Last September's taxpayer victory in Estate of Elkins v. Comm'r, 767 F.3d 445 (5th Cir. 2014), opened the door to a new tax-planning strategy for collectors of all stripes. Collectors of art, antiques, vintage automobiles, jewelry, stamps, and even baseball cards should be mindful of the lessons to be learned from this decision to best protect themselves from a 40% estate tax on the fair-market value of their collections. Given the rising value of art and other collectibles, this tax can be an unwelcome surprise. Heirs often find they are able to pay this tax only by selling part of the collection or other assets they inherit. For heirs who do not share their forbears' taste, selling part of the collection might not be unwelcome, but paying a tax equal to 40% of the fair-market value of their collection, particularly when this tax might be meaningfully reduced with a little planning, is a frustration the heirs might be spared.
Background on the Estate Tax
The first $5,000,000 of assets that we leave to our heirs is excluded from the federal estate tax (this exclusion amount is adjusted upward for inflation annually).1 This tax then begins to apply at graduated rates that quickly reach 40% of our assets' fair market value.2 This tax cannot simply be avoided by the gifting of assets during life, as a gift tax would then apply generally with the same effect. Moreover, a collector cannot avoid multiple applications of this tax to the same asset as it passes from a grandparent to a grandchild. In the most typical scenario, estate tax first applies when the grandparent bequeaths an asset to his child and applies a second time when the child bequeaths the same asset to the grandchild. If the grandparent were to simply give or bequeath the asset to the grandchild, a generation-skipping transfer tax, which is akin to a double estate tax, would then apply.
The federal estate tax (or gift tax or generation-skipping transfer tax, if applicable) has a broad reach. It applies not only to cash, securities, art, and other collectibles conveyed to heirs, but also to family homes, family businesses, 401(k) accounts, and sometimes even life insurance proceeds (notwithstanding the fact that such proceeds are free from income tax). Given the estate tax's potential cost, various techniques have been devised to minimize its impact.
Valuation Techniques
One technique for minimizing the federal estate tax (or gift tax or generation-skipping transfer tax) is to reduce the value of one's assets before their transfer. As no rational person would actually reduce his or her assets' value merely to save on taxes, such value suppressing techniques tend to be temporary in nature. Perhaps the most common of these techniques is the use of a partnership, where the partners' interests in the partnership are worth less than the partnership's assets.
By way of example, suppose a parent conveys a basket of publicly traded securities to a partnership and then gifts the partnership to his three children in equal parts. At first blush, one would expect each child's partnership interest to be worth one-third of the value of the partnership's assets. But, because the parent has conveyed an interest in the partnership, not an interest in the partnership's assets, the relevant inquiry is the value of the partnership interest itself. The valuation of this type of property often calls for a "lack of marketability discount" because the partnership interest is not tradable on the open market. Suppose further that the partnership is structured so that no partner can make a major decision without the other partners' consent. This often calls for a further "lack of control" discount. It is not uncommon for the successive application of these discounts to permit an appraiser to conclude that a partnership interest is worth less than half of the partner's indirect share of the partnership's assets. If one employs such a mechanism, it is preferable that the partnership remain in place for several years (to limit the perception that it is merely a device for discounting the fair-market value of assets subject to tax). Ultimately, however, the partnership can make liquidating distributions to the heirs so that they acquire the assets' full, undiscounted value.
While this technique has been used to great effect for financial assets, it generally has not been used for art or other collectibles. This may be due to inherent differences between financial assets and tangible property. Investors typically acquire minority interests in stocks and bonds and in partnerships that own the same. A parent might easily bequeath his stock holdings to his children in equal proportions. However, with an item like art, a buyer typically acquires the entire artwork. A person either owns a painting or does not. It is unusual for a parent to bequeath his art collection to his children in equal parts because there is no readily convenient means for sharing possession of the collection.
Elkins Decision
The Elkins decision is unique because the decedent owned percentage interests in 64 modern artworks and his children owned the remaining interests in those works. To address possession issues, certain works were leased and other works were rotated among the owners. Upon Mr. Elkin's death, his estate claimed a 44.75% discount for its percentage interests in the works (i.e., if the decedent owned a 50% interest in a painting worth $200, the estate claimed the value of this interest was $55.25, not $100). The IRS disputed the estate's claimed discount and litigation ensued.
The Tax Court initially assessed this dispute in Estate of Elkins v. Comm'r, 140 T.C. 86 (2013). The IRS argued to the Tax Court that a valuation discount should be disallowed for two reasons. First, the IRS claimed that because there generally is no market for fractional interests in art, it would be inappropriate to permit the estate to claim a discount in this context. Second, the IRS claimed that guidance it had previously issued authorizing charitable contributions for certain donations of percentage interests in art – guidance that permits the donor to disregard any discount upon donation of a fractional ownership interest – precludes the application of a fractional valuation discount for estate tax purposes. Notably, the IRS did not introduce expert testimony to dispute the amount of the estate's claimed valuation discount. The IRS's strategy was all or nothing. Perhaps the IRS feared that its introduction of expert testimony relating to the amount of a valuation discount for a fractional interest in art would legitimize the estate's claim for such a discount.
