|
ProForms™ 2011 Law Forms - Links
1.
Overview of CD
All
CD Category
Listings
Print ProGuide's
Brochure Free Sample -- "Cautions & Warnings For Law Firm Web Sites" (Accounting Firms Too) Other Links |
Using Limited
Liability Companies In Estate Planning
By ProGuide™
NEW - COMING 2011!
ProForms™ 2011 -
Legal Forms - CD
By ProGuide - Practically A Complete
Business
"Law Office On A Disk"™
a great business law forms collection in its own right
a "must have" supplement to your current legal forms collection
inexpensive and it will save you time & money
Use
of these materials
are subject to the terms of our
Cautions & Warranties
which may be found at www.proguide.com
liability company (LLC) has become a significant addition in the arsenal
of tools available for the business planner. Likewise, it has become a
significant tool in the area of estate
planning. However, like all new
tools, until it is clear precisely how it
should be used, it should be
used cautiously so as to avoid undue injury.
Because, however, it is
potentially avery powerful tool, its use
should be given careful
consideration.
2. Objectives of
Estate Planning
a. In general the
goals of estate planning are:
i. To manage and conserve assets during life
ii. To transfer those assets upon death or some earlier time to
the persons or entities desired by the owner
iii. To allow the transfer of the assets to be accomplished under
the terms and conditions selected by the
transferor, and
iv. To minimize taxes on the transfer of those assets
b. These objectives
often conflict. However, the
selection of the
right tools can help
a transferor to more nearly achieve his or her
objective.
3. Characteristics of
the LLC Which Affect Its Uses - Generally.
a. Limited Liability
i. All members shielded from personal liability
(1) like corporation
(2) uncertainty in some states - but number declining
b. Flexible Management
i. All members can actively participate - member managed
(1) no loss of limited liability as in the case of a limited
partnership
ii. Management can be restricted:
(1) "manager managed"
(a) can be by members or
non-members
(2) member managed, but
leave authority to manage in all
members but have smaller group of members
actually
administer it
(3) Those without expertise need not be involved in
management
c. Flexible Ownership
i. Generally there are no restrictions
(1) Different than S corporation's restrictions on ownership
(a) eliminates constant
monitoring and/or complex
agreements
restricting ownership
(2) No legal restriction on number of owners
(a) May get unwieldy if too
large
(b) May have more complex
securities rules and fall into
special tax rules re large and/or publicly
traded
partnerships
(3) Generally, no legal restriction on nature of owners
(a) foreigners (resident or
non-resident), corporations,
partnerships, trusts, charitable
institutions,
pension plans, estates, and other LLCs may
all be
members.
(b)
An S corporation can use an LLC
(i) may give it some of the
same advantages that C
corporations can get from owning a
subsidiary
(ii) can insulate some assets from the remaining
assets
(iii) Since
need two members, must be another
person or entity involved
1) S corporation
should be able to own almost
99%
2) Could structure
arrangement to allow S
corporation's shareholder(s) to own
remaining interests.
(c) A complex trust can be a
shareholder
(i) thus, we can control to
whom and when
distributions to people occur.
(4) Sometimes, licensing requirements of a particular
business or profession will require
limitations on
ownership which are not required by LLC law
or tax rules
d. Ownership Easily
Controllable
i. Statute restricts ability to transfer ownership and/or
management rights
(1) Can not become a member without the approval of at least
some others
(a) Fewer negotiations may
be needed as the statutory
default may be ok
(2) May be able to pre-approve transfer of some interests and
still avoid IRC "free
transferability" characteristic.
e. Flexible
Organization Structure
i. May be simple
(1) All ownership interests can be identical
(2) No need for general and limited partners
ii. May be complex
(1) Can differ the economic and voting rights of members and
create numerous classes of ownership rights
(a) flexibility in
allocation of rights:
(i) on liquidation
(ii) profits & losses
(iii)
cash flow
(iv) priorities in dissolution
(b) Watch IRC 704(b)
allocation Regs.
f. Flexibility In
Types of Capital Contributions
i. Capital contributions can be in cash, property,
services,
promissory notes or other obligations to
contribute cash or
property or to render services in the future
g. Readily
Transferable Economic Interests
i. Statute
allows assignment of rights to profits, losses, and
all distributions without any approvals
ii. Free transferability of interests will still not exist.
h. LLCs Can Have
"Subsidiaries"
i. LLC may own other entities, including:
(1) corporation,
(2) general partnership
(3) limited partnership
(4) another LLC
ii. Allows protection of limited group of assets
(1) Use corporation or another LLC
iii. May allow "consolidation" of profits and losses for tax
purposes
(1) Use another "pass through" entity
iv. May allow preservation of limited liability in states without
a limited liability statute
(1) use corporation
i. Familiar to Foreign
Investors
i. Similar to a GmbH and other entities used throughout
Europe
and South America
j. Uncertainty As to
How Treated Under Substantive State & Federal Law
i. Questions exist regarding:
(1) Will the limited liability provisions contained in the
state of organization's LLC statute be
accepted in the
other states in which the LLC operates?
(2) Can an LLC sue or be sued in its own right in such other
states?
(3) Since there is little law regarding LLCs, how will the
organizational state and other states apply
case law or
legal precedent in other areas to LLCs,
since there is
little authority actually pertaining to LLCs
(4) How will state securities laws apply to the transfer of
an LLC?
(a) Transfer of interest as
member?
(b) Transfer of interest in
economic rights only?
k. Uncertain State Tax
Treatment
i. Some uncertainty as to how the organizational state
will
handle some tax issues.
ii. Great uncertainty as to how states without LLC statutes will
handle taxation issues.
iii. Some issues are:
(1) How will the entity be treated for multi-state tax
allocation purposes?
(2) Will a sale of an interest be treated as intangible
personal
property, similar to the sale of stock, so that
gain is taxed to the members state of
residency?
(a) Most LLC statutes
classify an LLC interest as
personal property so expect similar
treatment to
that of stock
(b) Liquidation of the LLC
and distribution of assets to
the members can avoid LLC level taxation and
can
change the
source of the intangible assets
(i) How will LLCs be
treated?
(ii) Will it be effected by whether state taxes LLC
as a corporation?
(c)
Many other issues.
