LLCs are ubiquitous in tax and business planning for clients. They have become the default answer to questions like “how to I organize my new business,” or “I’m buying a rental property, how should I do it.” However, LLCs are an incredibly flexible planning tool, a veritable Swiss Army Knife of planning options, that can be molded to meet a wide range of planning goals. The checklist below discusses many common, and not-so-common, planning applications of LLCs. Some of the applications of LLCs are obvious to practitioners, yet many clients still fail to heed the common advice as to how and when to use them. Although these situations are well known, they’ve been added to this checklist to encourage practitioners to proactively address them with clients. Finally, while the changes made by the American Taxpayer Relief Act of 2012 to the estate tax may have been permanent (whatever that word means in Washington) there are seemingly always changes in the law and tax environment that affect planning. The changes that have occurred in recent years make it imperative that every client with FLP/LLC have a check-up meeting. Some of these points are noted as well.
√ Consolidation LLCs
It is common for client families to accumulate various investment accounts. Whereas in the past the use of FLPs and LLCs to hold investment assets was largely focused on securing estate tax discounts, these discounts may not be important to most clients. However, the other significant benefits from this application of FLPs/LLCs remains a valuable planning tool for many. Practitioners should consider:
- Consolidating many family accounts into a single investment entity may enhance investment opportunities and be used to lower overall investment management fees.
- A properly structured and operated FLP/LLC can provide family members important asset protection benefits. A multi-member entity will afford partners/members charging order protection in the event of a personal lawsuit. This could be instrumental in protecting what might otherwise be fully exposed and easily reached investment assets.
- If the parent or another specified person serves as general partner or manager of the investment entity it may negate arguments in a matrimonial case that the a child actively invested assets somehow transforming them into marital assets.
Practitioners reviewing Forms 1040 Schedule B should be alert for large investment income that is owned individually when a family entity could instead afford significant benefits.
√ Home Ownership
While the use of an LLC to own rental properties is common, there are some special circumstances when a client might wish to use a special adaption of an LLC to own a home. This might be appropriate in at least one unusual circumstance. The clients are very concerned about asset protection and the state where the residence is located does not afford any homestead or tenants by the entirety (husband and wife as owners) protection for a home. In these instances having a multi-member LLC own the home may address that issue. The home might be owned for example, 40% husband, 40% wife, 20% family trust. In many instances the cost of this type of structure, or the negative implications to home sale exclusion or mortgage interest will negate the planning. However, in some instances this might be the ideal tool.
√ Vacation Home Ownership
The client owns a vacation home in a state that has an estate tax so that owning property directly or in a living trust might leave that property subject to a state estate tax. However, if the property is owned by an LLC, and the client is domiciled in a state that does not have a state estate tax (or if it does, for which the client will not be liable), the LLC may also achieve the client’s tax planning goals and avoid ancillary probate as well.
When these “off-label” applications of LLCs to own homes are used, be certain that the attorney modified the legal documentation accordingly since typical commercial operating agreement provisions might make little sense in this context.
√ Home Based Business
Organizing a home-based business as an LLC is an obvious and common tool every practitioner is familiar with. The problem is that too many clients ignore practitioners’ advice to form an LLC for a “small” home based business worrying about the cost of creating the entity. The size of a home-based business has no correlation to the potential liabilities it can create. Anytime a practitioner files a Form 1040 with a Schedule C or E that includes a home based business or rental property that is not in an entity format (LLC or otherwise) consider sending a standard letter (or even email) cautioning the client that they should form an entity and that regardless of the profitability or revenue of the business or property, liability may exist.
√ Single Member LLCs
While it may be obvious to every practitioner that a single member disregarded LLC does not afford the asset protection that a multiple member LLC does, many clients ignore practitioners advice to use a multiple member LLC worrying about the cost of the annual Form 1065. Again, this is a common mistake that puts many clients at risk. If a client is sued the interests in a 100% LLC are fully reachable by a claimant of the client. However, if the LLC is a true multiple-member entity then the client’s interests may be attached generally by a claimant. The claimant, however, may not be able to force the liquidation of the entity to seize on the interests involved. As such, the client has greater protection from suits. Anytime a practitioner files a Form 1040 with a Schedule C or E that includes a single member disregarded LLC consider sending a standard letter (or even email) cautioning the client that they should reform the LLC as a multiple member entity to provide better protection.
