Family Limited Liability Companies

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bulletIntroduction and Description
bulletPurposes and Uses
bulletAttractive Attributes
bulletManager
bulletDuties and Responsibilities
bulletFederal Tax Attributes
bulletEnsuring Continuous Family Ownership
bulletReducing Values For Transfer Tax Purposes
bulletDiscount For Lack of Control
bulletDiscount For Lack of Marketability
bulletAsset Protection
bulletIncome Tax Benefits
bulletState Tax Implications
bulletDetriments
bulletUnder What State Law Should The FLLC Be Created?
bulletWhat Costs Are Associated With The FLLC?
bulletConclusion

Introduction and Description

A limited liability company is a business entity that insulates its owners from the liabilities of the entity like a corporation, but is taxed for income tax purposes like a partnership.  A family limited company (“FLLC”) is a limited liability company formed principally among family members under California’s (or another state’s) limited liability company act.  An FLLC must have business purposes.  An FLLC should only be formed in a state where the state law requirements for liquidation of the FLLC shall be as the owners (called members) specify in their operating agreement.  The FLLC remains in existence until the earlier of the unanimous consent of all members, the expiration of a fixed term, or judicial dissolution.

As in any LLC, the owners of the firm are called “members.”  In an ordinary LLC, either the members, or one or more managers (who may, but need not be, members) manage and control the FLLC’s business.  In the case of an FLLC, it is preferable to name one or more managers to manage and control the FLLC’s business.  A managing member can be appointed to control the day to day affairs of the FLLC.  Neither the managing member(s) nor any outside manager(s) take on any personal liability.  The managers decide when to make distributions to members which, when made, must be proportionate to each member’s interest in the FLLC (unless the FLLC’s operating agreement provides otherwise, and certain tax requirements are met). 

The FLLC may own closely held businesses (other than corporations that have made an election to be taxed as “S” corporations), real estate, marketable securities, or almost any other investment asset.  Homes, cottages, or other personal use assets are normally not suitable for an FLLC.

The family’s control of the FLLC assets will remain vested in the managers, but the members may gift during their lifetimes or transfer at death their interests in the FLLC.  Under current law, the value of FLLC interests should be less than the value of the assets contributed to the FLLC.  This discount can be significant.

Because of the many tax and non-tax benefits provided by a FLLC, it is frequently used as the foundation for a well-organized estate plan.  With proper planning, a FLLC ensures the orderly distribution of assets to subsequent generations at values that are reduced for estate and gift tax purposes.

Purposes and Uses

FLLC's serve a number of legitimate business purposes, e.g., providing for continuous ownership of property within a family unit; consolidating ownership; providing a deterrent against postmortem asset ownership controversies among family members; deterring claims of creditors and spouses; limiting personal liability for contract and tort damages; decreasing probate and estate administration costs; and minimizing guardianship costs for interests held by minors.  Ownership rights in the FLLC are governed by State law as modified by the FLLC agreement.

Some specific purposes for creating a FLLC are as follows: 

bulletTo adopt a succession plan for the ownership, management and control of assets.
bulletTo ensure the orderly transfer of property interests to family members while retaining control over the assets.
bulletTo simplify annual gifting by parents.
bulletTo reduce income, estate, gift and/or generation skipping taxes.
bulletTo ensure that arbitration will be the method for resolving family disputes over assets rather than costly litigation.
bulletTo protect assets from creditors and from waste by the heirs.
bulletTo consolidate asset ownership into a single entity.

Upon formation, family members contribute property in return for an ownership interest in the capital and profits of the FLLC.  Many parents are not willing to part with control over their assets when the FLLC is created.  In some cases the parents simply desire to continue managing their property and in other cases the children lack the maturity or business skills required to manage the assets.

Attractive Attributes

An FLLC is a very flexible planning tool.  In fact, FLLC’s are much more flexible than trusts in their operation and amendment.  FLLC advantages may include some or all of the following:

bulletPreservation of a family’s wealth within the family.
bullet

FLLC meetings may promote or facilitate family communication regarding wealth, family investment philosophies, and other family values.

