30 January 2008

Art and cultural assets news - winter: US court allows fractional interest valuation discounts for artwork

Paul M. Roy
Of counsel | US

In Estate of Stone, a federal district court in California ruled that an estate was entitled to a 5% discount when assessing the value of the estate's undivided one-half interest in a collection of paintings.  Though the discount allowed was much smaller than the discount claimed by the estate, since the IRS had argued that no discount was ever appropriate for fractional interests in art, the court's ruling was a significant victory for taxpayers.


The case involved a dispute between the IRS and an estate over the value, for estate tax purposes, of the estate's art collection.  The estate and the IRS could not agree on whether a fractional interest discount should apply to the estate's one-half interest in 19 paintings. 

The court applied the correct standard for determining the value of property under US estate tax regulations. The court noted that its task was to determine the fair market value of the paintings in the estate which is the price at which they would change hands between a hypothetical willing buyer and willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of the relevant facts.  The court further noted that the value of a particular item is not to be determined by a forced sale price, nor is the fair market value of an item to be determined by the sale price of an item in a market other than that in which it is most commonly sold to the public.

The court decided that the fair market value of a 100% interest in all 19 of the estate's paintings was $5.5 million. The court then moved on to address the question whether the estate was entitled to a discount due to its 50% ownership interest.

Court rejects comparison to real estate

The IRS argued that since no partial interest valuation discount was appropriate, the value of the estate's 50% interest in the paintings was $2.75 million; that is, one-half of the gross value of $5.5 million. The estate argued that a discount of 44% should be applied to the $2.75 million figure which would result in a valuation of the estate's interest in the 19 paintings of $1,540,000 (56% of $2.75 million).

The estate argued for its valuation discount based on data consisting of actual sales of undivided interests in real estate and limited partnerships holding real estate.  Due to the owner's inability to have full control over decisions concerning the piece of art (lack of control) and due to the difficulty of selling a 50% ownership interest in a piece of art (lack of marketability) the estate contended that a willing buyer would pay substantially less than full price.  The estate presented evidence that undivided interests in real property sell at a 44% discount to the pro-rata value of the real estate due to lack of marketability and lack of control, and therefore by analogy, an undivided interest in art would sell at a 44% discount to the pro-rata value. 

The court rejected the analogy to real property, agreeing with the IRS's experts that the art and real estate markets are not comparable.  The court determined that although evidence exists that undivided interests in real estate have actually sold at a discount to their pro-rata value, there is no evidence that undivided interests in art have sold at such a discount. That is, no evidence was presented which suggested that fractional interests in art sold at a discount in the marketplace.  Thus, the court concluded, no owner of a 50% interest in a piece of art would willingly sell his interest at a 44% discount to its pro-rata value. 

Court accepts cost-to-partition approach

In rejecting the comparison to sales of undivided interests in real estate, the court noted that a seller would accept no less money for his interest in a work of art than he would receive if he pursued a partition action. Valuing an interest in property based on what the owner would receive in a court action to partition the property is referred to as the cost-to-partition approach.  A partition action for real estate can result in the literal splitting of the property into two separate pieces.  Because a painting cannot be physically divided, a partition action effectively means that a court would order the sale of the painting and divide the proceeds among the owners.

The court rejected the IRS's contention that there can be no discount for a fractional interest in art, noting that the IRS's own experts, members of the art advisory panel, stated that a 2% discount is warranted to account for the costs of selling the art at auction.  The court also rejected the estate's proposed 51% cost-to-partition discount as unpersuasive and based on incongruous assumptions. In determining the discount under the cost-to-partition approach, the court stated that the estate was entitled to 2% for the hypothetical costs of selling the art at auction, $50,000 in legal fees for a hypothetical partition action and some discount “to allow for the uncertainties involved in waiting to sell the collection until after a hypothetical partition action is resolved.”  The court did not allow a discount for the hypothetical cost of an appraisal of the art, determining that an auction house would waive appraisal fees in order to be selected to conduct the sale.

Rather than decide on the appropriate fractional interest discount, the court ordered the estate and the IRS to negotiate and reach a compromise on the discount between the 2% proposed by the IRS's experts and the 51% proposed by the estate.

The Result

The IRS and the estate were unable to reach a compromise as to the valuation discount, and the matter was re-submitted to the court.  The IRS maintained its argument that no discount is appropriate, but agreed to a 5% discount “in the spirit of compromise.”  The estate's best compromise was a 35% discount, in lieu of the 44% and 51% discounts it argued for at trial.  In the end, the court ordered a 5% fractional interest discount based on the cost to partition approach. The court noted that, “after taking into account the 2% in sales fees and $50,000 in legal fees… a 5% discount includes only an approximate 1.2% discount for the uncertainties involved in waiting for the partition action to be resolved.  While this discount appears to be relatively low, the estate has provided no evidence from which this Court could reasonably base any larger discount.”


Despite the relatively small fractional interest discount of 5%, the Stone case provides some important guidance for taxpayers.  The court flatly rejected the IRS's argument that fractional interest discounts apply only to real estate and provided a roadmap for determining an appropriate fractional interest discount for artwork:  the discount may reflect (i) the sale commission incurred when selling the art at auction (ii) legal fees incurred in pursuing a partition action and (iii) a discount for the uncertainties involved in waiting for the partition action to be resolved.  Had the estate presented a more persuasive methodology for determining the discount attributable to the uncertainty of a partition action, the court might have awarded a discount greater than 5%. Moreover, the court also indicated that it would be receptive to any evidence that fractional interests in artwork have actually sold at a discount in the marketplace.

Paul M. Roy Of counsel | New York, New Haven, Greenwich

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