√ Child Funds
In many cases a child accumulates significant assets from gifts. These assets might then prove a temptation to the child to inappropriately or even dangerously use the funds. Large funds might be a temptation for a young client’s significant other or other predators or creditors. Ideally, gifts and other transfers should be made in trust for any minor beneficiary. Too often, however, clients ignore the advice of their professionals, or don’t realize the significant amount the funds will grow. After the fact the only trust structure that may be feasible is a self-settled trust. This would require that the client establish a trust in a jurisdiction permitting self-settled trusts (e.g. Delaware). This technique is complex, costly and embodies risks that many clients are not willing to assume. A simple family LLC might offer a practical and low cost option. Consolidate these assets into a family partnership or LLC. This may be an ideal tool to provide a measure of control and protection for these funds with the complexity and cost of a self-settled trust. If the child is a minority owner of the entity the manager or GP can provide brakes on distributions, asset protection, distance from a gold-digging spouse/significant other, etc.
√ Charity and LLCs
LLCs have not been used to a great degree by charities to insulate them from liability risks of donations. That may change. The change may open up greater possibility to help clients structure more complex charitable gifts. A charity may want to form a single member LLC that it owns and controls so that the activities conducted by the LLC do not subject the charity to liability, such as from accepting a donation of rental real estate. The IRS in 2012-52, confirmed that so long as all other requirements of IRC § 170 are met, the IRS will treat a contribution to the disregarded single member LLC as a tax-deductible contribution to the charity itself for income tax purposes. This option can provide a creative use of LLCs to facilitate client charitable planning especially for clients owning business or real estate interests. Practitioners should be certain that the charity discloses in the acknowledgment of the donation that the single member LLC is wholly owned by the charity and treated by the charity as a disregarded entity.
√ Charitable FLPs
While some uses of charitable partnerships have been abusive, there are planning opportunities that might be viable if properly implemented. The use of this technique is perhaps most readily explained by example. A client could create a family limited partnership (FLP). The client will own 100% of the entity that is a 1% general partner (GP). Initially, the client could own the 99% limited partnership (LP) interests (although a spouse and/or adult child could also own LP interests). The client contributes appreciated assets to the FLP. Thereafter, the client/donor would contribute some or all of the LP interest to a public charity (the self-dealing restrictions applicable to private foundations make them inadvisable to use). The client should realize an income tax charitable contribution deduction for the contribution of the LP interests at the appropriate discounted fair market value. This amount should be determined by a qualified appraisal. Treas. Reg. §1.170A-13. The FLP may then sell appreciated assets and capital gains should flow through to the then owners: i.e. perhaps up to 99% to the tax exempt charity, and 1% to the GP. If this sale was pre-arranged it would not past muster. Eventually, the charity may be willing to sell the LP interests for their fair market value to a family trust, such as a family dynasty trust. Even if the assets are not sold, and there is no capital gains minimization (which may eliminate a risk that some practitioners are uncomfortable with), the client could transfer value to a charity and obtain a contribution deduction, and also transfer value to the family dynasty trust leveraged for gift and generation skipping tax exemption purposes.
√ LLCs May Need to Supplement Asset Protection Trusts
Domestic asset protection trusts (“DAPT”) have been subject to a number of unfavorable cases. In re Huber, 2013 WL 2154218 (Bankr. W.D. WA, May 17, 2013), Battley v. Mortensen, Adv. D. Alaska, No. A09-90036-DMD, May 26, 2011 and Rush Univ. Med. Center v. Sessions, ____ N.E. 2d ____, 2012 IL 112906, 2012 WL 4127261 (Ill, Sept. 20, 2012) to name a few. Other types of irrevocable trusts that might be intended for asset protection may also face challenges for other reasons. So, if asset protection is a concern of your client, and the client has existing irrevocable trusts, layering LLCs onto the irrevocable trust plan may provide a backstop to the protection hopefully afforded by the trusts. Assuring that the documentation for these LLCs, if they already exist, is current may be an important planning step. There are a host of other asset protection considerations for existing client LLCs, and opportunities to creatively use an LLC to achieve asset protection benefits.
√ Many LLCs Need Service Calls
Whether or not it’s been 5,000 miles since your client’s LLC “oil change”, many LLCs are overdue for a service call. There have been a number of significant legal changes that make it advisable for every client to review their LLC operating agreement (the legal document governing the operations of the entity) and other aspects of their LLC structure and planning. While CPAs are not going to review the legal aspects of this, the tax aspects are vital. But as with so many planning areas, if the CPA doesn’t lead the client to the lawyer the work will never be addressed and the client will remain unprotected.
