The LIMITED LIABILITY COMPANY

By Nathaniel E. Clement, J.D.

I often recommend the revocable living trust (RLT) as the centerpiece of an estate plan. RLTs, with tax-planning features, are the best way to protect estates up to the "coupon" amount from estate taxes ($4 million combined estate for the married couple and $2.0 million estate for a single person as of 2007). The RLT, as good as it is, won't protect from estate taxation estates that are greater than the coupon, and the RLT won't bestow protection from lawsuits while the client is alive.

For estates that are going to be larger than the coupon amount (or two coupon amounts for the married couple), I have always recommended gifting while one is alive as the best way to reduce the size of the taxable estate. Each of us can give away up to $12,000 per year to as many donees as we wish (the North Carolina annual exclusion is the same as the federal annual exclusion). This $12,000 amount is known as the "annual exclusion" amount. If we're married, our spouses can join us in gifting, thus, doubling the annual exclusion to $24,000 per donee. With enough time - and assuming you can live without the money or assets given away - gifting is an ideal way to pare down the taxable estate. With just one beneficiary, a married couple can give away $240,000 over 10 years. With two beneficiaries, a married couple can give away $480,000 over 10 years. Assuming a 50% estate tax bracket (federal and state), gifts of these amounts can save $120,000 and $240,000 respectively in estate taxes - or more if the gifts grow in value in the hands of the donee.

But what if Mom and Dad, while highly desirous of eliminating estate taxes, need the assets to support their life styles? What if Mom and Dad don't have the type of assets that can be readily given away in $12,000 "chunks" - such as real estate or a family business. What if Mom and Dad don't trust what Junior or Sis will do with the assets given to them? What if Junior or Sis are minors? Irresponsible (at least at this point in their lives)? What if Mom and Dad's estate is - or will be - so large that a gifting strategy limited to the annual exclusion can't get nearly enough value out of the taxable estate to avoid estate taxes?

The limited liability company (LLC) can be the answer to all of these concerns. The LLC when combined with the revocable living trust, can be the ideal way to achieve control of your estate and tax planning simultaneously.

Benefits of the Limited Liability Company

The limited liability company (sometimes called an "LLC") is an attractive estate planning tool because it gives you--the "maker" or "creator"--the following benefits:

It permits you to significantly discount the value of assets put in the LLC. Discounts of one-third or more are not uncommon. Assets worth $1 million are often found to be worth only $750,000 (or less, depending on the discount achieved) after being contributed to an LLC. A married couple with a portfolio of stocks and mutual funds, worth, say, $2 million, can contribute that portfolio to an LLC and often achieve a reduction in the value of the portfolio to $1,300,000. This reduction in the size of the estate by $700,000 is worth $350,000 in estate tax savings. The reduction in value happens because of a good reason. The LLC has restrictions on transfer outside of the family and limits the management rights to just one or a few parties. If you were an outsider and buying into the LLC, how much would you pay for an ownership interest? Certainly not a hundred cents on the dollar.
An LLC allows you to "leverage" your annual exclusion. This is the same as making gifts to your children, grandchildren, and others at a discount. If gifts are made of assets owned by an LLC whose value has been reduced by one-third, what once would have been a $10,000 gift is really a $15,000 gift. Now, instead of taking Mom and Dad 10 years to give $400,000 in gifts to two children, it takes only 6.7 years to do so . Put another way, in the same 10 year period, Mom and Dad can give away $600,000 in value to their two children.
An LLC permits you to retain control over the gift to the younger generation even though you've made a legal gift. This is especially useful when the asset that you'd like to give away is the family business but whose control you would like to keep for awhile longer. We all know that the sooner you begin a gifting program, the more money the family will save in estate taxes. However, conventional gift programs require us to give up control - and often we are not ready to do that.
An LLC is a way to shift income from higher-taxed brackets to lower-taxed brackets. This happens when the assets contributed to the LLC produce income. This could be income from the family business, from the real estate portfolio or from the stock or bond portfolio.
An LLC is a way to teach less-responsible family members how to responsibly manage property. This is because Mom and Dad retain control (if they desire) over the asset given away, and thereby teach Junior how to manage it.
An LLC is a way to allow assets given to children to be "divorce-proof." Sometimes, Mom and Dad are concerned that if they make gifts of assets to Junior (maybe the asset is shares in the family business), the asset will end up owned by Junior's wife in the event of Junior's divorce. The use of an LLC can prevent this.