bulletControl of FLLC assets will be vested in the managers.  The successor to a manager will also be determined by the operating agreement.
bulletThe passing of membership interests by gifts or at death will not disturb the manager’s control of the FLLC.
bulletDespite gifts, the family’s wealth remains consolidated in the FLLC for management and investment purposes (e.g., investment advisers may be employed to manage all family wealth).
bulletFamilies with diversified investment portfolios are able to gift membership interests to younger generation family members without breaking up the diversified portfolio.
bulletThe FLLC may minimize or eliminate the corrupting influence wealth can have upon younger generation family members during their formative years.
bulletSpouses may use the membership interests to “split estates” to avoid the wasting of either spouse’s estate tax exemption or generation-skipping tax exemptions.[1]
bulletThe FLLC is much more flexible than irrevocable trusts when dealing with family wealth.
bulletWhen compared to trusts, FLLC activities are judged by the business purpose test, instead of the more stringent prudent person rule. FLLC assets may be invested using modern portfolio theories.
bulletThe FLLC provides some asset protection against failed marriages of family members.
bulletThe FLLC should substantially reduce the estate or gift tax burden that is imposed on wealth that is transferred to family members because the FLLC should be valued as a going concern, rather than at its liquidation value.
bulletThe FLLC protects member assets from the creditors of members. A creditor of a member may only obtain a charging order against the member’s interest in the FLLC and not its underlying assets.
bulletMembers are insulated from liability for the FLLC’s activities.
bulletThe FLLC can eliminate the need for probate of real property located outside of a member’s domiciliary jurisdiction.
bulletThe formation of the FLLC and capital contributions to it will normally be income tax free.[2]
bulletThe FLLC may distribute cash or other assets proportionately to its members without triggering gain or loss.[3]
bulletThe Operating agreement may require that FLLC disputes are settled confidentially by arbitration rather than litigation.  To discourage frivolous disputes, the agreement may require the losing party to pay both sides’ legal expenses.

Manager

The Manager of the FLLC exercises exclusive control over the limited liability company business operations and determines if, when, and how much of the limited liability company income to distribute to the members.  As part of the FLLC’s succession planning, a successor will be named to succeed in the duties of management and control upon the removal, resignation, bankruptcy, dissolution, death or incompetency of the manager.

Possible managers include one or both parents (or the trustee of their family living trust), another entity controlled by one or more parents, children or grandchildren (or trusts for their benefit).  However, generally it is not recommended that children be given management powers unless the parents expressly desire to relinquish control over their assets and the child has sufficient experience and maturity in managing the FLLC assets.

Even though much of the value of the FLLC may be gifted away by transferring membership interests to the children, the Manager maintains control of the assets in the FLLC.

Duties and Responsibilities

The Manager should have the necessary willingness, knowledge and experience to do the following:

bulletManage and invest limited liability company assets.
bulletMake decisions as to distributions of limited liability company income and/or assets.
bulletFile income tax returns on behalf of the limited liability company.
bulletFurnish annual limited liability company income tax information (schedule K-1) to the members.
bulletMake necessary filings with the Secretary of State.
bulletGive or withhold consent to transfers of limited liability company interests and amendment of the FLLC agreement.

Federal Tax Attributes

The FLLC will, unless a contrary election is made, be taxed as a partnership.  The FLLC is itself not subject to federal income tax.  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 FLLC income.

If the FLLC 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.

Ensuring Continuous Family Ownership

Continuous family ownership of the FLLC is guaranteed by restricting each member’s ability to sell or otherwise transfer his or her interest to non-family members.  Because most FLLC's are used by parents to transfer limited liability company interests to their children (or grandchildren) at reduced transfer tax values, the existence of rights of first refusal, buy-sell provisions, or other restrictions on transfer are of paramount concern and require considerable attention.

The FLLC agreement should prohibit the members from selling or transferring their interests in a manner disruptive to the continuation of the family asset arrangement plan or disruptive to family harmony.

Typically the FLLC agreement will provide the members a right of first refusal to deal with a circumstance where one member wishes to sell his or her interest to a non-family member.  In such cases the non-selling members will have the right to purchase the interest of the selling member for cash or with an unsecured long-term promissory note that bears an interest rate favorable to the buyer.  Only if the non-selling members fail to exercise their purchase rights may the interest then be sold to the non-family member.

If the family members do not wish for the new member to possess any voting rights, then the agreement should permit them to treat the new member as a mere assignee who is only entitled to receive income distributions and a proportionate share of limited liability company income, expenses, deductions and credits.

This mechanism provides the family members with protection from the influence of undesired active members.  In this way the FLLC agreement promotes continued family ownership and does not disrupt good asset management.