4. Some Federal Income
Tax Considerations Affecting Use of the LLC
a. Caution - the
discussion which follows in this section IV was
drafted prior to the publication of Rev.
Proc.95-10 and contains an
analysis of the impact of the uncertainty
surrounding the
categorization of an LLC member as a general
partner, limited
partner, or limited entrepreneur.
The categorization is
important as it effects the application of
the passive loss rules
and any other tax provision which
establishes different standards
for limited partners.
While these issues remain un-resolved, much
of the controversay was exaserbated by the
IRS' defining a _limited
partnership_ in Rev. Proc. 89-12 as _an
organization formed as a
limited partnership ... and any other
organization formed under a
law that limits the liability of the member
for the organizations's
debts or other obligations to a determinable
fixed amount._
(emphasis added).
Rev. Proc. 95-10 now provides that Rev. Proc.
89-12 does not apply to an LLC.
As such, the confusing definition
of limited partnership no
longer applies and, presumably, the
common meaning of the word limited
partnership will be applied in
the future.
b. General
i. To claim a deduction for a loss generated by a
pass-through
entity on his or her individual income tax
return, taxpayers
must have the loss allocated to them by
either operation of
law or by agreement.
However, in addition, certain types of
taxpayers (it varies
with the statute) must meet additional
requirements.
More specifically:
(1) his or her basis in the investment must be sufficient to
allow the use of the deduction,
(2)
he or she must be at risk with regard to the amount of
the loss
(3) and if the loss is a passive activity loss, it may only
be used to offset income from passive
activities.
c. Allocation of
Profits and Losses - IRC 704
i. Generally, the Wisconsin LLC statute provides that
profits and
losses will be divided between members in
proportion to the
respective values of their interests as
required to be
maintained in the records of the LLC.
It also allows the
members to vary that arrangement in any way
they wish in an
operating agreement,
ii. However, sections 704(a) and (b) of the IRC sets forth very
lengthy and complex rules regarding the
allocation of profits
and losses between partners.
These rules allow IRS to
disregard the agreed upon allocation if they
do not have a
"substantial economic effect" -
that is, an economic loss
consistent with the allocated loss.
(Essentially, a safe
harbor exists if certain criteria are met
and either a deficit
restoration agreement exists or qualified income
offset will
be made. A discussion of these rules is
beyond the scope of
these materials.)
iii. Since the basic set of "substantial economic effect" rules
contained
in the regulations do not apply to non-recourse
debt, it is necessary to distinguish between
categories of
debt. In
this instance, several different categories of debt,
other than recourse debt, are considered by
the regulations.
All of them have a bearing on LLCs and their
members.
(1) Essentially, debt is divided into non-recourse and
recourse liabilities, as tested by reference
to the
members and certain related persons - not
the LLC.
(a) Non-recourse liabilities
are then subdivided into:
(i) secured non-recourse
liabilities and
(ii)
exculpatory liabilities
(b) Recourse liabilities are
divided into
(i) partnership non-recourse
liabilities and
(ii) other recourse liabilities
iv.
Because of the limited liability attribute of the LLC, it will
generally be considered as having
non-recourse debt. If,
however, a member guarantees the LLC's debt
or the LLC borrows
the funds from a member or a person related
to the member, the
debt will be treated as partner non-recourse
debt. See Treas.
Reg. 1.752-2.
(1) Non-recourse liabilities are treated as not having actual
economic
effect since only the creditor bears any
economic risk.
Thus, the regulations artificially
allocate non-recourse debts to the members
as if they had
economic effect if certain requirements are
met,
including the minimum chargeback requirement
which
allocates to those receiving the deductions,
gains from
the sale of the asset or the repayment of
the debt, etc.
(2) If there is partner nonrecourse debt, the rules allocate
the deductions attributable to the liability
to the
person who bears the economic risk of loss.
Rules
similar to the minimum chargeback rules also
apply.
v. Although the rules are detailed and complex, the
important
thing to remember is that the allocations of
losses and gains,
etc., will be influenced by the
categorization of the debt and
compliance with the allocable rules.
Because most debt of an
LLC will likely be non-recourse debt, the
negotiation of the
terms of a bank loan will take on greater
significance to
members than they might to partners, etc.
d. At Risk Rules - IRC
465
i. In general, a
person is "at risk" for the amount of money
they contributed to the entity, the adjusted
basis of any
property they contributed to the entity, and
the amount of any
debt of the entity for which they are
personally liable. (IRC
465(a) and (b)).
This amount is also increased by any income
allocable to the person plus any additional contributions made
by him or her.
It is reduced, however, by the amount of any
losses taken and distributions received.
ii. Under normal conditions, the owner of an LLC will not be
liable for the debt of the LLC because of
the limited
liability attribute of LLCs.
iii. While it is not completely certain, a loan by a partner to a
partnership should be treated as at risk to
the extent of
their allocable share of the debt.
Prop. Reg. 1.465-7
(1) It is not clear, however, what the rule is in the case of
a limited partnership or LLC, where the
members or
limited partners have no direct liability
for the debt
and the member making the loan may bear all
of the actual
risk.
(2) Similarly, it is not clear what the result is if the
member of the LLC guarantees the debt of the
LLC.
(a) Logic would say that the
member is at risk, however,
subchapter S shareholders are not treated as
at risk
when they guarantee the corporation's loan.
See
Prop. Reg. 1.465-24.
(3) This issue is important since in many small business
operations, the bank will require a personal
guarantee of
the loan.
It might be wise to make the loan to the
members rather than the entity if the member
will not be
at risk for the guaranteed amount.
iv. Another issue arises in connection with the financing of real
estate and pertains what is referred to in
the at risk rules
as qualified non-recourse financing."
(1) Under this rule, if an entity incurs debt in connection
with a real estate activity and the
financing is
qualified non-recourse financing, then the
owners may be
treated as being at risk for a share of the
debt even
though none of the owners are actually
liable. In
general, qualified non-recourse financing is
financing
borrowed from a bank or other similar
qualified lender
for
which no one is personally liable and which is
secured by the real estate.
(2) The issue that arises in connection with LLCs is the
question of whether the LLC is a
"person" which may be
liable on the debt or whether it should be
disregarded.
(a) Susan Hamill, a member
of the staff of the IRS
Office of the Chief Counsel, while
expressing her
own
personal views, indicated that if the loan were
only secured by the real estate being
financed, the
members of the LLC would likely be treated
as at
risk with respect to the debt.
