Estate of Elkins v. Commissioner, 140 T.C. No. 5 (March 11, 2013)

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1 Estate of Elkins v. Commissioner, 140 T.C. No. 5 (March 11, 2013) Fractional Interests in Art Valued With 10% Discounts Considering Likelihood That Family Members Would Purchase Hypothetical Purchaser s Fractional Interest March 2013 Steve R. Akers Bessemer Trust 300 Crescent Court, Suite 800 Dallas, Texas akers@bessemer.com

2 Contents Synopsis... 1 Strategic Buyer Issue... 2 Copyright 2013 Bessemer Trust Company, N.A. All rights reserved. Important Information Regarding This Summary This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation. Bessemer Trust i

3 Synopsis Decedent owned % interests in 61 works of art and 50% interests in three other works of art. The remaining fractional interests were owned equally by his three children. A Cotenants Agreement provided that any item of the art could be sold only with the unanimous consent of all cotenants. The IRS argued that this restriction was included merely to reduce the value of the decedent s fractional interest for estate tax purposes. The court concluded that 2703 does not refer to intent as a controlling or even relevant factor. The parties disagreed as to whether the unanimous consent requirement constituted a restriction on the right of the individual owners to sell their fractional interests. The court concluded that the more important issue is that the unanimous consent to sale provision constituted a waiver of the cotenants right to institute a partition action, and concluded that any restriction on decedent s right to partition would be disregarded under 2703(a)(2). The IRS argued that no discount should be permitted in valuing fractional interests in art. One of the IRS s arguments is that the market for fractional interests in art (as well as for other types of personal property) [is] one in which the holder of the fractional interest either purchases or inherits the interest under circumstances in which the holder and the other co-owners (who may be family members, friends, or, in the case of art, art dealers) hold, or simultaneously acquire, their interest with a shared goal of selling (or, if the fractional interests are purchased, of reselling) the entire item of property at retail, either directly or after a partition of the property. Under any of those scenarios, the interest holders would each receive a pro rata share of the property or of the proceeds from the sale thereof, and no fractional discounts would be applied. The IRS reasons that in this circumstance, Reg (b) applies, so that the value is the price at which the item or a comparable item would be sold at retail. The court suggests that the IRS s argument (which the IRS reasoned would apply in valuing other types of personal property as well) would have merit in the absence of relevant facts that would render that approach unrealistic and, therefore, inapplicable. The court observes that such contrary facts do exist in Elkins because of the children s probable resistance to any sale or partition of the art that would result in new ownership. [The court s reasoning suggests that in valuing fractional interests in personal property in particular, evidence of the reticence of other co-owners to agree to a partition or sale of the property may be very important.] In addition, the IRS s argument that no discounts should be allowed for fractional interests in art is based, in part, on the Commissioner s long-standing position that fractional interests in art are not discounted for purposes of valuing charitable contributions, citing Rev. Rul and Rev. Rul The court observed that it is not bound by revenue rulings and viewed the Scull and Stone cases as supporting a discount in valuing the decedent s fractional interest in an art collection in order to account for various uncertainties that would confront a hypothetical buyer of the art. The court concluded that there is no bar, as a matter of law, to an appropriate discount from pro rata fair market value in valuing undivided fractional interests in art. In determining an appropriate discount for the undivided interests in this case, the court noted that the three children had strong sentimental and emotional ties to each of the works of art so that they treated the art as part of the family. The estate argued that a hypothetical purchaser of the estate s fractional interest would apply a discount, knowing that the children were unlikely to sell their fractional interests in light of their strong sentimental attachment to the art. The court turned this argument on its head reasoning that a hypothetical third-party purchaser of the estate s fractional interest would be in an excellent position to persuade the Elkins children, who, together, have the financial wherewithal to do so, to buy the buyer s interest in any or all of the works, thereby enabling them to continue to maintain absolute ownership and possession of the art. The court pointed to cases involving swing votes (Estate of Winkler) and properties with enhanced assemblage value (Pittsburgh Terminal Corp. and Serdar) in Bessemer Trust 1

