ESTATE PLANNING WITH FAMILY LLCS AND FAMILY LIMITED PARTNERSHIPS
Estate Planning with Family LLCs or FLPS is a method of income tax, estate tax, estate planning and asset protection planning. It is a concept used as a method of protecting your assets and passing them on to your family members.
It is often practical for families to form a limited partnership (LP) or limited liability company (LLC) to hold their family business, real estate or other assets for a legitimate business purpose. For wealthy families, especially those whose business or real estate portfolio is rapidly appreciating, it is often non-business purposes — such as tax planning, creditor protection planning and succession planning — that ultimately compel them to choose the family limited partnership as their preferred organizational structure.
Limited Liability Companies and Limited Partnerships
Forming limited partnerships (LPs) or limited liability companies (LLCs) is a common avenue for estate planning.
LLCs and LPs allow wealthy persons to give gifts to their family members utilizing valuation discounts. They are also a method for shifting income to other family members, assuming that certain tax law restrictions are satisfied. This reduces the assets values and avoids the increase in value of a parent’s estate for estate tax purposes. Income can be shifted to lower tax bracket family members and provide for their needs. As an important achievement, these entities help manage a family’s property after it has been gifted. They also allow the donor to control the assets and protect them from creditors.
Limited partnerships and limited liability companies are similar in nature. However, below I will discuss the differences. Sometimes one is more advantageous than the other, depending on the circumstances.
What Is an LLC?
LLCs are hybrid legal entities that combine characteristics of both partnerships and corporations. LLC owners are called members. LLCs are designed to protect a member’s personal assets, such as homes and cars, from liability in case of lawsuits or debts against the LLC.
An LLC is somewhere between a corporation and a partnership lies the limited liability company (LLC). This hybrid legal entity is beneficial not just for small-business owners but is also a powerful tool for estate planning. If you want to transfer assets to your children, grandchildren or other family members—but are concerned about gift taxes or the burden of estate taxes your beneficiaries will owe upon your passing—an LLC can help you control and protect assets during your lifetime, keep assets in the family, and reduce taxes owed by you or your family members.
Unlike corporations, LLCs can generally be operated the way members deem necessary. When the members of an LLC also serve as managers, the LLC is very similar to a general partnership. LLCs differ from typical business entities in the way that the profits and losses of an LLC are reported on the member’s personal tax returns. In addition to being advantageous to small-business owners, the hybrid nature of LLCs makes them a good choice for estate planning purposes. For income tax purposes, LLCs will usually choose to be treated as partnerships.
An LLC created for estate planning will typically be manager-managed, which means that not all of the owners will manage the LLC.
Family LLC estate planning provides several benefits, including:
- Member personal assets property protection
- Transfer of LLC ownership interests rather than direct LLC assets to family members
- Estate and Gift Tax reduction through the use of valuation discounts, transfer of future appreciation in LLC assets away from the parent to the children, and the transfer of income away from the parent to the children
- By making gifts of LLC or FLP interests to children, parent is also transferring out of their estate FUTURE APPRECIATION in value of entity assets. This is often the largest benefit of all if expected and actual appreciation in value are substantial over the following years.
Why Would I Want an LLC for Estate Planning?
The primary reason to form an LLC with your children is the reduction of estate taxes that must be paid on at your death, if you are the parent who creates the LLC. With a family LLC, you can also transfer assets to your children during your lifetime without paying gift taxes or incurring reduced gift tax liablity.
In fact, most people form a family LLC to avoid the estate tax. Though, the law requires strong, valid and sustainable business, non tax reasons for the formation of an LLC and the transfer of LLC units to children.
Note: the forty percent estate tax rate only applies to estates that are worth over $10,000,000 adjusted annually by inflation. Below that amount, you will not need to pay the estate tax. Gift tax only results when the parent gives away more than the lifetime estate and gift tax exemption mentioned above.
Family Limited Partnerships (FLPS)
But for a few differences, the LLC discussion applies to FLPS.
Uses and Pitfalls of FLPS and FLLCs
If you have a high net worth, a family LLC or limited partnership can be a good estate planning solution. However, these entities are often challenged by the IRS because they allow you to transfer assets between family members while reducing transfer taxes. If you create a business entity correctly, you will shield your valuable assets from transfer taxes. If you want to successfully reduce your potential transfer taxes, you have to make sure that your family business entity is properly managed and formed for a legitimate reason not related to taxes.
The family limited partnership (LP) or limited liability company (LLC) is a gifting and asset protection vehicle that can enable someone to make gifts of units (or interests) to children (or irrevocable trusts for their benefit) while maintaining management and control of the LP or LLC as its General Partner or Manager.
