LLC structure withstands IRS challenge; then taxpayer wins discount battle

Pierre v. Commissioner, 2010 WL 1945779 (U.S. Tax Ct.)(May 13, 2010) readers may remember the Tax Court’s first opinion in these proceedings. In Pierre v. Comm’r, 2009 WL 2591652 (Aug. 24, 2009)(Pierre I), the taxpayer formed a single-member family limited liability company (LLC). In assessing deficiencies of over $1.13 million, the IRS argued that the entity form of a single-member LLC should be ignored for federal gift tax purposes. Accordingly, it treated the transfer of LLC interests to the children’s trusts as transfers of proportionate shares of the underlying LLC assets, to be assessed at full, fair market value. In a split decision (9 to 6), the U.S. Tax Court sided with the taxpayer, despite a dissent that would have disregarded the family LLC as a separate entity when assessing federal gift tax liability.

The court postponed deciding the valuation issues, however, including the application and magnitude of the discounts. It also put off the question whether the “step transaction doctrine” would collapse the LLC and trust transfers into a single transaction. In this new opinion (Pierre II), the court addresses both questions.

Background on the formation and valuation of the LLC. After forming the LLC, the taxpayer then created two trusts for her son and granddaughter. Nearly two months later, she transferred $4.25 million in marketable securities into the family LLC. Twelve days after that, the taxpayer transferred her entire interest in the family LLC to the trusts, giving 50% to each trust. Her advisers later determined that she could gift a certain amount tax-free. Accordingly, the petitioner sold each trust a 40.5% membership in return for two promissory notes of $1.09 million apiece, and gifted them each a 9.5% interest. An appraiser arrived at the note amounts after valuing a 1% interest in the LLC at $26,965, including a 36.5% combined discount for lack of marketability and lack of control.

Tax avoidance was the primary purpose. The court first examined the family LLC’s operations and agreements. For instance, the LLC essentially ignored the promissory notes, having made sufficient distributions to the trusts to pay interest but receiving no principal payments in eight years. Further, although the taxpayer was the designated manager of the LLC, neither she nor her grown son actively managed the LLC or attended its sporadic meetings. In 2000, at the time of the LLC’s formation and funding, an attorney/adviser prepared a single ledger to record the distribution of capital and to prepare the taxpayer’s original gift tax returns. Notably, he credited each trust’s capital account with 50% of the value of the taxpayer’s original $4.25 million contribution and then discarded the ledger after filing the tax returns.

At trial, the attorney testified that he discarded the records because they characterized the transfers inaccurately, failing to include the four subsequent gift and sale transactions. The court was not persuaded. “We do not so easily ignore [his] contemporaneous description of the transaction,” the court said. Nor would it overlook the taxpayer’s “primarily tax-motivated reasons for structuring the gift transfers as she did.” The four gift and sale transactions were planned as a single transaction and took place at virtually the same time, with no independent, intervening non-tax event. The taxpayer intended not just to minimize her tax liability, the court said, “but to eliminate it entirely.” Under these circumstances, including the LLC’s failure to observe formal operations (failure to pay down the note, etc.), the court applied the step transaction doctrine to collapse the separate transfers into a single deal.

Given this ruling, the court valued the LLC interests not by reference to the trust’s ownership but by their value in the taxpayer’s hands. The parties agreed that under the fair market value standard, a willing buyer/willing seller would pay less for the LLC interests than for an outright purchase of the same block of freely traded marketable securities. To prove the applicable discounted value, the taxpayer offered the original discounted appraisal (10% for minority interest, 30% for lack of marketability [DLOM], for a combined 36.5% discount), as well as a second appraisal, prepared specifically for trial. This second expert also included a 10% minority discount, but believed a 35% DLOM was appropriate, for a cumulative 41.5% discount.

Notably, the IRS chose not to present its own expert valuation, relying instead on its original claims (in Pierre I) that the gifts were of the underlying assets of the LLC. Having lost that argument, in Pierre II the IRS simply requested the court to reduce the taxpayer’s proposed discounts.

Taxpayer wins by default? Although the taxpayer’s trial expert agreed with the original assessment of a 10% minority discount, he conceded that this applied to LLC interests of 40.5% and 9.5%. If he’d reviewed the rights and restrictions applicable to a 50% interest in the LLC, he would have reduced the discount to 8%, he said. Given the court’s collapse of the gift and sale transactions into transfers of 50% apiece, it accepted and applied the 8% discount for lack of control.

Despite her trial expert’s 35% DLOM, the taxpayer advocated for only 30%, as set forth in her original appraisal. Although the IRS argued that a 35% marketability discount was too high, it failed to contest the 30% DLOM at trial. Further, the IRS offered no evidence or expert testimony concerning the LLC interests. Based on the available evidence, presented by the taxpayer, the court held that a 30% marketability discount was appropriate and applied the same.