1. Using LLCs in Estate Planning.
  1. In General.
  1. From an estate planning perspective, LLCs merit serious consideration as an alternative to partnerships and corporations in several cases. However, numerous tax and legal issues may also arise which need to be addressed.
  1. Benefits Not Available to an S Corporation.
  1. The LLC will provide significant flexibility in planning which is not available to S corporations. The LLC has important advantages in classes of participation, forms of trust ownership, the ability of LLC members to benefit from basis available for entity-level debt, and the basis step-up available at the entity level for the LLC when a taxable transfer of an interest (including a transfer on death) occurs, none of which are available to an S corporation.
  1. Since there are no restrictions on the number or types of shareholders, complex trusts may be members of an LLC. Accordingly, restrictions with respect to access to, allocation of, and distribution of income and principal can be placed in the trust agreement without consideration of the S corporation rules. The ability to accumulate income or distribute income among a class of individuals may be important for clients who have concerns about their children's creditors or spouses, or concerns about their children's ability to judiciously handle trust distributions. In addition, a flexible master trust can be used with multiple beneficiaries, as opposed to multiple S corporation trusts with a single beneficiary each, and thereby significantly reduce administrative and return preparation costs. A master trust also provides the ability to allocate interests among trust beneficiaries as needed or desired. However, in most states an LLC needs to have at least two members, while an S corporation can have a sole shareholder.
  1. Significant S corporation disadvantages occurring on the death of a shareholder are avoided with the use of an LLC. The transfer of S corporation stock upon the death of a shareholder must be planned to meet the S corporation shareholder restrictions. Many existing estate plans must be modified when S corporation stock becomes an element of the taxpayer's holdings. These concerns are avoided completely by the use of an LLC since there are no restrictions on the number or type of owners permitted.
  1. An S corporation can achieve the same basic flexibility as an LLC if grantor type trusts are used to own the S stock. However, two possible disadvantages arise when using grantor trusts for S corporations: the grantor is deemed to have phantom income on all trust income and on the grantor's death, the trust must immediately revert to a trust with the normal restrictions of an S corporation shareholder trust. Neither of these concerns exist with the trust as a member of an LLC.
  1. Since an LLC is normally treated as a partnership for all purposes, an LLC may also take advantage of the § 754 election and the accompanying basis adjustments--adjustments which are not available to an S corporation. While an S corporation shareholder receives a step-up in basis when stock is acquired as a result of the death or in a taxable transfer, that basis adjustment is only made to the stock itself. Under § 1014, there is no adjustment to the basis of the entity's assets for an S corporation or a C corporation. Accordingly, upon the sale of the assets at the entity level, the new S corporation shareholder must recognize gain and the shareholder must wait until liquidation or sale of his stock before receiving an offsetting deduction for the difference between the shareholder's basis inside and outside the S corporation. In addition, the deduction at the time of stock disposition is generally a capital loss subject to the capital loss limitations in the event that the shareholder does not have current offsetting capital gains.
  1. In estate planning, the step-up basis for assets is generally desired and, accordingly, the loss of an inside step-up is a significant disadvantage in using an S corporation for planning purposes. In addition, an LLC member should be able to increase the basis of his LLC interest to the extent of entity-level liabilities. S corporation shareholders receive no comparable basis increase for the corporation's debts. The ability, generally, for LLCs to distribute appreciated property to members without triggering gain at the LLC level or income to the recipient members is another distinct advantage over an S corporation, particularly as an adjunct to a division or allocation of business assets pursuant to a business succession plan.
Example 2: Ann and Betty are equal partners in the AB Limited Liability Company. Each has a basis of $1,500,000 in her ownership interest in AB (outside basis). The only assets of AB are land with a fair market value of $2,000,000 and $3,000,000 in cash and other liquid assets. AB has an inside basis of $600,000 in the land. Ann dies in 2000 and her estate elects to value the estate assets as of the date of Ann's death. Her son Carl inherits her interest. Section 1014 provides that Carl's basis in his partnership interest (outside basis) is its fair market value on the date of Ann's death. Because AB has a fair market value of $5,000,000 a this time, Carl will take a basis of $2,500,000 in his one-half interest in AB.
Assume that AB makes the basis adjustment election allowed under § 743 and § 754. As a result, Carl's share of AB's basis in the land (inside basis) is increased from $300,000 (one-half of AB's inside basis of $600,000) to $1,000,000 (the fair market value of one-half of the land on the date of Ann's death). Note that Betty's share of AB's inside basis in the land remains at $300,000.
