If you have not yet inserted a limited liability company (“LLC”) into your overall wealth planning structure, it is time to reconsider. The LLC has emerged as the preferred cornerstone for the private client wealth planning structure because it provides: 1) enhanced asset protection, 2) wealth transfer with estate tax minimization, and 3) the underpinnings of a client’s “family office” structure.
ASSET PROTECTION
If the bulk of your wealth is currently owned in your individual name or by your living trust, it is exposed. A creditor has the ability to readily freeze, attach, and/or liquidate any such assets. When planning for the private client, a principal objective must be to ensure that wealth is insulated and not exposed in this manner. A simple way to achieve this is to retitle the assets away from the individual or living trust into the name of the family LLC.
An LLC is a business entity that affords asset protection on two important levels. First, it protects the owners from any claims against the assets or activities of the LLC. Second, and more importantly, it also protects the assets of the LLC from any claims against the owners (“members”) of the company. This second level of protection, which is not available to corporations, is achieved through what is known as a “charging order.”
A charging order is a specific type of remedy which essentially provides that the creditor of a member cannot attach the assets of the LLC; rather, the creditor may only “step into the economic shoes” of the debtor member. This remedy is very limited and practically useless in the family LLC context. The charging order holder has no right to manage, control, compel, or participate in the LLC in anyway. Therefore, the assets of the LLC (i.e., the private client’s wealth) are safe. However, if, and only if, the manager of the LLC (which is still the client) elects to make a distribution of profits, then, and only then, will the charging order holder actually receive an economic distribution to pay out the judgment.
The client/manager of the LLC will not likely entertain any such distribution of profits during a time when a charging order exists, thereby thwarting the creditor’s attempt to collect into perpetuity. Instead, the client/manager will either elect to retain all profits for further investment, or prefer to distribute funds to family members in the form of compensation, loans, or through direct investment – none of which are available to the claims of the charging order holder. Therefore, with a properly formed LLC, the creditor should have no ability to attach the assets or compel a distribution while the members maintain access to the wealth for their own benefit.
In addition, while unsettled, the current law allows for the position that the charging order holder, while not enjoying any actual distributions, is the appropriate party to receive the proportionate K-1 statement of profits for the economic interest so charged. The result is that the charging order holder, while not receiving any distribution of profits, is obligated pursuant to the issued K-1 statement to pay the taxes associated with the income allocation for such charged interest. Yes, that means that the creditor could pay the taxes of the debtor member. So, confronted with the prospects of never actually receiving any distribution while simultaneously being obligated to pay the taxes for the debtor member, most creditors (and more importantly, their lawyers) are not interested in “winning” a charging order. These charging order benefits can apply equally to business creditors, personal injury plaintiffs, and spouses of descendants in a divorce proceeding – the LLC can serve as a viable substitute to a prenuptial agreement.
In order to achieve this result, it is critical that the client organize the LLC in a jurisdiction which provides the charging order is the “exclusive remedy” for any creditor of a member, and that no other remedies are available at law or in equity. In addition, the drafting of the governing documents is very sensitive to ensure the appropriate asset protection provisions appear in the operating agreement and minutes to effect the desired result.
WEALTH TRANSFER AND ESTATE TAX MINIMIZATION
The ongoing challenge of the private client is to determine when and in which manner wealth should be transferred to the next generation and beyond. Instead of directly transferring the asset, or transferring through one of the many available trust options, the LLC should be interposed as owner of the assets. Using an LLC as a wealth transfer mechanism offers the following advantages: 1) the LLC management retains control of the assets, 2) the assets are more easily divisible, 3) the gifted interest is likely subject to significant valuation discounts.
Gifting an LLC membership interest is superior to gifting the actual assets since the LLC retains ownership of the underlying assets while management of the LLC remains separate. This fundamental split in ownership and control allows a donor to “part” with the economic value of assets for wealth transfer purposes, while still ensuring the assets are under the desired control and not subject to depletion by the donee. In addition, the LLC provides a practical benefit in that it is much easier to carve up assets by doling out fractional membership interests in the entity that owns the asset as opposed to actually carving up the assets (e.g., physically carving up boats, vacation homes, and collectibles may not be possible or practical).
From a tax perspective, perhaps the most compelling aspects of the LLC are found in the ability to take significant valuation discounts when assessing the value of the LLC membership interest subject to a gift or sale. Specifically, it is well established that the reported value of the typical LLC membership interest may be reduced for: 1) lack of marketability, and 2) lack of control. Since the LLC interests are not “marketable” in that they are not traded on an exchange and do not have a readily ascertainable fair market value, and since the transferred membership interests are likely minority interests without control over the entity, the interests may be reported to be worth much less than their proportionate share of the LLC’s book value. Reasonable discounts for each of the foregoing items generally results in a 25%-35% reduction in value of the asset transferred.
The effect of such discounts can be quite dramatic. For example, assuming a 30% valuation discount and an LLC with $15 M of portfolio assets, the reportable value of the membership interests gifted to descendants would be reduced to $10M. With today’s gifting exemption of $5.25M per taxpayer ($10.5M for a married couple), this means that a client could effectively transfer $15M, reported as $10.5M – with no gift tax whatsoever.
FAMILY OFFICE PLANNING
Managing one’s personal wealth has become a business in and of itself. Therefore, it is logical that the wealth plan should reach beyond wills and trusts, and pull from corporate law for a more elegant solution. Transitioning wealth from your typical trust structure into an LLC provides the core platform to establish a customized “family office” or “virtual family office.”
As wealth planning has become more sophisticated, the private client is more commonly leveraging the notion of a family office to better plan for dynastic wealth. Whether the client is large enough for a dedicated single family office structure, in which the multiple functions are internally employed and managed, or whether much of the professional and administrative function is substantially outsourced in a “virtual” family office structure, the long-term results are compelling.
With the well-documented trend toward dissipation of wealth and family harmony through the generations, most private clients are seeking to establish a mechanism whereby they can be assured that their wealth is not a destructive and fleeting inheritance, but rather a long-term investment and development opportunity for descendants. An entity form, with carefully crafted governance provisions, can provide the perfect solution to counter the typical trustee-beneficiary imbalance that often plagues the private client’s multigenerational plan.
The LLC is the most flexible legal form available from both a legal and a tax perspective. It can be managed by the owners (“members”), or by an appointed manager, or by a board of managers. In larger family mandates, a board of advisors may also be incorporated. In addition, it is not uncommon to include both family and nonfamily members on either the management committee or the advisory board. Inclusion of professionals from different disciplines who do not have an emotional tie to the wealth or the family members involved can be very instrumental in protecting the progress of the family wealth. The management of the LLC, generally governed by the “business judgment rule,” allows greater flexibility for investing in family members or in alternative investments than with the “prudent investor” rules followed by a typical trustee. This can allow the family wealth to better serve the family as a “family bank” offering, or allow for enhanced return in investments that a typical trustee may avoid for its own protection.
The goal with the family office is to bring a business discipline to the forefront of the wealth plan. A properly formed and implemented LLC can ensure that the next generation is better engaged, better reared, and better prepared to handle the wealth with a higher level of involvement and responsibility. Most importantly, it formalizes the wealth plan as a family business mission and not as a trust entitlement.
By: James M. Duggan, JD