However, she
expressed uncertainty as to the result if
the LLC
secured the loan with all of its assets.
e. Passive Activity
Rules - IRC 469
i. There are at least four "issues" involving
the "passive loss"
provisions of the IRC which are unique to
LLCs. All four turn
on the meaning of the term "limited
partner" or "general
partner" within the context of the
various sections of IRC
469. Three
of them pertain to rental real estate activities
and are discussed, below, in that section.
ii. The first issue is, "What level of participation must an
LLC
member have in
order to be treated as "materially
participating" under IRC
469(h)(2)."
(a) Generally, IRC 469
provides that for certain
specified persons and entities, passive
activity
losses and credits will not be allowed. IRC
469(a)(1).
(b) IRC 469 (c)(1) requires
that the conduct of a trade
or business will be passive if the taxpayer
does not
"materially participate" in it .
(c) IRC 469(h) defines
material participation. It
provides that "A taxpayer shall be
treated as
materially participating in an activity only
if the
taxpayer is involved in the operations of
the
activity on a basis which is-- (A) regular,
(B)
continuous, and (C) substantial.
(d) Treas. Reg. 1.469-5T
expands upon this general rule
and provides that, with two exceptions which
are
found in paragraphs (e) and (h)(2) of the
regulation, one of seven (7) conditions must
be met
in order for an individual to be treated as
materially participating.
Those 7 tests are:
"(1) The individual participates in the activity for
more than 500 hours during such year;
(2) The individual's participation in the activity
for the taxable year constitutes
substantially all
of the participation in such activity of all
individuals (including individuals who are
not
owners of interests in the activity) for
such year;
(3) The individual
participates in the activity for
more than 100 hours during the taxable year,
and
such individual's participation in the
activity for
the taxable year is not less than the
participation
in the activity of any other individual
(including
individuals who are not owners of interests
in the
activity) for such year;
(4)
The activity is a significant participation
activity (within the meaning of paragraph
(c) of
this section) for the taxable year, and the
individual's aggregate participation in all
significant participation activities during
such
year exceeds 500 hours;
(5) The individual materially participated in the
activity (determined
without regard to this
paragraph (a)(5)) for any five taxable years
(whether or not consecutive) during the ten
taxable
years that immediately precede the taxable
year;
(6) The activity is a personal service activity
(within the meaning of paragraph (d) of this
section), and the individual materially
participated
in
the activity for any three taxable years (whether
or not consecutive) preceding the taxable
year; or
(7) Based on all of the facts and circumstances
(taking into account the
rules in paragraph (b) of
this section), the individual participates
in the
activity on a regular, continuous, and
substantial
basis during such year.
(e) Thus, it would appear
that whether a general or
limited partner for tax purposes, meeting
any of the
above 7 tests would cause a taxpayer to meet
the
"material
" participation" requirement.
(f) However, IRC section
469(h)(2) also provides that:
Except as provided in regulations, no interest
in a limited partnership as a limited
partner
shall be treated as an interest with respect
to
which a taxpayer materially participates
(Emphasis added).
The term limited partner is not defined in the
IRC
and other sources must be looked to for
assistance.
(g) Treas. Reg. 1.469-5T(e)
provides that, except as
provided in paragraph (e)(3)(ii) of
1.469-5T, for
purposes of section 469(h)(2) and paragraph
(e) of
that regulation, a partnership interest will
be
treated as a "limited partnership"
interest if
either:
(i) the interest is
designated a limited
partnership interest in the limited
partnership
agreement or the certificate of limited
partnership (whether or not there is actual
limited liability under state law), or
(ii) there is actual limited liability under state
law.
(h) Under this definition of
a limited partnership
interest, all interests of members of an LLC
would
appear to be "limited partnership
interests" for
purposes of section 469(h)(2) and (e) of
Treas. Reg.
1.469-5T and a member would not be treated
as
"materially participating", even
if one of the 7
tests described above were
met. IRC 469(h)(2) and
Treas. Reg. 1.469-5T(e)(1)(i).
(i) Treas. Reg.
1.469-5T(e)(2) provides some minimal
relief, however, to holders of a
"limited
partnership interest" by providing that
the holder
will still be treated as materially
participating if
they meet tests (1), (5) or(6) set forth
above.
Those tests
are:
(1) The individual participates in the activity
for more than 500 hours during such year;
(5) The individual materially participated in
the activity (determined without regard to
this
paragraph (a)(5)) for any five taxable years
(whether or not consecutive) during the ten
taxable
years that immediately precede the
taxable year;
(6) The activity is a personal service activity
(within the meaning of paragraph (d) of this
section), and the individual materially
participated in the activity for any three
taxable years (whether or not consecutive)
preceding the taxable year;
These tests are very restrictive; much more so than
those provided in the remainder of the 7
tests, and
substantially restricts the use of losses.
etc. by
holders of "limited partnership
interests."
Fortunately, other relief is, perhaps,
available.
(j) Treas. Reg.
1.469-5T(3)(ii) provides that:
A partnership interest of an individual shall not be
treated as a limited partnership interest
for the
individual's taxable year if the individual
is a
general partner in the partnership at all
times
during the partnership's taxable year ending
with or
within the
individual's taxable year (or the
portion of the partnership's taxable year
during
which the individual (directly or
indirectly) owns
such limited partnership interest).
(k) No definition of
"general partner", however, appears
in either the IRC or the regulations.
(l) Rev. Pro. 89-12, dealing
with the classification of
an entity, provides in section 1.02 that:
Any reference to a "limited partnership"
includes an organization formed as a limited
partnership under applicable state law
and any
other organization formed under a law that
limits
the liability of any member for the
organization's debts and other obligations
to a
determinable fixed amount. References to
"general partners" and
"limited partners"
[apply] also to comparable members of an
organization not designated as a partnership
under controlling law and documents; the
"general
partners" of such an organization will
ordinarily be those with significant
management
authority relative to the other members.
(Emphasis and underlining
added.)
(m) This definition, or the
lack of a real definition,
leaves a great deal of uncertainty regarding
which
of the requirements of the 7 tests must be
met by a
member of an LLC.
