NY State Estate Tax of Non-Resident's LLC Determined by Entity Classification

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1 NY State Estate Tax of Non-Resident's LLC Determined by Entity Classification June 30, 2015 By Eric W. Olson, Richard Bowers, Jonathan E. Gopman, and Michael A. Sneeringer The New York State Department of Taxation and Finance (the Department) recently opined that a membership interest in a single-member LLC (SMLLC) owning a New York condominium is real property subject to New York State "estate tax." This conclusion is based upon and applies to SMLLCs that are "disregarded" for Federal income tax purposes. Facts In Advisory Opinion (TSB-A-15(1)M May 29, 2015), the Department responded to a New York resident (Petitioner) who contemplated contributing his New York condominium to a disregarded SMLLC and then moving to another state. The Petitioner intended to remain the sole owner of the SMLLC for the remainder of his life and to reside outside of New York until his death. The Petitioner asked whether the SMLLC is "intangible property" for estate tax purposes and would therefore not be treated as real property for New York State estate tax purposes. The Department, in considering the SMLLC s sole ownership, reasoned that the assets and activities of a disregarded SMLLC should be treated as the assets and activities of the SMLLC s sole member/owner. Accordingly, the condominium held by the SMLLC would be treated as real property held by the Petitioner for New York State estate tax purposes. Analysis New York State imposes estate tax on the transfer by the estate of a nonresident decedent of real property and tangible personal property located in New York. 1 In general, the transfer of a New York condominium by the estate of a nonresident decedent is subject to estate tax. 2 New York real property may be held by a corporation or partnership; however, the interest in such entity (i.e., the corporate stock or partnership interest) constitutes intangible property. 3 New York does not impose estate tax on intangible property held by nonresidents, even if such property is located in New York. 4 Accordingly, the New York State estate tax is not imposed on the transfer by the estate of a nonresident decedent of

2 an interest in a corporation or partnership that holds New York real estate. Under U.S. Treasury Regulations, the tax classification of a business entity is determined by its number of owners and by an election, if any, made by the entity. A business entity with only one owner is classified as either a disregarded entity or a corporation. 5 As a default, a SMLLC is disregarded as an entity separate from its sole member/owner and the tax attributes of the SMLLC are imputed to its sole member/owner. 6 Alternatively, a SMLLC may file IRS Form 8832 (Entity Classification Election) to be classified as "an association and taxable as a corporation."7 An LLC with two or more members (i.e., owners) is classified as either a partnership or a corporation. As a default, a multimember LLC is treated as a partnership and its tax attributes pass through to its members. 8 Alternatively, a multimember LLC may file Form 8832 to be classified as a corporation. 9 In Advisory Opinion (TSB-A-08(1)M October 24, 2008), the Department issued a similar opinion. Like Advisory Opinion (TSB-A-15(1)M May 29, 2015), the opinion explicitly mentioned that if an election is not made to treat an SMLLC as a corporation, the SMLLC is disregarded for New York estate tax purposes, and the value of the condominium is includible in a non-resident decedent's gross estate. 10 New York has a long standing statute that provides that a membership interest in an LLC is personal property and a member of an LLC has no interest in the specific property of the LLC. 11 This statute appears to conflict with the conclusion of Advisory Opinion (TSB-A-15(1)M May 29, 2015) and Advisory Opinion (TSB-A-08(1)M October 24, 2008) (collectively, the "Opinions") as neither of the Opinions implied that a SMLLC is tangible personal property. If under New York law a membership interest in an LLC is personal property, a member has no interest in specific property of the LLC. If neither of these Opinions recognized the fact that a membership interest in a SMLLC is tangible personal property, it seems clear that such a membership interest is by statute intangible personal property (which would, according to the Opinions, escape estate tax under N.Y. Tax Law 960(a)). In Pierre v. Commissioner, 12 the Tax Court ruled against the Internal Revenue Service (the Service) where the Service asserted a similar position to the position relied upon by the Department in both of the Opinions that is, under the check-the-box Regulations, the SMLLC did not exist and discounts were therefore not appropriate. Pierre dealt with a New York SMLLC. The Service argued that because the SMLLC was treated as a disregarded entity under the check-the-box regulations, the petitioner's transfers of interests in Pierre LLC should be "treated" as transfers of cash and marketable securities, i.e., proportionate shares of the underlying assets of the Pierre LLC, rather than as transfers of interests in the Pierre LLC for purposes of valuing the transfers to determine Federal gift tax liability. 13 The petitioner argued that state law determined what property interest was transferred and under New York law, and since a member has no interest in the specific property of a

