Art collections require specialized estate and tax planning. Without proper planning, a collection acquired over a lifetime could translate into tax debt for surviving heirs or become lost to creditor claims.

A recent court case addressed the impact of an individual’s fractional ownership of art holdings and how these are taxed. Estate of Elkins v. Commissioner might now set a precedent for art estate tax valuations. On September 15, 2014, the United States Court of Appeals for the Fifth Circuit ruled in favor of the decedent’s estate receiving a $14 million tax refund after reviewing the decedent’s ownership interests in the art in question.

The decedent James Elkins acquired dozens of valuable artworks during his life. In this particular case, the decedent and his wife utilized a GRIT (grantor-retained income trust) to hold art assets. Their three children were named as beneficiaries of the GRIT. Since five parties (the children and parents) had interests in the art assets, the fair market value was calculated with a 44.75% discount. The Internal Revenue Service rejected the discount and imposed a 10% discount without valuing the work. The taxes due were in excess of $14 million.

In the appeal, the judge “disagreed with the ultimate step in the court analysis that led it not only to reject the [proposed discount] but also to adopt and apply one of its own without any supporting evidence.” The court ruled that a larger discount for fractional ownership will be issued upon art valuation by experts.

This ruling might change how other art collectors manage their estates and fractional interests in art. No matter how large or small an art collection is, the owner(s) will need to decide how the collection will be passed on. Will the collection be sold, donated to a charitable organization, passed to family, or held in trust like in the estate above?

Selling art will likely create a significant capital gains tax since capital gains rates on art are higher than the top rate for most appreciated property. (Art sold after a deceased owner’s death might result in little or no capital gains tax, since art, along with most other property, receives a step-up in basis to fair market value upon death; consult a tax attorney for a more detailed explanation of how this step-up in basis works.) Art sales also impose the possible expenses of commissions and sales tax in the respective jurisdiction. In contrast, giving the art to a museum by will or trust could substantially reduce estate tax.

Transferring art to family, when not done properly, might result in gift and estate tax issues. Seek advice from a knowledgeable estate planning attorney – not only can it save tax dollars, but it might help to avoid battles with the IRS.