2016 NYC Skills Training for Estate Planners ... · in the Northern Great Plains. His firm,...

2016 NYC Skills Training for Estate Planners

Considerations and Strategies in Selecting Business Entities

David J. Dietrich

Dietrich & Associates, P.C.

404 North 31st Street, Ste 213

P.O. Box 7054

Billings, MT 59103

Phone: 406-255-7150

Email: [email protected]

mailto:[email protected]

2

David J. Dietrich

Dietrich & Associates, P.C.

404 N. 31st Street, Suite 213

Billings, Montana 59103-7054

(406) 255-7150

Email: [email protected]

David J. Dietrich graduated from Whitman College with a BA degree with honors in

1979. He served in the Peace Corps in Abidjan, Ivory Coast. He attended the University Of

Montana College Of Law and graduated with a Juris Doctor (JD) in 1984.

David is a fellow of the American College of Trust and Estate Counsel, one of fifteen in

Montana. David is currently the Vice Chair of the 20,000 member Real Property Trust and

Estate (RPTE) Law Section of the American Bar Association. He is a past Co-Chair of the

ABA’s Property Preservation Task Force, which lately resulted in the Uniform Law

Commission’s adoption of the Uniform Partition of Heirs Property Act. David is currently on

the University of Montana Tax Institute Advisory Board and serves on the Board of Trustees of

Rocky Mountain College in Billings. He served for six years on the Board of Directors of the

Montana Land Reliance, a private land trust in Montana, having in excess of 900,000 acres under

protection.

David is a fourth generation Montanan with a diverse ranching, real estate and estate

planning background located in south central Montana, Billings, the largest and most diverse city

in the Northern Great Plains. His firm, Dietrich & Associates, P.C., has provided real estate tax

and estate planning services to the region for over 24 years involving wills, trusts and real estate

transactions including conservation easements, business organizations and real estate litigation.

David’s publications include the 2011 ABA Book Conservation Easements: Tax and

Real Estate Planning for Landowners and Advisors; “Selected Post-Mortem Estate Tax

Elections for the Small Business Owner”, “Pleasing Mother Earth and the IRS: Using

Conservation Easements to Save Open Space, Income and Estate Taxes” for the Heckerling

Institute for Estate Planning for the University of Miami in January 2003 and other tax and real

estate related topics for the State Bar of Montana.

David and his family enjoy living in the Big Sky Country; he is an avid outdoor digital

camera user, loves reading and likes outdoor activities in any season.

3

A. Introduction

These materials focus on considerations and strategies in the selection of business entities

for estate planning purposes. The scope is intentionally broad and eclectic, because entity

selection is key to many different types of estate planning, ranging from liquid professional

medical practices to highly illiquid agricultural ranch operations. Further, business entities can

be closely held or publically held but the scope of these materials will be primarily on the closely

held business. As observed by the US Small Business Administration, there are approximately

27 million privately owned businesses in the country of which 21 million have no employees and

are either part time or are full time operators where only the owner is involved. In comparison to

publically traded companies, privately owned businesses represent over 99% of all businesses in

the country.1 Accordingly, estate planning for small businesses cannot be underestimated and is

about the successful transmission of wealth in a world where multiple interests compete for tax

efficient and liability protected methods to transfer wealth. Insurance, financial planners,

accountants and trust officers all often have a vested interest in participating in choice of entity

determinations, unlike the days of your when the attrition lawyer was the quarterback “in

control” of the client’s family estate plan, today Legal Zoom publishes a superficial choice of

business entity grid comparing various business entities with an appealing but superficial effort

to bring this topic to the masses. Thirty years ago, estate tax exemptions were approaching

$600,000.00 per husband and wife, without portability; today exemption amounts are now

$5,430,000.00 per spouse and are capable of being ported from the deceased spouse to the

surviving spouse. Less than 1% of Americans will have a federal estate tax problem. Thirty

1 Harris, Morten A. “Succession Planning for Closely Held Business and Professional Practices” program materials

for Closely Held Business Committee of Taxation, September 19, 2014

4

years ago entity considerations in estate planning were extremely tax sensitive and, in large

estates, remain so today. Today the paramount considerations are:

1. Achieving maximum step up on basis;

2. Reducing if not eliminating the 3.8% (Net Investment Tax) by insuring

maximum material participation to a trust or estate,

3. Insuring that the business entity achieves the clients’ objectives for shared

control at the boardroom or limited liability company operating agreement level,

4. Insuring the maximum level of limited liability protection thus separating

personal assets from business assets with appropriate observance of business entity

formalities,

5. Observance of state law default rules governing business entities such as

limited liability companies, limited partnership and domestic asset protection trusts;

6. Preventing partition or further fractionalization of real estate among heirs

through the use of a limited liability company, limited partnership, tenancy in common

agreement or conservation easement.

7. Preservation of valuation reduction options such as alternative use valuation

under I.R.C. § 2032A and post mortem conservation easement elections;

8. Preservation of the ability to use I.R.C. § 6166 and defer the payment of

Federal Estate Tax over a 15 year period with interest only paid in the first 5 years;

9. Last but not least, enhancing the ability of the client to gift business interests

in the corporation, limited liability company or limited partnership by navigating the

requirements that the gift be one of a present interest, that the gift no be disallowed under

Chapter 14 Rules, and that the gift not be drawn into the decedent’s estate under the

“hook” inclusion provision of I.R.C. § 2036 and 2038.

In selecting the business entity, the estate planner must identify the long term goals of the

client, which likely includes whether the business entity will be a profit motivated business entity

with strangers in ownership or a family business with the goal of transmitting wealth from the

founding generation to a junior generation. These goals may conflict. Further, the planning

must determine whether the client will want or need flexibility in selling underlying assets at

some future date, particularly if the entity is to hold real estate. The planner will also to

determine what level of liquidity will be required to pay potential Federal Estate Tax, can or

should a conservation easement or tenancy in common agreement be used as an underlying

method to reduce value and preserve key assets from further fractionalization. The planner must

likely examine and assess the impact of appreciation of the underlying assets, particularly real

5

estate, and the need to use alternative valuation devices such as conservation easements and sales

to intentionally defective grantor trusts all of which will likely influence planning decisions on

the selection of the business entity.

Identifying and planning the foregoing is a complex multilevel process and may require

the planner to use the team approach coordinating with the financial or trust officer, CPA, key

business decision makers of the client or whomever is on the horizon providing advice with may

influence how family wealth will be transferred. Important ethical issues are present at the outset

inasmuch as waivers of conflict between husband and wife and between and among members of

separate generations may need to be obtained. Insist on understanding precisely who the client is

and confine the engagement to the practical, if necessary get additional attorneys involved to

separately represent other owners.

The planner must be aware who the traditional advisors of the client have been and the

political content. Is the CPA or certified financial planner or trust officer the clients’ closest

advisor, if so get documents early and review if the business is a going concern. The documents

are likely outdated, insist on obtaining at least 5 years of tax returns, profit and loss statements

and income statements. Clients may view lawyers as advisories and other advisors may tacitly

promote this. Distinguish your role from that of a litigation attorney and insist on complete

candor with respect to the clients’ goals and objectives and insist on complete disclosure. If the

client is from a high net worth family, and there is likely a family business office, in house

financial planner, in house attorney or in house CPA, insist on full disclosure of information

from that office.

The attorney must be aware of the opportunities and limitations of asset protection. Does

the client have existing claims or threatened claims? Does the client do business in multiple

6

states? Can the client segregate personal use assets from business assets? Where does the client

reside more than 50% of the year? Is the client in a high risk profession such as medicine, law or

many types of business? Does the client rely on others to manage his business or does he have

direct and material participation himself? Is the client’s business a professional services

corporation? Are the assets to be transferred primarily real estate or other capital assets which

may appreciate rapidly? What is the likelihood that investors in the business entity may include

non-family members? What is the likelihood that the business will require securities law

compliance such as a private placement memorandum for accredited investors? If so obtain

securities advice promptly. Consider three types of businesses:

Jones Livestock, Inc., a C corporation existing since 1957 with 20 thousand acres of

highly appreciating real estate. The cost basis of the real estate is $750,000.00 and the

current fair market value is $15 Million Dollars. Brothers David and Larry have

functionally divided the ranch into two separate operations using, according to the

corporate accountant, division accounting. David is a visionary marketer and

entrepreneur; Larry is a confident farmer and mechanic. Neither of them want to be in

business any longer and the company has not had corporate meetings for over four years.

There is no shareholder restriction agreement;

Computer Systems, Inc. Owned equally by two shareholders, Michael Siegers and Paul

Kennedy. The company is a 50/50 subchapter S corporation generating gross profits of

$15 Million a year with net profits of $2 Million per year. It has 15 employees and

develops computer software code for small hospitals in the upper Midwest. Mr. Kennedy

has a serious gambling problem and Mr. Siegers just learned that the I.R.S. intends to

levy upon his stock in the corporation to satisfy a $200,000.00 Federal Income Tax

liability. Mr. Siegers is 70 years old, recently was diagnosed with pancreatic cancer and

has asked you to do his estate planning. There is no share restriction agreement.

The May Ranch consists of 5,000 acres in Carter County Montana which is prime white

tail deer hunting habitat. Mr. May is a retired hospital executive. He estimates the fair

market value of the ranch to be $9 Million in wealth. Mr. May is no longer married

having divorced over 10 years ago. He has three children. The ranch is leased on a cash

basis to a neighboring rancher. Mr. May resides in Florida except during October and

November when he visits Montana for hunting. Mr. May has been approached by the

Rocky Mountain Elk Foundation a 501C(3) Land Trust interested in obtaining a

conservation easement on his property. He is also interested in forming a limited

partnership or limited liability company which his son, an attorney practicing in

Philadelphia, believes is necessary. His son has also requested that you investigate

7

whether the formation of a business entity could avoid his father’s potential medical

creditors, because he has advanced diabetes liver cancer; he is not expected to live more

than 3 years. The son desires to transfer the ranch into a limited liability company or

limited partnership and gift a 20% interest to each of the children, immediately, leaving

the father with a 40% interest.

B. Broad Considerations in Type of Entity

The type of entity a client chooses for the family business has implications from both

business and estate planning perspectives. The entity choice affects: (a) the determination of the

value of interests for transfer tax purposes; (b) the income tax consequences while the entity is in

existence, as well as when the entity is liquidated; (c) the liability of the owners for the entity’s

debts, obligations, and liabilities; (d) the control over the entity, including day-to-day operations

and distributions; and (e) the expenses incurred to establish and maintain the entity.2

C. Use of Tenancy-In-Common Agreements.

Due to the uncertainty and variance of State partition laws, a common practice among co-

tenancy real estate owners is to use tenancy-in-common agreements. This practice has been

sanctioned by IRS Rev. Proc. 2002-22, which establishes for federal tax purposes the basis upon

which the IRS will not characterize a tenancy-in-common agreement as a partnership, primarily

to preserve tax deferral treatment under IRS § 1031.

The following are common features of a tenancy-in-common agreement:

1. The agreement specifies a specific term of the agreement.

2. The agreement specifies that an entity, usually a limited liability entity

such as a limited liability company, may manage the property to handle the leasing

operation and maintenance of the property.

3. The agreement provides that if additional operating capital be needed from

the owners to operate, improve or otherwise manage the property, the manager may

notify the owners of the requirement of such additional funds. The failure of any owner

to make such additional contributions within ten days after the notice, may constitute a

default under the agreement. Any non-defaulting owner has the right, not the obligation,

to pay the defaulting owners pro-rata share of the requested contribution.

2 Louis A. Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited

Liability Companies, and More, at 9 (3rd ed. 2010).