In 2001, AB sells the land for its fair market value of $2,000,000 and distributes one-half of the proceeds to Carl and one-half to Betty. Carl will recognize no gain on the transaction because his share of the proceeds of the sale ($1,000,000) is the same as his share of AB's inside basis. When Carl's share of the proceeds is distributed to him, his outside basis is reduced by $1,000,000 to $1,500,000.
Assume that the value of AB's remaining assets stays unchanged and in 2015, the business is sold to Mammoth Corporation for $3,000,000. Assume further that Carl's outside basis is still $1,500,000 at this time. Given these facts, Carl will recognize neither gain nor loss on the sale because his share of the proceeds ($1,500,000) is the same as his outside basis in AB.
Example 3: Assume the same facts as in Example 2 except that AB is an S corporation instead of a partnership. In this case, § 743 and § 754 would not be available, so Carl's share of inside basis cannot be adjusted after Ann's death. As a result, Carl's inside basis for calculating gain on the 2000 sale is $300,000 (his pro rata share of AB's inside basis of $600,000 in the land). Thus, Carl must recognize a gain of $700,000 on the sale of the land ($1,000,000 minus $300,000). The gain Carl recognizes on the sale is added to his outside basis in the stock, increasing it to $3,200,000 as of the date the business is sold ($2,500,000 plus $700,000). When the sale proceeds are distributed to him, his basis is reduced $1,000,000 to $2,200,000. As in Example 2, assume that Carl's outside basis does not change from 2000 until the time of AB's sale. When AB is sold in 2015, Carl will recognize a loss of $700,000 ($2,200,000 outside basis minus his $1,500,000 share of the proceeds from the sale).
Comparison of tax consequences - Note that although in Example 3 Carl eventually receives a deduction to offset the gain he recognized on the 2001 sale, he is not nearly as well off as he was in Example 2 because the offsetting deduction is deferred. If a 10-percent opportunity cost of capital is assumed, the present value of the 2015 deduction as of 2000 is only $167,574, $532,426 less than the $700,000 of gain recognized. Moreover, the 2014 loss deduction may be worth even less than $167,574 because it will be a capital loss. Assuming the capital gain rules remain unchanged, in 2015 Carl will be able to use the $700,000 deduction only to offset capital gains recognized in that year plus $3,000 of ordinary income. Although capital losses may be carried forward, this further defers their use and results in an additional reduction in their present value. The longer Carl must wait to use them, the less they are worth.
  1. Another advantage is that § 2036(b) should not apply to transfers of LLC interests. In Byrum v. Comm'r, 408 U.S. 125 (1972), the U.S. Supreme Court permitted a donor to transfer the economic benefit of stock while retaining voting control without inclusion of the stock in the donor's taxable estate. Congress responded by enacting § 2036(b), which generally precludes such a bifurcation of interests on transfer of corporate stock without causing the value of the transferred interest to be included in the transferor's estate. An owner of S corporation stock may be able to recapitalize to voting and nonvoting stock prior to a transfer, and thereby avoid application of § 2036(b) if he only transfers the nonvoting stock. However, the possibility that the IRS will view the steps as a single transaction has not been tested and remains an open issue. The so called anti-Byrum § 2036(b) rules do not apply to partnership interests, thereby allowing a transferor to gift an economic interest in an LLC without gifting the voting control, thus avoiding an estate tax inclusion issue.
  1. Under § 2036(b), stock transferred during life is included in the donor's gross estate if (1) the donor retained the right to vote the transferred shares, and (2) at anytime within three years of death, the donor owned at least 20-percent of the voting stock of the corporation whose shares were transferred. In determining whether the 20-percent test has been satisfied, the constructive ownership rules of § 318 apply. As a result, it is very difficult for a donor who transfers an interest in a closely held family business to avoid the 20-percent test because all the stock owned by other close family members will be attributed to the donor under § 318.
  1. If § 2036(b) applies, the amount includable in the gross estate is generally the full value of the stock transferred and not just the value of the interest retained. As Example 4 shows, this provision can seriously interfere with estate planning for donors with interests in S corporations.
Example 4: On May 1, 1996, Jack Green owns 250 shares of stock in Greenco, his family's closely-held business. The 250 shares represent 25-percent of the outstanding stock of Greenco and have a fair market value of $2,500,000. Jack's brothers Harold, Mike, and Bob each own a 25-percent interest in Greenco. Greenco's value has been increasing rapidly and Jack would like to transfer some of his shares to his son Roy so that the appreciation on these shares will avoid taxation in Jack's gross estate. At the same time, however, Jack does not feel Roy is ready to have a voice in corporate decisions and wants to keep the right to vote the shares he transfers.
