Under U.S. law, a tax generally is imposed whenever one individual gratuitously transfers an interest in property to another. This tax is computed on the value of the property interest transferred, whether during one’s life (to which the gift tax applies) or at one’s death (to which the estate tax applies). In some instances, a discount in the value of an interest in property may be taken by a donor or the executor of an estate when filing a gift or estate tax return, as the case may be. The 5th Circuit Court of Appeals recently decided Estate of Elkins v. Commissioner [767 F.3d 443 (5th Cir. 2014)] in which the court considered discounts to establish the value of fractional interests in artwork.

When James Elkins, son of the founding partner of the Vinson and Elkins law firm, died, he owned fractional interests in 64 very valuable works of art. Mr. Elkins and his wife had accumulated the artwork over the course of their marriage, which constituted the couple’s community property under the laws of Texas, where they resided during their marriage. Prior to Mr. Elkins’ death, the artwork had been maintained in his home, his office, the homes and offices of his children as well as on display in various public places. Mr. and Mrs. Elkins each settled a so-called grantor retained income trust (a GRIT) to which each of them transferred his or her respective interests in three works of art, which the Tax Court termed the “GRIT Art”. The other 61 pieces, which, for the reasons discussed next, were referred to by the Tax Court as the “Disclaimer Art”, were owned outright by Mr. and Mrs. Elkins.

Mrs. Elkins predeceased Mr. Elkins during the term of the GRITs, causing her 50 percent interest in the GRIT Art to pass to Mr. Elkins. At the conclusion of the term of the GRITs, the three Elkins children received the 50 percent interest in the GRIT Art held in Mr. Elkins’ GRIT in equal, 16.67 percent shares. Mr. Elkins, who was to receive Mrs. Elkins’ entire 50 percent interest in the Disclaimer Art, made a qualified disclaimer of a 26.945 percent interest in the Disclaimer Art causing each of the three Elkins children to receive an 8.98167 percent interest. Following Mrs. Elkins’ death, Mr. Elkins and the Elkins children entered into a lease agreement with respect to two of the three pieces of GRIT Art (whereby the Elkins children leased their combined 50 percent interest in each of the two pieces to Mr. Elkins) and a “Cotenants Agreement” with respect to the remaining piece of GRIT Art and the 61 pieces of Disclaimer Art. Each agreement constrained use and/or alienation, or transferability, of each party’s interest in the artwork.

Mr. Elkins’ and the Elkins children’s interests in the artwork remained unchanged until his death. The executors of Mr. Elkins’ estate filed the estate tax return, taking significant discounts to establish the value of Mr. Elkins’ fractional interests in the artwork. The IRS challenged the discounts. The estate asserted that 45+ percent discounts in the value of Mr. Elkins’ fractional interests was appropriate because, as its expert opined, there was no “recognized” market for fractional interests in art. The IRS countered that no discount—not even one percent—should be allowed because the Elkins children could agree to sell their combined interests in the artwork, making Mr. Elkins’ interests marketable. Additionally, testimony at trial suggested that  the Elkins children had emotional, psychic attachments to the art so that, presumably, the children’s attachment would spur them to “snatch up” Mr. Elkins’ interests, thereby creating a market for the fractional interests. The U.S. Tax Court decided that at least some discount was appropriate and allowed a 10 percent discount. The estate appealed.

The 5th Circuit affirmed the Tax Court’s decision that a discount was allowable but reversed the Tax Court’s decision to limit the discount to a nominal, 10 percent discount. The 5th Circuit held that the Tax Court clearly erred because, while the 45+ percent discounts may have been too large, the IRS presented no evidence as to what an appropriate discount might be; in other words, no evidence was presented on which the Tax Court could have based its decision. Accordingly, the 45+ percent discounts asserted by the estate were allowed.

Even though the result in Elkins was a significant victory for taxpayers, taxpayers should not count on the allowance of 45+ percent valuation discounts for fractional interests in art in their planning, absent compelling facts in support of a discount of that magnitude. In no way diminishing the importance of planning by Mr. and Mrs. Elkins in consultation with counsel, the 5th Circuit’s holding appears to have been grounded primarily on the failure by the IRS to present evidence rebutting the taxpayer’s evidence supporting 45+ percent discounts. Simply put, a taxpayer planning for the disposition of fractional interests in art should not expect that, if the taxpayer’s claim of discount is disputed, the IRS will not seek to support a lower discount by countervailing support testimony.

While taking a discount to establish the value of an asset, whether art or other property, to reduce transfer tax may be advisable in many cases, in the estate tax context any discount taken could result in the loss of part or all of a step-up in the income tax basis of the asset. Art collectors and enthusiasts should consult counsel when contemplating lifetime gratuitous transfers of interests in art or planning their legacies, not only because valuation issues may arise, but also because there is not a one-size-fits-all approach to estate planning, especially for someone who owns significant interests in artwork. Strategies that include the use of trusts, limited liability companies (and/or other entities), various types of contracts or a combination thereof could be appropriate in a given instance, depending upon many factors, such as family dynamics, an individual’s net worth, the composition of his or her portfolio, individual and family goals and the value and anticipated uses of the art.