Introduction
Family limited partnerships and family limited liability companies (collectively, “LLCs”) are the foundation of many client plans. LLCs can provide a myriad of planning benefits for the client:
- Management and control benefits (e.g., by naming a manager and successors).
- Investment benefits (e.g., by consolidating small accounts of various family members and family trusts into a single investment account that can simplify investment management and perhaps qualify for lower breakpoints on investment management fees).
- “Inside” asset protection (e.g., a real estate rental property owned by an LLC, if subject to a lawsuit by a tenant, should protect the client’s home and brokerage account and only expose LLC assets).
- “Outside” asset protection (e.g., a physician that has minority interest in an LLC holding family wealth may make those interests difficult to reach for a malpractice claimant).
- Estate planning (e.g., discounts, but proposals abound to restrict or eliminate these).
- Avoid ancillary probate (e.g., by transforming real estate that would be subject to probate in a state where the property is located, into an intangible asset that can pass without local probate).
With so many benefits, LLCs have become ubiquitous in planning. When preparing a Form 1040 identifying single member LLCs on Schedule C or E, and multi-member LLCs typically taxed as partnerships for income tax purposes on Schedule E, practitioners can begin to address a host of compliance and planning issues, and create real value added for clients and post-tax season work. Here is a checklist of some of the many items that might warrant addressing:
√ Permanent File: Be certain that you have, if not assemble, an appropriate permanent file. Without appropriate permanent file documentation you cannot ascertain who has authority to sign a tax return, or make required tax calculations. Often merely assembling a reasonable permanent file will identify glaring problems (e.g., not every member signed the operating agreement). This should include at minimum the following:
- Formation documents for the entity (e.g., the certificate filed with the state in which the LLC was formed). The name of the filing will vary by state. Be certain that the copy reflects stamps from the state agency indicating acceptance and the date of the acceptance.
- Amendments to the formation documents, if any.
- Authorization for the LLC to do business in other states. With the growing use of sophisticated dynastic and self settled trusts (typically formed in either Alaska, Delaware, Nevada or South Dakota) the LLC may be formed in one of those states but perhaps then should be authorized to do business in the state in which the LLC conducts business (e.g., even an investment business).
- Governing agreement (operating agreement for an LLC and partnership agreement for a partnership), including any amendments. It is generally advisable to have an annotated operating agreement that highlights and explains decisions pertinent to tax planning and compliance. If there is a Tax Matters Partner (TMP) you need to be aware of this. Some attorneys draft TMP provisions as a control feature for a particular member even if a TMP is not otherwise required. You cannot determine the tax consequences to the heirs of a deceased member, or of a new member buying an interest, without knowing whether the operating agreement provides for an IRC Sec. 754 election.
- Documentation of contributions to the LLC. This might include a bill of sale, wire transfer documents, deed, or other documents. Details on the member’s tax basis of each asset contributed, and for non-cash items an appraisal or other confirmation of fair value. Details on any contributed assets are subject to debt. If marketable securities constitute the majority of contributed assets work papers confirming the inapplicability of the IRC Sec. 721 investment company rule should be maintained.
- Membership interest certificates. Some lawyers issue certificates, analogous to stock certificates, for LLC membership interests. Determine if these are being used and if so obtain copies. Verify that the ownership interests reflected on the membership interest certificates, those in the current operating agreement and the Forms K-1 are all the same.
- Transfer of membership interests. Especially in the family LLC context, it is common to have membership interests transferred by way of gift to younger family members and trusts. Documents might include an assignment, executed counterpart of the operating agreement or an amended and restated operating agreement, appraisal or gift tax return.
- Good standing certificate. Periodically it is advisable for the attorney for the entity to order a good standing certificate [from the state] to corroborate the status of the entity.
- If trusts or other entities are members, basic documentation confirming who can sign and that they have the legal authority to be members should be included. A letter from the attorney for the LLC may be advisable.
- Transactional and operational records. This could include leases to or from the LLC, contracts with key employees, an investment policy statement for an investment LLC, and consents or actions by the manager of the LLC. The documentation will have to relate to the function and purpose of the LLC. So if a family or business LLC is used to own life insurance then copies of the insurance policies, buy-out agreement, if applicable, should be obtained.