As an example of how this strategy could be used, you could create an LP or LLC. Then, the you, as the initial partner or member make contributions of cash and/or other property to the LP or LLC. The LP or LLC is often structured so that you initially own all of the partnership interests or membership units. The partnership interests or membership units would have a right to vote or control the LP or LLC.
Following the creation of the LP or LLC, you could gift the LP or LLC interests to your children (or trusts for their benefit) and admit the transferee(s) to the LP or the LLC as a result of gifts of the LP or LLC interests. Generally, it’s possible to value the gifted LP or LLC interests for gift tax purposes using discounts to the underlying fair market value of the LP or LLC’s assets. The basis for these valuation discounts is lack of voting rights and control afforded to the members and restrictions on transferability of the partnership interests or membership units that would be included in the LP agreement or LLC operating agreement.
To justify such discounts, or to determine the fair market value of the gifted interests where the LP or LLC holds illiquid assets, have the value of gifted units determined by a professional business appraiser. A written appraisal must be filed with the gift tax return. The gift tax return is required to be filed by April 15 of the year following the year of the gift, even if the gift is valued within the annual exclusion amount.
Additional considerations are as follows:
- In contrast to an irrevocable trust, the General Partner of the LP or the Manager of the LLC with two important exceptions can control exclusively the investment policy of the LP or LLC. If the interests are gifted to the children or trusts for their benefit, you may be restricted from having exclusive power over decisions relating to distributions from the entity or liquidation of the entity to avoid inclusion of the transferred interests in your estate upon your death. To avoid this, name an independent, unrelated special manager or partner or have a supermajority of unrelated, uncontrolled partners or members to make these decisions. Alternatively, you could sell the interests to the children or their trusts for adequate consideration to avoid the loss of control over these important decisions.
- In general, the General Partner of the LP or the Managers of an LLC could be subject to a “business judgment” rule that is more lenient than a “prudent person” or “prudent investor” standard generally applicable to trustees. While a trust instruments give trustees broader investment powers than those provided under the prudent person rule, an LP or LLC may be the more appropriate vehicle to hold or reinvest in an undiversified portfolio of relatively high-risk investments. Nevertheless, the General Partner or Managers will have fiduciary duties owed to the other partners or members, which duties include the duties of loyalty and care that normally apply to trustees.
- The family LP or LLC vehicle can make it easier to make gifts of interests in property over a period of years.
- In general, gain is not recognized on the contribution of appreciated property to an LP or LLC, provided that the LP or LLC is not an “investment company” within the meaning of the tax law. Transfers of appreciated property that result in diversification to the transferor will trigger recognition of gain. Thus, the strategy should be implemented in a manner that does not result in the LP or LLC meeting the definition of an investment company, or, alternatively, in a manner that does not result in diversification.
Advantages and Disadvantages of FLLCs and FLPs
The following are some advantages and disadvantages to the family LP or LLC approach:
- Subject to the exceptions described above relating to voting for distributions and liquidations, the General Partner of the LP or the Manager of the LLC will be able to control the activities of the entity.
- The LP or LLC can make investments in other entities, such as a new venture (but cannot own an interest in an S corporation).
- The LP or LLC provides centralized management.
- An LP or LLC interest is somewhat protected against the claims of the member’s creditors.
- LP or LLC’s are not taxable entities for income tax purposes (except California does impose a LLC gross receipts tax).
- A limited liability company (LLC) can be a useful legal structure with which to pass assets down to your loved ones while avoiding or minimizing estate and gift taxes.
- A family LLC allows your heirs to become shareholders who can then benefit from the assets held by the LLC, while you retain management control.
- The tax benefit of the LLC lies in the fact that the value of the shares transferred to heirs can be discounted quite steeply, often up to 40% of their market value.
- Complexity and additional costs.
- the courts have consistently sustained IRS challenges to FLP’s (and FLLCs) where the formalities were not followed and in other circumstances that require careful planning.
- Treasury and Congress have contemplated major changes to these rules over the years that would severely restrict the ability to engage in valuation discounting of gifts or other transfers of minority interest within a family group. As a result, and without much advance notice, the benefits of using this technique may be limited by a significant change in these rules.
Why Would I Want an LLC for Estate Planning?
You probably want as much of your wealth as possible to stay in your family once you’re gone. Establishing a family LLC with your children allows you to effectively reduce not only the estate taxes your children would be required to pay on their inheritance, but it also allows you to distribute that inheritance to your children, during your lifetime, without being hit as hard by gift taxes. All of this while providing the ability to maintain control over your assets. It’s a win-win for you and your children.