However, some additional analysis
may be useful. Consider the following:
(i) The IRC 469(h)
requirement that persons holding
limited
partnership interests be treated as not
materially participating in an activity, and
the more restrictive position taken by the
IRS
in the regulations, are both consistent with
the general state law requirements which
prevent a limited partner from actively
participating in the management of the
limited
partnership.
(ii) IRC 469(h) and its legislative history
specifically contemplate that IRS will
promulgate regulations which handle these
situations.
However, no such regulations have
been drafted.
(iii) IRC
469(h), by its language, also
addresses only limited partnerships.
The
legislative history suggests that it is
the management characteristic, not the
limited liability characteristic, which is
pertinent to the issue of "material
participation".
(iv) Treas. Reg. 1.469-5T(e)(2), Treas. Reg. 1.469-
5T(3)(ii)
and Rev. Proc. 89-12 all look to the
level of management activity which is
attached
to the interest in determining the
difference
between a general partnership interest and a
limited partnership interest.
Even where the
interest is a "limited partnership
interest",
material participation is found and the
passive
loss allowed when the amount of activity is
significant.
(v) Perhaps more
importantly, shareholders in
Subchapter S corporations need only meet any
of
the seven tests to qualify for the use of
the
passive loss and there seems no reason to
distinguish between a Sub. S corporation and
an
LLC.
(vi) Members in a member managed LLC would seem more
like general partners than do Subchapter S
shareholder.
(vii) LLC
members in a manager managed LLC
should be more cautious since they have
restricted management authority (but not
necessarily
compared with other members,
if none are managers) and come more
readily within the concepts of Rev.Proc.
89-12.
(viii)
Notwithstanding the fact that there may be
no logical reason for distinguishing
between Sub. S corporation shareholders
and LLC
members, LLC members in a manager
managed LLC whose managers are members but
consist of less than all of the members,
fall almost squarely within the
description of the relationships contained
in Rev. Proc. 89-12 and are most readily
separated into categories of general and
limited
partnership interests under the
existing available guidelines.
(n) Regardless of the
possible arguments regarding why
LLC members should not be treated as holders
of
limited liability interests, until there is
clarification caution would dictate that any
LLC
member desiring to avoid losses being
characterized
as passive should have at least 500 hours of
activity or meet one of the other two more
restrictive tests.
Those desiring to ensure that
losses will be treated as passive
should make sure
that they do not exceed 100 hours of
participation
and avoid any of the 7 other tests.
iii. For further confusion on this subject, see the discussion of
"limited entrepreneur" under the
topic of "Agriculture",
below.
This concept, introduced in IRC 464, defines a
"limited entrepreneur" as a person
who:
(A) has an interest in an enterprise other than as a
limited partner, and
(B) does not actively participate in the management of
such enterprise.
5. Comparison of LLC
With Subchapter S Corp, Limited Partnership, and
Trusts in an Estate Planning Context.
a. LLC v. Subchapter S
Corporations
i. LLCs are more flexible than S corporations and have
many
advantages
ii. These advantages are likely to continue even if Congress
follows through with its proposed
liberalization of the S Corp
rules
iii. No restrictions on number or types of members
(1) Publicly traded partnership rules of I.R.C. 7704 will
apply to LLCs and, thus, will impose
practical limits. -
See Rev. Proc. 95-10, Section 1.05 provides
that ruling
request guidelines not applicable to IRC
7704 entities.
(2) Even complex trusts can be members and may afford some
flexability with regard to restricting the
distribution
of income or affecting the selection of the
beneficiaries
to whom it is distributed.
(a) Changes brought about by
the 1993 tax legislation
now penalize the accumulation of income in
the trust
by imposing higher rates.
(3) Less pre-death and post-death planning required to ensure
that only qualified persons_ become owners
of the
Subchapter S stock - or election may be
unexpectedly lost
with
very adverse consequences.
(4) May act as a general partner in a family limited
partnership to further limit liability.
iv. May have more than one class of ownership interest, with
different distribution rights
(1) To be valid, they must have substantial economic effect -
see IRC 704(b).
v. Can get the effect of a _consolidated_ income tax
return; no
prohibitions on LLC
like those prohibiting S Corp from being
part of an affiliated group
vi. No requirement that distributions be pro rata for all
members.
vii. Members of LLCs get full benefit of LLC debt in computing
their basis in their stock.
(1) Since all an LLC's debt is all nonrecourse for tax
purposes, members generally obtain an
increase in the
basis of their interests which reflects
their share of
the debt.
This may affect the amount of the losses they
may deduct.
(Passive loss rules and At Risk rules also
have an impact. Additionally, by assuming
some liability
for the debt, the manner in which the debt
is allocated
may be altered for some purposes.)
viii. As a partner, members of an LLC may also
take advantage
of the IRC 743 and 754 elections and adjust
the inside
basis of the assets of the LLC.
(1) S corporation shareholder receives a step-up in basis
when they acquire their S Corp stock
(whether at death or
in a taxable transfer),
(a) basis adjustment is only
made to the stock itself
(outside basis).
(b) there is no adjustment
to the inside basis (that
is the basis of the assets of the entity)
for an S
or C corporation.
(i) Net effect is that
although fair market value
is reflected in the outside basis at the
time
of the transfer, the acquiring shareholder
must
still pay tax on his or her share of the
gain
recognized on the sale by entity.
(ii)
Shareholder pays tax on the inside' gain in
the year in which the entity's gain is
treated
as distributable to him for federal income
tax
purpose.
(iii) Usually,
shareholder must await
liquidation of the entity or the sale of
his stock before receiving an offsetting
deduction.
1) Usually the
deduction will be a capital
loss deduction subject to the capital loss
limitations.
ix. Usually,
LLCs may distribute appreciated property to members
without recognizing gain at the LLC level or
income to the
recipient members.
See IRC 731.
(1) IRC 336 would produce a very different result for
corporations.
x. IRC section 2036(b), the "anti-Byrum" rule do
not apply to
partnership interests
(1) thus, it should be possible to gift an economic interest
in an LLC without gifting the voting control
while still
avoiding the inclusion of the value of the
transferred
interest in the taxable estate
(2) Other valuation discount rules will continue to apply.
b. LLC's v. Limited
Partnerships
i. No member of an LLC need be personally liable for the
debts of
the entity.
