LLCs possess the desirable corporate attribute of limited liability, and the valuable “flow thru” partnership tax attribute. New York’s LLC statute, although containing default terms, permits customization of the operating agreement. The LLC form therefore provides the opportunity for members to structure the management, tax classification and capital structure of the entity to suit the members’ needs.
An LLC may be formed for any lawful business purpose except where New York law requires another form of business entity. Closely resembling partnerships, the LLC permits members to increase their tax basis for certain LLC indebtedness. This enables members to receive greater LLC distributions without triggering capital gain. LLCs are more hardy than S corporations, and will not self-destruct when prohibited persons become members. Unlike corporations, LLCs can be liquidated without severe income tax consequences. The LLC form also improves on the partnership form by eliminating the personal liability of the general partner.
Since LLC members’ interests are considered personal property, in certain circumstances LLCs can also be used as a limited testamentary substitute for a Will. For example, a New York resident’s ownership of Florida real property will not require ancillary probate in Florida if the property is placed within a New York LLC.
As discussed below, since operating agreements typically restrict the transferability of members’ interests, as well as their right to demand liquidating or nonliquidating distributions, the interests are typically worth less than the underlying value of LLC assets. The fractionalization property within the LLC results not only in reduced transfer tax value, but also in greater asset protection.
A creditor of an LLC member may obtain a “charging order,” or a lien, against the member’s interest. Creditors who have obtained this lien may satisfy their claim out of LLC distributions, but since an assignee has no power to vote and cannot compel a distribution of profits, the disillusioned creditor may receive nothing — except a K-1 requiring the him to report “phantom income” for the assignee’s distributive share of LLC income. Although an assignee could ultimately succeed in forcing a distribution of LLC profits by resorting to litigation, the interests of non-debtor members, which must be protected by the court, might hinder an expeditious resolution of the assignee’s claim. Subject to fraudulent conveyance laws, the debtor’s interest in the LLC could also be purchased by other LLC members at a considerable discount. The confluence of these factors greatly enhances the asset protection features of the LLC.
LLCs are also valuable estate planning vehicles. Unlike irrevocable trusts, LLC operating agreements can be amended or even revoked. Irrevocable trusts are subject to the grantor trust rules, which can cause the grantor to be taxed on trust income if the grantor is considered owner for federal income tax purposes. Likewise, the retention by the grantor of a retained interest could cause estate tax inclusion of the entire trust under IRC Secs. 2036 – 2038. It seems improbable that the Service could successfully invoke those sections to justify estate tax inclusion of an LLC interest except in unusual circumstances.
To illustrate the benefits of using an LLC, first consider parents who own jointly rental real estate worth $1 million. To directly transfer fractional interests to their children, they could execute a quitclaim deed. However, to maximize annual exclusion gifts, successive gifts of fractional interests would be required, with each gift requiring a deed and each being subject to local transfer taxes and fees.
Parents could instead deed the real property to an LLC, and thereafter transfer membership interests to their children over a series of years, if necessary. The yearly transfers would require only an assignment of transfer and perhaps an amendment to the operating agreement. (An LLC, consistent with a business purpose, may also hold marketable securities. The applicable discounts appear to be available even to an LLC which holds only marketable securities. See Estate of Winkler, TCM 1997-4)
Of course, the principal allure of using the LLC in estate planning is to avail the donor of the transfer tax discounts which the IRS and the courts have recognized. Greater discounts will be available if the donor forms an LLC and then makes subsequent gifts of membership interests. Moreover, in order to avoid the application of the step-transaction doctrine, it may be advisable to permit a period of time to elapse before gifting the LLC interests. (Although a fractional interest discount would also be available for the transfer of an interest in real property by deed, the other two discounts would be unavailable, and the discount allowed for a transfer by deed would be less than that for a transfer of an interest in an LLC owning the identical real property.)
The regs provide that the fair market value (FMV) of property is the price at which such property would change hands “between a willing buyer and a willing seller, neither being under any compulsion to buy or sell.” The FMV of an entity may be determined by reference to either liquidation value or going-concern value. If the operating agreement places restrictions on the power of members to compel liquidation, then the liquidation value will be reduced. If the agreement restricts the power of members’ to compel distributions, then the going-concern value may be reduced.
Entities possessing significant but unprofitable assets should be valued at their going-concern value. Conversely, profitable entities possessing assets worth little should be valued at liquidation value. For example, a 400-room hotel sitting on land worth $10 million and generating $50,000 in annual profits would be better valued (for discount purposes) at its going-concern value of $500,000 than its higher liquidation value. Analogously, a profitable web-server entity with $100,000 in assets but which generates $10 million in annual profits would be better valued at its liquidation value. In any event, since the burden of proving FMV rests upon the taxpayer, the importance of a carefully drafted operating agreement is evident.
After determining the FMV of the entity, the following three discounts, each of which operates quasi-independently, are then applied to the transferred interests: (a) the fractional interest discount; (b) the minority interest discounts; and (c) the lack of marketability discount. Interests in other entities when transferred to an LLC may justify two separate valuation discounts.
The fractional interest discount arises because each co-owner of property has the right to use the joint property provided the rights of other co-owners are not adversely affected. In the event a dispute arises, a partition suit may be brought to sever the joint tenancy. The discount is based on the cost, delay, and uncertainty involved in a partition suit. Generally, the discount allowed by the courts for fractional interests is 15% to 25%.
A minority interest discount, which the Tax Court has recognized as 25% or greater, results from the owner’s lack of control over management, including the inability to compel distributions, and the inability to force liquidation and receive a proportionate share of the entity’s net asset value. Although family attribution is generally ignored for purposes of determining the discount (see Bright v. U.S., 658 F.2d 999), the IRS has indicated that “swing vote attributes” must be considered.
The lack of marketability discount, generally in the range of 0 to 30%, reflects the lack of a ready market for the valued interest. This discount is often fused with the minority interest discount. To maximize the discount, the operating agreement should restrict the right of the member to convert to cash his or her interest in the LLC, since this restriction will depress the value of the member’s LLC interest.
The following factors will enhance the available discounts: (a) the use of a limited term LLC not set to expire for fifty years emphasizes the permanent nature of the entity; (b) the recital of a broad business purpose may justify the retention of a substantial amount of cash to carry out that objective; (c) the selection of a state with favorable LLC law, since the application of Chapter 14’s restrictive rules may be dependent on the state’s LLC statute (Although only New York requires publication, its default statutory provisions may be modified by the operating agreement, unlike some other states’ inflexible “bulletproof” statutes.); (d) the discretionary power of the Managing Member to make or withhold distributions may justify the appraiser’s assumption that distributions will be infrequent or sparse; (e) restrictions on transferability make the interest less attractive to purchasers and creditors; and (f) restricting the admission of new members reduces the value of the LLC interest.
Obtaining a professional valuation appraisal is critical. In Estate of Cloutier v. CIR, 71 TCM CCH 2001, the Tax Court rejected as unpersuasive and conclusory the testimony of an accountant who had prepared a three-page report, since it failed to consider “basic information necessary to render an opinion on valuation.” Separate valuation appraisals may be required for the value of real property and the value of the member’s interest in the LLC.