If you are attempting to avoid estate taxes, the 40% federal estate tax only takes effect if an individual’s estate is valued over $10 million (adjusted annually by inflation). Estates worth less than this are considered exempt from the tax. Gift taxes, however, go into effect after $15,000 is transferred in a single year if the giver is unmarried (married couples can jointly give $30,000). This total resets each year, and the taxes are owed by the person giving rather than receiving the amount. This limit applies per recipient, so giving $15,000 to each of your three children and five grandchildren would not incur gift taxes.
Also, keep in mind: If you exceed the $15,000 per year annual gift tax exclusion limit, there is a lifetime cap of $10 million (adjusted by inflation). After that, the gift tax becomes 40%. Before you reach the cap, each amount given over the $15,000 limit is deducted from your lifetime cap, bringing you closer to the 40% tax rate.
How Does a Family LLC Work?
In a family LLC, the parents maintain management of the LLC, with children or grandchildren holding shares in the LLC’s assets, yet not having management or voting rights. This allows the parents to buy, sell, trade or distribute the LLC’s assets, while the other members are restricted in their ability to sell their LLC shares, withdraw from the company or transfer their membership in the company. In this way, the parents maintain control over the assets and can protect them from financial decisions made by younger members. Gifts of shares to younger members do come under the gift tax, but with significant tax benefits that allow you to give more, plus lower the value of your estate.
After you have established your family LLC according to your state’s legal process, you can begin transferring assets. You then decide on how to translate the market value of those assets into LLC units of value, similar to stock in a corporation. Now you can transfer ownership of your LLC units to your children or grandchildren, as you wish. Here’s where the tax benefits really come into play: If you are the manager of the LLC, and your children are non-managing members, the value of units transferred to them can be discounted quite steeply, often up to 40% of their market value. This discount is based on the fact that without management rights, LLC units become less marketable. Now your family can receive an advance on their inheritance, but at a lower tax burden than they otherwise would have had to pay on their personal income taxes, and the overall value of your estate is reduced, resulting in an eventual lower estate tax when you pass away.
The ability to discount the value of units transferred to your children also allows you to give them gifts of discounted LLC units, thus going beyond the current $15,000 gift limit without having to pay a gift tax. For example, if you wish to gift one of your children non-management shares of LLC units that are valued at $1,000 each, you can apply a 40% discount to the value (bringing the value of each unit down to $600). Now, instead of transferring 15 shares before having to pay a gift tax, you can transfer 25 shares. In this fashion, you can give significant gifts without gift taxes, all while reducing the value of your estate and lowering the eventual estate tax your heirs will face.
What Can I Transfer Into an LLC?
You can transfer just about any business asset into an LLC. Then, you can pass those assets along to your children and grandchildren. Typical assets include:
- real property
- business assets
- investment assets
Why and how do we use LP’s (limited partnerships) and LLCs (limited liability companies taxed as a partnership) for estate planning?
- Entity ownership of assets is better than individual/fractional ownership
- Real estate tax and transfer tax freezes, IRS Chapter 14 Rules anti-abuse regulations, valuation discounts.
- Non-Property/Transfer Tax Reasons:
- Asset protection,
- facilitates interest transfers,
- exempt annual gifts $15,000,
- centralized management,
- private resolution of disputes,
- allows retaining control,
- continuity of entity because the entity survives the death of a member, ease of probate,
- preserve step-up in basis,
- self-employment tax issues.
- When individual/fractional ownership better than entity ownership
- Avoid formation and maintenance costs, franchise/gross receipt taxes, flexibility in structuring.
Why prefer entities taxed as a partnership, such as a limited partnership (“LP”), a limited liability company taxed as a partnership (“LLC-P”) or a limited liability company taxed as a disregarded entity (“LLC-D”) for estate planning purposes over corporate entities and other entities taxed as a corporation, including limited liability companies taxed as an “S” corporation (“LLC-S’s”) and limited liability companies taxed as a “C” corporation (“LLC-C’s”)?
- One level of taxation –
- no double taxation,
- special allocations of profits and losses for partnership entities
- for inside and outside step-up in basis (754),
- tax-free transfer of property to and from the entity.
- Transfers to an entity taxed as a corporation may be taxable unless §351 applies.
- Losses deductible by members up to their basis in membership interest (basis includes LLC debt) ownership.
- No limit on the type of members who can hold ownership interests such as apply to ‘S’ corporations.
- No restrictions on the types (classes) of membership interests that may be issued. ‘S’ corporations can only issue one class of stock.
- Asset protection: Reverse alter ego (outside liability) protection better for an LLC.
Why prefer to use partnership entities such as LP’s and LLC-P’s over trusts?
- To avoid compressed income tax rates on trusts. An irrevocable accumulation trust will be taxed at the highest marginal rate on income in excess of $9800. The pass-through partnership entities such as LP’s and LLC-P’s allow income to pass through to its members whether or not the income is distributed. Some of these members will likely be in lower tax brackets than the granting, donor or senior generation.
