While the size of the discounts is always subject to challenge, the concept of discounting for estate tax purposes the value of fractional interests in property is a widely accepted practice, at least when applied to common assets like real estate or an equity interest in a business. The IRS has frequently asserted, however, that due to the unique nature of artwork and the market in which it is most commonly sold to the public, fractional interest discounts on artwork are not appropriate. While perhaps not agreeing with the IRS, the courts historically have approved only nominal discounts on artwork. A recent appeals court case gives taxpayers hope, however, as the court held that fractional interest discounts on artwork of over 40 percent were appropriate.

Estate of Elkins v. Commissioner

James Elkins, Jr., was a prominent Houston businessman and civic leader. Through a variety of transactions Mr. Elkins undertook individually and with his wife before she died, he structured his ownership of an art collection so that he owned fractional interests in each of 64 works of art that included such well known artists as Pablo Picasso, Jackson Pollock, and Paul Cezanne.

At his death, the artwork was held jointly in varying percentages by Mr. Elkins and his three adult children. Mr. Elkins' executors filed an Estate Tax Return, Form 706, that reflected valuation discounts on various items of real and personal property, including his fractional interests in the art. The IRS allowed discounts on various fractional-ownership interests in real and personal property, but insisted that no discount was available for the fractional interests in the artwork, and assessed a $9,068,266 deficiency. In response, the executors filed a petition in Tax Court.

In Estate of Elkins v. Commissioner (140 TC 86, 3/11/13), the Tax Court held that nothing in the law prohibits an appropriate discount from pro rata fair market value in valuing, for estate tax purposes, undivided fractional interests in artwork. The Tax Court, however, only applied a "nominal" 10 percent discount. The executors appealed the Tax Court decision to the Court of Appeals for the Fifth Circuit.

The Fifth Circuit (Estate of Elkins v. Commissioner (2014-2 USTC ¶60,683 (CA-5), 9/15/14)) reaffirmed that fractional interest discounts are appropriate and then addressed the question of the correct percentage discounts to apply. The Fifth Circuit reversed the Tax Court's holding that a nominal 10 percent discount was appropriate and ruled that the approximately 44.75 percent average discounts as computed by the estate's expert witness was appropriate and supported by credible evidence. The parties stipulated that the undiscounted appraised value of the artwork was approximately $35,000,000, so the increase in the discount yielded significant estate tax savings.

Although the Elkins case was a win for the estate and for wealthy families with valuable artwork, taxpayers cannot rely on the average approximately 44.75 percent discount afforded in this case. The IRS did not provide evidence to dispute the taxpayer's expert valuations. Going forward, one would expect the IRS to challenge discounts by offering evidence supporting lower discounts.

Proper Non-tax and Tax Planning for Artwork

Artwork is a unique category of asset and there are a host of issues related to ownership planning beyond the estate, gift, or income tax consequences. Proper storage, transit, display, as well as the emotional non-tax value associated with ownership may all play an important role in planning.

One of the main tax issues that wealthy families with valuable artwork face is the 40 percent gift and estate tax (plus possible state taxes). Many art collectors have expressed interest in the Elkins case because proper planning and holding structures resulted in significant fractional discounts on the artwork. The discounts significantly reduced the value of the assets included in Mr. Elkins' estate and thereby substantially reduced the estate tax liability. To that end, taxpayers should consult with competent professionals to appropriately structure an estate plan for their valuable artwork, which must include expert, credible, well reasoned valuations to support any discounts.

In light of the high gift and estate tax exclusion amounts (currently $5,430,000 per individual, $10,860,000 for a married couple), tax basis may be a more relevant consideration for some taxpayers. Gain from the sale of artwork held longer than one year is currently subject to up to a 28 percent capital gains tax rate, a potential 3.8 percent net investment income tax, the collateral damage higher taxable income creates due to the potential loss of deductions and credits, and possible state taxes. When the art passes through an owner's estate, the heirs will receive a basis equal to the fair market value at the date of death (or alternate valuation date) even if there is not a taxable estate. Individuals whot are not likely to be subject to estate tax may be better served to steer clear of fractional interests that generate discounts to avoid reducing the basis of the art to their heirs (i.e., the heirs may benefit in the form of higher income tax basis if no discount is available). If later sold for a profit, the higher basis will reduce their taxable gain.

The Elkins case affirms that fractional interests in artwork should afford some level of discount reducing the value on an estate tax return (similar to other assets such as real estate and entity interests). Taxpayers, however, are not guaranteed the 44.75 percent discount applied in this case. Taxpayers with valuable artwork and net worth in excess of the estate tax exemption may want to explore planning to take advantage of potential discounts. Keep in mind, however, that the lower estate tax value may result in larger gains upon a subsequent sale by the heirs, thereby generating a higher income tax liability.   

Careful analysis and planning are required; taxpayers are encouraged to work with professional advisors and qualified appraisers to ensure the most favorable tax result while meeting their personal objectives for their artwork. To learn more about the income and estate tax consequences of fractional discounting of artwork, please contact your local CBIZ MHM tax professional.

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