Wealth Matters: A Potential Game Changer for Estate Taxes on Art

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Estate Planning |A Potential Game Changer for Estate Taxes on Art

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Wealth Matters

By PAUL SULLIVAN

IN life, James A. Elkins Jr., a prominent Houston businessman and philanthropist, amassed a portfolio of art that was the envy of museums and collectors. He owned works by Pablo Picasso, Jackson Pollock, Jasper Johns, David Hockney, Willem de Kooning and other modern greats.

In death, that $35 million collection is the envy of the tax man.

After Mr. Elkins died in 2006, his estate paid millions of dollars in taxes on the art. But the Internal Revenue Service said it was not enough and asked for another $9 million. They have been battling in court ever since.

At issue is how to value fine art for tax purposes â€” and the estateâ€™s recent victory in an appellate court may help reshape the rules.

The case centers on an increasingly common move among wealthy families with sizable art collections.

While they were still alive, Mr. Elkins and his wife, who died before him, had given their three children partial shares of two groups of paintings and kept a piece for themselves. The goal, in part, was to lower the estate tax bill by giving away shares of the paintings in his lifetime while also being able to keep the art on his walls.

James A. Elkins Jr., left, and his father. Mr. Elkins’s estate successfully fought the I.R.S. in an appellate court over discounts on estate taxes for his art collection, earning a refund of $14 million plus interest. Dmitri Kessel/The LIFE Picture Collection, via Getty Images

When he died, he still had a 50 percent interest in three works by Pollock, Picasso and the sculptor Henry Moore worth $10.6 million and a roughly 73 percent stake in another 61 pieces worth $24.58 million. His children owned the other shares equally.

The tactic â€” partial ownership of an asset or group of assets â€” is typical for passing on private businesses or real estate holdings. In such cases, the I.R.S. generally allows discounts on the assets when figuring out the estate taxes. For family-held businesses, the discount amounts to about 30 to 50 percent of the fair market value. On real estate, it is 20 to 50 percent, according to Carsten Hoffmann, managing director at FMV Opinions, a valuation firm.

The I.R.S. does so because it recognizes that those assets might be hard to sell to someone who is not a family member. And even if someone who was not a family member bought the stakes, the price would probably be lower than fair market value because the minority, nonfamily interest would most likely have little say in the transaction.

But art has been treated differently. Some portion of its value resides in the ownerâ€˜s being able to look at it. You canâ€™t, after all, put a third of a Picasso on three peopleâ€™s walls the way you can divide profits from a company. To comply with the rules of fractional ownership, the owners have to take possession of a painting for a period of time each year equal to their share.

Over the years, the I.R.S. has rarely given a discount for art that is split among heirs. That has been the case even though it would be difficult for the heirs to sell their shares independently â€” and even assuming it was possible, a price cut would be necessary.

Another reason for the I.R.S.â€™s reluctance is the museum factor. Many people donate percentages of a painting to a museum over several years so that the deduction matches their income. While the ultimate goal is to give 100 percent of the painting to the museum, people might be deterred from giving art gradually if the I.R.S. discounted the value for charitable gifts, said Ramsay Slugg, managing director at the financial firm U.S. Trust and author of â€œThe Handbook of Practical Planning for Art Collectors and Their Advisers.â€

In the Elkins case, the art is the only asset the I.R.S. is challenging. (Discounting race horses, which Mr. Elkins also owned, is apparently easier to do.) After presenting exhaustive data on the prices and rationale for discounting each piece, the estate settled on a discount of 44.75 percent for the entire collection.

But the I.R.S. said no discount should apply to the art. So the estate went to court. It initially got less than it wanted. While the Tax Court disagreed with the I.R.S.â€™s decision against a discount, it ruled that the discount used by the Elkins estate was too high. The court assigned a 10 percent markdown.

The estate escalated the fight, appealing the ruling to the United States Court of Appeals for the Fifth Circuit. Last month, that court reversed the ruling on the discount and chastised the I.R.S. for not providing any evidence to support its position. It also awarded the estate a refund of $14 million plus interest, based on discounts for pieces that ranged from 50 to 80 percent.

The ruling may have created a template for other wealthy families.

â€œIâ€™ve had calls from estate planning attorneys that said they celebrated in the coffee room when this decision came out,â€ said Mr. Hoffman. â€œThis is a deal changer.â€

Mr. Hoffman was the appraiser in an earlier case involving discounted art, Stone v. U.S., which centered on half-interest in 19 paintings, including two by the impressionist master Hughes Claude Pissarro. In 2009, the Court of Appeals for the Ninth Circuit upheld a lower courtâ€™s 5 percent discount, citing the lack of supporting prices from the art world.

That does not mean it will be easy for other estates to get steep estate discounts on art past the I.R.S.

For one, the Elkins family had some pretty deep pockets to fund the effort. Mr. Elkinsâ€™s father founded a major law firm in Houston, and his wifeâ€˜s family helped start Exxon Mobil. He himself had a successful banking career until the bank he ran, First City Bancorp, crashed along with the oil companies it had lent to in the 1980s.

In the Stone case, the refund for the 5 percent discount amounted to $53,932.60. That is not chump change. But it is hardly a windfall given the associated legal bills.

â€œMy genuine view is this is a great result for taxpayers, but I donâ€™t think everything is clear,â€ said Diana Wierbicki, a partner and head of the global art practice at Withers Bergman, a law firm. â€œThe I.R.S. dropped the ball. The I.R.S. pushed this idea that you should get zero.â€

Eric Smith, an I.R.S. spokesman, declined to comment.

Mr. Slugg said there were practical ramifications of the ruling, namely that more families could start dividing up their art collections to get the estate tax break. But it is not necessarily practical to comply with the letter of the law. Such works have to be moved among the different owners so each had possession of it for a period of time commensurate with their ownership stake.

â€œThe most common time when damage occurs is when a painting is moved,â€ he said. â€œThere are all kinds of fractional interest considerations. Itâ€™s great for wealth transfers but not in the practical reality.â€

He advised clients with collections to put the art â€” or their current fractional ownership stakes in the art â€” into a family limited partnership or a limited liability corporation that would then be the owner. One downside is the additional costs attached to setting up and administering these vehicles.

Another option to stay in compliance with the law is for the owner to give the art to the heirs and rent it back. The art can still hang on the wall, while the heirs receive a percentage of the value each year as its owners. Such arrangements are common in areas like real estate where a person might give a townhouse to his children and then rent it back for a certain number of years.

For art, it is a newer concept. Paul Provost, deputy chairman of Christieâ€™s, said the auction house had been developing a methodology to charge rent for art. He said the starting point was the rental values for art valued at less than $20,000. Such art, he noted, often gets rented by home stagers.

Christieâ€™s takes that and extrapolates the value upward; it then considers a qualitative assessment of the art. â€œA lot of clients have just been coming up with their own number,â€ he said.

Whichever strategy someone chooses, though, valuing art shares is not an exact science. Mark L. Mitchell, director of valuation services at Peterson Sullivan and one of the three expert appraisers in the Elkins case, said that the collectorsâ€™ passion was what made it so difficult.

â€œArt could be owned by someone who is not concerned about generating a return on investment but would still derive an enormous nonmonetary value,â€ Mr. Mitchell said. â€œA fractional interest so diminishes the nonmonetary part of it that people simply donâ€™t want to do that.â€

Or put another way, other assets are less emotional to carve up. â€œYou really donâ€™t get any nonmonetary return from owning a stock or a bond or a piece of commercial real estate,â€ he said.