8

4. In the event a non-defaulting owner elects to pay the defaulting owners

share, the non-defaulting owner shall be entitled to a percentage of the defaulting owner’s

interest.

5. In the event of sale, the owner shall have the right to sell or exchange its

interest in the property but must first offer to sell such property to other owners. The

selling owner shall first offer to the other owners the property for a period of 30 days. In

the event the non-selling owners reject the offer, then the selling owner shall be free to

sell its interest in the property. In the event the non-selling owners accept the offer to

purchase the property, then the non-selling owners shall have 60 days within which to

purchase the property.

6. All owners shall have the right to partition the property provided that they

first offer to sell their interest to the other owners with an MAI appraisal. In the event the

non-selling owners decide to name their own appraiser, they may do so and those two

appraisers may identify a third appraiser to appraise the property.

7. The sale price, under the attached agreement, carries with it a 25%

discount from the appraised owner’s percentage ownership. In the event that the non-

partitioning owner rejects the offer, the partitioning owner is free to initiate a partition

action in the appropriate court.

8. The agreement contains an express waiver or statement that the parties do

not intend to become partners under the agreement.

D. IRS Rev. Proc. 2002-22

In response to the tenancy-in-common industry prevailing in the early 2000’s (referred to as

“TIC property”), the Internal Revenue issued Rev. Proc. 2002-22, which identifies the basis upon

which the Service will issue rulings as to whether a co-tenancy relationship is not a partnership.

The ruling specifically applies to co-ownership of rental real property, other than mineral

interests, in an arrangement classified under local law as a tenancy-in-common. It is therefore

critical to confirm that the rules applicable to the local jurisdiction do not create a partnership by

default.3 Generally, under RUPA § 204(c) property is presumed to be partnership property if it is

purchased with partnership assets, even if not acquired in the name of the partnership or one or

3 For a discussion of the involuntary application of the Revised Uniform Partnership Act to Tenancy-

in-Common Properties, see “Mandatory Sales of Joint Ownership Property Under the Revised Uniform

Partnership Act” by Dietrich, David J. in ABA;s Real Property, Probate and Trust Law Section publication

Probate & Property, September/October 2004 Vo. 18 No. 5, pps. 8-12.

9

more of the partners with an indication in interest transferring title to the property of the person’s

capacity as a partnership or the existence of a partnership. Furthermore, should the parties file a

partnership return, this would be fatal to any claim that the property is in fact tenancy-in-

common property. Rev. Proc. 2002-22 contains the following conditions for a ruling to

determine that property is not held as a partnership:

1. The number of co-owners must be limited to no more than 35 persons. All

persons who acquire interest from a co-owner by inheritance are treated as a single

person.

2. Co-ownership may not file a partnership or corporate tax return, or

execute a business entity agreement.

3. Co-owners may enter into a limited co-ownership agreement that runs

with the land which provides that a co-owner must offer the co-owner interest for sale to

the other co-owners or the sponsor before exercising any right to partition, or that certain

actions on behalf of the co-ownership require the co-owners holding more than 50% of

the undivided interest in the property.

4. The co-owners must retain the right to approve the hiring of any manager,

sale or other disposition of the property, in leases of a portion or all of the property, or the

creation or modification of a blanket lien. Any sale, lease or release of a portion or all of

the property in a negotiation or re-negotiation of indebtedness secured by a blanket lien,

the hiring of any manager, or the negotiation of any management contract must be by

unanimous approval of the co-owners. For all other actions on behalf of the co-owners,

the co-owners may agree to be bound by the vote of those holding more than 50% of the

undivided interest in the property. Individual limited powers of attorney in favor of the

co-owners are not permitted but a co-owner may not provide a manager or other person

with a global power of attorney.

5. Each co-owner must have the right to transfer, partition and encumber the

co-owner’s undivided interest in the property without the agreement or approval of any

person. The co-owners, the sponsor or the lessee may have a right of “first offer,” i.e. the

right to have the first opportunity to offer to purchase the co-owner interest (with respect

to any co-owner’s exercise of the right to transfer the co-owner interest in the property.

In addition, the co-owner may agree to offer the co-ownership interest for sale to the

other co-owners, the sponsor or the lessee at fair market value, determined either at the

time the partition right is exercised, before exercising any right to partition.

6. If the property is sold, any debt secured by blanket lien must be satisfied

and the remaining sales proceeds must be distributed pro rata to the co-owners.

7. Each co-owner must share in all revenues generated by the property and

all costs associated with the property in proportion to the co-owners undivided interest in

the property. Neither the co-owners nor the sponsor nor the manager may advance funds

to a co-owner to meet expenses associated with the co-ownership interest, unless the

advance is recourse to the co-owner for a period not exceeding 31 days.

10

8. The co-owners must share in any indebtedness secured by a blanket lien in

proportion to their undivided interest.

9. A co-owner may issue an option to purchase the co-owner’s undivided

interest (a call option), provided that the exercise price for the call option reflects the fair

market value of the property determined at the time the option is exercised. For this

purpose, fair market value of an undivided interest in the property is equal to the co-

owner’s percentage interest in the property multiplied by the fair market value of the

property as a whole. A co-owner may not acquire an option to sell the co-owner’s

undivided interest (a put option) to the sponsor, the lessee, another co-owner, or the

lender or any person related to the sponsor, lessee, other co-owner, or lender.

10. The co-owners activity must be limited to those customarily performed in

connection with the maintenance and care of rental property.

11. The co-owners may enter into a management or brokerage agreement

which must be renewable no less frequently than annually with an agent who may be the

sponsor or co-owner but who may not be a lessee. The manager must disburse to the co-

owners their shares within three months of the date of receipt of those revenues. The

management agreement may authorize the manager to prepare statements for the co-

owners showing their shares of revenue and costs from the property. It may also

authorize the manager to obtain and modify insurance on the property and to negotiate

modifications of the terms of any lease or indebtedness encumbering the property subject

to the approval of the co-owners. The determination of any fees paid by the co-

ownership to the manager must not depend in full or in part on the income or profits

derived by any person from the property and may not exceed the fair market value of the

manager’s services; any fee paid by the co-ownership to a broker must be comparable to

fees paid by unrelated parties to brokers for similar services.

12. Leasing agreements must be bone fide leases for federal tax purposes and

rents paid by a lessee must reflect the fair market value for the use of the property. The

determination of the amount of the rent must not depend in whole or in part on the

income of profits derived by any person from the property leased. The amount of rent

paid by lessee may not be based on a percentage of net income from the property cash

flow, increases in equity or similar arrangements.

13. The lender, with respect to any debt that encumbers the property or with

respect to any debt incurred to acquire an undivided interest in the property, may not be a

related person to any co-owner, the sponsor, the manager, or the lessee of the property.

14. The amount of any payment to the sponsor for the acquisition of the co-

ownership interest (and the amount of any fees paid to the sponsor for services) must

reflect the fair market value of the acquired co-ownership interest (or for services

rendered) and may not depend, in whole or in part, on the income of profits derived by

any person from the property.

E. Illinois Land Trusts

An Illinois Land Trust means a trust arrangement under which the legal and equitable

title to real estate is held by a trustee, the interest of the beneficiary of the trust is personal

11

property and the beneficiary or any person designated in writing by the beneficiary has (i) the

exclusive power to direct or control the trustee in dealing with the title to the trust property, (ii)

the exclusive control of the management, operation, renting and selling of the trust property and

(iii) the exclusive right to the earnings, avails and proceeds of the trust property.4 Id. at 1369-70.

See also Robinson v. Chicago Nat'l Bank, 176 N.E.2d 659 (Ill. App. Ct. 1961), where the court

stated as follows:

The land trust is a device by which the real estate is conveyed to a trustee under an

arrangement reserving to the beneficiaries the full management and control of the

property. The trustee executes deeds, mortgages or otherwise deals with the property at

the written direction of the beneficiaries. The arrangement is created by two instruments.

The deed in trust conveys the realty to the trustee. Contemporaneously with the deed in

trust a trust agreement is executed. The pertinent provisions of the trust agreement are

summarized as follows: While legal title to the real estate is held by the trustee, the

beneficiaries retain "the power of direction" to deal with the title, to manage and control

the property, to receive proceeds from sales or mortgages and all rentals and avails on the

property. The trustee agrees to deal with the res of the trust only upon the written

direction of the beneficiaries or the persons named as having power of direction ... The

trustee is not required to "inquire into the propriety of any direction" received from the

authorized persons. The trustee has no duties in respect to management or control of the

property or to pay taxes, insurance or to be responsible for litigation. The only specified

duties upon the trustee are to "execute deeds or otherwise deal with the property upon the

direction of the beneficiary or other named authorized persons." Another duty of the

trustee is to sell at public auction any property remaining in the trust twenty years from

the date of the agreement. The beneficiaries agree to indemnify the trustee for any

expenses or outlays incurred by the trustee on account of holding legal title, including

cases in which the trustee is a party to any litigation. The agreement forbids its

recordation in the Recorder's Office or elsewhere and forbids the trustee to disclose the

name of any beneficiary. The Illinois courts have construed the land trust as an active

trust and therefore not affected by the Statute of Uses. Id. at 58.

See generally, The Land Trust, Young Lawyers Network, Probate & Property, January/February

2007, at p. 6, which contains the following summary of the creation of a land trust and its

advantages:

4 See “The Use of Land Trusts and Business Trusts in Real Estate Transactions” eReport, RPTE Section, April

2007 and The Land Trust, Young Lawyers Network, Probate & Property, January/February 2007, at p. 6

12

Often, trustee action is limited to the conveyance of the property when the trust terminates. Land

trusts are unique because the duties and powers of the trustee are so limited, but it is still

considered a trust and generally governed by the principles that are otherwise applicable to all

other trusts. The land trust is created through two documents - a deed into land trust and the trust

agreement. The deed into land trust typically establishes the rights and responsibilities of the

trustee. It usually states that the beneficiary's interest is a personal property interest and that the

beneficiary does not hold title of any kind to the real property. The land trust usually provides

that the beneficial interest holders are able to direct the trustee in all matters of title and

management of the real estate. The land trust has attained its popularity and wide use because

of the practical elements that the beneficial interest provides: the interests of the beneficiaries

will not be disclosed without order of court; the interests are not subject to partition; the

beneficial interest is personal property and, therefore, avoids ancillary probate

requirements; transferability of beneficial interest is simple; the beneficial interest can be used as

collateral; and, testamentary dispositions can be set out within the trust agreement, thereby

avoiding probate.

F. Other Irrevocable “Domestic Asset Protection” Trusts May Be a More Viable

Choice. Illinois Land Trusts are primitive in comparison to more tax sensitive planning

possibilities with irrevocable trusts. One example is a grantor trust in which income tax is taxed

to the grantor and not the trust, which is irrevocable, where none of the contributing members

have asset protection problems at the time of contribution, in a state where a self-settled trust

enjoys asset protection. (A Domestic Asset Protection Trust) All of the fractional co-owners

must be located and convey their interests into the trust. Irrevocable trusts have been used for

decades for holding oil and gas mineral interests. Some of the critical considerations will be:

13

1. Is the trust located in a tax favorable jurisdiction for trust income?

2. Who will be the trustee? An individual? A corporate trustee?

3. How will trustee succession be arranged in the future?

4. Can a trust protector be located and paid?

5. What is the consequence of one beneficiary making a capital contribution?

Is it a loan and if so on what terms?

6. Will the trust achieve asset protection for a beneficiary’s existing or future

credit problems? This is particularly a problem for a trust which is self-settled in a state

that does

not recognize a “self-settled asset protection trust.”

