Impact On Estate Planning And Selection Of Entity

By: Randall A. Denha, Esq.

Choice of entity is an important decision not only for a start-up business, but also for an existing business, especially in the family estate planning context. Under current laws in many states, it has become easier and easier to convert from one form of entity to another, oftentimes without tax consequences. In addition, under the federal tax code, generally any entity may elect to be taxed as a different type of entity. The options are wide ranging: C-Corporation, S Corporation, limited liability company (“LLC”), general partnership, limited partnership, limited liability partnership, and limited liability limited partnership. Each of these entities has certain strengths relative to the others, whether its liability protection, supporting case law, or general operational considerations. Moreover, entity choice has tax consequences, some subtle, others not so subtle.

Income tax considerations are oftentimes considered at the onset and the following are typical items of concern:

• What assets and liabilities will be contributed, if any, at the formation of the partnership? 
• What is the tax impact on a subsequent contribution to the entity? 
• How does the type of entity affect Compensation, Profits and Self-Employment Taxes?
• What is the difference in tax impact on Purchase of Ownership Interest of a Withdrawing Owner?
• What are the Differences in Profit Allocation for LLCs and S Corporations? 

However, when estate planning is of greater concern then the choice is often narrowed to one of the corporate entities or an LLC. To the extent there exists an operating business with employees, there may be some advantage to corporate forms of business (e.g., fringe benefits, etc.). Where the business is primarily real estate, an LLC taxed as a partnership is most often the best choice because of general similarity of state laws and tax-free contributions and distributions.

On the other hand, where estate planning is the primary concern, especially for real estate and passive investments, the choice is often quickly narrowed to a partnership or an LLC. Partnerships have traditionally been the entity of choice for estate planning (e.g., “Family Limited Partnerships”), though LLCs are gaining favor. Valuation discounts are another consideration with regard to estate planning; these discounts are not limited solely to partnerships and LLCs, but also can apply to a corporate entity. There is never an “absolute” answer, however, for entity choice, and the special facts and circumstances in each situation must be considered.

Entities Taxed as Partnerships

1. Partnerships

A number of states now provide four choices of partnership entity. For many years, the only options were a general partnership and a limited partnership. In a general partnership, all partners are “general” partners, which means each partner can bind the partnership and no partner has any liability protection from debts of or claims against the partnership. In a limited partnership, there exist both general and limited partners. The limited partners have limited liability, but the limited partners are limited in their authority to act on behalf of the partnership or participate in partnership management. Until recent years, the traditional limited partnership was often the vehicle of choice for estate planning.

For family estate planning purposes, a partnership will, in fact, still often be the entity of choice, in part because of clients’, attorneys’ and accountants’ familiarity with this partnership structure and in part because these partnerships still “work” so well. Partnerships are attractive entities because they require fewer formalities and less ongoing documentation than corporations: no stock certificates to maintain, no required annual meetings, no shareholder meetings, no minutes, and so forth. Partnership taxation is also generally favorable.

2. Limited Liability Companies

LLCs are rapidly gaining favor as an estate planning tool. An LLC may elect to be disregarded, taxed as a corporation, or taxed as a partnership. Most often, the choice will be made to be taxed as a partnership.

Many states, including Michigan, have very good LLC Acts which include provisions that should help to support valuation discounts in an estate, such as provisions which provide that an LLC will not be deemed terminated until the occurrence of an event resulting in a “cessation of membership” as to the last remaining member, and provisions prohibiting a member from unilaterally withdrawing from the LLC.

A few words of caution about LLC operating agreements. Customization is essential; don’t rely on a form pulled off the internet or given to you by a friend or obtained through an online service!! Any operating agreement used in connection with estate planning should be drafted to contain both voting and non-voting units by an attorney who specializes in estate planning.

Corporations Compared

A partnership or LLC is generally far more widely used for estate planning purposes than is an S-corporation or C-corporation, except in the operating family business context. One primary disadvantage of using any corporate entity for family estate planning is the corporation’s inability to make tax-free distributions of property as can be done with a partnership or LLC. Another disadvantage to both corporate forms is illustrated where a new family member wishes to buy into the business. If appreciated property is contributed to a corporation, gain will be recognized unless certain “control” requirements under Section 351 of the Code are met. Contribution of appreciated property may be done tax-free in a partnership entity.

A corporation can still be an effective tool for family estate planning. An LLC will often be preferred, however, unless there is involved an operating business, and even then, an S-corporation may be preferred over a C-corporation.

Whether an S- or C- corporation, if an existing corporation is to be used for estate planning, gifting and valuation discounts, it may be necessary to undertake a recapitalization in order to have both voting and non-voting shares.

S-Corp Issues?

Without going into a long discussion of S Corp. versus LLC advantages and disadvantages, a few issues could arise such as the following:

• Company wants to bring in employees into ownership, but not straight up. Problem: second class of stock rule.
• Shareholder wants to do (should be doing) more sophisticated estate planning involving family holding companies and trusts. Problem: ineligible shareholders (or higher taxes on certain trust shareholders).
• Company wants to bring in a strategic partner to grow the business. Problem: ineligible shareholders and/or second class of stock rule.
• Shareholder wants to do (should be doing) asset protection planning and not leave all non-business assets exposed to creditor claims or claims of potentially divorcing spouses. Problem: ineligible shareholders and/ or higher taxes on certain trust shareholders.
• Retiring shareholder does not want to get bought out, but is to have a reduced and controlled share of distributions. Problem: second class of stock rule.
• Client finally agrees that the company real estate does not belong in the operating agreement (where it is subject to creditor claims). Problem: distributing the real estate to the shareholder triggers tax.
• Cyclical business generating losses during an economic downturn. Problem: losses limited to stock basis (unlike in a tax partnership, outside basis does not include company indebtedness).

If you do not see these issues for your client, you may not have had time to look, or they are just around the corner. Each of these problems would not be a problem (or would be a more manageable problem) in a tax partnership such as an LLC.

Valuation Discounts

Valuation discounts are theoretically available for any entity. Businesses have for decades sought discounts for minority interests, lack of marketability, and other grounds. The vast majority of new cases, however, reflect discounts for family partnerships (or LLCs). Discounts can range from a very small percentage to as high as 60%. It appears that the IRS is often not even challenging discounts of 25% to 30%, where the facts are not otherwise egregious, such as deathbed formations followed by immediate transfers of large interests.

There should always be business reasons for formation of an entity, even where it is clear that “estate planning” is a key reason. The business reasons for formation should be stated in the partnership or LLC Operating Agreement. These reasons can include, but are not limited to, the following:

1. Maintain control of and manage entity assets;
2. Increase the value of entity assets;
3. Protect entity assets from claims of creditors and from divorce;
4. Consolidate fractional interests in assets transferred to the entity;
5. Facilitate and simplify intra-family gifting and ownership;
6. Provide flexibility in business planning not available through trusts or corporations.

This is just a sample of business reasons. Additional reasons should be analyzed, based upon the facts and circumstances of each case. Having valid business reasons for the formation of an estate planning vehicle is arguably one of the most important issue in one’s ability to obtain discounts.

Summary In summary, the analysis of the type of entity to use for an estate planning vehicle requires careful consideration. Though both C- and S corporations have continued viability, entities taxed as partnerships are generally preferable. In forming any entity in conjunction with estate planning, it is essential to document the business reasons for its formation. Through careful documentation, planned giving and reasonable discounts, one can provide an estate planning tool that both reduces estate taxes and will provide other legitimate and non-tax business benefits to the younger generation for years to come.