Fifth Circuit Finds Tax Court Erred in Valuing Art Interests

In the Tax Court, the Commissioner steadfastly maintained that absolutely no fractional-ownership discount was allowable. This presumably accounts for his failure to adduce any affirmative evidence -- either factual or expert opinion -- as to the quantum of such discounts in the event they were found applicable by the court.

The Tax Court rejected the Commissioner's zero-discount position, but also rejected the quantums of the various fractional-ownership discounts adduced by the Estate through the reports, exhibits, and testimony of its three expert witnesses -- the only substantive evidence of discount quantum presented to the court.¹ Instead, the Tax Court concluded that a "nominal" fractional-ownership discount of 10 percent should apply across the board to Decedent's ratable share of the stipulated FMV of each of the works of art; this despite the absence of any record evidence whatsoever on which to base the quantum of its self-labeled nominal discount.

We agree in large part with the Tax Court's underlying analysis and discrete factual determinations, including its rejection of the Commissioner's zero-discount position (which holding we affirm). We disagree, however, with the ultimate step in the court's analysis that led it not only to reject the quantums of the Estate's proffered fractional-ownership discounts but also to adopt and apply one of its own without any supporting evidence. We therefore affirm in part, reverse in part, and render judgment in favor of Petitioners, holding that the taxable values of Decedent's fractional interests in the works of art are the net amounts reflected for each on Exhibit B of the Tax Court's opinion. This, in turn, produces an aggregate refund owed to the Estate of $14,359,508.21, plus statutory interest.²

Despite the size and complexity of Decedent's estate and the millions of dollars of federal estate tax that it returned and paid, the single question presented in this appeal is narrow, straightforward, and easily posed:

B. Background

Over the course of their marriage, the Texas-domiciled Decedent and his wife acquired property, both real and personal, essentially all of which fell into the community that existed between them and thus was owned equally by the spouses. Among their many and varied acquisitions were race horses, real estate, interests in closely held businesses, and the said 64 works of art. Their interests in each of those works were retained for the remainder of their respective lifetimes, and that art was displayed in their home or office, or those of their adult children, or, occasionally, at an art gallery, museum, or other public place, albeit not as one cohesive collection or assemblage.

Decedent and his wife each created an inter vivos Grantor Retained Income Trust ("GRIT") that held title to their respective half interests in three of the 64 works (the "GRIT Art"). After the death of his wife during the terms of the GRITs, and for the remainder of his lifetime, Decedent continued to own his 50 percent interest in those three pieces. His three children received his late wife's 50 percent interest, 16.667 percent each.

By virtue of a bequest to him from his wife of her 50 percent interest in each of the remaining works and his subsequent disclaimer of a 26.945 percent interest in each, Decedent owned at his death an aggregate 73.055 percent interest in each of those 61 pieces (the "Disclaimer Art"), comprising his original 50 percent and the 23.055 percent interest from his wife's bequest that remained after deducting the 26.945 percent interest that Decedent disclaimed. That disclaimed interest passed equally to their three children, as their mother's successor legatees, 8.98167 percent each, and was owned by them at his death.

From time to time following the death of his wife, Decedent and his children voluntarily subjected their respective interests in the works of art to various restraints on possession, partition, and alienation. For example, Decedent's three children leased their combined 50 percent interests in two of the three pieces of GRIT Art to Decedent, thereby ensuring his uninterrupted possession of those two works. That lease, which was still in effect at Decedent's death, specified, inter alia, that no co-owner could dispose of his or her interest in a leased work unless joined by all co-owners. The lease also provided that none could transfer or assign his or her "rights, duties and obligations" under the lease without the prior consent of all.

Similarly, Decedent and his children encumbered all 61 items of Disclaimer Art with a "Cotenants Agreement." Among other things, it spelled out each co-owner's right of possession for a specified number of days during any 12 month period. More pertinent to this appeal, that agreement prohibited the sale of an interest in any work by a co-owner without the prior consent of all. The one piece of GRIT Art that had not been subjected to the children's lease to Decedent was eventually added to the list of works covered by the Cotenants Agreement.

