mug martin shenkmanFunding Irrevocable Trust with Family or Closely Held LLC Interests

LLCs are the default entity for most family or closely held business and real estate ventures. Practitioners are therefore commonly involved in assisting clients with these transfers. The role of the CPA will vary depending on the involvement of the client’s lawyer, an outside appraiser and others. The following is a broad checklist listing much of the information that should be organized for each family or closely held LLCs interest and suggested steps to be taken with respect to the transfer of your interests to an irrevocable trust. Many of the examples use real estate as an example, but if the LLC owned different assets or business interests these would simply have to be changed to be relevant to the particular circumstances. Even though a number of the documents should be prepared by others, e.g., a real estate appraiser (assuming the practitioner does not perform real estate appraisals) or legal documents, the practitioner still needs these steps on his or her radar screen.

  1. Coordination of Legal, Appraisal and other Work. The more of these steps that can be handled internally by legal counsel for the real estate business/entities, the more efficient and cost effective. This will especially be true if other family members are undertaking similar planning.
  1. 2704 Regulations May Eliminate Valuation Discounts.
    1. The Treasury (IRS) recently issued Proposed Regulations that may eliminate valuation discounts. These Regulations could be effective as early as December 31, 2016. The loss of discounts could have a substantial adverse impact on leveraging these real estate LLC interests out of your clients’ estates. This might result in a flurry of gift and sale transactions before these Regulations become effective.
    2. This same issue should affect all other owners and thus many if not all owners should be undertaking similar planning by year-end. If this is the case then all owners can share the costs of the appraisals, preparation of transfer documents and other steps. This will greatly simplify the process and lower the cost of all the transfers involved for any particular owner (e.g., your client).
    3. This checklist might prove useful to coordinate that effort. If other owners will not become involved or will not proceed in this matter it is important that you guide your client to the appropriate steps and realistic cost estimates.
  1. LLC Owner Details.
    1. Information as to the owners and their relationships for each entity should be obtained.
    2. This may be essential to the interpretation of the operating agreement and what must be done to approve the particular transfers your client wishes to make.
    3. In the future this may be essential to determine the applicability of the 2704 valuation discount restriction rules (i.e., is it a family controlled entity in technical not common usage terms).
  1. Appraisal.
    1. Appraisals must be completed by “qualified appraisers” as defined in applicable Regulations. The qualified appraiser must complete a “qualified appraisal” which also must comply with a checklist of requirements contained in applicable tax laws.
    2. The appraisal must be a two-tiered process.
      1.                                                i.     First the fair market value of underlying real estate must be determined. An MAI appraisal of the fair market value of each real estate property owned by each LLC is necessary. The appraiser will require all the applicable information to complete this type of appraisal: rent rolls, historical operating expenses and rents, survey, leases, and so forth.  Whatever data you have used to make these estimates might be useful for an appraiser and might defray appraisal costs but formal appraisals should be collected (e.g. prior appraisals for estate planning purposes, bank appraisals, etc.).
      2.                                              ii.     An appraisal of the ownership entity and, in particular, the LLC membership interests of the member which will be transferred as part of the estate planning. This will require that the appraiser be provided with the governing legal documents for the entity, several years of tax returns, and other data. Some of this is discussed elsewhere in this checklist.
  1. Real Estate Documents to Collect.
    1. Narrative.
      1.                                                i.     A narrative for each property/entity that describes the relationship of the owners, who manages the property/entity, the type of property, any plans or anticipated future for the property (e.g., hold for long term, potential sale in a specified time frame, planned rehab, etc.).
      2. Accounting data.
        1.                                                i.     Rent roll.
        2.                                              ii.     Financial statements for a number of prior years.
        3.                                             iii.     Distributions, salaries and other economic benefits the family receives from the property, and any other important facts.
      3. Deed.
        1.                                                i.     For any entities that are closely held it is recommended that the deeds to the underling properties also be part of the documentation organized to be certain that they are held in the correct entity name.
        2.                                              ii.     While this might seem unnecessary, I have seen errors in deeds and entities for clients with similarly significant holdings. It is imperative that before any entity interests are transferred it be certain that the properties are properly titled in those entities. If such an error were discovered on an IRS audit following transfers it could be costly and could undermine significant components of a plan.
      4. Mortgage.
        1.                                                i.     Current balance will be necessary for the appraiser.
        2.                                              ii.     Mortgage documentation will be necessary for real estate counsel to review to ascertain what prerequisites if any may affect your intended transfers.
      5. Leases or other contractual agreements.
        1.                                                i.     These may affect valuations or assist your real estate counsel in identifying restrictions, notice or other requirements for transfer.
  1. Entity Documents to Collect.
    1. Formation Certificate.
      1.                                                i.     Documents filed on the formation of the entity.
      2.                                              ii.     Any amendments.
      3. Certificate of good standing for the entity.