(1) In Limited Partnership, general partners are liable.
ii. All members of the LLC may participate in management without
becoming liable as a general partner.
(1) A member's liability is generally limited to the amount
of its capital
contributions plus any contributions which
it agreed to make but which remain unpaid.
(2) May have exposure if functioning in a jurisdiction with-
out LLC statute
(a)
risk becoming minimal as most states adopt LLC
statute
(3) Ability to actively participate may have a positive
effect on avoiding adverse effect of the
passive loss
rules
iii. Limited Partnership must carry on a business;
(1) Wisconsin LLC may be formed for any lawful purpose
(2) Some states require the operation of a business.
c. LLCs v. Trusts
i. Trust income tax rates are much higher if income is not
distributed annually - raised by the Revenue
Reconciliation
Act of 1993.
ii. If a trust's income is used to meet a support obligation of
the grantor, the income is taxed to the
grantor. IRC 677
(1) A similar result could arise as a partnership also.
(a) IRS
could merely recharacterize the payment as a
distribution
for a particular partner.
iii. May be better protection of assets than that available with a
trust, even a spendthrift
trust - particularly against
federal income tax claims.
iv. Limited
Partnerships and LLCs may be a viable alternative to
an irrevocable life insurance trust or any
other type of
irrevocable trust established for gifting
purposes.
d. Disadvantages to
the LLC
i.
Must have more than one person to form a LLC since partnership
classification requires that there be
"associates".
(1) Rev. Proc. 95-10 confirms prior IRS releases and allows,
at least for some purposes, 99%-1% ownership
splits.
(2) Sudden end - surprise results
(a) Some states, such as
Arkansas, Georgia, Idaho,
Montana, N.Y., North Carolina
& Texas allow one
person
LLC's
(b) Federal tax consequences
are uncertain since
definition of partnership requires more than
one
associate
ii. The law is very complex, causing uncertainty as to results,
higher expense, and traps for the unwary.
(1) Franchise tax and other burdens may apply.
iii. There may be uncertainties as to foreign recognition and
qualification to do business.
iv. Disparate state income tax treatment can create substantial
administrative complexity if owners are
located in many
states.
v. There is a general lack of familiarity and lack of
precedent
concerning LLCS.
6. Using the LLC in
Estate Planning.
a. Major features
making LLC desirable for estate planning purposes:
i. Limited liability for all members
ii. Generally, taxed only at the member level; income and losses
passed through to the members - not
applicable to publicly
traded LLCs
iii. Unlimited members of all types
iv. Can have centralized management
(1) Management not tied directly to economic interests
(2) Control can remain with senior family members
v. Can have varying economic interests
(1) can facilitate transfer of future growth
(2) can provide for succession to people who will have
varying degrees of activity in a business
vi. Need not operate a business?
(1) statute says any lawful purpose
(2) however, heading is nature of business
vii. Allows active participation by all members
(1) can minimize adverse effect of passive loss and certain
other tax rules
viii. Relationship can be modified from time to
time
ix. Can create minority interests and obtain minority discounts
x. Comparatively good creditor protection
(1) Creditor does not get at assets of LLC - merely gets a
Charging Order
(a) Probably gets pass
through of income and obligation
to pay tax because of status as an assignee.
(i) May get no
cash
xi. Can have all members essentially get an undivided interest in
all of the assets
xii. Upon liquidation or at any time, appreciated assets may be
distributed without the recognition of gain
xiii. Entity and members can get step up in both
inside and
outside basis
(1) because of present value of money, this is a very
valuable right
b. Major disadvantages
i. Possibly confusing and adverse taxation by different
states
ii. Legal uncertainty because of lack of precedent.
7. Classification For
Income Tax Purposes. (See detailed discussion
attached.)
a. An unincorporated
entity will not be treated as an association
taxable as a corporation unless it has more
corporate char-
acteristics than noncorporate
characteristics. Treas. Reg.
301.7701-1.
b. These regulations
are based on case law and must be viewed in light
of that case law.
c. The Treasury
Regulations identify six major corporate
characteristics.
They are:
i. have associates
ii. an objective to carry on business and divide gain
iii. liability for debts limited to
corporate property
iv. centralization of management
v. free transferability of interests
vi. continuity of life
d. Treas. Reg.s and
cases say other characteristics exist.
e. Note - If the LLC
is not operating a business and has no profit
motive, the general analysis most often
presented is not adequate.
i. Watch out for what it means to run a business &
have a profit
motive
(1) See PLR 9313025 and 9313026 - corp. and public utility
join to develop new energy efficient process
ii. Treas. Reg. 301.7701-2 (a)(2) provides that absent an intent
to make a joint profit, the entity can not
be taxed as an
association.
iii. Treas. Reg. 301.7701-3 provides:
(a) IN GENERAL. The term "partnership" is broader in scope
than the common law meaning of partnership
and may include
groups not commonly called partnerships.
Thus, the term
"partnership" includes a
syndicate, group, pool, joint
venture, or other unincorporated
organization through or by
means of which any business, financial
operation, or venture
is carried on, and which is not a
corporation or a trust or
estate within the meaning of the Internal
Revenue Code of
1954. A joint undertaking merely to share
expenses is not a
partnership. For example, if two or more
persons jointly
construct a ditch merely to drain surface
water from their
properties, they are not partners. Mere
co-ownership of
property which is maintained, kept in
repair, and rented or
leased does not constitute a partnership.
For example, if an
individual owner, or tenants in common, of
farm property lease
it to a farmer for a cash rental or a share
of the crops, they
do not necessarily create a partnership
thereby. Tenants in
common, however, may be partners if they
actively carry on a
trade, business, financial operation, or
venture and divide
the profits thereof. For example, a
partnership exists if
co-owners of an apartment building lease
space and in addition
provide services to the occupants either
directly or through
an agent.
f. So may not have an
association or a partnership.
i. Watch out for vacation homes.
g. Since the presence
of associates and the objective to carry on
business for joint profit is common to all
organizations organized
for profit, those two common characteristics
are disregarded in
determining whether an entity is a
partnership or an association
for federal tax purposes
h. Review of
Characteristics Affecting Tax Classification
i. Limited Liability - Always Present
ii. So, for "partnership" classification, can only have
one more
of the following characteristics:
(frequently centralized
management is desired - then must avoid free
transferability
of interests and continuity of life.)
