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Estate strategies: Discount on undivided interest

Carsten Hoffmann

8 June 2007

Court ruling on interest in art collection could have far-reaching effects. Carsten Hoffmann is a managing director of FMV Opinions, a valuation and financial advisory services firm.

Overview

It brought to mind the buildup to the Thrilla in Manila.

Like Muhammad Ali, self-assured, over-confident |image1|from a previous victory over arch-rival Joe Frazier, the Internal Revenue Service (IRS), fresh from a district-court win in Estate of Lois M. Stone (3:06-cv-00259 TEH) would argue confidently that fractional undivided interest discounts didn't apply to personal property -- in this case a collection of impressionist paintings.

The IRS based its argument on three ideas.  Undivided interests in art work never change hands at discounts Under Revenue Ruling 57-293, a fractional interest discount is not appropriate when determining fair market value in the context of charitable contributions for income tax purposes Case law, namely the findings in Estate of Pillsbury (Commissioner 64 T.C.M. (CCH) 284 (1992)), prohibits the application of a fractional interest discount for personal property

And in the other corner: the taxpayer and his experts arguing that, for estate tax purposes, a discount for lack of control and lack of marketability is applicable to personal property.

As in the Thrilla in Manila, there was a lot of punching and a lot of bruising. But unlike that epic fight, the Stone decision didn't leave a clear victor.

Background

Lois Stone passed away on 1 September 1999, holding, among other assets, a 50% undivided interest in 19 impressionist paintings.

Judge Henderson had to determine the appraised value of the paintings -- only 2 out of the 19 paintings were in dispute -- and determine the applicability of a fractional interest discount for the 50% ownership. The experts on the case came from inherently different disciplines. The IRS' two experts were art dealers, members of the IRS'art-advisory panel. The tax payer's expert was yours truly, with a background in business valuation.

Analysis

The question of the appraised value of the portfolio was quickly resolved. So the court shifted its attention to the applicability of the fractional interest discount.

Experts on both sides agreed on the standard of value being fair market value as described under §20.2031-1(b). Most appraisers quote this section in their report, usually ending the definition after "willing buyer, willing seller, no compulsion to buy or to sell and having reasonable knowledge of relevant facts." In this case, the additional language of § 20.2031-1(b) is more relevant: "Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate."

Using this definition of fair market value, the IRS argued that fractional interests in art work change hands only in dealings between art dealers and that those transactions never occur at a discount because of the implied understanding that the paintings would be sold whole rather than chopped into pieces. Because of the inability by either IRS expert to produce actual undivided interest transactions of comparable art work, the court concluded "that a hypothetical willing seller of an undivided fractional interest in art would likely seek to sell the entire work of art and split the proceeds, rather than seeking to sell his or her fractional interest at a discount."

The IRS' second argument used Revenue Ruling 57-293, which states that a fractional interest discount is not appropriate when determining fair market value for charitable contributions for income tax purposes.

Because the IRS appraiser said a 2% discount was appropriate to account for the estimated costs of selling the art at auction before the proceeds are split among its interest holders, the court found that this marginal discount was undisputed by the IRS -- and in contradiction to its argument that no discount would apply under Revenue Ruling 57-293. Accordingly, even though the court didn't have to consider the "no discount" argument under Revenue Ruling 57-293, it said in a footnote that the ruling refers to income tax rather than estate tax matters, and that Revenue Rulings are entitled to consideration but are not dispositive. The footnote concludes: "For the reasons discussed in this opinion, this court determined that a discount is appropriate in this case when Treasury Regulation 20.2031-1(b) is properly applied."

The IRS' third argument dealt with the applicability of case law in Pillsbury: fractional interest discounts do not apply to personal property. But Judge Henderson disagreed. The court said the correct representation of Pillsbury was that a discount cannot be upheld based on a "bare assertion that a discount is appropriate with no evidence to support it." The court added that the same principles that held in Propstra v. United States (680 F.2d 1248, 1252 n.6 (9th Cir. 1982)), where the view that "the holder of an undivided interest in property would have to secure the consent of the owner of the remaining interests before being able to sell as a unit" would hold whether real or personal property was in question.

Taxpayer's appraisal

As appraisers, we try to find the most comparable data available. If an exact comparable doesn't exist, we try to find ones that may be subject to the similar risk profiles.

The market for undivided interests in artwork is extremely limited and has no reporting or tracking system for transactions. To have a true data point, one would need to know not only the price of the undivided interest changing hands, but also the price of the work in its entirety. So analyzing actual undivided interest transactions in comparable art work is almost impossible.

But because of the lack of control and lack of marketability, the undivided interest holder in personal property is in a similar position to an undivided interest holder in real property. Therefore we presented data from undivided interests in real property as well as data for partnerships holding both real and personal property. However, given the court's earlier ruling that undivided interests in art do not change hands at discounts in these markets, and the void of comparable data, it rejected "as unpersuasive the portions of Hoffmann's report that are based on undivided real estate interest transactions and limited partnership transactions." The court continued: "At a minimum, because an undivided interest holder has the right to partition, a hypothetical seller under no compulsion to sell would not accept any less for his or her undivided interest than could be obtained by splitting proceeds in this manner."

Cost-to-partition

With the court's cost-to-partition argument, we find ourselves in familiar territory. Ever since letting go of the family unity argument in 1993, the IRS has argued that the discount should be limited to the partitioning costs, since this is an inherent right of an undivided interest holder.

But in the context of real property undivided interest cases where actual transaction data is available, the court has consistently held that the partition approach is only one that should be considered in conjunction with a market approach. The thinking here is that the costs, time delay and uncertainty of the partition process can make this an onerous and expensive undertaking; one that the hypothetical investor would usually try to avoid in favor of a market transaction.

Of course, the owner would face the same hardship during a forced partition of personal property. But the absence of what the court considers comparable data necessitates this approach, in the court's opinion.

The IRS' and the taxpayer' approaches to quantifying the costs of a partition proceeding couldn't be more different. The IRS usually pre-supposes a small percentage discount quantified as a sales commission, while the taxpayer generally attempts to put together a model that looks at all cash flows and asset value changes for the time period of the partition process. A court-ordered partition takes usually between two and three years. The model should account for changes in asset value, legal fees, appraisal fees, sales fees, as well as the appropriate discount rate to fairly present value the cash flows during this uncertain, litigious period. FMV concluded that, based on a partition approach, the discount would be 51%. Although the IRS didn't have a partition approach, they did have the 2% sales commission expense.

In conclusion

The court ruled that "a hypothetical willing seller who is under no compulsion to sell would seek to gain consent from other co-owners to sell the collection and divide the proceeds or, barring such consent, would bring a legal action to partition." It added: "some discount is appropriate to allow for the uncertainties involved in waiting to sell the collection until after a hypothetical partition action is resolved."

In its final statement, the court decided that although it would be capable of determining a discount if necessary, it finds it preferable to allow the parties an opportunity to further meet and confer on this issue. If resolution is not reached, the court will decide the discount somewhere between the 51% arrived at by FMV or the 2% discount arrived at by the IRS.

Final thoughts

Looking over the history of undivided interest cases -- and that's a record rich only in real property cases -- it's obvious that undivided interest cases involving personal property are now set to follow the same evolution. Just as the IRS was initially calling for no discount based on family attribution for undivided interests in real property, the IRS was calling for no discount based on the notion that discounts don't apply to personal property. Now that the IRS has lost the argument, it will next contend that the discount is limited to the cost-to-partition. Until we find better market data to refute this argument, the cost-to-partition approach will get all the attention.

Stay tuned for more on this case and its implications. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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