Transferring business interests to family can preserve wealth

Structure LLC with intra-family asset transfers in mind

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 that will own the bulk of the assets and 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, licensed professionals, such as lawyers or doctors, can form an LLC, LLP, or a corporation only if all of the owners are licensed within the same profession. (Some states, such as California, closely regulate the type of entity that can be used by different professions--so make sure that you know the formation state's laws) 

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.

Protecting assets transferred to children

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.

Transfer interests into trust. To protect the assets, 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).

Transfers using UTMA. 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 (UTMA). This requires nothing more than properly titling the ownership interests. 

The disadvantage here is that, under the UTMA, 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.

An agreement restricting transfers. 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 becomes especially valuable. The more valuable the interest, the more difficult it becomes to make the transfers, while still preserving the unified estate and gift tax exemption.

Strategies to effectively transfer business interests to family

Now that we've discussed the entity form (the family limited liability company) best suited for transferring business interests to the family, it's time to explain how to make those transfers most effectively.

Discounting business interests to transfer wealth

A transfer in excess of the annual exclusion per person will reduce the lifetime gift tax exemption allowed under federal estate tax laws. This is where "discounting" becomes an important part of the transfer strategy when planning for estate taxes.

The ability to control the business has value. The interests transferred lack the ability to control the business. Consequently, the value of the transferred interests will be "discounted," or lower in amount. Thus, the transferred interest will use up a smaller portion of the exemption.

Discounts due to a lack of control and marketability should be documented by an appraisal. Law and accounting firms, as well as banks, provide this type of service. While there is a cost involved in obtaining an appraisal, the cost is usually more than offset by the estate tax savings.

The interests also can be discounted because of a lack of marketability. The interests in a closely held business are not worth as much as similar interests in a publicly-traded company, because there is no established market in which the interests can be sold. Discounts typically range from 10 percent to 50 percent.

Transfers from Corporations can be complex

If you are seeking to transfer business interests to the family, you may encounter complexities if your business is a corporation, especially if it is an S corporation.

There are restrictions on the types of trusts that may be shareholders in a subchapter S corporation. These trusts can qualify as shareholders under current law:

• Electing Small Business Trust (ESBT). The problem here is that all of the trust's undistributed income is taxed at the highest possible marginal tax rate for individuals.
• Qualified Subchapter S Trust (QSST). The rules here are similar to typical provisions found in trusts established for children. Basically, the rules require that a separate trust be established for each beneficiary and that the income and principal within the trust be managed exclusively for that beneficiary. While this may seem to be a burden where there are several children, one trust instrument can create multiple trusts (i.e., only one document, executed once, is actually necessary).

Nevertheless, the limitation here is that the parent will not be able to create a single trust that will "spray" income among all of the children/beneficiaries unless an ESBT (which results in all income taxed at a steep tax rate) or grantor trust (all income is taxed to the parent) is used.

None of these rules apply to the limited liability company (LLC). Thus, the LLC is a simpler and more flexible alternative than the corporation when transferring interests to trusts.

In addition, if interests in the business are transferred to the next generation during the life of the parents, the remaining value in the estate of the parents at death will be relatively small.

Effective use of grantor trust rules. When transferring the interest to an irrevocable children's trust, income tax rules governing trusts allow an experienced trust drafter to choose whether to have the income taxed to the children or taxed to the parent through the so-called "grantor trust rules."

While income tax splitting can result in tax savings to the family, the grantor trust rules provide simplification because all of the income can be reported on the parent's income tax return. 

This is especially desirable where income is accumulated in the trust, rather than distributed to the beneficiaries. This is a very likely scenario, in this case, because trust income tax rates are higher than those that apply to individuals.

In fact, many trust drafters intentionally make children's trusts subject to the grantor trust rules for this reason, by creating so-called "defective grantor trusts." (The term "defective" is used because, ordinarily, the children would be taxed on the trust's income, absent a defect in drafting the trust).

With a defective grantor trust, the income from the trust is taxed to the parent, but the value of the trust assets is excused from the parent's taxable estate.

Using tax-free gifts to transfer business interests

As an alternative to outright transfers of the business interests to the family, the annual gift exclusion (which is $14,000 in 2013 and 2014) provides a simple opportunity to pass on wealth. Annual gifts that qualify under this exclusion do not reduce the estate or gift tax exemptions.

Plus, a married couple can join together and increase the exclusion to $28,000 by "gift splitting." This requires a gift-splitting election and the filing of Form 706 with the IRS. In addition, the $14,000 figure ($28,000 for joint gifts) is the exclusion per donee. 

Thus, parents with four children could transfer to the children's interests in the business that total $112,000 each year, without reducing the unified tax exemption they each enjoy ($28,000 x four donees). With effective discounting the interests, this $112,000 represents a much larger value to the children. For example, at a 30 percent discount rate, the $112,000 will really represent $160,000 ($112,000/70 percent).

Using annuities to transfer business interests

Advanced estate planning strategies exist that allow transfers of business interests to the family to be made, without reducing the unified tax exemption.

For example, a private annuity may be used. Here, a child promises to pay a life annuity to the parent, in return for the interest in the business. The annuity is structured so that its value is equal to the discounted value of the business interest transferred to the child. 

There is no gift, as the child gives the parent an equal value in return, and thus there is no reduction in the $5 million exemption. If the parent dies before the annuity is paid off, nothing is counted in the parent's estate, because the annuity terminates at that point.

Case study: Transferring LLC interests to the family

John owns a limited liability company (LLC) with a value of $600,000 (value of assets less liabilities). He wants to avoid the estate tax, as he knows the value of his business, and his other assets, will steadily increase above his exemption amount. John owns 100 percent of the business, represented by ownership of one share as a member/manager, and nine shares as a member/non-manager.

John transfers the nine-member/non-manager shares to his children as a gift. Because this represents nine of the ten outstanding shares, or 90 percent ownership in the business, the transfer should be valued at $540,000 ($600,000 x 90 percent), and would reduce John's unified exemption by this amount.

However, because of discounting, due to a lack of control and marketability, the interest would only be valued at $378,000, if a 30 percent discount were applied ($540,000 x 70 percent). This discounted amount is what counts against his estate and gift lifetime exemptions. Thus, John will have preserved a portion of his exemption, which could be used to make future tax-free transfers of business interests to the family. He accomplished this even though, in reality, he transferred 90 percent of his business to his children.

In addition, 90 percent (the children's ownership share) of the future appreciation in the value of the business, which John projects will be quite substantial, will be attributed to the children. In other words, nearly all of the future appreciation in value will be passed on to the children free of estate taxes. John will not have to be concerned about paying hundreds of thousands of dollars in estate taxes when passing this value onto the children.

Note that, in practice, as much as 99 percent of the business can be transferred in this way to the next generation, without a loss of control.

Note, too, that it would be important to form the LLC in a state that protects the business owner's interest against the claims of his personal creditors, and that allows for the complete elimination of voting rights for certain membership interests, such as those held by members who are not managers. For example, Delaware is one state where both of these objectives can be accomplished.

Now let's assume John owns an LLC with a value of $600,000 but does not want to reduce his $5 million exemption when he transfers the interests to his children. The discounted value of the interests he plans to transfer is $378,000 (90 percent of the business is $540,000, then $540,000 x 70 percent = the discounted interests).

If John and his spouse join in making the gifts, and they have four children, it will take four years to complete the transfers, using only the $14,000 annual gift tax exclusion and, thus, preserving the entire $5 million exemption ($28,000 x four donees = $112,000 per year that may be transferred under the exclusion; at that rate, in five years, they could transfer $448,000 ($112,000 x four years).