Tax Court Allows 10% Discount For Fractional Interest in Art; Decedent's Waiver of Right of Partition Disregarded Under Section 2703

By Deborah M. Beers, Esq.

Buchanan Ingersoll & Rooney P.C.,Washington, DC

Facts: James A. Elkins, Jr. ("Decedent") and his wife purchased 64 works of contemporary art between 1970 and 1999, including works by Pablo Picasso, Henry Moore, Jackson Pollock, Paul Cezanne, Jasper Johns, Ellsworth Kelly, Cy Twombly, Robert Motherwell, Sam Francis, and David Hockney. The art became community property under Texas law and had been displayed primarily in Decedent and Mrs. Elkins' family home and at the family office both before and after Decedent's death, although some of the works were at various other locations, including the homes of Decedent's children.

The "GRIT Art." On July 13, 1990, Mr. and Mrs. Elkins each created a grantor retained income trust (GRIT) funded by each of their undivided 50% interests in three of the works in the collection: a large Henry Moore sculpture, a Pablo Picasso drawing, and a Jackson Pollock painting (GRIT art).  Each trust was for a 10-year period, during which the grantor retained the "use" of the transferred interests in the art. At the conclusion of the 10-year period, each grantor's interests were to go to the Elkinses' three children, which, in effect, would give them 100% ownership of the GRIT art, one-third each.

However, Mrs. Elkins died before the expiration of the 10-year period of her GRIT, and her 50% undivided interest in the GRIT art passed to Mr. Elkins. Because Mr. Elkins survived the 10-year term of his GRIT, his original 50% undivided interests in the GRIT art passed to his three children in equal shares so that each received 16.667% interests in the GRIT art.

Decedent and the Elkins children executed a lease agreement covering the Picasso drawing and the Pollock painting that leased the children's 50% interest in the two works to Decedent on an annual basis, with automatic extensions. As part of the lease, Decedent and his children each agreed not to separately sell or assign their partial interest in the art.

The "Disclaimer Art." Under Mrs. Elkins' will, her 50% community property interests in the other 61 works of art passed outright to Decedent. Mr. Elkins decided, however, to disclaim a 26.945% interest in each of the 61 works equal in value to the unused unified credit against estate tax, available to his estate so that the disclaimed portion could pass to the Elkins three children free of estate tax. As a result, each child received an 8.98167% interest in each item of the disclaimer art, and the balance, a 23.055% interest in each item, passed to Decedent. Thus, Decedent retained a 73.055% interest in each item of the disclaimer art (his original 50% interest plus the additional 23.055% interest received from Mrs. Elkins that he did not disclaim).

Shortly after Decedent executed his partial disclaimer, Decedent and his children entered into a co-tenancy agreement that gave each of them, upon request, the right of possession, dominion, and control of each work of art for a total number of days out of the year that is equal to his or her percentage ownership. The art works could only be sold with the unanimous consent of all of the co-tenants.

Decedent's Will. Decedent's will left his personal and household effects, which included his undivided fractional ownership interests in the art, to his children. Decedent's residuary estate passed to the James A. Elkins, Jr. and Margaret W. Elkins Family Foundation (Elkins Foundation).

Decedent's Estate Tax Return. Decedent's federal estate tax return, filed on May 21, 2007, reported a federal estate tax liability of $102,332,524. Included in Decedent's gross estate was his 73.055% interests in the 61 works of disclaimer art that were subject to the original co-tenants' agreement, valued at $9,497,650, and his 50% interests in the three works of GRIT art (two of which remained subject to the art lease on the valuation date), valued at $2,652,000. Those amounts were derived by, first, determining Decedent's pro rata share of the fair market value of the art as determined by Sotheby's, Inc., and, then, applying a 44.75% combined fractional interest discount (for lack of control and marketability), as determined by Deloitte LLP, to those pro rata share amounts.

In the government's notice of deficiency, it determined that Decedent's gross estate included his 73.055% interests in the disclaimer art at an undiscounted fair market value of $18,488,504 and his 50% interests in the GRIT art at an undiscounted fair market value of $5,300,000. The government initially contended that the estate was not entitled to any discount to the fair market values of the art because: "(1) the restrictions on the sale of art subject to the cotenants' agreement and fractional interests in art subject to the art lease constituted `an option, agreement, or other right to acquire or use such artwork at a price less than the fair market value' and, alternatively, `a restriction on the right to sell or use the Decedent's interest in such artwork' so that, pursuant to section 2703(a)(1) and (2), respectively, Decedent's interests in the art covered by those agreements `should be valued without regard to' those restrictions; (2) `the discounts used in calculating the fair market value of Decedent's fractional interests in *** [the art] are overstated and no discount is appropriate.'"

