Wednesday 1 October 2014

The quantification of estate taxes: even more obscure than the valuation of art?

A recent decision of the United States Court of Appeals for the Fifth Circuit has been lauded as a victory for art collectors. More accurately, however, it appears to be a victory for the extremely wealthy seeking to avoid paying taxes.

While a lengthy, rather technical, case, it is hoped that the essential elements have been reproduced below.

James A. Elkins, Jr. and his wife collected 64 works of art during their lives. The collection included pieces by Jackson Pollock, Henry Moore, Pablo Picasso, Rene Magritte, David Hockney, Paul Cezanne to name just a few. At the same time, they were thinking ahead, both creating a Grantor Retained Income Trust (GRIT) that held title to their respective interests in the works, and entering into various agreements which also partitioned and allocated their interests in their art.

The result was that at the time of death of Mr Elkins in 2006 (his wife had died in May 1999), the art was jointly owned in varying percentages by Mr Elkins and his three adult children.

In 2007, his children filed a United States Estate (and Generation Skipping Transfer) Tax Return (estate tax return) in which they reported a Federal estate tax liability of over $100million. It listed, among other assets, fractional interests in various items of real and personal property, including the artworks.

In assessing the federal estate tax due on Elkins' estate, the Internal Revenue Service decided that tax should be paid on the full value of the art, refusing a discount based on Elkins' pro rata share—his fractional-ownership interest— of the art.

In 2010, the Executors of the Estate petitioned the United States Tax Court to review the assessment on the basis that there should have been a fractional-ownership discount applied when determining the taxable values of Elkins' fractional interest in the 64 items of art.

The Tax Court rejected the IRS' zero-discount position, but also rejected the quantums of the various fractional-ownership discounts adduced by the Estate through the reports, exhibits, and testimony of its three expert witnesses. Instead, the Tax Court concluded that a “nominal” fractional-ownership discount of 10% should apply across the board to from pro rata fair market value of Elkins ratable share of each of the works of art.

Still unhappy with the decision, the Estate appealed again and the case was heard by the US Court of Appeals for the Fifth Circuit.

The only question to be resolved was whether the federal estate tax due on the artworks was to be calculated based on Elkins' undiscounted pro rata share of the art (as the IRS contended) or should there be a fractional-ownership discount of either (i) a uniform 10% (as held by the Tax Court) or (ii) the various percentages that the Estate advanced through the testimony and reports of its expert witnesses?

The Court found:
  • Just as it was obvious to the Tax Court that the IRS had no viable basis for rigidly insisting that no fractional-ownership discount was applicable, it should have been equally obvious that, in the absence of any evidentiary basis whatsoever, there was no viable factual or legal support for the the Tax Court’s own nominal 10% discount. 
  • The Estate was entitled to apply a fractional-ownership discount to the tax due on Elkins' ratable share of the each of the 64 works of art. 
  • The answer to the question of the correct quantum was to be found with the proper administration of the willing buyer/willing seller test for fair market value: '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 sell and both having reasonable knowledge of relevant facts.'
  • The Estate's evidence was that the sale of Elkins' undivided interests in the artworks would produce prices substantially below his pro rata share of the works as any hypothetical willing buyer would demand significant fractional-ownership discounts in the face of becoming a co-owner with the Elkins descendants (given their financial strength and sophistication, their legal restraints on alienation and partition, and their determination never to sell their interests in the art).
  • The correct quantums of the fractional ownership discounts applicable to Elkins' pro rata share of the various artworks were those determined by the Estate’s experts. 

The full list of the 64 artworks and the discounts can be found in Appendix B to the Tax Court’s decision. The discounts range from over 50% to just under 80%. A substantial difference from the Tax Court's nominal 10% discount. As a result, the Court ordered a refund payment to the Estate of $14,359,508.21, plus statutory interest, for overpaid taxes.

While apparently "nothing is certain except for death and taxes," you could add to that the certainty that those with enough money will seek to avoid both. And that, in itself, is an art form. But that is just a [reckless] opinion....what do you think?

Source: Forbes, 24 September 2014

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