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A Disregarded Entity Is Not Disregarded in Valuing an LLC Successor Member Interest. (Parker Tax Publishing August 27, 2014)

The Tax Court denied the IRS's motion for summary judgment that (1) the actuarial tables under Code Sec. 7520 do not apply to value a successor member interest in property contributed to a university, and (2) a partnership failed to substantiate the value of the successor member interest with a qualified appraisal. RERI Holdings I, LLC v. Comm'r, 143 T.C. No. 3 (8/11/14).

RERI Holdings I, LLC (RERI) was formed as a Delaware limited liability company on March 4, 2002, and was taxed as a partnership for federal tax purposes. It was dissolved on May 11, 2004. On its 2003 partnership tax return, RERI reported as a charitable property contribution its transfer to the University of Michigan of 100 percent of the remainder estate in the membership interest in H.W. Hawthorne Holdings, LLC (Holdings). The contribution amount was approximately $33 million. Holdings, RERI reported, owned all of the membership interest of RS Hawthorne, LLC, a single purpose, single member Delaware limited liability company. RS Hawthorne was described by RERI as owning "the fee simple absolute in a parcel of land improved as an AT&T web hosting facility" located in Hawthorne, California.

The Hawthorne property had come to be owned by RS Hawthorne in 2002, pursuant to RS Hawthorne's execution of a real estate contract that it had received from Red Sea Tech I, Inc. (Red Sea). Initially, Red Sea was the sole member of Holdings. On February 7, 2002, Red Sea created two temporal interests in its membership interest in Holdings a possessory term of years member interest (TOYS interest) and a future, successor member interest (SMI). The TOYS interest began in February 2002 and is to run almost 18 years, through December 31, 2020. The SMI becomes possessory on January 1, 2021, on termination of the TOYS interest.

RS Hawthorne purchased the Hawthorne property from InterGate LAII, LLC (Intergate), for approximately $42.4 million. To fund that purchase, RS Hawthorne borrowed approximately $43.7 million, signing a promissory note and securing its repayment obligation by, among other things, a mortgage and an "Absolute Assignment of Rents and Lease." The promissory note called for payments in installments (including interest) over a period of 14 years and three months (February 15, 2002 May 15, 2016), with the final payment, due May 15, 2016, constituting a balloon payment of $11.8 million. AT&T occupied the Hawthorne property pursuant to a triple net lease between it and Intergate. That lease had begun on December 1, 2000, and was for a term of 15-1/2 years, until May 31, 2016, with AT&T having three renewal options.

On February 7, 2002, RJS Realty Corp. purchased the SMI for approximately $1.6 million. The following month, RJS sold the SMI to RERI for almost $3 million. RERI paid $1.88 million in cash and executed a nonrecourse promissory note for the balance.

On August 27, 2003, RERI's principal investor, Stephen Ross, pledged that he would make a gift of $4 million (later increased to $5 million) to the University of Michigan for the benefit of its athletic department. Under the gift agreement, Mr. Ross pledged and agreed to transfer, or to have transferred the SMI to the university no later than December 31, 2003. Upon receiving the SMI, the university was to hold it at a nominal value of $1 and credit Mr. Ross's pledge in the amount of $1. The university agreed to hold the SMI for a minimum of two years, after which it could sell the SMI. After the two-year period expired, and after obtaining its own appraisal of the remainder interest in the Hawthorne property as of July 20, 2005, which valued that interest at $6.5 million (on the basis of a reversion value of the Hawthorne property after 15 years), the university sold the SMI to HRK Real Estate Holdings, LLC (HRK), a Delaware LLC indirectly owned by RERI and an associate, for $1.94 million.