        1.                                                i.     This is inexpensive but, surprisingly even for well-organized clients, some issues are identified. It is preferable that any issues as to the validity of the entity be addressed by the CPA or attorney before estate planning transactions are consummated.
      4. Confirmation of the tax status of each entity.
        1.                                                i.     While most LLCs are taxed as partnerships some elect to be taxed as S or C corporations. Confirmation of the tax status is vital because of the importance of achieving a basis step up on death.
        2.                                              ii.     If the ownership entity is a partnership or LLC taxed as a partnership the ability to step up the inside basis of the partnership in the asset, referred to as a IRC Sec. 754 basis adjustment, will be crucial whether this has been addressed for entities involved. This should all be reviewed now and if amendments are advisable, negotiating (if necessary) with other owners, an amendment and restatement of the entity documents to give members/partners the right to demand that the entity make a 754 basis adjustment.
      5. Operating Agreement.
        1.                                                i.     Copies of the governing documents for each entity. This is generally an “operating agreement” for an LLC but sometimes other records are involved.
        2.                                              ii.     Copies of all amendments. The most current agreement should reflect all current owners and their correct owners and should be consistent with applicable income tax returns (e.g., Forms K-1 of Form 1065 if the LLC entity is taxed as a partnership).
        3.                                             iii.     Please be certain all copies provided are of fully executed documents. If these do not exist, have the client follow up with counsel.
        4.                                             iv.     This should be reviewed by your corporate/real estate counsel to ascertain whether transfers of your interests as between each of you and then trusts is permitted.
        5.                                              v.     As noted below an amended and restated operating agreement should be prepared reflecting all transfers. Many lawyers simply prepare an assignment of LLC membership interests. On a tax audit it is preferable to have an operating agreement reflecting ownership interests before the transfer and one reflecting the revised ownership percentages after the transfer.
      6. Other key legal documents.
        1.                                                i.     This could include minutes or consents or other documents.
      7. Recent federal income tax returns for the entity.
        1.                                                i.     If the LLCs have all chosen to be taxed as partnership for income tax purposes then this would be Form 1065.
      8. Tax Basis.
        1.                                                i.     An estimate of the tax basis for the properties held by each entity. This is important to consider the pros and cons of shifting any of these interests outside of your estates (e.g. via direct gifts, gifts through GRATs, or sales to a grantor trust, etc.).
        2.                                              ii.     Depending on the anticipated holding period for a particular property or entity, the magnitude of appreciation, and other factors, it may prove more advantageous to retain a particular asset inside your client’s estate rather than shifting it out. Real estate, in particular, is a somewhat unique asset for purposes of this type of analysis in that if a property is a quality property that you intend to hold for the long term, or for which a tax deferred Code Section 1031 is feasible (but beware that proposals have been made to severely restrict this tax benefit), then removing that asset from your client’s estate may be more beneficial than retaining it to realize a basis step up. In all events consider putting the client on notice of basis considerations.
  1. Transfer restrictions.
    1. Confirmation by real estate counsel that any contractual restrictions on transfer have been met or that none exist.
    2. This could include lender requirements (e.g., due on transfer clauses).
    3. Depending on the nature of the properties involved, anchor tenants, or others may have negotiating contractual restrictions or perhaps only notification requirements before transfers.
  1. For LLC interests gifted to an irrevocable trust.
    1. Gift letter. A letter signed by the donor member transferring by gift LLC interests to the irrevocable trust.
    2. Assignment of LLC interests.
      1.                                                i.     An assignment document transferring LLC interests from you as owner to the irrevocable trust.
      2.                                              ii.     This should be signed by the trustee confirming acceptance of the gift.
      3. If the LLC certificates its membership interests, a new membership certificate indicate the interests or units owned by the trust. If not all interests or units are being given a second certificate reflecting the interests or units retained by the transferor member after the gift should also be provided.
      4. Amended and restated operating agreements reflecting membership interests and owners after the gift.
  1. For LLC interests sold to the irrevocable trust.
    1. All the same documents listed above for gifts but instead of a gift letter the following documents might be included.
    2. A sale of interests will be necessary if you wish to transfer more value of interests then a mere gift will permit. This will depend on the size of the member’s estate, the value of the interests involved, how much exemption the member still has remaining (the total in 2016 is $5,450,000), and other factors.
    3. LLC membership interest purchase and sale agreement.
    4. Note given by irrevocable trust for purchase of LLC membership interests.
    5. Security agreements with respect to sale if trust buys interests for a note.
  1. Gift tax returns.
    1. Be certain the client is aware of the requirements to file a gift tax return reporting the transactions.
    2. Sales may be reported as “non-gift” transactions on the gift tax return.
  1. Consolidation.
    1. It might be useful to consolidate smaller holdings into a single family real estate holding entity to simplify the legal work and formalities of gifts and/or sales to various trusts.
    2. If, for example, no other members wish to make transfers, it may be simpler for you to transfer all your family real estate LLC interests to a new personal LLC holding company and then use membership interests in that new holding company to transfer interests to your irrevocable trust.

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