Although there have been many high-profile estate tax cases regarding ownership of artwork, we have yet to see consistency in how courts rule on discounts.

March 06, 2019

Unless you run your painting through a shredder, as the anonymous artist known as Banksy did in October last year, it is impossible to equally divide a painting between several owners.

How does co-ownership impact value? Often, we look to court cases to provide that insight, and indeed there is much to learn from undivided interest cases involving personal property. Just don’t expect to learn much about the fair market value computation of a fractional interest. This is somewhat of a revelation, given that the affluent have been planning and dying with undivided interests in artwork and other personal property for close to three decades, and yet no bright line has emerged on the fundamental question of value.

Well-versed estate planning attorneys might be quick to point out that several seminal art cases provide lengthy discussions on and insight into the determination of fair market value. These cases include:

  • Estate of Georgia O’Keeffe et al. v. Commissioner (T.C. Memo. 1992-210)
  • Estate of Eleanor O. Pillsbury v. Commissioner (T.C. Memo. 1992-425)
  • Estate of Robert C. Scull et al. v. Commissioner (T.C. Memo. 1994-211)
  • Robert Grove Stone et al. v. United States (3:06-cv-00259 TEH)
  • Estate of James A. Elkins et al. v. Commissioner (140 T.C. 86, 2013 WL 892399) (2013)

However, a detailed analysis reveals that despite addressing fair market value concepts, the specific issue of the fair market value of an undivided interest is conspicuously lacking, or at best one-sided. Several of the seminal “discount” cases only address the issue of a blockage discount and don’t have a fact pattern that would require a fractional interest discount.

With this in mind, we examined these seminal art cases. Our goal is to understand the cases’ short-comings in providing a bright line for the determination of a fractional interest discount associated with personal property.

Fair Market Value and Fractional Interests

When it comes to the valuation of an asset (or the valuation of an interest in an asset), the valuation community generally looks to the definition of fair market value as outlined in the Internal Revenue Code under section 20.2031-1(b) (estate) or section 25.2512-1 (gift), which states:

“Fair market value is the price at which the property would change hands between a hypothetical willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Once this definition of fair market value was established, Revenue Ruling 59/60 has provided the backstop for valuations since 1959. Revenue Ruling 59/60 was originally intended to provide guidance for the determination of closely held stock in a corporation but has since been applied to valuing a host of assets and instruments, including guidance on how to value fractional interests in corporations and assets (including real and personal property). Revenue Ruling 59/60 gives support for the consideration of the size of the block to be valued and whether that block has control over the corporation (or asset) and the existing market or lack thereof of the interest. In other words, when determining the fair market value of an undivided fractional interest in personal property (such as artwork), the appraiser is tasked with figuring out the appropriate reduction in value due to the lack of control and the lack of marketability suffered by the hypothetical interest holder.

The Cases

Estate of Georgia O’Keeffe

Georgia O’Keeffe lived to be almost 100 years old and created over 2,000 total works. Estate of O’Keeffe has become a seminal estate planning case primarily because she surprised a few heirs when she left most of her estate to Juan Hamilton, an artist and live-in assistant for the last 13 years of her life. But the contested will was not the only dispute with regard to the estate. In Estate of O’Keeffe, Judge Mary Ann Cohen was tasked with determining the fair market value of 400 works of art and the blockage discount appropriate to reflect the impact on the price from 400 works coming on the market at the same time. The estate’s expert concluded a 75% blockage discount based on his assumption that the entire collection would be sold in bulk to one purchaser. The court concluded that the experts’ reports contained hundreds of pages of “repetition, inconsistency and immaterial information … Each conclusion as to the appropriate blockage discount suffers from substantial defects and is patently unreliable.” Instead, Judge Cohen was looking for an analysis following the IRS Valuation Guide, which states:

“The concept of blockage is essentially one of timing. A discount may be allowed where a large quantity of any one type of art is offered on the market at one time and would substantially depress its value. The amount of the discount would be determined, in part, on a reasonable estimate of the time it would take to sell the entire quantity in smaller lots. Some of the factors to be considered in determining whether a blockage discount is available are the opportunity cost of holding the inventory, the carrying costs of the inventory, and the expected period of time it will take to dispose of the inventory.”

Frustrated by the lack of reliable expert opinion supporting the blockage discount, the court came up with its own analysis of applying a 75% discount for blockage to 50% of the works of art and a 25% discount for blockage for the remaining 50% of the art, in essence discounting the 400 works of art by 50% of their individual appraised values. Since the estate held a 100% interest in the works of art, there was no discussion or application of any fractional interest discount.

