June 2, 2014
By Kenneth Lackey
A limited liability company (LLC) is a type of entity that can be thought of as a cross between a corporation and a partnership. As with a corporation, there is limited liability meaning that the person or persons who own interests in the LLC are generally not liable for the debts and other liabilities of the LLC and also a creditor of an owner of an LLC interest cannot satisfy a judgment against the assets inside the LLC. Unlike corporations, LLCs are not taxed at the entity level. The tax "passes through" to those who own interests in the LLC.
LLCs have become extremely popular as an entity through which to operate a business. For instance, this law firm is organized as an LLC. LLCs are also popular estate planning vehicles.
This Wall Street Journal article discusses LLCs as estate planning vehicles. A key component of the popularity of LLCs for estate planning is the ability for transfer tax purposes to discount the value of the gift or bequest based on lack of marketability and lack of control.
Lack of marketability means that the LLC interest cannot be quickly and cheaply sold for cash. Unlike common stocks traded on the New York Stock Exchange or NASDAQ, Smith Family LLC shares generally cannot be sold quickly and inexpensively. Thus, the value of a share of Smith Family LLC is discounted due to lack of marketability.
A second type of discount commonly taken with respect to LLC interests is the discount for lack of control. For instance, a shareholder in Smith Family LLC who is not the manager and does not otherwise have the ability to make decisions regarding the LLC is said to have a lack of control. Types of control that are relevant include the authority to make distributions or dividends, buy and sell assets, and otherwise determine the operation of the LLC. As with lack of marketability, lack of control can translate into a discount against the LLC interest's pro rata share of the underlying assets.
Assume the hypothetical Smith Family LLC assets consisting of publicly-traded stock worth $1,000 and there are ten Smith Family LLC shares outstanding. Based on a pro rata share of the underlying assets, each share would be worth $100. But if Mr. Smith gives away one share of the LLC and the recipient of the share suffers from a lack of marketability and lack of control, then Mr. Smith will not be deemed to make a $100 gift. The combined discount for lack of marketability and lack of control generally ranges from 10% to 35%. Making lifetime gifts using discounted values is tax-efficient way to transfer wealth to the next generation.
LLCs are also popular as creditor protection vehicles. If a creditor has a judgment against Mr. Smith then the creditor can go after any shares of Smith Family LLC that Mr. Smith owns but the creditor cannot take the publicly-traded stock inside the LLC. It is important to consider the fraudulent conveyance laws when doing this type of planning. In other words, Mr. Smith would have to set up the LLC before he has a known creditor, not after.
If you have any questions about LLCs and estate planning, please give us a call.