22 May 2020 - Article
Prior to the enactment of the Pension Protection Act of 2006 (“PPA”), owners of artwork faced substantial monetary penalties if their artwork was incorrectly valued for tax purposes. Appraisers also faced penalties if their appraisals “aided and abetted” an understatement of tax liability. The PPA has increased the potential penalties against owners of artwork for inaccurate appraisals, and has added a new section to the Internal Revenue Code which imposes an additional penalty against appraisers who over value or under value property. New standards have also been created with regard to the qualifications of art appraisers and the contents of written appraisals made for purposes of substantiating charitable contributions of property.
Valuation for Tax Purposes
The standard for valuing property for US income, gift and estate tax purposes is essentially the same. The value of property is the price at which the property would change hands between a willing buyer and a willing seller, neither of whom is under any compulsion to buy or sell and both having knowledge of relevant facts. For income tax purposes the taxpayer’s bias is always toward a higher valuation as such a valuation increases the charitable deduction. For gift and estate tax purposes, the bias is for a lower valuation, as that would minimize estate or gift tax. Although the valuation of property must generally be done by a competent appraiser for tax purposes, the taxpayer is held responsible for inappropriate valuations.
In preparing appraisals of personal property for tax purposes most appraisers take guidance from the Uniform Standards of Professional Appraisal Practice (USPAP) published by the Appraisal Standards Board of the Appraisal Foundation. The USPAP rules prescribe a methodology for conducting an appraisal, including the use of comparable sales, and set forth guidelines for the content of written appraisals. Although the USPAP rules are not binding on the IRS, the IRS has increasingly been making reference to those rules in determining whether a well reasoned appraisal of property has been made.
Penalties on Taxpayers
The PPA lowers the threshold for imposing accuracy-related penalties on donors for “substantial” and “gross” valuation misstatements. The penalty tax rates imposed on donors continue to be 20% of the tax underpayment resulting from a substantial valuation misstatement and 40% of the underpayment resulting from a gross misstatement.
For income tax purposes, the threshold for determining whether a penalty is imposed on donors for substantial valuation misstatements is reduced to 150% (from 200%) of the correct value as determined by the IRS. For example, a penalty will be triggered if the donor values a gift to charity as $150,000, where the correct value is $100,000. For estate and gift tax purposes, the threshold for a substantial valuation misstatement is increased to 65% (from 50%) of the correct value. For example, a penalty will be triggered if the property left to a child is valued at $1,000,000 for estate or gift tax purposes, where the correct value is $1,538,500.
For income tax purposes, the threshold for determining whether a penalty is imposed on donors for gross valuation misstatements is reduced to 200% (from 400%) of the correct value as determined by the IRS. For estate and gift tax purposes, the threshold is increased to 40% (from 25%) of the correct value.
In addition, the PPA eliminates the “reasonable cause” defense in the case of gross valuation misstatements for both income tax and gift and estate tax purposes.
Penalties on Appraisers
Under prior law, appraisers were subject to a penalty for aiding and abetting an understatement of a donor’s tax liability. The penalty on an appraiser was a flat $1,000 ($10,000 if a corporate tax return was involved). Under the PPA, appraisers are now subject to additional penalties under Code Section 6695A. Under this new Code section, the penalty is the greater of $1,000 or 10% of the amount of tax attributable to a substantial or gross valuation misstatement, up to a maximum of 125% of the gross appraisal fee received by the appraiser. The penalty is imposed if the appraiser knew or reasonably should have known that the appraisal would be used in connection with a tax return and the claimed value of the property which is based on the appraisal is considered a substantial or gross valuation misstatement. There is a limited exception to the penalty if the Secretary of the Treasury determines that the value established in the appraisal is more likely than not to be the correct value.
As under prior law, appraisers can be barred from practice before the Department of Treasury or IRS after notice and a hearing based upon inappropriate valuations.
New Qualified Appraisal Requirements for Charitable Gifts
The PPA has changed the definition of a qualified appraisal for income tax purposes by refining the definition of who is a qualified appraiser and requiring that a qualified appraisal be prepared in accordance with generally accepted appraisal standards. The new law defines a qualified appraiser as an individual who:
- Has earned an appraisal designation from a recognized professional appraiser organization or who has otherwise met education and experience requirements prescribed under treasury regulations;
- Regularly performs appraisals for which the individual receives compensation;
- Can demonstrate verifiable education, experience in valuing the type of property subject to the appraisal;
- Has not been prohibited from practicing before the IRS at any time during the three (3) years preceding the appraisal; and
- Meets any other requirements prescribed by treasury regulations.
Under existing regulations that remain in effect, the following persons cannot be a qualified appraiser:
- The donor;
- The donee, prior to the donor’s acquisition of the property;
- A person regularly employed by either party; and
- An appraiser used regularly by the above unless a majority of work is performed for others.
A qualified appraisal must contain the following elements which remain unchanged by the PPA:
- A description of property in sufficient detail so that a person who is not generally familiar with the type of property could ascertain whether the appraised property was contributed;
- In the case of tangible property, the physical condition of the property;
- The date or expected date of the contribution;
- The terms of any agreement or understanding entered into by the donor or donee relating to the use, sale or disposition of contributed property;
- The name, address and taxpayer identification number of the qualified appraiser is active in his or her capacity as a parther in a partnership, an employee of a person or an independent contractor engaged by a person other than the donor, the name, address and taxpayer identification number of the partnership or person employed as a qualified appraiser;
- The qualifications of the qualified appraiser who signs the appraisal, including the appraiser’s background, experience, education and membership in any professional appraisal associations;
- A statement that the appraisal was prepared for income tax purposes;
- The date on which property was valued;
- The appraised fair market value of the property on the date or expected date of contribution;
- The method of valuation used to determine the fair market value of the property such as the income approach, the market data approach, or the replacement cost less depreciation approach; and
- The specific basis for the valuation such as comparable sales transactions with statistical sampling, including a justification for using sampling and explanation of the sampling procedure employed.
Since the new PPA rules take effect for tax returns filed after August 17, 2006, both appraisers and any other persons involved with a transfer of art in the calendar year 2006 should make sure that they seek advice as to whether they are effected by the new legislation.