This essay is about fractional interests in visual art. For a long time the Internal Revenue Service position has been that fractional interests in tangible personal property such as visual art (ownership in, say, a painting, divided between several people, often family members) are not entitled to reduced gift or estate tax valuations. Recently, the US Tax Court and the Fifth Circuit Court of Appeals decided that the IRS position was wrong, and a fractional ownership interest in visual art is, indeed, entitled to a reduced valuation. This opens interesting planning options for art owners who can bring themselves to give up part ownership of their art.

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For many years, the Internal Revenue Service has resisted estate and gift tax valuation discounts for fractional undivided interests in works of art. But in 2013–2014, the US Tax Court and Fifth Circuit Court of Appeals decided that the IRS no-discount position was wrong.¹

Fractional Interests in Visual Art and Restrictions on Sale and Use

The decedent, Elkins, owned undivided fractional interests in 64 works of contemporary art. The remaining interests in such works were owned by Elkins’s children. Before Elkins’s death, he entered into a “Cotenants’ Agreement” with his children as to 61 of the works, which provided in paragraph 7 that “An item of Property [any of the 61 works of art subject to such agreement] may only be sold with the unanimous consent of all of the Cotenants.”

The Tax Court Reasoning

The Tax Court examined two issues: first, whether the paragraph 7 restriction on sales was a restriction on the right to sell or use property within the meaning of Internal Revenue Code Section 2703(a)(2) and, second, the amount of the discount to be applied to decedent’s fractional interests in the art. On the first issue, the Tax Court decided that IRC Section 2703 applied:

With exceptions not here relevant, section 2703(a)(2) instructs that “the value of any property shall be determined without regard to any restriction on the right to sell or use such property.” Whether paragraph 7 of the cotenants’ agreement is a restriction on decedent’s right to sell the cotenant art or is a restriction on his right to use the cotenant art is not important. It is clear that, pursuant to paragraph 7 of the cotenants’ agreement, decedent, in effect, waived his right to institute a partition action, and, in so doing, he relinquished an important use of his fractional interests in the cotenant art. While, as we shall explain, it makes little or no difference to our conclusion as to the value of the art, we shall, in determining the value of each of the items of cotenant art, disregard any restriction on decedent’s right to partition.²

The Tax Court allowed a 10% valuation discount—rejecting the Estate’s 45% discount as unrealistically high—reasoning as follows:

Petitioners [the Estate] 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.³

The Fifth Circuit Agrees that the IRS Position on Valuing Fractional Interests is Wrong

On appeal, the Fifth Circuit Court of Appeals described the Tax Court decision as follows:

The Tax Court rejected the Commissioner’s zero-discount position, but also rejected the quantums of the various fractional-ownership discounts adduced by the Estate through the reports, exhibits, and testimony of its three expert witnesses—the only substantive evidence of discount quantum presented to the court. Instead, the Tax Court concluded that a “nominal” fractional-ownership discount of 10% should apply across the board to Decedent’s ratable share of the stipulated FMV of each of the works of art; this despite the absence of any record evidence whatsoever on which to base the quantum of its self-labeled nominal discount.

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 [Tax] 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.⁴

For the Fifth Circuit, “This entire appeal thus begins and ends with the question of taxable value of Decedent’s fractional interests in those 64 items of non-business, tangible personal property [the visual art] that were jointly owned in varying percentages by Decedent and his three children …” The Fifth Circuit went on to describe the following restrictions decedent and his children placed on the art by means of the Cotenant’s Agreement—including each co-owner’s right of possession for a specified number of days during a 12-month period. And, “More pertinent to this appeal, that agreement prohibited the sale of an interest in any work by a co-owner without the prior consent of all.”⁵ The Fifth Circuit did not address consent-to-sale and other restrictions beyond saying they were “pertinent.” It is therefore difficult to know how important these restrictions would be, as opposed to discounts inherent in fractional ownership itself, such as those for lack of marketability, lack of control, and the cost and inconvenience of partition.

The Estate’s expert witnesses testified in the Tax Court that any hypothetical willing buyer would demand significant fractional ownership discounts in the face of becoming a co-owner with the Elkins children, given their financial strength and sophistication, their legal restraints on alienation and partition, and their determination never to sell their interests in the art. By contrast, the IRS produced no expert testimony as to the amount of discount that should be allowed for a fractional interest, other than an expert who testified that there was no “recognized market” for partial interests for works of modern art. Indeed, the Fifth Circuit quite reasonably noted that the IRS expert’s testimony that there is no recognized or established market for fractional interests in art, lends support, not for a zero discount (as the IRS argued), but for a greater discount.⁶

IRC Section 2703 Requires that Value of Any Property Be Determined Without Regard to … Any Restriction on the right to Sell or Use such Property … Unless Terms Are Comparable to Similar Arrangements Entered into … in Arms’ Length Transaction.

As noted above, the Tax Court decided that IRC Section 2703(a)(2) required it to disregard, for purposes of valuation, the no-partition restriction contained in the Cotenants’ Agreement. In spite of stressing in its opinion that the no-sale restriction was “… pertinent to this appeal…”,⁷ the Fifth Circuit did not address Section 2703 at all.

Fifth Circuit Appears to Consider Express Restrictions on Sale and Use, But its Reasoning Addresses Only the Effect of Fractional Interests on Value.

We are then left to conclude from the Tax Court opinion, which addressed the IRC 2703 no sale/partition and the Fifth Circuit opinion which did not, that IRC 2703 may apply to require a court to disregard such restrictions but, in any case, that art value for estate and gift tax purposes will chiefly be affected by discounts inherent in holding a fractional, as opposed to a whole, interest in the decedent’s art.

Where the law will settle on the appropriate percentage, or range of percentages, of the valuation discount for fractional interests in art remains to be seen. But, art owners who are willing to relinquish, to children or grandchildren, partial ownership (and, perhaps, in addition, some control of sales and possession) have the possibility of obtaining substantial estate tax savings.

New York, New York
July 2015

Marjorie W. Hornaday
Ronald D. Spencer
Carter Ledyard & Milburn LLP

Notes

¹ Estate of Elkins v. C.I.R., 140 T.C. 86, 121 (2013), aff’d in part, rev’d in part, 767 F.3d 443, 449 (5th Cir. 2014).
² 140 T.C. 86, 116.
³ Id., at 135.
⁴ 767 F.3d 443, 445 (5th Cir. 2014).
⁵ Id., at 447.
⁶ Id., at 452.
⁷ Id., at 447.

Editor’s Note

This is Volume 5, Issue No. 3 of Spencer’s Art Law Journal. This spring/summer issue contains three essays, which will become available on artnet in August 2015.

The first essay discusses the process by which Old Master paintings are authenticated in the context of a claim that an autographed Caravaggio replica had been overlooked by a major auction house.

The second essay examines dealer exposure and buyer legal protections for works of art in multiples.

The third essay focuses on a recent court decision valuing fractional interests in art, which may help keep your collection in the family.

Three times a year, this journal addresses legal issues of practical significance for institutions, collectors, scholars, dealers, and the general art-minded public.

— RDS