7. What about amendments to the trust document? Must amendments be

made only by court action?

8. Can the trust assets be decanted? Is the trust located in a Uniform Trust

Code state or a jurisdiction which allows amendments or decanting without court action?5

G. Types of Traditional Business and Estate Planning Entities.

Attached as Exhibit B is a grid of various forms of business organizations currently used

in estate planning. The following entity choices are available to operate a family business: (1) the

sole proprietorship; (2) the general partnership; (3) the limited partnership; (4) the limited

liability partnership; (5) the limited liability company; (6) the S corporation; and (7) the C

corporation. Naturally, the facts and circumstances surrounding each client’s choice of entity will

differ. Taking the following factors6 under consideration will likely help when counseling a

client with regard to selecting the most appropriate entity for that client’s unique family business.

Is a new business being created or is the form of an existing business being

changed?

A cost benefit analysis may need to be completed as the tax consequences of converting

an existing business may outweigh any benefits secured under the new entity’s form.7

5 Engle, Barry S. and Kaplan, Eric R., “Recent Developments In Asset Protection Planning – Parts 1 and 2”.

Estate Planning Journal, April, May 2013 (WG&L) 6 Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 9-12. 7 Id. at 9.

14

What is the projected number of prospective owners?

Generally, if there is but one owner, the entity choice will likely be limited to a sole

proprietorship, some corporate form, or possibly a limited liability company. However, if there

are going to be multiple owners, the form can be one of several forms of partnership, a limited

liability company, or some corporate form.8

Will any of the prospective owners be other business entities?

Typically, if the owners will be one or more corporations, partnerships or limited liability

companies, an S corporation, absent an exception, will not be an option in most cases.9

What is the projected nature of the prospective business?

Generally, if the business will be a personal service business, there are special provisions

in the Internal Revenue Code (“IRC”) that will apply to the entity if it is operated in corporate

form.10

What is the projected duration of the prospective business?

Normally, if the business is going to be operated for the short term, a joint venture, which

is treated similarly to a partnership, may be preferable over an entity in the corporate form.11

What are the projected profits or losses of the prospective business?

Typically, the S corporation may be a better option than either a partnership or a limited

liability company if no losses are expected. In contrast, a partnership or a limited liability

company may be a better option than the S corporation if loss is expected, as the partners or

members, respectively, receive basis for the debt of the entity.12

8 Id. 9 Id. at 9-10. 10 Id. at 10. 11 Id. 12 Id.

15

What are the projected capital requirements of the prospective business?

Usually, if the capital requirements are high, then the owners will want an entity that

affords them the ability to withdraw the capital later without unfavorable tax consequences. If

that is the case, a partnership or a limited liability company is generally an appropriate choice.

However, if it is projected that the prospective business will be accumulating large amounts of

profits in the business out of current profits, a C corporation may be the appropriate choice as it

will generally allow that accumulation at a lower tax rate. Notice however, that a C corporation

generally creates a double taxation situation during operation and liquidation, whereby the

business is taxed at the entity level and the owners are taxed at the shareholder level. 13

Will the prospective owners be active participants or inactive investors?

Generally, if the owners are simply going to be passive investors, a general partnership is

not advisable as they usually want some form of limited liability that is only available in the

limited partnership, limited liability company, or corporate forms. The active investors may

desire the limited partnership or limited liability company form as both would allow income to

be allocated in a manner other than on a pro rata basis. Both the limited partnership and the

limited liability company might require registration with the Securities Exchange Commission

(SEC) under state law, unless exempt. General partnerships usually are not required to register

with the SEC.14

Will the prospective owners make different types of contributions (e.g., cash,

property, or services)?

If a person exchanges personal services for an equity interest in the business, it might be

more beneficial to use a partnership or limited liability company where he or she receives an

13 Id.; See also Goldberg, Choice of Entity for the Family Business, at 8-9. 14 Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 10.

16

interest in future profits for the services rendered rather than a share of the capital. Receiving an

interest in future profits in a partnership or limited liability company may not result in any

current taxable income. On the other hand, if a capital interest is received, income tax

consequences are immediate, whether as a shareholder, partner, or member.15

Will the prospective owners or others make loans to the prospective

business?

Generally, if owners will be making loans to the business, then under an S corporation,

the shareholders are allowed to increase their basis for deducting losses by the amount of those

loans. If it will be third parties providing the loans, then under a partnership or limited liability

company, the partners or members, respectively, are allowed to increase their basis by their

respective shares of the loans. If the business is in the form of a C corporation, then shareholder

provided loans are generally better suited, from a tax perspective, for raising capital than issuing

shares.16

What is the income tax bracket of the prospective owners?

Normally, if the owners are in lower tax brackets, pass through entities such as general

partnerships, limited partnerships, limited liability partnerships, limited liability companies, and

S corporations (in most cases) result in lower income tax on profits accumulated in the entity. A

pass through entity allows taxable income of the business, and oftentimes the losses, to pass

directly to the partners or members as the case may be.17

What is the wealth of the prospective owners?

Sometimes owners may have substantial wealth, yet remain in a lower income tax

Bracket and desire cash flow more than tax deductions. In contrast, others may be in high

15 Id. at10. 16 Id. at 11. 17 Id. at 9, 11.

17

income tax brackets and desire tax deductions more than cash flow.18

What is the family status of the prospective owners (especially for estate

planning)?

Depending on the age of the owners, transfer tax savings may be of interest when

attempting to transfer ownership interests to younger generations in the family. Using a form of

partnership or limited liability company can assist in simplifying the process of making the

transfers, especially if real estate is involved.19

Where is the prospective business projected to be located in the United

States?

It is important to be aware that not all states recognize S corporation status for state

income tax purposes and that some states may tax a limited liability company’s income at the

entity level or even have greater franchise taxes on a limited liability company when compared

to a limited partnership.20

Is the prospective business projected to involve any foreign business?

A multitude of other issues become relevant if the domestic family business will have

foreign-source income or engage in business outside the United States.21

What is the projected form of compensation to be paid to the prospective

owners and others (e.g., salary, interest, rent, dividends, or royalties)?

C corporations typically face a double taxation regime. However, if it is desirable,

creative payment methods can sometimes allow a C corporation to operate similar to a pass

through entity.22

18 Id. at 11. 19 Id. 20 Id. 21 Id. 22 Id. at 8-9, 12.

18

Is it projected that there will be distributions of capital in the near future as

a result of refinancings, redemptions, or partial liquidations of the

prospective business, or other transfers to the owners?

Generally, distributions of this nature have little or no negative tax consequences when

performed by an entity formed as a sole proprietorship, partnership, or limited liability company.

For instance, a partnership or limited liability company can be dissolved and liquidated without

tax consequence. On the other hand, if a family decides to dissolve and liquidate a C

corporation, tax at both the entity and shareholder level will likely result. 23

Will there be restrictions on transfers of ownership in the prospective

business?

Normally, if free transferability is desired, an S corporation will be less appropriate, as

maintaining the S election requires that the initial shareholders restrict distributions to eligible

shareholders only. Instead, a general partnership may be appropriate. While stock in a C

corporation is easy to transfer, the C corporation will not have the income tax benefits of a

partnership, limited partnership or limited liability company. On the other hand, if restriction on

transferability is desired, stock restriction agreements may be used in conjunction with

partnerships, including the limited partnership and limited liability partnership, as well as the

limited liability company.24

What form of management is the prospective business projected to have?

Typically, the corporate form provides centralized management, whether in the form of a

C corporation or S corporation. The owners (shareholders) do not manage the business, but

rather elect a board of directors who appoint officers to manage the business. Centralized

management is also attained in the limited partnership form. The general partners have

management rights that cannot be separated from their general partnership interest without their

23 Id. at 5-6, 12. 24 Id. at 12.

19

consent. Generally, to retain limited liability, the limited partners must refrain from

management. In the case of a manager managed limited liability company, the members may

vote on who will be the manager (depending on the operating agreement) and leave management

to that manager.25

In contrast, a general partnership provides non-centralized management as all the owners

(partners) participate in managing the business. Further, a member managed limited liability

company may also decentralize management by giving all owners a voice in management based

on their respective ownership interest.26

H. Client Goals.

In addition to the foregoing list of factors that should be considered, a client’s specific

estate planning and business goals should also be considered when selecting the proper entity for

a client’s unique family business. The following goals27 are common amongst family business

owners.

Control of the prospective business.

Older family members generally want to keep control over the business operations and

investments and out of the hands of the younger generation for as long as possible. Transferring

assets to an entity like a limited partnership, limited liability company, or some type of

corporation allows the older generations to retain control over those assets. Further, it will

prevent the creditors of the younger generation (the donees) from accessing the assets.

Moreover, it can prevent the donee from simply selling the assets, or may protect the assets from

25 Id. at 12; See also Goldberg, Choice of Entity for the Family Business, at 10-11. 26 Id. 27 Id. at 14-15.

20

a donee’s spouse, or from going to a party the donor may not have chosen if the donee has an

untimely death.28

The older generation may retain control by being the only general partners in a limited

partnership, the only managing members of a limited liability company, or the only directors of a

corporation.29 Notice the correlation between management (control) and estate planning

considerations. Specifically, for estate tax purposes a decedent’s assets will be valued at fair

market value, but if the assets are a fractional interest in a business entity, those assets oftentimes

can be valued at a discount for tax purposes due to a lack of marketability and potentially for

lack of control.30 Notice also that control can also be achieved by being the trustee over a trust,

but if the trustee serves as trustee with discretionary power over the distribution of income and

principal, any transfer tax benefits may be lost due to that power.31

Limited Liability for the projected owners of the prospective business.

Owners will typically want some form of limited liability. The limited partnership,

limited liability partnership, limited liability company, or a corporate form can protect the

owners from liability arising from torts and trade creditors. Yet, in the closely held business

context, it is difficult for the owners to secure limited liability regarding borrowing unless the

entity has assets of its own to serve as collateral. Only the limited partners in a limited

partnership are shielded from liability. However, a corporation or LLC could be used as general

partner to provide extra insulation form liability, but that adds an additional entity.32 Some states

28 Id. at 5; See also Howard M. Zaritsky, Tax Planning for Family Wealth Transfers, at ¶ 10.01[2][a] (4th ed. 2010). 29 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 5 30 See Goldberg, Choice of Entity for the Family Business, at 11. 31 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 5. 32 Id. at 6-7.

21

allow the use of limited liability limited partnerships, which negate the need for an additional

entity by providing limited liability among the general partners as well as the limited partners.

Generally, depending on state law, judgment creditors of a partner in a partnership or

member of a limited liability company will only be entitled to a charging order giving the

creditors the right to receive distributions to which the partner or member would have been

entitled, but no right to manage the business or to cause the liquidation of the entity.33

Valuation discounts on interests in the prospective business for taxation

purposes.

Older family members generally want discounts for transfer tax purposes, so lack of

marketability and lack-of-control and/or minority discounts will be important. As mentioned

above, for estate tax purposes, a decedent’s assets will be valued at fair market value, but if the

assets are a fractional interest in a business entity, those assets oftentimes can be valued at a

discount for tax purposes due to a lack of marketability and potentially for lack of control.

Simplicity in the formation, continued operation, and structure of the

prospective business.

