Many taxpayers have art collections. However, the art collections of some high-net-worth individuals, family offices, and business taxpayers may draw the unwanted eye of the IRS. With the increased focus on auditing high-income taxpayers, large partnerships, and using increased staff and artificial intelligence will almost certainly increase the number of cases involving artwork. At the end of 2023 the IRS also announced that they had “multiple” active abusive art donation investigations underway and that more than 60 taxpayer audits were completed producing $5 million in adjustments.[1]
Valuation of the artwork itself is a large issue for art collections. The litigation of these disputes has recognized that the value of any art collection is “inherently imprecise.” The inquiry is very fact-intensive given the subjective aesthetic judgments involved, shifting prices based on the critics, and the flux in attention from both investors and collectors. For example, digital art was highly favored and Non-Fungible Tokens (NFTs) were highly traded and highly priced until attention waned and both interest and prices dropped dramatically. The timing of the valuation can also be important if the art collection is part of an estate. The value of the artwork for estate tax purposes is determined by the fair market value at the time of death or, if elected, an alternate valuation date. Regardless, if artwork is valued at more than $50,000 it will mostly likely require review by a special IRS Art Advisory Panel that meets in closed session twice a year. This review could increase the time to complete estate tax or income tax audits. In an estate tax audit, this could result in last minute proposed deficiencies with an inability to voluntarily extend the statute. Facing a notice of deficiency, the only response is payment or filing a petition in U.S. Tax Court.
Although fair market value may seem like a simple concept (i.e. the price of a willing buyer and seller with reasonable knowledge and no compulsion), issues still arise. For example, the IRS has successfully argued that the fair market value includes certain buyer premiums and private art dealer commissions claiming that the inquiry is what could be received from and not what is actually retained from the sale. Valuation issues get even more complicated when fractional interests in artwork are involved. These fractional interests are usually subject to discounts in their value which the IRS frequently challenges. In one case the family produced five expert witnesses to support their 44.75% discount and the IRS produced two witnesses claiming no-discount. The result was that the Tax Court allowed a much smaller 10% discount. This 10% discount was eventually undone by the Fifth Circuit court of appeals, noting the IRS complete lack of evidence, and the 44.75% discount as reinstated. See Elkins v. Comm’r, 767 F.3d 443 (5th Cir. 2014). However, this required an audit, Tax Court litigation, and an appeal of the $9 million proposed deficiency. Taxpayers can, proactively, seek a Statement of Value from the IRS by following the procedures and paying the fees outlined in Revenue Procedure 96-15. However, the IRS can decline to issue a Statement of Value if it feels it doesn’t support efficient tax administration. See Internal Revenue Manual 8.18.1.1.8.1(6).
The valuation for estate tax or donation purposes, and any associated discounts, usually involves the use of experts. This results in another highly litigated issue over the expert’s method and opinion regarding the artwork involved. The IRS has its own team of trained appraisers who provide assistance and advice to the IRS as part of the IRS’s examination function. These same appraisers assist IRS Counsel and Department of Justice lawyers if a dispute finds itself in Tax Court or Federal District Court. Taxpayers and the IRS need to ensure that any such appraisal expert is sufficiently independent, even if an insider may be the most familiar with the artwork itself. The Tax Court has invalidated expert opinions on behalf of both Taxpayers and the IRS for potential bias. For example, one taxpayer used the owner of an auction house who was bidding to sell the artwork and the IRS used one of its own internal experts that usually assists with examination decisions. Both experts were ignored in favor of other experts without potential bias. Considering potential evidentiary issues on the front-end could avoid additional time and costs if litigation is required.
As the IRS ramps up its audit efforts for high-income taxpayers and large partnerships and corporations more disputes over artwork, usually held by those taxpayers, will arise and estates and other taxpayers must be prepared to defend their positions. Taking proactive steps to properly document the value and discounts involved, before a dispute arises, could save taxpayers both time and cost.
[1] See IRS warns taxpayers of improper art donation deduction promotions; highlights common red flags | Internal Revenue Service.
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