Beware of Standard Provisions in LP & LLC Documents

They can inadvertently divest your client’s family from controlling the business or cost millions in additional estate, gift or income taxes!

beware-of-lp-llc-documents-ed-morrowBy Edwin Morrow, J.D., LL.M., MBA, CFP®, RFC®

Investors increasingly use limited liability companies, limited liability partnerships or limited partnerships (“LLCs”, “LLPs” and “LPs”) to operate a trade or business, to hold real estate or hold other investment assets, as opposed to state law corporations. When only immediate family are owners, these are often referred to as family limited partnerships or limited liability companies (“FLPs” and “FLLCs”). There are numerous business, asset protection and estate planning reasons for using these newer entities (lumped together for simplicity here as “LLCs”), over old-fashioned corporations (whether “C” or “S” corporations).

There are two frequently overlooked issues, however, when investors transfer LLC interests to a spouse, children, trusts or others, as opposed to ordinary corporate stock. The first issue may lead to loss of control of the business, especially when there are co-owners outside the immediate family. The second issue may lead to decreased basis for heirs, and a corresponding increase in the beneficiary’s income tax. Understanding these two aspects of LLCs is even more crucial today because of the increased use of LLCs for asset protection and the increased gift, estate and generation skipping transfer tax exemption (currently $5.34 million, adjusting annually for inflation, to $5.43 million in 2015).

These issues mainly stem from a stark difference between LLC/partnership law and corporate law and the concept known as “assignee interests”. Let’s explore how these differences lead to better asset protection for LLCs than ordinary stock, but how they may lead to adverse economic and tax results if investors are not alert.

An LLC owner (called a “member”, not a “stockholder”) has two bundles of rights:

  1. Economic rights – which are the rights to receive property from the LLC both during existence and upon liquidation, along with tax attributes and profit/losses; and
  2. Management rights – the right to vote, participate in management or conduct of company affairs and have access to company reports, records and accountings.

It is the latter category that can cause problems when transferring LLC interests by gift or at death, and the division of these two bundles of rights are important in distinguishing from ordinary stock (although corporations may have voting/non-voting shares and C corporations may have preferred stock).

Members of an LLC usually establish an Operating Agreement to set the rules for transfer of interests. State statutes (such as the Uniform Limited Liability Company Act) usually provide default rules where the document is silent (or nonexistent).

The problem occurs when an LLC member transfers a portion of his or her ownership interest in the LLC to another person, either during lifetime or at death. At that point, the transferee may become a mere assignee of the LLC interest, and not a full substitute member. Under the laws of most states, unless the Operating Agreement provides or parties otherwise agree, an assignee only receives the transferor’s economic rights in the LLC, but not the management rights (see, e.g. Uniform Limited Liability Act §502). The management rights may be lost (Id. §602(5(B)).

In fact, some court cases require member consent even if the operating agreement seems to otherwise permit such transfers (Ott v. Monroe, 719 S.E.2d 309, 282 Va. 403 (2011). These state laws were enacted to protect business owners from unwillingly becoming partners with someone they never intended or contracted to be partners with.

This treatment is completely different from transferring state law corporation stock (whether C or S) – when you buy P&G stock, you get the same rights as the previous owner. S Corporation stock is not even allowed to have differing classes of ownership interests (although voting/non-voting is permitted). Usually, this feature in the law has numerous asset protection benefits to LLC owners, because the charging order protection stymies both creditor and debtors alike. However, it can cause havoc to one’s business and tax planning in unforeseen circumstances.

Examples of Inadvertent Loss of Control

#1 – Able and Baker, unrelated parties, form and operate an LLC. Able owns 49% and Baker owns 51%. Baker has a controlling interest in the LLC. Baker dies and his 51% interest in the LLC is transferred to his revocable (now irrevocable) living trust. Now, the trust is a “mere assignee” and while the trust receives 100% of Baker’s economic rights in the LLC (51% of the total LLC economic rights), it has none of the management rights (although a personal representative of a deceased member may have some additional information rights) . After Baker’s death, Able may have 100% of the LLC’s management rights. The trustee and Baker family may have serious difficulty even getting books, contracts and records of the LLC, much less have any say on reviewing Able’s business decisions for the LLC (including new hire and new salary expectations).

#2 – Same ownership structure as above, but Baker leaves assets via Transfer on Death designation or via Will to his spouse, children or others directly. Same result.

#3 –  Same ownership scenario as above, but Baker gifts his membership interests during life to his spouse, children, UTMA account or an irrevocable grantor trust. Same result.

#4 – Same scenario as above, but Baker simply transfers his shares to his revocable living trust (called “funding”) via Schedule A attached to his trust or other valid assignment, or to an incomplete gift irrevocable trust, such as a DAPT or a DING. Same result.

#5 – Same scenario, but Baker owns 1-99.9% prior to transfer, Able the remainder. Same result.

#6 – Same scenario, but Baker got express permission of Able to transfer his LLC interest to his revocable living trust during life and have it remain a full substitute member. No issue – until Baker dies and the LLC interests pass to a new irrevocable subtrust, such as a bypass, marital, QTIP, or other irrevocable trust, or to beneficiaries outright. Able must have agreed to this subsequent transfer as well, otherwise the transfer to the new subtrust or heirs will be a mere assignee interest and the Baker family loses control.

Creditor Issues

Again, Able and Baker own 49%/51%. Baker has some creditor issues from an unrelated tort claim or co-signed loans unrelated to the LLC. He files bankruptcy to reorganize or get a clean start (or perhaps the creditor forces a bankruptcy). This is probably another trigger that causes Baker to lose all of his management rights in the LLC (although this brings up more complicated issues such as whether the bankruptcy trustee becomes a member that are beyond this article – see bankruptcy code sections 541(c)(1) and 365(e) discussion of “ipso facto” clauses and executory contracts).