Owners typically want an entity that provides simplicity so that enormous amounts of

time are not spent on formalities and so they understand the structure of the entity. All entity

choices will require some formalities such as regular meetings of the directors, shareholders,

partners, managers and members, as the case may be, along with keeping minutes.34 Typically, a

limited partnership or limited liability company is more flexible than a corporation with regard to

formalities, as changing certain provisions in connection with a corporation generally requires

certain formalities. If allowed by state law and the partnership agreement for a limited

partnership, or operating agreement for a limited liability company, changing the operative

33 Id.; See also Zaritsky, Tax Planning for Family Wealth Transfers, at ¶ 10.01[2][a]-[b]. 34 Zaritsky, Tax Planning for Family Wealth Transfers, at ¶ 9.02[2][b].

22

agreement can be handled at any time by a simple majority of the partners or members.35 The

partnership and limited liability company are not required to elect directors annually as are

corporations and can establish a management structure initially that is constant throughout the

life of the partnership or limited liability company.

Minimal costs for maintaining and operating the prospective business.

Clearly, the owners will want an entity that meets their objectives but also falls within

their budget. Some costs to consider include accounting costs, legal fees, filing costs, and

syndication costs. However, using an entity to hold family assets can actually reduce

administration expenses. For example, a limited partnership or limited liability company

owning real property will avoid ancillary estate administration and may avoid state estate and

death taxes on real property located outside the state of the transferor’s residence. Notice that

real estate typically has to be probated in both the state of the decedent’s domicile and the state

where it is located, but interests in a business entity are personal property that only must be

probated in the state where the interest holder is domiciled, even if the entity holds only real

estate. Further, a limited partnership or limited liability company owning real property allows

gifts of partnership and limited liability company interests through deeds of gift, avoiding any

need to record deeds at the courthouse when real estate is involved.36

Transfer restrictions on ownership interests in the prospective business.

Owners usually want transfers of ownership in the business to be restricted, at least while

the business is developing. Each entity provides a method to meet this objective. For example, a

limited partnership, limited liability company, or a corporation can allow older family members

to restrict the right of other owners to transfer their interests, voluntarily and involuntarily, to

35 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 5-6. 36 Id. at 6; See also Zaritsky, Tax Planning for Family Wealth Transfers, at ¶ 9.02[2][b].

23

nonfamily. In this regard, family or the entity itself may be given a right of first refusal to

purchase any interest another family member wants to transfer. Further, a donee can retain a

partnership or limited liability company interest as separate property, excluding it from inclusion

in marital property in the event of divorce or in the augmented estate in the event of death.37

Tax-free withdrawals from the prospective business.

Owners generally want the ability to liquidate their interests in the business with the most

favorable tax result and lowest nontax cost. Partnerships and limited liability companies taxed as

partnerships typically can be liquidated tax-free.

Tax benefits related to the choice of entity for the prospective business.

Generally, if the business expects to have tax losses early, then owners may wish to have

the losses pass through to them directly. In that case, a pass through entity would be desired. On

the other hand, if the business expects to have profits, the owners will want those profits taxed at

the lowest level possible. Again, this is likely achieved with a pass through entity, like a

partnership, limited liability company taxed like a partnership, or an S corporation (absent some

exception). Again, C corporations generally involve a double tax regime–tax on the earnings and

profits at the entity level and tax on the dividends at the shareholder level. Additionally, C

corporations are taxed at the entity level upon liquidation and at the shareholder level upon

distribution.38

Tax-free cash flow from the prospective business.

Owners may desire to have any cash the business generates flow to them while avoiding

negative tax results. A partnership, limited liability company, or S corporation will generally


Companies, and More, at 5. 38 Id. at 1-2; See also Goldberg, Choice of Entity for the Family Business, at 8-9.

24

meet this objective. However, certain loans from a C corporations may provide cash that is not

taxable on a temporary basis to shareholders if the proper formalities are met.39

Passive income opportunities from the prospective business.

In some instances, the owners may be looking for passive income to offset passive

losses.40

Generally, from an estate planning perspective, the most important entity forms for

operating the family business or holding investment assets include limited partnerships, limited

liability partnerships, limited liability companies, S corporations, and C corporations.41 While the

sole proprietorship and general partnership are common entities for operating a business, neither

provide liability protections or very favorable valuation discounts;42 therefore, neither will be

discussed in great detail here. However, when considering passive income, it is important to

consider the new Net Investment Income Tax that became effective in 2013.

I. Implications of the New Net Investment Income Tax on the Choice of Business

Entity

The Health Care and Education Reconciliation Act of 2010 added a new chapter to

income taxes of the Internal Revenue Code. IRC §1411 imposes a 3.8% tax on “net investment

income” of taxpayers whose modified adjusted gross income (MAGI) exceeds certain threshold

amounts, that vary depending on the taxpayer’s filing status.

Filing Status Threshold Amount

Married filing jointly $250,000

Married filing separately $125,000

Single $200,000


Companies, and More, at 15. 40 Id. at 15. 41 See Mezzullo, Guidelines for Choosing the Most Favorable Entity, at 18. 42 Id.

25

Filing Status Threshold Amount

Head of household (with qualifying person) $200,000

Qualifying widow(er) with dependent child $250,000

This surtax is also imposed on estates and trusts which will impact business entities to the

extent that the entity is a party to the estate or trust. For example, using an Electing Small

Business Trust (ESBT) both sides of the trust including the S corporation stock and the

additional property will be added together for purposes of this surtax.43

Net investment income is the sum of three different categories of income, less allowable

deductions allocable to such income. These categories are:

1. Portfolio Income: Interests, dividends, annuities, royalties and rents other than

income derived in the ordinary course of business.44

2. Passive Activity Income: Income gained through passive activity or in the trade or

business of trading financial instruments or commodities.45

3. Net Gain: net gain from the disposition of property other than property held in a trade

or business.46

When considering which business entity is right for a client, it will be important to note at

which point they might see income from one of the three categories. For example, consider a

limited partnership or an LLC put in place to transfer interests in a family business. If the

business is sold each partner will be subject to net gain tax, unless they can establish their

involvement wasn’t a passive activity.

43 Juras, Kristen G. (2013). Implications of the New Medicare Surcharge Tax and Net Investment Income Tax.

61st Annual University of Montana Tax Institute, pp. 7. 44 IRC §1411(c)(1)(A)(i). 45 IRC §1411(c)(1)(A)(ii). 46 IRC §1411(c)(1)(A)(iii).

26

For pass-through entities an analysis at both the entity level and taxpayer level must be

taken to establish if the entity is engaged in a trade or business and if the taxpayer materially

participates in the entity’s activities. In many cases, no matter what business entity is chosen,

one of net investment categories will pick up the income a client generates from the entity,

making the choice the same as before the surtax was implemented.

Establishing passive activity will be critical to avoiding the net investment tax. Generally,

a passive activity is one in which the taxpayer does not materially participate. IRC § 469(h)(1)

defines “material participation” as involvement in operations of the activity on a regular,

continuous, and substantial basis.47 Now that income from a passive activity will carry a tax

burden, taxpayers will want to reconsider their respective activities and the manner in which they

have been measuring and documenting their material participation.

In any event, choosing a business entity will require considerations of how the entity and

its organizational tools will allow clients to participate in order to avoid the additional tax.

Other important things to consider:

1. Income derived from working capital investment is NOT treated as income from a trade

or business for purposes of Section 1411(c)(1) and is potentially subject to net investment

income tax.48

2. A proposed Treasury Regulation requires that when a client wants to sell a partnership

interest or S corporation stock, they must attach a statement of their return showing the

fair market value of all assets of the entity, along with their gain or loss realized on each

47 Juras, Kristen G. (2013). Implications of the New Medicare Surcharge Tax and Net Investment Income Tax.

61st Annual University of Montana Tax Institute, pp. 13. 48 Id at 12.

27

asset. A large burden that could cause significant compliance issues, which should be

watched closely. Prop. Treas. Reg. § 1.1411-7(d)(3). 49&50

The Sole Proprietorship.

A sole proprietorship is typically the simplest form of operating a business if there is

only one business owner.51

The General Partnership.

A general partnership, likewise, is typically the simplest form of operating a business if

there are multiple owners. In the case of a general partnership, when no written partnership

agreement exists, the state’s law on partnerships applies. Oftentimes, the state’s law will be

either the Uniform Partnership Act (“UPA”) or the Revised Uniform Partnership Act

(“RUPA”).52

J. The Limited Partnership (“LP”).

An LP is state law created. Normally, an LP is created by filing a Certificate of Limited

Partnership with the Secretary of State. Generally, the partners enter into a partnership agreement

that sets forth operation and management terms between the partners. The partnership agreement

is analogous to an operating agreement used by a limited liability company. An LP can only be

dissolved by the general partners. Further, normally only the general partners have a right to

withdraw from the partnership and receive value for their partnership interest at any time.

Limited partners may not have a reciprocal right under state law.53

49 Id at 13.

50 For more information on Section 1411 see the ABA RPTE Section’s Comments to Treasury entitled Comments

on Internal Revenue Code Section 1411 with Respect to an Estate or Trust; See RTPE website at:_______________ 51 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 12. 52 Id. 53 Id. at 2-3, 12, 33.

28

Typically, only the general partners are subject to personal liability for the debts,

obligations, and liabilities of the LP. Normally, the limited partners will not be personally liable

for the debts, obligations, and liabilities of the LP, but certain formalities must be followed for

limited liability to apply. For example, limited partners must refrain from actively participating

in the conduct of the business or they may be considered general partners under the state’s

partnership law, exposing them to liability. Oftentimes, state law will be the Revised Uniform

Limited Partnership Act (RULPA) or the Uniform Limited Partnership Act (ULPA).54

For taxation purposes, LPs and other partnerships are more flexible and generally act as

pass through entities, creating only one level of tax at the partner level. Generally, an LP can be

liquidated tax-free. Fringe benefits available to C corporation shareholder-employees are not

available to partners in an LP.55 Complex rules apply relative to the allocation of company debt

and the allocation of profits and losses to the partners. However, the LP form allows for special

allocations of income, gain, loss deduction and credit to its partners. A partner’s basis generally

will include his or her share of liabilities of the business. Normally, contributions and

distributions of property to and from the entity are less likely to involve taxable gain. Further,

only a partnership can adjust inside basis of its assets when a partnerships interest is acquired in

a sale or exchange, or at the death of a partner.56

A family’s passive investments should oftentimes be held in LPs (or limited liability

companies if state law is favorable), as normally, there is lower concern for exposure to liability

with such assets. If a limited liability company is more likely to experience an event of

withdrawal causing dissolution, then an appraiser might assign a lower value to an otherwise

54 Id. at 2-3, 12; See also Zaritsky, Tax Planning for Family Wealth Transfers, at ¶ 10.01[1]. 55 Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 2-3, 12, 33. 56 See Mezzullo, Guidelines for Choosing the Most Favorable Entity, at 18-19; See also Zaritsky, Tax Planning for

Family Wealth Transfers, at ¶ 10.01.

29

equivalent interest in an LP. Some state’s limited liability company acts require a limited

liability company to dissolve upon the death, retirement, expulsion, bankruptcy, or dissolution of

a member unless all or a majority-in-interest of the remaining members agree to continue the

business. On the other hand, in most states, LPs dissolve only upon the death, retirement,

expulsion, bankruptcy, or dissolution of the sole remaining general partner, absent consent of all

or a majority of the remaining limited partners.57

Moreover, using an LP (limited liability companies and partnerships generally) can assist

in simplifying the process of making gifts, especially annual exclusion gifts. A simple deed of

gift may be used whereby a donor transfers a percentage of his or her interest in the LP to the

donee, eliminating real estate deeds and a trip to the courthouse, when real estate is involved.

