Business Formation and Transactions
The use of limited liability companies nationwide has become very popular based on the many advantages and the increased flexibility that comes with these types of entities. Below is a little of the history and the benefits that are available, especially to small businesses and families, through the use of limited liability companies.
Holding Real Property. The Limited Liability Company (LLC) is an alternative form of business organization that combines certain features of the corporate form with others more closely resembling general partnerships. The purpose of originally creating the entity now known as a LLC came about in Wyoming in 1977, the least populated state within the United States in order to allow mining companies an alternative to the then-existing choices of a corporation with all of its formalities and a partnership with its limitations. In 1988 the IRS finally rules that a limited liability company could be taxed as a partnership, depending on whether or not it met a multiple pronged test including centralized management, stock, what happened upon the death of a Member etc. The principal purpose of this type of entity was to provide limited liability and flexibility. The “check the box” regulations which were later adopted in 1996 and provided the more or less IRS’s final blessing on the flexibility of LLC’s.
In my practice, I generally see that the principal use of limited liability companies is to hold real property, especially when such property is income producing property. For example, I would always recommend to my client’s to hold income-producing properties such as apartment complexes, motels, hotels, gas stations, strip centers, offices or retail spaces within a LLC rather than their own personal name or in a partnership or corporation. One of my clients purchased a motel in Moab, UT where the Seller has held the real property and business in their personal names. This exposed the Sellers to personal liability from any personal injuries, contractual disputes or other litigation arising out of the operations of the motel. Not having an LLC put their personal assets at risk if there was any liability that needed to be satisfied. I recommend that my clients not make the same mistakes as the Sellers and put the real property and business in an LLC. Because this is what I call “two way liability protection” which does not exist in a corporation or in direct ownership. It does exist with a partnership, but the partnership structure is much more complicated to accomplish the same thing as I will explain.
The reality is that a limited liability company can be used theoretically in place of any type of entity that you can think of: including irrevocable trusts, revocable trusts, corporations, partnerships limited/general, Tenant in common or TIC agreements, HOA’s, charitable organizations.
Limited liability. In an LLC the statutory liability protection in each state which exists with respect to the Managers and Members of a Utah limited liability company. This is the limited liability that we are all familiar with. Basically no creditor of the Company can seek to recover from the Manager or Members of the Company because of their relationship with the Company. This is very similar to the statutory language which provides limited liability for corporations.
However, with a limited liability company, there is a second type of liability protection which is unique to limited liability companies and partnerships. That is that a creditor of any Member is also prohibited from executing upon or taking away the Membership Interest of a debtor or other obligor in any collection process. The rights of a creditor of any Member is limited to the “exclusive” remedy of a Charging Order.
Not subject to Garnishment or Attachment/Charging Order. Most state statutes also prohibit any garnishment or execution on an individual Member’s Membership Interest in and to a limited liability company. What all of this means is that a creditor cannot take away from a debtor the Membership Interest of the debtor in a limited liability company. The Creditor only succeeds to the interest of the debtor in any distributions.
Flexibility. As noted in the reason for the creation of limited liability companies, there is a great deal of flexibility in the formation, use and operation of limited liability companies which do not exist with corporations or partnerships. For example, there is no statutory requirement of regular or annual meeting with a limited liability company like there is with a corporation. There is also no need to have a meeting and vote to continue the existence of a limited liability company following the death of a Member like there is with a limited partnership. Another example of flexibility with a limited liability company is that it may be member managed or manager managed, it can even make distributions with do not track with the ownership of the company which is impossible with a corporation.
For example, parents may contribute property worth $100,000 to a limited liability company and retain ownership of only 10% of the Company, but receive all gains and distributions from the Company for a term certain or for the entire existence of the Company.
A person could only own 5% of the company, but can make 100% of all decisions for the company.
Tax Benefits. A key tax benefit with a limited liability company in owning real property is that property can be contributed to the limited liability company without any tax consequence and then can be removed without a tax liability. On the other hand, if property is placed in a corporation, whether C or S, then upon removal of the property it must be treated as a sale or exchange and taxes must be paid accordingly.
Limitations. There are a few types of property which really should not be placed in a limited liability company. For example one should be very cautious about placing a personal residence into a limited liability company. First of all the placement of a personal residence into a limited liability company in my opinion would interfere with the designation of the residence under the Homestead Exemption. Also, if one places a residence into an limited liability company then that individual should also enter into a lease agreement because it makes no business sense and would violate the business purpose of the entity to hold real property and allow someone to live there free of charge.
