Planning Using Family Partnerships & Limited Liability Companies (FLPs & LLCs)
Business entity planning is a valuable estate planning tool. The most popular benefits that may be obtained utilizing business entities in an estate plan are limited liability for most or all of the entity owners and estate and gift tax savings through valuation discounts.
There has been a glut of litigation over the past ten years surrounding FLPs and LLCs. The IRS has been concerned with the possibility of exploitation in using these type of taxation entities (pass-through) in estate planning as well as abuses surrounding valuation discounts. The litigation has resulted in a set of judicially determined guidelines which if adhered to will result in a successful plan.
Your estate planner must remain updated on reported court decisions and IRS guidelines in the design, entity formation and funding of an LLC and FLP. The timing and the order of the steps in the process are crucial to a successful plan. Your estate planner must be aware of the consequences of this type of planning with regard to gift, estate, generation-skipping, income and real property taxes.Family Limited Partnerships (FLP)
As with partnerships, the FLP is a flow-through entity for profits and losses, and those profits and losses are allocated in accordance with the ownership percentages.
A properly structured FLP will protect assets from potential claims and lawsuits. However, general partners have full responsibility for the limited partnership's debts, liabilities, and obligations. They also have unlimited liability with respect to partnership creditors. Limited partners are not responsible for debts, liabilities or obligations of the partnership. Their losses are limited to their respective investments in the partnership.
Using a FLP, you could transfer assets that would otherwise use all or a significant portion of your applicable exclusion amount for gift and estate tax purposes (see Federal Transfer Tax). Tax savings are realized because of valuation discounts and should the asset being transferred appreciate over time, that future appreciation will have been transferred out of your estate.
Typically, parents will transfer property to a FLP and gift a percentage of the partnership to their children. The parents will want to control the transferred asset and will keep a general partner interest. Therefore, the gift to their children should be less than 50% of the partnership. If the asset appreciates, that appreciation has also been transferred out of the parent's estate resulting in further tax savings. The children's limited partnership interests cannot be sold or converted to cash, and the children have a lack of control and management regarding the dispensation of the asset. Since the children lack control and management, their interest is deemed to be less marketable. Due to this lack of marketability, tax law says for gift tax purposes, the value of the children's interest will be substantially less than the value of the underlying FLP asset. This is a valuation discount.Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a business entity that has the federal and estate income tax attributes of a partnership and the liability protection similar to a corporation. The limited liability is extended to all members and managers of an LLC. Members enjoy limited liability status regardless of their participation in the day-to-day affairs of the business.
Each state has their own rules regarding liability protection and creditor remedies for assets held in LLCs. California allows a creditor of a LLC member to obtain a charging order. The charging order is generally limited to profits and distributions made by the company to the debtor-member. The creditor cannot force a distribution. In some states, the charging order is the creditor's exclusive remedy. However, California law allows a "foreclosure" on a member's interest that is subject to a charging order.Single Member LLC
In California, the liability protection of a single member LLC is unclear. Some professionals believe that single member LLCs offer no liability protection at all. Others believe the protection will fail only as to outside debts. Currently, single member LLCs are still better than no LLC. Delaware, Wyoming, Nevada and other states are preferable to California to set up an LLC because California allows a creditor to foreclose on a debtor member's interest in the LLC, which of course would mean the entire interest of the debtor if it is a single member LLC.
Besides the limited liability benefit provided from LLCs, these entities can reduce the value of your estate for transfer tax purposes. As with the FLP, the LLC will qualify for valuation discounts due to the minority interests and lack of marketability as will the interests in the entity that are included in the decedent's estate.