The following scenarios highlight the effect this uncertainty surrounding art transactions can have on clients (and, perhaps, the professional liability of advisors).
Charitable Gifts
If a charitable gift of art is unwound because it is later determined that the client did not have clear title to the work, the client faces adverse tax consequences and the qualified 501(c)(3) institution faces financial loss. The donor (or the decedent's estate, depending on when the title defect is discovered) faces a loss of the charitable tax deduction plus accrued interest and likely penalties. If a museum is involved, it will likely suffer economic loss because museums build their permanent collections around important gifted works, relying on the assumption that they are acquiring valid legal title. There are complex statute of limitation issues one must consider when assessing the penalty on charitable gifts that were void from the beginning. These issues, as well as the interface of fraud and discovery rules under the IRC, are topics for a separate discussion.
Also, the donor and recipient can find themselves at odds when gifts of art turn out to have a defective title. If a donor gives a museum a piece of art, and then a third party claims ownership, the institution has two unattractive choices. On one hand, it can fight the claim, (which it can rarely afford to do). On the other hand, it can acquiesce to the third-party, but that means the donor will likely claim a monetary loss because his tax deduction has been invalidated. Thus, in an unfortunate twist, the client becomes an adversary of the very institution he or she sought to support. And the advisor, meanwhile, could become the target of the client, who will undoubtedly ask the logical question, "Why was this title risk not managed when the philanthropy was planned?"
Estate Plans
Similar problems lurk in estate plans when art (or other tangible personal property) is sold to pay estate taxes or supplement life insurance purchased for paying those taxes. Heirs often do not want to keep their parents' art because they have different taste or because they prefer to preserve the more traditional assets, such as real property holdings, in the family's estate.
Fiduciaries, such as personal representatives and banks and trust company officers acting as independent estate settlement agents, may universally sell the art in an estate at public auctions in order to assure market neutrality and thus meet their fiduciary duties. But if the auction sale is later rescinded because of defective title-and the art returned and the sale proceeds refunded to the auction house under the auction contract terms-the heirs must be told why it was necessary to liquidate other estate assets and suffer significant tax consequences.
Identical challenges exist for estate transfers of art to tax-beneficial entities such as private operating foundations. The only difference is that the defective title issue is delayed. The fiduciaries (which may include an independent trust company officer, who is now posing challenging trust administration questions) will be charged with managing the foundation's art assets. When the foundation sells, lends for exhibition or buys works of art to fulfill its mission, the fiduciaries will face the same title risk.
An Alternative To Self-Insuring
The proactive risk management of your clients' art has never been more important now that the values and complexities of art transactions are increasing. Clients can continue to self-insure against this risk, as long as their decision is based on a complete understanding of the risk's nature and severity. But few clients are likely to have enough knowledge to make that decision.