Family Business Entities for Estate Planning Purposes
Quite often
clients have real property that produces income or stock that they want to pass on to
their heirs, yet they have competing interests of retaining control over the assets and
saving on estate taxes. Over the years,
families have utilized a business entity to successfully pass on assets to their children. However, the Internal Revenue Service does keep a
close eye on these transactions.
There are
several forms that the business entity can take - a limited partnership, limited liability
company or a corporation. All three forms
provide a level of limited liability and an easy vehicle to transfer interests to others.
Workings of a Family Business Entity in Estate Planning
Using a
limited partnership (“LP”) for the example, assume that you own real property
that is worth $2,224,000. It is decided
that an LP is advantageous. The LP-1 is filed
with the Secretary of State and an operating agreement is executed. Then the real property is formally transferred to
the LP by deed (potentially subjecting the property to reassessment). Assuming it is a married couple (partnerships can
only be formed by two or more people), the
husband and wife are named as the managing general partners.
Each would retain a 1% interest as general partners. And then transfer the
other 98% of the asset into the business entity and issue themselves 98% entity interests
as limited partners. Over a few years or all
at once, the husband and wife transfer 49% of the limited partners interests to each of
their children, assuming they have two.
Is
this gift worth $2,179,520 and subject to either gift tax or estate tax at the husband and
wife’s deaths? No. Although an individual is only allowed to gift
$11,000 to each individual on an annual basis, an individual can use their lifetime
exemption of $1,000,000 and control the valuation of the gifts rather than have the IRS
control the value of the property passing at their death.
The way to control the value is by taking a discount on the portion gifted. The total value of each gift in the above example,
after discounts, is arguably only worth $544,880, or $272,440 from each parent.
As limited
partners, the children have no say in the management of the business entity. As managing
general partners, the husband and wife have total control, and would be entitled to a
management fee (probably equal to the income in the asset).
Because the limited partners have no control and little or no income, when valuing
their interest in the asset, one would typically take a discount of 40-60% of the market
value of the asset transferred. This would
allow the husband and wife to leverage the value of the gifts, and minimize the value of
the gift that is filed on the Gift Tax Return, which would have to be subtracted from the
$1 million death time exclusion if the gift is over $44,000 (the husband and wife each
gifting over $11,000 to each of their children).
The final
result is that the husband and wife only own 2% of the LP at their deaths. Yet while they are living, they still retain
control over the assets and receive the income (within IRS guidelines).
Characteristics of Business Entities
As
stated, there are three forms that the entity can take - limited partnership
(“LP”), limited liability company (“LLC”) or corporation. Most everyone is familiar with how corporations
and limited partnerships work. However,
limited liability companies were first recognized by California
in 1994 and are less familiar.
The main
characteristic of the three entities is that generally the owners of the entity are not
personally liable for the business’ debts and obligations. The owners of the LP are those that hold
partnership interests - whether limited or general. The
owners of an LLC are the members. And the
shareholders of a corporation are its owners.
Corporate
shareholders, directors, and officers are ordinarily not liable for the debts and other
obligations of a corporation. As a separate
legal entity, the corporation itself is liable for such obligations. Individuals, however, may be held liable:
to the extent that they have personally guaranteed corporate debts;
to the extent that they have received improper distributions;
if a court “pierces the corporate veil” of a corporation
to impose personal liability on the shareholders; or
if a director, an officer, or a controlling shareholder breaches a
duty to the other shareholders of the corporation.
The general
partners of an LP are (a) jointly and severally liable for the wrongful acts or omissions
of any partner acting in the ordinary course of partnership business or with authority of
the partners and (b) jointly liable for all other debts and obligations of the
partnership. Like shareholders in a
corporation, limited partners are not normally liable for debts of the partnership. The liability of a limited partner is usually
limited to the amount of his or her agreed capital contribution and any distributions
received by the limited partner from the partnership at a time when the partnership’s
assets were insufficient to satisfy its liabilities. Limited
partners may become liable as general partners if they participate in the control of the
partnership business.
The members
of an LLC are not personally liable for the debts, obligations, or liabilities of the LLC
solely by reason of being a member of the LLC. Despite
the general rule of limited liability, the following liabilities and obligations apply:
a member may be liable to the extent that he or she personally
guaranteed debts of an LLC;
a member may be subject to liability to third parties for the
member’s participation in tortious conduct;
a member may be liable to the extent he or she agreed to be
personally bound in the articles of organization or written operating agreement;
a member may be obligated to return, or may otherwise face personal
liability with respect to, distributions from an LLC made in violation of the
Beverly-Killea Limited Liability Company Act; and;
a member may be liable if a court “pierces the company
veil” of an LLC to impose personal liability on the member.
The main
advantage of an LLC is that the members are free to determine the management structure of
the LLC. The LLC may be managed by
member-managers, nonmember-managers, or by all of its members.
There are a
few advantages of using an LLC rather than an LP.
Although an LP allows pass-through tax treatment, flexibility in
financial structuring, and limited liability for limited partners, at least one person,
i.e., a general partner, must be fully liable for the obligations of the business, and
limited partners may not take part in the control of the business without jeopardizing
their limited liability. An LLC can provide
the advantages of an LP without the disadvantages. Unlike an LP, no LLC owner (a
“member”) need be personally liable for the company’s obligations, and each
member is permitted to manage the company and to take part in the control of its business
without losing the member’s limited liability.
A few recent
Tax Court cases have specifically attacked transfers of LLC interests and the discounts
taken. This could be a disadvantage to
an LLC. However, these rulings could arguable
be an advantage to using an FLLC. If there is
more of a risk of an attack for an FLLC, doesn’t that mean a larger discount can be
taken on the transfer of an FLLC interest? In
practice, these rulings have been applied to family limited partnerships as well.
Some say
that since the LLC form is newer to California than the partnership form, it could be a
disadvantage because the laws governing LLCs are not settled and there is no surety on how
the courts will rule on LLC issues. The flip
side is that this can be an advantage because who is to say that the court cases will be
unfavorable to LLCs. The newness may also be
an advantage because when drafting the LLC code, the committee was very careful and
thorough to avoid any court interpretation.
A
corporation is slightly more expensive to set up than an LP or LLC. Bylaws and shareholder and director minutes are
required, whereas only a partnership agreement or an operating agreement are required for
the other two. Also, there are more corporate
formality requirements that must be followed in order to retain the limited liability with
a corporate structure (i.e., annual meetings of the shareholders and directors).
For income
tax purposes, the entity can be organized so that you are not faced with a double taxation
situation. Partnerships, LLCs, and S
Corporations are pass-through entities for income tax purposes. All income that the entity generates will pass
through to the owners and reported on the owner’s individual tax returns. However, all three entity forms are subject to an
Annual California Minimum Franchise tax of $800. The
entity pays this tax to the state for the pleasure of doing business in California. This annual tax is waived for the first year of a
corporation’s existence, but not LPs and LLCs. An
LLC is also subject to a statutory tax on gross revenues over $250,000. This tax is in addition to the annual minimum
franchise tax of $800. The amount was set in
2001 as follows:
$900
for total income between $250,000 to $499,999
$2,500 for total income between $500,000 to $999,999
$6,000 for total income between $1,000,000 to $5,000,000.
Conclusion
Whichever
business entity you choose, it can be utilized to pass property to your heirs and save on
estate taxes. Please contact us if you feel
the need to discuss whether a business entity is appropriate for you.
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