• Tax Court applies nominal discount to fractional interests in art—In Estate of James A. Elkins, Jr., 140 T.C. No. 5 (March 11, 2013), the Tax Court addressed the valuation of fractional interests in 64 pieces of artwork owned by the decedent, James A. Elkins, Jr. The decedent and his wife originally owned the artwork together, 50 percent each, under the community property laws of Texas. By the time of his death, James’ interests were further fractionalized due to his transfer of a portion of the artwork to his children through trusts during his life and a disclaimer of partial interests in the artwork received from his wife when she died. As a result, he and his three children owned fractional interests in all 64 pieces of artwork on his death.

During his life, James and his children executed a co-tenancy agreement, in which they agreed to share possession of the artwork according to their various percentage interests and prohibit the sale of any item of artwork without the unanimous consent of all of the co-tenants.

James’ executors filed an estate tax return reporting an estate tax liability of $102,332,524. The estate tax return reported the value of his interests in the 64 pieces of artwork by applying a 44.75 percent combined fractional interest discount to the pro rata value of his share of each. The Internal Revenue Service determined that Internal Revenue Code Section 2703 should apply to disregard the restrictions contained in the co-tenancy agreement, found that no discount was justified and issued a deficiency notice. The parties stipulated that the undiscounted fair market value (FMV) of the artwork was about $35 million. 

The Tax Court agreed with the IRS that IRC Section 2703(a)(2) applied to disregard the co-tenancy agreement when valuing the property. Section 2703(a)(2) provides that for estate and gift tax purposes, the value of any property is determined without regard to any restriction on the right to sell or use such property, unless the restriction is a bona fide business arrangement comparable to other arm’s-length transactions and not a device to transfer the property to family members for less than full and adequate consideration. The court found the co-tenancy agreement waived the tenants’ right to partition the art and didn’t qualify for the exception. As a result, it was a “restriction on the right to sell” such property and was disregarded under Section 2703.

However, the crux of the case was the Tax Court’s application of the willing buyer/willing seller test. The FMV of any interest in property, for estate tax purposes, is the price at which the property would exchange hands between a willing buyer and willing seller, both being informed with reasonable knowledge of relevant facts and not under any compulsion to buy or sell. The estate presented multiple experts who described the inherent difficulty in partitioning or selling a fractional interest in art to an unrelated party, with all of the associated uncertainty and costs. The IRS, however, asserted that because owners of fractional interests collectively sell art on the retail market frequently and divide the proceeds among themselves according to their interests, no discount was warranted. The IRS was acknowledging that there was no market for fractional interests per se, but disregarding the problem of trying to reach consensus with the other co-tenants on a decision to sell. The court didn’t agree with the IRS because of the factual situation in the case. Here, the children were emotionally attached to the artwork, as it was part of their family legacy, and they expressed great interest in retaining the art. It was clear they wouldn’t easily agree to sell the artwork because the monetary value was only part of its value to them.

However, the court didn’t agree with the estate’s arguments regarding the partition, legal fees, time and other costs of trying to monetize a fractional interest in the artwork. The court noted that a hypothetical buyer might not be able to sell a fractional interest in the artwork held by the Elkins children to an unrelated party, nor would it be easy (or inexpensive) for a hypothetical buyer to enjoy the artwork himself as a co-tenant. However, the court explained that a hypothetical buyer would know that the Elkins children would be quite interested in buying his fractional interest to retain full ownership within the family. Testimony from the Elkins children corroborated this, as they acknowledged they would be willing to pay a fair price to purchase a hypothetical buyer’s interest in the art, the amount of which could be a straight pro rata value of the art. The Elkins children’s attachment to the art and financial resources were “relevant facts” that must be considered by a hypothetical buyer and seller. The court’s position was interesting because the willing buyer/willing seller test is supposed to assume rational interests and not particular motivations; that is, neither the willing buyer nor willing seller is supposed to be “strategic.” Here, the court valued the interest based on an assumption that the willing buyer was rational and not “strategic,” but that he would turn around and sell the interest to a strategic buyer. In essence, the court used the potential for a strategic buyer “down the line,” rather than in the initial transaction, to influence value. 

