Estate Tax: Fifth Circuit Court Upholds Fractional Discounts for Fractional Interests.
(Parker Tax Publishing October 22, 2014)

An estate could heavily discount the fair market value of works of art left in the estate to account for the fractional interests a decedent held with his surviving children. Est. of Elkins v. Comm'r, 2014 PTC 483 (9/15/14).

During his life, James Elkins, Jr. and his wife owned over 60 pieces of modern and contemporary art. They each held a 50 percent interest in each work of art and, when James' wife died, her interests in the pieces were split among their three children. Thereafter, James shared fractional interests in the works of art with his three children. James died in 2005 and his estate filed a tax return listing, among other assets, the works of art valued according to his pro-rata share less a discount due to the fact he only owned fractional interests in the pieces. The IRS disallowed the fractional ownership discount and assessed an estate tax deficiency of approximately $9,000,000.

The executors of James' estate petitioned the Tax Court to review and eliminate the deficiency. In the Tax Court, the IRS insisted that absolutely no fractional-ownership discount was allowable. The Tax Court rejected the IRS's zero-discount position, but also rejected the various fractional-ownership discounts adduced by the estate through its expert witnesses. Instead, the Tax Court concluded that a discount of 10 percent should apply across the board to James ratable share of the stipulated FMV of each of the works of art. The estate executors appealed to the Fifth Circuit to determine what, if any, discount should be applied to James' fractional interests.

Under Reg. Sec. 20.2031-1(b), the fair market value of a piece of property 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 primary issue before the Fifth Circuit Court was whether James' estate was taxable on the undiscounted pro rata share of the FMV of the works of art, or whether it was taxable only on those values reduced by fractional-ownership discounts of either (1) a uniform 10 percent each, as held by the Tax Court, or (2) the various percentages that the estate advanced through its expert witnesses. The IRS stuck by its initial assessment that no discount was allowed but offered no evidence to support this conclusion, aside from the testimony of an expert witness that there was no readily available market for fractional interests in works of art. The estate argued that a proper application of the willing buyer/willing seller test would produce prices for James' undivided interests in the works of art substantially below his pro rata share of their respective FMVs. According to the estate, any hypothetical willing buyer would demand significant fractional-ownership discounts in the face of becoming a a co-owner with James' descendants, given their determination never to sell their interests in the art.

The Fifth Circuit Court affirmed the Tax Court's rejection of the IRS's position. The court affirmed the Tax Court's holding that the estate was entitled to apply a discount, but reversed the Tax Court's holding that the appropriate discount was 10 percent. Instead, the Fifth Circuit concluded that the estate's experts had correctly calculated the applicable discounts to be more than 10 percent. In reaching this decision, the court noted that the IRS had offered no evidence as to why no discount was appropriate. The court realized that a potential willing buyer of the art would be well aware that, by virtue of becoming a co-owner with the heirs to James' estate, he or she could not make a quick resale. Additionally, the court noted the situation was only exacerbated by the various restrictions on partition, alienation, and possession that were attached to the art. Because of this, the court concluded that the discounts determined by the estate's experts were not just the only ones proved in court; they were eminently correct. Therefore, the court rendered judgment in favor of the estate for a refund of taxes of approximately $14,000,000 plus interest.

For more on valuation of estate property for estate tax purposes, see Parker Tax ¶224,700. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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