When used strategically, limited liability companies ("LLCs") can be a vital estate planning tool. As with most other areas of tax planning, however, the use of LLCs for estate planning purposes requires a nuanced analysis that balances the utility of any given approach along with its potential risks in order to determine what the best strategy will be to achieve each client’s unique goals. This article is the first in a series discussing several ways in which the use of LLCs can be advantageous, specifically when used for estate planning purposes.
Advantages of Using an LLC
An LLC offers a flexible form in comparison to many other business entities, which makes it an attractive choice for use as an estate planning instrument. The relative freedom of members, the protection from liability, and the option to elect to be taxed as a corporation, a partnership, or a "disregarded entity" all make LLCs a smart choice as business or investment vehicles.
For these reasons, LLCs are widely used in many contexts. When we consider the passing of assets from one generation to the next—the particular context of estate planning—several other advantages of using LLCs become apparent. Broadly, because management of an LLC is not based on ownership, one generation can transfer the assets held by an LLC to the next generation without giving up control. Additionally, LLCs can use transfer restrictions in order to protect assets against potential creditors of members, and children’s ex-spouses. Appreciation in the value of an LLC’s assets is not includible in the taxable estate of the transferor; only the value of any retained interest in an LLC will be taxed.
Beyond the broad advantages described above, specific arenas of investment benefit in different ways from the use of an LLC: If parents who own rental property want to pass that property to their children, the use of an LLC will allow them to divide the interest into equal shares and pass LLC membership interest to each child, thus accomplishing their goal without having to create separate fractional deeds for each transfer. For stock investors who want to distribute investments among children or other parties, holding the entirety of an investment in an LLC and distributing LLC membership interest, instead of splitting the investment assets into separate stock portfolios, allows each recipient to enjoy the benefits of greater diversification. For parents managing an active business, gifting LLC membership interest in that business can allow them to pass interest to their children gradually over time, without relinquishing management and control.
In addition to these advantages, in this article we will look at the particular role that valuation discounts can play, and what tax savings can be achieved, when transferring ownership of interest in an LLC. Future articles will cover other tax-planning use of LLCs, including the use of LLCs by owners of out-of-state real property in order to avoid ancillary probate, and a discussion of how the rules governing the annual exclusion from gift tax relate to gifting of LLC interests.
Perhaps the strongest argument for use of an LLC as part of an estate plan is to take advantage of the transfer tax discounts that passing fractional shares of LLC interest can create. The two types of valuation discounts that the IRS most commonly applies in determining the value of a business entity for tax purposes are (1) a discount for "lack of control" or "minority," and (2) a discount for "lack of marketability."
Conceptually, discounting LLC interests for these reasons makes sense: owning a minority share in an entity comes with significantly fewer rights, and as a consequence, the value of a minority share may be worth less, and will be less marketable to a potential buyer.
The Tax Court has recognized minority interest discounts of 25 percent or greater, resulting from an owner’s lack of control over management. Whether or not the minority interest holder has the ability to compel distributions and to force liquidation and receive a proportionate share of the entity’s net asset value are factors that are frequently taken into account in determining whether to apply a discount, and if so, how much. Without the ability to compel distributions or force liquidation, a potential buyer of such an interest will likely not want to pay a price that might be fair for the full value of the assets if they were held outright or even as a majority interest.
A discount for lack of marketability can range from zero to 30 percent, and reflects the lack of a ready market for the LLC interest. Practically, this discount is often closely related to the minority interest discount. In order to take full advantage of the available discount here, an LLC’s operating agreement should contain restrictions on the right of members to convert their interests to cash, because such a restriction will decrease the value of each member’s LLC interest.
Property transferred to an LLC will not receive a step-up in income tax basis, except to the extent of the discounted value of the transferor’s retained interest in the LLC at the time of the transferor’s death. Particularly now, with income tax rates plus the "Medicare Surtax" potentially combining to create a higher tax rate on income than would be paid in estate or gift tax, close attention should be paid to which assets would be best suited for an LLC in order to maximize overall tax savings.
Additionally, it should be noted that in order to receive the kind of valuation discounts discussed above, an appraisal of LLC assets will likely be required.
LLCs can be a very useful tool in estate planning, and use of this form has become widely popular for both practical and tax-savings reasons. Determining whether an LLC is the best instrument to achieve your particular goals requires some level of analysis, however. Future articles in this space will discuss other considerations relating to the use of LLCs for estate planning purposes.
Related Files: Estate Planning Advisor - Spring 2013