Lifetime Tax Planning for LLC Owners

Editor: Albert B. Ellentuck, Esq.

Several steps can be taken before a limited liability company (LLC) member’s death to reduce estate and income taxes and to plan for an orderly succession. One common technique to remove value from an estate is to transfer assets or an interest in assets by gift during a member’s lifetime. A member can make a gift outright or in trust.

Although lifetime gifts remove assets from a member’s estate, there are downsides, including:

1. Gifts during 2012 of present interests in assets that have a value in excess of the gift tax annual exclusion amount ($13,000 per donee) reduce the donor’s applicable exclusion amount ($5.12 million in 2012). To qualify for the annual exclusion, the gift must be of a present interest.

2. Lifetime gifts do not generate significant estate planning benefits unless the assets transferred appreciate substantially after the date of the gift.

3. The donee’s basis in a gifted asset equals the donor’s basis (i.e., no basis step-up).

4. To qualify as a gift, the gift must be complete, which requires the donor to give up complete control of the asset transferred.

5. The donor of an LLC interest may recognize income if the donor’s debt relief exceeds his basis in the transferred interest.

6. An agreement by the donee to pay additional estate taxes that may be incurred on gifts made within three years of a decedent’s death does not reduce the value of the gift (Estate of Armstrong, 119 T.C. 220 (2002); and Estate of McCord, 120 T.C. 358 (2003), rev’d and remanded, 461 F.3d 614 (5th Cir. 2006)).

These disadvantages affect the decision to gift an interest in an LLC during the member’s lifetime. In addition, all of the other members of an LLC generally must approve of a gift of an interest in LLC capital under the provisions of applicable state law. (Members may want to consider including a specific provision in the operating agreement to allow assignments by gift of a percentage of a member’s interest to family members without the approval of the other members.) Gifts of assignee (profits-only) interests usually can be made without the consent of other members.

A lifetime gift of a noncontrolling interest in an LLC can be an effective means to transfer ownership at a reduced gift tax cost. If the donor is appointed as a manager for life, control can effectively be retained, while the benefits of ownership can be passed to the younger generation. Gift tax savings are generated by applying valuation discounts to the value of the transferred property. The value of the asset for gift tax purposes is net of the appropriate minority discount or discount for lack of marketability.

Planning tip: Due to recent economic uncertainty, many assets are at or near historically low values. Lower fair market values (FMVs) coupled with valuation discounts and a $5.12 million applicable exclusion amount (in 2012) make this a great time to consider gifting LLC interests.

Reporting Gifts

The statute of limitation for assessing gift tax does not begin to run unless a gift tax return is filed (Sec. 6501). Accordingly, it may be beneficial to file a return for certain gifts that have a value below the annual exclusion (i.e., so the statute begins to run) if there is a risk the IRS will challenge the valuation of the gifted assets. When gifts required to be shown on the return are omitted, the assessment period is open indefinitely (Sec. 6501(c)(9)).

A gift made in an earlier calendar year cannot be revalued if it was adequately disclosed on a gift tax return and the period of limitation on assessment has expired (Sec. 2504(c)). Additionally, a gift cannot be revalued for estate tax purposes if the gift tax statute of limitation period has expired, and the value of the gift is shown on the gift tax return or is disclosed in the return, or in a statement attached to the return, in a way that notifies the IRS of the nature of the gift (Sec. 2001(f)). In Rev. Proc. 2000-34, the IRS provided guidance on how to adequately disclose a gift if the information was not initially submitted with a gift tax return filed for the calendar year in which the gift was made. The statute of limitation begins when the taxpayer adequately discloses the gift on an amended gift tax return.

Compliance with the adequate disclosure rules is not difficult if the transferred item is marketable securities. However, if the transferred item is a nonmarketable security, such as an LLC interest, it is not clear what is considered adequate disclosure. If the value of the LLC interest is properly determined based on the net value of the assets held by the LLC, a statement must be provided regarding the FMV of 100% of the entity (determined without regard to any discounts), the pro rata portion of the entity subject to the transfer, and the FMV of the transferred interest as reported on the return (Regs. Sec. 301.6501(c)-1(f)(2)(iv)).

If 100% of the entity’s value is not disclosed, the taxpayer bears the burden of demonstrating that the FMV of the entity is properly determined by a method other than a method based on the net value of the assets held by the entity. If the LLC holds an interest in another nonmarketable entity, the information described in this paragraph must be provided for each such entity if it is relevant and material in determining the value of the interest. Alternatively, a qualified appraisal, as defined in Regs. Sec. 301.6501(c)-1(f)(3), will be accepted.