Using an LP (limited liability companies and partnerships generally) may reduce the value of

gifts because of minority and lack of marketability discounts. An LP can also allow older family

members, as general partners, to retain control. Notice however, that since a general partner

typically has the right to cause a liquidation of an LP under state law, valuation discounts

vailable for LP interest transfers held by those elder general partners (both during life and at

death) may be reduced as compared to if they were simply limited partners.58

K. The Limited Liability Partnership (“LLP”).

An LLP is basically a general partnership registered with the state as a limited liability

partnership so as to remove a general partner’s personal liability for acts or omissions of other

partners, employees, and agents of the LLP. In some states, general partners in an LLP are not

personally liable for the LLP’s liabilities either. LLPs are allowed in every state and some states


Companies, and More, at 33. 58 See Mezzullo, Guidelines for Choosing the Most Favorable Entity, at 18-19; See also Zaritsky, Tax Planning for

Family Wealth Transfers, at ¶ 10.01[2][a].

30

even allow for a Limited Liability Limited Partnership (“LLLP”).59 The LLLP mirrors the LP in

most respects but adds an additional layer of liability insulation for the general partners.

L. The Limited Liability Company (“LLC”).

An LLC is also created by state law. Generally, an LLC requires few formalities to form.

Normally, an LLC is created by filing Articles of Organization with the Secretary of State.

Generally, the members enter into an operating agreement which sets forth operation and

management terms between the members. The operating agreement is analogous to a partnership

agreement. LLCs may be structured as a general partnership, an LP or corporation. The LLC

may be member-managed, meaning that any or all members have a right to participate in

management, or it may be manager-managed, meaning that the members have decided to appoint

a manager who will oversee the operations of the company. A manager does not need to be a

member (owner) in the LLC and may be a person or entity. Similarly, members may be

individuals, trusts, corporations, partnerships, other LLCs or other entities. 60

Neither the members nor the managers of an LLC are liable personally for the debt

obligations, or liabilities of the LLC. However, if a member is personally responsible for the act

or omission that causes damage to a third party, or personally guarantees a debt or becomes

liable under state or federal law, then that member can be personally liable. Moreover, like a

corporation, the protection of an LLC can be pierced if the LLC is formed or operated as a

sham.61


Companies, and More, at 12. 60 Id. 61 Id. at 2.

31

The LLC provides ownership, operation tax and liability benefits in a way the LP and S

corporation cannot. LLCs that are taxed as partnerships act as a pass through entities, creating

only one level of tax at the member level, providing the same benefits as an LP, with additional

benefits. LLCs taxed as partnerships typically can be liquidated tax-free as well. A member’s

basis will be increased by the debts of the LLC so long as the member did not guarantee the debt.

This allows members to receive tax-free distributions of loan proceeds as well as take losses

greater then their contributions to the LLC. Moreover, many LLC acts give members a right

under state law to withdraw and receive value for his or her interest. Subject to state law, an

LLC may be dissolved upon the death, retirement, expulsion, bankruptcy, or dissolution of a

member. Similar to LPs, fringe benefits available to C corporation shareholder-employees are

not available to members in an LLC.62 Like LPs, complex rules apply relative to the allocation

of company debt and the allocation of profits and losses to the members.

If there is any chance that operating the business may place the owners at risk for

exposure to liability, the LLC will be the entity of choice in most cases. All members (owners)

of an LLC will be insulated by limited liability. Further, the LLC affords its members the

income tax benefits of a partnership for federal tax purposes and in some cases may provide a

better result. Notice, however, that some states may not treat an LLC as a partnership for income

tax purposes. Members may be actively participating in the conduct of the business under the

passive loss rules without risking liability. Members may also materially participate in the

LLC’s management without risk of becoming personally liable for the LLC’s debt and

liabilities.63

62 Id. at 2-3, 12, 33; See also Mezzullo, Guidelines for Choosing the Most Favorable Entity, at 19; and Zaritsky, Tax

Planning for Family Wealth Transfers, at ¶ 10.01. 63 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability


32

Moreover, using an LLC (and partnerships) can aid in simplifying the process of making

gifts, especially annual exclusion gifts. A simple deed of gift may be used whereby a donor

transfers a percentage of his or her interest in the LLC to the donee, eliminating real estate deeds

and a trip to the courthouse, when real estate is involved. Using an LLC (and partnerships),

especially an LP may reduce the value of gifts because of minority and lack of marketability

discounts.64 Because of the variation in state LLC acts, the best training material on state law

issues for LLC’s is the Uniform Law Commission’s website and the Reporter’s Comments on

Re-ULLCA. See Exhibit A.

M. The S Corporation (“S Corp”).

An S Corp is treated the same as a C corporation for state corporate law purposes but is

taxed similar to a partnership for federal income tax purposes. An S Corp may be taxed similar

to a partnership for state income tax purposes as well, but it depends on the state. One unique

advantage of an S Corp is an ability of a shareholder-employee to decrease his or her

compensation, within reason, to minimize payroll tax.65

N. The C Corporation (“C Corp”).

The C Corp is treated as a regular corporation under state corporate law but may have

undesirable tax consequences such as double taxations as discussed above. Except for a

personal service business, a C Corp typically should be avoided unless the objectives of the

owners can only be met through it. However, if an operating business is likely going public or is

to be held in the family for a long time, a C Corp may be preferable. In these instances, earnings

can be accumulated for the reasonable needs of the business at lower tax rates. Moreover, certain

fringe benefits can be provided to the shareholder-employees tax-free. In contrast, no more than

64 See Mezzullo, Guidelines for Choosing the Most Favorable Entity, at 19; See also Zaritsky, Tax Planning for

Family Wealth Transfers, at ¶ 10.01[2][a]. 65 See Goldberg, Choice of Entity for the Family Business, at 15.

33

two percent (2%) of shareholders in an S Corp are entitled to these fringe benefits and no

members of an LLC, or partners in a general or LP are entitled to these fringe benefits. 66

Nonetheless, there are nontax benefits to the corporate form, including limited liability

for all shareholders regarding debts, obligations, and liabilities of the corporation. Further, a

shareholder does not have a right to withdraw and receive any value for his or her stock and this

may reduce the value of the shareholders interest when considering transfer taxes.67

For purposes of this discussion, the main focus will be on exploring the beneficial and

detrimental differences between the S Corp and the partnership forms (including the LP, LLP,

and LLLP), as well as the LLC form.

O. Comparing S Corps and Partnerships (including LPs, LLPs, and LLLPs) and

LLCs.

Formation.

a. Partnerships.

Generally, partnerships are formed without creating a taxable event. Unlike S Corps,

there is no restriction on the type or number of owners of a partnership. Partners can include

individuals (including nonresident aliens), corporations, other partnerships, any kind of trust, and

estates. The amount of partners is unrestricted. Further, there is typically no constraint on the

capital structure of a partnership, so interests in the business with preferences pertaining to

distributions can be issued without risking partnership status for income tax purposes. 68 This

permits the partners in a partnership, or members in an LLC for that matter, to adjust risk and

reward among themselves by creating priority distributions and/or to maximize return and


Companies, and More, at 33-34. 67Id. at 2. 68 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability

Companies, and More, at 19-20.

34

minimize risk. In contrast, the S Corp cannot have two classes of shares, so the preferential

distributions of a partnership or LLC are simply incompatible with the S Corp form.

b. S Corps.

Generally, S Corps are formed without creating a taxable event if the corporation is not

treated like an investment company and the transferor receives only stock and, immediately after

the contribution, owns eighty percent (80%) or more of the voting power of the corporation and

the value of the stock. There are limitations on who may own stock in an S Corp in order to

maintain the S election. Only individuals who are citizens or resident aliens, estates, and certain

qualified trusts can own stock in an S corp. Further, the number of shareholders is constrained to

one hundred (100). The capital structure of an S Corp is also limited to one class of stock, but

there can be voting and nonvoting common stock. 69

P. Operations.

a. Partnerships.

The partnership form is generally more flexible than that of an S Corp. Like most S

Corps, a partnership is a nontaxable entity. Income, gains, losses, and deductions pass through to

the partners in the partners’ taxable year that includes the end of the partnership taxable year.

The partners are responsible for income tax in their separate or individual capacities. As such,

the various items of income, gain, deduction, loss and credit included in the partner’s distributive

share are taken into account by the partners individually.70

Losses generally can be deducted by the partners to the extent of their basis in the

partnership. Typically, a partner’s basis in the partnership (outside basis) will equal the amount

of cash transferred to the partnership, increased by the partner’s basis in any property transferred

69 Id. at 20; See also Goldberg, Choice of Entity for the Family Business, at 15-17. 70 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited Liability


35

to the partnership and decreased by any liabilities the property is subject to or which the

partnership assumes pertaining to that property. General partners share in recourse liabilities

based on their share of the economic risk of loss regarding such liabilities. Limited partners or

members of an LLC share in recourse liabilities only to the extent they are obligated to make

contributions to the partnership, pay the creditor directly, restore a deficit balance in their capital

account upon liquidation, or reimburse another partner or member pursuant to an indemnity

arrangement. Following allocations to reflect minimum gain and built-in appreciation, general

and limited partners both (and members of an LLC) share nonrecourse liabilities to the extent of

their share of the profits of the partnership or LLC.71

A partner’s basis will go up due to his or her distributive share of partnership income and

will go down due to losses, nondeductible expenditures, and distributions to the partner from the

partnership. When a partner’s share of liabilities is decreased, it is treated as a distribution of

cash that decreases his or her basis. In contrast, when a partner’s share of liabilities is increased,

it is treated as a contribution of cash that increases his or her basis. A partnership has the ability

to allocate items of income, gain, loss, deduction, or credits in any manner it wishes, so long as

the allocation has substantial economic effect, and if family members are involved, the allocation

satisfies the family partnership rules.72

b. S Corps.

S Corps, except those that were formerly C Corps, are normally a nontaxable entity.

Similar to a partnership, an S Corp’s items of income, gain, loss, deduction, and credit pass

through to the shareholders; however, those items cannot be specially allocated to various

71 Id. at 21. 72 Id.

36

shareholders. Allocations to shareholders are based on their stock ownership and according to

the number of days of the year that the shareholders have held their stock.73

Loss deductions are limited to the shareholder’s basis in his or her stock. Typically, the

shareholder’s basis will equal the amount of cash, increased by the shareholder’s basis in any

property that he or she transferred to the S Corp in exchange for stock and decreased by any

liabilities assumed by the S Corp or which the property was subject. For loss deduction purposes,

the shareholder’s basis includes loans made to the S Corp. Unlike partnerships and LLCs, a

shareholder’s stock basis does not include the shareholder’s share of corporate liabilities. The

passive loss rules and at-risk limitations also may apply to losses generated by an S Corp.74

Q. Transfers of Interests.

a. Partnerships.

Generally, capital gain is recognized by a partner in a partnership following the sale or

exchange of his or her interest in the partnership. Notice that a partnership may elect to adjust the

basis of its assets with respect to a purchasing partner or successor of a decedent partner to

reflect the difference between the acquiring partner’s outside basis (purchase price) in his or her

partnership interest plus his or her share of partnership liabilities and the acquiring partner’s

share of the partnership’s basis in its assets (inside basis). 75

b. S Corps.

Generally, capital gain is recognized by a shareholder in an S Corp following the sale or

exchange of his or her stock. Unlike a partnership, the purchasing shareholder’s inside basis (his

or her share of the basis of the S Corp in its assets) cannot be adjusted to reflect the difference

between his or her outside basis and his or her inside basis. Moreover, the S Corp may lose its

73 Id. at 21-22. 74 Id. at 22. 75 Id. at 22-23.

37

pass through tax advantage if a shareholder passes shares to a non-qualified holder and it loses its

S election. 76 The partnership forms do not have this issue, nor does an LLC, because LLCs

generally have check-the-box regulations.