The Revised Uniform Limited Liability Company Act (“LLC Act”) was adopted into law in a number of states including Iowa, Idaho, Utah, Wyoming, Nebraska, New Jersey, California, and the District of Columbia. For LLCs in these jurisdictions the changes in the law could have an important impact and it may be advisable to take action. Every client in these states should meet with their attorney and review their documents. Some of the comments below are based on the New Jersey law changes, but the key point is that any client who has not reviewed their LLC documents in recent years should do so:
- Creditor’s Rights
The LLC Act permits a creditor of a member (e.g., a physician member’s malpractice claimant) to foreclose on the LLC membership interest. This can undermine LLC protection in a significant manner. Forming new LLCs in states with more favorable laws might make sense. While cumbersome, it may be feasible to convert or reform an existing New Jersey (or other state with similar laws) LLC in a better jurisdiction. For clients worried about lawsuits this is vital to address.
- Written Agreement
The LLC Act permits an LLC operating agreement (the legal document that governs the management and operation of the LLC) to be in writing, oral or even implied based on how the LLC operates. This might make it more important to have annual review meetings, written consents and appropriate amendments of written operating agreements to minimize any unintended implication that another arrangement superseded or modified the existing operating agreement.
- Statement of Authority
The LLC Act permits an LLC to file a document, referred to as a “statement of authority,” with the State Treasurer specifying individuals or entities whom have (or don’t have) the authority to execute agreements transferring LLC real estate, or entering into any other transactions on behalf of the LLC. This might be useful to certain LLCs, perhaps those with independent parties who want to assure who can or cannot bind the LLC legally. In the family context, the use of this mechanism should be considered in a tax context as well. For example, might naming a person to hold authority to sell real estate affect the characterization of the LLC for purposes of the passive income or loss rules under IRC Sec. 469, or the Medicare Surtax Rules under IRC Sec. 1411? Might naming a parent who made gifts of LLC interests to hold authority to sell real estate or a business of the LLC be argued by the IRS as a retained right that could cause estate inclusion under IRS Sec. 2036? While this mechanism might provide a useful simplification for real estate and business transactions, its use should first be reviewed in the broad context of your overall planning.
- Fiduciary Duties
Under the LLC Act, the Operating Agreement cannot eliminate or restrict a member or manager’s fiduciary duties unless it is not manifestly unreasonable. If an existing operating agreement has restrictions that may run afoul of this criterium, amendment may be appropriate. Also, those members or managers that are affected may wish to reassess their level of involvement if a change is warranted. Caution should be exercised in family LLCs in that restricting fiduciary responsibilities could have tax ramifications. For example, if a parent made gifts of LLC interests and the operating agreement restricts the parent’s fiduciary responsibilities as a manager or member the IRS may argue that the restrictions permit excessive control by the donor/parent and may therefore support an argument of estate inclusion. The operating agreement may include a mechanism by which a particular transaction that would otherwise violate the duty of loyalty may be approved by a disinterested and independent person, after full disclosure of all material facts. This may be a concept that is worthwhile to integrate into some LLC arrangements.
- Indemnification
Under prior LLC law the LLC operating agreement could alter or eliminate the indemnification for a manager or member. The LLC Act provides that the Operating Agreement may eliminate or limit a member or manager’s liability to the LLC and members for money damages, except for: (1) breach of the duty of loyalty; (2) an unentitled financial benefit received by the member or manager; (3) an improper distribution; (4) intentional infliction of harm on the LLC or a member; or (5) an intentional violation of criminal law. It is advisable to review the indemnification and related provisions to assure that the standards of the LLC Act are acceptable, and if not whether the operating agreement should be modified to address these matters. It may be advisable to review your liability, errors and omissions and other insurance coverage to confirm what is in fact addressed in your policy.
- Resigning Member Rights
Under the LLC Act, a resigning member of an LLC is no longer entitled to the “fair value” for his LLC interest as of the date of resignation. Instead, a resigning member disassociates himself as a member and will only have rights as an economic interest holder (i.e., he will retain an equity interest but forfeits his voting interest).
- Oppressed Member Rights
The Revised LLC Act allows a member of an LLC to apply for an order from the Court dissolving the LLC, or appointing a custodian to manage the LLC, because the LLC’s activities are either unlawful or the LLC manager or controlling members are acting illegally, fraudulently or oppressively to the other member. The right might be of particular concern where key employees or other third parties have minority interests in family businesses organized as LLCs. In family investment LLCs, which have become a common planning vehicle, might this permit an antagonistic family member to unwind the family entity?
- Distributions
The Revised LLC Act provides that unless the members of the LLC agree otherwise, any distributions to members, before the dissolution and winding up of the LLC, are to be made to members in equal shares. If the LLC is owned by family members, it is important to have an operating agreement specify the ownership and distribution percentages. If, for example, a parent made gifts of most of his or her LLC interests and distributions were still made equally by a member, that might cause an estate inclusion issue for the parent. In some instances the default law may be desirable to provide a position to argue that the LLC interests are included in the parent’s estate to obtain a basis step-up.
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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