Valuation discounts still apply to transfers of interests in a single-member entity. But the fact that the Tax Court produced so many opinions in this one case makes advisors a little nervous
Is the transfer of an interest in a single-member limited liability company (LLC) — a “disregarded entity” — valued as a transfer of a proportionate share of the underlying assets owned by the LLC or as a transfer of an interest in the LLC subject to valuation discounts for lack of marketability and control? According to a recent en banc Tax Court decision, Pierre v. Commissioner,1 a disregarded entity is not to be forgotten.
The taxpayer, Suzanne Pierre, received a $10 million inheritance and wanted to use some of it to benefit her son and granddaughter. With the help of advisors, she formed Pierre LLC, a single-member LLC validly formed under New York law. She funded it with $4.25 million in cash and marketable securities. Twelve days later, she transferred the entire LLC to two trusts by gift and sale. First, she gifted a 9.5 percent interest to each trust to utilize a portion of her unified credit and generation-skipping transfer tax exemption. Then, she sold a 40.5 percent interest to each trust in return for a secured promissory note. The face amount of the note was determined by appraisal. She filed a gift tax return reporting the gifts.
So what went wrong?
The Internal Revenue Service took the position that because Pierre LLC was a single-member LLC that had not filed a “check-the-box” election to be treated as a corporation, it was a “disregarded entity.” The Service maintained that because the entity classification rules apply “for all purposes of the Code,” the existence of the LLC as an entity separate from its owner should be disregarded in valuing the property transferred to the trusts.
While some planners have wondered over this point for years — sometimes going to great lengths to have children or other family members contribute capital to a family LLC or limited partnership to ensure that the entity would not be disregarded — few expected quite this result.
All the Judges Speak
The case was decided en banc, giving planners an unusual insight into this particular precedent. Sometimes, we are left with the feeling that a case can be explained as much by the judicial outlook of the particular judge who decided it as by the facts themselves. In this instance we get to see what all of the judges on the tax court think. Well, sort of.
On its face, the case is a 10-to-six taxpayer victory, with the majority holding that, for gift tax purposes, interests in “disregarded” entities should be valued as interests in entities — with all the appropriate valuation discounts. But the case did spark four separate opinions, with the majority opinion signed by 10 of the judges, a concurrence signed by six, plus two dissents, one signed by only three of the judges, and another signed by all six dissenting judges.
Taken together these opinions leave one cautiously optimistic, but still wondering what will come next.
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Under the entity classification rules of the so-called “check-the-box” regime contained in Treasury Regulations Sections 301.7701-1 through 301.7701-3, a business that is not per se a corporation may elect, within limits, what type of entity it will be for tax purposes. A multiple-owner entity generally may elect to be treated as a corporation or a partnership, or may rely on its default classification. A single-owner entity may elect to be treated as a corporation, or may retain its default classification as a disregarded entity — that is, an entity that is ignored, not separate from its owner. Both the Tax Court in Medical Practice Solutions, LLC v. Commissioner,2 and the Second Circuit in McNamee v. Dept. of the Treasury,3 have upheld the IRS' authority to issue the check-the-box regulations. Under these rules, entities that are disregarded are supposedly “disregarded for all purposes of the Code.”
So, if an LLC is to be disregarded under the IRC, how do we value the transfer of an interest in it? To the IRS and the dissent, the answer is obvious. If we follow the plain language of the regulations, we ignore the entity and value the underlying assets.
Judge Mary Ann Cohen addresses this “plain language” argument in her concurring opinion. She reminds us that the law does not simply provide — as we may say in short-hand — that a disregarded entity is disregarded for all purposes of the IRC. Instead, the IRC Section 7701(a) classification rules (which the regulations implement) apply “except where ‘manifestly incompatible with the intent’ of the Internal Revenue Code.” And the majority clearly found that allowing the IRS to disregard entities validly created under state law would be “manifestly incompatible” with the “fundamental premise of transfer taxation.” That is to say, state law defines property interests.
The taxpayer argued, and the majority agreed, that for federal gift tax valuation purposes, state law rather than federal law determines the nature of the property transferred. Only after that has been determined are federal tax principles applied to determine the extent of the taxpayer's gift tax liability. Giving weight to a long line of precedent, the majority reminded us that the IRC creates “no property rights but merely attaches consequences, federally defined, to rights created under state law.”4
Under New York law, a membership interest in an LLC is personal property, and a member has no interest in specific property of the LLC. As a consequence, the majority wrote, the taxpayer had no legal interest or right in the underlying property that could be taxed.
It is worth noting that this opinion addresses only the issue of whether the single-member LLC should be disregarded for purposes of gift tax valuation. It does not address when (if ever) Pierre LLC became something other than a single-member LLC. While the IRS contends that the step transaction doctrine should apply to combine the gift and sale transfers, the applicability of the step transaction doctrine will be addressed only in a separate opinion and may well be moot if this decision stands on appeal. That said, if the IRS' view on step transaction prevails, it would eliminate the argument that even if the gift transfers should be valued as transfers of underlying assets, the subsequent sales should be valued as transfers of an interest in an entity. (Of course this assumes that the trusts were not grantor trusts, and/or that grantor trusts would not be similarly disregarded in determining whether Pierre LLC had more than one member!)
What's next? First, this decision is appealable to the Second Circuit. If it is appealed, the resulting decision could be really interesting. Some planners are wondering if we could see a ruling along the lines of the Second Circuit's infamous Rothstein5 decision, in which the court ruled that grantor trusts are not disregarded, but their income, deductions, etc. must be reported by grantors on their tax returns. The largely disregarded portion of the Second Circuit ruling — that grantor trusts do have a separate existence for tax purposes — leads to the logical conclusion that transactions between a grantor and his grantor trust also may exist, and may result in adjustments to basis and gain recognition. A new Second Circuit decision on when juridical entities are and aren't really there should prove thought provoking.
If upheld on appeal, this opinion could have far reaching consequences — and some of them arise in unexpected places. Consider, for example, a foreign corporation that had elected to be treated as a disregarded entity. If such a “disregard” were defined as a foreign entity for estate tax purposes, it would be non-taxable in the estate of a non-resident alien. At the same time, the sale of the disregarded entity would be treated as a sale of the underlying property. As a result, the sale of U.S. real property would get capital gains treatment, and the sale of stock in a U.S. corporation would be non-taxable. While by its terms Pierre speaks only to the gift tax, one wonders where the logic of the majority's underlying theory will lead us.
For now, this ruling lets planners who do (and have done) planning with a single-member entity breathe a little easier. There is one less avenue of attack to defend. In the gift tax arena at least, disregarded entities are not forgotten — but rather defined by state law. And that means appropriate valuation discounts are still available. Good news, right? Yes, but the majority is also quick to point out that while the IRS commissioner may not have the right to change the fundamental principles of gift tax valuation, Congress does, and given the current environment, it may.
- Pierre v. Commissioner, 133 T.C. No. 2 (Aug. 24, 2009).
- Medical Practice Solutions, LLC v. Commissioner, 132 T.C. __ (March 31, 2009).
- McNamee v. Dept. of the Treasury, 488 F.3d 100, 107 (2d. Cir. 2007).
- Pierre, supra note 1, citing U.S. v. Nat. Bank of Commerce, 472 U.S. 713, 722 (1985), quoting U.S. v. Bess, 357 U.S. 51, 55 (1958).
- Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984).
Karen Yates is a partner in Withers Bergman LLP and is based in the firm's Greenwich and New Haven, Conn. offices