Valuation Discounts for Gift of Single-Member LLC Interests

Demystifying Valuation, Economic Damages + Forensic Accounting

In a split decision by the U.S. Tax Court (Suzanne J. Pierre v. Comm., 133 T.C. No. 2), the court dealt with the issue as to whether a single-member LLC is to be disregarded for transfer tax purposes (i.e., gift tax purposes), thus treating the gift as a direct gift of the underlying property of the LLC. A single-member LLC has the option to be treated as an association taxable as a corporation or as an entity disregarded as an entity separate from its owner. The IRS regulations implementing these rules are known as the “check-the-box” regulations.   If no election is made by the taxpayer, the default rule is that the entity is disregarded as an entity separate from its owner. In other words, the owner of the LLC is treated as the owner of the property.

The basic facts in the case were as follows. The taxpayer received a cash gift of $10 million in 2000 from a wealthy friend (we should all have friends like this!) and wished to provide for her son and daughter. Taxpayer created the Pierre Family LLC on July 13, 2000 and created a trust for each of her children on July 24, 2000.   Funding of the LLC occurred on September 15, 2000 with the transfer of $4.25 million in cash. The LLC was validly formed under New York state law.  Taxpayer then made the following transfers to each of the trusts on September 27, 2000:

• Gift of 9.5% member interest in the LLC
• Sale of 40.5% member interest in the LLC

The value of both the gifts and the sales were based on independent valuations that included a discount for lack of marketability of approximately 37%. The IRS claimed that the entity should be disregarded for gift tax purposes resulting in a direct gift of the cash to the trusts. Taxpayer argued that the LLC should not be disregarded for gift tax purposes.

The full Court reviewed the case and the majority held in favor of the taxpayer. The Court noted that state law creates property rights and the Federal tax law defines only the Federal tax treatment of those property rights. The Court also noted that the check-the-box regulations govern how a single-member LLC will be taxed for income tax purposes, either as an association taxable as a corporation or as a disregarded entity (i.e., a sole proprietorship). To go farther than this classification would be tantamount to redefining the property rights actually transferred. Six judges disagreed with the majority arguing that the plain language of the check-the-box regulations requires the LLC to be disregarded as an entity separate from its owner for gift tax purposes.

The Court did not consider the issue of whether the step-transaction doctrine should be applied thus treating the transfer of the interests were indirect transfers of the underling cash nor whether the amount of the valuation discount was appropriate, leaving these two significant issues to future resolution of litigation.

Steve Koons, CPA/ABV, ASA, CFF