The Family LLC

Many different estate planning strategies can be used to eliminate or, at the very least, significantly reduce estate taxes, ensuring the family's wealth is passed on to the next generation. One such strategy involves transferring business interests to the family through the use of a limited partnership (LP) or a limited liability company (LLC). Parents transfer to their children "discounted" shares in their LP or LLC, without giving up control of the business.

Parental control of the business is ensured in the LP because limited partnership interests are transferred to the children, while the parents retain the general partnership interest (limited partners may not participate in the management of the business.) Historically, the LP has been used in estate planning strategy because of this attribute.

Today, the LLC can be used to accomplish this same purpose, but with all of the owners having limited liability for the business's debts. An LLC can be structured as a "member-managed" entity, wherein all of the owners participate in management, similar to the partners in a general partnership. However, the LLC can also be formed as a "manager-managed" entity, wherein the owners who are also the managers control the business, while the owners who are not managers act in a capacity similar to limited partners. In short, the "manager-managed" LLC is well suited to accomplish this estate planning objective.

Parents can transfer ownership interests, in the form of non-voting non-manager interests, to the children without giving up control of the business. In the immediate future, many practitioners will continue to use the LP in employing this estate planning strategy, because a body of favorable case law has built up over the years supporting the use of the LP for this purpose. However, many practitioners are already embracing the LLC as a better alternative to the LP, because all of the owners of the LLC enjoy limited liability.

Sometimes an LP is created solely to transfer wealth tax-free. In this case, it is usually funded with the family's securities or real estate holdings. However, its best use exists when the family is using the entity to operate a legitimate business. As the limited liability limited partnership (LLLP) begins to become more common, the limited partnership form may, once again, be the choice of practitioners employing this estate planning strategy, at least in those states that allow the owner's personal creditors to foreclose on the owner's business interest, and force a liquidation of the business to satisfy the debt.

In contrast, the corporation has never been used for this purpose. The corporation does not offer the same protection to owners from the claims of the owners' personal creditors (personal creditors of the owner of a corporation, but not an LLC in many states, may foreclose on the interest of the owner and force a liquidation of the business, or simply vote in favor of liquidation).

Moreover, the subchapter S corporation limits estate planning opportunities because it places restrictions on the types of trusts that may be shareholders. This can be a problem especially in the small business, because most small business owners will make the subchapter S election. Therefore, in short, the LLC presents a better choice than the corporation.

Most small business owners operating a corporation will make the subchapter S election, which requires that there be only one class of stock in the corporation. For this estate planning transfer strategy to work, there would have to be two types of stock--voting for the parents and nonvoting for the children. In reality, voting common stock and nonvoting common stock are considered, for purposes of this rule, to be one class of stock. Thus, it is possible to employ this strategy in the corporation electing subchapter S status. However, the S corporation has never been widely used in executing this strategy.

The Manager-Managed LLC. The small business owner should consider creating a manager-managed LLC at the outset, even when the owner does not anticipate immediately making transfers. This can be done even in the one-owner LLC, in anticipation of the possibility of transferring interests some time in the future. This eliminates the need, in the future, to make amendments to the articles of organization and operating agreement, which would be necessary had a member-managed LLC been created.

If a holding entity and an operating entity are created, it is important to use this strategy when structuring the holding entity, which will own the bulk of the assets, as well as own the operating entity--which is the entire wealth of the business. Thus, the operating entity may then be a member-managed or a manager-managed LLC, with the holding entity as the only owner.

When the owner directly creates and owns both entities, each entity should be manager-managed. Clearly, having the holding entity own the operating entity simplifies this strategy.

Finally, professionals can form an LLC, LLP or a corporation only if all of the owners are licensed within the same profession. Only the operating entity has to meet this requirement. The holding entity, which will contain nearly all of the wealth of the business, will not be engaged in the practice of any profession. Thus, children, or other family members, for example, can still be co-owners of the holding company, even when it is formed by professionals. However, the operating entity would have to be directly owned by the professionals, rather than by the holding company.

Parents may wonder whether interests can be transferred to children who are minors. Or, they may be concerned as to whether their children will responsibly manage their interests. These issues can be resolved. First, it must be remembered that the children's interests are non-voting non-manager interests, meaning the children will not have the power to control the business in any event. In addition, however, the children's interests can be transferred to an irrevocable children's trust, with the parents as trustees. There, the interests can be completely protected from the children's creditors (see our detailed discussion on trusts and, in particular, the types of provisions that can be used in a trust to protect assets from the claims of creditors). Drafting such a trust would require the services of an estate planning attorney. A simpler strategy would be to transfer the interests to the children under the Uniform Transfers to Minors Act (UTM). This requires nothing more than properly titling the ownership interests. The disadvantage here is that, under the UTM, the children gain control over the interests at a relatively young age (age 21 in most states). In contrast, in an irrevocable children's trust, the parents, as trustees, can retain control until the children reach a specific age the parents select. Finally, an agreement restricting transfer of ownership interests is essential in any small business with multiple owners. Such an agreement effectively gives the parents control over the disposition of the shares owned by the children, even when the children own the shares outright.

It is clear that the most effective strategy involves transferring business interests to the next generation, before the interest become especially valuable. The more valuable the interest, the more difficult it becomes to make the transfers, while still preserving the $5 million unified estate and gift tax exemption.