On May 2, 1996, Jack transfers 100 shares to Roy, but retains the right to vote these shares for the rest of his life. When Jack dies in 2006, the family members still have the same respective ownership interests in Greenco. Assume that at the time of Jack's death, the 10-percent interest held by Roy has increased in value to $2,000,000.
On these facts, the full $2,000,000 value of the stock in which Jack retained the voting rights will be included in his gross estate under § 2036(b). Although Jack owned only 15-percent of the Greenco stock directly during the last three years of his life, the 85-percent owned by Roy, Harold, Mike, and Bob are attributed to him under § 318 and he is deemed to own 100-percent of the Greenco stock at the time of his death.
Comparison of tax consequences - The problem illustrated in Example 4 would not have been encountered if Greenco had been an LLC instead of an S corporation. Section 2036(b) applies to stock in corporations and not to ownership interests in a partnership. Because LLCs are subject to the partnership tax provisions and not the corporate tax provisions of the Code, the "Anti-Byrum" Amendment would presumably not be applicable to them.
  1. The ability to create various classes of ownership of an LLC provides many planning opportunities not available to S corporations, particularly in the area of succession planning. However, if an LLC has different classes of ownership interests, the planner needs to ensure that the tax results follow the economic substance of the transaction (see the substantial economic effect regulations of § 704(b)). This is particularly true since LLCs have the ability to take advantage of special allocations under § 704(b). The new partnership anti-abuse rules apply a facts and circumstances test to determine if the IRS can recast a transaction even if a reduction in federal tax liability is not the primary purpose of the transaction (Reg. § 1.701-2).
  1. Conversion to an LLC.
  1. In practice, the one great advantage that the S corporation currently holds over the LLC is that it is tried and true: the legal rights and restrictions and tax implications are generally uniform and well understood by most tax practitioners. Until a body of LLC case law or a uniform act is adopted, the S corporation will remain the comfortable choice, even if not the most advantageous for planning purposes.
  1. In those situations where concern over the unknown is not a limiting factor, the tax consequences of converting from a corporation to an LLC may still make conversion prohibitive. Corporations that convert to LLCs and their shareholders who become LLC members will be required to recognize gain or loss upon conversion as if the corporation were liquidated for its fair market value and its assets were distributed to the shareholders. Thereafter, the shareholders would be deemed to contribute the assets to the LLC.
  1. To avoid the taxable gain upon conversion from a corporation to an LLC, the corporation could transfer a portion of its assets to the LLC in a tax-free exchange for an LLC membership interest (see § 721). One or more other parties could participate as LLC members. The LLC would then operate the transferred business, making distributions to the corporate member and other LLC members in accordance with the terms of the organizational documents. Rev. Rul. 94-43, 1994-27 I.R.B. 8, has removed some of the last remaining issues which had previously prevented tax advisors from utilizing this technique.
  1. Rev. Rul. 94-43 reconsidered the ruling in Rev. Rul. 77-220, 1977-1 C.B. 263. In Rev. Rul. 77-220, a single business was to be organized by 30 individuals. At the time, S corporations had a ten shareholder limitation. The individuals divided into three groups of ten, and formed three S corporations, which then organized a partnership for the joint operation of their business. The IRS determined that the principal purpose of forming the partnership was the avoidance of the ten shareholder limitation. The IRS viewed the three corporations as a single corporation with 30 shareholders resulting in an invalid S corporation election.
  1. Rev. Rul. 94-43 revoked Rev. Rul. 77-220. In Rev. Rul. 94-43, the IRS states that "the purpose of the number of shareholders requirement is to restrict S corporation status to corporations with a limited number of shareholders in order to obtain administrative simplicity in the administration of the corporation's tax affairs." In this context, administrative simplicity is not affected by the corporation's participation in a partnership with other S corporation partners; nor should a shareholder of one S corporation be considered a shareholder of another S corporation because the S corporations are partners in a partnership. Thus, the fact that several S corporations are partners in a single partnership does not increase the administrative complexity at the S corporation level. As a result, the purpose of the number of shareholders requirement is not avoided by the structure in Rev. Rul. 77-220 and, therefore, the elections of the corporations should be respected.
