Limited liability companies and family business

Originally published in The Journal Record on Aug. 26, 1999.
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Elizabeth K. Brown’s practice is focused at a strategic level on serving her clients as outside counsel where she assists privately held companies in managing the many legal issues that arise in running a business.

Elizabeth K. Brown’s practice is focused at a strategic level on serving her clients as outside counsel where she assists privately held companies in managing the many legal issues that arise in running a business.

Have you noticed that many new businesses are being formed as limited liability companies instead of corporations or partnerships?

Have you wondered what the reason is for the change?

Have you wondered whether you should explore the possibility of using a limited liability company in your family business?

In recent years, the use of the family LLC has become increasingly popular in the business world as the entity of choice, surpassing the corporation and the partnership.

The reasons for its popularity include that it provides asset protection to the owners of the LLC, has income tax advantages over the corporate form of business and is a convenient vehicle for effectuating a succession plan including giving assets to family members.

Until 1992, there was no such thing as a limited liability company in Oklahoma. Other states had experimented with the concept of creating a business entity that combined the best features of a corporation and a partnership.

In 1992, the Oklahoma Legislature decided to create this new type of business entity and enacted a statute governing its existence and characteristics. Since that time, thousands of new Oklahoma LLC’s have been formed.

The reason for the limited liability company boom is the advantages that the LLC provides over both corporations and partnerships.

Like a corporation, the LLC has the corporate characteristic of providing a liability shield to the owners of the business. Generally, as with a corporation, the creditors of a limited liability company cannot reach the assets of its owners.

For example, if the LLC operates a retail business and a customer slips and falls in the store, the customer may be able to recover from the assets of the LLC, but should not be able to recover from the assets of the LLC owners.

Like a partnership, the LLC provides asset protection to the business itself from the claims of a creditor of the owner of the LLC. While a creditor of a shareholder of a corporation can obtain a judgment against the owner and levy on the stock of the corporation, a creditor of an owner of an LLC can only obtain a charging order against the owner’s interest in the LLC. A charging order only entitles the creditor to receive the owner’s share of distributions from the LLC when made and does not entitle the creditor to become an owner of the LLC or to any voting rights in the LLC.

This asset protection aspect can be quite advantageous to the business owner when the business owner has creditor problems of his own.

For example, if the LLC owner has an outstanding judgment against him personally for $25,000, his judgment creditor would not be able to take his ownership interest in the LLC to satisfy the judgment. Instead, all the creditor would be entitled to receive is the distributions that are made from the LLC to the owner.

Since oftentimes no distributions are made to owners of closely held businesses and instead the profits are reinvested in the business, a creditor of an LLC owner may not be able to collect on any part of his judgment against the LLC interest.

Another advantage of the LLC is that it generally is a flow-through entity for income tax purposes since it is taxed as a partnership.

Many family-owned businesses historically have been operated through a C corporation, which is a separate taxable entity. The problem with the C corporation is that dividend distributions are not deductible by the corporation, so there is the possibility the corporate earnings could be taxed twice before they reach the owner’s hands, once at the corporate level and again at the shareholder level when dividends are paid. As a flow-through entity for income tax purposes, the LLC reports its income on a separate income tax return but pays no income tax. Instead, each owner of the LLC reports his or her prorata share of the income from the LLC on their separate individual income tax returns. The result of partnership taxation is that the income from the LLC is only taxed once.

An important concern for a family business owner is planning for the transition in ownership and management of the family business to the younger generation and the effect of estate taxes on the assets of the business owner. LLCs can help out here, too.

The LLC structure can facilitate the shift in control from the business owner to the child or children who have been groomed to take over the family business when the time arises.

Many family businesses face a cash crisis on the death of the survivor of the business owner and spouse as a result of the estate tax imposed.

With proper planning, the combined estate of a husband and wife are exempt from estate tax up to a value of $1.3 million in 1999. For family businesses that have a value in excess of $1.3 million, business owners need to consider other estate planning techniques to reduce the value of their taxable estates.

One such technique is making annual gifts to children of a portion of their ownership interest in the family business. By making gifts of interests in the family limited liability company, the business owner can substantially reduce the size of his estate and still retain control over the family business.

A big concern of many business owners is that they may lose control over their family business if they give away ownership interests in it. Using a family limited liability company for making gifts can alleviate many of those concerns.

One method for retaining control by the family business owner is by having him or her hold the position of manager of the limited liability company. As the manager, the owner of the limited liability company has authority to control the operations of the business. By a contract called the operating agreement, the business owner can be assured that he will remain as manager for as long as he desires.

Another method for the business owner to maintain control over the family business is by giving away ownership interests that do not have voting rights. By retaining his or her voting rights, the business owner can maintain control over the business but still reduce the value of the estate by gifting the non-voting interests.

With LLCs, more value can be transferred to family members at a reduced gift tax cost by making gifts of an ownership interest in a limited liability company as opposed to gifts of individual assets.

This is because a minority interest in a closely held business is typically not worth as much as the prorata part of the value of the underlying assets of the business. For example, if the business itself is worth $100,000 and the business owner gives a child a 10 percent interest in the business, the gift is worth something less than $10,000.

In determining the value of the gift, the test is what a willing buyer would pay a willing seller for the minority interest. It is well recognized that a buyer will not purchase the minority interest in the limited liability company for an amount equal to the prorata part of the underlying assets of the business — $10,000 in this example. The reason a buyer would pay less than $10,000 for the interest in the limited liability company is that there is no ready market for the minority interest in the family business — discount for lack of marketability — and the minority interest owner cannot control the business — discount for minority interest.

A buyer may substantially discount the amount he would pay for the limited liability company interest because of these factors. Assuming a discount of 30 percent, the buyer would be willing to pay only $7,000 for a 10 percent interest in a limited liability company having assets worth $100,000.

These valuation techniques can be utilized with limited liability companies to provide a bigger benefit to the business owner from certain gift tax exclusions available under the tax law.

One such exclusion, the annual exclusion, allows the business owner to annually give up to $10,000 — $20,000 for the business owner and his spouse — to any one or more individuals without any gift tax consequences. If the business owner wan
ts to reduce the value of his estate by making annual exclusion gifts to his children, he could for example give a child a $10,000 interest in the family limited liability company with no gift tax consequences. A $10,000 gift in the family limited liability company may equal a 13 percent interest in the LLC worth $100,000.

By giving away an interest in the family limited liability company, the business owner can transfer assets which in his hands would be worth about $13,000 for a gift tax cost of only $10,000. Over time, the business owner can transfer a substantial amount of the family business to family members at a reduced gift tax cost and still remain in control of the business.

As you can see, utilizing a family limited liability company in the succession and asset protection plan for the family business can result in tremendous advantages to the business owner and family. The key to designing and implementing a plan that fits your family business is working with your lawyer, accountant and financial planner. Your team of advisers can evaluate your personal situation, recommend a plan that is right for you and your family and then see that the legal documents necessary to effectuate the plan are put in place. Limited liability companies may not be right for every family business, but with the advantages they hold, don’t you think it is worth exploring the possibilities?