√ Convert Partnerships: Identify situations in which the client owns an interest as an individual general partner in a limited partnership. It may be advisable, subject to income tax implications of debt or guarantees, to convert the entity into a limited liability company to provide the client limitation on personal liability. As a general partner, the client faces unlimited personal liability on lawsuits or claims against the limited partnership. See Rev. Rule 95-37, IRB 1995-17, 10. The consequences of debt must be considered. To avoid any tax consequences on the conversion of a partnership into a limited liability company, there must not be any change in the proportionate responsibility of each partner for the debts of the partnership. If a shift in a partner's share of liabilities occurs, for example, as a result of the LLC assuming recourse debt of the predecessor partnership, gain could be realized. Treas. Reg. Sec. 1.722-1.
√ Watch Out for the Investment Company Rule: With so many taxpayers setting up LLCs in 2012 to fund gifts to take advantage of what many thought would be the last great chance at estate planning before a $1 million 2013 estate tax exemption, watch out for this trap. The contribution of property to an LLC in exchange for equity interests in the LLC is a realization event for tax purposes. Treas. Reg. Sec. 1.1001-1(a). Therefore, absent an express Code provision providing for non-recognition gain will have to be recognized by the taxpayer making the contribution to the extent that the fair market value of the LLC interests received in exchange exceed the adjusted tax basis of the property contributed. IRC Sec. 1001; Treas. Reg. Sec. 1.1001-1(a). Non-recognition treatment, however, will generally apply to such transactions. IRC Sec. 721(a). However, if specified exceptions to the non-recognition rules are applicable, gain may have to be recognized. IRC Sec. 721(b); 7701(a)(45). If appreciated securities are transferred to the LLC on funding, all gain may be triggered if the LLC is characterized as an “investment company.” The LLC must be classified as an investment company by virtue of having more than 80% of its assets constituting “listed property” which generally means marketable securities. Second, once the LLC is classified as an investment company, taxation will occur if the assets transferred are not “diversified portfolios.” If the assets transferred are not diversified, then the transaction must result in diversification which is not insignificant. Practitioners should test all transactions and take remedial action. While ideal to address before the transaction there are steps which can be taken after the fact to potentially cure the problem.
√ Business Purpose: To be respected for tax purposes, the LLC must be bona fide, and transactions must be for business reasons. Treas. Reg Sec. 1.701-2(a)(i). If the LLC is not respected as a distinct legal entity, any asset protection benefits the client hoped for will be lost. Identify LLCs that may have uncertain or uncorroborated business purposes for post-tax season follow-up. Many of the determining factors of a business that will be respected are in the purview of the practitioners (independent books and records, handling matters in a business like manner and no commingling of funds, proper documentation for loans, etc.).
√ Phantom Income: How does income on the K-1 compare to actual cash flow received by the client? Many families use LLCs to manage assets, provide asset protection and provide discounts for estate planning purposes. But what happens if distributions lag well behind taxable income. Language can be added to an operating agreement to require minimum distributions to meet tax costs. Because of different tax status of different members and different states, the distribution cannot be calculated exactly. If a formula is used, or a specified percentage, be certain that it is reasonable for your client. The objective in many instances is to assure some reasonable level of distribution to meet expected tax costs. Guidelines could be added for distributions of an estimated amount equal to the federal maximum tax rate multiplied by taxable income to assure members adequate cash flow to pay federal tax. However, inclusion of such provisions in an operating agreement will undermine discounts for tax purposes and asset protection as well. In the context of a divorce, a mandatory distribution provision may change the evaluation of the LLC interest as a source for the payment of alimony and child support.
√ Built in Gain or Loss: If the market value of contributed assets exceeds the contributing members adjusted tax basis in that property, any gain the LLC realizes on the sale of that property has to be allocated back to the contributing partner during the seven years following the contribution. Be certain to track the necessary information in the LLC permanent file to facilitate the appropriate calculations and allocations. IRC §704(c)(1)(A).
√ Change in Partnership Interest: You have to determine a member’s distributive shares of LLC (for an LLC taxed as a partnership) items when a member's interest changes during the year. The general rule is that the LLC should determine the member's distributive share using the interim closing of the books method. However, by agreement of the members (what does the operating agreement provide for?) it may be permissible to use the proration method. Under this method, the partnership allocates the distributive share of LLC partnership items (except for extraordinary items) under IRC Sec. 702(a) among the members in accordance with their pro-rata shares of those items for the entire year. See Prop. Reg. 1.706-4 and the proposed changes to Reg. 1.706-1.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.
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