On March 11, 2013, the U.S. Tax Court issued its highly anticipated opinion in Estate of Elkins v. Commissioner,1 in which the court concluded, among other things, that there was no bar, as a matter of law, to claiming a pro rata discount on a decedent’s undivided fractional interests in 64 works of art.
The Elkins decision followed on the heels of Robert G. Stone v. United States,2 which was the first case to consider whether valuation discounts should be allowed for undivided fractional interests in artwork, given such interests’ lack of both control and marketability. The court in Stone allowed a meager 5 percent discount for the 50 percent undivided fractional interests in 19 paintings that were left to various family members. The court’s decision was primarily informed by the estimated costs that a hypothetical buyer would have to incur to monetize the acquired fractional interests by bringing a partition action in state court.
Practitioners were hopeful that the unique facts in Elkins would yield a substantially higher estate tax discount. Unfortunately for those planners, the Tax Court only allowed a 10 percent discount, and it didn’t provide clear guidance as to why it settled on 10 percent specifically. What’s evident, however, is that the court ignored the reasons proffered by the estate for greater discounts and, instead, focused on the decedent’s children’s documented desire to retain full ownership of the artwork and their willingness to purchase the fractional interests for an amount equal to or close to undiscounted values.
While Elkins can be viewed as a modest victory for the estate because the Tax Court recognized that discounts were indeed possible and granted a greater discount than that in Stone, the court’s analysis leaves many unanswered questions. In particular, can works of art be transferred under today’s Chapter 14 regime of the Internal Revenue Code by using them to fund grantor retained income trusts (GRITs)?
Elkins’ GRIT Art
James Elkins and his wife were residents of Texas and avid modern and contemporary art collectors. Their impressive collection included works by Joseph Albers, Paul Cezanne, Helen Frankenthaler, David Hockney, Jasper Johns, Ellsworth Kelly, Robert Motherwell, Hanz Kline, Henry Moore, Pablo Picasso, Jackson Pollock, Frank Stella and others—all of which were (and remain today) highly collectible.
Prior to engaging in transfer-tax planning, the couple partitioned their community property in their entire collection. On July 13, 1990, each spouse established a 10-year GRIT and contributed to it his or her one-half undivided fractional interest in the collection. Each GRIT gave its grantor possession and any resulting income for 10 years, after which time title and possession would pass equally to the grantors’ three children. The GRITs satisfied the requirements of IRC Section 2036(c), which was in existence at the time of funding.
However, Section 2036(c) was repealed shortly after the GRITs were funded, resulting in the Elkins’ GRITs becoming common law GRITs—no longer subject to the repealed Section 2036(c). The GRITs also weren’t subject to Chapter 14 because they were created prior to its effective date (see “Timeline,” p. A8). Because they were common law GRITs, the Elkins’ retained interests and their children’s remainder interests would have been easily valued under the-then actuarial tables of IRC Section 7520 for purposes of filing a federal gift tax return (Internal Revenue Service Form 709).
Unfortunately, James’ wife passed away in May 1999, just two months prior to her GRIT’s termination date. Her death caused her GRIT’s 50 percent fractional interests in the art to pass to James. In addition, her 50 percent community property interests in 61 other works passed outright to James, who disclaimed a 26.945 percent interest in such works, which has a value equal to his wife’s unused unified credit against estate tax. As a result, each child received an 8.98167 percent interest in the disclaimed art.
When James’ GRIT expired, its 50 percent fractional interest passed to his three surviving children so that each child received a 16.667 percent undivided fractional interest in the GRIT art. James thereafter retained the other 50 percent fractional interests that he received from his wife’s GRIT until the date of his death.
After his GRIT expired, James entered into a 10-year lease agreement with his children for a Picasso drawing and a Pollock painting, which were among the items in which his children received a fractional interest by reason of his disclaimer. The lease was meant to compensate the children for their father’s year-round possession and, presumably, remove the works from the inclusion clutches of Section 2036(a). For reasons unstated in the court’s written opinion, the lease agreement didn’t include a statue by Henry Moore and was never amended to include it.
The annual rent due was left blank until 2006, when Deloitte LLP determined that the accumulated rent due since inception was $841,668. Notwithstanding Deloitte’s calculation, no rent was ever paid during James’ lifetime. However, the executor intended to pay it and sought to deduct the $846,668 as a debt of the estate. On audit, the IRS and the estate agreed to reduce the rent due to only $10,000.
It was curious that no evidence was offered at trial as to the proper rental rates for the Picasso or the Pollock, or for the proper rental rates for the undivided fractional interests in said art. Instead, the experts on both sides of the case limited their analysis to the primary and secondary markets for purchasing fractional interests.
