Check-the-Box Regs. Do Not Affect the Valuation of LLC Interests

By James Beavers, J.D., LL.M., CPA

The Tax Court held that limited liability company (LLC) interests transferred by a taxpayer into trusts set up for the benefit of her children should be valued as transfers of LLC interests and not as transfers of the underlying assets owned by the LLC.

Background

The taxpayer, Suzanne Pierre, received a $10 million gift from a wealthy friend in 2000. Pierre, who was in her eighties, wished to use some of the gift to provide support for her son and granddaughter but wanted to keep the family wealth intact. To achieve these goals, later that year she set up a valid single-member New York LLC, the Pierre Family, LLC, which was treated as a disregarded entity under the check-the-box regulations (Regs. Secs. 301.7701-1 through -3), and separate trusts for her son and granddaughter. She then transferred $4.25 million in cash and publicly traded securities to the LLC and subsequently transferred a 9.5% membership interest in the LLC to each of the trusts by gift and sold each trust a 40.5% interest in the LLC in return for promissory notes.

Pierre filed a gift tax return for 2000 that reported the gifts of the membership interests to the trusts. When valuing the transfers for federal gift tax purposes, she applied substantial discounts for lack of marketability and control and therefore paid no gift tax on the transfers.

On examination, the IRS determined that the entire amount of the 9.5% interests transferred by gift should be treated as gifts of the LLC’s underlying assets because, under the check-the-box regulations, the LLC was classified as a disregarded single-member entity. This treatment eliminated the valuation discounts, resulting in a much higher gift value for gift tax purposes. It also found that the value of the 40.5% interests, less the value of the promissory notes given by the trusts, should be treated as gifts.

Pierre challenged the IRS’s determination in Tax Court. She argued that state, not federal, law determines the nature of a taxpayer’s interest in transferred property. She further argued that, 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. Therefore, she properly valued the gifts as gifts of an LLC interest rather than gifts of the LLC’s assets.

The Tax Court’s Opinion

The Tax Court held that the determination of the value of the LLC interests transferred by Pierre should be made under state law. Because under New York law Pierre, as the owner of the LLC, did not have an interest in the specific property of the LLC, the Tax Court held that Pierre had transferred interests in the LLC and that her gift tax liability should be calculated based on the value of the transferred interests, not on the value of the LLC’s underlying assets.

The court agreed with the IRS that the check-the-box regulations govern how a single-member LLC is taxed for federal tax purposes, but it did not agree that they should govern whether the donor of an LLC interest is subject to federal gift tax. According to the Tax Court, under the federal gift tax regime, the determination of the amount of gift tax on a transfer could be broken down into three steps: (1) the determination under state law of the property interest transferred; (2) the determination of the value of the property and the amount of the value subject to tax; and (3) the calculation of the tax.

The court found that neither the check-the-box regulations nor any of the cases cited by the IRS supported a conclusion that the check-the-box regulations applied to disregard the existence of an LLC in determining what property the taxpayer had transferred in the first step of the process. The Tax Court stated that if the regulations were thus interpreted, they would go “far beyond classifying the LLC for tax purposes” and would overturn the existing, long-established federal gift tax valuation regime, which “would be ‘manifestly incompatible’ with the federal estate and gift tax statutes as interpreted by the Supreme Court.”

Reflections

Two complementing dissenting opinions disagreed with the majority’s reliance on state law and instead found that the determination of what property Pierre transferred should be made under federal law, in this case as expressed in the check-the-box regulations. Analyzing those regulations, the dissents found that they were not incompatible with the federal gift tax regime and that, based on the plain language of the regulations, the IRS’s interpretation of them with respect to the treatment of the gifts of the LLC interests was plausible. Therefore, the dissents would have treated the LLCs as disregarded entities for gift tax purposes and treated the taxpayer’s transfers as transfers of the LLC’s property.

The dissents stated that the majority had incorrectly read the phrase “federal tax purposes” in Regs. Sec. 301.7701- 1(a)(1) to mean “federal income tax purposes.” According to the dissents, this interpretation was wrong because the regulations did not say “federal income tax purposes,” and the regulation drafters could have specifically excluded federal gift taxes from the scope of the regulations had that been their intent. The dissents also noted that the majority’s position ignored the IRS’s consistent treatment of single-member LLC owners as the owners of the LLCs’ assets.

Pierre, 133 T.C. No. 2 (2009)

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