Estate of Pillsbury

It is rare that a case tackles the treatment of an undivided interest in both real estate and personal property. Yet this is exactly the matter that Judge Cohen was faced with in 1992, shortly after the O’Keeffe case, in Estate of Pillsbury. The decedent’s estate tax return included an undivided interest in real estate filed with a 15% discount for the fractional nature of the real property as well as undivided interests in various items of personal property (furnishings) with the same 15% discount. At trial, the estate presented an expert who concluded that a 20% discount for the undivided interest nature of the real property was appropriate to account for the lack of control, lack of marketability, and potential partitioning expenses. The Internal Revenue Service’s (IRS) expert did not present any analysis of the appropriate undivided interest discount and yet pointed out that the estate’s analysis was lacking in specificity and that therefore the discount should be zero. With regard to the real property, Judge Cohen decided that the estate did not present sufficient proof to overcome the initial IRS filing position of 15% and therefore concluded a 15% undivided interest discount was appropriate.

Although the analysis was thin with regard to the real property, it got even thinner with regard to the personal property. Lacking any analysis or supporting data, the estate simply claimed that if a discount is appropriate for the real property, then the same discount would be applicable to the personal property. Not allowing a discount would be “contrary to common sense.” The common sense argument does make some sense – the point being that an undivided interest holder in the personal property suffers from the same lack of control, lack of marketability, and potential partitioning expenses as the fractional interest holder in the real property. The problem with the common sense argument is that, according to Judge Cohen, “a bare assertion that a discount is appropriate; however, with no evidence to support it cannot be upheld.” Accordingly, the resulting discount for the undivided interest in personal property was zero.

Estate of Scull

With the hope of finding an on-point case for undivided interest discounts in personal property, Estate of Scull got off to a promising start. The first page of the case’s memorandum of findings indicated that the issue for decision would be “the fair market value, as of January 1, 1986, of decedent’s undivided 65-percent interest in the art collection owned by the decedent.” The personal property in question was a 200-piece collection of pop art that had been acquired by the decedent over a span of 40 years.

Determining the fair market value of an undivided interest in personal property has two elements to it: the value of the underlying artwork and the determination of the appropriate fractional interest discount. Much of this case revolved around establishing the value of the personal property and to what extent post-valuation-date sales can be considered in establishing the value of the art. Judge Edna Parker noted:

“… we prefer evidence of actual sales of the property to be valued, within a reasonable period of time after the valuation date, rather than estimates or approximations of the price upon which a willing buyer and willing seller might agree. Foreseeable subsequent sales will be considered for date of death valuations, as no evidence is more probative of fair market value than direct sales of the property in question.”

After the court adjusted many of the auction sales prices for the passage of time and the changing of the strength of the art market during that time, the next issue was the determination of the undivided interest discount appropriate for the 65% undivided interest held by the decedent. The discount concluded by Judge Parker for the undivided 65% interest was 5%. How can the discount possibly be so low? How can 5% compensate the investor for having to share control over each piece of art and having no ability to make the unilateral decision to sell the art (meaning no liquidity)? 

The answer is that the 65% undivided interest was not an undivided interest at all. Rather, the 65% interest was an allocation of assets reached by a trial court when Mr. and Mrs. Scull divorced in 1974 after 30 years of marriage. The allocation was set forth in a judgment made by the trial court that Mrs. Scull was entitled to a 35% share of the art collection and a 35% share of the proceeds from the sale of the art. The 5% discount was not a discount for fractional ownership but rather a small discount for the fact that both parties had appealed the judgment and that there was some resulting risk of litigation. Judge Parker stated:

“In any event, given the trial court’s detailed explanation of its basis for its determination of the 65-35 split, we think that a purchaser would not require a reduction in excess of 5 percent for any uncertainties involved in acquiring decedent’s 65-percent interest, despite one or both appeals.”

Stone v. United States (Estate of Lois M. Stone)

As we continue to look at the seminal art discount cases, Estate of Lois M. Stone seems spot on. The successor trustees filed a claim for a partial refund of the estate taxes paid by the estate of their mother for neglecting to consider the diminution in value resulting from owning a fractional interest. The primary issues were the value of several impressionist paintings as well as the supposed error by the IRS of not applying a discount for the estate’s 50% undivided interest in the paintings.

The IRS’ argument for not applying a fractional interest discount was threefold:

  1. undivided interests in artwork never change hands at discounts
  2. under Revenue Ruling 57-293, a fractional interest discount is not appropriate
  3. the fact that case law, namely the findings in Estate of Pillsbury, prohibits the application of a fractional interest discount for personal property

Judge Thelton Henderson felt that all three arguments were incorrect. To begin, the IRS had looked only to the market between art dealers, where joint ownership is not uncommon, but the artwork is always sold in totality and is also governed by contracts that stipulate the timing of the anticipated sale. With regard to the revenue ruling, the ruling was found to be misplaced as it dealt with charitable contributions in the income tax realm. And as explained earlier, the Pillsbury case never stated that a discount wasn’t appropriate, only that the bare assertion thereof wasn’t enough. 