4 assessing the bargaining position that a hypothetical buyer of the decedent s interest would have in negotiating with the Elkins children. The court concluded that the Elkins children would be anxious to acquire the decedent s fractional interest to preserve for themselves 100% ownership and possession of the art, and that a hypothetical willing buyer and seller of decedent s interest in the art would agree upon a price at or fairly close to the pro rata fair market value of those interests. It allowed a nominal 10% discount because a hypothetical purchaser could not be certain that the Elkins children would agree to pay the full pro rata fair market value for those interests. Estate of Elkins v. Commissioner, 140 T.C. No. 5 (March 11, 2013, opinion by Judge Halpern, not a reviewed opinion by the Tax Court). At least the estate can be comforted that the 10% fractional interest discount in Elkins is greater than the 5% discount that was allowed in the Scull and Stone cases. Strategic Buyer Issue Various cases have emphasized that courts cannot use the price that a strategic buyer would pay, but must consider what a hypothetical willing buyer would pay. The brief cited two Tax Court cases. Estate of Jung v. Comm r, 101 T.C. 412, (1993) (assumption that closely held entity will redeem interests to maintain family harmony violates hypothetical willing buyer/willing seller test); Estate of Andrews v. Comm r, 79 T.C. 938, 956 (1982) (Commissioner cannot tailor hypothetical so that the willing seller and willing buyer were seen as the particular persons who would most likely undertake the transaction ). Court of appeals cases from the 5th and 9th Circuits have reiterated this approach. Estate of Jameson v. Comm r, 267 F.3d 366 (5th Cir. 2001) (reversing Tax Court because the court should not have assumed the existence of a strategic buyer Fair market value analysis depends instead on a hypothetical rather than an actual buyer ); Morrissey v. Comm r, 243 F.3d 1145 (9th Cir. 2001)( [t]he law is clear that assuming that a family-owned corporation will redeem stock to keep ownership in the family violates the rule that the willing buyer and willing seller cannot be made particular ); Estate of Simplot v. Comm r, 249 F.3d 1191, 1195 (9th Cir. 2001)(Tax Court assumed buyer would probably be well-financed, with a long-term investment horizon and no expectations of near-term benefits; reversed, holding that [t]he facts supplied by the Tax Court were imaginary scenarios as to who a purchaser might be [A]ll of these imagined facts are what the Tax Court based its 3% premium upon. In violation of the law the Tax Court constructed particular possible purchasers ). These cases all have strong language saying not to assume particular purchasers, and in particular, not to assume that the entity will redeem interests of a prospective seller of an interest in the entity. The Elkin opinion is consistent with the reasoning in Holman v. Commissioner, 130 T.C. 170, aff d, 601 F.3d 763 (8 th Cir. 2010). (Interestingly, the Tax Court opinion in Holman was also written by Judge Halpern.) Holman allowed only a 12.5% marketability discount for limited partnership interests in a family limited partnership, partly based on a consideration that the remaining partners would have an economic interest to purchase an interest for a value somewhere between the discounted price that a third party was willing to pay and a pro rata share of net asset value, thus placing a floor on the marketability discount. The 8 th Circuit affirmed that approach and held that it did not violate the hypothetical willing buyer/willing seller valuation standard. Despite the body of case law saying not to base valuation on what a strategic buyer would pay, the 8 th Circuit majority opinion in Holman agreed with the Tax Court: When assessing hypothetical transactions between hypothetical buyers and sellers, it is improper to ascribe motivations that are personal and reflective of the idiosyncrasies of particular individuals. [Citations omitted.] Rather it is necessary to view such persons as economically rational actors possessing all relevant information and seeking to maximize their gains. [Citations omitted.] Bessemer Trust 2

5 Here we believe the Tax Court s approach in adopting Mr. Burns s analysis comports with this general rule of casting the potential buyer merely as a rational economic actor. A buyer possessed of all relevant information would know that (1) the underlying assets are highly liquid and easily priced; (2) the amount held by the partnership could be absorbed by the broader market ; (3) the partnership agreement permits the buying out of exiting partners or dissolution upon unanimous consent of all partners; and (4) there would be little or no economic risk and likely no additional capital infusion necessary for remaining partners to buy out an existing partner. Against this backdrop, it is not necessary to look at the personal proclivities of any particular partner or the idiosyncratic tendencies that might drive such a specific person s decisions. Rather it is only necessary to examine what is technically permissible in accordance with the agreement and forecast what rational actors would do in the face of a pending sale at a steep discount relative to net asset value. Simply put, the Tax Court did not ascribe personal non-economic strategies or motivations to hypothetical buyers; it merely held that, presented with the opportunity, rational actors would not leave money on the table. The dissent in Holman believed that a critical element of the analysis was ignored by the majority: That is not to say that courts err whenever they consider partnership agreements dissolution provisions while calculating an appropriate marketability discount. For example, if the Holman limited partnership had a significant history of dissolving and buying out wishing-to-assign partners, a hypothetical willing buyer would consider this fact while assessing the partnership interests marketability The dissent concluded that the misapplication of the willing buyer/willing seller test was reversible error and the case should be remanded to the Tax Court for a new determination of the marketability discount. The Elkins case is appealable to the 5 th Circuit court of Appeals. If the case is appealed, query whether the court will apply its reasoning in Jung rejecting the approach of considering the likelihood of a purchase by a strategic buyer to the valuation of fractional interests in art? If it is inappropriate to consider the price that a strategic buyer would pay, it would also seem inappropriate to consider that a hypothetical purchaser would assume that he or she could sell to a strategic buyer at close to pro rata fair market value. Bessemer Trust 3