Modest Discount Allowed for Fractional Interest in Art
Elkins, 140 TC No 5, Tax Ct Rep (CCH) 59471, Tax Ct Rep Dec (RIA) 140.5, 2013 WL 892399.
The Tax Court in Elkins1 applied Section 2703 to ignore restrictions contained in a co-ownership agreement involving artwork and allowed a 10% discount in valuing a fractional interest in the artwork for estate tax purposes.
The decedent and his wife owned 64 works of contemporary art. In 1990 the decedent and his wife each created a grantor retained income trust (GRIT) and transferred each of their 50% undivided community interests in three pieces of artwork (the "GRIT artwork") to their respective GRIT. The term of each GRIT was ten years, and the remainder beneficiaries of each GRIT were the couple's three children.
Mrs. Elkins did not survive the ten-year term of her GRIT and, therefore, pursuant to the terms of her GRIT, her GRIT's 50% ownership interest in the GRIT artwork passed to Mr. Elkins. Similarly, the will of Mrs. Elkins left her 50% community interest in the other 61 pieces of artwork outright to Mr. Elkins. Within nine months of the death of Mrs. Elkins, Mr. Elkins disclaimed approximately a 27% interest in the 61 pieces of artwork that passed to him pursuant to the will of Mrs. Elkins in order to use the estate tax exemption of Mrs. Elkins. As a result of the disclaimer, the 27% interest in the disclaimed artwork passed to the three children, and Mr. Elkins retained approximately a 73% interest in the 61 pieces of artwork (consisting of his 50% community interest and the 23% interest in the artwork that passed to him by the will of Mrs. Elkins that he did not disclaim). Following the disclaimer, Mr. Elkins and the three children entered into a co-ownership agreement regarding the 61 pieces of artwork. The agreement provided that any sale of the artwork would require the unanimous consent of the parties.
Mr. Elkins survived the ten-year term of his GRIT. Therefore, his GRIT's 50% ownership interest in the GRIT artwork passed to the three children at that time. Accordingly, following the termination of Mr. Elkins GRIT, his three children owned a 50% interest in the GRIT artwork, and he retained a 50% interest in the GRIT artwork that he received on the death of Mrs. Elkins. Following the termination of Mr. Elkins' GRIT, he and the three children entered into a lease regarding the GRIT artwork that provided for Mr. Elkins to retain possession of the artwork on a yearly renewable basis in return for his payment of rent.
Mr. Elkins died in 2000, and his will passed his 50% interest in the GRIT artwork and his 73% interest in the other 61 pieces of artwork to his three children. On his estate tax return, the estate valued (1) his 50% interest in the GRIT artwork at approximately $2.6 million and (2) his 73% interest in the other 61 pieces at approximately $9.5 million. These valuations included a 45% combined discount for lack of control and lack of marketability.
The IRS issued a notice of deficiency, indicating that the artwork should be included in the estate of Mr. Elkins without any discount. The position of the IRS was based on two arguments:
- Section 2703(a)(1) required that the restrictions contained in both the co-ownership agreement and the lease should be ignored for valuation purposes.
- No discount should be allowed because there is no market for sales of fractional interests in artworks. Thus, the proper market in which to determine the value of the estate's fractional interest in the artwork was the retail market for the entire work; accordingly, following such a sale, a fractional interest owner of artwork would receive his or her pro rata share of the sales proceeds for the artwork without any discount.
The estate argued that Section 2703 did not apply to the co-ownership agreement because the agreement restricted the sale of only the 61 pieces of artwork but did not restrict the sale of a co-owner's interest in the artwork. In this case, the owner's interest in the artwork, not the artwork itself, was being valued. The estate conceded that Section 2703 did apply to the lease of the GRIT artwork.
The court found that any restrictions imposed by the co-ownership agreement and the lease on the decedent's right to partition or sell the artwork would be disregarded as required by Section 2703. The court then addressed the issue of whether any discount would be permissible. Although the IRS's experts and the estate's experts agreed that there was no market for fractional interests in artwork, the court stated that the testimony of the experts did not mean that the artwork had to be valued for estate tax purposes at its full value without any discount. The court found that some discount was appropriate.
The court emphasized the fact that the three children had strong sentimental and emotional ties to the artworks and, therefore, a hypothetical buyer would be dealing with owners who were unlikely to sell either an interest in the artwork or any piece of artwork in its entirety. The court believed that it was appropriate to consider the fact that the three children were not disposed to sell any of the artwork, and that they were willing to forgo the financial gain from a sale of the artwork in order to keep the collection intact and continue to enjoy it. Therefore, the court found that some discount was appropriate to reflect the uncertainty of the buyer's ability to monetize his investment.
In determining the discount, the court stated that because of the children's strong desire to retain the artwork for themselves, the children would be willing to pay the buyer an amount close to the decedent's pro rata share of the full value of the artwork. Moreover, the court believed that because of the children's attachment to the artwork, they would be willing to pay more for the decedent's fractional interest in the artwork than most other buyers. The court, therefore, applied only a 10% discount to the decedent's pro rata value of the artwork in valuing the artwork for estate tax purposes.
While the court held that undivided interests in artwork are entitled to discounts, because of the non-existence of sales data for sales of such fractional interests, the court permitted the application of only a very minimal discount. The appraisal reports for the estate could have articulated better the reasons for a more significant discount. Because of the significant estate tax liability involved in this case, the case likely will be appealed to the Fifth Circuit. It will be interesting to see to what extent the parties augment the arguments they made in Tax Court.
1140 TC No. 5.
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more about fractional interest, contact Frank at (301) 657-0175 or firstname.lastname@example.org.