  1. Rev. Rul. 94-43 did not address whether an S corporation could enter into a partnership with partners that were not otherwise qualified Subchapter S shareholders or into a partnership with multiple classes of ownership interests. Private letter rulings have previously approved of such arrangements provided that there existed a valid business purpose for the partnership outside of the avoidance of the S corporation restrictions (see PLR 8711020, PLR 8819040, and PLR 9238034).
  1. An extension of Rev. Rul. 94-43 could be particularly useful in estate planning by permitting the S corporation to transfer operations to an LLC in exchange for a preferred return interest and essentially freeze the amount of its gain at the difference between the inside basis and fair market value at date of transfer. For example, assume that the S corporation transferred its assets to the LLC in a tax-free exchange for a preferred return interest in the LLC that met the requirements of § 2701. All income in excess of the preferred return and all appreciation could be directed to the other members of the LLC, such as trusts for the benefit of the donor's children, which would hold common interests. If the S corporation were the manager/member of the LLC, then the donor would retain management control of the entity through his ownership of the S corporation stock, yet future appreciation in the value of the entity could be shifted to the next generation. In addition, since the donor has not transferred any of his rights or interests in his stock in the S corporation, the § 2036(b) anti-Byrum rules should not apply.
  1. However, until a ruling is issued which explicitly extends Rev. Rul. 94-43 to those situations, it is probably advisable to retain some assets in the S corporation so that the S corporation is not merely a shell. Likewise, it may be advisable to have a separate business purpose for the transfer if the LLC has nonqualifying shareholders or multiple classes of interest.
  1. Advantages Over a Limited Partnership.
  1. When compared to a limited partnership, there are relatively few tax differences, but two important non-tax distinctions. First, no member of an LLC needs to be liable for entity obligations unlike the general partner of a limited partnership. Second, an LLC member may actively participate in management without risking personal liability in most cases unlike a limited partner. Active participation by an LLC member may also allow the member to treat LLC income or losses as active, as opposed to passive, for income tax purposes (but a member's share in LLC income is generally considered as self-employment income if the member either actively participates in the LLC operations or is a member/manager of the LLC).
  1. The avoidance of personal liability as a general partner will be particularly important for a family business that has possible liability exposure for product liability or other large claims. In addition, since any LLC member may engage in the management of the LLC without creating personal liability, participation in management may be afforded to the next generation of family members by their parents. Such management responsibility can be increased or decreased by the senior family members as they desire. Thus, senior members can retain ultimate control, while instilling a sense of responsibility in the next generation for purposes of family business succession and training. However, if a controlling member has gifted LLC interests to noncontrolling members who are members of the donor's family, then the noncontrolling members must, at a minimum, have the right to liquidate their LLC interests without financial penalties. Otherwise, all LLC income may be taxed to the donor under the family partnership rules of § 704(e). The donor may actually view the imposition of the income tax liability on the donor as an estate planning advantage (particularly if marginal income tax rates of the members are similar) since the income tax liability will reduce the donor's estate and allow the donees' LLC interests to grow tax-free. Under current law, no income is assessed on the shifting of tax liability to the donor from the donee.
  1. The IRS has ruled that both general and limited partnerships may generally convert to LLCs without tax on the partnership or the partners (Rev. Rul. 95-37, 1995-17 I.R.B. 10). The conversion will be deemed to be a continuation by the partners of their partnership interest to the LLC in exchange for membership interests in the LLC. Thereafter, the partnership is considered to dissolve and distribute its asset to the LLC. The basis of the assets in the LLC is the same as in the partnership and a member's basis in the LLC will be the same as the partner's basis in the partnership. A partner may have taxable income upon the conversion of a partnership to an LLC only to the extent the partner is deemed to have received a distribution in excess of its basis due to a reduction in that partner's share of the entity's liabilities.
  1. Advantage Over a Trust.
  1. Like a limited partnership, an LLC may be a viable alternative to an irrevocable life insurance trust, or any other irrevocable gift trust, in estate planning. In the case of an irrevocable life insurance trust, the LLC could purchase life insurance with cash provided by the insured, either directly to the LLC in exchange for a membership interest or to the members of the LLC who would then contribute the cash to the LLC. The insured can retain management control (including control over investments and access to cash value) through a membership interest in the LLC. The family could own the balance of the membership interests in the LLC. Provided that the policy proceeds were paid to the LLC on the insured's death, management authority retained by the insured should not cause the policy proceeds to be included in the taxable estate in excess of the insured's percentage interest in the LLC.
