If the IRS Wasn’t a Government Agency, Might This Count as Conspiracy?

If the IRS Wasn’t a Government Agency, Might This Count as Conspiracy?

A private party that coerced estate planners to sell drugs and other contraband -- much less turn a blind eye to failures to report illegal workers -- would risk jail time. But in order for the IRS to keep feeding the government the funds it needs, all of this is necessary proper and quite legal.

IRS efforts to get tough on tax crime have paradoxically put the agency in the awkward position of “suggesting” that U.S. citizens who want to avoid big fines dabble in the black market and pay unregistered workers under the table.

Case in point: when contemporary art dealer Ileana Sonnabend died in 2007, the crown jewel of her $876 million collection was a Robert Rauschenberg assembly that included a stuffed bald eagle carcass.

Unfortunately, it’s illegal to traffic in endangered species, so while she had permission to keep the work and exhibit it, she couldn’t exactly sell it without earning herself at least a year of jail time.

The art experts at Christie’s auction house agreed and told her executor that its market value was effectively zero. That’s what the estate put on its tax return.

The IRS, however, sent back a note assigning the piece an apparently arbitrary value of $15 million.

When pressed, they raised their appraisal to $65 million and tacked on an $11 million fine, justifying themselves by saying that the heirs could easily fetch that much for selling it on the black market.

Too rare to sell, too precious to keep

Sonnabend’s lawyers are suing for relief from the double jeopardy the IRS has put them in, but the shocking thing is that while their case is bizarre, it’s not unique.

The IRS has taken a hard line that contraband they find in estates is still taxable even though there’s no legal market for the firearms, hard drugs or stolen art.

As such, the heirs have to liquidate legitimate property in order to give the government its cut or else run the risk of being caught lining up illicit buyers.

Even in cases where the contraband can’t be sold -- for example, when the drug smuggler crashed his plane and his 600 pounds of marijuana were seized and destroyed -- the IRS still wanted its cut from the heirs.

Giving people an incentive to commit crime is especially ironic when you consider that the IRS has proved that it’s eager to look the other way when people hire illegal aliens, provided once again that the employer fills out the paperwork.

“It’s exactly this type of ridiculousness that makes the IRS the most reviled of all the government agencies,” says Colorado tax pro Tony Nitti.

“The service is taxing the estate on the hypothetical purchase price a piece of art could fetch on the black market, even though such a sale would constitute a federal crime.”

Ominous for all hard-to-value “exotic” assets

Most of the coverage of the Sonnabend estate’s tribulations has focused on the apparent double bind situation now facing her executor.

But in the big picture, this case should send a chill down the spines of all advisors who mark assets under their management to market price.

If the IRS can overrule expert opinion on what the “market value” of this piece of art is worth, what’s stopping them from assigning their own numbers to real estate, private equity or intellectual property?

As every bank left holding “toxic” bonds that nobody wanted to buy in the credit crunch found out, mark-to-market accounting in any asset class is arbitrary if there’s no market.

The IRS itself defines fair value as the price at which assets should change hands in a normal market situation where a buyer exists and the seller isn’t under special compulsion or duress.

Otherwise, the banks could concoct any number of hypothetical Asian billionaires willing to buy their toxic portfolios at an arbitrarily high price and book a big paper profit instead of a loss.

Even a headache for trusts

The theory is that contraband -- drugs, stolen jewelry, firearms, antique taxidermy -- is taxed at its street value, even though owning it is technically illegal.

That works well enough when we’re looking at a commodity with an established black market, but the Rauschenberg piece is definitely one of a kind.

Ironically, Sonnabend never transferred any of her collection into a trust and didn’t even seem too eager to avoid paying a staggering estate tax bill.

Her executor already sold close to $500 million in art to ensure that the rest of her $876 million collection passed on unencumbered.

Had she been more concerned with estate planning, it’s likely she would have cost the IRS a lot more than $40 million, so they should be grateful.

In fact, because the Rauschenberg had zero market value while she was alive, her heirs would have been better off if she’d donated it to a museum for a whopping zero deduction.

That means taking a total loss on what she paid for it in the first place, but it’s what the art gurus insist is the best scenario.

Get rid of the contraband before you die. Otherwise, it’s still illegal to sell, but your heirs will be stuck with the bill.

Scott Martin, senior editor, The Trust Advisor.

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