A Divided Tax Court Chooses to Recognize a Single Member LLC for Purposes of the Federal Gift Tax

A Divided Tax Court Chooses to Recognize a Single Member LLC for Purposes of the Federal Gift Tax


In Pierre v. Commissioner, 133 T.C. No. 2 (2009), the Tax Court, in a divided opinion, rejected the government’s argument that transfer of interests in a single member limited liability company (LLC) should be treated as a transfer of the underlying assets because the check-the-box regulations disregard the entity. After receiving a $10 million cash gift from a friend, Ms. Pierre, the taxpayer, determined that she wished to preserve her wealth for the benefit of her son and granddaughter. To do so, the taxpayer validly formed a single member New York limited liability company called Pierre Family, LLC on July 13, 2000. Eleven days later, the taxpayer created two trusts, one for her son, and one for her granddaughter. Eleven days after formation of the trusts, the taxpayer transferred $4.25 million in assets, consisting of cash and marketable securities, to the LLC. Finally, 12 days after funding the LLC, the petitioner made four transfers to the two trusts consisting of her entire interest in the LLC. She gave each of the trusts a 9.5 percent membership interest in the LLC. She also sold a 40.5 percent interest in the LLC to each of the trusts in exchange for a secured promissory note. 
 
The taxpayer applied a discount in arriving at the value of the LLC interests for gift and sale purposes. An appraisal valued a “nonmanaging interest in Pierre LLC at $26,965" resulting in a 30 percent discount. However, a mistake caused the taxpayer to apply a 36.55 percent discount to the transfer by gift of the LLC interests. The Service took the position that value should be based on a transfer of the full value of the underlying LLC assets, and determined that both the gift and sale transfers resulted in increased gifts with an asserted deficiency of $1,130,216.11 in gift taxes, and $24,969.19 in generation- skipping transfer taxes. It based the deficiency on the argument that a single member LLC is a disregarded entity for tax purposes under the check-the-box regulations.
 
Judge Wells issued the majority opinion which began with the premise that “State law determines the nature of property rights, and Federal law determines the appropriate tax treatment of those rights,” citing Knight v. Commissioner, 115 T.C. 506 (2000). The majority opinion also noted that the reference in the check-the-box regulations to “federal tax purposes” must be read in light of the purpose of those regulations to provide entity classification either as a corporation or as a partnership or single member disregarded entity. The majority determined that to extend the regulations would be “manifestly incompatible” with the premise of federal estate and gift tax law. Finally, the court noted that Congress has not specifically acted with respect to valuation discounts as it has done in other instances as demonstrated by the enactment of Chapter 14.
 
It is notable, that the majority in footnote 3 reserves for a separate opinion the issue of whether the step transaction doctrine applies, and the appropriate valuation of the transfers. In the event the court applies the step transaction doctrine, the various steps would be collapsed, and the taxpayer would be deemed to have transferred the underlying transfers. Were the court to accept this argument, the Service would achieve its objective to deny any valuation discounts on the transfers. 

Judge Cohen wrote a separate concurrence in order to distinguish this case involving gift tax issues, from an opinion she authored disregarding the entity for purposes of applying employment taxes. She explains: “The check-the-box regulations might be applied to determine for gift tax purposes whether the owner of a single-member LLC or the LLC is the transferor of the assets used in the business or the activities for which the LLC was formed. In that event, the determination would parallel the determination in the employment tax cases as to who is liable for the Federal tax in dispute and would consider whether the LLC should be “disregarded” under those regulations. The only transfer at issue here, however, is the transfer by the owner of the LLC of certain interests that she held in that LLC.” Judge Cohen further takes issue with the dissent’s deference to the Service’s litigating position. 

Judge Halpern in his dissent focuses on the regulation and its intent that the “wrapper” of the LLC should be disregarded for federal tax purposes, and indicates that the regulations should be given “Chevron” deference as a valid construction of the underlying statute. Judge Kroupa wrote separately to dissent based on the plain language of the regulations, and notes that the regulations do not apply solely for federal “income” tax purposes. In addition, Judge Kroupa indicates the majority inadequately distinguishes the decisions in McNamee v. Dep’t of the Treasury, 488 F.3d 100 (2d Cir. 2007) and Littriello v. United States, 484 F.3d 372 (6th Cir. 2007) that applied the check-the-box regulations to employment tax liability.
 
The majority opinion appropriately relies on state law recognition of the family limited liability company as a valid entity. The taxpayer transferred LLC interests. It is the transfer of these interests that is the focus of the gift tax, and as Judge Cohen notes, not the taxation of the LLC itself. If it were the latter, then the check-the-box regulations should be applicable. The dissenting opinions, however, do not draw this distinction. The court noteably leaves open the possibility, however, of applying the step transaction doctrine to the transaction. Given this line of attack by the Service, if it is anticipated that transfers will be made to family members of entity interests, the estate planner should consider forming the family limited liability company with more than one member, either the donor and trusts or the donor and children.