Checklist: Single Membership LLC Creative Planning Applications

shenkman martinLimited liability companies (LLCs) are ubiquitous in client planning. The default format for most new business and investment endeavors is to recommend the client use an LLC unless there is some overriding reason to consider another form of entity. The common use of LLCs can mask the incredible array of creative planning applications LLCs can provide to a range of different planning options. The following checklist suggests some of the myriad of possibilities and shows how LLCs are a powerful tool in every practitioner’s planning kit.

√ Business Successtion Plan

If a client has a business or professional practice, a creative use of an LLC structure can provide a simple and efficient means of creating a robust succession plan. Instead of operating the practice or business as a sole proprietorship have the client form a manager-managed LLC. This can all be done using pretty standard documentation for modest cost. The client can be named the initial manager of the manager-managed LLC. Operating agreements for a manager-managed LLC are common documents that should not require significant cost or effort. Third parties, such as banks, are quite familiar with manager-managed LLCs. While your client is well he or she can manage the LLC as manager with no impact on the operation of the entity. However, if your client should become ill or incapacitated, fairly routine provisions for a successor manager can provide a practical and simple succession plan. The client might name a colleague (e.g., if a license is required for the practice involved), or a family member or friend (if licensure is not required) as the successor manager. With little more than using a managermanaged LLC structure and standard operating agreement provisions, the succession plan is in place. If the client is incapacitated the successor can use the operating agreement to obtain signature authority over bank and other accounts and manage the business until the client recovers. Because the manager has a fiduciary obligation to the client as member, the client has some assurance that the manager will have an incentive to operate the business during this transition in a reasonable manner. Since LLCs can have a manager who is not a member this application of an LLC should not create any complications. The LLC, even with the successor manager serving, would remain a disregarded entity for income tax purposes.

√ LLCs Formed In Trust Jurisdiction

A physician client or another client seeking stronger asset protection than his home state may afford may create a trust in a state known for better asset protection laws. Alternatively, a client may create a trust in a state, in Delaware for example, that has favorable tax and other laws to reduce state income taxation or achieve other goals. If the client begins a new business or buys a new investment that will be owned in part by that Delaware trust instead of forming the new LLC in the client’s home state, it might be better to be formed in Delaware (or whatever state the trust is in) to increase the connections to that state and perhaps to thereby strengthen the validity of the trust under that state’s laws.

√ Irrevocable Trust Real Estate Ownership

The use of trusts is growing with the aging population and with the growing transfers of wealth, irrevocable trust use will accelerate. Trends in modern trust drafting include using long term, even perpetual, trusts. Often this is accomplished by having the trust based (situs) in a state with laws quite favorable to trust administration. Physicians and other clients concerned about malpractice and liability concerns increasingly rely on trusts formed in states like Alaska, Nevada and South Dakota to provide better protection. A trust formed in say Alaska, by a client living in, for example, New York, cannot own real estate outside of Alaska. To do so would undermine the application of Alaska law and taint the benefits Alaska law might provide. This is because real estate owned in another state would subject that real estate, and hence the trust, to the laws of that second state, New York in the above example. The solution for many irrevocable trusts is simple. The trust can form a single member disregarded LLC, infuse money for a down payment (or even all of the money), and that disregarded LLC can then purchase the home. This transmutes foreign (e.g., New York) real estate into an intangible asset that can be held by the Alaska (or other trust friendly state) trust.

√ Aging Client and Revocable Trust Ownership of a Home

With clients aging the use of revocable trusts to manage assets in later years and protect clients will burgeon. Many clients should name a trust company or bank as successor trustee or successor co-trustee in order to obtain the independence and professionalism an institutional trustee will offer. For many clients there are simply no family members that have the time, ability and integrity to serve in such capacity. Similar to the use of an LLC in the context of planning for an asset protection trust above, the bank or trust company named might be located in a state other than where the client resides or other than where the client owns a vacation home. This raises similar issues to a bank having to deal with real estate in a state where the bank may not be based. Transferring that personal residence to a single member LLC owned by the client’s revocable trust has no impact on home ownership tax benefits (mortgage interest and property tax deductions or home sale exclusion) but can assure proper supervision if the client should become incapacitated. Caution is in order that even though both the single member LLC and revocable trust are disregarded for income tax purposes the transfer might trigger a due on transfer clause in the client’s mortgage, and might change the status of the house for local property tax purposes (e.g., jeopardizing veteran status or senior citizen status for favorable property tax rates).

√ Liability Protection from Inside

Liability LLCs are commonly used to provide protection from what can be referred to as inside liability. This is liability exposure created by the actual property or asset held. So if a rental property can create liability from a tenant filing a lawsuit holding that rental property in a single member disregarded LLC can provide liability protection from suit by a visitor or tenant. So in many instances clients that own rental real estate, a vacation home, a home based business, or other asset that creates exposure can transfer that business or asset to a single member LLC. Because the LLC is disregarded for income tax purposes there is little additional operational cost or complexity involved. Practitioners, however, need to be mindful of the distinction between “inside” and “outside” liability so as not to misadvise clients. If a physician who is quite concerned about malpractice risks owns a rental property (or her practice office) having that property held in a single member disregarded LLC can provide protection from inside liability, the risk emanating from that property. However, it will provide no protection from risks emanating from outside that property, e.g., malpractice risk. If instead the LLC were a true multi-member entity it may then be afforded what is referred to as “charging order” protection under state LLC law. This means that if a malpractice claimant seized on the physician client’s interests in a multi-member LLC owning the property the claimant can reach the distributions made on the physician/member’s interests in the LLC but cannot become a substitute member (e.g., cannot vote or force the liquidation of the LLC). This is an important measure of protection and practitioners should be alert to the inadvisable use of a single member LLC when a stronger form of protection is warranted.