R. Contributions of Property.

a. Partnerships.

Generally, a partner will not recognize gain or loss upon the contribution of property to a

partnership. However, if the contribution is a disguised sale, it will be treated as such and gain

or loss will be recognized. The income, gain, loss, and deductions regarding property

contributed by the partner to the partnership must be shared amongst the partners. In effect, this

will reflect the variation between the partnership’s basis in the property and its fair market value

at the time it was contributed. 77

b. S Corps.

A shareholder contributing property to an S Corp in a tax-free exchange will effectively

shift a portion of the resulting tax consequences pertaining to any inherent gain or loss that is

built-in to that property to the other shareholders. However, if the shareholder contributes

property with built-in gain to an S Corp in a transaction that fails to meet the requirements of a

tax-free exchange, he or she will recognize gain equaling the built-in appreciation. 78

S. Distributions.

a. Partnerships.

Unless a distribution of cash to a partner exceeds his or her outside basis, there will be no

resulting taxable income to that receiving partner. Likewise, a distribution of property that

includes something other than cash to a partner will result in no taxable income to that receiving

76 Id. at 23. 77 Id. 78 Id. at 23-24.

38

partner except when the cash distributed exceeds that partner’s outside basis in the partnership.

Partners recognize loss following a distribution only if it was in complete liquidation of his or

her partnership interest and the only property distributed is cash and unrealized receivables and

inventory. Notice that a partnership typically will not recognize gain or loss following a

distribution of cash or property to a partner except when there is a deemed sale of its interest in

unrealized receivables or substantially appreciated inventory. 79

b. S Corps.

When an S Corp does not have subchapter C earnings and profits, distributions of cash

and other property will be tax-free to the shareholder up to his or her basis in the stock of the S

Corp with any excess being capital gain. Notice that an S Corp will realize gain or loss (unless

the loss is otherwise denied) upon distribution of appreciated property to a shareholder. That

gain or loss will be reflected in the shareholder’s basis in his or her stock. In effect, this avoids

double taxation or double loss. Moreover, unlike a partnership, an S Corp or its shareholders

will recognize at least one level of taxable gain upon the distribution of appreciated property to

its shareholders. 80

T. Liquidations.

a. Partnerships.

As discussed previously, the liquidation of a partnership generally will not involve

taxable gain to partners unless the amount of cash distributed exceeds a partner’s basis in the

partnership. 81

b. S Corps.

79 Id. at 24-25. 80 Id. at 25. 81 Id. at 27.

39

An S Corp will recognize taxable income in a liquidation if appreciated property is

distributed to shareholders. However, gain typically will not be recognized twice, as the

shareholder’s basis will be increased by the amount of income recognized except when the

income and loss are of different character. 82

U. Comparing LPs and LLCs.

Treatment of liabilities.

a. LPs.

Limited partners receive an increase in basis for nonrecourse liabilities as only specific

assets of the partnership are subject to the liability. 83

b. LLCs.

Members of an LLC are not personally liable for debts, obligations, or liabilities of the

LLC absent an agreement to the contrary. As such, each member receives an increase in his or

her outside basis in the LLC for his or her share of the debts, obligations, and liabilities of the

LLC. 84

V. Passive Loss Rules.

a. LPs.

Limited partners who materially participate in the business of the partnership, within the

meaning of the passive loss rules, risk exposure to liability as a general partner for the

partnership’s obligations. 85

b. LLCs.

82 Id. at 27-28. 83 See Mezzullo, Estate Planner’s Guide to Family Business Entities: Family Limited Partnerships, Limited

Liability Companies, and More, at 29. 84 Id. 85 Id.

40

While a member of an LLC may be treated as a limited partner under the passive loss

rules, a member of an LLC may still materially participate in the LLC so that the income and

losses passed through to the member will be considered active income and losses under the

passive loss rules and still not risk exposure to personal liability. 86

W. Distributions to Withdrawing Partner or Member.

a. LPs.

If capital is not a material income-producing factor, payments to a general partner in

liquidation of his or her interest in the partnership’s goodwill may be treated as a distribution of

partnership income or as guaranteed payments. This, in turn, reduces the taxable income of the

remaining partners. 87

b. LLCs.

It remains unclear how a liquidating distribution to a member of an LLC is treated.

Hopefully, a manager-member in a manager-managed LLC and a member in a member-managed

LLC would be treated like a general partner. 88

X. Characterization of Income for Self-Employment Tax Purposes.

a. LPs.

Currently one can separate a partner’s share of the partnership’s net income into self-

employment income and non-self-employment income, but the partner must own both a general

and a limited partnership interest. Similar results may be possible in an S Corp in the case of a

shareholder-employee who receives compensation income and dividends. 89

b. LLCs.

86 Id. 87 Id. 88 Id. 89 Id. at 30.

41

It remains unclear whether distributions to members of an LLC will be subject to self-

employment tax. 90

Y. Annual Exclusion Gifting.

Provided that the estate planner has formed and funded a limited partnership or

limited liability company or other entity suitable for the clients’ needs, serious consideration

needs to be given to the gifting of business assets. Under IRC 2035, with certain exceptions,

gifts from a donor to any donee aggregating less than $14,000.00 as adjusted for inflation in a

calendar year, are removed from the donor’s estate at the moment of the gift. The number of

permissible donees is without limit. The amount in excess of any $14,000.00 gift will be brought

into the estate tax calculation as adjusted taxable gifts.

A fundamental requirement of the gift is it must be a gift of a present interest, not

a future interest. A case of major importance in this regard is Hackl v Commissioner, 118 T.C.

Memo 279, which held that gifts of entity units in a limited liability company were gifts of future

interests and not entitled to an annual exclusion. The court based its holding on a finding that the

operating agreement did not allow the donees to presently access any economic or financial

benefit from the gifted interests; had there been in Hackl current income distributed or available

for distribution, the ability to sell the gifted interest or the right to put the gifted interest, the

result may have been different.91 In Price, there was no immediate enjoyment of the donated

property itself because the donees had no ability to withdraw their capital accounts and could not

sell their interests without the written consent of all other partners and there was no immediate

enjoyment of income from the donated property in the absence of a steady flow of income since

distribution of profits was in the discretion of the general partner and the partnership agreement

90 Id. 91 See Kelly, Donald H, Estate Planning for Farmer and Ranchers Chapter 6:35 at 6-87; See also Price v

CRR,T.C. Memo 2010-2.

42

provided that distributions would be secondary to the partnership’s primary purpose of

generating a long term reasonable rate of return.92

From a compliance standpoint, it is necessary to start the statute of limitations

running under the “adequate disclosure” regulations.93 Thus, as a practical matter, upon the

filing of a federal gift tax return, Form 709, the grantor is required to (1) describe the gifted

property and any consideration received by the donor; (2) the identity of in relationship between

the donor and the donee; (3) a detailed description of the method used to determine the fair

market value of the gifted property including relevant financial data and a description of any

valuation discounts taken such as blockage, minority, fractional interests and lack of

marketability. In the case of an entity such as an FLP or LLC, a description of the discount taken

and a statement of the fair market value of 100% of the entity value without discounts must be

included; and a statement of the relative facts affecting the gift tax treatment of the transfer

sufficient to apprise the service of the nature of any potential controversy concerning gift taxes,

describing any legal issue presented by the facts and disclose any position taken contrary to any

temporary or final regulations.

Z. Practical Comment: Initial Due Diligence

An identifiable category of any estate planning engagement is the formation of

business entities for the purpose of transmitting wealth. However, many estate plans come laden

with historic business organizations which may not meet the financial and estate planning goals

of the client. While fifty years ago the estate planner was limited to C Corporations, S

Corporations, and business trusts, as well as general partnerships and sole proprietorships, today

the planner has at his or her disposal domestic asset protection trusts, limited liability limited

92 Kelly, Donald, H, Estate Planning for Farmers and Ranchers Chapter 6:25, Supplement Page 463. 93 See Proposed Regulations Section 20.25001-1, 25.2504-2, and 301.6501(c)-2(f).

43

partnerships, limited liability companies, and more traditional C Corporations, S Corporations

and general partnerships. Since 1986 and the repeal of the General Utilities Doctrine, many C

Corporations remain high capital gains tax zombies with operational risks because of highly

appreciated real estate assets with a lurking 50% to 60% tax liability in the event of liquidation

or sale. Often the most valuable task that can be performed by the estate planner is a tax free

division under IRC §355, discussed below. In addition, the planner should review whether any

buy sell agreements exist, whether they are outdated, the integrity of the “financial health of

existing life insurance policies (i.e. get in force illustrations from the life insurance company or

an independent analysis by a non-commission based insurance analyst). In addition, the planner

should review the stock transfer legends of the corporation to confirm that such legends are up to

date. The planner should also review whether the corporation has a capital structure extending

beyond a single class of stock or the differentiation between voting and non-voting shares, i.e.,

are there preferential voting rights or distribution rights upon liquidation. In this connection, the

most valuable work that a planner might possibly perform is encouraging all shareholders to

elect subchapter S treatment to enjoy greater net sales proceeds upon sale or liquidation date the

expiration of a ten (10) year period or of the ten year period required under rules governing

Subchapter S election.

AA. Tax Free Divisions of Corporations with Active Shareholders.

While the matriarch or patriarch of an agricultural operation is still alive,

(although it is not required under IRC §355 and related regulations), it is most feasible to achieve

a tax free division of a C Corporation or S Corporation, and avoid the prospect of a taxable

liquidation or shareholder oppression claims.

44

Examining the scope of the requirements under IRC §355 is beyond the scope of

this outline. The issue should be recognized, however, by the estate planner because often

siblings inheriting stock by gift or devise have different business objectives and latent or overt

hostility; some owners may be active and others may be passive. Although electing Subchapter

S and waiting the ten year period may soften the tax on liquidation, often business owners do not

want to liquidate the entire entity, or cannot afford the tax issue. As a consequence, a tax free

division under IRC §355 may provide a solution. One or more subsidiary corporations are

formed by the existing corporation transferring some or all of the assets to them. The subsidiary

stock is then transferred to the owners in exchange for the stock in the original corporation. To

qualify for tax free division, both the distributing and controlled corporation (original parent and

new subsidiary) must be engaged in the active conduct of a trade or business immediately after

the division. In a farming situation, a problem may arise if the operation has changed to a

passive rental, which may occur of the next generation has left the farm and the older generation

has retired using the farm property as a source of retirement income from the rents.94 The active

conduct of a trade or business requires the corporation itself (through its officers and employees)

to perform active and substantial management and operational functions. If the corporation

engages in substantial management and operational functions, an IRC § 355 division may be

available so that the next generation of owners can then work toward their independent goals

without incurring a substantial tax cost.95 Importantly, in Rev. Ruling 2003-52, the National

Office of the Internal Revenue Service ruled that a disagreement between a brother and sister

operating a corporation with respect to future operations was significantly serious such that it

94 See Kelly, Donald Hl, Estate Planning for Farmers and Ranchers,Chapter 8:52, see also Brunell E.

Steinmaver, Jr., Burnell E., and Turner, Todd D., Second Generation Planning – The Corporate Division

Alternative,20 Probate and Property 49, Volume 20, Number 6, (Nov/Dec 2006). 95 See Generally Rev. Ruling 73-234, Rev. Ruling 86-126 and Rev. Ruling 2003-52.

