Discounts in Art: “Starving Artist” Prices?

The 9th Circuit Court of Appeals recently issued a decision (highlighted by Carsten Hoffman’s FMVOpinions) affirming a tiny fractional interest discount applied to a jointly-owned collection of paintings. In Stone vs. U.S. (2009), the district court rejected the opinion of the estate’s expert, who testified in favor of a 44% fractional interest discount, citing the expert’s “total lack of experience with the art market; the dissimilar motives driving purchasers to acquire art, on one hand, and real estate or limited partnership shares, on the other; and the unreasonably low appreciation rate and unreasonably high present-value discount rates Hoffmann used in his cost-of-partition analysis.” The district court refused, on the other hand, to apply no discount, as urged by the government. Instead, the district court settled upon a 5% fractional interest discount, the percentage that was conceded by the IRS. The 9th Circuit affirmed.

On appeal, the estate argued that the lack of data regarding real-world  sales of fractional interests in art justified its use of discounts derived from sales of fractional interests in real estate and limited partnerships. The estate also argued that the district court had erroneously assumed that the estate’s 50% interest in the art collection would be sold together with the other 50% interest. The appellate court dismissed both arguments under an abuse of discretion standard.

In his post-mortem analysis, Carsten Hoffman (who was the estate’s expert in Stone) speculated that fractional interest discounts in art should actually be higher than, not lower than, discounts in real estate and partnerships.

To begin with, empirical data regarding discounts for lack of marketability as it relates to restricted stock, demonstrates that the magnitude of the discount is directly related to the degree of volatility. This is logical, as an investor would rather surrender liquidity for low volatility assets compared to high volatility assets. For example, the FMV Restricted Stock Study shows that the discount for lack of marketability is approximately 300 percent higher for stocks in the top 10 percent, measured by volatility, compared to those in the bottom 10 percent (approximately 45 percent vs. 11 percent). This is significant, as art has provided the least attractive risk and return potential of any asset class as reported by Merrill Lynch. The report also indicates that over a 5-year investment horizon, the risk of loss in art ownership is 70 percent higher than the risk of loss in the S&P 500 Index. Further, the standard deviation (a measure of volatility) for art is 44 percent higher, on average, than for the S&P 500.

Hoffman noted that data did not exist in 1982 when the courts first confronted the challenge of applying a fractional interest discount to real estate and partnership interests. The data that supports such discounts has been developed over the intervening years. Similarly, the scholars will have to compile data for the art market.

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Jelke and BIG Tax Liability

Chris Mercer’s Value Matters newsletter offered a succinct summary of the Eleventh Circuit’s recent decision in Jelke v. Com., an important decision dealing with built-in capital gains (BIG) tax liability of Subchapter C corporations. The subject company in the case was a C corporation established 80 years ago, whose principal asset was an investment portfolio managed for long-term capital growth. The company was valued for estate tax purposes, and the decedent’s expert discounted the net asset value by $51.6 million tax liability, assuming liquidation of the investment portfolio. The IRS took the position that liquidation was not imminent, and spread out the tax liability over 16.8 years (which was consistent with the slow rate of asset turnover). Discounting the future tax liability back to its net present value, the IRS estimated the tax liability at $21.0 million. The Tax Court adopted the IRS position, and the taxpayer appealed.

The Eleventh Circuit Court of Appeals employed the principal of substitution in its analysis, wondering why a hypothetical buyer would choose to purchase an interest in a corporation with BIG tax liabilities when the buyer could simply buy the underlying stocks in the market. The Eleventh Circuit court held that liquidation was the proper assumption when determining net asset value, and sided with the taxpayer by discounting the corporation’s value for the entire tax liability.

This decision might be persuasive in the divorce courts of Pennsylvania, where hypothetical tax consequences may be considered in determining the value of marital assets. Were the divorce court faced with the valuation of a C corporation having BIG tax liability, it might be appropriate to subtract the tax liability from the company’s net asset value. The market alternative for an interest in a corporation having BIG tax would be the underlying assets themselves without tax liability, according to Jelke.