√ Family Vacation Home

Vacation homes are a common asset. It is also common for parents to wish to bequeath a vacation home to children and other heirs. Ownership of a vacation home by several or more siblings presents a number of issues. There can be some liability exposure when owning any real estate. This exposure can be limited to the children by having the vacation home owned by an LLC. See the discussion above concerning inside liability as it applies to this type of application. Often the children have moved out of the home state where they grew up and where the vacation home is located, or the vacation home is in a different state (e.g., near a lake, ocean or in the mountains). That could subject each child to ancillary probate (probate in a state where the property is located in addition to probate in the state where the child is domiciled). If the vacation home is instead held in a family LLC that issue can be avoided. Leaving aside tax and legal considerations, governance can often be a significant issue for family vacation homes. Who should make decisions concerning the property? Should the mortgage be refinanced? The roof replaced? Who gets to use the property over Christmas week (or perhaps Fourth of July week depending on the location and nature of the property)? One or a combination of approaches utilizing simple LLC structures can be employed to address governance concerns. The LLC can be formed as a manager-managed LLC and one heir, or even an independent family member (an older and wiser uncle who does not use the property) might be named manager. Alternatively, the children might in appropriate circumstances elect a manager each year based on provisions in the operating agreement. A second approach (and they need to be mutually exclusive) is for the operating agreement to incorporate rules and regulations as to the use and maintenance of the vacation home. For example, to accommodate everyone’s differing desires the operating agreement could mandate that the vacation property is strictly a no-smoking property and that anyone that wishes to smoke must do so outdoors. Another common issue is usage. A lottery system could be incorporated into the operating agreement where each child is given 365 points a year and the children can bid their points to use the home for given weeks. Another common alternative is to incorporate a rotational use in the operating agreement (e.g., child A gets use of the vacation home over spring break every third year, and so forth). While these examples might sound petty these and other similar issues have created incredibly family conflict, and addressing them with some specificity in an operating agreement has often proven a simple and inexpensive solution.

√ Disregarded LLC For Estate Freeze Transactions

A client seeking to freeze the value of an asset, e.g. a family business, might sell some of the equity in that business to a grantor trust (an intentionally defective irrevocable trust). As a grantor trust, no gain should be recognized on the sale for income tax purposes, but the transaction, if respected, could remove the value of that equity from the client’s estate. The IRS has become more aggressive in auditing and challenging these sales to grantor trusts. Another approach to freeze transactions might involve the client selling assets to an LLC that is a multi-member disregarded entity. The LLC could be owned by the client and one or more grantor trusts. It’s worth noting that sale transactions might be consummated to an LLC instead of a trust. Interests in this disregarded buying LLC can thereafter be gifted to a grantor retained annuity trust (GRAT) thereby freezing the reduced value. Some commentators believe that this type of transactions might be less risky from a gift tax planning perspective. This might be because a GRAT has an automatic adjustment mechanism if the IRS disagrees with the taxpayer’s valuation of the assets transferred, i.e. interests in the disregarded buying LLC above. This adjustment mechanism is contained in the Chapter 14 regulations.

√ Charities May Benefit from Single Member LLCs

A charity may be able to form a single member disregarded LLC to insulate the main charity from the liability risks associated with the assets or activities isolated in the single member LLC. The entirety of the charity and the LLC will all have to comply with the requirements for being a tax-exempt charity. IRS Notice 2012-52 and PLR 200150027. A client may donate an asset, e.g., real estate to a single member disregarded LLC created by a charity to receive the donation, and still obtain the same income tax charitable contribution deduction.

√ LLC Gifts and Discounts

If a client intends to make a gift of LLC interest to his or her children, it is preferable that the LLC have multiple members as of the date of the gift rather than gift gifts of what was prior to the gift a single member LLC. The risk of gifts of interests in a single member LLC that only becomes a multiple member LLC following the gift is that the discounts might be disregarded. Pierre v. Commissioner - T.C. Memo. 2010-106, May 13, 2010. In the new tax world of $5 million inflation adjusted discounts most clients will not benefit from discounts. Perhaps if there is no desire for discounts the additional steps of creating a multi-member LLC prior to consummating the gifts may not be necessary.

√ Use an LLC to Make Real Estate Intangible

Common planning is to have a client that owns real estate in a state that has an estate tax in an LLC so that the real estate will be an intangible property interest not subject to estate tax in that state. Unfortunately, this approach may not always succeed. New York State issued an Advisory Opinion (TSB-A-15(1)M May 29, 2015 holding that a single member LLC holding real estate will be ignored and the underlying property taxed. There are limits on the creative applications of single member LLCs.

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