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Estate strategies: The case of the disappearing LLC

Lance Hall

31 August 2009

Established gift-tax regulations trump check-box classification of entities. Lance Hall leads the estate and gift tax valuation practice of FMV Opinions, a valuation and financial-advisory services firm.

Suzanne Pierre has great friends. Early in 2000, one of them gave her $10 million in cash. To meet the dual objectives of providing for her son and granddaughter while preserving this new-got fortune, she established a single-member LLC -- Pierre Family LLC -- on 14 July 2000, and contributed $4.25 million in cash and marketable securities to it on 15 September 2000. In the meantime, on 24 July 2000, she formed two trusts, one for her son and one for her granddaughter.

On 27 September 2000, Pierre gifted two 9.5% interests in the LLC to the two trusts. And she sold 40.5% interests in the LLC to the two trusts. For the gifts and the sales an appraisal valued the LLC interests at a 30-percent discount to the underlying value of the cash and marketable securities -- though, because of a mistake in valuing the underlying assets, the actual discount utilized was 36.55%.

Pierre Family LLC was validly formed under New York law. However, as a single-member LLC, the so-called "check the box" regulation's default classification is "that the entity is disregarded as an entity separate from its owner" for federal-tax purposes. Accordingly, the IRS contends that the gift and sale was comprised of the underlying assets of the LLC, and not the disregarded LLC itself.

"The question before us is whether the check-the-box regulations require us to disregard a single-member LLC, validly formed under State law, in deciding how to value and tax a donor's transfer of an ownership interest in the LLC under the Federal gift tax regime," goes the 16-judge en banc Tax Court decision in Pierre v. Commissioner .

The court also promised that, under forthcoming separate opinions, it would address the step-transaction doctrine as well as the IRS challenges to the discounts taken.

Check-the-box regulations

Years ago, U.S. federal regulations recognized three types of entities: corporations, partnerships, and sole proprietorships. To determine the correct entity classification for federal-tax purposes the IRS used the Kintner Regulations, which set forth six characteristics ordinarily found in a corporation which distinguish it from other organizations:

Associates, An objective to carry on business and divide the gains therefrom, Continuity of life, Centralization of management, Limited liability, and Free transferability of interests.

In recent decades, however, with the proliferation of different types of entities that share both corporate and partnership attributes, the Kintner Regulations have become less useful in classifying entities for federal-tax purposes. So the check-the-box regulations were promulgated to simplify the classification of hybrid entities, like LLCs. Section 301.7701-1 of the Treasury Regulations says: "Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law."

The opinion

The court paid homage to the guiding precept that "State law determines the nature of property rights, and federal law determines the appropriate tax treatment of those rights." It recognized, "pursuant to New York law petitioner did not have a property interest in the underlying assets of Pierre Family LLC, which is recognized under New York law as an entity separate and apart from its members. Accordingly, there was no State law 'legal interest or right' in those assets for federal law to designate as taxable, and federal law could not create a property right in those assets. Consequently, pursuant to the historical federal gift-tax valuation regime, petitioner's gift tax liability is determined by the value of the transferred interests in Pierre Family LLC, not by a hypothetical transfer of the underlying assets of Pierre Family LLC."

"While we accept that the check-the-box regulations govern how a single-member LLC will be taxed for Federal tax purposes, i.e., as an association taxed as a corporation or as a disregarded entity, we do not agree that the check-the-box regulations apply to disregard the LLC in determining how a donor must be taxed under the federal gift-tax provisions on a transfer of an ownership interest in the LLC. "

"To conclude that, because an entity elected the classification rules set forth in the check-the-box regulations, the long-established federal gift-tax valuation regime is overturned as to single-member LLCs would be manifestly incompatible with the federal estate- and gift tax-statutes as interpreted by the Supreme Court."

Note that the court's decision to treat these transfers as transfers of interests in the LLC rather than as transfers of a proportionate share of LLC assets came from a divided court with six judges dissenting from the majority decision.

What the court has to say about how the step-transaction doctrine applies to collapse the separate transfers to the trusts and the appropriate valuation discount, if any, will be interesting. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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