C. Proceedings Prior to Tax Court Litigation

Decedent died testate in February 2006. His will was probated in Harris County, Texas, and his three children qualified as co-executors.⁴ The Decedent's Estate Tax Return, Form 706, was filed the following May, reporting a tax liability in excess of $102 million. It listed, among other assets, fractional interests in various items of real and personal property, including his 73.005 percent interest in the Disclaimer Art and his 50 percent interest in the GRIT Art.⁵

Following its audit of the estate tax return, the Internal Revenue Service ("IRS") accepted net values that remained after deducting various fractional-ownership discounts on essentially every property, real and personal, in which Decedent owned a fractional interest, with but one exception: the 64 works of art. The IRS refused to allow any discount against the Decedent's pro rata share -- his fractional-ownership interest -- of the stipulated FMVs of these works. The IRS assessed an estate tax deficiency of $9,068,266.

D. Tax Court Proceedings

The Estate filed the instant action in Tax Court in July 2010, addressing the single substantive issue of the taxable values of Decedent's fractional interest in the 64 items of art.⁶ By the time of the trial in September 2011, the parties had narrowed a number of issues by joint stipulations. During that one-day trial, six witnesses testified, five of whom were tendered as experts, three by the Estate and two by the Commissioner. The lone non-expert witness was Mrs. Leslie Keith Sasser, Decedent's daughter and co-executor.

The gist of Mrs. Sasser's responses to questions on direct, on cross, and from the court, was that she and the other Elkins heirs are strongly attached to the art work, largely sentimentally; that they do not view those works as business assets, primarily because they simply do not need the money; and that they are determined to retain the art for life, i.e., they would never be sellers. In response to hypothetical questions from the court, Mrs. Sasser did respond -- also hypothetically -- that she and presumably the other Elkins heirs might be buyers of Decedent's interest from a hypothetical willing buyer of that interest, but only if assured by an expert or experts that the price was fair:

By contrast, the Commissioner adduced no expert testimony or other evidence to establish alternative quantums of fractional-ownership discounts, sticking instead to his no-discount position.⁷ He did proffer two experts as rebuttal witnesses. The Tax Court "received" one of them, Ms. Karen Hanus-McManus, as an expert appraiser of modern and contemporary art, and the other, Mr. John R. Cahill, as an expert on "art transactions," but rejected his opinion as "not germane to the issues in this case." Ms. Hanus-McManus's testimony is best summarized by her stated conclusion that "there is no recognized market for partial interest[s] in works of modern art and contemporary art within the secondary markets, with the galleries, and with private dealers."⁸ She would not state, however, that there had never been, or never could be, sales of undivided interests in such art; only that there was no established or "recognized" market for such fractional interests.

The Tax Court issued its opinion in March 2013.⁹ Applying the "fictitious willing buyer/willing seller" test to determine the taxable value of Decedent's undivided interests in the various works of art, the Tax Court ultimately held that such interests are indeed subject to fractional-ownership discounts, but that the price on which the fictitious buyer and seller would finally agree would be the jointly stipulated values reduced by a "nominal" discount of 10 percent only.

We review appeals from the Tax Court under the same standards which we review appeals from the district courts: de novo for purely legal conclusions; clear error for findings of fact.¹⁰ "Clear error exists if we are left with a definite and firm conviction that a mistake has been made."¹¹ We review mixed questions of fact and law de novo.¹² We have long held that "determination of fair market value is a mixed question of fact and law."¹³ As noted in the Estate's appellate brief, de novo review is appropriate here because "there is a pure question of law imbedded in the valuation calculus."¹⁴

B. Framework

At oral argument, appellate counsel for the Commissioner insisted that the Tax Court's sole reason for rejecting the discounts determined by the Estate's experts was their failure to include, or assign sufficient weight to, the Elkins heirs' strong emotional ("psychic") attachment to the family's works of art. Counsel claimed that the court faulted those experts for not concluding that, in and of itself, such psychic attachment would guarantee the hypothetical willing buyer a virtually undiscounted purchase price for the Decedent's fractional interests, regardless of those heirs' strong legal and financial positions as putative hostile co-owners with such a hypothetical willing buyer. According to Commissioner's counsel, this is what led the Tax Court to reject the expert's discounts out of hand. We disagree with counsel's cherry picking of the Tax Court's analysis. But even if counsel's reading of the Tax Court's reasoning were correct, it would not absolve that court of clear error.

