The recent decision from the United States Court of Appeals for the Fifth Circuit, Estate of Elkins v. Commissioner, resulted in the reversal of the prior Tax Court opinion (140 T.C. No. 5; March 11, 2013) and a repudiation of the IRS position of not allowing discounts for fractional interests in art.
The Fifth Circuit opinion reinstated the very large discounts taken by the taxpayer’s expert. However, the decision in Elkins was not necessarily a vindication of the taxpayer’s position on valuation discounts. Rather, it was more about the IRS’ perfunctory no-discount position and the Tax Court’s attempt to come to its own novel conclusion on the appropriate discounts. The decedent, James A. Elkins, Jr., held undivided interests in 64 works of contemporary art. Mr. Elkins acquired the works of art between 1970 and 1999. Both before and since the decedent’s death in 2006, the art has been displayed primarily in Mr. and Mrs. Elkins family home and at the family office, both in Houston, Texas. For three works of art, the decedent held a 50% undivided interest and each of his three children held a 16.7% undivided interest. For 61 works of art, the decedent retained a 73% undivided interest and each of his three children held a 9% undivided interest. A lease in effect at Mr. Elkins’ death required that no co-owner could dispose of his interest in the leased artworks unless joined by all of the co-owners. A co-tenancy agreement stipulated how the artworks would be shared among the co-owners, including how many days of possession each owner was entitled to each year. Plus, the co-tenancy agreement apparently prohibited the sale of an interest in any artwork by any co-owner without the prior consent of the other co-owners and provided that the co-owners could not transfer or assign their “rights, duties and obligations” under the lease without the consent of the other co-owners. The value of the decedent’s undivided interests was initially reported on Form 706 at $12.1 million. At trial, the taxpayer presented two expert reports indicating values of $7.7 million and $5.5 million. The undiscounted pro-rata value of the art was stipulated to be $23.3 million. At both the Tax Court trial and on appeal the IRS argued that no discount from the pro-rata value of the decedent’s interest in each of the 64 works of art was warranted because, among other reasons, the proper market in which to determine the fair market value of fractional interests in artwork is the retail market in which the entire work is commonly sold at full fair market value, and that the fractional interest holder is entitled to a pro-rata share of the proceeds (in reality there is no recognized market for undivided interest in art, which is a fact that makes valuing such interests difficult). In addition, the IRS cited the fact that, since discounts are not to be applied with respect to the valuation of charitable contributions of undivided interests in art (Rev Rul 58-455 and 57-293), they should not be applied in an estate or gift tax context.
One of the estate’s valuation experts used a cost-of-partition analysis. Based on one scenario the resulting discounts were between 50 and 80%. In another scenario the discounts were higher (and even 100% for certain interests!!). In our opinion, the cost-of-partition approach is the best way to look at this due to the absence of transaction data. Essentially this is an income approach in which you consider any income (say from a lease to another party) and expenses related to the art (insurance, maintenance, etc.), estimate an appreciation rate in the value of the art, and determine a rate of return to apply to the future proceeds resulting from the sale in a partition action. It is imperative for the valuation expert to talk to an attorney experienced in personal property law in the subject state in order to make the appropriate assumptions as to duration and cost of the partition process.
The Tax Court did not buy into the IRS’ arguments. It also did not agree with the taxpayer’s much higher discounts on the grounds that a buyer “would be in an excellent position to persuade [the other owners] to buy [the interest]” and that knowing this, a buyer and seller would agree upon a price that was close to pro-rata (undiscounted) value. Ultimately, the Tax Court applied a 10% discount to account for the fact that a hypothetical buyer could not be certain that the other undivided interest owners would agree to pay pro-rata value for the interest.
Similar to the discounting rationale found in Holman v. Commissioner, 130 T.C. 170, aff’d, 601 F.3d 763 (8th Cir. 2010), the Tax Court assumed a specific “strategic” buyer (the other undivided interest owners in this case). The Court also noted the strong sentimental and emotional ties to the artwork. The Fifth Circuit opinion clearly states that the Tax Court’s construct violates the hypothetical buyer/seller fair market value standard.
The Appeals Court ruled that the IRS did not meet its burden of proof since it did not produce any valuation evidence. It also noted that the Tax Court had no basis for its 10% discount. Therefore, the only valuation opinion left to be considered was that of the taxpayer (the Appeals Court noted that the taxpayer’s valuation evidence “is not just the preponderance of the evidence, it is the only such evidence”). Thus, the taxpayer’s valuation won by default.
While the Elkins case was a clear victory for the taxpayer one must take caution in relying too much on the results of this case since the IRS did not put forth credible valuation support and since the Tax Court did not substantiate its discount position. While the 5% discount allowed in cases like Scull (T.C. Memo. 1994-211), and Robert Grove Stone et al. v. United States; No. 3:06-cv-00259, do not make any sense (given the unattractiveness of undivided interests), the discounts allowed in the Elkins case (40-50%) may not necessarily be sustainable. That leaves a lot of room in between to fight over the valuation of undivided interests in art.