Reducing Values For Transfer Tax Purposes

An incidental but important benefit of a FLLC is its reduction of values for estate and gift tax purposes.  Such reduction is a byproduct that accompanies indirect ownership of assets in the FLLC.  As a general rule, the value of a FLLC interest is worth less than direct ownership of the same percentage interest in the underlying assets of the FLLC.  This is because ownership of a FLLC interest does not convey any rights of management or control over the underlying assets (except to the manager) and the FLLC agreement prohibits the members from freely transferring their interests to non-family members.  Conversely, transfer tax values are reduced by the application of discounts (determined by appraisal) to reflect these restrictions.

Members who elect to implement a program of making annual gifts of FLLC interests will find that transfer tax values are lower compared to gifting assets outside the FLLC.  Similarly, by holding family assets in the FLLC, estate taxes owed at death are generally lower than if undivided interests in the property are held.

Despite the reduction in value of FLLC interests, the real income production and growth potential of the FLLC’s assets remain available to the members since control remains within the family unit.

Discount For Lack of Control

A discount for lack of control may be applied in establishing estate and gift tax values of FLLC interests.  This discount reflects the inability of a member to control the operations of the FLLC or to invest its assets in a manner that is of greatest benefit to the member.  Because management and investment decisions (including the decision as to when to distribute limited liability company income) are outside the control and influence of the members, the value of a member’s interest is reduced to reflect such lack of control.

Typical discounts for lack of control (minority interest) generally range between twenty percent (20%) and thirty percent (30%).  This discount is sometimes referred to as a minority interest discount.

Discount For Lack of Marketability

An underlying purpose of the family limited liability company is to maintain ownership of assets for the benefit of members of one or more selected families.  Thus, the transfer of limited liability company interests to persons outside the family unit is disfavored and, in extreme cases, may even be prohibited by the limited liability company operating agreement.  Furthermore, private limited liability company interests generally lack access to a readily available exchange for trading.  For this reason it is said that a limited liability company interest lacks marketability and is not easily convertible into cash or cash equivalents.

This circumstance has resulted in further discounts in the range of 20% to 40%.

Asset Protection

FLLC's provide a limited degree of protection for assets of the limited liability company since these assets generally cannot be directly attached to satisfy personal debts of the members.  Instead, the remedy of a personal creditor is to obtain a “charging order” from a court against the interest of the member.  The charging order entitles the creditor to receive the distributions that would normally be paid to the member until the debt is fully paid.

A charging order, however, does not give the creditor any voting rights in FLLC matters.  Further, the creditor is not assured that the manager will elect to pay out the FLLC income to the members.  Even though the manager does not pay out any income to the creditor and other members, the responsibility for paying the income tax attributable to the attached member’s interest will fall upon the creditor.  Thus, a creditor of a member may be persuaded to accept a lower settlement offer in satisfaction of the debt rather than pursue a charging order.

Income Tax Benefits

FLLC’s also provide a number of valuable income tax benefits to the members.  Among these benefits are the following:

bulletAllows pass through of items of income, expense, credit and deduction to the members.
bulletPermits “step-up” in income tax basis in FLLC assets for interests received from a deceased member.
bulletGenerally permits contribution, withdrawal of assets or limited liability company liquidation without recognition of taxable gain, unlike corporate ownership.
bulletAllows income shifting since gifted FLLC interests carry with them the responsibility for a proportionate share of the limited liability company income.

State Tax Implications

An FLLC that is situated in California is required to file returns for and pay annual franchise taxes.  Generally, California law conforms to federal law with respect to the income taxation of LLC’s, except that, unlike federal law, California law imposes taxes and fees on LLC’s at the entity level.  FLLC’s organized in California, and foreign FLLC’s doing business in California, are subject to the following annual fees:

bulletAn annual franchise tax of $800 for the privilege of doing business in California; and
bulletA statutory fee for any year in which the FLLC’s total income is $250,000.00 or more.

The statutory fee ranges from a minimum of $900.00 for FLLC’s with annual total income of $250,000.00 to $499,999.00, to a maximum of $11,790.00 for FLLC’s with annual total income of $5,000,000.00 or more.

The FLLC conducting business or owning property in other states may be subject to taxation in those states as well.

