Using a family LLC for estate planning

Limited liability companies (LLCs) provide flexibility in allocating rights to profits and capital and are frequently used to shift income and property appreciation from higher-bracket, older generation taxpayers to lower-bracket children and grandchildren. Family LLCs are created by the transfer of property from one or more individuals to the LLC for the common benefit of the family members. The transferred assets are titled in the LLC's name.

Typically, the senior family members (parents) transfer assets to a family LLC in exchange for membership interests, which under the terms of the operating agreement carry certain rights, such as management control and income distributions. This initial capitalization of the LLC is generally a tax-free event. LLC interests are then gifted or sold by the parents to junior family members (children) or trusts established for the children's benefit. A family LLC is normally governed by written articles of organization and a written operating agreement that establishes the rights of the members and their interests in the capital and profits of the LLC. Family LLCs are subject to the special income tax rules of Sec. 704(e), governing partnership interests created by gift.

The insulation of all owners from liability and the ability to concentrate management power in the hands of less than all of the owners are consistent with the business and tax objectives of most family business owners. In addition, an LLC offers the power to amend the operating agreement and articles of organization to reflect changes in family relationships. The formation of an LLC allows family business owners to provide for the continuation of their businesses after death. It normally will take advantage of the valuation discount rules and any rules limiting the donor's appreciation in the underlying assets.

Using family LLCs can result in the exclusion of assets from the gross estate and provide valuation discounts due to restrictions in the entity's agreement. Based on the applicable case law, a taxpayer wanting to enjoy these benefits must form and operate the entity carefully.

Once the family LLC has been formed, it is important to monitor its ongoing operations to make sure the integrity of the planned structure and function of the LLC is maintained. Practitioners advising their clients to transfer assets to an LLC as part of a comprehensive estate plan must be sure the client is aware of the importance of adhering to the form of the structure selected.

If the operational review of a family LLC is performed by the practitioner, it should be a separate engagement with a separate engagement letter and responsibilities. This will help ensure that the client cannot later claim the LLC's failure to meet the Sec. 2036 rules resulted from an inadequate review by the practitioner.

These items should be monitored:

• Compliance should be reviewed regularly. Consistently complying with the family LLC's organizational documents is critically important.
• The minutes of LLC meetings of members and managers should be reviewed to ensure the nontax business purposes are being addressed.
• Maintain a dialogue with the LLC's managers regarding any proposed financial transactions, particularly proposed transactions with the transferor. Make sure that any transactions with related parties comply with the provisions of the operating agreement and are commercially reasonable.
• Review cash distributions to ensure they are made pro rata and according to the terms of the LLC's operating agreement.
• Review minutes of manager and member meetings to ensure they document the involvement of family members and the reasons for decisions made during the year.
• Depending on state law requirements, the written operating agreement may have to be amended when there is a change in ownership. This may include changes in relative ownership interests or may apply only to changes in the identities of the members. In some states, changes in ownership are reported on an annual report filed with the secretary of state.

If the practitioner uncovers problems with the operation of the family LLC, the authors recommend the following actions:

• Address the problem with the members and managers. If needed, get approvals from the unaffected members for the necessary actions to bring the LLC into compliance with its organizational documents.
• If the LLC's organizational documents are inadequate or unclear, the documents should be amended (by an attorney). Make sure the members and managers understand the necessity of complying with the provisions of the organizational documents on an ongoing basis.
• Recommend that the members be given timely copies of LLC financial statements, tax returns, and other financial and transactional information.
• If one of the stated business reasons for formation of the LLC is to diversify, review the LLC's investments to ensure that diversification is occurring.

Within the framework of these items, it appears that family LLCs still offer the opportunity to fragment the ownership interest of a family business or other assets to apply valuation discounts. Practitioners can help their clients look ahead and properly form and structure a family LLC to preserve capital by reducing estate and gift taxes. Additionally, practitioners can aid in minimizing the opportunity for an IRS challenge by downplaying the benefits of valuation discounts in communications with the client.

Warning: If a family LLC revises its operating agreement to create limited member interests to avoid self-employment tax, it may jeopardize the availability of any valuation discounts due to the application of Sec. 2704. Limited interests generally are subject to restrictions (e.g., voting rights or distributions) that may exceed restrictions under the LLC statute of the state of formation. Practitioners must be familiar with the relevant state's LLC statute, including any recent amendments, prior to suggesting revisions to an LLC's operating agreement.

This case study has been adapted from PPC's Guide to Limited Liability Companies, 26th edition (October 2020), by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).