Many families select a trust in order to avoid estate taxes, manage assets, and provide that the assets pass to later generations. In some situations, a family limited liability company (“FLIC”) may be a superior vehicle for managing assets and ensuring that they are kept within the family.
Let’s look at an example: Mom and Dad own a 200-unit apartment complex and a beach house, and they want both to pass on to their children. Their three children range in age from 17 to 27. Although they are good kids, they don’t always agree on everything and are not experienced in running a business. Mom and Dad are considering establishing a trust or a FLIC to manage these two assets following their death. What are the considerations?
For an apartment complex of this size, a management company should be hired to provide day-to-day management. But the management of the manager and making decisions about major matters such as sale, financing, refinancing, and major property improvements or repairs should be handled at the ownership level. For the beach house, sticky questions, such as who gets the beach house on July 4, whether the owners can bring pets, and how to pay for operating expenses, should be resolved by the owners.
The person making ownership decisions for a trust is generally the trustee. For a FLIC, it generally is the member-manager of the FLIC. In either case, Mom and Dad could, through the trust agreement or the FLIC’s operating agreement, select a manager or trustee and that person’s successors. Mom and Dad could also name successor managers or trustees, or they could give the trustee and manager the right to appoint their successors. When the children mature to a point at which they can participate in management, they too can be appointed as trustees or FLIC managers. If the three children are the managers, the FLIC’s operating agreement can allow a majority vote to determine whether a particular action should be taken.
A trust can also split control and allow the beneficiary, and not the trustee, the right to make certain major decisions. Typically, this would include a decision to sell a major property or use it as collateral to secure a loan. Such rights can spring into existence when the youngest child is age 25, for example.
Keeping It Within the Family
The trust can pass on the beneficial ownership of the asset following the death of a child to that child’s children. A trust agreement generally provides that as each child dies, his or her interest passes to the grandchildren. Typically in a FLIC, each child can pass on his or her interest to only family members as well, but the child can select whom it should pass to. Thus, the child can pass the interest to a spouse, if allowed in the FLIC’s operating agreement, to siblings, or to the child’s children. But the decision about to whom to transfer the interest within the class of permissible transferees rests with the owner of the FLIC interest. This might mean, for example, that a parent could pass on more assets to the child who has the greatest need for those assets. This can be done with a trust as well, through a power of appointment, which can be exercisable during the child’s lifetime or only at death.
Most trusts strictly prohibit, in a provision called a spendthrift clause, the right of a beneficiary to in any way transfer or borrow against his or her interest in the trust. A FLIC can also prohibit or greatly restrict the rights of its members to sell, gift, or pledge the membership interest. But a spendthrift clause in a trust can defeat a judgment creditor, while a judgment creditor can reach a member’s ownership interest in a FLIC.
Distributions of Principal and Income
For a trust, the trustee generally has the power to distribute trust income and principal to the beneficiaries. For example, a trustee might have the power to give money to one child to establish a business, while making no distribution to a second child who has a substance-abuse problem. For a FLIC, while it is technically possible for the manager to make such distinctions, generally the manager has the power only to make distributions to all the FLIC members on a pro rata basis based on each child’s ownership percentage. But the FLIC manager can withhold distributions, except for any amounts needed to pay taxes, and invest the FLIC’s cash assets in stocks and bonds instead of distributing the assets.
So far, one can see that both a trust and a FLIC have their advantages and disadvantages. But one area that may favor a FLIC is its flexibility. A FLIC can be amended based on rules set forth in its operating agreement. Typically a majority, or perhaps two-thirds of the members, can revise the agreement. The operating agreement could provide that the right to vote to amend the agreement will not exist until the children reach a particular age. A limitation on the flexibility of a FLIC is that all the members of the FLIC must be at least 18 years of age because it is essentially a contract. Thus, a 17-year-old child would need to have his or her interest held in trust or possibly a Uniform Transfers to Minors Act account at least until reaching age 18.
While such a power could be given to children in a trust, it would be very unusual. Trusts designed to manage assets for children are typically irrevocable. It is not at all unusual after an irrevocable trust has been created that Mom and Dad desire to revise the trust because of a change in circumstances. While an irrevocable trust can be modified, it generally requires going through a complex process, which might include obtaining court approval and unanimous approval of the beneficiaries. So a FLIC can offer more flexibility than a trust.
A trust that is used to manage assets can be established to avoid estate taxes and generation-skipping taxes (typically, a tax on transfers to grandchildren) on its assets on the death of the children, provided that the property remains in trust for the entire lives of the children. But a child will not be subject to estate taxes until his or her estate exceeds $5.25 million. That number jumps to $10.5 million for most married children. So for the overwhelming majority of families, avoiding transfer taxes on the death of children is not an issue. If it is an issue, an irrevocable trust designed to save estate taxes and generation-skipping taxes on the death of the children may be the right answer.
A FLIC has a big advantage because it will generally save significant income taxes. A trust starts paying taxes at the highest federal tax rate of 39.6 percent on $11,950 of income that is not distributed to its beneficiaries. FLICs do not pay income taxes. A FLIC’s owners are taxed on all the income, which will be taxed at the highest federal tax rate of 39.6 percent starting when an owner’s total income reaches $400,000. Likewise, the new 3.8 percent tax on certain investment income will kick in much earlier for a trust that does not distribute all its income. Further, assets in a typical irrevocable trust held for children until death do not receive a step-up in tax basis. Assets held in a FLIC, however, do receive a step-up in basis at death, and the FLIC’s operating agreement can even provide that the heirs have the right to higher depreciation and lower capital gains taxes based on the stepped-up basis of their share of the FLIC’s taxable income.
While a trust and a FLIC each have their own advantages and disadvantages, a FLIC may be the big winner in the areas of income-tax saving and flexibility. Further, Mom and Dad might see a FLIC as a more natural way to involve mature, adult children in the ownership and management of assets. Note also that this brief article does not cover every issue in what can be a very complex area. And it is not a substitute for a thorough discussion of the issues with your advisors.
Related Files: Estate Planning Advisor - Fall 2013