(1) Free Transferability of Interests - heavily facts &
circumstances
(a) all but 20% can probably
be freely transferable - see
attached analysis and Rev. Proc. 95-10
(b) if member managed, no
free transferability if at
least a majority of the non-transferring
member-
managers must approve person becoming a
partner
(c) may exist if, in fact, a
small group actually
controls the entity -
see attached discussion at
4(F)6 &
Rev. Rul 93-4.
(i) Watch out if all
controlled entities are
involved.
(ii) Unknown impact if owners are parent & child &
parent has actual control.
(iii) IRS
suggests that documents can provide
for restricted transfer rights &/or
dissolution on attempted transfer and
avoid free transferability even if the
entity is controlled by a small group
(2) Centralized Management
(a) Requires that management
be concentrated in a small
group
(i) IRS current view (Rev.Proc.
95-3, 5.03) is if
entity
is manager managed, it probably has
centralized management unless:
1) managers own at
least 20% of the total
interests
2)
and other factors do not indicate that the
members control the managers in which case
centralized management may still exist.
3) IRS says won't
issue ruling if managers
can be replaced at periodic elections or
if non-managing members can remove
managing
members
a) These rules are
ideal for a family
LLC as seniors can have interests >
than 20% and not be subject to
removal except under limited
circumstances eg. cause.
(ii) possible to have a smaller group actually carry
out
management activities so long as all
members have actual management authority
(b) An issue arises when
transferors exercise managerial
control in the context of an LLC taxed as a
partnership.
(i) IRC sections 2036
(Transfers With Retained Life
Estate),
2038 (Revocable Transfers), and
2503(b) (Taxable Gifts)(Present
interests) and
other similar provisions can all be
triggered
if the manager has too much control and is
not
subject to what the IRS might consider to be
standard fiduciary duties.
1) See PLR 9131006 and
9415007. Both suggest
that the LLC is probably O.K., but there
is
no case law clarifying the extent of
the fiduciary duties.
The operating
agreement should clarify that such duties
exist. Query how IRS requirement
of few
limitations on removal of managers ties
with ordinary fiduciary duties.
Consider
at least removal for cause or breach of
fiduciary duty.
(3) Continuity of Life
(a) Rev. Proc 95-10, Sect.
5.01 provides new guidelines.
(i) No continuity of life if
death, insanity,
bankruptcy, retirement, resignation or
expulsion of any member causes dissolution,
even if business can be continued thereafter
with
consent.
(ii) If majority vote needed to continue, dissident
family members could block this.
(iii) Rev
Proc 95-10 provides almost no relief.
It requires a vote of the majority in
interest of all members to continue. But
it allows the events of dissolution to be
tied
solely to all of the member managers
(smaller group so fewer events.)
(iv) If the statute allows less than all of the
enumerated events (death, insanity etc) to
trigger dissolution & LLC operating
agreement
ties to less than all such events, then IRS
won't rule unless LLC establishes to IRS
satisfaction that the event is meaningful.
8. Valuation Issues
a. General.
i. Obviously, one significant use of the LLC is to
transfer
interests by gift or at death in a manner
which minimizes the
tax liability.
ii. Short of exempting the transfer from tax, the best savings
can
be achieved by having a low valuation of the
asset
transferred.
iii. This is often achieved by transferring minority interests in an
entity or by otherwise restricting
marketability.
iv. IRS has finally acknowledged in Rev. Rul. 93-12 that stock in
a family owned corporation was entitled to
to be evaluated
without regard to the fact that control
existed within the
family.
(1) A similar rationale should apply to partnerships,
including LLCs
b. Marketability
Discount
i. A discount in value should apply to an interest in an
LLC
because of a lack of marketability.
(1) Since an LLC is likely to be both closely held and its
interests not freely transferable, the
marketability of
the interest will likely be impaired and,
thus, a
discount for lack of marketability should
apply. If few
possible buyers exist the discount could be
in the range
of 10-25% or more.
(2) Note - free transferability here refers to the actual
legal right to transfer an interest..
It is only
tangentially related to the free transferability test
used for classification purposes.
(3) Note also that if an LLC has no operating agreement in
effect or one which provides for a buyout of
the LLC
interest,
marketability of an LLC interest may, in fact,
be enhanced and, thus, no discount applied.
(a) Wis. Stat. 183.0604,
Distribution upon Dissociation,
generally provides that, upon an event of
dissociation under s. 183.0802 that does not
cause
dissolution of the limited liability
company, a
dissociating member is entitled to receive
any
distribution to which the member is entitled
under
an operating agreement and, if not otherwise
provided in an operating agreement, within a
reasonable time after dissociation, the
dissociating
member is entitled to receive a distribution
in
complete redemption of the fair value of the
member's interest in the limited liability
company
as of the date of dissociation based on the
member's
right to share in distributions from the
limited
liability company.
c. Minority Interest
Discount
i. A discount may also be applicable if the interest
transferred
is a minority interest.
This is true because the lack of
control decreases the value of the interest
considerably.
(1) Particularly true in the case of LLC and other pass
through entities since they may cause the
owner of the
interest to incur a tax liability without
receiving any
cash to pay it.
d. Premium for Control
i. Where control is transferred, there may be a premium
added
to the value. Rev. Rul 59-60.
(1) could impact more heavily on manager members
(2)
Query what the impact is in situations where the managers
are not members
(a) may be like stock
e. Transfers with
Retained Interests - IRC 2701
i. If a person transfers an interest in a family
partnership
but retains certain types of interests and
control exists in
the hands of all of the family members, then
IRC 2701 provides
that the value of the retained interest is
$0.00 - thus,
putting all value on the transferred
interest, unless the
arrangement provides for the transferor to
get a qualified
payment.
(1) A qualified payment is one which requires payments at a
fixed rate on a periodic basis and are
cumulative if not
paid.
(2) The retained interest must be:
(a) a right to distribution
- other than one which is
junior to all other such rights, or
(b) a put, call, liquidation
right, or conversion right
other than one which must be exercised at a
specific
time
for a specific amount, or
(c) certain rights to
convert into interests of the same
class.
(3) Retained interests arise in recapitalizations and when
certain liquidation rights exist. eg. older family
member transfers assets to an LLC for
preferred and com-
mon interests, and transfers the common
interests to
younger family members.
