Limited Liability Company – Cutting Edge Estate Planning

By Stuart G. Schmidt, Esq.

A family Limited Liability Company has great potential as an estate planning device to reduce the Federal Estate and Gift Tax by as much as 40%. Although most people hear about Family Limited Partnerships (“FLPs”), a Limited Liability Company (“LLC”) may actually be the better choice. However, either of these entities allows people to make gifts, avoid paying Federal Estate and Gift tax and maintain control. In addition to the tax savings, an LLC, unlike an FLP, can provide the entire family with asset protection. An FLP or an LLC is only really needed as an estate planning technique if a person’s estate exceeds $5,340,000, if single, and $10,680,000 if married. This is because as of 2014, each individual person has an estate tax exemption which allows him or her to pass $5,340,000 tax free upon death. If your estate exceeds this $5,340,000 per person exemption and you do not want your beneficiaries to pay a 40% tax, an LLC or FLP must be considered.

Making Gifts and Maintaining Control 

While most people are aware that they can make tax free gifts of $14,000 each year (adjusted annually for inflation), few people can afford to give away large sums of cash. For those who have the cash to give, they often have concerns that the money would be wasted. An LLC or FLP provides a solution by allowing parents to make gifts of property while continuing to maintain control over the assets gifted.

An LLC is usually started with parents transferring property, such as rental property or stock, to an entity in exchange for ownership “shares”. The parents would then be the owners of the LLC shares rather than the underlying assets. This ownership structure allows the parents to gift interests in the LLC, instead of the underlying assets. While children and grandchildren receive valuable LLC shares, such shares do not need to have any management or voting rights. The parents, as Managers, remain in sole control of the affairs of the company. In addition, to limiting voting rights, the shares in the LLC can be restricted so that children or grandchildren cannot sell their interest in the LLC without first obtaining consent and / or offering it to the parents.

While most parents choose this two tiered structure to maintain control, gifting shares that lack management or voting rights can actually achieve an estate / gift tax savings of more than 40%. Shares that have no voting or management rights are clearly less valuable than voting shares and are usually given a 40% discounted value. Because the Federal Estate and Tax is based on the fair market value of the property given, this reduction in value (known as a “discount”) will also reduce any estate or gift tax that may be assessed on the transfer. This discount effectively allows a person to give 40% more property each year tax free. Thus, the $14,000 annual tax free exemption that each of us have can be used to completely shelter a gift of an interest in an LLC, even though the underlying assets are actually worth more than $23,000. When these gifts are made each year to each child, and maybe grandchildren, the savings over the years can be astronomical. Keep in mind that the Federal Estate tax is assessed on the fair market value of all property owned upon a person’s death. By transferring wealth to children and grandchildren during life, not only are the assets removed from your estate tax fee (so they will not be subject to the 40% estate tax) but so is the future growth of the assets.

Consider the Following Example: 

Assume that Mr. and Mrs. Smith own rental properties and a stock portfolio valued at $12 million. Even if the Smiths have already completed the initial tax planning with a will or living trust, which should make use of their combined lifetime Estate Tax exemptions of $10,680,000, the children will still have an estimated estate tax of almost $528,000.

To plan around this problem, the Smiths can begin to make yearly tax free gifts of property valued at $14,000 to each child. They can also make larger gifts but part of their combined lifetime estate tax exemption of $5,340,000 would be used. Assuming Mr. and Mrs. Smith have three children, they could gift away $84,000 each year, gradually reducing the value of their estate.

Unfortunately, the Smiths face a second “problem” in their planning: growth. If they are worth $5.6 million today, their property could easily appreciate faster than they can gift or spend it. Assuming a modest 5% rate of growth, their estate would double in less than 15 years, increasing the eventual estate tax. Even if they gift $84,000 each year, every year, the growth would still far outpace the gifts and an estate tax would have to be paid upon their deaths.

In addition, it is unlikely the Smiths can afford such large cash gifts. While they could make gifts of interests in the underlying real estate or stock, this creates management problems, threatens their control and exposes the Smith’s children to liability if the Smiths were sued.

An LLC provides the perfect solution. By making gifts of an interest in an LLC, the Smiths can give 40% more through the use of the yearly $14,000 tax free gifts which will help speed up their gifting program and possibly eliminate, or at least minimize, the potential estate tax. More importantly, the Smiths can remain in sole control, continue to manage the property and ensure that the entire family’s personal assets are protected against creditors.

Controlling Distributions From the LLC and Minimizing Income Tax 

The parents, as Managers of the LLC, are in control of all distributions of income. When distributions are made, they should be made to each member in accordance with his or her interest in the LLC. The income attributable to each member is taxed to that individual at his or her tax bracket, whether it be children or grandchildren. Often these younger members are in a lower tax bracket which can help reduce the overall family income tax burden. Distributing the income over a number of lower tax brackets, rather the parents’ top tax bracket, can minimize the yearly income tax. The money that is attributed to a younger member, and taxed at his or her bracket, can then be used to pay for such child’s education or other worth while causes. The only limitation in this regard is the “kiddie tax”, which directs that unearned income of children under 17 is taxed at the parent’s rate. Parents who do not want to part with any of the distributions can pay themselves a salary for acting as Managers.

Limited Liability for All / Asset Protection 

With an LLC, all Members, including the Managers, are protected from personal liability for debts of the LLC or the acts of the other Members. This is an improvement over a Family Limited Partnership (“FLP”), where the General Partner, who is the Manager, does have personal liability for the debt and actions of the FLP. This is the main distinguishing factor between the FLP and LLC and a very important aspect which makes the LLC a better family entity.

Gross Receipts Tax for LLCs

An LLC does pay an extra tax that an FLP does not have to pay. While both entities do pay an annual fee of $800.00 to the State of California, only an LLC has an extra tax for the limited liability. California charges a “gross receipts tax” on gross receipts in excess of $250,000. The annual tax, based on gross receipts, is as follows: $250,000 to $499,999, the tax is $900; $500,000 to $999,999, the tax is $2,500; $1,000,000 to $4,999,999, the tax is $6,000 and for gross receipts greater than $5,000,000, the tax is $11,790. This tax can be avoided and limited liability achieved by creating an FLP and then forming an LLC to be the General Partner holding just a 1% General Partner interest. This will eliminate the “gross receipts tax” and provide the important limited liability, at the cost of simplicity and increased accounting fees.

Conclusion

An LLC is an extremely important estate planning tool that should be considered by anyone with an estate over $10,680,000. Although an LLC is not a substitute for the fundamental estate planning provided by a living trust, a will, durable powers of attorney for property and health care directives, for many people it is the next step.

It is time to review your estate plan. If you don’t yet have an estate plan, it’s time to get it done. Your death or incapacity will be emotionally traumatic for your family; don’t make it legally difficult as well. Contact one of our estate planning attorneys , Stuart G. Schmidt or David J. Lee, to assist in the creation, review and/or update of your estate plan. Our job as your attorneys is to make this process easy and painless and, most importantly, put a proper plan in place. Call us today at (408) 356-3000 or send us an email at sschmidt@smwb.com.