In a split 10–6 decision, the Tax Court ruled in favor of a taxpayer that the check-the-box (CTB) regulations do not apply for purposes of valuing the transfer of property held through a single-member limited liability company (LLC) for federal gift tax purposes; rather, the CTB regulations govern how the entity will be taxed for federal income tax purposes (Pierre, 133 T.C. No. 2 (2009)). Under this holding, the CTB regulations (Regs. Secs. 301.7701-1 through -3) should not be applied to disregard an LLC in determining the nature of the property that is being transferred by the donor for purposes of the federal gift tax. Instead, the transfer of an ownership interest in a single member should be recognized as a transfer of an interest in an entity separate from its owner for federal gift tax valuation purposes and not as a transfer of the underlying assets in the LLC.
Under the facts of the case, the Tax Court held that the CTB regulations did not, for federal gift tax purposes, transform donations and sales of interests in a single-member New York LLC into transfers of the underlying cash and marketable securities in that LLC. The court determined that state law—rather than federal tax law—determines the nature of a taxpayer’s transferred ownership. For example, because New York state law recognizes the entity as being separate and apart from its owner, the transferred LLC ownership interests were subject to discounts for lack of control and lack of marketability, rather than being valued as direct transfers of undiscounted, proportionate shares of the LLC’s assets.
The Tax Court decision did not specifically address the computation of an appropriate valuation discount. In reaching its decision, the majority noted that the CTB regulations provide that they are to apply for “federal tax purposes.” The IRS argued that the regulations do not limit the application of the rules to the federal income tax. The Tax Court rejected the IRS’s argument, noting that the courts have consistently held that state law creates the legal interests and rights that are to be valued for purposes of federal gift and estate tax.
In holding that a single-member LLC is not disregarded as an entity separate from its owner for federal gift tax purposes, the decision has broad-ranging implications for state transfer tax and international estate planning, in addition to gift and estate tax valuation considerations. For example, the decision supports the position that for state estate and inheritance tax purposes where property is held through a singlemember LLC, the asset potentially subject to tax should be the LLC interest (intangible property) and not the property held by the LLC. With respect to international estate planning, the decision suggests that a nonresident alien could use a foreign disregarded entity to hold U.S. property and avoid U.S. gift and estate taxes on what would otherwise be taxable U.S. situs property. The decision can also be read as contrary to the lookthrough approach that the IRS applies in determining the estate and gift taxation of partnership interests held by nonresidents. Note that the decision may be appealed by the IRS (to the Second Circuit), or the IRS could choose to address the decision by amending the CTB regulations.