The Fifth Circuit Court of Appeals has overturned a Tax Court decision in a ruling that has major implications for estate planning and works of art. While the central basis for the decision in favor of the Estate of James Elkins was the inexplicable failure by the IRS to rebut the taxpayer’s evidence, the decision nonetheless offers guidance for an important estate planning tool: fractional interests. Eileen Kinsella has also analyzed the case at Art Net (I’m quoted) here.
The case concerned the amount of estate tax owed on sixty four paintings. The decedent (the person who died) had, by the time of his death, given away fractions of the title to these works, either to individual family members, or to a Grantor Retained Income Trust ("GRIT"). Moreover, most of the paintings were subject further to "co-tenant" agreements, which dictated where and who would have custody of the paintings at various points. All told, his interest was 73.005% of sixty one of the paintings, and 50% of the GRIT paintings.
Upon Elkins’s death, the estate identified a total fair market value of roughly $25 million for the sixty one paintings, and $10 million for the GRIT artwork, discounted for the reduced percentage that Elkins owned. The implication of that is a direct reduction in estate tax: smaller value, lower tax. The IRS, however, refused to recognize that discount, despite allowing every other discount proffered by the estate on other property that Elkins owned. the upshot was significant: a $9 million tax deficiency assessment.
The estate challenged the assessment in Tax Court (where taxpayers can take issue with an assessment before actually paying it, compared to making the payment and seeking a rebate in the Court of Federal Claims). The estate put on an extensive evidentiary case about the value of the art, in particular the reduced subjective value to the family given the myriad restrictions on who could possess it. In other words, the value that one would be willing to pay for the (fractional) interest that Elkins held at his death was less than fair market value for the obvious reason that it was less than outright ownership. The outcome that the estate and its experts advocated was that "any hypothetical willing buyer would demand significant fractional-ownership discounts in the face of becoming a co-owner with the Elkins descendants."
The IRS did not put on any evidence about the value or the appropriate discount by which the estate tax should be reduced. It did proffer an expert who testified about the absence of a recognized market for fractional interests.
After trial, the Tax Court recognized the fractional interests held by the decedent in the art, but elected to discount them by 10%, not the 26.995% and 50%, respectively.
The Court of Appeals opinion focuses mostly on this disparity of evidence. It endorsed the willing buyer/willing seller perspective on fair market value (happily, to do otherwise would have been at odds with settled industry practice). But it is the IRS, not the taxpayer, who bears the burden of proof to establish the correct fractional ownership discount. The IRS’s decision to stick to a "no discount" position was thus its undoing.
From there it was not difficult to dispense with the 10% discount applied by the Tax Court. Although couched in respectful language for the court whose decision it overturned, the Court of Appeals opinion concluded that "there is no viable factual or legal support for court’s own nominal 10% discount."
Estate tax has serious ramifications for collections of this magnitude, and the decision can certainly be read to endorse fractional interests as a planning tool. Beyond that, the effects of the decision are likely specific to this particular case. After all, estate planning is designed to plan for unexpected contingencies, and this plan seemed to rely on the cooperation of many different family members. One always hopes for the best, but any collection’s plan should carefully account for all the stakeholders involved.