3 SMLLC under New York law, the petitioner properly valued the transferred interests. In Pierre, the Court held that the petitioner s SMLLC was not disregarded for gift tax valuation purposes under the "check-the-box" regulations of sections through , Proced. & Admin. Regs. Thus, a transfer by the petitioner of an interest in the petitioner s SMLLC was treated as such, rather than as the transfer of a proportionate share of the underlying assets owned by the LLC. Should Treasury Regulations Trump State Law? In its analysis, the Pierre court made a few observations relevant to the facts at hand. For instance: While we accept that the check-the-box regulations govern how a single-member LLC will be taxed for Federal tax purposes, i.e., as an association taxed as a corporation or as a disregarded entity, we do not agree that the check-the box regulations apply to disregard the LLC in determining how a donor must be taxed under the Federal gift tax provisions on a transfer of an ownership interest in the LLC. If the check-the-box regulations are interpreted and applied as respondent contends, they go far beyond classifying the LLC for tax purposes. The regulations would require that Federal law, not State law, apply to define the property rights and interests transferred by a donor for valuation purposes under the Federal gift tax regime. We do not accept that the check-the-box regulations apply to define the property interest that is transferred for such purposes. The question before us (i.e., how a transfer of an ownership interest in a validly formed LLC should be valued under the Federal gift tax provisions) is not the question addressed by the check-the-box regulations (i.e., whether an LLC should be taxed as a separate entity or disregarded so that the tax on its operations is borne by its owner). To conclude that because an entity elected the classification rules set forth in the check-the-box regulations, the long-established Federal gift tax valuation regime is overturned as to single-member LLCs would be "manifestly incompatible" with the Federal estate and gift tax statutes as interpreted by the Supreme Court. See sec We note that Congress has enacted provisions of the Internal Revenue Code, see secs. 2701, 2703, that disregard valid State law restrictions in valuing transfers. Where Congress has determined that the "willing buyer, willing seller" and other valuation rules are inadequate, it expressly has provided exceptions to address valuation abuses. See chapter 14 of the Internal Revenue Code, sections 2701 through 2704, which specifically are designed to override the standard "willing buyer, willing seller" assumptions in certain transactions involving family members. By contrast, Congress has not acted to eliminate entity-related discounts in the case of LLCs or other entities generally or in the case of a single-member LLC specifically. In the absence of such explicit congressional action and in the light of the prohibition

4 in section 7701, the Commissioner cannot by regulation overrule the historical Federal gift tax valuation regime contained in the Internal Revenue Code and substantial and well-established precedent in the Supreme Court, the Courts of Appeals, and this Court, and we reject respondent's position in the instant case advocating an interpretation that would do so. 14 The key take-away point from the excerpted portions of Pierre is that applicable state law creates legal interests and property rights for federal tax purposes, while the federal revenue acts designate what interests or rights, so created, shall be taxed. 15 Although the check-the-box regulations authorize the proposed entities to be ignored for federal income tax purposes, nothing in the Code or regulations authorizes or mandates that those entities should be ignored for purposes of the federal estate, gift and generation-skipping transfer taxes. 16 Thus, a person with similar circumstances as the taxpayers in the Opinions, albeit one with an iron stomach, could take on the Department using the rationale articulated in Pierre, so long as New York continues to have N.Y. LLC Law 601 on its books. Possible Solutions Without Litigation As noted above, one should be able to rely upon the decision in Pierre despite the Opinions issued by the Department. However, to avoid future protracted litigation, clients will demand an alternative. One way to avoid litigation is to have a partnership own the underlying condominium, whether a traditional partnership structuring with perhaps one or more limited partners and a general partner, or through the creation of an LLC making an election to be taxed as a partnership. Partnerships and multiple-member LLCs have their own set of separate issues, such as dealing with other partners/members and filing a partnership income tax return annually. Especially in the case of owning a single condominium unit, why would anybody want to put up with such a headache? Additionally, while one could follow the Opinions and opt to simply create a SMLLC and make the election to have it taxed as a corporation, this would entail its own sort of problems due to the basis step-up issues involved with corporations. Query whether the Opinions would differ if the taxpayer formed an LLC to serve as a 1% general partner of a limited partnership where the condominium transferee owned all of the limited partnership interests as the 99% partner? While the partnership is deemed not to exist under Federal law for income tax purposes, this result differs under the check-the-box regulations. What would be the result if the taxpayer's grantor trust is the 1 percent general partner? These variations still create an existing partnership for state law purposes. Conclusion

5 In Advisory Opinion (TSB-A-15(1)M May 29, 2015), the Department narrowly addressed a specific estate tax inquiry as it related to the facts presented by the Petitioner. Decisions regarding entity classification may have significant federal and state tax implications and filing requirements. Accordingly, taxpayers should make such decisions in consultation with their professional advisors This Akerman Practice Update is intended to inform firm clients and friends about legal developments, including recent decisions of various courts and administrative bodies. Nothing in this Practice Update should be construed as legal advice or a legal opinion, and readers should not act upon the information contained in this Practice Update without seeking the advice of legal counsel. Prior results do not guarantee a similar outcome. 1 N.Y. Tax Law 960(a). 2 N.Y. Real Prop. Law 339-g. 3 N.Y. Tax Law 951-a(c). 4 N.Y. Partnership Law 51; Estate of Havemeyer, 17 N.Y.2d 216 (1966). 5 Treas. Reg (a). 6 Treas. Reg (b)(1)(ii). 7 Treas. Reg (c)(1)(i). 8 Treas. Reg (b)(1)(i). 9 Treas. Reg (c)(1)(i). 10 Advisory Opinion (TSB-A-08(1)M October 24, 2008) at page N.Y. LLC Law T.C. 24 (2009) ( Pierre I ). Note that Pierre v. Commissioner, T.C. Memo, (May 13, 2010) ( Pierre II ) and its specific set of issues is not applicable to this particular commentary. For an in depth discussion on Pierre II, see Steve Akers, Akers on Pierre II, LISI Estate Planning Newsletter #1649, (June 2, 2010) at 13 Pierre, 133 T.C. at Pierre, 133 T.C. at See e.g., Knight v. Comr., 115 T.C. 506 (2000); U.S. v. Bess, 357 U.S. 51 (1958); Morgan v. Comr., 309 U.S. 78 (1940); Aquilino v. U.S., 363 U.S. 509 (1960); Aldrich v. U.S., 346 F.2d 37 (1965); McGehee v. Comr., 260 F.2d 818 (1958); and TAM Gopman, Estate Planning with S Stock: the Spreeze Transaction, 27 Est., Gft. & Tr. J. 155 (May 9, 2002).

6 Related Practices Real Estate Real Property Tax Planning & Appeals Tax Related Biographies Richard Bowers Jonathan E. Gopman Eric W. Olson Michael A. Sneeringer