Grossman LLP | Federal Appellate Court Case Has Implications for Estate Planning and Taxation of Fractional Art Ownership
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  • Federal Appellate Court Case Has Implications for Estate Planning and Taxation of Fractional Art Ownership
    In mid-September, the U.S. Court of Appeals for the Fifth Circuit issued a decision with important tax and estate-planning ramifications for art collectors.  This case is being hailed as a “victory” for collectors in that it supports the general availability of fractional-ownership discounts as a viable tool in the arsenal when it comes to tax and estate planning regarding art assets.

    The case arose out of the spectacular art collection amassed by Houston businessman James Elkins and his wife Margaret.  Their holdings included works by some of the greatest names in modern and contemporary art, from Picasso and Cézanne to Pollock and de Kooning.  During their lifetimes, they had given their three children partial shares of the ownership of over 60 paintings and artworks, either as gifts to the individual family members or as transfers to a Grantor Retained Income Trust (“GRIT”), an irrevocable trust agreement whereby the grantor transfers assets to the trust while retaining the right to receive all of the net income from the trust assets for a fixed term of years.   Almost all of the works were also encumbered by a “co-tenant” agreement, spelling out how the co-owners would share and maintain the works (for example, providing each co-owner with a right to possess the works for a certain number of days per year), and prohibiting the co-owners from selling an interest in any work without prior consent from the others.

    Mrs. Elkins died in 1999 and her husband passed away in 2006.  By the time Mr. Elkins died, he owned a 73.005% interest in one group of 61 works, and a 50% interest in three other works subject to the GRIT.  Following Mr. Elkins’s death, his three children, as executors, filed an estate tax form listing, among other assets, his fractional interests in the art, and estimating the assets’ fair market value, generally “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” In looking at fair-market value, the IRS generally recognizes that, when the asset in question is only a partial interest in a piece of property that is co-owned by other family members (such as real estate or a family business), the fair-market value should be subject to an additional discount (a “fractional-ownership discount”), because such an asset would likely be difficult to sell to someone who is not a family member, and a buyer would expect the purchase price to account for the fact that he would face limitations on what he could do with the asset given the interests of the remaining family members.  Based on this reasoning, the Elkins estate took the position fractional shares in the artwork should be subject to a blanket fractional-ownership discount of 44.75%.

    The IRS accepted the estate’s declared value concerning many of the estate’s assets, including many assets subject to a fractional-ownership discount.  The IRS, however, took the position that it would not allow such a discount for fractional interests in art, and that therefore the estate had underpaid its federal estate taxes—resulting in a tax deficiency to the tune of about $9 million.

    The executors of the Elkins estate then went to the U.S. Tax Court for a review of the deficiency determination, where the IRS put forward no factual evidence or expert opinion challenging the amount of the fractional-ownership discount sought by the Elkins family; rather, the IRS continued to maintain that it would not allow any fractional-ownership discount on the art.  The estate, for its part, put forward extensive evidence and expert testimony regarding the amount of fractional-ownership discount that should be applied to each individual work, given the restrictions that would be imposed on any potential buyer by the Elkins family.  The Tax Court (perhaps in an attempt to reach some middle ground) concluded that the estate was entitled to some fractional-ownership discount, but that instead of the estate’s proffered discount figures (which ranged from about 50% to 80%, depending on the work), a lower 10% discount should apply across the board.

    Not satisfied with this result, the estate appealed to the Fifth Circuit, where it found a sympathetic ear.  The three-judge panel held, in a unanimous decision, Estate of James A. Elkins, Jr. v. Commissioner of Internal Revenue, No. 13-60472 (5th Cir. Sept. 15, 2014), that while the Tax Court had been right to reject the IRS’s zero-discount position, it had been wrong to apply the 10% discount that was not supported by evidence.  The Fifth Circuit noted that the “result of the combined, interrelated, and interdependent testimony and reports of [the estate’s] experts was that a proper application of the willing buyer/willing seller test would produce prices for [Mr. Elkins’s] undivided interests in the works of art substantially below his pro rata share of their respective” fair market values and that “any hypothetical willing buyer would demand significant fractional-ownership discounts in the face of becoming a co-owner with the Elkins descendants, given their financial strength and sophistication, their legal restraints on alienation and partition, and their determination never to sell their interests in the art.”  In contrast, the IRS put forward no evidence of any alternative way to quantify the appropriate fractional-ownership discount.  And there was “no viable factual or legal support” for the Tax Court’s 10% discount.  The Fifth Circuit therefore held that a remand was unnecessary, and rendered judgment based on the fractional-ownership discounts determined by the estate’s experts—resulting in a refund to the estate of more than $14 million.

    As with most tax and estate planning matters, this case does not suggest a one-size-fits-all answer to the complex issues faced by individuals and families with significant art collections.  Depending on a family’s goals and practical considerations, any number of options might be available, including creation of a family limited partnership to assume ownership of the works; gifting the works to heirs and then “renting” them back on specified terms; or strategic donations of works to non-profit entities.  And fractional-ownership arrangements may not be the right choice in many situations—they carry with them complicating factors including the logistics involved in actually transporting art from the custody of one partial owner to another, the willingness of family members to cooperate and coordinate with one another, and the necessity of extensive legal documentation of the gifts and agreements governing the art.  In any case, however, this is a significant decision for art collectors seeking the benefit of fractional-ownership discounts when it comes to tax and estate planning regarding art assets.
    ATTORNEY: Kate Lucas
    CATEGORIES: Art MarketLegal Developments