Therefore, the court held that a nominal 10 percent discount for a fractional interest in the artwork would apply, to reflect the uncertainty of whether and how quickly the Elkins children would buy back the interest in the art and if so, whether it would be at full, non-discounted pro rata price.


• Grantor trust and incomplete gift ruling—In Private Letter Ruling 201310002 (Nov. 7, 2012), the IRS ruled on the income tax and gift tax consequences of a trust established by a grantor from which distributions were made at the direction of a distribution committee. The trust was for the benefit of the grantor and his four sons, all of whom were the initial members of the distribution committee. A corporate trustee was the sole trustee. However, the trustee was permitted to make distributions only of:


income and principal to the grantor or his issue on the direction of a majority of the distribution committee and with the grantor’s consent; and

income and principal to the grantor or his issue on the unanimous direction of the distribution committee (excluding the grantor).


In addition, the grantor (in a non-fiduciary capacity) could make distributions to his issue for their health, education, support and maintenance under a lifetime power of appointment (POA).

The grantor had a limited testamentary POA, which allowed him to direct the trust property to any person or entity other than himself, his estate, his creditors or the creditors of his estate. On the grantor’s death, in default of the exercise of the POA, the trust property was to be held in trust for the benefit of his issue.

The IRS ruled that the trust wouldn’t be a grantor trust to the grantor. This was due to the fact that the distribution committee was made up of the grantor’s sons, who were also beneficiaries of the trust and were, therefore, “adverse.” IRC Section 674(a) provides that a grantor is treated as the owner of any portion of a trust of which the beneficial enjoyment is subject to a power of disposition exercisable by the grantor or a non-adverse party, without the approval or consent of any adverse party. There’s a further exception to this rule, providing that it won’t apply if a power is limited by a reasonably definite standard. Since a majority of the sons, or all of the sons, would have to consent to a trust distribution made by the trustee, the test under Section 674(a) wasn’t met because the sons, as beneficiaries, were adverse parties. And, since the grantor’s power to make trust distributions (under the POA) was limited to an ascertainable standard, his power didn’t give rise to grantor trust status under Section 674 either.  

IRC Sections 676 and 677, similarly, cause grantor trust status if the grantor has certain powers or beneficial interests in the trust, but only if the powers can be exercised or the benefit conferred without the consent of an adverse party.

However, the gifts to the trust were incomplete because of the grantor’s retained powers. If the grantor transfers property to a trust but retains a power to name new beneficiaries or change the interest of beneficiaries, the gift will be incomplete. The grantor could distribute (in a non-fiduciary capacity) trust property to his issue for their health, education, support and maintenance and had a limited testamentary POA. These powers allowed him to control the beneficial enjoyment of the trust property, which rendered the gifts incomplete.  

The ruling also held that the grantor’s required consent for the trust distributions directed by a majority of the distribution committee kept gifts to the trust incomplete. Here, the IRS noted the regulations under IRC Section 2511, which provide, in part, that the gift will be incomplete if the grantor’s retained power may be exercised only in conjunction with other persons, if any, who don’t have a substantial adverse interest. The taxpayer’s consent required a majority decision of his sons, who were beneficiaries of the trust. Section 2511 doesn’t define “substantial adverse interest,” so the IRS looked to IRC Section 2514, which does. Based on Treasury Regulations Section 25.2514-3(b)(2),
“substantial adverse interest” requires the coholder of the power to be a taker in default or possess the power after the other possessors’ death and be able to exercise it at that time in favor of himself, his estate, his creditors or the creditors of his estate. The sons weren’t takers in default of the decision to distribute or not distribute because they wouldn’t necessarily receive the assets if they didn’t distribute them. Because the sons’ powers to make distribution decisions ceased at the grantor’s death, the IRS held that their powers weren’t “substantial adverse interests.”  

This conclusion wasn’t determinative because of the grantor’s other powers, but the discussion was interesting in that the IRS reads the definition of “substantial adverse interest” under the gift tax rules much more narrowly than the definition of an “adverse party” under the grantor trust rules. Treas. Regs. Section 25.2514-3(b)(2) says, “A coholder of the power has no adverse interest merely because of his joint possession of the power nor merely because he is a permissible appointee under a power.” Being a discretionary beneficiary isn’t enough to be adverse for purposes of Section 2514, unlike IRC Section 672.

