Tales from the Tax Court: Artwork value is in the eye of the beholder – and the IRS
Owners of artwork should be prepared to prove the value of their pieces before reporting sales and other transfers on their tax returns
Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
It seems like every few months, a previously undiscovered Jackson Pollack or Andy Warhol painting is plucked from hiding and the world speculates about how much the masterpiece might fetch at auction.
Reports of talented forgers, wartime seizures, and insurance fraud prove that even expert appraisals might be miscalculated. But how is the value of art determined?
For tax purposes, the value of art arises in many situations, most often when pieces are transferred to charities, sold, or pass through to the owner’s estate after death.
Special reporting requirements also apply to certain art transfers. For example, to deduct certain donated artwork worth more than $5,000, taxpayers must attach an official appraisal to the return.
Sometimes, taxpayers and the IRS disagree about the appraised or reported value of artwork. As described in part one of this series, when taxpayers and the IRS don’t agree on an issue, they sometimes look to the U.S. Tax Court and other federal courts for resolution.
This article highlights some major artwork-valuation cases, the results, and their impact on the art world.
When value is in dispute, the Tax Court applies the willing buyer/willing seller test
Under the estate tax and charitable contribution regulations and subsequent court cases, the IRS determines fair market value of a piece of art based on the “willing buyer/willing seller” test. This test values a piece of art based on the price it would command if neither the willing buyer nor the willing seller were under compulsion to buy and had reasonable knowledge of relevant facts about the art.
For tax reporting, the value of a piece of art is usually the fair market value of the piece determined at the time of transfer, or at the time of the owner’s death for estate tax filing.
Several factors help determine the value of a piece including:
- Post-valuation events
- Market volatility
- Special discounts
Here are several court cases that helped shed light on how artwork valuation works for tax purposes.
The Tax Court settles a battle of experts over authenticity
George O. Doherty and Emelia A. Doherty v. Commissioner, TC Memo 1992-98
In this charitable contribution case, the Ninth Circuit Court affirmed the Tax Court’s fair market value determination of a painting called Attacking Stagecoach (supposedly an original by Charles M. Russell), after the taxpayers donated the piece to a museum.
Originally, the taxpayers claimed that the painting was worth $200,000. But the Tax Court lowered that value because experts disputed the painting’s authenticity at the time of the transfer. The court agreed with the IRS that the value of a piece of art whose authenticity is in dispute will change hands at a lower price than a piece with undisputed authenticity.
The IRS expert appraised the painting’s value at $50,000, claiming that the painting was a forgery, based on the poor quality of the painting and poor condition of the canvas. The Tax Court settled on a $30,000 value based on the sales price at the time of other Russell paintings in poor condition.
To clean or not to clean? The Tax Court says cleaning raised fair market value
Franzen, Eva, Est, TC 2017-40
In the Franzen case, two 17th century pieces were professionally cleaned after the owner died – causing their value to rise significantly. The estate expert originally valued the pieces, Maypole and Orpheus, at hundreds of thousands of dollars less than the IRS expert. He heavily factored in the dirty condition of the art caused by the previous owner’s heavy tobacco use. The estate’s expert may have also had an incentive to provide a lower value to the beneficiaries, because he wanted exclusive option rights to the paintings.
Less than a month after the owner died, a leading art-restoration company informed the estate expert and beneficiary that cleaning the paintings was “reasonably safe” and would influence the pieces’ value.
After Maypole was cleaned and reappraised, the Tax Court reassigned its value at just under $2 million. The painting sold three years after the original valuation date for $2.4 million, a whopping $1.9 million more than the estate expert had valued the painting before it was cleaned. Orpheus was eventually found to have a value of $375,000, while the original appraisal valued it at only $100,000.
The Tax Court didn’t agree with the estate expert’s reliance on the paintings’ dirty condition without considering the low risk of cleaning the pieces and the significant increase in value after the valuation date. The conflict of interest between the appraiser and the estate’s beneficiaries also caused the court to question the validity of the assigned values.
Similarly, in November 2017, a previously undiscovered and last known Leonardo DaVinci painting, Salvator Mundi, was authenticated only after a thorough cleaning. It sold at Christie’s for $450 million.
Market volatility and appreciation increase the value of pieces—even if it’s a “fluke”
Estate of Newberger v. Commissioner, T.C. Memo. 2015-246
The Newberger case involved pieces by Pablo Picasso, Robert Motherwell and Jean Dubuffet, which the IRS claimed were significantly undervalued. The estate’s experts originally valued the pieces at $5 million, $450,000, and $500,000, respectively.
When the Picasso sold for nearly $13 million soon after the owner’s death, the estate said the high price was a “fluke.” But the Tax Court agreed with the IRS appraised value of $10 million, which considered the auction price. The estate’s appraisal experts adjusted the value of the Motherwell to $800,000 and kept the Dubuffet at $500,000, according to similar paintings sold after the decedent’s death. The Tax Court agreed with those valuations.
“Blockage” discounts reduce value for larger art lots—but the discounts must be reasonable
Estate of Georgia T. O’Keeffe v. Commissioner, TC Memo 1992-210
One of the most notable cases involving art valuation concerned the estate of the prolific and beloved artist Georgia O’Keeffe. O’Keeffe painted until her death in 1986 at the age of 98. In her lifetime, she produced more than 1,000 substantial works.
The estate’s appraiser originally valued the estate’s 400 pieces at $18 million. That amount reflected a 75% “blockage discount.” A blockage discount lowers the value of a group of pieces because, if the owner floods the market with many paintings by the same artist, the value of the art will go down.
The court found that this discount “defies common sense” when the works of art had a total value of $72 million when valued individually. The court reviewed O’Keeffe’s history of sales and the global art market at the time, and sought the advice of several art experts to determine the appropriate value for the famed pieces.
The Tax Court landed on a compromise, valuing the works in the estate at $36.4 million. The court allowed a 75% discount to apply to half of the pieces, and a 25% discount for the other half, which was in the middle of the experts’ wide range of possible discounts.
The court determined that the pieces should be divided into two categories: works that would sell within a short timeframe, and works that would need marketing over many years with substantial effort. Pieces that required more time and effort would be allowed the 75% discount proposed by the estate.
Artwork owners should be prepared to back up the piece’s value if they plan to report it on their returns
Artwork owners can take proactive steps to prevent some common tax issues in valuing artwork.
One best practice is to get an appraisal that can stand up to scrutiny. Proper appraisals of damaged or otherwise delicate pieces can cost upwards of $50,000, especially if the piece requires techniques such as carbon dating, sonar scans, or digital cleaning.
Here are the rules that tax professionals and art owners should keep in mind if they plan to report art transfers on their return:
- Consult a qualified appraiser when transferring pieces worth more than $5,000.
- Request a statement of value from the IRS for items worth more than $50,000.
Note that a special IRS panel reviews returns selected for audit that have artwork worth more than $20,000 in appraised value.