What’s the fair market value (FMV) of a deceased collector’s undivided fractional interest in 64 works of art—art that includes pieces by Pablo Picasso, Henry Moore, Jackson Pollock, Paul Cezanne, Jasper Johns, Ellsworth Kelly, Cy Twombly, Robert Motherwell, Sam Francis and David Hockney?  Such was the daunting question facing the Tax Court in Estate of James A. Elkins, Jr. deceased, et al. v. Commissioner, 140 T.C. No. 5 (March 11, 2013).

Quite a Collection

Decedent James A. Elkins, Jr. and his wife Margaret collected contemporary art between 1970 and 1999.  They displayed their collection primarily in their Houston home and family office.  A few pieces were displayed at other locations, but none of the 64 paintings were ever sold.  Because the art was purchased during the Elkins’ marriage, the art became community property under Texas law.

On July 13, 1990, James and Margaret each created a grantor retained income trust (GRIT)) funded by each spouse’s undivided 50 percent interest in a large Henry Moore sculpture, a Picasso drawing and a Pollock painting (the GRIT art).  Each GRIT was for a 10-year period, during which each spouse retained the use of the transferred interests.  After 10 years was up, each spouse’s interest was to pass to the three children.  Thus, after 10 years, the children would have 100 percent ownership of the GRIT art, with each child possessing a one-third interest.

Margaret died in 1999, prior to the expiration of her GRIT, and her 50 percent undivided interest in the GRIT art passed to James.  James survived the 10-year term of the GRIT, so his original 50 percent undivided interests in the GRIT art passed to his three children in equal shares (16.67 percent each).  James retained the 50 percent interest he received from Margaret, and that interest became part of his gross estate. 

James and his three children executed a lease agreement, effective July 13, 2000, for the Picasso drawing and the Pollock painting.  The children leased their combined 50 percent interest to James, so that he could retain year-round possession of the two artworks.  The lease contained automatic extensions, unless James decided to opt out (which he never did).  Under the lease terms, James and his children agreed not to sell their respective percentage interests in any of the artwork during the initial or additional terms without the joinder of the parties.  The parties left blank the rent due under the lease until May 16, 2006, when Deloitte LLP determined an appropriate monthly amount for the two art pieces.  Deloitte determined that from July 13, 2000, through the valuation date, $841,688 was the amount of rent due.  James’ estate sought to deduct payment of that rent amount to James’ children.  On audit, the parties agreed to reduce the amount of that deduction to $10,000, the propriety of which wasn’t at issue in the case.

Disclaimed Art

Under the terms of Margaret’s will, her 50 percent community property interests in the other 61 pieces of art passed outright to James.  However, James disclaimed a portion of those interests equal to his unused unified credit against estate tax available to Margaret’s estate.  By doing so, the disclaimed portion could pass to James’ children free of estate tax.  Relying on appraisals obtained by Margaret’s estate, James disclaimed a 26.945 percent interest in each of the 61 artworks (the disclaimed art).  Pursuant to Margaret’s will, those fractional interests passed in one-third shares to each of the children, resulting in each child receiving an 8.98167 percent interest in each item of disclaimed art.  The balance, a 23.055 percent interest in each item, passed to James.  Added to his 50 percent interest in each item of disclaimed art, James retained in total a 73.055 percent interest in each item of disclaimed art.

In February 2000, shortly after James executed his partial disclaimer, he and his three children entered into a “cotenants’ agreement” relating to the disclaimed art.  Among other provisions, the cotenants’ agreement provided that each cotenant is entitled to possession and control of each item during a one-year period, equal to the percentage interest in each such item, multiplied by the number of days in such year.  The parties also agreed, among other things, to pay for the transport of each item and to maintain/restore each item.  Moreover, the parties agreed that any item may only be sold with the unanimous consent of all of the co-tenants; the net sale proceeds would be payable to each party in accordance with their respective percentage interests in the property.  The parties agreed that the cotenants’ agreement would be binding on their heirs and representatives and governed under Texas law. 

After James’ GRIT terminated in July 2000, the parties to the cotenants’ agreement amended it to include the Moore sculpture, which was one of the art pieces covered in the GRIT but not included in the July 2000 art lease.  On Feb. 17, 2006, the children signed the amended cotenants’ agreement for themselves and on behalf of their father (under a prior power of attorney form).

James’ Will and Estate Tax Return

James’ will provided that his children would inherit his personal and household effects, including his undivided fractional ownership interests in the art.  His residuary estate passed to a foundation (the Elkins Foundation), which entitled his estate to a charitable deduction under Internal Revenue Code Section 2055.  All estate taxes, interest and penalties due from James’ death were to be charged against James’ residuary estate, reducing the distribution to the Elkins Foundation and thus reducing any corresponding charitable deduction.