We have again reviewed the entire transcript of the testimony of the Estate's experts and their written reports, and we are satisfied beyond cavil that they considered and correctly weighed all factors and characteristics of the Elkins heirs when determining how much a hypothetical willing buyer would pay for Decedent's fractional interests and thus become a co-owner with them. Those experts took into account both the pros and the cons: the children's financial astuteness and their net worths; their hypothetical desire to acquire Decedent's fractional interests if a hypothetical willing buyer should acquire them first, but also their uncontradicted testimony that they would do so only for a "fair price," as determined by experts (presumably those who testified for them); their legal and financial ability to prevent any hypothetical willing buyer from quickly "flipping" his fractional interests in the art to third parties, particularly given the heirs' contractual restraints on alienation and partition, as well as their predictable determination to rid themselves of unrelated co-owners regardless of how much time it might take. In sum, we do not read the Tax Court to have rejected the importance of all aspects of the children's legal relationships to the art other than their "psychic" interests.

We repeat for emphasis that the Estate's uncontradicted, unimpeached, and eminently credible evidence in support of its proffered fractional-ownership discounts is not just a "preponderance" of such evidence; it is the only such evidence. Nowhere is there any evidentiary support for the Tax Court's unsubstantiated declaration that "a 10% discount would enable a hypothetical buyer to assure himself or herself of a reasonable profit on a resale of those interests to the Elkins children." Besides the error in logic of presuming that the hypothetical willing buyer must turn right around and sell his fractional purchases to those heirs, we cannot escape the conclusion that, under the facts of this case and the way the parties tried it, such a determination constitutes reversible error under any standard of review.

It is principally within the last few pages of its opinion that the Tax Court's reversible error lies. While continuing to advocate the willing buyer/willing seller test that controls this case, the Tax Court inexplicably veers off course, focusing almost exclusively on its perception of the role of "the Elkins children" as owners of the remaining fractional interests in the works of art and giving short shrift to the time and expense that a successful willing buyer would face in litigating the restraints on alienation and possession and otherwise outwaiting those particular co-owners. Moreover, the Elkins heirs are neither hypothetical willing buyers nor hypothetical willing sellers, any more than the Estate is deemed to be the hypothetical willing seller.

We acknowledge, of course -- as did the Estate's experts -- that a hypothetical willing buyer would be aware of and take into account all aspects of the remaining fractional interests in the art that the Elkins heirs owned, not just the likelihood of their hypothetical desire to acquire the Decedent's fractional interests in the art from any successful hypothetical buyer thereof. An objective reading of the entirety of those experts' written reports and their testimony at trial demonstrates beyond question that the heirs' financial strengths, their out-of-hand rejection of the idea of ever selling their interests, and the time and money that the legal restraints in their arsenal would cost a willing buyer, combine to minimize any effect to the contrary that their "psychic" attachment to the art might otherwise have on the discounts that apply here. To repeat, Mrs. Sasser testified that if, hypothetically, she and her siblings were to purchase such interests, it would only be after first determining from experts that any price was fair and reasonable. And the experts consulted would likely be those persons whom the Tax Court accepted at trial; experts whose ultimate values were based on their substantial discounts below FMV.

Furthermore, like the absence of an established market, the subjective characteristics of the Decedent's descendants as the owners of the remaining fractional interests would likely cut the other way: A potential willing buyer would undoubtedly insist that his potential willing seller further discount the sales price to account for the virtual impossibility of making an immediate "flip" of the art. Such a fully informed willing buyer would be well aware that, by virtue of becoming a co-owner with the sophisticated, determined, and financially independent Elkins heirs, he could not possibly make such a quick resale -- absent a deep discount, that is. And, the situation is only exacerbated by the effect of the various restrictions on partition, alienation, and possession that survived the death of the Decedent.

At bottom, we find nothing in this record or in the Tax Court's opinion that would justify any conclusion other than that the Estate is entitled to a final determination of the estate tax owed that produces a tax refund calculated on the basis of the fractional-ownership discounts and net taxable FMVs set forth on Exhibit B to the court's opinion. The record on appeal is sufficient for us to render a final judgment and dispose of the sole issue in this case without prolonging it by remand at the cost of more time and money to the parties. Accordingly, we (1) affirm the Tax Court's rejection of the Commissioner's insistence that no fractional-ownership discount may be applied in determining the taxable values of Decedent's undivided interests in the subject art work; (2) affirm the Tax Court's holding that the Estate is entitled to apply a fractional-ownership discount to the Decedent's ratable share of the stipulated FMV of each of the 64 works of art; (3) reverse the Tax Court's holding that the appropriate fractional-ownership discount is a nominal 10 percent, uniformly applied to each work of art, regardless of distinguishing features; (4) hold that the correct quantums of the fractional-ownership discounts applicable to the Decedent's pro rata share of the stipulated FMVs of the various works of art are those determined by the Estate's experts and itemized on Exhibit B to the Tax Court's opinion; and (5) render judgment in favor of the Estate for a refund of taxes overpaid in the amount of $14,359,508.21, plus statutory interest in a sum to be agreed on by the parties, based on the timing of the payment of that refund to the Estate, all as jointly stipulated to us by the parties.

