Estate Taxes. You must consider the tax bill your children might inherit. Unless the collector’s will stipulates otherwise, the beneficiary is responsible for paying estate taxes on inherited property. Your advisors can show you how to ease the burden on heirs created by estate taxes (the federal rate is 45 percent, and some states impose their own estate taxes) that could stretch into six figures. "If you’re not leaving your property to either your spouse or charity," says Susan Porter, a managing director with U.S. Trust, Bank of America Private Wealth Management, "the most significant beneficiary of your estate will be Uncle Sam." While we’re on the subject of taxes: If your children later decide to sell your works, they will be liable for the 28 percent federal capital gains tax on fine art—nearly double that of most other assets. In some cases, a will may specify that certain assets be bequeathed. Those assets that are not specifically accounted for (known as the "residue") can then be used to pay estate taxes as well as the cost of executing the will.

Another mechanism is an irrevocable life insurance trust, whose proceeds, when you die, could be used to cover estate taxes.

Prepare for an Audit. When a tax return that includes artwork valued at $20,000 or more is selected for audit, the taxpayer’s case is referred to the Art Advisory Panel, an arm of the Internal Revenue Service that reviews the art to determine whether the works in question have been assigned the proper value.
 
Living taxpayers and estate executors have different goals when it comes to valuing their art. To help members of the panel maintain objectivity when assessing an object, they are not told whether the object they’re valuing is from an estate or a charitable donation.

Taxpayers who find their cases called before the 20-member panel need to provide detailed documentation to win their case. It’s not always easy. In 2006 the panel reviewed 124 taxpayer cases involving more than 1,600 items with a combined taxpayer valuation of more than $219 million. Of those cases, the panel upheld only 38 percent of valuations submitted by taxpayers’ appraisers. Among the other items, the panel recommended adjustments that reduced charitable contribution claims by a total of 57 percent (or nearly $1.9 million) and increased estate and gift appraisals by a total of 95 percent ($117.7 million).

"It all boils down to documentation," says IRS spokesman David Stewart, "and that’s going to be true for any taxpayer for any reason." Karen Carolan, the chief of Art Appraisal Services for the IRS, says any art valued at more than $3,000 needs to be appraised. Carolan says the appraisal should contain: the name of the artist or culture; a description of the work; the work’s provenance; the appraisal date (and whether the appraisal was done in person); and a description of special circumstances that could affect the work’s value. For higher-value pieces, the appraisal should include an explanation of how the appraiser arrived at the value as well as the comparables (results from recent sales of similar works with an explanation of how they compare).

Carolan says it’s imperative that the taxpayer or executor provide high-quality photographic images of the artwork in question. These may include: 4-by-5-inch transparencies; 8-by-10-inch clear color photographs of professional quality printed on photographic paper or high-resolution color digital images labeled with descriptive information and submitted on CD. For a more detailed list of what is and is not acceptable regarding formats for images submitted to the panel, visit irs.gov, type in "art advisory panel" and click on "Art Appraisal Services."

Taxpayers may also request a "fast-track" appraisal from the IRS, to be done before the tax return is filed. To qualify for the fast-track procedure, the taxpayer’s art collection must contain at least one piece worth $50,000 or more. This option costs $2,500 for the first three objects and $250 for each additional object.