The Art of Valuation: Fifth Circuit Reverses Tax Court and Accepts Estate's Appraised Values of Artwork in the Absence of Credible Evidence from the Commissioner

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By Deborah M. Beers, Esq. 

Buchanan Ingersoll & Rooney, Washington, DC



As we reported earlier in the discussion of the Tax Court's decision, Estate of Elkins v. Commissioner,1 in this case, 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, the 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 anydiscount to the fair market values of the art because, among other reasons, the restrictions placed on the art by the co-tenants' agreement and the lease should be disregarded under §2703(a)(1) and §2703(a)(2) because they did not contain arms-length terms that would be entered into by unrelated parties independently of estate planning motivations. The government continued to adhere to its "no discount" position throughout the Tax Court proceeding.




Tax Court


The Tax Court first addressed the application of §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."2 It essentially agreed with the government's position that:" … the only apparent reason for including the restriction on sale language in the Co-tenants' 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."

However, the Tax Court rejected the government's "no discount" approach, determining that, at a minimum, the cost of partitions should be accounted for.


Moreover, while giving lip service to the "hypothetical" willing buyer and willing seller, the Tax 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 - a being whose existence is to be taken into account in the hypothetical seller and buyer test posited in Reg. §20.2031-1(b) - 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."


From this, the Tax Court concluded that "the Elkins children would be willing to purchase the hypothetical buyer's interests in the art at a much higher price 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.'"


In the end, the Tax Court theorized – based on no tangible evidence - that the buyer would never have the certainty of knowing that the seller(s) (the Decedent's children) would not attempt to re-purchase 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," despite the absence of any record evidence whatsoever on which to base the quantum of its self-labeled nominal discount.


The Fifth Circuit


On appeal, the Fifth Circuit agreed with the Tax Court's rejection of the Commissioner's zero-discount position, but refused to countenance the Tax Court's arbitrary application of a 10% discount, opting instead to apply the estate's discounts in full. The rationale for the appellate court's position was as follows:


1. Burden of Proof


The Tax Court failed to require the Commissioner to bear that burden of proof, even though the applicable statute3 mandates that when, as here, the taxpayer "adduces sufficient evidence to establish the material facts—in this case, the amounts of the discounts—the Commissioner has the burden of refuting such facts and proving different ones." However, the Commissioner "chose not to adduce any evidence of discount quantum whatsoever, sticking instead to his no-discount position." The taxpayer/estate, in contrast "adduced a plethora of credible and highly probative evidence in support of both the applicability of such discounts vel non and the precise percentages of the discount to be applied to each separate item…." The case, observed the court "should have ended at that point."


2. Preponderance of the Evidence


While the Tax Court purported to apply a "preponderance of the evidence" standard, the Fifth Circuit noted that when, as here, "the only evidence on an issue is that presented by but one party—and by the one that did not have the burden of proof, at that—there is no `preponderance': It takes two to tango. …[H]aving put all of his eggs in the one, no-discount basket at trial, the Commissioner cannot be heard on appeal to question the quantity, quality, or sufficiency of the evidence adduced by the Estate to prove the quantum of the fractional-ownership discounts to be applied." In summary, evidence trumps no evidence.


3. Merits


Just as it was evident that the Commissioner's no discount position was unsustainable, it was just as evident to the Fifth Circuit that "in the absence of any evidentiary basis whatsoever, there is no viable factual or legal support for the court's own nominal 10 percent discount." In the words of the court: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.

4. Misapplication of Willing Buyer/Willing Seller Test


While giving lip service to the willing buyer/willing seller test reflected in the regulations, the Tax Court went off the rails by "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." As perhaps need not be said, neither the Elkins heirs nor the estate were "hypothetical."




In summary, the Fifth Circuit: (1) affirmed the Tax Court's rejection of the Commissioner's insistence that no fractional-ownership discount may be applied to the undivided fractional interests in art held by the Decedent; (2) affirmed the Tax Court's holding that the Estate is entitled to apply a fractional-ownership discount to the Decedent's ratable share of the stipulated value of each of the 64 works of art; (3) reversed the Tax Court's holding that the appropriate fractional-ownership discount is a nominal 10 percent, uniformly applied to each work of art; (4) held that the correct quantums of the fractional-ownership discounts applicable to each work of art were those determined by the Estate's experts; and (5) rendered judgment (without the need for remand) in favor of the Estate.


Notably, the appellate court did not discuss the application of §2703, which doubtless will be raised in future cases. In theory, under that section, restrictions, such as those imposed in the co-tenancy and lease agreements in Elkins, should be disregarded if their purpose is "testamentary" in nature. However, carefully drafted agreements that document the business purposes for the restrictions should not necessarily be accorded less weight than similar LLC agreements. In fact, in cases where an investment or business purpose can be established, holding art in an art LLC in which fractional interests can be given away or sold, might be one way to plan effectively with art while retaining the discounts customarily accorded to such interests. And, of course, all claimed valuations should be carefully supported by qualified appraisals.


For more information, in the Tax Management Portfolios, see Mezzullo, 835 T.M., Transfers of Interests in Family Entities Under Chapter 14: Sections 2701, 2703 and 2704,  and in Tax Practice Series, see ¶6290, Valuation — Generally.



 1 140 T.C. 86 (2013).

 2 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 arms-length.

 3 §7491.

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