The decision in Estate of Elkins illustrates how families with valuable collections of art can, with careful planning, give undivided interests in that art to family members with increased confidence in how such interests should be valued. However, gifts of interests in art need to be properly documented, valued and reported to avoid certain pitfalls and mitigate the risks associated with a challenge by the Internal Revenue Service.1
James A. Elkins, Jr. and his wife, Margaret Weiss Elkins were both lifelong collectors of predominantly post-war works by artists such as Jasper Johns, Robert Motherwell, Henry Moore, Pablo Picasso and Jackson Pollock. In 1990, Mr. and Mrs. Elkins transferred interests in three paintings to trusts that would ultimately benefit their children. Mrs. Elkins died in 1999, at which time Mr. Elkins declined an interest in some of the works left to him by Mrs. Elkins (known as a “disclaimer”), as a result of which a portion of his wife’s interests in 61 works passed to their children. At the time of his death in 2006, Mr. Elkins owned fractional interests in each of the 64 works (50% interests in three paintings and 73% interests in the other 61 works).
On Mr. Elkins’ Estate Tax Return, the value of his interests in the works was calculated by taking his pro rata share of each work’s value, then applying a discount to account for the difficulties that would be present in finding a buyer for the interest in light of its fractional nature (known as an “undivided interest discount” due to its “lack of marketability”). The IRS audited the Estate Tax Return and took the position that no discounts should be applied to the Estate’s interests in art, i.e., that in each case the pro rata fair market value was the correct value for estate tax purposes. While the IRS allowed discounts for undivided fractional interests in other types of property owned by the Estate, e.g., real estate and racehorses, the IRS argued that “art was different.”
In the United States Tax Court, the Estate argued that, based on the testimony of its three experts, discounts of 50% to 80% should apply to the Estate’s interests in art. The IRS maintained its position that no discounts should apply, and the IRS presented no testimony regarding appropriate discounts. The Tax Court recognized that discounts should apply, but chose to limit those discounts to 10%. On appeal, the United States Court of Appeals for the Fifth Circuit overturned the Tax Court’s opinion in part, holding that the discounts determined by the Estate’s experts were correct. The Fifth Circuit’s decision primarily rested on the quality of the Estate’s experts and the failure by the IRS to present any evidence at all regarding appropriate discounts. As a result, the discounts determined by the Estate’s experts (averaging nearly 70%) applied and the Fifth Circuit ordered that an estate tax refund of more than $14 million be paid to the Estate.
It is not known whether the IRS, in tax disputes that arise outside the jurisdiction of the Fifth Circuit (i.e., outside of Louisiana, Mississippi and Texas), will continue to assert that no discounts should apply when valuing undivided fractional interests in art. It seems likely that in the future the IRS will present evidence that discounts, if they do apply, should be relatively small. To increase the chance that a discount survives IRS scrutiny, it will be important to begin careful planning far in advance. Such careful planning includes properly documenting the transfer, obtaining a professional valuation and adequately disclosing the transfer to the IRS. In addition, it is critical that great care be given to respecting the shared ownership of any art held in fractional interests by sharing among the owners the enjoyment of the art and the responsibilities associated with its transportation, security, insurance and maintenance.
Please note that this article presents general information and is not intended as legal advice. Please send comments to firstname.lastname@example.org.
Perrin W. Clark is a trust and estate attorney at Ytterberg Deery Knull LLP. Perrin has extensive experience representing high net worth individuals and their families in connection with personal wealth planning, including domestic and international trust and estate planning, business structuring, governance and succession planning, and the administration of complex trusts and estates.
J. Graham Kenney is a trust and estate attorney at Ytterberg Deery Knull LLP. Graham has extensive experience representing high net worth individuals and their families in connection with personal wealth planning, including domestic and international estate and trust planning and representation during all stages of complex tax controversies. Graham assisted with the representation of the Elkins Estate before the Tax Court, including during trial, and during the appeal to the Fifth Circuit.
1 Estate of James A. Elkins, Jr. vs. Commissioner, 140. T.C. No. 5 (2013); reversed in part, __ F.3d __., 2014 U.S. App. LEXIS 17882 (5th Cir. 2014).