- To provide for private resolution of disputes, state law limits a grantor’s right to restrict the remedies of beneficiaries (see Probate Code Section 21300 et seq.). LP’s and LLC-P’s may use arbitration clauses to force members and the entity to resolve disputes in less expensive and time consuming manners.
- To reduce the rights of non-members and non-family members to acquire interests. Divorces and creditors can lead to problems with outright ownership of trust interests by outside parties. LP’s, LLC-P’s and LLC-D’s can limit the rights of in-laws or creditors to interfere with family assets.
- Use of a LP or LLC-P may help reduce the impact of income in respect of a decedent (IRD) upon the death of a member by requiring the entity to close on the death of a member.
- Use of an LP, LLC-P or LLC-D allows for reduction of estate and gift taxes because of the application of asset freeze and transfer discount strategies.
If there are substantial assets outside of California, a non-California LP, LLC-P or LLC-D may be used in some circumstances to reduce California’s ability to tax out-of-state activities.
Why would an LLC-P be better than an LP?
- Flexibility in organization and capital structure.
- Simplicity of structure, one entity to obtain limited liability for all.
- Limited liability for all – Passive members do not risk exposure by taking part in the control of the business, which would potentially expose limited partners to both inside-out liabilities (alter ego) and outside-in liabilities (reverse alter ego).
- LLC-P allows participation in management by all members without risk of liability.
- All debt of the LLC-P is non-recourse, creditor remedy against a member is limited to a charging order.
- LLC Act provides answers to many issues and clear default rules Corporation Code §17000 et seq.
- No limitation on step-up in basis for assets of LLC when management dies such as for a limited partnership with an individual general partner (GP).
Why would a California limited partnership (“LP”) be better than a California limited liability company taxed as a partnership (“LLC-P”)?
- No California gross receipts taxes.
- Reduced self-employment tax confusion, distributions to limited partners clearly not subject to self-employment tax.
- Long history of limited partnership statutory law and cases; the Uniform Limited Partnership Act tends to promote unity of limited partnership laws among the states. California Corporations Code §15001 et seq. California Revised Limited Liability Act effective January 1, 2008 (California Corporations Code Sections 15611 et seq.
- Chapter 14 issue (IRC §2704(b) – LLC restrictions beyond LLC statute default provisions not enforceable for purposes of valuation. For purposes of valuing the lack of liquidity (the right to liquidate) an appraiser must disregard any restriction on liquidation that is beyond that required by state law. California default provisions for an LLC provide that a California LLC shall be dissolved and its affairs wound up upon the “vote of a majority in interest of the members, or a greater percentage of the voting interests of members as may be specified in the articles of organization or a written operating agreement.” Corporations Code §17350(b). Under California law, unless otherwise set forth in the limited partnership agreement, a California LP may be dissolved only upon vote of a majority of the limited partners and all of the general partners.
- Better valuation discounts for LP interests
Solutions to the Chapter 14 issue for a California LLC include:
- Use an LLC from a jurisdiction that requires, as a default, the unanimous vote of all members to liquidate the LLC and register it in California. Jurisdictions such as Nevada and Wyoming, require as a default unanimous vote of all members to liquidate.
- Make sure the donor does not own a majority of interests in the California LLC at the date of the bequest (death) or that he does not gift 51% of the membership interests at one time (within the same taxable year).
Argue the California statute default also includes “a greater percentage of the voting interests of members as may be specified in the articles of organization or a written operating agreement.” Corporations Code §17350(b).
Using LLC-P’s as an Alternative to LP’s for Estate Planning Purposes
In the past, most estate planning strategies were carried out through limited partnerships (sometimes called “Family Limited Partnerships” or “FLPs”). First of all, limited partnerships have been available for use for this purpose for many years, whereas limited liability companies have only been available since the 1990’s. Evan after limited liability companies became available as an alternative to limited partnerships, there were many reasons why California advisors had a preference for limited partnerships over LLC-P’s. Such reasons included the advisors’ failure to understand LLC-P’s and how to structure LLC-P’s to function as a substitute for LP’s, the longer history of case law in handling limited partnerships, the frequent use of LP’s in the mid-1980’s for syndicated tax shelters and their immediate familiarity to practitioners and clients alike; the relative newness of the LLC structure in the law, and inconsistency from state to state in the laws governing LLC operation. Over time, as the laws became more or less understood and/or uniform in certain respects, and as cases began appearing interpreting LLC laws, LLC-P’s have become increasingly popular as a substitute (or supplement, in some cases) to family limited partnerships.