Generally, the retained interest
will be have a zero value, unless the
preferred interest
has a fixed right for payment which is
cumulative.
ii. There is an open question as to how Section 2701(b) applies
to
an LLC.
Section 2701 applies when control exist within the
transferor and the rest of the family.
(1) Control, for a partnership, means holding 50% or more of
capital or profits interests,
(2) Control, for a limited partnership, means holding an
interest as a general partner.
(a) It is not clear what an
LLC is for these purposes.
(i) However, the
fact that new Rev. Proc. 95-3
removed LLCs from definitions in Rev. Proc.
89-
12 may suggest that the LLC will be a
partnership not a limited partnership.
1) Will member-manager
status vs. member have
any impact.
f. Lapses of Voting or
Liquidation Rights - IRC 2704
i. Two cases arose, Estate of Watts v. Comm., TC Memo
1985-595
(1985) and Harrison v. Commissioner, 52 TCM
(CCH) 1306 (1987),
in which substantial discounts in the value
of an interest in
a controlled entity arose because the
transferor, by contract,
could not force a liquidation of the
enterprise or exercise
certain other rights . (The going concern
value was lower.)
ii. Proposed Treas. Reg. 25.2704-1 provides that the lapse of a
voting right or a liquidation right will
constitute a transfer
giving rise to a gift if during lifetime or
a transfer tax if
the lapse is at death.
iii. To deal with contractually based restrictions, Congress also
enacted 2704(b) which essentially ignores
the existence of the
restriction.
(1) these rules are complex and there breadth is subject to
debate
(2) there is also a disparity between the statute and the,
regulations with the regulations. See Treas.
Reg.
25.2704-2(b)
(3) When solving the problem of how to avoid the application
of these provisions when a liquidation right
is involved,
it will be important to also consider the
continuity of
life test for classification purposes.
(4) If an operating agreement contains provisions which are
more restrictive regarding a member's right
to cause a
dissolution or a liquidation, the
restrictions may be
ignored in computing the value of the
interest under
I.R.C.
2704(b).
9. Estate Freezes.
a. Subject to many of
the restrictions referred to above with regard
to retained interests, many opportunities
exist for freezing the
value of a retained interest and passing on the
future growth.
i. could include a transfer to an LLC in exchange for
common and
preferred interests and subsequent gifting
of preferred
interests
ii. might
include a transfer of assets to LLC in exchange for an
interest which provides for a fixed payment
which is
cumulative.
iii. could be an arrangement where there is
a transfer to to the
LLC for a note or other fixed
obligation, where transferor has
no other interest but is a manager
iv. many other alternatives exist.
10. Family Partnership Rules
a. If an LLC is
partnership for federal income tax purposes, the
family partnership rules of
IRC Section 704(e) will apply.
i. The details are found in Treas. Reg. 1.704-1(e)
ii. The rules apply to all transfers of partnership capital
interests by gift, regardless of whether the
person is a
family member or not.
b. The purpose of the
rules are to outline the circumstances under
which a person or entity receiving a capital
interest in a
partnership in which capital is a material
income producing factor
will be treated as a partner and when they
will not be so treated.
It also provides rule for the allocation of
income under certain
circumstances.
c.
Section 704(e)(1) provides:
i. A person shall be recognized as a partner... if he owns
a
capital interest in a partnership in which
capital is a
material income was derived by purchase or
gift from any other
person.
(1) If so qualify, then the donee's distributive share of the
income will be allocated to him provided
that the donor,
if providing services, is receiving adequate
compensation
and provided that the amount received by the
donee in
respect of his capital is proportionate to
the amount the
donor is receiving in respect of his
capital.
(a)
In other word, you can't shift income.
ii. If capital is not a material income producing factor then
Section 704(e) does not apply.
Instead, case law will apply.
iii. Section 704(e) only applies if the donee-partner actually own
his interest.
(1) The Treas. Regs. set out criteria for testing ownership
of a capital interest in a partnership and
in a limited
partnership.
These rules look to the following factors
in connection with partnerships (not limited
partnerships):
(a) Whether an alleged
partner who is a donee of a
capital interest in a partnership is the
real owner
of such capital interest, and whether the
donee has
dominion and control over such interest
(b) The execution of legally
sufficient and irrevocable
deeds or other instruments of gift under
State law
(c) the conduct of the
parties with respect to the
alleged gift and not by any mechanical or
formal
test
(d) Whether the donor
retained controls over the
interest such as:
(i) control of the
distribution of amounts of
income or restrictions on the distributions
of
amounts of income
1) If there is a
partnership agreement
providing for a managing partner or
partners,
then amounts of income may be
retained in the partnership without the
acquiescence of all the partners if such
amounts are retained for the
reasonable
needs of the business.
(ii) Limitation of the right of the donee to
liquidate or sell his interest in the
partnership
at his discretion without
financial detriment.
(iii) Retention
of control of assets essential
to the (for example, through
retention of assets leased to the alleged
partnership).
(iv) Retention of management powers inconsistent
with normal relationships among partners.
(v) Retention by the donor
of control of business
management or of voting control, such as is
common in ordinary business relationships,
is
not by itself to be considered as
inconsistent
with normal relationships among partners,
provided the donee is free to liquidate his
interest
at his discretion without financial
detriment. (Emphasis Added.)
(vi) Controls inconsistent with ownership by the
donee may be exercised indirectly as well as
directly, for example, through a separate
business organization, estate, trust,
individual, or other partnership. Where such
indirect
controls exist, the reality of the
donee's interest will be determined as if
such
controls were exercisable directly.
(e) Substantial
participation by the donee in the
control and management of the business
(including
participation in the major policy decisions
affecting the business) is strong evidence
of a
donee partner's exercise of dominion and
control
over his interest.
(2) As to limited partners it provides:
(a) The recognition of a
donee's interest in a limited
partnership will depend, as in the case of
other
donated interests, on whether the transfer
of
property is real and on whether the donee
has
acquired dominion and control
over the interest
purportedly transferred to him.
(b) To be recognized for
Federal income tax purposes, a
limited partnership must be organized and
conducted
in accordance with the requirements of the
applicable State limited-partnership law.
(c) The absence of services
and participation in
management by a donee in a limited
partnership is
immaterial if the limited partnership meets
all the
other requirements prescribed in this
paragraph.
