRS’s expert because, the expert (1) had a “significant conflict of interest that could cause a reasonable person to question his objectivity” as he and Sotheby’s (his employer) stood to gain economically by appeasing the executor and trying to “curry favor” with the executor by providing a “lowball” estimated value at the same time he was negotiating with the executor to sell the artworks; (2) exaggerated how dirty the paintings were on the date of death, and also exaggerated the risks associated with cleaning the artworks; (3) didn't appropriately consider and offer comparables in support of his valuations. Though they rejected the appraisal offered by the estate’s expert, the Court permitted certain discounts acknowledged by the IRS expert that are unique to art valuation for the risks associated with one painting of a lesser provenance and the uncertain attribution of the artist of the other painting, as well as discounting associated with cleaning the paintings and the bowed condition of one of the paintings.
With respect to Maypole, using a comparative market data approach as his valuation method, the IRS’s expert compared it to another Maypole-scene painting that sold at auction in 1997 for $3,330,272 which allegedy was considered by some to be the prototype for the others (the “1997 work”). The IRS expert report permitted a downward adjustment in Maypole's value to account for the fact that the 1997 work's provenance was superior to Maypole's (the 1997 work came from the collection of a well-known collector, and Maypole was likely from a collection in London and then was in a lesser-known American private collection from approximately 1940. Relying principally on the 1997 work, and Maypole's similar superior artistic quality and condition, yet lesser provenance, the IRS’s expert concluded that Maypole's fair market value on the decedent’s date of death in 2005 was $2,100,000, which the Tax Court accepted.
With respect to Orpheus, while the Tax Court agreed with the IRS expert’s report that Orpheus should be attributed to Jan Brueghel the Elder, rather than Jan Brueghel the Younger, because of the existence of the attribution dispute, the Court still applied a 10% discount to the value reported for the painting if it were done by Jan Brueghel the Elder. According to the IRS Expert, if Orpheus was attributed to Jan Brueghel the Elder then it would be conservatively valued at $500,000; however, if Orpheus is attributed to Jan Brueghel the Younger, a lesser regarded artist, then a conservative value would have been $325,000.
STEP 4: Insurance, Transporting the Artwork to the intended beneficiary
As legal representative of the estate, the Executor/ Personal Representative/ Administrator has a fiduciary duty to ensure the artwork is secured during the administration and delivered safely to the intended recipient at the close of the administration without incurring any damage. This can be difficult and there is often a lot of money at stake. We recommend, for works of art that are of significant value, that the estate representative take out an insurance policy on the work as an expense of the estate (unless the Will or Trust state otherwise).
1The Federal Estate Tax is a tax on property transferred by a deceased person’s estate to his or her heirs or beneficiaries
2“Taxable gifts” are not usually what you think of when you think of a gift, so please do not go tallying up every toy given to a grandchild or check placed in a relative’s holiday card, unless it is very expensive (generall speaking, $15K or more). This is a particular type of giving that a person must report on an IRS Form 709, which is a federal gift tax return, in the the year that the gift was made.