The notice also reduced the estate's charitable deduction for the residuary bequest because of the additional estate tax payable by the estate out of the residue.

Experts Opinion:

The Estate. The estate produced three experts, all of whom concluded that the potential buyers of partial interests fine art would all demand steep discounts from the pro rata fair market value of Decedent's fractional interests. The low end of the discount scale suggested by the estate's experts was 50%, and the high end was 100% (for those works as to which the cost of partition exceeded their value). Costs of partition, which were estimated separately for each art work by one expert, were said to range from $25,000 to over $1,100,000 (for Jasper John's Figure 4).  The court noted that the estate's art expert (Mr. Nash, from Sotheby's) was convinced that "any buyer of decedent's interests in the art would have to take into account the fact that the children (whom he [referred] to as "the other shareholders") are `committed to retaining the art in the family until the last shareholder dies.'"

The estate's experts at trial argued for a reduction from the estate tax return total value of $12,149,650, to a reduced total value of $7,658,645.

The Government. One of the government's experts argued that "there is no established marketplace for the sale of a partial interest in a work of art." She noted that there are dealer-to-dealer sales of fractional interests in art in what she refers to as "the wholesale market" but that such a sale would be made in connection with an agreement between the dealers to sell the whole work at a profit and split the proceeds.  She further concludes that, while there are sales of fractional interests in art, they involve co-owners who intend to sell or donate the entire work of art at a later date and, therefore, are not germane to the hypothetical sale of fractional interests in this case. She admits, however, to having no experience with the buying or selling habits of pure speculators who deal in art without regard to its aesthetic quality.

A second expert for the government, a lawyer who chaired the Art Law Committee of the New York City Bar Association, concluded "[i]n my opinion, the Sale Restriction and related terms in the Cotenant's Agreement, Amendment to Cotenants Agreement and Art Lease are not comparable to similar arrangements entered into by persons in arm's length art market transactions."

The total value of Decedent's art argued for by the government was $23,257,393.

Application of Section 2703(a)(2). The court first addressed the application of Code §2703(a)(2) which requires that (unless certain exceptions are met) "the value of any property shall be determined without regard to *** any restriction on the right to sell or use such property."1

The government argued that:"In view of the irrefutable evidence that the only way to sell a fractional interest in artwork is by selling the entire art by agreement or through a partition action filed with the court, the only apparent reason for including the restriction on sale language in the Cotenants' Agreement and the Art Lease Agreement *** was to reduce the value of Decedent's retained fractional interests in the Artwork as part of a plan to make a testamentary transfer of his remaining interests in the Artwork to his children at a reduced transfer tax rate-a purpose which section 2703 was specifically intended to prevent."

The government also argued that a determination that a discount is appropriate in valuing Decedent's fractional interests in the art would be inconsistent with the Commissioner's long-standing position that fractional interests in art are not discounted for purposes of valuing charitable contributions thereof under §170.2

The court essentially agreed with the government, noting that:

"It is clear that, pursuant to … 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 … 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."

Discounts. The court then moved on to its analysis of precedents, including Estate of Scull v. Comr.,3 and Stone v. U.S.4

In Stone, the district court rejected the plaintiffs' proffered 44% fractional interest discount for the decedent's 50% interest in 19 paintings on the ground that a hypothetical seller would seek to sell each entire work of art (with the co-owners' consent or via partition) and take his or her pro rata share of the proceeds or sell the partial interest at a price equivalent thereto.  The district court did, however, decide that "some discount is appropriate to allow for the uncertainties involved in waiting to sell the collection until after a hypothetical partition action is resolved," and allowed, in its supplemental opinion, the "relatively low" 5% discount proposed by the Government.

In Estate of Scull, the decedent died owning a 65% undivided interest in a "pop" and minimalist art collection that he and his wife had accumulated before their divorce.  In connection with divorce-related litigation in the New York State courts, there was a court-ordered in-kind division of the collection (65% to decedent, 35% to Mrs. Scull) that did not go into effect before the decedent's death. The decedent's estate argued that the value of the decedent's 65% interest in the collection was less than 65% of the entire collection. On the facts of that case, the Tax Court allowed a 5% valuation discount from pro rata fair market value.

The court noted that, in both cases, the court approved a discount from pro rata fair market value for the decedent's fractional interest in an art collection in order to account for various "uncertainties" that would confront a hypothetical buyer of the art. "Although the 5% discount approved in each case was essentially nominal, that was because of a lack of proof that any greater discount was warranted, not because of any regulatory prohibition against discounts for art that is normally sold at retail." Thus, the government's argument that no discount was warranted was rejected. At a minimum, the court stated, the costs of partition should be accounted for.