The estate’s expert presented various data-driven approaches looking at undivided interest discounts resulting from real estate transactions as well as entities holding real estate. Furthermore, the estate’s expert looked at the costs associated with a forced partition of the artwork over a two- to three-year time period. The data-driven approaches did not fare much better than the IRS’ arguments, with the judge accepting that “some discount is appropriate” and suggesting that the parties would simply agree to sell the entire collection and split the proceeds. Based on this conclusion, the judge stated that some discount between 2% and 51% was appropriate (the 2% discount being the sales commission in the IRS report and the 51% being the cost to partition in the estate’s expert report) and asked the parties to find common ground. When no common ground was reached, the judge concluded an arbitrary discount of 5% was appropriate.

Estate of James A. Elkins

Our final chance to find some clarity lies in this case. Estate of James A. Elkins at the onset looks very much like Estate of Stone – the primary question being the appropriate undivided interest discount applicable to a 73% undivided interest in 61 pieces of various artwork. In the original decision, filed in March 2013, Judge James Halpern decided once again that the zero discount proposition of the IRS was not appropriate but also disagreed with the data-driven approaches that concluded various discounts ranging from 50% to 80% (an initial appraisal done as of the date of death concluded an average discount of 44.75%). The discounts were supported by the experts with the narrative that it would be impossible to sell the fractional art at auction houses; there was a lack of exclusive possession and an inability to force a sale; there was possible litigation surrounding time of possession and proper care, storage, or transportation; and it was impossible to insure the purchased art. The IRS’ 0% discount was based on the argument that the estate tax regulations mandate a valuation for personal property with reference to the market where the property is most commonly sold, which the IRS surmised would be the retail market, with all fractional interest holders agreeing to sell the art in its entirety with a pro rata allocation thereafter.

Judge Halpern, like so many judges before him, blazed his own trail by concluding that the Elkins children collectively were a likely purchaser of the artwork and that a resulting 10% discount would provide the appropriate profit margin to the hypothetical investor selling the 73% undivided interests to the eager-to-purchase children.

The case was appealed to the Fifth Circuit, which agreed with much of the groundwork done by the Tax Court but also disagreed with the final conclusion reached by the court. The Appeals Court stated,

“… we agree in large part with the Tax Court’s underlying analysis and discrete factual determinations, including its rejection of the Commissioner’s zero-discount position (which holding we affirm). We disagree, however, with the ultimate step in the court’s analysis that led it not only to reject the quantums of the Estate’s proffered fractional-ownership discounts but also to adopt and apply one of its own without any supporting evidence ... having put all of his eggs in the one, no-discount basket at trial, the Commissioner cannot be heard on appeal to question the quantity, quality, or sufficiency of the evidence adduced by the Estate to prove the quantum of the fractional-ownership discounts to be applied.”

Given how strongly the Appeals Court disagreed with the assumption that the Elkins children should be viewed as either the most likely buyer or the hypothetical buyer, the Appeals Court was left with the one-sided discount range of 50% to 80%, as provided by the estate’s experts.

The Bottom Line

As stated previously, the bright line on the best approach for valuing undivided interests in personal property remains elusive. Despite having some good case law with regard to the blockage discount, we have had no such luck with regard to the fractional discount. We continue to see the IRS on one side of the debate, suggesting that a discount is not applicable (though we have probably seen the last of this argument, especially in the Fifth Circuit). On the other side, we see the estates’ analyses either being nonapplicable to the question of fractional interest discounts, being disregarded by the courts as not being applicable enough, or being accepted by default with no opposition.

What continues to prove elusive is a thorough debate between experts on opposing sides of the data that judges can use as a catalyst to provide a bright line for planners and valuation experts. What does seem to be firmly established is that fractional interest discounts for personal property are appropriate. This certainly presents some excellent planning opportunities for individuals with significant pieces or collections.

As Stout has been fortunate enough to be involved in several fractional art appraisal assignments, we continue to believe that a strong data-based approach will eventually become the bright line. What is paramount is a thorough understanding of the rights, preferences, and privileges of the undivided interest holder, the investor’s ability to create liquidity for their investment, the volatility of the particular art, and the strength of the art market at the time of the valuation. Given that these skillsets are rarely encapsulated in one expert, we believe that close cooperation between the art appraisers and the business/fractional interest experts will also be paramount.

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