Detriments

As exists with the formation of any entity, a FLLC has some detriments.  For example, the following issues will generally be encountered:

bulletThe FLLC must file annual income tax returns and keep separate accounting records.
bulletGreat care must be taken in contributing real property to the FLLC so that the property tax assessment property is not changed.
bulletThere are costs associated with the formation of the FLLC and transferring title of assets into the FLLC.
bulletTransfer of Subchapter S corporation stock to a limited liability company will terminate the Subchapter S election.
bulletThe IRS is challenging the use of FLLC’s to achieve gift and estate tax discounts, although a number of taxpayers have settled their cases and achieved a discount.

Is The FLLC “Risk Free”?

The FLLC valuation discounts arise out of valuation principles.  When an asset is given or owned at death, its fair market value must be determined.  Fair market value is the price a willing buyer would pay a willing seller when both are reasonably aware of relevant facts.  In early 1993, the Internal Revenue Service abandoned its long-held position that family relationships must be considered when determining fair market value.  Since that abandonment, FLLC interests should be valued at the price strangers would pay for the interest.

It is this price that produces the substantial discounts.  Because liquidation of the FLLC is remote, a “stranger” would value an FLLC interest as an interest in a going concern.  However, the value of an FLLC interest that appears on a gift tax or estate tax return may be challenged by Internal Revenue Service auditors.

Planning techniques may help blunt a gift tax valuation challenge.  One technique to reduce gift tax exposure involves a formula gift.  The formula gift defines the amount of the gift to family members as a fixed dollar amount with any value in excess of that amount to charity or a spouse.  Because any value above a family member’s defined amount (e.g., a gift of $20,000 to a child) passes to charity or a spouse, any valuation increase on a gift tax audit should produce a charitable or marital gift tax deduction instead of the payment of gift tax.  Any charitable benefit should also qualify as an income tax deduction, subject to normal rules regarding deductibility for income tax purposes.

Careful planning, a properly drafted operating agreement, and a competent appraisal whenever significant FLLC interests are subject to gift or estate taxation mitigates, but cannot eliminate, the risk of an Internal Revenue Service valuation challenge.

Under What State Law Should The FLLC Be Created?

We recommend that a California limited liability company be used.  A California FLLC is formed by filing articles of organization with the State of California ($70 filing fee and usually a $15.00 expedited service fee).  The FLLC is thereafter required to file annual reports that list only the manager(s), registered agent and registered office.  The public filings with the State of California do not disclose financial or other details about the FLLC. 

What Costs Are Associated With The FLLC?

The preparation of the operating agreement presents the greatest cost -- usually in the $2,000 to $2,500 range.  Transfer and recording fees, e.g., for the transfer of assets to the FLLC, can cost in the range of just a few dollars to several hundred dollars, depending on the number and location of assets to be transferred.  In addition to the fees and expenses noted above, you will have legal fees for the planning, formation, and transfer of assets to the FLLC. 

The FLLC must file annual informational tax returns, just as a partnership would.  Your accountant should give you an estimate of his or her probable annual charges for the returns.

An appraisal of the FLLC interest is strongly recommended if you give membership interests to your family members and seek to support valuation discounts.  To properly appraise FLLC interests, it may also be necessary to separately appraise FLLC assets (e.g., real estate or closely held businesses).  While an appraisal of an FLLC may cost several thousand dollars, it is essential to support the going concern, instead of liquidation, value of the interests. Your estate must also appraise the remaining interests that you own at your death.

Conclusion

An FLLC is a very attractive tool that may be used to serve many goals of families with wealth.  A FLLC can serve as an integral part of an estate plan and provide great flexibility in transferring assets to subsequent generations.  FLLC’s offer considerable tax and non-tax benefits to family members and their use should be seriously considered by those individuals having taxable estates and/or those individuals who desire to pass ownership of assets to their children without giving up immediate control over their assets.

[1] The estate tax exemption is $1,000,000 in 2002, increasing in stages to $3,500,000 by 2009 but the current law repeals the estate tax in the year 2010 only with the tax returning in 2011 with again a $1,000,000 exemption.  The GST exemption is similar to the estate tax exemption, but it has an exempt amount in 2002 of $1,100,000 that is adjusted for inflation in 2003 when it will match the estate tax exemption in 2004 and after. (Back to text)

[2] Careful planning is required when a diversified investment portfolio or encumbered assets are contributed to the FLLC. (Back to text)

[3] Careful planning is required if an encumbered or low basis asset is distributed to members. (Back to text)

 

 

Content 2003-2011 Myra S. Mitzman, Attorney at Law