Level 3 Planning - Family Limited Liability Companies and Valuation Discounts
Situation
There is a projected estate tax liability that exceeds the life insurance inside irrevocable trusts.
Objectives
- Use the federal gift tax exemption to make lifetime gifts. Gifts can be of real estate, closely held stock, or publicly traded stocks and bonds. Thus, the future appreciation on the gifted property is effectively removed from the estate.
- Take advantage of valuation discounts (for lack of control and marketability) so that (with a 30% discount) $2,857,143 of gifted assets can be "reduced" to $2,000,000 for gift tax purposes.
- Maintain total control over the gifted property in the hands of the donor.
- Shift income to children and/or grandchildren who may be in lower income tax brackets.
Tools & Techniques
- Family Limited Liability Companies ("FLLCs").
- Valuation Discounts.
Disadvantages
- Transfers to FLLCs are irrevocable.
- Donor loses the income allocated to the donee members.
- Donor's heirs lose stepped-up basis on appreciated property transferred to the FLLC.
Family Limited Liability Companies
A family limited liability company ("FLLC") is established as follows and will provide the following benefits:
- A donor transfers marketable securities or assets (e.g., building or equipment) to a FLLC. The donor may use multiple LLCs to further limit liability (i.e., one LLC for real estate, and another for marketable securities).
- The donor is the "manager" and in that capacity owns a small (1%-5%) membership interest in the FLLC.
- The donor's spouse, children and/or grandchildren (or trusts for their benefit) are gifted the non-managing membership interest, and in that capacity own the balance (95%- 99%) of the FLLC.
- The Tax Court recognizes a minority discount from the full value of the membership interests gifted to children and grandchildren because such interests do not have any control over the FLLC and lack marketability. Discounts of 25% to 40% are typical, but must be determined by a qualified appraiser, higher discounts create greater scrutiny by the IRS.
- The FLLC can lease equipment or buildings to the donor's corporation, or to any other person or entity.
- As manager, the donor has exclusive control and management of the FLLC's business and assets. The operating agreement permits the manager to accumulate (as opposed to distribute) profits, and the operating agreement also permits the manager to pay himself/herself a reasonable management fee.
- The FLLC's profits are allocated to the members in proportion to their ownership interests even if not distributed. If the members are in a lower tax bracket than the donor/manager, an income tax savings will result.
- Only the value of the donor/manager's membership interest is included in his or her gross estate - despite the fact that he or she "controlled" the FLLC.
- The initial assets transferred to the FLLC plus any after-tax earnings and appreciation thereon, are removed from the donor/manager's gross estate (except to the extent of the donor/manager's membership interest).
- Assets in the FLLC are difficult for the creditors of a member to reach.
- The donor/manager's Crummey/Dynasty Trust can be made a member. Thus, the FLLC's income can be used to pay premiums without having to use any of the donor/manager's $11,000 annual gift tax exclusion.
Note: In some states a family limited partnership instead of a FLLC may be preferable to accomplish the same results. Seek out an experienced estate planning attorney for the best type of arrangement for your situation.
Click on the image below for a larger view of the family limited liability companies diagram.
Special Section
The Charitable Remainder Trust
A Charitable Remainder Trust ("CRT") enables an individual to make a deferred gift to charity, usually of appreciated assets such as marketable securities, real estate and closely held stock, while retaining a right to payments from the CRT. Since the CRT is a tax exempt entity, when it sells the appreciated assets it does not pay any capital gains tax. This results in increased cash flow to the donor (and the donor's spouse). Moreover, the donor is entitled to an immediate charitable income tax deduction resulting in reduced taxes. Finally, upon the death of the donor (and the donor's spouse), the assets in the CRT pass to the designated charity estate tax free!
The CRT can be a unitrust or an annuity trust. A unitrust would provide for the donor to receive a variable payout of a set percentage (at least 5% but not more than 50% of the initial fair market value of the trust's assets) of the CRT's annual value, whereas the annuity trust would provide for the donor to receive a fixed payout of a set percentage (at least 5% but not more than 50% of the initial fair market value of the trust's assets) of the initial value of the CRT.
Either type of CRT can require that payments be made for the lives of the donor and one or more persons, such as the donor's spouse.
The donor (and the donor's spouse) can act as the trustee(s) of the CRT, and can control and manage the trust corpus. If non-marketable assets (land, closelyheld business interests) are contributed to the CRT, an independent co-trustee is required. In managing the trust assets, the trustee(s) can not be obligated to a pre-existing contract to sell trust assets. Property with verbal pre-existing contracts might also be viewed as obligating the trustee(s) to sell, and are generally not appropriate assets for a CRT. The trustee(s) have a fiduciary responsibility to manage the trust assets not only for the benefit of the income beneficiaries (donor(s)), but also the charitable remaindermen. It is also best to allow time to pass before selling highly appreciated assets and diversifying them into higher income producing assets.
The income tax deduction is the present value of the remainder interest passing to charity (which must be at least 10% of the initial fair market value of the trust's assets), and is based on the age of the donor (and the donor's spouse), the selected payout, the amount contributed to the CRT and the IRS' assumed rate of return (published monthly). For example, an older donor and a smaller payout will result in a larger charitable income tax deduction, and vice-versa.
Upon the death of the surviving spouse, assuming there are no other income beneficiaries, the balance in the CRT passes to the designated charity free of estate tax because of the unlimited charitable estate tax deduction. Thus, at first blush, it would appear that the donor's children are being disinherited. However, simultaneous with the creation of the CRT, the donor will usually establish an Irrevocable Life Insurance Trust for the benefit of his/her children. This is sometimes called a "Wealth Replacement Trust." A married donor will typically use a second-to-die life insurance policy in his/her Wealth Replacement Trust. The donor will use the tax savings from the charitable income tax deduction and the increased cash flow resulting from the use of the CRT to make gifts to the Wealth Replacement Trust, thereby providing for the "replacement" of the property eventually passing to charity.