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Can standard boilerplate and default corporate law provisions inadvertently disinherit your family from controlling the business or cost millions in additional estate/gift tax?
By Ed Morrow, JD, LL.M. (tax), MBA, CFP®
[Manager, Wealth Strategies Communications, Key Private Bank]
Many physicians use limited liability companies, limited liability partnerships or limited partnerships (“LLCs”, “LLPs” and “LPs”) to operate a trade or business, to hold real estate, or even to hold investment assets. When only immediate family are owners, these are often referred to as family limited partnerships or limited liability companies (“FLPs” and “FLLCs”). There are numerous business, asset protection and estate planning reasons for using these entities (hereinafter lumped together for simplicity as “LLCs”). In many cases, these are preferable to old-fashioned corporations (see separate companion article on LP/LLC Advantages).
As a doctor – you must be very careful, however, when transferring LLC shares during lifetime or at death, to your spouse, children, trusts or others. Especially when there are co-owners outside the immediate family. This is due to a stark difference between LLC/partnership law and corporate law and the concept known as “assignee interests”. Understanding this is even more crucial in 2012 because of the overwhelming demand and interest in transferring LLC interests to irrevocable trusts to exploit the $5.12million gift tax exclusion, which is slated to reduce to only $1 million in 2013.
An LLC owner (called a “member”, not a “stockholder”) has two bundles of rights:
- Economic rights – which are the rights to receive property from the LLC both during existence and upon liquidation, along with tax attributes and profit/losses; and
- Management rights – the right to vote, participate in management and receive reports and accountings.
It is the latter category that can cause problems when transferring LLC interests by gift or at death.
Members of an LLC usually establish an Operating Agreement to set the rules for transfer of interests. State statutes (such as the Uniform Limited Liability Company Act) usually provide default rules where the document is silent.
The problem occurs when an LLC member transfers a portion of his or her ownership interest in the LLC to another person, either during lifetime or at death. At that point, the transferee may become a “mere assignee” of the LLC interest, and not a full “substitute member.” Under the laws of most states, unless the Operating Agreement provides or parties otherwise agree, an assignee only receives the transferor’s economic rights in the LLC, but not the management rights.
In fact, some court cases require member consent even if the operating agreement seems to otherwise permit such transfers (Ott v. Monroe, 719 S.E.2d 309, 282 Va. 403 (2011). These state laws were enacted to protect business owners from unwillingly becoming partners with someone they never intended or contracted to be partners with.
This treatment is completely different from transferring C or S corporation stock – when you buy P&G stock, you get the same rights as the previous owner. S Corporation stock is not even allowed to have differing classes of ownership interests (although voting/non-voting is permitted). Usually, this quirk in the law has numerous asset protection benefits to LLC owners (discussed in the companion article), but it can cause havoc to one’s business planning in unforeseen circumstances.
Examples of Inadvertent Loss of Control
#1- Doctors Able and Baker, unrelated parties, form and operate an LLC. Able owns 49% and Baker owns 51%. Baker has a controlling interest in the LLC. Baker dies and his 51% interest in the LLC is transferred to his revocable living trust. Now, the trust is a “mere assignee” and while the trust receives 100% of Baker’s economic rights in the LLC (51% of the total LLC economic rights), it has none of the management rights. After Baker’s death, Able will have 100% of the LLC’s management rights. The trustee may have serious difficulty even getting books and records of the LLC, much less have any say on reviewing Able’s business decisions (including new hire and new salary expectations).
#2 – Same ownership structure as above, but Baker leaves assets via Transfer on Death designation or via Will to his spouse, children or others directly. Same result.
#3 – Same ownership scenario as above, but Baker gifts his membership interests during life to his spouse, children, UTMA account or an irrevocable grantor trust. Same result.
#3a – Same scenario as above, but Baker simply transfers his shares to his revocable living trust (called “funding”) via Schedule A attached to trust or other assignment. Same result.
#4 – Same scenario, but Dr. Baker got express permission of Able to transfer his LLC interest to his revocable living trust and have it remain a full substitute member. No issue – until Baker dies and the LLC interests pass to a new subtrust, such as a bypass, marital, QTIP, or other irrevocable trust, or to beneficiaries outright. Able must have agreed to this subsequent transfer as well, otherwise the transfer to the new subtrust will be a mere assignee interest and the Baker family loses control.
Creditor Issues
Again, Able and Baker own 49%/51%. Baker has some creditor issues from a tort claim and co-signed loans unrelated to the LLC. He files bankruptcy to reorganize or get a clean start (or perhaps the creditor forces a bankruptcy). This is probably another trigger that causes Baker to lose all of his management rights in the LLC.