  1. The insured's children or other family member donees could obtain their LLC membership interests through outright gifts of the LLC interests. These gifts, if properly structured, could fall within the current $10,000 annual gift exclusion without the need for Crummey notices.
  1. The LLC organizational document could include restrictions on distributions and transferability, which would mirror those normally found in a trust. In the event family circumstances change, the LLC members could agree to amend the organizational document or terminate the LLC, a feature not generally available in an irrevocable life insurance trust.
  1. Because distributions in kind may be made to fund a distribution on termination, the managing member may be able to direct the policy or policy proceeds to a certain member or members and other assets to other members. An irrevocable life insurance trust which is a spray trust may have greater benefit in this situation since the trustee could direct all assets to one beneficiary in particular, while avoiding distributions to all others. Similarly, the irrevocable life insurance trust has the advantage of allowing Crummey gifts for annual exclusion purposes to contingent beneficiaries who may never actually benefit from the trust (Cristofani Est. v. Comm'r, 97 T.C. 74 (1991)). A gift of an LLC interest is vested in the donee immediately upon receipt.
  1. If the insured is a member of the LLC, then the transfer for value rules set forth in § 101(a)(2) will be avoided, both upon contributions of the policy to the LLC and dissolution or other distribution of the policy from the LLC, since the members of an LLC are treated as partners of a partnership for federal income tax purposes.
  1. Income tax rates provide an additional benefit of an LLC over an irrevocable life insurance trust. With current trust income tax rates at 39.6% for $7,500 of income, it is now often advantageous to distribute trust income to beneficiaries with lower marginal tax rates. Trust income distributions to individuals may not be desirable, however, for creditor protection, investment consideration, or other purposes. Since an LLC is a flow-through entity for income tax purposes, LLC income will automatically be taxed to the members (whose marginal rates will often be lower than the trust's rates) whether or not income is actually distributed. In some circumstances, the LLC may choose to distribute only enough income to pay taxes and retain the remaining income.
  1. Valuation Discounts.
  1. Based on restrictions that can be built into the LLC organizational document, and the type of assets held, it may be possible to reduce the value of membership interests for gift giving purposes with lack of marketability and minority interest discounts. The IRS has recognized that, even in a family situation, a minority interest in a business is subject to a valuation discount for gift tax purposes (Rev. Rul. 93-12, 1993-1 C.B. 202). In addition, with enough restrictions on transferability and control built into the LLC organizational document, an additional discount for lack of marketability may be available for valuation purposes. The discounts may even be available for an LLC which holds marketable securities if a member's rights are significantly restricted. Utilization of the $600,000 exemption equivalent, with the application of the discounts, could easily result in a transfer of a majority of the value of the LLC, thereby leaving the donor with a discountable minority interest upon his death.
  1. Under most LLC acts, the LLC will dissolve upon the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member, absent further member action. Thus, like a general partnership, any member can theoretically cause the LLC to dissolve at any time. It is then up to the remaining members to elect to continue the LLC. A provision in the operating agreement which could prevent the LLC from liquidating upon a dissolution event has often given rise to a discount in value due to the restriction on a member's ability to liquidate and obtain his capital.
  1. Whether a valuation discount due to a restriction on liquidation is permitted is dependent on the application of § 2704(b), which was designed to address what Congress considered an abusive result in Harrison v. Comm'r, 52 T.C.M. 1306 (1987). In that case, the taxpayer's right to liquidate a partnership and obtain full value for his partnership interest terminated on his death. The taxpayer's sons, who were the other partners in the partnership, were then able to buy the taxpayer's partnership interest from his estate at a discount because the partnership interest being purchased carried with it no ability to cause a liquidation of the partnership. The Tax Court held that the discount was appropriate with respect to the transferred interest even though the sons independently possessed an ability to liquidate both before and after purchase of the taxpayer's interest.
  1. In certain family controlled LLCs, discounts obtained through restrictions on liquidation may be disregarded for purposes of valuing the transferred interests under § 2704(b). Under that provision, if there is a transfer of an interest in an LLC among family members and the transferor and members of the transferor's family control the LLC, certain restrictions on the transferor's liquidation rights will be disregarded.
  1. Conclusion.
  1. LLCs should be seriously considered in planning for any estate. An LLC is more flexible than a limited partnership or an S corporation for planning purposes. However, until more guidance is issued by the IRS and the courts, estate planners may still prefer using a limited partnership or an S corporation, especially since most practitioners have little experience in dealing with LLCs.