45

would prevent each of them from developing a business in which they would have a majority

interest; a division would eliminate the disagreement and allow each of them to operate separate

businesses to which they could devote their full time and energy. The senior generation, i.e.,

mother and father, would each own 25% in both of the two surviving corporations and would

continue to participate in major management decisions related to the businesses of each

corporation; however, in other situations the senior generation could no longer be active as to

their vote concerning the stock.96

BB. Designing Capital Structure of LLCs, FLP’s and Other Entities to Avoid Estate Tax

Inclusion

The limited liability company and limited liability limited partnership are the entities of

choice to hold real estate using agricultural operations. With respect to limited liability

companies, the choice of the capital structure often ranges between a member managed

organization with straight up pro rata voting depending on ownership percentages and a manager

managed structure where notwithstanding the percentage of ownership of the managers, the

managers control the operation, not unlike a corporation or limited partnership. A critical

determination here is the interplay between the capital structure of the limited liability company,

and the possible inclusion of the capital interests in the limited liability company under IRC §

2036(a)(2).97 The Turner case provides excellent instruction to the estate planner forming a

family limited partnership or LLC about its original capital structure and eventual operation and

how to avoid estate tax inclusion under IRC§ 2036(a)(2). Specifically, the planner must achieve

the threshold requirement that the formation and operation of the entity meet the requirements of

a “bona fide sale for adequate and full consideration” exception to IRC § 2036 inclusion in the

96 Kelly, Donald, H., Estate Planning for Farmers and Ranchers,Chapter 8:54, Supplement at page 707. 97 See Generally Estate of Turner, TC Memo 2011-2009. See also Breed, Richard P. and Hilario, Lessons From

Turner to Protect Against IRS Challenge FLP, Estate Planning July 2012, Volume 39, Number 7, Page 13.

46

estate. Specifically, to fit under the Turner requirements, and its bona fide sale exception, the

FLP or LLC must pass a two part test:

1. The facts and circumstances of the FLP or LLC transaction must

present, as actual motivation for planning, a “legitimate and

significant” non-tax reason to create the FLP or LLC; and

2. The Transferor must receive a proportionate partnership interest

equal to the property transferred to the FLP or LLC.

In the Turner case, the court considered the following factors:

1. Whether the assets by their nature required active management or

special protection;

2. Whether in fact the business entity required active management

and whether a special investment strategy was implemented;

3. Whether the use of the FLP structure provided greater efficiency of

management;

4. Whether there was litigation or a threat of litigation among family

members creating a real risk to the family estate so as to justify the

creation or formation of an FLP; and

5. Whether there was an actual need to protect family assets.

In reviewing the factors, the Turner court held that the estate’s purported non-tax business

reasons for forming the LLC were unsubstantiated. The court also found additional factors

evidenced in the lack of a bona fide sale, as follows:

1. There was no meaningful or real negotiation with the parties

involved in the transaction;

2. There was a co-mingling of personal assets and partnership funds;

3. There was a short time between the formation of the business

organization and the ultimate transfer (here 8 months); and

4. There was evidence of transfer tax motives for the formation of

FLP because of an attorney’s letter discussing the need to have an

appraisal for gift tax purposes.

47

In forming an LLC or FLP it is very critical to document the non-estate tax

reasons, (i.e. legitimate business reasons) for the formation of the LLC or FLP. In addition, with

respect to the capital structure of the LLC, or the FLP, care should be given to avoid the

following:

1. The ability of the senior generation to unilaterally amend the

partnership agreement without the consent of the limited partners

or other limited liability company owners;

2. The decedent or majority owner’s sole and absolute discretion to

make distributions of partnership and income and distributions in

kind; and finally

3. Because the decedent owned in excess of a majority interest of the

limited partnership, he could make any decision concerning the

FLP or LLC that effectively allowed him to control the limited

partnership (in other words there was no super majority voting

carve outs in the agreement).

In consequence of the foregoing, the tax court held that § 2036(a)(2) applied because Mr.

Turner, in conjunction with his wife, could designate who could possess or enjoy the property

transferred to the FLP.

As difficult as it may be for the estate planner, it is critical that the patriarch and

matriarch, acting in conjunction, cannot simply control all aspects of the limited liability

company or family limited partnership; to do otherwise risks inclusion under IRC § 2036(a)(2),

particularly if the bona fide sale exception cannot be made because of legitimate non-tax reason

that the formation of the entity cannot be demonstrated.

CC. Valuation Rules Under Chapter 14 of the IRC.

Chapter 14 was enacted as part of the Revenue Reconciliation Act of 1990 (“RRA 90”).

Chapter 14 contains valuation rules for determining whether a gift has been made, and the value

of such gift, when older generations in a family transfer partnership interests (including LLC

48

interests), corporate interests, and trust interests to the younger generations in the family. To

determine the value of the transferred interest in property (including a family business), one

subtracts the value of any interest retained by the transferor from the fair market value of the

transferred property.98

DD. Valuing Transfers of LLC, Partnership and Corporate Interests.

Special valuation rules under Chapter 14 are used to figure out the value of minor equity

interests in LLCs, partnerships, and corporations transferred to a member of the transferor’s

family if that transferor or an applicable family member retains a superior equity interest in the

entity that gives the holder an applicable retained interest (either a put, call, conversion, or

liquidation right) or in a controlled entity, a distribution right other than a qualified payment

right. An applicable retained interest is valued at zero under the special valuation rules.99

A controlled entity is an LLC, partnership, or corporation controlled immediately prior to

the transfer by the transferor, any applicable family members, and any lineal descendants of the

parents of the transferor or the transferor’s spouse. Holding at least fifty percent (50%) of either

the capital interest or profits interest in the entity is synonymous with control. Specific to an LP,

holding any interest as a general partner is also synonymous with control. While no such

authority is directly on point, member managers in a manager-managed LLC and members of a

member-managed LLC will likely be considered general partners for this purpose as well.100

Neither a qualified payment right, nor a guaranteed payment right, is subject to the

special valuation rules. Qualified payment rights are the right to receive a fixed amount on a

periodic basis. Guaranteed payment rights are rights to receive a fixed amount from a

98 Id. at 99. 99 Id. 100 Id. at 100

49

partnership or LLC irrespective of the income of the partnership or LLC. The payment cannot

be contingent as to amount or time.101

A frozen LLC or partnership interest refers to an equity interest retained by an older

generation family member after transferring residual interests to younger generations in the

family. Future growth in the value of the business will inure to the benefit of the holder of the

residual interests. The idea is to have the frozen interests remain at the identical value as the date

on which it was created. There are at least two scenarios where that is the case:

(1) A new business with a low value that is expected to increase in value quickly into the

future. Here the older family member holds the frozen interest in the entity while providing the

younger family members the residual interests. The older family member’s frozen interest will

be valued at zero either because he or she does not keep a qualified payment right or a

guaranteed payment right, or elects out of qualified payment right treatment. Since the value of

the business is low at the time of creating the frozen interest, the value of the residual interest

that is treated as a taxable gift will not be burdensome, even though it represents the entire value

of the business.102

(2) A business is expected to grow quickly enough to pay the older family member either

a qualified payment or a guaranteed payment. Here the value of the residual interests transferred

to the younger family members would not include the present value of the qualified payment

right or the guaranteed payment right. Future growth in the business, to the extent it exceeded

the value of the qualified payment right or the guaranteed payment, would inure to the benefit of

101Id. 102 Id. at 100-101.

50

the younger family members holding the residual interest, providing transfer tax savings to the

older family member in effect.103

Rights and restrictions.

Under the special valuation rules of Chapter 14, for purposes of estate, gift, and

generation skipping transfer taxes, the value of property is determined without considering any

right or restriction relating to the property. A right or restriction is an option, agreement, or other

right to obtain or use the property for a fee below that property’s fair market value, or any

restriction on the right to sell or use that property. These restrictions are oftentimes found in the

partnership agreement or operating agreement but may also be implicit in the structure of the

entity. Prior to the special valuation rules, family members could be tempted to understate the

values of interests in intrafamily buyout agreements. This temptation was especially true in the

case of older generation owners who were understating the value of their interests to make it

appear lower than it truly was for estate tax purposes upon their death.104

However, there are three (3) exceptions to the special valuation rules. Under the statutory

exception, a right or restriction is not disregarded if: (1) it is a bona fide business arrangement;

(2) it is not a device to transfer the property to the natural objects of the transferor’s bounty for

less than full and adequate consideration in money or money’s worth; and (3) at the time it is

created, the terms of it are comparable to similar arrangements entered into by persons in an

arm’s length transaction. Under the regulatory exception, a right or restriction is considered to

meet each of the above three (3) requirements if more than fifty percent (50%) by value of the

property subject to it is owned directly or indirectly by individuals who are not members of the

transferor’s family. Thus, while it may be possible for federal estate tax purposes to get

103 Id. 104 Id. at 102; See also Goldberg, Choice of Entity for the Family Business, at 18.

51

valuation discounts for interests in partnerships, LLCs, and even for corporate interests, the IRS

will not allow game playing.105

EE. Practical Comments: Care and Feeding of the Plan.

It is critical in selecting a business entity and estate plan to examine the estate planning

objects, family dynamics, and personal and tax related financial information, in addition to

performing due diligence on the business organizations and real estate already in place involved

in the estate. Probing the client for their estate planning objectives is often a challenging

engagement inasmuch as the most trusted advisors may not be present during the meeting. It is

important to identify the long term goals of the client individually and the family generally,

which likely includes a determination of whether a limited partnership, limited liability company,

or Sub Chapter S corporation is a feasible business entity, involving non-family members, and

whether existing business organizations have been properly formed and are capable of

transmitting wealth by gifting or post mortem transfers to family members with appropriate

discounts. Estates rarely come in neat packages. Often in a going concern operation, clients will

deliver a 25 year old corporate minute book of a C Corporation holding highly appreciated real

estate where the minutes have not been maintained, the bylaws are outdated, no stock restriction

agreement exists, and family members negotiated a “detente” with a defacto business division

that they have made of the operation (farming and ranching). This may be a treasure trove of

legal work.

In agricultural planning, it may be necessary to identify what the client’s goals are on the

“liquidity” or “legacy” spectrum. “Liquidity” is often a luxury in many estates because many

successful agricultural operations consider their most valuable liquid assets to be livestock,

unencumbered machinery, and land which may not be necessary for the operation. Many such

clients do not have an established 401k program or portfolio of non-qualified assets. The value

of cattle and land remain volatile while the value of machinery and equipment depreciates

rapidly. On the other end of the spectrum, the client may be equally concerned with preserving

the “legacy” of the family ranch. Using conservation easements to restrain the development and

fractionalization of real estate is a valid but potentially radical solution to a concern about

piecemeal sales of the family ranch. A compromise position may be a limited liability company

105 Id.

52

with centralized management which can avoid partition but provide for limited distributions in

kind (at the expense of deep discounts for gifting or estate tax). Beware of tenancies in common

where the income is reported on a partnership tax return. The Revised Uniform Partnership Act

may fold it into a partnership.

In addition, the planner must be aware of the asset protection and preservation motives of

the client. Does the client have multi-state assets? Can the client segregate his personal use

assets from the business assets, often a difficult task if the traditional family ranch has been

owned “all in” by a C corporation but likely necessary to avoid 2036 inclusion? Is state income

tax planning an overriding consideration, as may be the case in a no-tax state such as Wyoming;

is the client also in a high risk profession such as medicine, law or other professions; does the

client have a large amount of high risk assets engaged in trucking, shipping, cattle feeding, oil

and gas or other high risk operations; are the assets to be protected primarily real estate; to what

extent may insurance be used to achieve asset protection and to what extent should “firewalls” of

other limited liability entities be created; are the assets to be created primarily real estate and if

so, are the real estate assets held in a limited liability company, limited partnership or

corporation which business interests themselves could be successfully protected in a domestic

asset protection trust under the laws of the local jurisdiction or another jurisdiction?

