Family Limited Liability Companies
Persons who own vacation houses or apartments in desirable locations often want to share the benefits of such properties with their children or other family members. Use of a limited liability company (LLC) may enable an owner to transfer interests in property to others at a significantly reduced tax cost and avoid family disharmony at the same time.
Ownership vs. Control.
Interests in an LLC are represented by fractional shares or units. For example, if an LLC is created with 1,000 units, a holder of 100 units owns an undivided one-tenth interest in all of the assets of the LLC. LLC units can be gifted, allowing ownership to be spread among family members. Significantly, however, an LLC can be structured so that control for purposes of making business decisions and managing assets can be retained by one or more individuals, called managers. Owners of LLC interests who are not managers are referred to as members.
Assume Mr. and Mrs. Smith own a vacation home. They have two adult children and four adult grandchildren. Although the Smiths would like to share their property with family members, they would like to keep control of the property to make sure it is maintained to their standards. The Smiths create an LLC and transfer the property to it along with $5,000 of cash for expenses. Ownership of the property is now represented by 1,000 units in the Smith Family LLC. Mr. and Mrs. Smith each own 500 units and name themselves as the LLC managers. Over the years, they transfer units to each of their children and grandchildren, so that each owns a percentage of the property. This reduces Mr. and Mrs. Smith's taxable estates, but they retain control of the property.
Restrictions on Transferability.
LLCs can restrict the ability of members to transfer their interests in the LLC. A common restriction in a family LLC is to prohibit transfers to anyone other than family members, or to require that before any transfer can be made to a non-family member, the family members must be given an option to buy out the interest of the person wanting to make the transfer. These restrictions, and other provisions relating to how the LLC will be organized and operated, are contained in the LLC's Operating Agreement.
Gift Taxes and Valuation Issues.
The value of a small minority LLC interest, when coupled with restrictions on transferability, is less than its proportionate share of the total value of the LLC, so case law and IRS rulings have allowed valuation discounts ranging from 10% to 45%, depending on the specific facts involved. As a result of the ability to transfer fractional interests and to discount the value of those interests, families can significantly reduce (and, in some cases, eliminate) the tax burden involved in transferring properties to the next generation.
Assume the Smiths' property is worth $395,000, so that the LLC has total assets of $400,000 (i.e., the property plus $5,000 cash), and that the LLC OperatingAgreement strictly limits transfers of units to anyone other than lineal descendants of Mr. and Mrs. Smith. Each of the 1,000 LLC units is initially valued at $400 a piece. In 1999, Mr. and Mrs. Smith each give 30 LLC units to each of their two children and four grandchildren. Because of the restrictions on transferability and the small minority interest represented by 30 units, the Smiths each discount the value of their respective gifts by 25%. Thus, on their gift tax returns, they both show gifts to each family member valued at $9,000 computed as follows: 30 units x $400 per unit = $12,000; $12,000 -- 25% discount = $9,000. Each gift is within the donor's current annual gift tax exclusion amount of $10,000 per recipient per year.
Notably, if the Smiths make similar gifts each year, they could give away their entire LLC interest to their children and grandchildren over a period of three years at no gift tax cost. Sometimes, however, a donor will prefer to retain a fractional interest in the property so as to avoid having to pay fair market value rent for use of the property.