Moreover, while giving lip service to the "hypothetical" willing buyer and willing seller, the court focused on subjective facts "demonstrating that the Elkins children had strong sentimental and emotional ties to each of the 64 works of art so that they treated the art as `part of the family.' Those facts strongly suggest that a hypothetical buyer of Decedent's fractional interests in the art would be confronted by co-owners who were resistant to any sale of the art, in whole or in part, to a new owner, a resistance that the Elkins children specifically communicated to Mr. Nash."

"In this case, it is not necessary for the executors to speculate or `make delicate inquiries into the feelings, attitudes and anticipated behavior' of the other owners. It is clear that they have a deep and abiding love for the art and, therefore, could be expected to be hostile to a joint sale of any one or all of the 64 works to a new owner, a hostility that they explicitly expressed to Mr. Nash during their meeting with him preparatory to his inspection of the art. That being so, the hypothetical seller and buyer necessarily would be faced with uncertainties regarding the latter's ability to monetize his or her investment in the art . As in Stone, `some discount is appropriate to allow for *** uncertainties'… ".

Their "probable hostility" to a sale constitutes one of the "`relevant facts and elements of value as of the *** valuation date [that] shall be considered [by the hypothetical seller and buyer] in every case,' as mandated by section 20.2031-1(b), Estate Tax Regs."

However, "[t]he fact that there exists a retail market for works of art with multiple owners does not necessarily mean that all fractional interests in art must be valued as if it is certain that the art will be sold in that market. The regulation should not be read in a vacuum, without reference to actual circumstances." The family's "psychic attachment" to the art must be taken into account. This attachment would make them unwilling to part with the art. "Thus, the hypothetical buyer would be in an excellent position to persuade the Elkins children, who, together, had the financial wherewithal to do so, to buy the buyer's interest in any or all of the works, thereby enabling them to continue to maintain absolute ownership and possession of the art."

Indeed, Decedent's daughter testified that, "in the light of a relatively short period of possession of the art to which she and her siblings would be entitled vis-a-vis a hypothetical buyer, and considering that the buyer would, most likely, not reside in the Houston area, she `would be willing to pay *** a fair price' to purchase the hypothetical buyer's 73.055% or 50% interests in the art."

From this, the court concluded that "the Elkins children would be willing to purchase the hypothetical buyer's interests in the art at a much higher prices than a disinterested buyer would be willing to pay for the same interests because of the children's added motivation of keeping the art within the family as, in petitioners' words, `a memorial to their parents rather than [as] an investment.'"

Conclusion. The court appeared to be attempting to channel the hypothetical buyer's thought process to the extent of theorizing that the buyer would never have the certainty of knowing that the seller(s) (Decedent's children) would not attempt to repurchase the art through any means available. This uncertainty would cause the buyer to agree to a 10% discount to the pro rata fair market value in arriving at a purchase price. "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."

Although the 10% discount allowed in Elkins was not substantial in light of the 44.75% discount claimed on the return and the even higher discounts argued for by the estate's experts at trial, it was probably worth the effort to fractionalize the ownership of the art. It is also possible that, if the Elkins children had not been so vocal about their attachment to the art, the court would have had little basis upon which to speculate about the "willing buyer's" likely uncertainties.

This commentary also will appear in the May 2013 issue of the  Estates, Gifts, and Trusts Journal.  For more information, in the Tax Management Portfolios, see Streng, 800 T.M., Estate Planning, Kelley and Hood, 830 T.M., Valuation: General and Real estate, Blattmachr, Slade, and Zeydel, 836 T.M., Partial Interests - GRATs, GRUTS, QPRTs (Section 2702), and Cline, 848 T.M., Disclaimers, and in Tax Practice Series, see ¶6290, Valuation - Generally, and ¶6350, Estate Planning.


  1 There is a "safe harbor" under §2703 that would permit the restriction to be taken into account if it is established that: (1) the restriction was part of a bona fide business arrangement; (2) it was not a device to transfer property to family members for less than full consideration; and (3) its terms are comparable to similar arrangements made by people at arm's length.

  2 See, e.g., Rev. Rul. 58-455, 1958-2 C.B. 100, and Rev. Rul. 57-293, 1957-2 C.B. 153.  The court in Elkins refused to follow these income tax rulings, finding them unpersuasive in the estate tax context.

  3 T.C. Memo 1994-211.

  4 2007-2 USTC ¶60,545 (N.D. Cal. 2007), aff'd by unpub. opin., 2009-1 USTC ¶60,572 (9th Cir 2009).