Editor’s Note: Stuart B. Dorsett is a member of the Trusts and Estates Practice Group at Ward and Smith, P.A. and is a Board Certified Specialist in Estate Planning and Probate Law and a Fellow of the American College of Trust and Estate Counsel.

Limited liability companies (“LLCs”) and limited partnerships (“LPs”) are frequently used to accomplish two important estate planning objectives. First, these entities can facilitate gifts by you to your children and grandchildren, thereby minimizing the value of your assets subject to estate taxation at your death. Second, LLCs and LPs can centralize management of your family property during and after the gifting process, affording you effective control over the assets and providing a level of asset protection from creditors. Operationally, LLCs and LPs are closely related. However, because LLCs provide limited liability to all owners (including the manager), and because the management structure of an LLC is more flexible, in North Carolina LLCs are generally favored over LPs for estate planning purposes.

Operation of an LLC

An LLC is a form of business entity, the owners of which are “members.” LLCs typically elect to be treated as a partnership for income tax purposes. The management of an LLC is vested in one or more “managers.” A “member managed” LLC operates much like a general partnership, in that one or more of the members serve as managers. For estate planning purposes, so-called “family LLCs” (“FLLCs”) are generally “manager managed” LLCs, where management is segregated from ownership.

With a manager-managed FLLC, those members who are not managers (e.g., your children and grandchildren) have no right to participate in the management of the FLLC, may not withdraw unilaterally and receive cash for their membership interests, and are subject to restrictions on the transfer of their membership interests. In contrast, those members who are managers (e.g., you, your spouse, a financial institution, or anyone else you select) control all of the assets of and all business decisions for the FLLC without interference by other family members.

Benefits of an FLLC

An FLLC can provide you and your family with both tax and non tax benefits, which may be summarized as follows:

Non-Tax Benefits

• Consolidation and succession of management and control of your family assets to improve the efficiency of the management of those assets;

• Arbitration or other dispute resolution mechanisms of family disputes regarding the FLLC;

• A streamlined mechanism for transfers of interests in your family assets, thereby simplifying the gifting process;

• Maintenance of the ownership of certain family assets within your family through rights of first refusal;

• Protection of FLLC assets from claims made against your family members by third parties;

• Protection of your family members from claims arising out of the assets held by the FLLC;

• Segregation of assets to preserve their status as “separate property” in the event of a divorce by you or any family member;

• Ongoing management of your family assets in the event of the mental incapacity of a family member;

• Pooling of your family assets to maximize returns and to provide access to private investments that require a “qualified investor” under SEC rules; and,

• Establishment of a family investment policy.

Tax Benefits

The tax benefits are derived from valuation discounting, which allows you to “leverage” your gift tax annual exclusion and your lifetime gift tax exemption. For purposes of valuing a non-controlling FLLC interest given to a child or grandchild, the value of the underlying assets is discounted because your child or grandchild has no control over the business decisions for the FLLC and that interest cannot easily be sold to a third party for cash.

The cumulative effect of these lack of control and lack of marketability discounts may be as high as 50%, which effectively doubles the utility of your gift tax exemptions. For example, if you form an FLLC to hold real estate worth $3,000,000, and a 50% non-controlling membership interest is then transferred to a child, if the combined valuation discounts equal 40%, then the value of the gift, for gift tax purposes, is not $1,500,000, but only $900,000.

It is important to note that the IRS has challenged the discounts claimed with FLLCs and has attempted to bring the FLLC assets back into the donor’s taxable estate. Therefore, the use of an FLLC to generate discounts is not without risk. However, the cases in which the IRS has prevailed have involved “bad facts,” such as deathbed transfers and the failure to observe the legal formalities of the FLLC. Accordingly, while no guarantees can be given, an FLLC that is properly organized and managed should survive scrutiny by the IRS.

Administration of FLLCs

Even the most meticulously organized FLLC is vulnerable to attack by the IRS or third parties if your family members do not operate and maintain it in a way that supports and achieves the FLLC’s non-tax purposes. Accordingly, an FLLC should be administered as follows:

• Any distributions to your family members who are owners of the FLLC should be made pro rata.

• The terms of the FLLC operating agreement with respect to its management and distributions to its owners should be strictly observed.

• Consideration should be given to the payment of compensation to the manager of your FLLC to reflect the services provided.

• While most operating agreements do not require annual meetings of the members, the better practice is to hold annual meetings and to document those meetings with minutes reflecting the discussions of your FLLC’s business.

• The assets of your FLLC should be segregated from personal assets; separate bank accounts and investment accounts should be maintained for your FLLC; and detailed separate records should be maintained of all FLLC transactions, income, and expenses.

• Partnership income tax returns should be filed annually for your FLLC.

• “Personal use” assets, such as residences, generally should not be transferred to your FLLC.

• Funding your FLLC with assets requiring active management will help to support the centralized asset management purpose of your FLLC.

The bottom line is that, if you want the IRS and the courts to treat your FLLC as a legitimate business enterprise, separate and apart from your personal assets, you need to make sure that your actions in operating the FLLC are consistent with your FLLC’s legitimate business purposes.

Conclusion

The appropriateness of an FLLC for your family must be evaluated by a competent attorney, taking into account your family’s particular circumstances. As a general proposition, however, individuals with a high net worth can achieve significant estate and gift tax savings through the use of an FLLC, without sacrificing managerial control of family assets.

© 2014 Ward and Smith, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Stuart B. Dorsett practices in the Trust and Estates Practice Group, where he assists clients in the areas of estate planning, estate administration, business succession planning, and asset protection planning. Comments and questions may be sent to sbd@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.