The main feature of a limited partnership that distinguishes it from a LLC-P is that the general partner(s) of a limited partnership are subject to unlimited liability for the acts of the entity, while no member (managing member, manager, officer or otherwise) is normally subject to the liability of the LLC-P. Also California LLC-P’s (limited liability companies taxed as partnerships) are subject to gross revenue taxes whereas LPs are not. Both family limited partnerships (FLPs) and family limited liability companies taxed as partnerships (FLLC-P’s) are typically established by a member of the senior (donor) generation to accomplish continuity of management and asset protection/preservation during intergenerational transition planning. The senior generation takes control of the entity (general partner in the case of FLPs, manager(s) in the case of the LLC-P) by holding a majority of voting membership interests while the junior generation members (limited partners in the case of an FLP) hold only the non-voting membership interests (the economic interests) in the LLC-P. These economic interests (non-voting membership units or limited partnership interests) are then gifted or sold directly to heirs or to their trusts for the benefit of junior generations and, occasionally, family-controlled charities or charitable trusts.
Often, to obtain the full benefit of protection from creditors and also to minimize self employment tax as well as the California LLC gross receipts tax, a family will form a FLP, with a LLC as the general partner owning a 1% interest.
LLC-P and LP Asset Valuation Discounting Strategies
(a) Key Concepts for Valuation Discounts – Valuation for estate and gift tax purposes is based upon three fundamental concepts.
Hypothetical Willing Buyer, Willing Buyer. All property is valued knowledge of all relevant facts. Treas.Regs §§20.2031-1(b), 20.2031-3, for transfer tax purposes using the hypothetical “arm’s length” transaction between a “willing buyer” and a “willing seller”, neither of whom is acting under any compulsion to buy or sell, and each of whom has reasonable 25.2512-1, United States v. Cartwright, 411 U.S. 546 (1973).
Gift Taxes and Value Received. Gift taxes are imposed on the donor based on the value of what is received by the transferee. Estate of Chenowith v. Commissioner, 88 T.C. 1577 (1982).
Estate Taxes and Value Held. Estate taxes are imposed on what was held by the decedent at the time of his death and passed to his estate, not on what was transferred to his beneficiaries. Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981).
(b) What is Fair Market Value?
The value of lifetime gifts and bequests at death are measured by the same standard. IRC §§2033(a), 2512(a). Thus, the value of the transfer is the “value of the property which is actually transferred as contrasted with the interest held by the decedent before death or the interest held by the legatee after death.” See Estate of Bright v. United States, 658 F.2dc 999 (5th Cir. 1981). The objective of the estate planner in achieving valuation adjustments is to create an entity, such as a LLC-P or LP, that permits the membership interests to be valued for their “distributable cash flow” value (sometimes expressed as the “going concern value”) rather than the “liquidation value” of the underlying assets. The manner in which this is accomplished involves creating a structure to which a business appraiser can properly apply either “percentage discounts” or from which he or she can determine a “capitalization rate” in order to approximate what an investor’s return on invested capital might bring in that particular enterprises. In either case, the “adjusted” value reflects “true economic value” as opposed to pro-rational (liquidation value) value relative to the underlying assets.
(c) How is Fair Market Value Determined?
In determining value, the Treasury Regulations for transfer taxes require that the fair market value of a business interest be determined on the basis of all relevant factors, including a fair appraisal of all the business assets and the demonstrated earning capacity of the business. Treas. Reg. 20.2031-3 (1992), 25.2512-(3)(a) (1958). The best evidence of value would be previous arm’s-length sales of the entire partnership interest or partial interests. However, since that rarely occurs, the appropriate starting point is the determination of the value of the entire partnership on a pre-discounted basis. The pre-discounted value is typically determined based on the “going concern value” or the “net asset value” or perhaps a combination of both. Courts have favored a valuation that uses a combination of both analyses. Ward v. Comm’s, 87 T.C. 78 (1986). The IRS usually takes the position that the appropriate valuation approach is the one that produces the highest value. What a surprise!
(d) Going Concern Value. The going concern value of a LLC-P or LP is determined by capitalizing its past and projected net earnings. This approach properly recognizes that the members do not have the ability to unilaterally liquidate the LLC-P or LP. The only value to them in currently owning a partnership interest is their right to receive the distribution of earnings, which is often substantially less than the net asset value of the partnership. See Estate of Gallo v. Comm’s, 50 T.C.M. (CCH) 470 (1985) and Watts v. Comm’s, 823 F.2nd 483 (11th Cir. 1987). The nature of the underlying partnership assets and/or the business conducted by the entity will determine which valuation method will be most persuasive to the courts.