James’ estate timely filed a Form 706 on May 21, 2007, reporting a federal estate tax liability of $102,332, 524.  The estate also filed a Schedule F that included James’ 73.055 percent interests in the 61 works of disclaimed art subject to the original cotenants’ agreement, valued at $9,497,650 and his 50 percent interests in the three pieces of GRIT art (the Picasso drawing and Pollack painting remained subject to the art lease on the valuation date), valued at $2.652 million.  The estate derived at these values by determining James’ pro rata share of the FMV of the artworks as determined by Sotheby’s Inc. and then applying a 44.75 percent combined fractional interest discount for lack of control and marketability, as determined by Deloitte, to those pro rata share amounts.  The estate and the Internal Revenue Service stipulated a total undiscounted FMV of $24,580,650 for the disclaimed art and $10.6 million for the GRIT art.

IRS Says “Pay Up”

The IRS determined that James’ gross estate included his 73.055 percent interests in the disclaimed art, at an undiscounted FMV of $18,488,504, and his 50 percent interest in the GRIT art, at an undiscounted FMV of $5.3 million.  As an alternative basis for using the undiscounted values of James’ fractional interests in the art, the IRS argued that the restrictions on the art subject to the cotenants’ agreement and the fractional interests in the art subject to the art lease were “an option…to use such artwork at a price less than fair market value” and “ a restriction on the right to sell or use” the interest in the artwork so that pursuant to IRC Section 2703(a)(1) and (2), James’ interests should be valued without regard to those restrictions.  The IRS further claimed that the discounts used in determining the FMV of James’ fractional interests in the artwork were overstated and a discount was inappropriate.  Finally, the IRS argued that because James’ will provided that estate taxes should be paid out of the residuary estate passing to the Elkins Foundation, the deduction for the charitable bequest to the foundation by the amount of the additional estate tax payable, should be reduced.

James’ Estate Says “No Way

James’ estate timely filed a petition, assigning error to the IRS’ deficiency, seeking a refund of estate tax based on the estate’s 1) overvaluation of the art, 2) entitlement to a greater charitable contribution deduction than claimed, and 3) entitlement to deductions for attorney, accountant, appraisal and administration fees.

Expert Nash Speaks

To support its proposed discounts in valuing James’ fractional interests in the art, the estate offered the testimony of three experts.  David Nash, the estate’s first expert, was accepted by the court as an expert in the art market, the marketability of art and art valuation.  Before his valuation report, Nash viewed each of the 64 pieces, met with James’ three children and was asked to assess the marketability of James’ interest in each work.  He believed that any potential buyer would have to take into account that the children (whom Nash called “shareholders”) are “committed to retaining the art in the family until the last shareholder dies.”  Nash determined that potential buyers of the pieces would demand steep discounts from the pro rate FMV for James’ fractional interests; noted that auction houses don’t sell fractional interests in art; and believed that a collector would be “put off by the uncertainty of his ever being able to acquire the whole work.”  He also noted that it would be highly unlikely that a museum would pay “anything close” to the pro rata value of the fractional share, when it would never know if or when it could obtain full control of the pieces.  Noting, however, that although it’s common for two museums to jointly buy a work of art and rotate exhibiting the pieces in proportion to their interests, Nash concluded that in this instance, museums wouldn’t be interested in buying joint interests when the co-owners were James’ children (rather than another museum) and would face potential litigation to force a sale of the art.  Finally, Nash concluded that art dealers, investors and funds would similarly have little interest in buying the fractional interests, due to the logistical difficulties surrounding the ownership of the pieces.

Nevertheless, Nash did acknowledge that spectators would be willing to buy James’ interests if appropriately discounted.  To determine the FMV of James’ fractional interests in each of the 64 pieces, he categorized the pieces into three groups.  Category I consisted of five pieces that were “highly desirable” and included a Jasper Johns piece that he valued at $8 million and a Robert Motherwell piece that he valued at $1.5 million.  Nash’s discounts from the pro rata FMV of James’ interests in Category I pieces were between 50 percent and 80 percent.  Category II contained 19 pieces for which “alternate choices could be found and purchased outright.”  Nash considered these pieces as good examples, but “not masterpieces” by the artists.  He concluded that a potential buyer would demand a discount of about 80 percent to 90 percent of the pro rata value.  The 40 pieces in Category III were “not worth the risk at any level” and a potential buyer would demand a discount of about 95 percent.  As such, the interests in Category III pieces had only a nominal value.  Thus, Nash determined the discounted FMV of James’ interests in the art as Category I, $4,336,859; Category II, $976,451; and Category III, $149,056, for a total of $5,462,66.