Editor’s note: Stuart Dorsett is a member of the Ward and Smith law firm. His practice involves tax and business succession planning for the owners of technology, entrepreneurial, and other closely-held businesses, including tax planning, estate planning, estate administration, and related services

RALEIGH, N.C. – Founders and early employees of entrepreneurial companies always believe their stock will be worth a fortune some day. As a result, they often want to be able to get some of that stock to their children or other family members so those members can benefit from the windfall that comes with the sale of the company or in an IPO. Of course, not all the dreams will come true and not all such stock will be worth a fortune, but for the stock that does become valuable, a little advance planning can save a lot of taxes and heartache.

Use of an LLC

One of the best alternatives in this regard is the creation of a limited liability company ("LLC"), which can facilitate gifts of stock by individuals to their children while minimizing the value of assets that ultimately will be subject to estate taxation at death. By placing the stock in an LLC managed by the stockholder giving the gift (who is called the "Donor"), effective control over the voting of the stock during and after the gifting process remains with the Donor. It should be noted, however, that if the company is an "S" corporation, an LLC cannot be used because an LLC cannot own voting "S" corporation stock. Nevertheless, a similar result may be obtained by recapitalizing the "S" corporation stock into voting and non-voting shares, and giving the non-voting shares to the children. This article assumes that the company stock contributed to the LLC is "C" corporation stock.

The Donor’s continued control of the stock is very important in convincing the company to allow stock to be transferred from the founder or employee to others, including the LLC, because most early stage companies want their stock to be controlled by persons they know and in whom they have confidence. Companies certainly do not want the stock in the hands of a 12 year old. For this reason, most entrepreneurial companies place restrictions on the transfer of their stock and allow transfers only when it can be shown that the transferee cannot cause harm to the company. The LLCs discussed below can be one solution to this problem.

Operation of an LLC

An LLC is a form of business entity authorized by statute. The owners of the LLC are "members." The management of the organization is vested in one or more "managers." There are two types of LLCs: "member-managed" LLCs which operate much like a general partnership with all members automatically serving as managers, and "manager-managed" LLCs with the management being separate from ownership. Either a member or a non-member, such as a professional business executive, can be designated as a manager, and membership does not automatically bestow management powers.

So-called "family LLCs" take advantage of this separation of control from ownership. Using a "manager-managed" LLC, the members are both the children and the parents. The children-members have no right to participate in the management of the LLC, may not withdraw unilaterally and receive cash for their membership interest in the LLC, and are subject to restrictions on the transfer of their membership interest. In contrast, the parent-members, who are also the managers, control all business decisions for the LLC, including the power to buy, sell, trade, and operate the LLC assets without interference by other family members. In other words, they control what happens to the company stock that is put into the LLC.

Benefits

Placing stock in an LLC achieves several important goals for both gift and estate planning. First, as discussed above, it allows a parent-shareholder to retain complete managerial authority over the gifted assets, i.e., the company stock, even if children or grandchildren receive 99% of the equity interest in the family LLC.

Second, a family LLC facilitates the gifting process by simplifying the annual paperwork. Use of the tax annual exclusion to transfer company stock over time to children typically requires the parent or grandparent to execute a separate stock transfer process each year. In contrast, the parent can transfer all of the stock into a family LLC with a single transfer and then each year sign a simple unrecorded assignment giving the children an additional percentage membership interest in the LLC.

Third, a family LLC protects the LLC assets from claimants (including spouses) against the LLC members. A creditor suing a spendthrift member of a family LLC cannot attach the underlying assets owned by the LLC, but may obtain only an interest in distributions received or to be received by the member. As the parent manger controls the amount and timing of distributions to LLC members, the LLC interest is an unattractive target.

Fourth, through valuation discounting, a family LLC "leverages" a donor’s gift tax annual exclusion and the lifetime gift tax exemption. For purposes of valuing a family LLC interest given to a child or grandchild, the value of the underlying assets is discounted to reflect the fact that the donee member has no control over the business decisions for the LLC and that the member’s interest cannot easily be sold to a third party for cash.

Finally, gifting the stock now, through the LLC, removes all future appreciation in the value of the stock from the donor parent’s taxable estate, If there is a future liquidity event (e.g., an IPO or a sale to another company) at a substantially increased value, all of that appreciation accrues to the children, free of any gift or estate tax.

An Example of the Family LLC as an Estate Planning Tool

An example illustrates the use of a family LLC in an estate planning context. Assume that the parent owns stock currently worth $1,000,000, and that the parent forms a family LLC and names himself or herself as the member manager. The parent subsequently contributes all the stock to the family LLC. Thereafter, the parent makes annual exclusion gifts to four children and eight grandchildren.

The gift tax annual exclusion allows a husband and wife to make a joint gift of $24,000 to each child and grandchild. Before taking into account the discounts for lack of control and lack of marketability, a $24,000 gift would amount to 2.4% of the LLC membership interest. Assuming a combined 40% valuation discount, however, a $24,000 gift equates to a 4% interest in the LLC. Accordingly, with the use of a family LLC, a husband and wife could give away 48% of the LLC to their family members in any one year free of gift tax (as opposed to only 28.8% of the property without the use of the family LLC). If these annual gifts continue until the children and grandchildren own 99% of the LLC interests, the husband and wife effectively will have removed the stock (and its future growth in value) from their taxable estates at a discounted value, potentially saving hundreds of thousands of dollars in estate taxes at the death of the survivor, while retaining control of the stock during their lives.

Documentation Important

To avoid challenge by the IRS, it is important that the LLC documentation be prepared correctly, that competent appraisers be hired to appraise both the underlying assets and the appropriate valuation discounts, and that the managers and members of the LLC "play by the rules" by observing the formalities of the business entity. The parent manager must maintain separate books and records for the LLC, allocate any income earned by the LLC assets to a separate LLC account, and file income tax returns for the LLC.

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

Stuart Dorsett’s practice involves tax and business succession planning for the owners of technology, entrepreneurial, and other closely-held businesses, including tax planning, estate planning, estate administration, and related services. Mr. Dorsett is certified by the North Carolina State Bar as a Board Certified Specialist in Estate Planning and Probate Law. Questions and comments can be sent to sbd@wardandsmith.com.