(e) Difference Between Going Concern Value and Liquidation Value. The Watts case illustrates the difference between the going concern value and the liquidation value. The parties in that case agreed that the liquidation value of the decedent’s fifteen percent interest was $20,000,000 and the going concern value of that same interest was $3,933,181 before the application of any valuation discounts to the decedent’s minority interest, the Eleventh Circuit, finding for the taxpayer, held that because the death of the partner did not cause the partnership to dissolve, but instead, the partnership continued under the partnership agreement and state law, the partnership was properly valued on the basis of its going concern value, and not its liquidation value. The court concluded that because, under all the facts of the case, there was no reasonable prospect of the partnership being liquidated, the liquidation value of the partnership was irrelevant. (See also Harwood v. Comm’s 82 T.C. 235 (1984) where the court rejected the going concern approach because the business of the partnership consisted solely of acquiring timber for the use of its affiliated companies. Consequently, the partnership’s real value was tied directly to the current value and expected future value of its timber holdings.)
(f) Types of Discounts that Might be Applied to LLC-P or LP Interests.
Restricted Securities Discount – There are cases involving holders of restricted securities of publicly traded companies. Estate of Piper v. Commissioner 72 T.C. 1062 (1979) held that in such instances, the discount should not exceed the cost of registering and selling the stock. In the Estate of Gilford v. Commissioner 88 T.C. 38 (1987), the court allowed a 33% discount for a block of stock that could not be sold without registration.
Portfolio Discount – If the LLC-P owns a large amount of a single asset, courts recognize a discount for having a non-diversified portfolio. See Estate of Barudin v. Comm’s T.C. Memo 1996-335. See also Piper, supra, in which the court, analogizing to closed end mutual funds, recognized a 17% discount for “relatively unattractive portfolios.”
Blockage and Absorption Discounts – The Treas. Regulations expressly recognize a discount for the time frame that the market would require to absorb a large block of stock. See Treas. Reg. 20.2031-2(e) (1992). The same reasoning can apply to real estate. See Carr v. Commissioner 49 T.C.M. (CCH) 507 (1985) in which the court found that a thirty percent discount was appropriate when valuing a large block of lots in the same geographic area.
Fractional Interest Discount – A number of cases have recognized that significant discounts should be applied to partial interests in real estate. See Propstra v. United States 680 F.2d 1248 (9th Cir. 1982) 15% discount; Estate of Anderson v. Comm’r 56 T.C.M. (CCH) 78 (1988) 20% discount; and Estate of Della van Loben Sels v. Comm’r 52 T.C.M. (CCH) 731 (1986) 60% discount.
Promissory Notes – The face value of a promissory note is rarely indicative of its real value. Fractional ownership of the note, the quality of the collateral that secures the note, the interest rate and other factors affect its marketability. Accordingly, significant discounts may be applied in valuing these interests. See Smith v. U.S. 923 F.Supp 896 (S.D. Miss. 1996); Hoffman v. Commissioner, T.C. Memo, 2001-109 citing Treas. Reg. Sec 20-2031-4 which provides that the burden of proof is on the taxpayer to prove that a promissory note is not worth its face amount plus accrued interest, but nonetheless found that the burden of proof had been met and applied substantial discounts to the promissory notes.
Built-in Capital Gains – A number of cases have held that the repeal of the General Utilities doctrine, the built-in capital gains inside C corporations, is a relevant factor to consider when valuing the stock of the corporation. See Estate of Davis v. Commissioner, 110 T.C. No. 35; Estate of Simplot v. Comm’r, 112 T.C. 13 (1999) rev’d on other grounds, 87 AFTR 2d Par. 2001-923 (oth Cir. 2001); Estate of Borgatello v. Comm’r, T.C. Memo 2000-264 (2000); Estate of Jameson v. Comm’r, 2001 AFTR 2d Par 2001-3253 (5th Cir. 2001); Estate of Welch v. Comm’r 85 AFTR 2d Par. 2000-534 (6th Cir. 2000). However, the Tax Court recently denied discounts for built-in gains when valuing limited partnership interests reasoning that a Code §754 election would correct any built-in gains disparity. Estate of Jones II v. Commissioner, 116 T.C. No. 11 (2001). More recently, however, the Tax Court has shown some willingness to allow the built-in gains inside a partnership to be considered. Estate of Dailey v. Commissioner T.C. Memo 2001-263 (2001).
(g) Determining the Discount
A discount is based upon the value of the asset transferred. Once the underlying assets in the LLC have been properly valued, the next step in the valuation process is to determine the nature of the interest that is being transferred. As mentioned previously, a transfer for estate tax purposes focuses on the property that passed to the decedent’s estate and not on what was received by the decedent’s beneficiaries. Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981). So, while the decedent’s interests in the LLC-P may be aggregated for estate tax purposes, if the same interests in the LLC-P were transferred to the same beneficiaries through lifetime gifts, the focus would not be on what the donor held, but instead on the value of the interests transferred to each donee. Chenoweth v. Comm’r 88 T.C. 1577 (1987).
