Jul 1, 2007 12:00 PM, Rorie M. Sherman Editor in Chief

By: Rorie M. Sherman Editor in Chief

David A. Handler, partner in the Chicago office of Kirkland & Ellis, LLP, reports:

• Fractional interest in artwork discounted for cost to partition. Based on a recent decision by the U.S. District Court for the Northern District of California in Robert Grove Stone v. United States, No. 3:06-cv-00259 (May 25, 2007), discounts for partial interests in personal property may be quite limited. An alternative worth considering is holding title to such jointly owned property in an entity such as an limited liability company (LLC) or limited partnership. In those instances, the owners would not have a right to partition and a greater valuation discount may be warranted.

  In Stone, the estate of Lois Stone listed a 50 percent undivided interest in a collection of 19 works of art on her estate tax return. The estate claimed a 44 percent fractional interest discount, valuing the interest at about $1.55 million rather than about $2.87.

  The federal district court held that a hypothetical seller who is under no compulsion to sell would not accept the 44 percent discount proposed by the estate. The Internal Revenue Service's experts testified that, while they were aware of sales of undivided interests in art occurring, none of these sales had ever occurred at a discount. The estate's expert also testified that he could find no data regarding sales of undivided interests in art. He based his valuation in part on sales data for undivided interests in real estate and limited partnerships holding real property.

  The court held 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. At the very least, a hypothetical seller would consider the potential proceeds from the partition process before agreeing to accept any fractional interest discount when selling his or her partial interest.”

  The court also addressed whether the estate is entitled to a discount based on the costs to partition and sell the art collection. The estate's expert calculated the cost-to-partition discount to be 51 percent of the value of the artwork. To reach this figure, he assumed it would require a court-ordered sale that would take three years to complete. He assumed that the art would appreciate in value by about 3 percent per year. He then deducted commissions and sales fees, which he assumed to be 2 percent of the projected value of the collection, as well as estimated legal fees of $50,000 and appraisal costs of $5,000. Using a net-present value (NPV) analysis, he found the estate's interest in the collection to be about 51 percent less than half of the current value of the collection as a whole. The expert used a 28 percent discount rate to calculate the NPV.

  The experts agreed that 2 percent discount for estimated costs of the sale was appropriate to account for the actual costs of selling the art by an auction house. The court agreed that the costs of a court-ordered partition must be considered in determining the value of the estate's interest in the collection, and accepted the estate's estimated $50,000 in legal fees. However, the court did not allow a deduction for appraisal costs, because the experts testified that an auction house would most likely waive the appraisal fees as part of its efforts to be selected to sell the collection.

  The court held that “some discount is appropriate to account for the uncertainties involved in waiting to sell the art until after the partition action is resolved,” but found the discount rate used by the estate to be too high. Given those circumstances, the court left it to the parties to agree on the appropriate discount, and if unable to do so, the court said it would decide on a discount “somewhere between the 2% discount proposed by the government and the 51% cost-to-partition discount proposed by Plaintiffs.”

• Section 2039 will not apply to retained annuity interests. On June 6, 2007, the IRS issued proposed regulations (REG-119097-05) providing guidance on the portion of a trust that will be includible in a grantor's gross estate under Internal Revenue Code Sections 2036 and 2039 if the grantor has retained use of property in a trust or the right to an annuity, unitrust or other income payment from the trust. The trusts impacted would include a charitable remainder trust (CRT), grantor retained annuity trust (GRAT), grantor retained unitrust (GRUT), qualified personal residence trust (QPRT) and “non-qualified” personal residence trust (PRT).

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