Finally, serious consideration needs to be given to whether the family organization will

have non-family members. Make sure that appropriate waivers of conflict and independent

counsel relationships exist. Pay special attention to the drafting of the triggering event/buyout

provisions in stock purchase operating agreements or limited partnership agreements. What is

the net worth of the non-family members and can they dilute with capital all of the family’s

ownership? Is a private placement memorandum possible for a high net worth investor; are

securities being sold over state lines and is an exemption from the state security commissioner

necessary or advisable. Consider obtaining specialty counsel for securities compliance.

An often overlooked aspect of estate planning is maintaining and defending the plan.

Traditionally, estate planners have considered the estate planning engagement, on a legal basis,

to be finite, although in the clients’ mind the engagement is continuing. The initial engagement

is the due diligence and formulation of the will or trust including a business entity, with

healthcare or financial powers of attorney. It is at this juncture that estate planners are

particularly vulnerable to changes in technology which are rapidly changing our profession in the

53

form of do-it-yourself (“DIY”) wills or DIY corporations and LLC’s. Enter a query on Google

for “do-it-yourself wills and trusts” and the first ten entries generate websites including

legalzoom.com, totallegal.com, uslegalforms.com, ca-trusts.com, Quicken Willmaker Plus and

Suzie Orman’s Will and Trust Kit. The Texas legislature amended its unauthorized practice of

law statutes in response to a court decision finding that Quicken Family Lawyer violated the

unauthorized practice of law requiring it to specify that such products are not a substitute for the

advice of an attorney. Legal scholars who have studied the subject recommend that any such

programs affirmatively disclose that the organization selling the product is not a law firm, that

the ethical duties lawyers have to clients may not apply to the transaction between the buyer and

the seller of the product, and that the organization selling such software should be required to file

with an appropriate agency wherever it authorizes its services or products the location of its

principal business and the names and addresses of its senior officers with the fact and the

location of this filing revealed on this organization’s website. Furthermore, if any lawyers have

participated in the creation of the program or its content, their names, business addresses and bar

number status must be posted on the website; or, if no lawyers participated in the content or

creation of the program, then that fact must also be stated.106

Make no mistake about it, the planner must justify to the client, agricultural or otherwise,

that the value of their services are significantly better than anything they can obtain from DIY

internet websites. An initial meeting with the client identifying the clients’ objectives,

explaining the risks of DIY programs cited above, comparing the use of a will or a trust, with or

without entity planning, with or without more advanced estate planning topics such as

irrevocable life insurance trusts or advanced planning techniques, certainly will impress the

client and possibly dissuade them from Quicken Willmaker Plus or Susie Orman’s Will and

Trust Kit.

In addition, the attorney must not only justify the nature and extent of his or her initial

engagement, but also provide a clear basis for the clients’ continuing use of the estate planning

attorney. In this connection, the client should be advised of when and under what circumstances

the estate plan should be reviewed, including death, divorce, inheritance of additional assets,

change in the family structure, or change in tax laws.

106 See Generally Stephen Gillers, A Profession If You Can Keep It, How Information, Technology And The

Fading Boarders Are Reshaping the Legal Marketplace and What We Should Do About It, p. 155 found at

https://ssrn.com/abstract=2026052.

https://ssrn.com/abstract=2026052

54

It is advisable that the attorney send annual letters advising the client to meet with the

attorney to update the estate plan, on an automatic basis. This can usually be done on the basis

that there is considerable continuing uncertainty with respect to the federal gift and estate tax and

clients need to know that they need to continually reassess their plan.

55

Exhibit A

Uniform Law Commission Website on Re ULLCA

http://www.uniformlaws.org/shared/docs/limited%20liability%20company/ullca_fin

al_2014.pdf:

Noteworthy Provisions of the 2006 Act. The Revised Uniform Limited Company Act is

drafted to replace a state’s current LLC statute, whether or not that statute is based on ULLCA.

The new Act’s noteworthy provisions concern:

the operating agreement

fiduciary duty

the ability to “pre-file” a certificate of organization without having a member at the

time of the filing

the power of a member or manager to bind the limited liability company

default rules on management structure

charging orders

a remedy for oppressive conduct

derivative claims and special litigation committees

organic transactions—mergers, conversions, and domestications.

The Operating Agreement: Like the partnership agreement in a general or limited

partnership, an LLC’s operating agreement serves as the foundational contract among the

entity’s owners. RUPA pioneered the notion of centralizing all statutory provisions pertaining to

the foundational contract, and—like ULLCA and ULPA (2001)—the new Act continues that

approach. However, because an operating agreement raises issues too numerous and complex to

include easily in a single section, the new Act uses three related sections to address the operating

agreement: Section 110—scope, function, and limitations; Section 111—effect on limited

liability company and persons becoming members; preformation agreement; and Section 112—

effect on third parties and relationship to records effective on behalf of limited liability company.

The new Act also contains a number of substantive innovations concerning the operating

agreement, including: better delineating the extent to which the operating agreement can

define, alter, or even 3 eliminate aspects of fiduciary duty; expressly authorizing the operating

agreement to relieve members and managers from liability for money damages arising from

breach of duty, subject to specific limitations; and stating specific rules for applying the

statutory phrase “manifestly unreasonable” and thereby providing clear guidance for courts

http://www.uniformlaws.org/shared/docs/limited%20liability%20company/ullca_final_2014.pdf

http://www.uniformlaws.org/shared/docs/limited%20liability%20company/ullca_final_2014.pdf

56

considering whether to invalidate operating agreement provisions that address fiduciary duty and

other sensitive matters.

Fiduciary Duty: RUPA also pioneered the idea of codifying partners’ fiduciary duties in

order to protect the partnership agreement from judicial second-guessing. This approach—to

“cabin in” (or corral) fiduciary duty—was followed in ULLCA and ULPA (2001). In contrast,

the new Act recognizes that, at least in the realm of limited liability companies: the “cabin in”

approach creates more problems than it solves (e.g., by putting inordinate pressure on the

concept of “good faith and fair dealing”); and the better way to protect the operating agreement

from judicial second-guessing is to: increase and clarify the power of the operating agreement to

define or re-shape fiduciary duties (including the power to eliminate aspects of fiduciary duties);

and provide some guidance to courts when a person seeks to escape an agreement by claiming its

provisions are “manifestly unreasonable.” Accordingly, the new Act codifies major fiduciary

duties but does not purport to do so exhaustively. See Section 409. The Ability to “Pre-File” a

Certificate of Organization: The Comments to Section 201 explain in detail how the new Act

resolves the difficult question of the “shelf LLC” (i.e., an LLC formed without having at least

one member upon formation). In short, the Act: (i) permits an organizer to file a certificate of

organization without a person “waiting in the wings” to become a member upon formation; but

(ii) provides that the LLC is not formed until and unless at least one person becomes a member

and the organizer makes a second filing stating that the LLC has at least one member. The Power

of a Member or Manager to Bind the Limited Liability Company: In 1914 the original Uniform

Partnership Act codified a particular type of apparent authority by position, providing that “[t]he

act of every partner . . . for apparently carrying on in the usual way the business of the

partnership binds the partnership . . . .” This concept of “statutory apparent authority” applies by

linkage in the 1916 Uniform Limited Partnership Act and the 1976/85 Revised Uniform Limited

Partnership Act and appears in RUPA, ULLCA, ULPA (2001), and almost every LLC statute in

the United States. The concept makes good sense for general and limited partnerships. A third

party dealing with either type of partnership can know by the formal name of the entity and by a

person’s status as general or limited partner whether the person has the power to bind the entity.

The concept does not make sense for modern LLC law, because: (i) an LLC’s status as member-

managed or manager-managed is not apparent from the LLC’s name (creating traps for 4 unwary

third parties); and (ii) although most LLC statutes provide templates for member management

and manager-management, variability of management structure is a key strength of the LLC as a

form of business organization.

The new Act recognizes that “statutory apparent authority” is an attribute of partnership

formality that does not belong in an LLC statute. Section 301(a) provides that “a member is not

an agent of the limited liability company solely by reason of being a member.” Other law—most

especially the law of agency—will handle power-to-bind questions. Although conceptually

innovative, this approach will not significantly alter the commercial reality that exists between

limited liability companies and third parties, because: 1. The vast majority of interactions

between limited liability companies and “third parties” are quotidian and transpire without

57

agency law issues being recognized by the parties, let alone disputed. 2. When a limited liability

company enters into a major transaction with a sophisticated third party, the third party never

relies on statutory apparent authority to determine that the person purporting to act for the

limited liability company has the authority to do so; 3. Most LLCs use employees to carry out

most of the LLC’s dealings with third parties. In that context, the agency power of members and

managers is usually irrelevant (if an employee’s authority is contested and the employee “reports

to” a member or manager, the member’s or manager’s authority will be relevant to determining

the employee’s authority. However, in that situation, agency law principles will suffice to

delineate the manager or member’s supervisory authority); 4. Very few current LLC statutes

contain rules for attributing to an LLC the wrongful acts of the LLC’s members or managers.

Compare RUPA § 305. In this realm, this Act merely acknowledges pre-existing reality; 5. As

explained in detail in the Comments to Sections 301 and 407(c), agency law principles are well-

suited to the tasks resulting from the “de-codification” of apparent authority by position. The

moment is opportune for this reform. The newly issued Restatement (Third) of Agency gives

substantial attention to the power of an enterprise’s participants to bind the enterprise. In

addition, the new Act has “souped up” RUPA’s statement of authority to permit an LLC to

publicly file a statement of authority for a position (not merely a particular person). Statements

of authority will enable LLCs to provide reliable documentation of authority to enter into

transactions without having to disclose to third parties the entirety of the operating agreement.

(The new Act also has eliminated prolix provisions that sought to restate agency law rules on

notice and knowledge.)

Default Rules on Management Structure: The new Act retains the manager-managed and

member-managed constructs as options for members to use in configuring their inter se

relationship, and the operating agreement is the vehicle by which the members make and state

their choice of management structure. Given the elimination of statutory apparent authority, it is

unnecessary and could be confusing to require the articles of organization to state the members’

determination on this point.

Charging Orders: The charging order mechanism: (i) dates back to the 1914 Uniform

Partnership Act and the English Partnership Act of 1890, and (ii) is an essential part of the “pick

your partner” approach that is fundamental to the law of unincorporated businesses. The new Act

continues the charging order mechanism, but modernizes the statutory language so that the

language (and its protections against outside interference in an LLC’s activities) can be readily

understood.

A Remedy for Oppressive Conduct: Reflecting case law developments around the

country, the new Act permits a member (but not a transferee) to seek a court order “dissolving

the company on the grounds that the managers or those members in control of the company . . .

have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to

the [member].” Section 701(5)(B). This provision is necessary given the perpetual duration of an

LLC formed under this Act, Section 104(c), and this Act’s elimination of the “put right”

provided by ULLCA § 701.

58

Derivative Claims and Special Litigation Committees: The new Act contains modern

provisions addressing derivative litigation, including a provision authorizing special litigation

committees, and subjecting their composition and conduct to judicial review. Organic

Transactions—Mergers, Conversions, and Domestications: The new Act has comprehensive,

self-contained provisions for these transactions, including “inter-species” transactions

59

Exhibit B

2016 NYC Skills Training for Estate Planners ... · in the Northern Great Plains. His firm,...

Documents

Transcript of 2016 NYC Skills Training for Estate Planners ... · in the Northern Great Plains. His firm,...