Common Law GRITs
Before the enactment of Section 2036(c), families regularly used GRITs to shift future appreciation in closely held businesses from older family members to younger ones at reduced transfer tax costs. This goal was sometimes accomplished by transferring an asset into a GRIT, retaining the use and income of that asset for the term and providing that the asset would revert to the grantor’s estate if the grantor died before the end of the term. After the term, if the grantor was living, the asset would pass to a younger family member. Such transfers were considered completed gifts at funding. The gift tax value of the remainder was determined at funding by subtracting the present value of the retained interest (determined by interest rates prescribed by the IRS at the time) from the asset’s entire fair market value (FMV). If the grantor survived the term, the asset would be transferred to the younger family member(s) without any additional transfer tax complications.
Chapter 14 GRITS
Sections 2701 through 2704 of IRC Chapter 14 apply to all transfers made after Oct. 8, 1990. These sections work to severely diminish the efficacy of common law estate freeze strategies. In limited circumstances, however, GRITs are viable estate-planning strategies. For example, GRITs are best known today for transferring remainder interests in residential property. A
qualified personal residence trust is a GRIT that’s explicitly exempted from the deleterious valuation rules of Chapter 14.
GRITs are also now used to transfer remainder interests in assets to non-family members. A “family member” is defined in IRC Section 2701(e)(1) and Treasury Regulations Section 25.2701-1(d)(1) to include a donor’s spouse, any ancestors or lineal descendants of a donor or donor’s spouse, a donor’s siblings and any spouse of the forgoing. The definition works to categorize nieces and nephews and aunts and uncles as non-family members. Thus, GRITs are often used today to pass wealth downstream to nieces and nephews and, on rare occasion, to transfer wealth upstream to donors’ ancestors.
In addition, before the U.S. Supreme Court struck down Section 3 of the Defense of Marriage Act in United States v. Windsor,3 it was common for same-sex couples, whether legally married under state law or not, to engage in GRIT planning to equalize assets between partners because they didn’t fall under the IRC’s definition of family member. After Windsor, legally married same-sex couples don’t have to rely on GRIT planning to transfer assets between themselves because they can rely on the unlimited marital deduction under IRC Section 2523 or at death under IRC Section 2056. GRIT planning remains relevant to unmarried same-sex couples, even those who’ve entered into a civil union or domestic partnership.
For purposes of this article, the statutory exception that’s of most interest is a GRIT that’s funded with tangible personal property.
IRC Section 2702(c)(4) provides:
If the non-exercise of rights under a term interest in tangible property would not have a substantial effect on the valuation of the remainder interest in such property—
(A) subparagraph (A) of subsection (a)(2) shall not apply to such term interest, and
(B) the value of such term interest for purposes of applying subsection (a)(1) shall be the amount which the holder of the term interest establishes as the amount for which such interest could be sold to an unrelated third party.
Personal Property GRITs
Section 2702 negates the benefit of a common law GRIT with a family member as a remainderman by valuing the retained interest at zero, resulting in a taxable gift of the entire value of the transferred property. As set forth above, Section 2702(c)(4) provides a limited exception to this “zero-value” rule for transfers of tangible personal property to a trust with a family member as remainderman and with the transferor retaining a term interest in the trust. The exception applies when the non-exercise of rights with respect to that term interest wouldn’t have a substantial effect on the valuation of the remainder interest in such property. Works of art fall within this exception because the failure of a GRIT term holder to exercise rights over a work of art (for example, the right to exhibit and loan a work to a dealer or museum) shouldn’t increase the work’s value at the end of the GRIT term.
The IRS has acknowledged that works of art (for example, paintings) are tangible property that can satisfy Section 2702(c)(4). Treas. Regs. Section 25.2702-2(d)(2)expressly provides the following examples:
FACTS. A transfers a painting having a fair market value of $2,000,000 to A’s child, B, retaining the use of the painting for 10 years. The painting does not possess an ascertainable useful life. Assume that the painting would not be depreciable if it were used in a trade or business or held for the production of income. Assume that the value of A’s term interest, determined under section 7520, is $1,220,000, and that A establishes that a willing buyer of A’s interest would pay $500,000 for the interest.
A’s term interest is not a qualified interest under section 25.2702-3. However, because of the nature of the property, A’s failure to exercise A’s rights with regard to the painting would not be expected to cause the value of the painting to be higher than it would otherwise be at the time it passes to B. Accordingly, A’s interest is valued under section 25.2702-2(c)(1)
at $500,000. The amount of A’s gift is $1,500,000, the difference between the fair market value of the painting and the amount determined under section 25.2702-2(c)(1).
