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LOST AND FOUND:
Finding Self-Reliance after the loss of a spouse.
by P. Mark Accettura, Esq.
The book is designed to assist surviving spouses, those planning for the eventual loss of a spouse and the families of surviving spouses in the grieving process and in navigating the complex legal, governmental, financial and accounting requirements associated with the death of a loved one.
Whether through outright gift, transfers in trust, or charitable transfers, reducing estate tax liability involves some sort of gifting. The $10,000 dollar, per beneficiary, annual gift tax exclusion allows for substantial annual gifts. Assuming you begin a systematic gifting program early enough in life, significant estate tax reduction can be achieved over time. Not only are the gifted assets removed from your estate, but the future appreciation of the gifted assets is removed as well.
Having lost a spouse and experiencing your economic future as somewhat uncertain, you may be hesitant to make large gifts. You may not want to part with cash you believe you may need for a rainy day. You may be concerned that outright gifts to your children or other beneficiaries will negatively affect their work ethic. Or, you may simply not have sufficient liquid assets to make substantial cash gifts each year.
Most, if not all, of your gifting concerns can be addressed by using a Limited Liability Company (“LLC”) as a gifting vehicle. Limited Liability Companies are relatively new. They offer the liability protection of a corporation but are taxed as a partnership. LLC owners are called “members,” and their ownership is expressed as a percentage.
Like shareholders in a corporations, members’ liability is limited to the extent of their investment in the LLC. Members share in LLC profits and loss in direct proportion to their ownership.
Limited liability companies created for gifting purposes are often called “family” LLCs. Most family LLCs provide for the appointment of a manager who controls the day-to-day operation of the LLC. Naturally, you would appoint yourself as the manager to allow you to control investment of LLC assets as well as disbursement of LLC income and principal. Exclusive management authority allows you to make gifts without relinquishing control of the gifted assets.
To create an LLC, Articles of Organization must be filed with your state’s Corporations and Securities Bureau. The initial LLC members then execute an Operating Agreement that sets forth the names and ownership interests of all members, appoints a manager, and establishes the rules of operation for the LLC.
Once these steps have been completed, you can begin to transfer selected assets to the LLC. During your life, you act as manager, retaining full control of company stock, real estate, or other assets transferred to the LLC. After death, the successor manager appointed by you in the Operating Agreement implements the terms of the LLC to provide structure among the competing interests of your beneficiaries.
Tension, and even outright conflict often manifest after the death of the family patriarch or matriarch. Such family disputes can be minimized by clearly defining ownership and authority succession in your LLC.
LLCs are the preferred vehicle for gifting business, investment and real estate assets. It is difficult if not impossible to divide a shopping mall, family farm, or apartment building in precise fractional shares. However, if such hard to divide assets are first transferred to an LLC, precise membership interests can be calculated and easily gifted.
Once transferred, the LLC provides for the orderly management of the property by its appointed manager (you). As an added bonus, substantial gift tax “discounts” (discussed below) are available when LLC interests are gifted.
LLC interests, once gifted, are insulated from the claims of outside creditors. Unlike outright gifts, LLC gifts are relatively secure from the claims of your children’s spouses and creditors. The LLC Operating Agreement prohibits members from making voluntary transfers and severely limits involuntary transfers due to the bankruptcy, divorce or insolvency of a member.
Such events trigger an automatic “buy back” under the Agreement for a nominal price. Buyback may not even be necessary. The inherent lack of marketability of LLC interests make them unattractive to outside creditors. Even if a creditor were able to acquire a member’s share, the creditor would only be an assignee, and as such would not eligible to participate in LLC activity or management.
As a “pass through” entity, LLCs pay no tax. Instead, items of income and loss pass through to the members in proportion to their ownership interest, and are taxed at the member’s marginal tax rate.
As a separate entity, the LLC must file annual income tax returns (IRS Form 1065). Each member’s share of income and loss is calculated on Schedule K1 of Form 1065, which must be given to members by January 31 of the following year. As a practical matter, members cannot file their personal income tax returns until they have received a copy of their K1.
LLCs are the preferred gifting vehicle for all gifts except gifts of life insurance (which should be made to an ILIT). While the manager of an LLC may both manage and enjoy LLC assets, the grantor of an irrevocable trust may neither retain an interest in the trust nor act as Trustee. While an irrevocable trust cannot be amended, modified or revoked, an LLC may be amended as circumstances change.
Valuation is a critical issue in gift and estate tax. In fact, the majority of gift and estate tax audits involve valuation issues. To avoid IRS problems, all gifts must be valued. For gifts of cash and publicly traded securities, the value of the gift can easily be determined. However, gifts of real estate and business interests require that you obtain a written appraisal from a licensed appraiser.
If the gift is an interest in an LLC, determining value is a two-part analysis. First, the LLC’s assets must be valued, and then the membership interests must be valued. Interestingly, the member’s pro rata share of LLC assets is only the starting point in determining the value of the member’s interest.
A discount must then be applied to account for the member’s lack of participation in management (“minority discount”), and the restrictions on transferability imposed by the operating agreement (“marketability discount”).
The courts have reasoned that an outside purchaser would pay less to acquire the membership interest than to acquire the underlying LLC assets directly.
Valuation discounts allow you to make larger annual gifts. For example, a thirty five percent (35%) discount allows you to make a 35% larger gift within the annual gift tax exclusion. In the long run, the ability to make larger annual gifts can dramatically reduce your estate tax liability.
The earlier gifts are made the better, since future appreciation of LLC assets will be owned by your beneficiaries instead of by you. The following example illustrates the operation of LLCs and the benefit of valuation discounts:
EXAMPLE: Mary wishes to give her four children an interest in her waterfront vacation home worth $1,000,000. Mary creates a limited liability company to which she transfers the vacation home. Mary appoints herself as manager. Without a valuation discount, Mary could transfer a 1% LLC interest to each of her children, representing a gift of $10,000 (1% x $1,000,000), all of which is sheltered from tax by Mary’s annual gift tax exclusion. Since Mary’s children are acquiring minority interests, and are subject to the transfer restrictions imposed by Mary in the LLC Operating Agreement, Mary is eligible for a valuation discount on the gifted interests.
A 35% valuation discount (readily acceptable by the IRS in such circumstances) allows Mary to gift $15,385 ($10,000 gift exclusion ¸ (1 -.35)) annually to each child. Accordingly, Mary could make larger tax-free gifts of 1.55 % to each child, retaining a 93.8 % interest in the LLC after the gift. Using the LLC, Mary is able to gift precise fractional interests in the vacation home annually. She also retains full control of the vacation home after the transfer, which would not have been the case if Mary had simply added her children to the deed as joint owners.
Mary would be advised to annually gift LLC membership interests until she gave away all but one (1%) percent of her interest in the LLC. Since in our example it would take Mary 16 years to gift 99% of her interest, she should consider gifts to grandchildren and other family members as well as making taxable gifts.