Using Limited Liability Companies in Estate Planning
Since the repeal of the Florida corporate income tax (in 1996) relative to limited liability companies (LLCs), and the subsequent repeal of the Florida intangible tax (2006), the LLC has become the most popular entity in Florida and the entity of choice among estate planners.
An LLC is a hybrid business entity having characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are). An LLC, although commonly used as a business entity, is an unincorporated association which is not a corporation. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation. It is more flexible than a corporation, and it is well-suited for companies with a single owner, a single member limited liability company.
LLC members are subject to the same alter ego piercing theories as corporate shareholders. However, it theoretically is more difficult to pierce the LLC veil for lack of conformance with entity formalities because LLCs have almost no formalities to maintain. Membership interests in LLCs are also afforded some protection through the charging order mechanism afforded to partnerships. The charging order regime limits a creditor of a debtor-member to the debtor’s share of distributions, without conferring on the creditor any voting, ownership or management rights.
LLCs frequently are used to accomplish two important estate planning objectives. First, these entities facilitate gifts by individuals to their children and grandchildren, thereby minimizing the value of assets which ultimately are subject to estate taxation at death. Second, LLCs centralize management of the family property during and after the gifting process, affording the donor effective control over the assets and providing a level of asset protection from creditors.
Some of the notable non-tax benefits of using LLCs in estate planning are as follows:
- Providing for the consolidation and succession of management and control of family assets to improve the efficiency of the management of those assets. It should be noted, however, that this benefit can be better achieved through the use of a trust.
- Providing a streamlined mechanism for transfers of interests in family assets, thereby simplifying the gifting process.
- Maintenance of the ownership of certain family assets within the family through rights of first refusal.
- Protection of LLC assets from claims made against family members by third parties. However, it should be noted that Florida recognizes remedies in addition to the charging order in the context of single-member LLCs.
- Protection of the family members from claims arising out of the assets held by or operations of the LLC (i.e., protection from “inside liabilities”).
- Segregation of assets to preserve their status as separate property for purposes of equitable distribution in the event of a divorce. A trust may also be employed to provide this result.
- Providing a “guardianship substitute” for the ongoing management of family assets in the event of the mental incapacity of a family member. Again, a trust would better achieve this purpose if it is a primary focus of the client.
- Pooling of assets to maximize returns and to provide all family members with access to private investments that require a “qualified investor” under SEC rules.
- Establishing a family investment policy promoting the education of and communication among family members with respect to that investment policy.
Of course, in addition to the non-tax benefits of using LLCs in estate planning, there are also significant tax benefits. The primary tax benefit is derived from changes in value that results from discounts in the value of the member interests of the LLC for lack of marketability, minority interest and other matters that adversely affect the value of an asset because of its location, characteristics, etc., which helps a donor to “leverage” the gift tax annual exclusion, the lifetime gift tax exemption, or better enables a sale to a defective trust using an LLC. For purposes of valuing an LLC interest given to a child or grandchild or a sale to a defective trust that benefits 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 of the LLC and that the member’s interest cannot 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 the gift tax exemption or a sale to a defective trust transaction.
It is important to note that the IRS has challenged the discounts claimed with respect to LLCs and has attempted to bring the LLC assets back into the donor’s taxable estate. Therefore, the fact that an LLC generates valuation 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 entity.