Finally, the IRS held the committee members wouldn’t have general powers of appointment (GPAs). If a committee member can vote for a distribution to himself, he may have a GPA over the trust property. For example, if the distribution committee consists of beneficiaries A, B and C, and the trustee proposes a distribution to beneficiary A, if A can vote on that distribution, he may have a GPA, even though he would need B and C to also agree on the distribution.  

Section 2514(c)(2) provides that a POA isn’t a GPA if exercisable only in conjunction with the creator of the power (grantor). So, the committee’s power to direct distributions by majority vote isn’t a GPA because the grantor’s consent is also required for the trustee to act. And, under the regulations, a GPA doesn’t include a power reserved by a grantor to himself, so the grantor’s distribution powers don’t create a GPA, either.  

At issue is whether the committee members are “adverse” to each other for purposes of their “unanimous consent” distribution power. If they’re not, then their power to direct distributions by unanimous consent (without the grantor) would give them a GPA. As noted above, they’re not adverse merely because they’re coholders of the power and permissible appointees. However, a coholder of a power is considered as having an adverse interest when he may possess the power after the possessor’s death. The example in the Treasury regulation above states: 


. . . if X, Y, and Z held a power jointly to appoint among a group of persons which includes themselves and if on the death of X the power will pass to Y and Z jointly, then Y and Z are considered to have interests adverse to the exercise of the power in favor of X.


This sentence, standing alone, suggests that Y and Z inheriting X’s vote is sufficient, even if neither will ever have the sole vote (because the committee will disband in our structure if the committee has less than three members). The vote doesn’t have to eventually fall into one person’s hands, despite the next sentence in the regulation. If the committee members aren’t replaced as they resign/die, then the vote of former members will pass to the remaining members, making the committee members adverse within the regulation. Revenue Rulings 76-503 and 77-158 and PLR 201310002 support this. While the PLR says all vacancies on the committee were replaced, the attorney who obtained the ruling said that the initial four members would only be replaced if there would be less than two members. Therefore, the current committee members wouldn’t be replaced if one died/resigned, leaving the others to inherit his vote, making them adverse for purposes of the unanimous consent power. Therefore, the committee members didn’t presently have a GPA.

This ruling is one of a related series (PLRs 201310003 through 201310006). These trusts may have been Delaware incomplete nongrantor trusts, designed to shift income tax liability related to the trust assets to Delaware, which doesn’t tax accumulated income or retained capital gains in a trust for the benefit of non-Delaware residents. The IRS initially issued several similar rulings between 2001 and 2007, but then requested comments on this strategy in an information release in 2007, which created some uncertainty about the technique.


• Ruling on GST tax consequences of transfer by non-citizen, non-resident to resident alien—
PLR 201311004 (Nov. 28, 2012) is a good reminder of the rules regarding the generation-skipping transfer (GST) tax treatment of transfers from persons who are neither citizens nor residents of the United States. A non-citizen, non-resident decedent had established two inter vivos trusts, each of which had a situs in a foreign country and held assets in that country. The second trust was for the benefit of the taxpayer, who was a resident alien of the United States and more than 37½ years younger than the decedent.

The decedent’s will provided that, on his death, the assets of the first trust were to pass to his estate, a portion of which was to be paid to his sister-in-law and the balance to be paid to the second trust for the benefit of the taxpayer. The second trust terminated on the earlier of the death of the decedent or the date on which the taxpayer’s eldest child reached age 21, at which time the trust property was to be distributed to the taxpayer. The taxpayer asked whether there would be any GST tax consequences to the distributions to the taxpayer from the decedent’s estate or the second trust on his death.

The GST regulations provide that the GST tax only applies to transfers by a non-citizen, non-resident transferor if the transfer is subject to federal estate or gift tax. The trusts weren’t subject to gift tax because the property transferred to the trusts wasn’t situated in the United States, and the estate wasn’t subject to estate tax because the estate wasn’t situated in the United States. Therefore, no GST tax was due on the property transferred to the taxpayer from the trust or the estate.