By: Randall A. Denha, J.D., LL.M.
Many of us are familiar with the limited liability company (“LLC”). Similar to a corporation, it’s another form of business entity that insulates its owners from the liabilities of the entity but is taxed for income tax purposes like a partnership. This type of business entity is now recognized in all 50 states and each state has its own set of laws for an LLC. One type of LLC that is oftentimes used in the family context is called a Family LLC. In fact, it is probably safe to say that the Family LLC has become the most ubiquitous estate planning vehicle in the United States. Why? A popular reason for utilizing a family LLC is the valuation discount which allows the assets that make up the family LLC to be discounted for lack of control and lack of marketability. For example, if you place $100.00 of real estate into a family LLC and then gift 50% of the family LLC interest to your child, is that 50% interest worth $50.00? No. It’s worth far less because your child lacks any control over governance of the family LLC and the interest gifted is not readily marketable. As such, the 50% interest is probably worth 30% to 40% less than you think. That’s the valuation discount that families like but the IRS watches.
The Family LLC is formed principally among family members and must have a business purpose. Unlike an LLC with only one member (commonly referred to as a single member LLC), the Family LLC is an entity made up of parents, children, grandchildren or trusts for any of the family members. The Family LLC is managed by managers who are generally the senior generation members who can control whether to buy or sell assets and whether to make distributions, especially cash, to the partners. Anyone can serve as the Manager, but the parents are generally the first choice in this regard for purposes of always maintaining control. Some very common reasons for establishing a Family LLC are: control, centralized management, reduction of expenses, creditor protection, facilitation of other estate planning techniques, expanded investment opportunities and having a platform for resolution of family disputes to name a few.
The Family LLC is taxed as a partnership and is not subject to income tax. Instead, each member reports his or her proportionate share of income or loss on his or her tax return each year regardless of whether a distribution is made to the member. Likewise, cash distributions to the members will not create taxable income because the members are taxed directly on Family LLC income. If the Family LLC pays a wage or salary to anyone, it must report and pay all normal employment-related taxes. The FLLC must annually file partnership tax returns.
Because the American Taxpayer Relief Act of 2012 (“ATRA”) has eliminated estate tax worries for most people, many wonder what to do with these now for estate planning purposes. No one wants to incur additional cost and expense in preparing another income tax return and update corporate action each year, however this vehicle, if properly used, is going to be the “new kid on the block” and continue as a cornerstone in many estate plans. The Family LLC will continue to provide all of the benefits discussed earlier and possibly be the tax tool needed to shift income to lower income taxpayers. Given the restrictions on itemized deductions whose thresholds are pegged at a lower income level then the maximum income tax rates, many high income taxpayers will find deductions disappearing. For these taxpayers, creative and careful use of Family LLCs to shift income (subject to the family partnership rules) and qualifying deductions to lower income taxpayers may provide valuable income tax benefits. For example, there is a 39.6% income tax bracket and 3.8% Medicare tax on passive income, so if a distribution from the Family LLC were instead made to your partner-child who has significantly less income, then an income tax savings will occur and presto, senior generation all of a sudden has less income tax to pay but all the control.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.