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The Fine Art Of Establishing Value

Tax planning is not a glamorous profession, which is why Hollywood probably won’t release a summer blockbuster starring George Clooney or Jason Statham as a CPA with nothing to lose.

But now and then, you find yourself staring down the wallet of an imaginary Chinese billionaire.

The heirs of modern-art dealer Ileana Sonnabend faced exactly this improbable scenario when the Internal Revenue Service challenged their valuation of a particular art piece: “Canyon,” a collage by Robert Rauschenberg. Sonnabend’s heirs had already sold several pieces of her collection to pay a hefty estate tax bill. But “Canyon,” arguably the piece with the highest profile, was not eligible for sale because it incorporates a stuffed bald eagle. (Sonnabend had a special permit to own and lend the work to museums in the United States, but selling a protected species’ remains, or possessing them without a permit, is illegal.)

Appraisals from Christie’s and two others supported the decision to value it at zero on Sonnabend’s estate tax return, since the work could not legally be sold. The IRS, however, valued “Canyon” at $65 million, which resulted in an additional tax bill of $29 million (the heirs had already paid more than $470 million in federal and New York taxes on an estate worth about $1 billion), as well as a “gross valuation misstatement” penalty.

Even in the context of a $1 billion estate, the gap between zero and $65 million is wide. In this case, it was exceeded only by the gap between fantasy and reality.

Taxpayers and the IRS both hire appraisers to estimate the worth of assets that, unlike cash or publicly traded stocks, have no readily determined value. The appraisers are supposed to determine “fair market value,” defined as the price at which a property would change hands between a buyer and seller who were both willing and knowledgeable.

The Sonnabend estate determined that “Canyon” was worth nothing because no buyer or seller could legally exchange it at any price. Consequently, the estate could not even claim a tax deduction if it chose to donate the work to a museum, since such deductions are also based on fair market value. The estate clearly had both law and logic on its side.

But the IRS did not consider itself bound by law or logic. The agency’s appraisers valued “Canyon” solely on its artistic merit without regard to the legal restrictions on its sale. In other words, they determined that “Canyon” would sell for $65 million, in a world in which “Canyon” could be sold.

The IRS could not pursue the $29 million it convinced itself it was owed unless it first got past the problem that the tax code requires a hypothetical willing buyer and willing seller to agree on a price for an equally hypothetical transaction, which in this case was prohibited by federal statute.

Enter the imaginary Chinese billionaire.

Ralph E. Lerner, the lawyer who represented the Sonnabend estate, contacted the chairman of the IRS art panel to inquire how it could support its $65 million valuation for a work that has no market. According to him, the panel’s chairman claimed that a hypothetical, though highly illegal, market could exist if a hypothetical Chinese billionaire was willing to buy “Canyon” and hide it. This scenario also required the concurrent assumption that the Sonnabend estate, which had already paid more than $470 million in compliance with the law, would be willing to break it to sell an unsalable and world-renowned work of art.

The IRS argued that fair market value includes black market value. Who says government workers can’t be creative? The idea might not fly if a screenwriter pitched it to a film producer, but the tax auditors had no qualms about putting it in their report.

Lerner sued the IRS on the Sonnabend family’s behalf. Eventually, as part of a $41 million settlement, the heirs agreed to donate the collage to The Museum of Modern Art in New York. The IRS dropped the tax assessment, and the family agreed that it would not claim any tax deduction, which, in all likelihood, it never planned to do anyway.

Most of us will never get the chance to spitball ideas like fantasy Chinese billionaires with IRS estate tax examiners. This year’s fiscal cliff compromise set a high ticket price to get into that audience, as each of us gets a $5.25 million lifetime exemption from transfer taxes, a figure indexed for inflation. You have to be a genuine high-net-worth A-lister to get the agency’s real creative types to pay attention to you. But if you make the cut, they will routinely show you their unique kind of love.

I have seen this movie before, though on a much lower budget than the “Canyon” blockbuster. A client of ours some years back commissioned an outdoor jade sculpture, comprising three large stones. I walked past the polished stones in the client’s yard many times without giving them a second thought. After the client died, we had the sculpture appraised professionally; the fair market value came to $25,000. The IRS, however, claimed that the sculpture should be worth $45,000, a number it apparently produced by ignoring market conditions during the financial crash (which is when the client happened to die), and by claiming that breaking up the site-specific installation to either transport it or to sell in components would not reduce its value.

This real-world example is a much lower-value but much more typical case. The IRS, upon disagreeing with a taxpayer’s estimate, pulled its own number out of very thin air.

In fairness, many taxpayers must also pull numbers out of a rarefied atmosphere, because no actual transaction has happened on which to base a tax. Fair market value, under our current estate tax system, is often based on guesses, some of which are more educated than others.

Taxpayers may act in the best of faith; they may hire one or more highly qualified appraisers; they may regularly update their appraisals to reflect changing market conditions and demand. At the end of the day, however, no sale has taken place, so the numbers cannot be pinned down with anything like certainty.

We have seen the IRS attempt to value businesses and heirlooms during the financial crash as though the crash had never happened. The agency takes the incongruous position that, since nobody was willing to sell at the fire-sale prices that existed in 2008 and 2009, those prices were not relevant in determining value. The IRS wants to value things at what sellers wished they could have gotten for them, instead of what they could have actually gotten - much as in the case of the jade sculpture or “Canyon.”

The indexed $5.25 million per-person exemption ensures that most Americans will never have to deal with this legal mess. But those who do will continue to face the unpredictability and the unfairness of having to ransom family possessions from the government just because someone died. Or, as in the case of “Canyon,” having to give those possessions away.

The simple and logical answer is to get rid of the estate and gift tax completely, which is what happened to the estate tax (though not the gift tax) in the single halcyon year of 2010. The government could then eliminate or limit the step-up in basis that forgives capital gains tax at a person’s death. Instead of being forced to liquidate assets to pay an estate tax immediately, heirs would keep the original cost basis on the assets they inherit, and they would pay the appropriate capital gains taxes whenever they actually sold the assets. This would provide both an accurate market value and the cash with which to pay the tax. Uncle Sam would get his due, and neither party would be required to guess what a willing buyer might pay, or what laws the buyer and seller might be willing to break.

Some people, mainly those who sell estate tax-planning services for a living, argue that it is difficult or impossible to track cost basis across generations. In some cases it is, though bad recordkeeping is not the government’s fault. When the taxpayer cannot show the correct cost basis, the law already entitles the IRS to assume it is zero. This allows the agency to tax the entirety of the asset’s value whenever it is finally sold, which is a fair result.

This approach would allow the government to collect its tax on a work like “Canyon” if, and only if, a Chinese billionaire actually emerges to buy it. After all, art is subjective, but taxes shouldn’t be.

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