Incapacity Issues
Again, Able and Baker own 49% and 51% economic and management rights respectively. This time, Baker has a stroke or an accident and his wife or one of his family takes over as guardian or conservator. Similar result. Able now has 100% controlling management rights, even though Baker still keeps the same economic rights. He can fire Baker and raise his own salary.
Estate/Gift Tax Issues
Able and Baker’s company is worth $10Million. Baker’s 51% interest gets marketability discount, but a controlling premium, so valuation experts and the IRS agree it is worth $4Million. Able’s 49% interest gets a marketability and lack of control discount, so his interest is only worth $3 million. Yet when Baker dies, he leaves this 51% interest to his spouse (or marital trust) as a mere assignee, and because the interest has no voting control or management rights, it may be worth only about $3 million in the hands of the spouse/trust (because there is no “control” or management rights, the 51% is worth considerably less). Thus, Baker’s 51% interest is taxed at $4 million, but only gets a $3 million marital deduction (this same discrepancy is true for charitable gifts, which is why physicians should also be careful gifting LLC interests to charities or charitable trusts). Did $1 million in value inadvertently pass to Able? At best, this wastes Baker’s estate tax exemption. At worst, it may lead to an additional 55% tax (and probably penalties, since it would unlikely be reported and caught on audit) on $1million, or $550,000 additional tax that could easily be avoided.
This same issue arises in gifting shares to a spouse or to a trust for a spouse that is intended to qualify for the marital deduction (or to charities or charitable trusts).
In addition, gifting a mere “assignee” interest risks disqualifying any LLC/LP gifts for the “present interest” annual exclusion under IRC 2503(e) ($13,000 per donor per donee) pursuant to the recent IRS wins in the Hackl, Fisher and Price cases.
Furthermore, it adds grist to a favorite line of attack that the IRS uses to add to taxpayers’ estate tax bill. If a taxpayer has a “retained interest” in a gift, the IRS has been successful in pulling such gifts back into a taxpayer’s estate (therefore causing additional 35-55% estate tax).
What Can Physicians Who Own LP/LLCs Do?
If you want to transfer both economic rights and management rights in your LLCs, similar to shares of stock of a corporation, then the LLC’s written Operating Agreement should be reviewed and/or revised to admit certain transferees or assignees (like a guardian/conservator, spouse, children, trust, subtrusts, etc) as full “substitute members”, while other transferees (like creditors, ex-spouses) can remain “mere assignees”, with no management rights.
LLC owners may decide on other variations on the above solution if desired. For instance, some owners might prefer to exclude a surviving spouse or children from management rights, but be perfectly comfortable with having an independent or agreed upon trustee of a marital trust accede to those rights. The key to good planning is to know the consequences of gifts/bequests beforehand to adequately plan.
Make sure your entire wealth management team is on the same page when orchestrating your wealth planning. Ask whether they use a checklist of any sorts in their planning, or even if they do, whether they communicate the checklist with other advisors on your team – many do not.
Assessment
As noted in Atul Gawande’s The Checklist Manifesto, simple checklists can often prevent mistakes and miscommunications among even the most educated of professionals – this is certainly true for asset protection and tax planning for LLC interests, and at no time more than in 2012 with all of the anticipated tax changes and proposals threatening to snare any missteps in planning.
ABOUT THE AUTHOR
© 2012 Edwin P. Morrow III and KeyBank, NA. The author holds the following designations: J.D., LL.M. (masters in tax law), MBA, CFP® and RFC®. He is a Board Certified Specialist in Estate Planning, Probate and Trust Law through the Ohio State Bar Association. He is an approved arbitrator for the Financial Industry Regulatory Association (FINRA). He currently provides educational and consultative services nationwide for the financial advisors and clients of Key Private Bank. Contact: (937) 285-5343 or: Edwin_P_Morrow@KeyBank.com Ed is also a friend of the ME-P and designated “thought-leader”.