An LLC is a way to institutionalize family relationships. Mom and Dad can, for example, contribute the family business, the investment portfolio, the rental properties, etc., to an LLC and make their children partners. The LLC can bring all family members together for business meetings.
The LLC is an excellent way to protect your assets from seizure through lawsuits or from other creditors/predators.

What is a Limited Liability Company?

A limited liability company is a statutory entity authorized under state law. It bestows limited liability on the "members" (the parties which own the LLC). An LLC usually has two classes of members - the managing member (members) and the non-managing members. The managing member manages the LLC; the non-managing members are passive members and have no right to participate in management. All members, whether managing or non-managing, have limited liability from lawsuits or judgment creditors. Both classes are in effect "partners" (although that term isn't used in LLC law) similar to the partners in a partnership. The members own fractional interests in the LLC in accordance with the amount they have contributed or in accordance with the percentage gifted to a member by another member. In a typical LLC, the patriarch and matriarch of the family ("Mom and Dad") are the initial members and own 100% of the LLC.

After the LLC is formed, Mom and Dad contribute an asset with value to it. Such assets could, for example, be all of the stock in the family business, all of the assets of the family business, their investment portfolio, their rental property. In return for this contribution of assets to the LLC, Mom and Dad get "units" of ownership in the LLC, say 1,000 units, representing 100% ownership. These units are often called "LLC interests." It is after this point, that Mom and Dad give away some membership units to other family members. This is what makes it truly a great family estate planning tool.

What is Each LLC Unit Worth?

The value of each LLC unit depends on the value of the assets before they were contributed to the LLC and how strict the terms of the LLC are. The more restrictive the terms of the LLC, the less "valuable" become the assets in the LLC. Say, Mom and Dad contribute $1 million in rental real estate. The terms of the LLC may mean that the assets are now reduced in value to $667,000. Mom and Dad's 1,000 units of ownership are worth $667 each.

How Do the Children Acquire Any Ownership?

The children acquire ownership in the LLC when Mom and Dad give the children LLC units, which Mom and Dad may do on a regular basis. Assume Mom and Dad each own, initially, 500 units in the LLC. Now, if Mom and Dad want to give each of their two children $10,000 in value this year, Mom and Dad each give each child 15 LLC units, so each child gets 30 units per year. Mom and Dad repeat the gifts the next year, and so on until all 980 LLC units are given away (16.3 years). When all gifts have been made, Mom and Dad own 20 units (2%) and the children own 980 units (98%).

So, How Do Mom and Dad Retain Control?

Mom and Dad can give away 980 units and retain control . In fact, they could give away ALL units and still retain control under the North Carolina LLC Act. So long as Mom and Dad are designated "managing members" they retain all control over the LLC. Can they pay themselves a salary for managing the LLC? Yes. Can they vote themselves benefit packages? Yes. Can Mom and Dad declare distributions of cash from the LLC to the members? Yes.

Where Does the Protection from Creditors Come From?

A creditor can be the person who sues you in a slip and fall or a defamation case and wins a big judgment. A creditor can be the spouse of a limited partner who seeks a property settlement in a divorce action. Members of the LLC do not own the underlying assets - the members own only pieces of paper (or units) representing an ownership interest in the LLC. Under our law, a successful creditor can never get access to the underlying assets in an LLC- the creditor can only acquire a member's right to distributions from the LLC. This is known as a "charging order." Because the right to distributions also carries with it a burden to pay a prorata share of income taxes - even without an actual distribution from the LLC - which managing members control, creditors shy away from obtaining charging orders against LLC units.

Our firm stands ready to help our clients understand LLCs and put them in place where called for. If you decide on an LLC, we will fund your LLC, help document the appropriate discount on valuation, and we will coordinate the LLC with your revocable living trust.

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1709 Legion Rd., Ste 214, Chapel Hill, NC 27517

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