CANAL CASE SPARKING DEBATE

Practitioners are debating the implications of the recent Tax Court decision in Canal Corporation and Subsidiary, et. al., v. Commisioner of Internal Revenue, 135 T.C. No. 9 (8-5-10), which involved an LLC contribution of a corporate subsidiary's balance sheet to a new LLC in exchange for a small residual interest, and the LLC's subsequent distribution of financing proceeds that were distributed to the contributing member under an arrangement whereby the member had agreed to indemnify the other member and the LLC for the distribution indebtedness.  The Tax Court found the member had insufficient assets to support the indemnity obligation and the indemnity covenant could not be relied upon to allocate the LLC debt to the contributing member, and that the disguised sale rules under IRC Section 707(a)(2)(B) applied.  The Tax Court also imposed a substantial understatement penalty, holding that no reliance could be placed upon the tax opinion issued by the taxpayer's advisor due to bias resulting from the opinion writer having participated in the structuring of the transaction and therefore lacking sufficient objectivity to provide a basis of reliance.  See the link below for a copy of the case.

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FAMILY LLC TRANSER RESTRICTIONS INVALID UNDER SECTION 2703

On September 1, 2010 in Fisher v. United States, No. 1:08-cv-00908, the United States District Court for the Southern District of Indiana held that family LLC transfer restrictions must be ignored under IRC Section 2703 in the valuation of gifts of family LLC units by the taxpayers to their children.  The basis for the ruling was that the LLC was not a bona fide business because the lake front lot that was it's principal asset was not a business.  The District Court relied on the decision in Holman v. Commissioner, 601 F.3d 763 (8th Cir. 2010) which held that a family LLC passively holding publicly traded stock served no bona fide business purpose for purposes of respecting transfer restrictions under IRC Section 2703.  The determination did not eliminate the application of valuation discounts for lack of control or marketability, but it did require that any gift valuation discounts not take the LLC's operating agreement transfer restrictions into account.  This case reflects the Service's ongoing challenge to family LLC estate and gift transfer valuations, particularly in cases where the family LLC holds nothing but passive investment assets without any specific investment criteria or focus.