Last month, the United States Court of Appeals for the Fifth Circuit issued a decision granting a multimillion dollar estate tax refund to the Estate of James A. Elkins, Jr., a prominent Houston businessman, philanthropist and art collector. The reason? The Elkins family had employed a tax-planning technique whereby each family member (including Mr. Elkins) owned a fractional interest in the family’s art collection. The Fifth Circuit held that the Estate was entitled to discounts ranging from 52% to 80% of the value of the artworks, rejecting the position of the IRS that no discount should apply.

Here’s a summary of the case.

Tax Planning

Between 1970 and 1999, Mr. Elkins and his wife purchased 64 works by top artists including Pablo Picasso, Jackson Pollock, Henry Moore, Cy Twombly and Robert Motherwell. Mr. Elkins and his wife gave their three children fractional interests in the works and kept shares for themselves. Elkins family members also entered into lease and co-tenancy agreements, which contained restrictions on rights of possession, partition and sale of the artwork.

Mr. Elkins died in 2006, owning fractional interests in the 64 works of art, with his children owning the remaining shares. On the estate tax return, the Executors sought to reduce the Estate’s tax liability by applying discounts to its fractional ownership interests in many different properties (including the art collection). The IRS accepted the discounts for all of the properties except the art collection, and assessed an estate tax deficiency of over $9 million.

The Estate Challenges the Tax Bill

The Estate contested the IRS position and filed a proceeding in the Tax Court, offering expert witness testimony to show that, given the financial strength of the Elkins heirs, the legal restrictions on sale and the family’s resolve never to sell the artwork, a hypothetical willing buyer would agree to co-own the artwork with the Elkins heirs only at a significant discount. By contrast, the IRS took the position that no discount was warranted and did not offer any expert testimony or other evidence to establish alternative discount amounts. Although the Tax Court concluded that a “nominal” discount of 10% was appropriate, in a surprising turn of events, the Fifth Circuit overruled the Tax Court, citing the lack of a legal or factual basis for the 10% discount, and instead adopting the discounts recommended by the Estate’s experts (ranging from 52% to 80%). Result: the Estate was entitled to a tax refund of over $14.3 million.

The Take Away

While the IRS has permitted discounts of varying ranges in connection with the transfer of fractional interests in many different types of property, the IRS has historically taken a more conservative stance with respect to the disposition of fractional interests in art – perhaps in part because of the unique nature of the art market. For example, in Stone v. United States, No. 07-17068, 2009 WL 766497 (9th Cir. 2007), the Ninth Circuit confirmed the lower court’s application of a mere 5% fractional interest discount when valuing the decedent’s 50% interest in a collection of 19 paintings, essentially limiting the discount to the costs of partitioning the property (in this case, selling the artwork and dividing the proceeds). In the Elkins case, the court appeared to focus on the IRS’s failure to present evidence supporting an alternative discount. While this case suggests that significant fractional interest discounts may now be available to taxpayers, the one-sided presentation of evidence in the Elkins case makes it difficult to predict the impact this case will have in future estate tax matters.