Conclusion
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Filed under: Estate Planning, Experts Invited, Health Law & Policy, Insurance Matters, Practice Management, Risk Management | Tagged: "LLCs", A Review of LP/LLC Transfer Hazards for Physicians, atul gawande MD, C corp, creditor proof, Edwin P. Morrow III, estate tax, gift tax, irrevocable trust, limited liability companies, limited liability partnerships, LPs, medical businss rik mangemen, QTIP, S corp, The Checklist Manifesto, Uniform Limited Liability Company Act |
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The dangers of being “listed”
[A warning for 419, 412i, Sec.79 and captive insurance]
From: Accounting Today: October 25, 2010
Taxpayers who previously adopted 419, 412i, captive insurance or Section 79 plans are in big trouble. In recent years, the IRS has identified many of these arrangements as abusive devices to funnel tax deductible dollars to shareholders and classified these arrangements as “listed transactions.” These plans were sold by insurance agents, financial planners, accountants and attorneys seeking large life insurance commissions. In general, taxpayers who engage in a “listed transaction” must report such transaction to the IRS on Form 8886 every year that they “participate” in the transaction, and you do not necessarily have to make a contribution or claim a tax deduction to participate. Section 6707A of the Code imposes severe penalties ($200,000 for a business and $100,000 for an individual) for failure to file Form 8886 with respect to a listed transaction. But, you are also in trouble if you file incorrectly.
I have received numerous phone calls from business owners who filed and still got fined. Not only do you have to file Form 8886, but it has to be prepared correctly. I only know of two people in the United States who have filed these forms properly for clients. They tell me that was after hundreds of hours of research and over fifty phones calls to various IRS personnel.
The filing instructions for Form 8886 presume a timely filing. Most people file late and follow the directions for currently preparing the forms. Then the IRS fines the business owner. The tax court does not have jurisdiction to abate or lower such penalties imposed by the IRS. Many business owners adopted 412i, 419, captive insurance and Section 79 plans based upon representations provided by insurance professionals that the plans were legitimate plans and were not informed that they were engaging in a listed transaction. Upon audit, these taxpayers were shocked when the IRS asserted penalties under Section 6707A of the Code in the hundreds of thousands of dollars. Numerous complaints from these taxpayers caused Congress to impose a moratorium on assessment of Section 6707A penalties.
The moratorium on IRS fines expired on June 1, 2010. The IRS immediately started sending out notices proposing the imposition of Section 6707A penalties along with requests for lengthy extensions of the Statute of Limitations for the purpose of assessing tax. Many of these taxpayers stopped taking deductions for contributions to these plans years ago, and are confused and upset by the IRS’s inquiry, especially when the taxpayer had previously reached a monetary settlement with the IRS regarding its deductions. Logic and common sense dictate that a penalty should not apply if the taxpayer no longer benefits from the arrangement.
Treas. Reg. Sec. 1.6011-4(c)(3)(i) provides that a taxpayer has participated in a listed transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the published guidance identifying the transaction as a listed transaction or a transaction that is the same or substantially similar to a listed transaction. Clearly, the primary benefit in the participation of these plans is the large tax deduction generated by such participation. It follows that taxpayers who no longer enjoy the benefit of those large deductions are no longer “participating ‘ in the listed transaction. But that is not the end of the story. Many taxpayers who are no longer taking current tax deductions for these plans continue to enjoy the benefit of previous tax deductions by continuing the deferral of income from contributions and deductions taken in prior years. While the regulations do not expand on what constitutes “reflecting the tax consequences of the strategy”, it could be argued that continued benefit from a tax deferral for a previous tax deduction is within the contemplation of a “tax consequence” of the plan strategy. Also, many taxpayers who no longer make contributions or claim tax deductions continue to pay administrative fees. Sometimes, money is taken from the plan to pay premiums to keep life insurance policies in force. In these ways, it could be argued that these taxpayers are still “contributing”, and thus still must file Form 8886.
It is clear that the extent to which a taxpayer benefits from the transaction depends on the purpose of a particular transaction as described in the published guidance that caused such transaction to be a listed transaction. Revenue Ruling 2004-20 which classifies 419(e) transactions, appears to be concerned with the employer’s contribution/deduction amount rather than the continued deferral of the income in previous years. This language may provide the taxpayer with a solid argument in the event of an audit.
The Author
Lance Wallach, National Society of Accountants Speaker of the Year and member of the AICPA faculty of teaching professionals, is a frequent speaker on retirement plans, financial and estate planning, and abusive tax shelters. He writes about 412(i), 419, and captive insurance plans. He speaks at more than ten conventions annually, writes for over fifty publications, is quoted regularly in the press and has been featured on television and radio financial talk shows including NBC, National Pubic Radio’s All Things Considered, and others. Lance has written numerous books including Protecting Clients from Fraud, Incompetence and Scams published by John Wiley and Sons, Bisk Education’s CPA’s Guide to Life Insurance and Federal Estate and Gift Taxation, as well as AICPA best-selling books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Small Business Hot Spots. He does expert witness testimony and has never lost a case.
Lance Wallach
516.938.5007
wallachinc@gmail.com
http://www.taxaudit419.com
http://www.taxlibrary.us.
The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
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