Editor: Rick Klahsen, CPA
The increased use of limited liability companies (LLCs) has brought many questions to the gift and estate planning forefront, especially those dealing with the single-member LLC (SMLLC). For federal tax purposes, an SMLLC can be disregarded as an entity separate from its owner. Accordingly, does the owner, specifically for transfer tax purposes, have an interest in an LLC or the underlying assets of the LLC?
The answer could make a difference in the valuation of the transfer because of the effect of discounts. Obviously there is no lack of control with an SMLLC. However, as with other privately held companies, there are marketability issues that may warrant discounts. If a member transfers an interest in an LLC, discounts are acceptable. If the LLC is disregarded and the gift is treated as an interest in the underlying assets of the LLC, no discounts are allowed on the transfer. If SMLLCs are not allowed valuation discounts, that will decrease their appeal and usefulness.
There has been relatively little guidance on how LLCs should be treated for transfer tax purposes. However, in 2009 a case was brought to the Tax Court to determine if the transfer of an SMLLC was a transfer of an interest in the LLC or an interest in the underlying assets of the entity (Pierre, 133 T.C. No. 2 (2009)). The Tax Court ruled in favor of the taxpayer (although there was a 10–6 split in the judges’ opinions) that a transfer of an interest in an SMLLC should be valued as a transfer of an interest in the entity. The opinion did not decide whether the step-transaction doctrine would apply to collapse the separate transfers to the trust or what valuation discount percentage would be allowed; the Tax Court stated that another opinion would be issued to address these questions.
Suzanne Pierre received a gift of $10 million in 2000. In July 2000, she created a valid LLC under New York State law. She transferred cash and marketable securities of approximately $4.25 million to the LLC, known as Pierre Family, LLC, and retained 100% of the interest in it. She did not elect association status, so the LLC was deemed a disregarded entity. She also created two trusts—one for her son and one for her granddaughter. In September 2000, Suzanne gave a 9.5% interest in Pierre Family, LLC, to each trust. A few days later, she sold a 40.5% interest in the LLC to the trusts for promissory notes worth $1,092,133 each.
When valuing the transfers for gift tax purposes, the taxpayer took valuation discounts of 36.55%. The IRS issued a notice of deficiency, taking the position that because Pierre Family, LLC, was a disregarded entity, its underlying assets should be valued, not the interest in the LLC itself. Since the underlying assets were cash and marketable securities, the IRS allowed no valuation discounts.
The IRS argued that the check-thebox regulations (Regs. Secs. 301.7701-1 through -3) make it clear that for all federal tax purposes, an SMLLC will not be an entity legally separate from its member. According to the IRS, it would be inconsistent if for federal gift tax purposes the entity was legally separate from the taxpayer but for federal income tax purposes it was not.
Pierre argued that state property law takes precedence over federal tax law in a transfer tax situation. New York State law does not disregard the entity. The formation of an LLC in New York creates an interest in an entity completely separate and apart from its member. The LLC is deemed to be the member’s personal property. If the LLC itself is the property, the entity, not the member, holds the legal title to the underlying assets. New York Limited Liability Company Law Section 601 explicitly states, “A member has no interest in specific property of the limited liability company.”
Past U.S. Supreme Court precedents also helped the petitioner. Morgan, 309 U.S. 78 (1940), and National Bank of Commerce, 472 U.S. 713 (1985), both support the notion that state property law defines entity property interests. In Knight, 115 T.C. 506 (2000), the Tax Court held that state law creates a property interest: “A fundamental premise of transfer taxation is that State law defines and Federal tax law then determines the tax treatment of property rights and interests.”
Finally, the Tax Court examined whether the check-the-box regulations affect the federal gift tax valuation regime. Those regulations deal with the entity’s classification, and the IRS promulgated them to simplify the income taxation of LLCs. The classification does not define property interests; it only allows the election of specific treatment under the federal tax law. The court also noted that Congress has not specifically disallowed for transfers of SMLLC interests the right to a valuation discount as it has with other transactions. Secs. 2701–2704 list certain transactions that are specifically not allowed a valuation discount; transfers of SMLLCs are not among those excluded. The Tax Court found that if Congress had not wanted valuation discounts to apply to transfers of SMLLCs, it would have added that entity form to the list of exclusions.
Consequently, the Tax Court held in favor of the taxpayer. However, six dissenting judges argued that this ruling negated the plain language of the regulations that provides that disregarded entity status applies “for federal tax purposes” (Regs. Sec. 301.7701-3(a)).
Any valuation case that finds in favor of the taxpayer is always a big win for estate planners. However, this case plays an even bigger part in the taxpayer’s ability to use discounts even when the taxpayer retains control over the assets. First, the case affirms using LLCs as gifting vehicles. Second, the control issue and marketable assets of the LLC did not affect the decision in the case.
SMLLCs are owned by one member, and that member has absolute control of the entity. However, state property law trumped the control issue. The cash and marketable securities that funded the LLC also were not questioned. While the Tax Court did not rule on the percentage discount allowed, the ruling allows the taxpayer to take a lack-of-marketability discount on the transferred LLC interest because the LLC is privately held and not actively traded.
It is also relevant to note that state law played a huge part in the outcome of the ruling. Properly forming the entity, along with following all the necessary administration procedures, allowed the taxpayer to establish an entity legally separate from its member. Absent those details, the case could have had a different outcome. It is also important to realize that planning in which state an SMLLC should be organized is important. If New York’s law had not specifically stated that the LLC’s assets were not the property of its member, the case result also may have been different.
While waiting for further opinions evaluating the possibility of a step transaction and the percentage of the valuation discount allowed, it seems that for now estate planners can rest a little easier when using valuation discounts with SMLLCs.
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or email@example.com.