Reporting Nongift Transactions

Disclosure rules also apply to certain nongift transfers (Regs. Sec. 301.6501(c)-1(f)(4)). A nongift is a transfer or payment that is not considered a gift when made. Nongifts include payments and sales between family members. Completed transfers to members of the transferor’s family made in the ordinary course of operating a business are deemed to be adequately disclosed, even if the transfer is not reported on a gift tax return, provided the transfer is properly reported by all parties for income tax purposes. For example, in the case of salary paid to a family member employed in a family-owned LLC, the transfer will be treated as adequately disclosed for gift tax purposes if the item is properly reported by the LLC and the family member on their respective income tax returns. However, a sale of property between family members, including the sale of a business, is not considered to take place in the ordinary course of business.

Charitable Donations

Clients with charitable intent can make donations of property, including LLC interests, during their lifetimes to remove the property from their gross estate. In addition, the charitable donation is deductible for income tax purposes. For individual income tax purposes, the deduction for charitable contributions is limited to a percentage of adjusted gross income (AGI), depending on the type of charity and type of property donated. If an LLC in which a client is a member makes a charitable contribution (including a conservation contribution of property, a remainder interest, or an easement), the members can deduct their allocable share of the LLC deduction on their individual return.

Family LLC

The formation of a family LLC can allow business owners to gift interests to younger generation family members to minimize estate taxes. Practitioners should advise their clients to observe the formalities of the intended structure to avoid potential recharacterization by the IRS. In Shepherd, 283 F.3d 1258 (11th Cir. 2002), and Letter Ruling 200212006, taxpayers who intended to transfer interests in a partnership to their children were deemed to have transferred an interest in property because the form of the transaction did not support its characterization as a transfer of a partnership interest. The recharacterization of a gift of a partnership interest as a gift of nonpartnership property generally results in no or a decreased valuation discount being allowed.

Buy/Sell Agreements

A buy/sell agreement is a popular way to establish parameters for the estate tax valuation of a closely held business while ensuring the financial welfare of the deceased owner’s heirs and protecting the interests of the surviving owners. A buy/sell agreement is a contract between the members of an LLC that generally provides for the sale of a member’s interest to the other members or the LLC upon the occurrence of a specified event—usually, the death, disability, or retirement of the member. The sales price is determined by a valuation method specified in the agreement. The sale is considered to have occurred one moment before the member’s death and is treated as being made by the decedent prior to death, closing the LLC tax year with respect to the interest sold (Regs. Sec. 1.706-1(c)(3)(iv)). If 50% or more of the total LLC interests in capital and profits is sold, a termination of the LLC occurs (Sec. 708).

An LLC’s operating agreement can be structured to include matters that are typically addressed in a buy/sell agreement, therefore avoiding the need for two separate documents. If two documents exist, the practitioner should review them to ensure they are drafted in a consistent manner.

Family Business Assets

If an LLC holds a family business, the business owner should consider establishing business policies that will provide income to the surviving spouse after the business owner’s death. This might entail a deferred compensation plan that makes payments to the business owner upon retirement that continue (to the surviving spouse) after the business owner’s death, or a distribution policy to ensure that business funds will be distributed to the surviving spouse unless needed in the business.

If a business owner owns real property outright and leases it to the business, consideration should be given to having the business enter into a long-term lease with the business owner for use of the property. This will ensure a regular income stream for the owner’s surviving spouse in the event of the owner’s death.

Choosing the Successor in Interest

If a buy/sell agreement is not in effect, the recipient of a deceased member’s LLC interest becomes entitled to the financial rights of a member in the LLC but is not necessarily able to participate in the management of the LLC unless the other members consent. The choice of the individual to serve as a decedent’s successor in interest is an important element in planning for the orderly continuation of the LLC’s activities and the wrapping up of the decedent’s affairs.

If the logical beneficiary is the client’s spouse or child, and neither is currently involved in the LLC’s business, the other co-owners may not be pleased about suddenly having to deal with an uninformed or uninterested new owner. Consequently, it may be advisable to consider the issue of compatibility when determining who the successor in interest will be, to improve the chances that the business will continue smoothly.

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 17th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Fort Worth, Texas, 2011 (800-323-8724; ppc.thomson.com).