For estate planning purposes, a family partnership is typically a limited liability company or a limited partnership. A limited liability company ("LLC") is an entity that combines the limited liability of a corporation with the "pass-through" taxation of a partnership. A family limited liability company ("FLLC") is a standard LLC which is owned exclusively by family members. The typical FLLC is formed with two classes of ownership interests (voting and non-voting), and is managed by a "manager" who is selected by the owners (or "members"). A family limited partnership ("FLP") is very similar to an FLLC. Although, an FLLC offers more protection than an FLP since no general partner (with unlimited liability) is required.
Parents transfer $2 million of commercial real estate to an FLLC in exchange for a 1% voting interest and a 99% non-voting interest. With the voting interest they appoint themselves as the managers of the FLLC. Soon afterward, they gift the non-voting interests to their children, grandchildren and/or to trusts for the benefit of their children and grandchildren (the "donees"). These gifts will be gift tax-free to the extent of the parents' $13,000 ($26,000 for a married couple) annual gift tax exclusion and $1,000,000 ($2,000,000 for a married couple) lifetime gift tax exemption.
There is no gain or loss to the parents upon the contribution of the real estate to the FLLC. The parents, as managers, will continue to manage the real estate and can even receive a reasonable management fee for their services. Each member will owe income taxes on his/her/its proportionate share of the FLLC's income.
• The future income and appreciation on the nonvoting membership interests gifted are removed from the parents' gross estates, even though the parents continue to manage the FLLC. While there is a present lapse in the estate and generation-skipping transfer taxes, it's likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%.
• To the extent the donees are in lower income tax brackets than the parents, income tax savings are achieved.
• If the gifts of the non-voting membership interests are made to a so-called "grantor trust" established by one of the parents, the grantor-parent will be taxed on the trust's income. The grantor's payment of the trust's income taxes is the equivalent of a tax-free gift to the beneficiaries of the trust.
• Because the non-voting membership interests lack control and lack marketability, those membership interests are usually eligible for significant valuation discounts, ranging from 15% to 45%! Such discounts "leverage" the parents' $13,000/$26,000 annual gift tax exclusion and $1,000,000/$2,000,000 lifetime gift tax exemption.
• An FLLC allows the donor to serve as the manager of the FLLC even if he/she gives away 100% of his/her membership interests in the FLLC.
• An FLLC makes it much easier to make fractional interest gifts of assets like real estate which would otherwise require the preparation and recording of separate deeds each time a gift is made.
• An FLLC consolidates investment assets to promote efficient and centralized management of those assets. It also allows donors to involve their heirs in the operation of the FLLC without losing control. Finally, FLLCs provide the members with privacy since the state filings and annual reports neither require the names of the members to be disclosed nor any information regarding the FLLC's underlying assets.
Outside Protection. The FLLC accomplishes the goal of protecting the members' personal assets from business risks. Members of an FLLC are generally not liable for the debts, contracts or acts of the FLLC. In other words, a member's personal wealth is not exposed to the "outside" debts and liabilities of the FLLC. Members can only lose what they invest in the FLLC. However, this protection will not shield the FLLC's members from personal liability arising from unlawful acts committed personally or contracts signed personally.
Inside Protection. Conversely, the FLLC's assets are protected from the creditors of one of the members. The creditors of a member cannot force a sale of a member's interest, nor do they step into the member's shoes as a substitute member. The creditor can only apply to the court for a "charging under" to require the FLLC to pay to the creditor distributions that would otherwise go to the debtor/member. However, if the manager of the FLLC decides not to make distributions, then the creditor (as opposed to the debtor/member) may be taxed on the FLLC's undistributed income. This potential for negative cash flow may facilitate an out of court settlement for pennies on the dollar. Thus, the debtor/member receives "inside" protection from his/her personal creditors.
The IRS has been scrutinizing FLLCs closely and has challenged the size of the valuation discounts applied to the non-voting membership interests. The burden of proving the appropriateness of the discounts falls on the taxpayer. Thus, following are the leading principles established by recent cases to achieve the desired results:
• The FLLC must be operated as an actual business, including maintenance of accurate records, proper titling of assets, and compliance with applicable laws as well as the FLLC's governing documents.
• Assets transferred to the FLLC should not be used for the donor's personal use (unless fair market value rent is paid), nor leave the donor without sufficient assets to maintain his/her standard of living without having to rely on distributions from the FLLC. Moreover, there should be no commingling of the donor's assets with the FLLC's assts.
• When distributions are made by the FLLC, they must be made to all members in proportion to their respective membership interests.
Recently, the IRS has been successful in including in a decedent's estate all of the assets that the decedent transferred to an FLP or FLLC. Under Internal Revenue Code Section 2036, transferred assets can be included in the transferor's estate if the transferor retained until his/her death (1) the possession or enjoyment of the assets, or (2) the right to determine who would possess or enjoy the assets.
Despite the IRS's recent success in some cases, the FLLC remains a powerful vehicle for transferring wealth when properly designed and operated.
Following, is a checklist of ways to minimize an IRS attack under IRC Section 2036:
1. Include some operating business or real estate investment in the FLLC. Do not transfer personal use assets to the entity.
2. Create the FLLC well before death, and adhere to the terms of the operating agreement.
3. Do not transfer all of the donor's assets to the FLLC; and make sure the donor has sufficient liquidity apart from the FLLC.
4. Distribute profits unless needed for business purposes; and always make distributions pro rata.
5. Avoid making distributions, before and after death, to meet the personal obligations of the donor or the liabilities of the donor's estate.
6. Document the business purpose in the operating agreement.
7. Keep valuation discounts within amounts that are less likely to draw audit suspicion.
8. Have junior generational members contribute capital to the FLLC, instead of relying exclusively on gifts of membership interests.
9. Have annual partnership meetings to update events; and actively manage the FLLC's assets.
10. Finally, by operating the FLLC as though the members were non-family members, the likelihood of challenging an IRS attack should be much greater.
In order to achieve the desired tax results, the FLLC must have a valid business purpose. Whether a valid business purpose exists (other than to secure tax benefits) is a facts and circumstances test requiring the input of estate planning specialists. In any event, the FLLC is an important technique that should be considered as part of any estate plan, asset protection plan, or business succession plan.
TO THE EXTENT THIS ARTICLE CONTAINS TAX MATTERS, IT IS NOT INTENDED OR WRITTEN TO BE USED AND CANNOT BE USED BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER, ACCORDING TO CIRCULAR 230.
Julius Giarmarco, J.D., LL.M, is the Chair of the Estate Planning Group of Giarmarco, Mullins & Horton, P.C., Troy, Michigan.