After the IRS determined that an estate had underreported the value of its interest in a limited liability company (LLC), it assessed an estate tax deficiency. The estate responded with a new appraisal, prepared by another professional appraiser, which valued the LLC interest at a figure that was lower than what was reported on the estate tax return. The estate sought a refund. While the Tax Court seemed sympathetic to part of the estate’s argument, it ultimately refused to admit the second appraisal into evidence at least partly because the second appraiser wasn’t available to testify in support. This article emphasizes the importance of having a valuation supported by a qualified valuation expert. A sidebar discusses how LLCs and family limited partnerships (FLPs) can save taxes. Valuing LLC interests: How to lose in Tax Court A recent U.S. Tax Court case — Estate of Tanenblatt — offers an important lesson for executors and other personal representatives: When valuing assets for estate tax purposes, be sure you’re satisfied with the valuator’s methods and conclusions before you file an estate tax return. Offering new valuation theories in court can backfire. LLC owned Manhattan real estate The sole issue to be decided was the fair market value of the deceased’s 16.667% interest in a New York limited liability company (LLC). The LLC’s principal asset was a 10-story commercial building in Manhattan that contained retail and office space. The deceased’s interest was held in a revocable trust. The LLC was owned by three family groups, and its operating agreement restricted transfers outside those groups. A nonfamily member couldn’t become a member of the LLC without the unanimous consent of all members. Without such consent, a nonfamily transferee would be entitled to share in the LLC’s profits and losses but would have no right to participate in management. The deceased died in 2007. Her personal representative timely filed a federal estate tax return, which valued the LLC interest at $1,788,000 based on a professional appraisal. To value the interest, the appraiser started with a real estate appraisal, which valued the building at $19,960,000 using an income capitalization approach. Adding the LLC’s cash and other current assets and subtracting its liabilities, the appraiser determined that the LLC’s net asset value was $20,628,221 ($3,438,106 for the deceased’s interest). The appraiser applied a 20% discount for lack of control and a 35% discount for lack of marketability to arrive at the interest’s $1,788,000 value. (See the sidebar “How LLCs and FLPs save taxes.”) The IRS determined that the estate had underreported the value of the interest. Although it accepted the estate’s calculation of net asset value, it allowed discounts of only 10% for lack of control and 20% for lack of marketability. On that basis, the IRS valued the interest at $2,475,882 and assessed an estate tax deficiency of $309,547. Estate attacks its own valuation In Tax Court, the estate offered a new appraisal, prepared by another professional appraiser, which valued the LLC interest at $1,037,796. Because this figure was lower than what was reported on the estate tax return, the estate sought a refund. The estate challenged not only the IRS expert’s valuation methodology, but also the methodology of its own original appraiser, on which it had previously relied. Based on the second appraisal, the estate argued that:
  1. The interest should have been treated as an assignee interest, which is less valuable than a member interest, and
  2. The LLC’s value should have been based, at least in part, on its history of earnings and distributions, not just its net asset value.
As to the first argument, the court found that the deceased’s trust held a member interest in the LLC, and that was the interest being valued. Any restrictions that would apply to a purchaser of that interest were reflected in the discount for lack of marketability. The court acknowledged, however, that the second argument might have had some merit. The LLC was not just a real estate holding company; it also managed the building’s rental activities as a going concern. As an operating company, it was appropriate to value the LLC, at least in part, using income-based valuation methods, which might have resulted in a lower value. But there was a significant problem with this argument: The estate had no evidence to back it up. Because the second appraiser wasn’t available to testify (apparently because of a fee dispute with the estate), and for other procedural reasons, the court refused to admit the second appraisal into evidence. The court noted that values reported on an estate tax return may be considered admissions, “restricting an estate from substituting a lower value without cogent proof that those admissions are wrong.” In this case, with no admissible expert testimony to the contrary, the estate failed to meet this burden. Lessons learned Tanenblatt serves as a cautionary tale for people planning their estates as well as for their personal representatives. In order for your asset values to hold up before the IRS or in court, be sure they’re supported by qualified appraisals. And if you decide to change your valuation strategy, make sure you can back it up with the testimony of a qualified valuation expert. Sidebar: How LLCs and FLPs save taxes Family limited liability companies (LLCs) and family limited partnerships (FLPs) can be powerful tools for transferring valuable assets to family members, usually at deeply discounted gift and estate tax values, without giving up control. In a typical arrangement, parents establish an LLC or FLP, retaining all of the membership or partnership units. Next, they contribute assets to the entity, such as real estate, securities or business interests. Finally, they transfer (by gift or sale) LLC interests or minority limited partner interests to their children, either outright or in trust. Structured properly, this technique allows the parents to retain management control over their assets while shifting ownership to the younger generation. And because the children’s rights to sell their interests or to participate in management are strictly limited, the transferred interests are entitled to substantial valuation discounts — often as high as 40% or more — for gift tax purposes. Keep in mind that, to ensure the desired tax result, the LLC or FLP must have a legitimate nontax business purpose, such as maintaining family control over a business, consolidating management of an investment portfolio or protecting family assets from creditors. © 2014