In September 2003, RERI retained Howard Gelbtuch of Greenwich Realty Advisors to appraise a hypothetical remainder interest in the Hawthorne property. Mr. Gelbtuch concluded that the fair market value of the leased fee interest in the Hawthorne property as of August 28, 2003, was approximately $55 million and that the investment value of a hypothetical remainder interest in that property vesting on January 1, 2021, was almost $33 million. Mr. Gelbtuch determined that value by multiplying his valuation of the underlying leased fee interest by an actuarial factor taken from the tables issued under Code Sec. 2031 and Code Sec. 7520. In his appraisal report, Mr. Gelbtuch stated that he was "advised that the applicable Remainder Interest Actuarial Factor as provided in Section 7520 of the Internal Revenue Code of 1986 for the month of contribution is .598793705." Mr. Gelbtuch appraised the leased fee interest assuming that it was "free and clear of any and all liens or encumbrances."

The IRS determined that RERI overstated the value of the contribution by over $29 million and assessed a tax deficiency and an accuracy-related penalty on the underpayment of tax. The IRS argued that Mr. Gelbtuch appraised the wrong property because it was the SMI that should have been appraised and not the Hawthorne property. The IRS also argued that Reg. Sec. 1.7520-3(b)(2)(iii) precludes application of the Code Sec. 7520 tables to determine the value of the SMI. Additionally, the IRS argued that, because of the two-year hold-sell requirement, the SMI was a restricted beneficial interest within the meaning of Reg. Sec. 1.7520-3(b)(1)(ii) to which the Code Sec. 7520 tables cannot be applied. The IRS also said that RERI failed to substantiate the value of its contribution with a qualified appraisal.

RERI defended Mr. Gelbtuch's application of the Code Sec. 7520 tables to the fair market value of the Hawthorne property on the ground that both Holdings and its wholly owned subsidiary, Hawthorne, which owned the Hawthorne property, were LLCs wholly owned by Red Sea and, therefore, were disregarded entities pursuant to Reg. Sec. 301.7701-3(b)(1)(ii). RERI argued that the Tax Court's opinion in Pierre v. Comm'r, 133 T.C. 24 (2009), in which the court held that an LLC constituting a disregarded entity under Reg. Sec. 301.7701-3(b)(1)(ii) may not be disregarded for purposes of valuing the gift of an interest therein, applies only for federal gift tax purposes, not for purposes of determining the income tax deduction for a charitable contribution of an interest in a disregarded LLC, the sole asset of which is an interest in real estate. The IRS rejected that argument, saying that the Tax Court's rationale in Pierre was equally applicable to the instant case.

The Tax Court agreed with the IRS that the rationale in Pierre was equally applicable in this case that is, an LLC constituting a disregarded entity under Reg. Sec. 301.7701-3(b)(1)(ii) may not be disregarded for purposes determining the income tax deduction for a charitable contribution of an interest in that LLC. However, the court denied the IRS's motion for summary judgment and concluded there were numerous issues left to be resolved. Thus, it did not rule that the Code Sec. 7520 tables could not be applied in valuing the property at issue. The court agreed with the IRS that the property transferred to the university was the SMI. However, the court said, Mr. Gelbtuch's appraisal of the hypothetical remainder interest in the Hawthorne property, rather than of the SMI, did not, in and of itself, prevent his appraisal from constituting a qualified appraisal. The court also determined that Mr. Ross's right to renege on all or part of his $5 million pledge to the university, should it violate the two-year hold-sell requirement, raised an unresolved issue of state law and, therefore, an issue of material fact as to the economic impact on the university had it violated that requirement. The court determined that there were additional issues of material fact concerning the adverse impact, if any, on the value of the SMI in the university's hands should it either violate or, alternatively, observe the two-year hold-sell requirement. Those unresolved factual inquiries, the court said, are relevant because an appraisal's failure to take into account the terms of a restriction described in Reg. Sec. 1.170A-13(c)(3)(ii)(D)(1) does not automatically result in the failure of that appraisal to constitute a qualified appraisal. Such a result is justified, the court observed, only if the omission relates to a restriction that reasonably can be said to have some adverse impact on the value of the donated asset. Otherwise, the omission may be disregarded, the court said. Therefore, the court also denied the IRS's motion to rule that RERI failed to substantiate the value of the SMI with a qualified appraisal.

For a discussion of what constitutes a qualified appraisal for purposes of a charitable contribution deduction, see Parker Tax ¶84,198. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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