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Discount Valuation of Artwork

Posted Thursday, May 9, 2013 by John S. Palmer

Owning undivided, fractional interests in assets is extremely common. Couples who own a home, for example, each own an undivided 50% interest in the whole property. And discount valuations (reducing the value of a taxpayer’s ownership interest in an asset to reflect lack of marketability or control) are also commonly used for a variety of assets, such as closely-held or family-owned business entities in which a right of first refusal or other restrictions have been placed on a participant’s ability to sell his or her interest on the open market.

Estate of Elkins v. Commissioner, 140 T.C. No. 5, decided March 11, 2013 is an interesting case because it demonstrates the unique issues involved in applying discount valuations to works of art. The case required the US Tax Court to place a value on the decedent’s undivided fractional interest in 64 works of art, including works by Pablo Picasso, Jackson Pollock, Paul Cezanne, and Jasper Johns. All of the artwork was originally owned outright by the decedent and his wife. The wife died in 1999 and the decedent died in 2010.

At the time of his death, the decedent owned a 50% interest in 3 of the works. The other 50% was co-owned by his 3 children. The decedent also owned an undivided 73.055% interest in each of the remaining 61 pieces; the 3 children owned just under 9% each.

After his death, the decedent’s ownership interests in the artwork were part of his taxable estate. His fractional interests in all 64 pieces were worth just under $24 million, but on the estate tax return the estate claimed a 44.75% fractional interest discount for lack of marketability and control. The IRS took the position that no discount was permissible.

The estate argued that no single buyer would be interested in purchasing the entire collection, requiring the fair market value and applicable discount for each work to be analyzed separately. Its expert witnesses testified that all potential buyers of the decedent’s interest in the artwork would demand deep discounts for the decedent’s fractional interest in any given work due to (1) the uncertainty of whether they could ever acquire the children’s interests and own the entire work; (2) the logistics involved with shared ownership; and (3) the prospect of litigation with the children if the buyer tried to force a sale. The estate also argued that potential buyers would demand additional discounts if similar works by the same artists were available elsewhere. Based on these factors, the estate’s experts claimed buyers would want discounts of 50% to 80% for the most desirable works, and discounts of 95% or even 100% for the less desirable works.

Under Estate Tax Regulation 20.2031-1(b):

The value of every item of property includible in a decedent’s gross estate…is its fair market value…The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate…All relevant facts and elements of value as of the applicable valuation date shall be considered in every case.

The IRS took the position that under this regulation, no discount was available because the market in which artwork is “most commonly sold to the public” is the retail market whereby all fractional interest holders agree to sell and the art is sold for its undiscounted fair market value, after which each fractional interest holder receives his or her pro rata share of the proceeds.

The Tax Court disagreed, and said that the children’s probable hostility to selling any of the art constitutes one of the “relevant facts and elements of value” to be considered under the regulation. This proved to be a double edged sword, however, because the court also concluded that it was relevant to consider that the children’s desire to keep the art within the family was so strong that potential buyers were likely to assume the children would pay close to fair market value for any fractional interest in the artwork purchased by third parties from the estate, thereby driving the fair market value up by reducing the uncertainty that a buyer could profit from their investment. The court was also not persuaded that a museum or collector would object to sharing possession with the children, particularly with regard to the 61 works in which a buyer could acquire a right to possess them 73% of the time, noting that museums commonly share ownership of expensive art works.

Nonetheless, the court found that some discount was appropriate because a hypothetical buyer could not be certain that the children would seek to buy back their interest, or be willing to pay full fair market value for it. It ruled that the estate was entitled to a 10% discount from pro rata fair market value for the decedent’s interest in the artwork, on the grounds that this is what a hypothetical buyer and seller would find acceptable and assure the buyer that he or she could make a reasonable profit on their investment by selling the interest back to the children.

Footnote: the parties spent a great deal of time arguing whether Internal Revenue Code Section 2703 was relevant to the analysis. IRC section 2703 generally states that the value of property shall be determined without regard to “any restriction on the right to sell or use such property” unless certain criteria are met, including that the restriction is a bona fide business arrangement. The IRS argued that under 2703, a Cotenants’ Agreement signed by the decedent (stating that 62 of the works could only be sold with the unanimous consent of all the co-owners) was to be disregarded in calculating the discount. The court agreed, albeit for a slightly different reason, but stated that in the end, it made little difference to its conclusion that the estate was entitled to a 10% discount.

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