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When planning their estates, professionals and owners of businesses have a particular problem: how to transfer their accumulated wealth to the next generation. The objective has been to shift wealth to the younger generation without the imposition of gift or estate taxes, while preserving for the older generation control over the business or property transferred (and, thus, control over its future). One such means of achieving this is the family limited liability company (FLLC).

Interests in controlled corporations or real property may be ideal for transfer to an FLLC. Routine gifts of minority (or non-controlling) interests in the FLLC can then be made to younger generations. When the business or property in the FLLC is sold, a portion of its appreciated value passes to the next generation free of gift and estate taxes.

The following is a general discussion of FLLCs; it does not cover all the intricacies of partnership taxation or the associated implications for income, estate, and gift taxes.

An FLLC is typically created when parents transfer property to a limited liability company in exchange for membership interests. While retaining control of the business as the manager(s) of the LLC, the parents can then make gifts of the membership interests to their children.

The gifts of the membership interests are valued at a discount. The rationale for this is quite straightforward: The membership interests lack both control and marketability.

Membership interests lack control -- and therefore are minority interests -- because the members who are not managers generally have no voice in management; cannot control investment policies, distributions, or assets; and cannot force dissolution of the limited liability company. These restrictions make minority interests less valuable.

The lack of marketability derives from the operating agreement, which should be drafted so that members cannot assign their interests without the consent of the manager and so that any transfer of membership interests is subject to a right of first refusal by the limited liability company and/or the other members.

To be recognized for federal income tax purposes, a limited liability company must be organized and conducted in accordance with the requirements of the applicable state law. A formal operating agreement should be drafted, and articles of organization filed with the appropriate authority. If the FLLC will be doing business in other states, it needs to be qualified to transact business in those jurisdictions, as well.

LEGAL FORMALITIES

All formalities of limited liability company law should be followed: All company income should be allocated in accordance with the operating agreement; reasonable compensation should be paid for any services a member renders to the FLLC; tax returns for the company should be filed; and all third parties with which the FLLC will transact business should be advised that a limited liability company has been created.

Formalities of transfer should not be ignored. When stock of a closely held company is transferred to an FLLC, new stock certificates should be issued in the FLLC's name, and an assignment of the stock certificates to the company should be executed. Written instruments of transfer should be used to document the gift of the FLLC interests to the children.

The value of both the property to be transferred to the FLLC and the membership interests to be transferred to the children should be determined by an independent, qualified appraiser. And that appraiser should issue a written appraisal.

In forming an FLLC and subsequently gifting the membership interests, the requirements of Internal Revenue Code § 704(e) must be taken into consideration. Under §704(e), a person is recognized as a partner if he or she owns a capital interest (i.e., an interest originally acquired for money or property) in a partnership in which capital, as opposed to services, is a material income-producing factor, regardless of how that interest was acquired by, or transferred to, the partner in question.

However, a donee of a capital interest is not recognized as a member unless the capital interest was acquired in a bona fide transaction -- i.e., its acquisition was not a mere sham for tax-avoidance purposes. In the FLLC context, this means that the donee/child must have dominion and control over the membership interest transferred. The determination of whether the child has dominion and control is made based upon a review of all facts and circumstances surrounding the transfer.

TRUST OPTION

The FLLC interests can also be gifted to a trust set up for the benefit of the children. The interests would be held and distributed in accordance with the terms of the trust, with the trust having dominion and control over the interests.