FAMILY OWNED LLC's
Estate Planning BenefitsThe Managers of an FLLC can hold a small amount of the equity interest, yet retain complete managerial authority over the assets, even where the children/Members hold the majority of the equity interest. In an effort to maximize estate-planning efforts, a better result is achieved where the donor of the assets retains the Manager and non-Manager interests initially, but then gifts the non-Manager interest to children and grandchildren in increments that do not exceed the annual exclusion amount.2 Therefore, later generations slowly gain a greater interest in assets still controlled by the Manager of the FLLC, tax free. An added benefit from such a plan is that the gifted interests can be “discounted” due to lack of control or marketability, thus the actual value of what is gifted may well exceed the annual exclusion amount without triggering gift tax consequences.
Discounting an interest means valuing the interest based upon the monetary face value as well as any limitations on that interest that may make it worth less in the hands of a disinterested buyer. For instance, restrictions on the right to sell an interest in an FLLC make that interest worth less than its face value. This is potentially a HUGE estate tax savings feature. By gifting interests in the FLLC that have a face value of more than $11,000, but which are discounted in value to be gifts of an interest worth $11,000 or less, it is possible to shift more value each year under the annual gift exclusion then would be possible outside of the FLLC context. The one warning bell that goes off when using discounts is that the IRS looks very closely at them during an audit; therefore it is important to substantiate any discount taken, and ensure that the amount is reasonable.
One drawback to this approach results from the funding of the FLLC with highly appreciated property. When an interest in property is gifted the basis in that property is carried over to the recipient of the gift. In the case of highly appreciated assets in the FLLC, the recipients of the gifted membership interests are receiving the property tax-free; however the difference in the carry over basis from the fair market value of that property is quite large, and will result in high capital gains taxes when sold.
Asset ProtectionAs was briefly discussed above, the FLLC serves a dual purpose, as both an estate planning vehicle and an asset protection tool. To preserve ownership of the FLLC within the family, sale or transfer of interests in the FLLC is often restricted by means of the Operating Agreement. Such provisions, in conjunction with the limited liability granted by state law, provide significant creditor protection.
The Operating Agreement lays out the rules under which the FLLC operates. It dictates how and to whom an interest in the FLLC can be transferred, if it can at all.3 It also establishes the powers held by the Manager(s) regarding what types of distributions can be made, as well as whether they are purely in the Managers discretion or not. Operating Agreements include a multitude of different options, many of which can significantly impact whether or not the entity fulfills the purpose for which it was created. When forming an FLLC it is a good idea to consult a lawyer who can guide you through the complex drafting process and ensure that the Operating Agreement incorporates all the necessary provisions.
Unlike a corporation, in which a creditor can seize a debtor’s stock, a creditor generally cannot seize an ownership interest in an FLLC. Creditors holding a judgment against a Member of an FLLC, and not against the FLLC itself, are limited to a “charging order” against that Member’s interest in the FLLC. A charging order stipulates that any “capital distributions” of property or funds from the FLLC to the debtor are instead payable to the creditor to the extent of the unsatisfied judgment.
What makes this a successful asset protection device is that the creditor can only collect on the judgment against the FLLC Member when a “capital distribution” is made to that individual. Distributions are only made at the discretion of the Manager; therefore the creditor has little hope of ever collecting on the judgment without agreeing to a settlement. However, the term “capital distribution” does not encompass expense or salary payments. Therefore, a Manager can cease capital distributions in order to avoid collection by a Member’s creditor, but can still make payments in the form of salary, for example, which are beyond the creditor’s reach (assuming the Member does something to warrant the salary payment). The creditor cannot force the sale of FLLC assets or a Member’s interest, nor can it vote on behalf of the debtor/Member. The charging order is a creditor’s sole recourse against an FLLC, hence the Manager(s) of the FLLC dictate when (and if) the creditor gets paid.
The only way that the assets of the FLLC are put at risk is if the FLLC itself is liable to a creditor. Unlike an operational LLC, however, the FLLC is never used as a true business entity, and therefore should not be engaging in any activity that could jeopardize its assets from a liability standpoint.
By setting up an FLLC before any problems exist, it is possible to protect valuable assets and retirement funds from potential disaster. Where appropriate, such a tool can also be used as a means of transferring assets to children and grandchildren tax free, and without making use of the Unified Credit. Clearly the Family Owned LLC is a versatile tool that should be considered when discussing asset protection or estate planning with your attorney.
1. A Manager is not required to hold an ownership interest as a Member.
This article is designed to introduce you to the importance of asset planning and the need to protect your wealth. It is published as part of general information series for visitors to our web site. If you need to pursue an asset protection strategy, make sure you do it with the assistance of a professional.
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