Discount for Lack of Marketability – If an asset is less attractive and more difficult to sell than publicly traded stock, a discount for its relative lack of marketability may be available to adjust it’s value for transfer tax purposes. If a member wanted to get out of the LLC-P, who would buy their interest? An interest in a closely held enterprises is less attractive and more difficult to sell than a publicly traded interest. This discount acknowledges the economic reality of the inherent inflexibility of getting into and out of investments where there is no ready market. Discounts are not automatic and must be established by empirical data and appraisal. The lack of marketability discount is available for both majority and minority interests. See Estate of Mazcy v. Commissioner, 28 T.C.M. (CCH) 783 (1969), rev’d on other grounds, 441 F.2d 192 (5th Cir. 1971), Estate of Folks v. Commissioner, 43 T.C.M. (CCH) 427 (1982) (40% discount allowed in closely held real estate investment company where decedent owned 62% of stock).
Discount for Costs of Liquidation. For stock in a corporation, the costs of liquidation alone of the corporate form must also be taken into account. The court in Estate of Curry v. United States, 706 F.2d 1424 (7th Cir.) (1983), rejected the argument that the majority shareholder may liquidate. The Court found that the fiduciary duties of the controlling shareholder restrained the majority interests without regard to the minority interests. Discounts have also been held to apply to assignee interests in general partnerships. Adams v. United States, 218 Ff.3d 383 (5th Cir.) (1971). Taken together, this line of cases demonstrates that there is a quantifiable discount for lack of marketability.
Many cases indicate that the courts recognize the validity of marketability discounts. See Peracchio v. Commissioner, T.C. Memo 2003-280 (September 25th, 2003) (25% marketability discount and 6% minority discount); Lappo v. Commissioner T.C. Memo 2003-259 (September 3rd, 2003), (24% marketability discount and 15% minority discount); Estate of Godley v. Commissioner T.C. 2000-242 (2000) (20% marketability discount); Estate of Strangi v. Commissioner 115 T.C. No. 35 (2000) (31% discount), rev’d on other grounds (5th Cir. 7/15/2005); Estate of Hoffman v. Commissioner, T.C. Memo 2001-109 (2001) (35% lack of marketability discount and an additional 18% minority interest discount); Knight v. Commissioner 115 T.C. No. 36 (2000) (15% discount); see also Estate of Jones II v. Commissioner, supra, where the court valued two separate partnership interests, one which had the power to cause the dissolution of the partnership interests, and one which did not. The court applied a 7% marketability discount to both partnership interests and an additional “secondary market discount” for the interests that lacked the ability to dissolve the partnership.
Minority Interest or Lack of Control Discount – The lack of control or minority interest discount is distinct from a marketability discount. The minority interest discount is applied when the owner of the interest does not have managerial control over the partnership entity. Also consider that individual equity cannot be sold if transfer rights are restricted. Liquidation value has little meaning to an individual investor if the owner cannot compel or vote to force liquidation. A proper analysis of value would consider comparable sales. However, there usually are not comparable sales. Typically, minority discounts range from 25% to 55% of the pre-discount value of the partnership interest. See Gallun v. Commissioner 33 T.C.M. (CCH) 1316 (1974) which allowed a 55% discount on a partnership interest whose assets consisted of an investment portfolio.
Application of the Discounts – When both minority and marketability discounts are available and taken, they are not simply added together. The minority interest discount is placed on top of the lack of marketability discount.
Use of LLC-P’s in Estate Planning
(g) General Reasons for Use of LLC-P’s in Estate Planning
Asset Transfer Discounting – The formation of a family limited partnership or PFLLC or corporation is another estate-valuation-discount planning vehicle sometimes used by persons with over $2,000,000 in assets who wish to transfer property to younger generation family members at reduced transfer tax costs. It involves setting up one or more LLC-P’s or LP’s in which asset and control features are differentially distributed to younger generation family members over time. In the beginning the parents own and control. Later, they may own less as a result of transferring shares to children while retaining control, at least initially. Limited Partnerships and Limited Liability Corporations taxed as partnerships are the preferred forms of business organization because entities taxed as corporations do not receive a step-up in basis for appreciation of the underlying assets when the shares are transferred at death. The result is that lifetime gifts, including annual exclusion gifts, and the balance of the parents’ interests at death, may be discounted for tax purposes because of the lack of liquidity and control inherent in shares of closely held business organizations. Such interests are typically appraised at 35% to 45% of the value of the underlying assets. Interest transferability and income distribution discretion provisions in the LP and LLC-P documents need to be drafted carefully obtain annual gift exclusions.