Assume that the only evidence produced by A to establish the value of A’s 10-year term interest is the amount paid by a museum for the right to use a comparable painting for 1 year. A asserts that the value of the 10-year term is 10 times the value of the 1-year term. A has not established the value of the 10-year term interest because a series of short-term rentals the aggregate duration of which equals the duration of the actual term interest does not establish what a willing buyer would pay a willing seller for the 10-year term interest. However, the value of the 10-year term interest is not less than the value of the 1-year term because it can be assumed that a willing buyer would pay no less for a 10-year term interest than a 1-year term interest.
With a modest exclusion for de minimis tangible property, the ability to use a GRIT to make current tax-efficient gifts of art is expressly limited to collectors and is unavailable to artists, investors and dealers under Treas. Regs. Section 25.2702-2(c)(2). However, if the experts in Elkins are to be believed, even the ability of collectors to use GRITs seems to be effectively quashed by the experts’ testimony that there’s no active or regular market for buying, selling or renting fractional interests.
Section 2702(c)(4) places the burden of determining the value of the retained term interest in a personal property GRIT on the transferor by requiring the transferor to establish what the term interest could be sold for to an unrelated party. Treas. Regs. Section 25.2702-2(c)(1) provides: “If the transferor cannot reasonably establish the value of the term interest pursuant to this paragraph (c)(1), the interest is valued at zero.”
In establishing the value of the retained term interest, transferors to personal property GRITs aren’t permitted to rely on the actuarial valuation rules found in Section 7520 as they could have in the case of a common law GRIT. Nor can the transferor rely on the opinion of an appraiser, unless the appraiser can point to actual sales or rentals of comparable property for a comparable term in support of the appraisal. Treas. Regs. Section 25.2702-2(c)(3) provides:
Evidence of value of property. The best evidence of the value of any term interest to which this paragraph (c) applies is actual sales or rentals that are comparable both as to the nature and character of the property and the duration of the term interest. Little weight is accorded appraisals in the absence of such evidence. Amounts determined under section 7520 are not evidence of what a willing buyer would pay a willing seller for the interest.
The 1992 Treasury Regulations suggest that the IRS believed (and still believes, since the regulations haven’t been amended or repealed on this point) that fair market rental rates for full interests in fine art (or sale prices for term interests) can be readily established. It’s difficult to square this regulation with the experts’ opinions in Elkins, which agreed that there was no active or regular market for buying, selling or renting fractional interests in art. What these experts didn’t specifically address, but which I believe, is that there’s also no regular or active market for renting full interests in fine art—other than among IRC Section 501(c)(3) institutions, like museums—thus, there are no market comparables whatsoever for renting either full interests or fractional interests in art. In theory, the value of a term interest should equal the cost of renting the art for a period equal to the term, if the rent were paid up front in a lump sum, but no rental market exists. Likewise, there’s no market for the actual sale of term interests in works of art. Therein lies the rub. If there are no such markets, how can taxpayers ever fund GRITs with art (whether full interests or partial interests) and satisfy their burden of proof? As it relates to Elkins, if there’s no active market for selling fractional interests, and as I believe, no active market for renting such interests, how did the IRS advance a rental value of $10,000 for the two works subject to the art lease?
Like an abstract painting, Elkins is viewed by some practitioners as raising more questions than it answers. What’s clear is that there’s a statutory exception to Chapter 14 for funding GRITs for family members with tangible property. However, grantors with art do so at their own risk, as the IRS and the courts continue to struggle with how to determine the FMV of such interests, regardless of whether the interests are full interests or undivided fractional interests. Perhaps the only clear path ahead lies with grantors who wish to fund GRITs with artwork for non-family members. The requirement under Section 2702(c)(4)(B) that FMV be determined by what an unrelated third party would pay only applies to GRITs established for family members. Thus, a grantor who wishes to transfer works of art to a nephew, for example, should be able to rely on the actuarial valuation rules set forth in Section 7520. Of course, if the grantor wants to retain the works at the end of the GRIT term by paying the-then FMV rent rate for such interests, the grantor will face the seemingly impossible task of substantiating what such works should be rented for.
1. Estate of Elkins v. Commissioner, 140 T.C. No. 5 (March 11, 2013).
2. Robert G. Stone v. United States, 99 A.F.T.R.2d (RIA) 2007-2992 (N.D. Cal. 2007), supplemented by 100 A.F.T.R.2d (RIA) 2007-5512 (N.D. Cal. 2007), aff’d, Stone ex rel. Stone Trust Agreement v. U.S., 103 A.F.T.R.2d (RIA) 2009-1379 (9th Cir. 2009).
3. U.S. v. Windsor, 570 U.S. ____, 133 S. Ct. 2675 (2013).