In Estate of Tanenblatt, T.C. Memo. 2013-263, Diane Tanenblatt owned a 16.67 percent membership interest in 37-41 East 18th Street Realty Co, LLC (the LLC), which she transferred to a revocable trust during her life. Three family groups owned the LLC, and the LLC operating agreement restricted transfers of membership interests outside of those family groups. A nonfamily member transferee couldn’t become a member of the LLC without the unanimous approval of all members. A nonfamily member transferee who received an LLC interest but didn’t become a member was entitled to receive the distributions and allocations of profits and losses relating to that interest, but had no right to participate in management and control of the LLC. The LLC’s principal asset was a 10-story building with retail and office space in New York City.
Diane died in 2007, and her personal representative filed an estate tax return, reporting the value of the subject interest in the LLC to be $1,788,000. This value was determined pursuant to an appraisal prepared by Management Planning, Inc. (MPI). MPI established the fair market value (FMV) using an income capitalization approach to determine that the net asset value of the building was $19,960,000. MPI then added the LLC’s cash and other assets, subtracted its liabilities and sequentially applied discounts of 20 percent for lack for control and 35 percent for lack of marketability to calculate the FMV of the subject interest. The Commissioner determined that the estate had underreported the FMV of the subject interest, agreeing that the net asset value of the building was $19,960,000, but allowing discounts of only 10 percent and 20 percent, respectively, for lack of control and lack of marketability. On the basis of these discounts, the Commissioner determined that the FMV of the subject interest was $2,475,882, thereby creating an estate tax deficiency of $309,547.
Estate Objects to IRS’ Methodology
The estate petitioned for a redetermination of the deficiency. Rather than rely on the MPI appraisal, the estate introduced a new appraisal, prepared by Dr. Laura Tindall (the Tindall appraisal), which asserted that the true value of the subject interest was $1,037,796. Since this value was lower than that reported on the Form 706, the estate’s also asked for a refund from the Internal Revenue Service. The Tindall appraisal established the value of the LLC by taking into account not only the net asset value, but also the historical distributions of the LLC. As a result of certain procedural hurdles that the estate failed to meet, the Tindall appraisal was excluded from evidence at trial. Nevertheless, based on the methodology set forth in the Tindall appraisal, the estate asserted two primary objections to the IRS’ determination of value.
First, the estate claimed that the value of the LLC shouldn’t have been defined exclusively by reference to its net asset value, because it was at least partly an operating company and not just a holding company. The estate argued that since the LLC was an operating company, its valuation must take into account its historical distributions. The court agreed that in general, it’s appropriate to utilize different methods in valuing holding companies and operating companies. The court cited various authorities for the proposition that an asset-based method of valuation is appropriate for entities that function as holding companies, whereas an earnings-based method should be used for entities that are going concerns. The rationale for this rule is that unlike an operating company, a holding company may be managed for appreciation in the value of its property, rather than for current income; therefore, the net asset value is often the best indicator of a holding company’s value. The court acknowledged that the LLC provided services to the public by leasing a gross rentable area of 77,725 square feet and that it, therefore, managed a going concern. Nonetheless, the court upheld the net asset value approach utilized by the IRS because there was no evidence in the record to suggest that an income-based approach would have yielded a different valuation conclusion.
The court also noted that both the IRS and MPI appraisals reached the same conclusion as to the LLC’s value. The MPI appraisal was submitted to the IRS in connection with the estate tax return; therefore, the court stated that the value reported on the Form 706 could be considered an admission by the estate. The admission restricted the estate from subsequently substituting a lower value without strong proof that the reported value was wrong. The court found that the estate didn’t present adequate proof to establish that the value reported on the Form 706 was wrong.
The estate’s second objection to the IRS’ valuation was that the IRS shouldn’t have classified the subject interest as a membership interest in the LLC. Instead, the estate argued that the subject interest should have been classified as an assignee’s interest (that is, a nonfamily member’s interest) and that, in applying the willing buyer-willing seller standard, the hypothetical willing buyer must be assumed to be a nonfamily member who would be purchasing an assignee’s interest, because he couldn’t become a member of the LLC without unanimous approval of all membership interests. The court acknowledged that a member’s interest is more valuable than an equivalent percentage interest of an assignee because a member can participate in the management and control of the LLC. Nonetheless, the court found that the subject interest owned by Diane’s revocable trust was a member’s interest because the trust shared in the management and control of the LLC and didn’t merely share in profits and losses. The court noted that in applying the willing buyer-willing seller test, the restrictions on transfer to nonfamily members should be a factor in determining the value of the subject interest; however, that doesn’t change the character of the subject interest from a member’s interest to an assignee’s interest. Furthermore, the court found that the IRS adequately accounted for the restrictions on transferability in its marketability discount analysis.
The estate also objected to the IRS’ methodology in determining the 10 percent and 26 percent discounts for lack of control and lack of marketability. However, because the estate provided no expert testimony in support of its position, the court was unable to consider this claim. Accordingly, the court upheld the IRS’ determination that the subject interest had a fair market value of $2,303,000 and that there was a $309,547 estate tax deficiency.
Evidentiary Issues
The outcome of this case depended heavily on the evidentiary issues. As a preliminary matter, it was unusual for the estate to introduce the Tindall appraisal at trial rather than rely on the MPI appraisal that was submitted in connection with the estate tax return. This decision put the estate in a dubious position from the outset. Then, the estate failed to meet the procedural requirements necessary for the Tindall appraisal to be admitted into evidence, which further damaged the estate’s position. Had the Estate either relied on the MPI appraisal from the outset or been able to admit the Tindall appraisal into evidence, the outcome of the case would likely have been different.