Asset Protection – Another effect may include increased protection from creditor claims. To the extent family assets consist of shares or interests in family partnerships creditors may only be able to attach future distributions of income. Such distributions are subject to considerable control and discretion of the family members possessing the control features of the organization.
Additional Benefits – Additional advantages include the spreading out of income among family members (thus potentially lowering overall income tax rates), less exposure to divorced spousal claims (shares of family organization are not easily commingled with marital assets), and facilitation of annual exclusion giving (no need to divide up assets, shares of family organization gifted instead).
Using LLCs for Asset Freezes
(a) What is an asset Freeze? An estate freeze is a transaction or series of steps undertaken to allow future growth in the value of one or more assets to accrue to someone else, the beneficiary of the freeze.The beneficiary of the freeze is usually the person, or persons, who will ultimately become the beneficiary of the owner’s estate. The simplest method of an asset freeze is to gift assets to heirs before death in a manner that takes the asset out of the owner’s estate. A simple gift of an asset will remove the asset from the owner’s estate, and from the owner’s control.
(b) What is Frozen In An Asset Freeze? The owner of the asset (the “freezor”) is the individual who initiates the freeze. The asset value and/or the income from the frozen asset is transferred to the beneficiaries, thus freezing this asset/income value outside of the freezor’s estate. An estate freeze eliminates the value of the frozen asset and/or income from that asset from the freezor’s estate.
(c) What is the Goal of An Asset Freeze? The term “freeze” refers to fixing the value of an asset at its current value. By freezing the values today, the freezor can accomplish a number of objectives. The freezor can quantify the tax liability, which will be triggered upon death or the disposition of a freezor’s assets. The freezor can also take steps, in many circumstances, to actually work towards reducing those liabilities over a period of time. By limiting the value of the estate, the freezor also reduces the exposure to probate and other estate settlement costs.
(d) When Would You Use An Asset Freeze? If a client expects at their death to have more than the $2,000,000 estate tax exemption amount, less taxable gifts made during their life, and it is unlikely that they will be able to lower the amount using tax exemption vehicles, their estate will likely benefit greatly from use of estate valuation freezing and discounting tools to reduce heirs tax exposure. The primary reason to implement an estate freeze is to maximize the value of the estate that will accrue to the freezor’s beneficiaries. One of the most important questions to address at the outset is whether a person is ready to embark upon an estate freeze. The freezor must accept that all or some of the future growth in his or her assets will be limited or will not accrue to him or her at all. The problems for an owner may be both financial and psychological. Financially, the freezor must be satisfied that they have left themselves with enough capital to sustain their lifestyle, even after taking inflation into account. Psychologically, they must be prepared for the fact that to a greater or lesser degree they are giving up a portion of their assets to the beneficiaries of the freeze and that beneficiaries, too, will have an interest in how the business or property is managed. Next to the financial matter, the issue that most often concerns the freezor is the extent of the control they may exercise over the assets after the freeze takes place. The desire to exercise control may stem from the fact that the beneficiaries cannot manage the frozen property because they are minors, or it may stem from an unwillingness on the part of the freezor to “let go”.
(e) What Tools Are Available to Accomplish An Asset Freeze? Some of the commonly used tools used to accomplish an asset freeze are the grantor retained interest trust (“GRIT”), the grantor retained annuity trust (“GRAT”), the grantor retained unitrust (“GRUT”), the qualified personal residence trust (“QPRT”), the personal residence life estate trust (“PRLET”), asset installment sales, self cancelling installment notes (“SCINS”), corporations, limited partnerships and LLC’s. In many fact situations, a PLLC will be the best entity for an asset freeze, often along with one or more of the asset freeze tools mentioned above, and would usually be structured for discounted valuation transfers to minimize gift and estate taxes.
(f) A Simple LLC Freeze. An example of a simple asset freeze using a PLLC would be the transfer of an appreciating asset of any type, it could be a business, real estate, personal property or any other appreciating asset, to a newly formed PLLC in exchange for a preferred membership interest in the LLC that equals or exceeds the value of the asset transferred to the PLLC. An example would be the transfer of real estate with a net value of $1,000,000 to a PLLC in exchange for preferred membership interests in the PLLC that provide the holder of the preferred membership interests with the first $1,000,000 in operating (profits) and/or capital distributions from the PLLC. The PLLC could then sell non-preferred membership interests to heirs at a minimal cost, or such membership interests could be gifted to heirs with little or no gift tax result, because the non-preferred membership interests would have little or no value at the time of the transfer. However, over time, the non-preferred membership interests would represent all of the appreciated value of the asset. The “freeze” PLLC would also be structured to maximize the discounts for any membership interest that might be gifted in the future, including the preferred membership interests should the owner wish to gift them, or sell them, to heirs prior to death to reduce estate tax on the owner’s estate.