The Tax Court agreed with the estate that a valuation discount should be permitted, but did not agree to the discounts proposed by the estate's expert witnesses, who had asserted discounts in the range of approximately 50% to 80%. The Court instead ruled that a 10% discount applied. On appeal, the Fifth Circuit Court of Appeals affirmed the estate's entitlement to a valuation discount but chided the Tax Court for adopting its own determination for the amount of such discount. The Court of Appeals reasoned that the Tax Court was ill suited to determine the amount of a valuation discount for the fractional ownership of art under consideration and, because the estate's expert testimony on this was not countered by any expert testimony introduced by the IRS, held that the estate's claimed discounts ranging from 52% to 80% should apply. Thus, the government's "all or nothing strategy" doubly failed. The appeals court not only upheld the use of a discount, but also found that it had to accept the decedent's proposed discount because the IRS offered no evidence of what a reasonable discount would be. Had the IRS introduced its own expert testimony on the discount for a fractional ownership interest in art, a lesser discount might have been applied.
It is difficult to predict how the IRS will proceed given its loss in Elkins. On the one hand, it might continue to argue that discounts for fractional interests in art should not be permitted outside of the Fifth Circuit (which includes only Texas, Mississippi, and Louisiana), perhaps even with the "all or nothing" litigation strategy that it pursued in Elkins. Alternatively, the IRS might introduce its own expert witnesses who concede the existence of a valuation discount but conclude that the amount of such discount should be minimal, perhaps only the 10% discount proposed by the Tax Court in Elkins. It is also unclear whether the IRS will revoke its earlier guidance allowing certain charitable contributions of fractional interests in art to be claimed without a fractional interest discount. Revoking such guidance would protect the IRS from taxpayers' taking advantage of inconsistencies in valuation (i.e., no discount for charitable contribution but maximum discount for gifts and bequests). The IRS might be reluctant to revoke this earlier guidance because doing so would create the impression that it concedes the legitimacy of valuation discounts for fractional interests in art, which could undermine its potential future litigation efforts outside of the Fifth Circuit. What is clear for the moment at least is that taxpayers can have the best of both worlds by claiming (1) no discount for charitable contributions and (2) full discounts for gifts and bequests of fractional interests in art.
Practical Tips
A taxpayer should be able to replicate the successful strategy employed in Elkins by taking the following steps:
- Create any fractional interests in art during one's lifetime.Creating fractional interests upon death, for example, by having the decedent bequeath percentage interests in art to his children, is insufficient because the estate tax measures the value of one's assets as they are owned immediately before death.
- After creating fractional interests in art, make sure that possession and enjoyment of the art are consistent with those fractional interests. This might be implemented with rental arrangements. Alternatively, the fractional interest owners might be permitted to possess the art for a number of days per year corresponding with the owners' percentage interests. These arrangements are important because neither the IRS nor the courts are likely to respect contracts creating fractional interests in art if the parties' actions do not conform to such contracts' terms.
- Ensure that no owner of a fractional interest in art is able to force a sale of the work. Such an ability would undermine one basis for the discount by creating liquidity.
- Arrange for the joint ownership structure to remain in place for at least several years after the gift or death that is subject to tax. Eliminating the joint ownership arrangement shortly after the taxable event could create the impression that the circumstances creating the valuation discount were contrived solely to avoid taxes.
- Make sure no fractional owner is provided with voting control, or some other tie-breaking mechanism that would cause such person's fractional interest in the art to inadvertently be valued at a premium.
- The fractional interest owners should not collaborate among themselves informally to trade their percentage interests in all the art for exclusive interests in a portion of the art assuch informal arrangements might also undermine the basis for the discount to be claimed.
Needless to say, the tips offered above run counter to what collectors might envision when providing for their children. Causing art to be jointly owned, without any owner able to cast a tie-breaking vote, and with the owners paying rent to one another or rotating the art, and having this arrangement continue indefinitely, may create too many difficulties. For example, the shareholders may disagree on a rotation schedule or the determination of the amount of rent to be paid. In addition, rental payments themselves could give rise to income and sales tax nuisances. All technicalities and drawbacks need to be taken into account before a collector attempts to implement an Elkins-style tax-saving strategy.
* IRS Circular 230 Disclosure: To ensure compliance with Treasury Department regulations, we inform you that any U.S. federal tax advice contained in this document (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the U.S. Internal Revenue Code of 1986, as amended (I.R.C.) or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
Footnotes
1 I.R.C. § 2010.
2 I.R.C. § 2001.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
