By Scott S. Miller
The Fifth Circuit recently delivered a significant verdict for the estate of an art collector, reversing the March of 2013 decision of the Tax Court. In Estate of Elkins v. Commissioner, No. 13-60472 (5th Cir. Sept. 15, 2014), the Fifth Circuit held that the appropriate fractional discount for the undivided interest held in a collection of artwork by the decedent's Estate was the 44.75% originally determined by the estate's appraisers, not the 10% applied by the Tax Court.
The Fifth Circuit's opinion is important on several levels. The overarching message the opinion sends is confirmation for the possibility of obtaining significant valuation discounts for fractional interests in artwork for gift and estate tax purposes. On a broader level, the Court's opinion underscores the complications and impairments associated with fractional ownership of property in general, whether the property at issue is artwork, real estate or other investment assets.
Overview & Tax Court Decision
James A. Elkins, Jr. (Estate) died on February 21, 2006. At the time of his death, Mr. Elkins owned undivided fractional interests in 64 valuable works of art, and this ownership was central to the case. The other co-owners of the art were Mr. Elkins' three children. All co-owners entered into, and were bound by the provisions of a "Cotenants' Agreement" which included provisions covering matters of possession, maintenance responsibilities and procedures for the sale of the pieces of art.
The IRS originally challenged the Estate's valuation, claiming that no discount was appropriate. In March of 2013, the Tax Court in Estate of Elkins determined that the undivided interests in 64 works of art held by the Estate should be subject to a 10% discount – in stark contrast to the 44.75% discount used by the Estate in its Form 706 filing. The following excerpted narrative from the Tax Court's conclusion issued in March 2013 explains their position:
"Petitioners argue that the Elkins children would spend whatever was necessary to retain their minority (or 50%) interests in the art. It is much more likely, however, that, given their undisputed financial resources to do so, they would be willing to spend even more to acquire decedent's fractional interests therein and thereby preserve for themselves 100% ownership and possession of the art. The question is how much more.
We believe that a hypothetical willing buyer and seller of decedent's interests in the art would agree upon a price at or fairly close to the pro rata fair market value of those interests. Because the hypothetical seller and buyer could not be certain, however, regarding the Elkins children's intentions, i.e., because they could not be certain that the Elkins children would seek to purchase the hypothetical buyer's interests in the art rather than be content with their existing fractional interests, and because they could not be certain that, if the Elkins children did seek to repurchase decedent's interests in the art, they would agree to pay the full pro rata fair market value for those interests, we conclude that a nominal discount from full pro rata fair market value is appropriate.
We hold that, in order to account for the foregoing uncertainties, a hypothetical buyer and seller of all or a portion of decedent's interests in the art would agree to a 10% discount from pro rata fair market value in arriving at a purchase price for those interests. We believe that a 10% discount would enable a hypothetical buyer to assure himself or herself of a reasonable profit on a resale of those interests to the Elkins children."
Fifth Circuit Review & Decision
The Fifth Circuit agreed with the Tax Court's rejection of the IRS's contention that no discounts are applicable. Furthermore, The Fifth Circuit delivered a very concise opinion in which it overturned the entirety of the discount determination by the Tax Court and accepted the 44.75% discount used by the Estate in its Form 706 filing. The judgment rendered in favor of the Estate provided for a refund of taxes overpaid in the amount of $14,359,508.21, plus statutory interest. The following are excerpts from the Fifth Circuit opinion:
"We repeat for emphasis that the Estate's uncontradicted, unimpeached, and eminently credible evidence in support of its proffered fractional-ownership discounts is not just a "preponderance" of such evidence; it is the only such evidence. Nowhere is there any evidentiary support for the Tax Court's unsubstantiated declaration that 'a 10% discount would enable a hypothetical buyer to assure himself or herself of a reasonable profit on a resale of those interests to the Elkins children.'"
"Besides the error in logic of presuming that the hypothetical willing buyer must turn right around and sell his fractional purchases to those heirs, we cannot escape the conclusion that, under the facts of this case and the way the parties tried it, such a determination constitutes reversible error under any standard of review."
"While continuing to advocate the willing buyer/willing seller test that controls this case, the Tax Court inexplicably veers off course, focusing almost exclusively on its perception of the role of "the Elkins children" as owners of the remaining fractional interests in the works of art and giving short shrift to the time and expense that a successful willing buyer would face in litigating the restraints on alienation and possession and otherwise outwaiting those particular co-owners. Moreover, the Elkins heirs are neither hypothetical willing buyers nor hypothetical willing sellers, any more than the Estate is deemed to be the hypothetical willing seller."
"… our review of the court's extensive explication of this case and its ultimate conclusion that the proper discount is 10 percent, leaves us with the 'definite and firm conviction that a mistake has been made.'"
While there are several important takeaways from this big win, this case highlights how essential it is for an estate to engage and obtain reputable and expertly performed professional appraisals to support fractional interest discounts on undivided interests. Another lesson to be learned is that properly drafted co-tenancy and lease agreements with meaningful restrictions on the partition, use, possession and/or transfer of property held through tenancy in common can be a beneficial component of estate planning, and can have a material impact on the ultimate determination of estate tax.
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