Taxpayer Wins Lawsuit on Valuing Transfers of LLC Interests

In a case involving the proper valuation of LLC interests that were transferred by a taxpayer into trusts set up for the benefit of her children, the Tax Court has held that transfers should be valued as transfers of LLC interests and not, as the IRS had argued, as transfers of the underlying assets owned by the LLC (Pierre, 133 TC no. 2 (8/24/09)).

The taxpayer, Suzanne Pierre, transferred cash and publicly traded securities to Pierre Family LLC, a limited liability company she wholly owned and that was treated as a disregarded entity under the check-the-box regulations (Treas. Reg. §§ 301.7701-1 through -3). The taxpayer subsequently transferred her interest in the LLC to trusts established for the benefit of her son and granddaughter. 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.

The IRS argued that because the LLC was a disregarded single-member entity, the transfers should be treated for valuation purposes as transfers of the underlying assets. This would erase the large valuation discounts the taxpayer had applied to the transfers.

The taxpayer countered that state, not federal, law determines the nature of a taxpayer’s interest in transferred property and 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.

The court agreed with the IRS that the check-the-box regulations determine how a single-member LLC will be taxed for federal tax purposes, but did not agree that they should govern whether the donor of an LLC interest is subject to federal gift tax. The court said that this goes “far beyond classifying the LLC for tax purposes” (Pierre at 20) and would overturn the existing, long-established federal gift tax valuation rules.

Therefore, the court held that the taxpayer’s transfers to the trusts should be valued for federal gift tax purposes as transfers of interests in the LLC and not as transfers of a proportionate share of the underlying assets of the LLC.

Dissenting Opinion

A dissenting opinion disagreed with the majority’s reliance on state law and instead declared that the determination in the case should be made under federal law, in this case as expressed in the check-the-box regulations. It focused on Treas. Reg. § 301.7701-2(a), which states, regarding treatment of a disregarded entity, “its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.” The dissent also considered Treas. Reg. § 301.7701-1(a)(1), which states that the treatment of a disregarded entity applies for “federal tax purposes.” The dissent found that the IRS’s interpretation of the regulations with respect to the treatment of the gifts of the LLC interests was plausible and would therefore have looked through the LLC structure and treated the taxpayer’s transfers as transfers of the LLC’s property for federal gift tax purposes.

The dissent also argued that the majority opinion amounts to an invalidation of Treas. Reg. § 301.7701-2(a) and that this was done without giving the regulation proper deference under Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).