Holding Personal Property. Limited liability companies are very well suited to hold may types of personal property as well. It is common practice for individuals to form a Montana limited liability company in order to hold title to RV’s, boats and planes, in order to avoid personal property taxes on these types of assets.
As a Valuation “Freeze” Entity. In past years the use of a limited liability company has been very prevalent in estate planning and specifically in avoiding estate taxes on larger estates. The various uses of a limited liability company in estate planning is discussed more fully in the following section. The present use of a limited liability company in order to “freeze” the value of an asset has, in today’s world, is much more limited. This is in great deal because of the current estate tax exemptions which are in excess of $11 million.
The use of a limited liability company to freeze the value of an asset or assets worked basically as follows. An individual or couple would identify an asset or assets which were expected to experience explosive growth such as tech stocks of property which was ripe for development. The asset would be placed in a limited liability company and in many events the original grantors would then gift interests in the limited liability company to family members, primarily children. The gifting was done in short order and in many cases intended to take up the entire estate tax exemption.
The idea is to take advantage of gifting discounts since interests in a limited liability company can be structured to create a lack of marketability and a lack of control. The interests can be discounted in some cases up to 40% of what the equivalent value of a pro rata share of the real property would be. Then the asset experiences explosive growth outside of the estate of the grantors, being shared by many family members and also allowing any income to be divided among taxpayers at a lower tax rate. All of this while providing an additional layer of liability protection for the family members.
Estate Planning Options. One of the purposes of estate planning is to provide for the smooth transition of ownership between generations and to provide liability protection to families. Both of these can be accomplished in a limited liability company better than any other entity available. For example, an irrevocable trust can provide for the management of assets as they pass from generation to generation as well as liability protection. However, an irrevocable trust is irrevocable and cannot be changed except usually with court approval and the approval of the Settlors, Trustees and Beneficiaries. However, a limited liability company can provide even better liability protection and can also provide for succession planning and can remain fully or partially amendable. Plus it is more easily accepted and recognized by title companies, banks, buyers and others.
One other situation which is best suited for a limited liability company is the situation of a family farm or family business. Imagine that you have a family that owns a dairy farm which was originally obtained and operated by mom and dad. Then two sons come along and participate, expand and increase the value of the farming operation. There are other siblings who have their careers and do not participate in the farming operation. How do we provide for the transition between generations and still treat each child of the original owners equally or equitably.
First of all, placing the farm operation into a trust makes no sense as there is no liability protection for the farm assets from liabilities of individuals and there is not protection for the individuals from liabilities arising from the farm operation.
Second, we need to have the two sons each receive some ownership in order to reflect their contribution to the operation and allow them to participate in the increased value of the operation over time. However, we do not wish to cut out the other siblings altogether. This is assuming that the farm is the only major asset of the family.
It makes no sense to divide up the operation among the siblings as it cannot function without all of the assets being used together.
So the bottom line is we place the assets and business operation into a limited liability company with the parents having management control during their lifetimes. Then we provide in the Operating Agreement for the transition of the management to the involved sons. We then include the other siblings to a lesser amount in order for them to receive a share of profits and distributions. Then the operation can continue for generations without interruption and all benefit.
In the above-described scenario it would be imperative that the family member working actively in the farm operation to also be paid a fair wage for all work done on behalf of the company which should be included in an employment agreement.
For Life Insurance. A limited liability company can also be easily used in place of the old traditional irrevocable life insurance trust. The limited liability company again has all of the flexibility and advantages over an irrevocable trust as mentioned before. However, for a limited liability company to function in place of an ILIT, it is necessary to assure that the Insureds (the parents) do not hold Membership or Management control of the entity. Theoretically they could own a Membership Interest, but the whole point of an ILIT or Life Insurance limited liability company is to make sure that the entire asset is outside of the estate of the original grantors. This can only be accomplished if the grantors do not take back an interest in the limited liability company, or act as managers.
Limited liability companies are very useful and if structured properly can also serve as a vehicle for raising capital for all kinds of projects, joint ventures and in lieu of corporate subsidiaries especially where the holding of real and personal property is involved.
Thank you to the business formation and dissolution lawyer from our friends at Clarkson & Associates, LLC for the above blog.