By Ori Bash, ASA, and Stuart Solomon
Pluris Valuation Advisors LLC, Palo Alto, CA
In Pierre v. Comr., T.C. Memo 2010-106, the IRS prevailed on the step-transaction doctrine. However, with no appraisal fire power to back it up, the IRS's win ultimately fizzled out when it came time to value the gifts made.
In 2000, Suzanne J. Pierre (petitioner) received a cash gift of $10 million. At the time, petitioner was 85 years old, already had a net worth of approximately $2 million, and was concerned with both the income and estate tax implications of the gift. The petitioner worked with financial and estate-planning professionals to devise a plan to satisfy her own annual income concerns as well as her desire to gift approximately $4.25 million to her son and granddaughter.
On July 13, 2000, petitioner organized the single-member Pierre Family, LLC (Pierre LLC) and subsequently created the Jacques Despretz 2000 Trust and the Kati Despretz 2000 Trust on July 24, 2000. On September 15, 2000, petitioner transferred $4.25 million of cash and marketable securities to Pierre LLC. On September 27, 2000, petitioner made a gift of a 9.5% member interest in Pierre LLC to each trust. Additionally, on that same date, the petitioner sold each trust a 40.5% member interest in Pierre LLC. The sales were made in exchange for a note bearing interest at 6.09% per annum, payable in 10 annual installments, and secured by each respective 40.5% member interest. Each valuation incorporated a 10% discount for lack of control and a 30 percent discount for lack of marketability.
In Pierre v. Comr., 133 T.C. No. 2 (Pierre I), the Tax Court held that Pierre LLC should not be disregarded for gift tax valuation purposes under the "check-the-box" regulations of Regs. §§ 301.7701-1 through -3 (as such, discounts for lack of control and marketability were allowed). In the current case, the Tax Court was to decide whether the step-transaction doctrine applies, thus collapsing petitioner's individual gift and sale transfers into transfers of two 50% interests in Pierre LLC. Furthermore, the court must determine the appropriate level of discounts for lack of control and marketability for the underlying transactions.
The step-transaction doctrine treats a series of formally separate steps as a single transaction if the steps are in substance integrated, interdependent, and focused toward a particular result. While the petitioner argued the four transfers of her entire interest in Pierre LLC each had independent business purposes, the IRS argued the transfers were effected as separate transactions for the sole purpose of avoiding gift tax. Under the step-transaction doctrine, the IRS was targeting to collapse the four transactions into two larger block transactions. The key facts that supported the step-transaction doctrine were:
(1) the transfers at issue all occurred on the same day (i.e. virtually no time elapsed between the transfers);
(2) the transfers were originally recorded as two gifts of 50% interests in the journal and ledger for the LLC's tax return, and then modified later to reflect four transactions;
(3) no principal payments were made on the notes over an 8-year period; and
(4) the petitioner structured the series of transactions with the intent of not paying any gift tax.
Accordingly, the court held that the petitioner made a gift to each trust of a 50% interest in Pierre LLC, and the valuation should be adjusted to reflect this.
When effecting the transactions in question, petitioner relied upon an expert appraisal that determined the appropriate discounts for lack of control and lack of marketability to be 10% and 30%, respectively. At trial, petitioner called on an additional expert who testified that the appropriate discounts in this instance should be 10% for lack of control and 35% for lack of marketability. The IRS failed to introduce any expert testimony at trial, and even failed to argue that the 30% lack of marketability discount taken on the tax return was too high (while arguing that the 35% discount taken by the petitioner's expert at trial was too high).
Ultimately, the application of the step-transaction doctrine was of little consequence in this case, with the lack of control discount slightly reduced from 10% to 8% and the lack of marketability discount held at the original level of 30%. A slight reduction to the lack of control discount was determined to be applicable since a 50% ownership interest demonstrates a modest increase in the degree of control through the right to block the appointment of a new manager, a right that a less than 50% interest cannot exercise. The two trusts were in effect equal 50-50 owners. This implies lower discounts than for minority ownership interests, but not zero discounts. In a different case involving the bifurcation of a controlling interest into two or more non-controlling interests, losing on the step-transaction doctrine would have had more fatal results.
In all, we believe the petitioner got quite lucky here. It is somewhat surprising that the IRS did not hire a qualified expert to counter the discounts argued by the petitioner's expert. Had it done so, the court's valuation might have been significantly different.
For more information, in the BNA Tax Management Portfolios, see Streng, 800 T.M., Estate Planning, Mezzullo, 812 T.M., Family Limited Partnerships and Limited Liability Companies, and Hood, 830 T.M., Valuation: General and Real Estate, and in Tax Practice Series, see ¶6180, Introduction — The Estate and Gift Taxation System, ¶6290, Valuation — Generally, and ¶6350, Estate Planning.
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