AFFIRMED in part; REVERSED in part; and RENDERED.

² The Estate and the Commissioner have jointly stipulated this amount as the tax refund that would be due under these circumstances and have further stipulated that they will confer and calculate the proper amount of statutory interest owed if the stipulated refund is ultimately determined to be due and owing.

³Anthony v. United States, 520 F.3d 374, 377 (5th Cir. 2008) (citing Treas. Reg. § 20.2031-1(b)).

⁴ Decedent's son, who was one of the three co-executors, died unexpectedly in June 2010, after which his two sisters, Petitioners herein, continued to serve as the Independent Executors of Decedent's estate.

⁵ The Commissioner and the Estate eventually stipulated undiscounted FMVs totaling $24,580,650 for the Disclaimer Art and $10,600,000 for the GRIT Art, differing slightly from the appraisal of $23,530,650 for the Disclaimer Art and $9,600,000 for the GRIT Art previously received by the Estate.

⁶ The Estate's petition included additional refund claims that turn on the valuation of the art work, including a greater charitable deduction produced by that valuation and deductions for greater fees and cost of administration than originally projected. Such claims are ancillary to and controlled by the ultimate determination of the taxable value of the art.

⁷ The Commissioner appears to have ignored, or been unaware of, the venerable lesson of Judge Learned Hand's opinion in Cohan: In essence, make as close an approximation as you can, but never use a zero. See Cohan v. Comm'r, 39 F.2d 540, 543-44 (2d Cir. 1930).

⁸ Emphasis supplied.

⁹Estate of Elkins v. Comm'r, 140 T.C. 86 (2013).

¹⁰Green v. Comm'r, 507 F.3d 857, 866 (5th Cir. 2007).

¹¹United States v. Roussel, 705 F.3d 184, 195 (5th Cir. 2013) (citing United States v. Griffin, 324 F.3d 330, 365 (5th Cir. 2003)).

¹²Succession of McCord v. Comm'r, 461 F.3d 614, 626 (5th Cir. 2006).

¹³Estate of Dunn v. Comm'r, 301 F.3d 339, 348 (5th Cir. 2002).

¹⁴Adams v. United States, 218 F.3d 383, 385-86 (5th Cir. 2000).

¹⁵United States v. Ricks, 639 F.2d 1305, 1309 (5th Cir. Unit B Mar.1981).

¹⁶Black's Law Dictionary defines "preponderance of the evidence" as: "The greater weight of the evidence, not necessarily established by the greater number of witnesses testifying to a fact but by evidence that has the most convincing force; superior evidentiary weight that, though not sufficient to free the mind wholly from all reasonable doubt, is still sufficient to incline a fair and impartial mind to one side of the issue rather than the other." See Black's Law Dictionary 1301 (9th ed. 2009).

¹⁷ For the first time on appeal, the Commissioner attempts to address the quantum of the fractional-ownership discounts as supporting the Tax Court's 10 percent discount. It is well settled, however, that we do not consider contentions raised for the first time on appeal. Crawford Prof'l Drugs, Inc. v. CVS Caremark Corp., 748 F.3d 249, 267 (5th Cir. 2014).

¹⁸ Indeed, the testimony of Ms. Hanus-McManus that there is no recognized or established market for undivided interests in art lends support to a greater discount. The absence of an established market would be a factor that a willing buyer would consider as calling for a deeper discount of fractional interests in art. Such absence does not, however, mean that willing buyers and willing sellers of fractional interests in art do not exist and cannot find one another through means other than an established market, e.g., eBay, art galleries, art dealers' networks, conventions, social networking, and the like.

¹⁹Green v. Comm'r, 507 F.3d 857, 866 (5th Cir. 2007).