(d) If the limited partner's
right to transfer or
liquidate his interest is subject to
substantial
restrictions (for example, where the
interest of the
limited partner is not assignable in a real
sense or
where such interest may be required to be
left in
the business for a long term of years), or
if the
general partner retains any other control
which
substantially limits any of the rights which would
ordinarily be exercisable by unrelated
limited
partners in normal business relationships,
such
restrictions on the right to transfer or
liquidate,
or retention of other control, will be
considered strong evidence as to the lack of reality
of ownership by the donee.
iv. The regs. also provide that:
If the reality of the transfer of interest is satisfactorily
established, the motives for the transaction
are generally
immaterial. However, the presence or absence
of a
tax-avoidance motive is one of
many factors to be considered
in determining the reality of the ownership
of a capital
interest acquired
by gift.
v. It will be important to keep these rules in mind when
drafting
an operating agreement.
Particularly the safe harbor provided
if their is a right to liquidate the
interest.
vi. The issue of whether an LLC is a partnership or a limited
partnership is also at issue as the regs
were not drfated with
LLCs in mind.
11. Insurance
a. LLCs may be used to
hold life insurance contracts.
i. Can avoid the transfer rules
ii. Can avoid the corporate alternative minimum tax which could
arise if the insurance proceeds are paid to
the corporation.
See Treas. Reg. 1.56(g)
b. Gross income will
not, generally, include amounts
received under a
life insurance contract, if the amounts are
paid by reason of the
death of the insured. (IRC 101(a)(1).
c. If a life insurance
contract, or interest in one, is transferred
for a value, gross income will include all
of the policy proceed
received except for an amount equal to the
sum of the actual value
paid plus the amount of any premiums or
other amounts paid by the
transferee. IRC 101(a)(2).
d. Excluded from the
transfer for value rules are transfers of a life
insurance contract to the insured, a partner
of the insured, a
partnership in which the insured is a
partner, or a corporation if
the insured is a shareholder or officer of
it. IRC 101 (a) (2)
(B).
i. Partnership has greater flexibility than corporation
since
other co-shareholders are not within the
excepted group.
ii. Can be used to
fund cross purchase agreements.
(1) LLC can generally distribute the policies into joint
ownership since transfers to partners are
exempt.
iii. The insurance policy proceeds should be allocated to the
partners who will purchase the deceased
partner's interest.
(1) increases the basis of the purchasing partner to reflect
the tax exempt income generated by the
payment of death
benefits.
Treas Reg 1.704-1(b)(2)(iv)(i) and should
avoid increasing value of deceased partners
interest
(a) Watch timing of
distributions of proceeds since
basis is not stepped up till last day of
year and
distribution in excess of basis could have
extremely
adverse tax consequences.
(b) Treat pre-year end
distributions as an advance or
loan,
not a distribution. See IRC 731 (a)
(1).
(i) Not clear whether the
insurance proceeds
transferred to a partnership will be
included
in the decedent's estate as coming from a
policy owned by the deceased.
See IRC 2042.
Issue arises if policy proceeds are paid
"other
than for the benefit of the
partnership,".
then incidents of ownership may exist.
12. Miscellaneous Other
Matters To Consider.
a. Use of LLC as
general partner in Limited Partnership
b. Special Elections
i. Redemptions to pay death taxes under I.R.C. 303
ii. Deferral of payment of estate tax under 6166
c. LLC may help avoid
an ancillary probate of real property
13. Summary of Some Family
Estate Planning Considerations
i. Family partnerships and corporations have frequently
been used
for estate planning purposes.
LLCs may help to facilitate
that planning.
(1) While estate freezes have been restricted by changes to
the
IRC in recent years, many estate planning objectives
can still be accomplished.
(2) Older family member owners of corporations, partnerships
and LLCs can make annual gifts to younger
members of the
family and gradually divest themselves of
ownership while
avoiding gift taxes if the gift has a value
which is less
than the amount of the gift tax exclusion.
(a)
The shifting of these interests from the older
generation to a younger generation affords
both
generations some protection from creditors
and, if a
majority of the interests are shifted,
allows for
the application of some discounting of the
value of
the ownership interests which are included
in the
deceased owner's estate.
(b)
If gifts are given to younger family members who are
active in a "partnership" or LLC
operated business,
emphasis can be placed on giving interests
in
"capital" rather than
profits. (Interests in future
profits can be obtained tax free by the
younger
members in exchange for contributions of
future
services and any increase in the future
profits
interest of a younger member has the effect
of
decreasing the value of the profits interest
of the
older members.)
(c) If a controlling family
member has gifted LLC
interests to noncontrolling family members,
then the
non-controlling members should be able to
liquidate
their interests without financial penalty so
that
the LLC income is not taxed to the donor
under
704(c).
(i) A controlling
shareholder could, however,
consider the obligation to pay the tax as an
additional estate planning mechanism,
particularly if there is little disparity in
tax
rates.
ii. Since a properly structured LLC is a partnership for tax
purposes, a natural person's basis in
his/her interest in the
LLC will be stepped upon the death of the
owner. IRC 1014.
If the LLC allows the adjustment of its
inside basis under IRC
754, the assets of the LLC will also be
stepped up to reduce
the amount of gain recognized by the LLC on
the disposition of
the LLC's assets.
iii. There are numerous provisions of the IRC pertaining to estate
and gift taxes which impact on family held
partnerships and
corporations which will also pertain to LLCs.
Provisions such
as those found in IRC 2701--2704 are of
particular concern
because of the characteristics of the LLC.
(1) The Wisconsin LLC statute, like most others, grants
certain rights to members of LLCs with
regard to voting,
withdrawing and obtaining payment for the
interest, etc.
(2) These provisions are particularly important when estate
planning for LLCs.
Many of these rights affect issues
such as fair market value of the LLC
interest and the
legitimacy of applying a discount.
(a) For example, although it
is common to discount a
minority interest in an enterprise because
of the
lack
of marketability of the interest, the existence
of a statutory right to be bought out
certainly
impacts on the the argument that there is no
market
or that the value should be discounted.
Similar
issues arise because of the rights granted
LLC
members and the lapse of those rights
(particularly
voting rights.)
Copyright © 1994-2000 Institute of Professional and Consumer Education, LLC. All Rights Reserved.