Incapacity Issues

Again, Able and Baker own 49% and 51% economic and management rights respectively. This time, Baker has a stroke or an accident and his wife or one of his family takes over as guardian or conservator. Similar result. Able can now asset 100% controlling management rights, even though Baker still keeps the same economic rights. He can fire Baker and raise his own salary.

Estate/Gift Tax Issues

Able and Baker’s company is worth $10 million. Baker’s 51% interest gets marketability discount, but a controlling premium, so valuation experts and the IRS agree it is worth $4Million. Able’s 49% interest gets a marketability and lack of control discount, so his interest is only worth $3 million (valuation experts, please excuse my simplification). Yet when Baker dies, he leaves this 51% interest to his spouse (or marital trust) as a mere assignee, and because the interest has no voting control or management rights, it may be worth only about $3 million in the hands of the spouse or marital trust (because there is no “control” or management rights, the 51% is worth considerably less). Thus, Baker’s 51% interest is taxed at $4 million, but only gets a $3 million marital deduction. Did $1 million in value inadvertently pass to Able? At best, this wastes Baker’s estate tax exemption. At worst, it may lead to an additional 40% tax and/or up to 20% state estate tax (and perhaps penalties, since it may be unreported and caught on audit) on $1 million.

This same issue arises in gifting shares to a spouse or to a trust for a spouse that is intended to qualify for the marital deduction. The same would of course hold true for the charitable deduction, if LLC interests are transferred to a charity or charitable trust – the lack of management rights may reduce the value of the deductible gift.

In addition, gifting a mere “assignee” interest risks disqualifying any gift of LLC interests for the “present interest” annual gift tax exclusion under IRC §2503(e) ($14,000 per donor per donee) pursuant to the recent IRS victories in the Hackl, Fisher and Price cases.

“Step up” in Basis – Do LLC restrictions overly limit the basis increase heirs may be eligible for?

All of the above default provisions and clauses typically inserted into LLC agreements to restrict transfers lead tax attorneys to prefer LPs/LLCs for maximum valuation “discounts”. Causing LLC interests to be valued less for tax purposes may save 40% estate tax (or perhaps more, in states with a separate estate and/or inheritance tax), for larger estates. However, the price for this reduction in value is a corresponding reduction in basis adjustment at death. For those LLC owners with less than $5.43 million estates ($10.86 million if married), this reduction in valuation for estate purposes can actually harm the family by reducing the amount of basis increase at death. Since LLCs often contain depreciable property, this can be a much greater tax benefit than the step up in basis as to other property.

Example #1: Mr. Able owns 50% of an LLC with Mrs. Able, who owns the other 50%. The LLC owns $1 million in rental property, which, due to depreciation, has a basis of $100,000. The Ables’ combined estate is well under $10.86 million.  They do not live in a community property state. When Mr. Able dies, he leaves his LLC interest to a bypass or QTIP marital trust. Even if they avoid the problem with assignee interests noted above, Mrs. Able’s QTIP trust would NOT receive a $500,000 basis for Mr. Able’s share, it would be discounted depending on the terms of the LLC – perhaps to as low as $300,000. Let’s say for simplicity that the value of the property doubles between the time of Mr. Able and his wife’s later death. When Mrs. Able dies, her 50% LLC share and her QTIP trust’s LLC share would be valued separately, and the Able family would inherit the LLC with an overall basis perhaps as low as $1,200,000, rather than the current overall FMV of $2 million for the underlying property (a 40% discount may be high, but is not unheard of). Thus, when the children later sell the property (assuming full $2 million FMV), they would pay tax on $800,000 of capital gain.

If Mr. Able transferred his 50% LLC share to an ordinary bypass rather than a QTIP trust, the income tax result would be worse. Rather than the $600,000 basis for the 50% share in trust, the bypass trust would receive a carry-over basis of only $300,000 (the FMV of the 50% interest at the time of Mr. Able’s death, not counting subsequent depreciation or capital improvements). If, however, Mr. Able’s trust were an optimal basis increase trust, with formula general powers of appointment, or limited powers exercised by Mrs. Able so as to trigger the Delaware Tax Trap, the shares might be included in her estate, if she had sufficient applicable exclusion amount, enabling BOTH 50% interests to be considered together for discounting, enabling a full $2 million FMV basis for the children.

This benefit may be quite substantial, considering the additional basis can offset 43.4% plus up to 13.3% tax rates via depreciation, or 23.8% plus up to 13.3% state tax rates for long term capital gains upon sale.

What Can LLC Owners Do to Protect Against These Hazards?

If LLC owners want to transfer both economic rights and management rights in your LLCs, similar to shares of stock of a corporation, then the LLC’s written Operating Agreement should be reviewed and/or revised to admit certain transferees or assignees (like a guardian/conservator, spouse, children, trust, subtrusts, etc) as full “substitute members”, while other transferees (typically creditors, ex-spouses) can remain “mere assignees”, with no management rights.

LLC owners may decide on other variations on the above solution if desired. For instance, some owners might prefer to exclude a surviving spouse or children from inheriting management rights, but be perfectly comfortable with having an independent or agreed upon trustee of a marital trust accede to those rights. The key to good planning is to know the consequences of gifts/bequests beforehand to adequately plan.

LLC agreements are typically written, and transfers typically arranged, to achieve maximum restrictions and valuation “discounts” – this is optimal for those with over $5.43 million estates ($10.86 million married couples). However, for those with estates unlikely to be subject to estate taxes, these agreements should be reviewed in light of the dramatically increased estate tax exemption. Clauses in LLC agreements might be amended to cause less “discount”, enabling higher valuations for basis adjustment at death. LLC owners should also consider the effect of dispositions of LLCs in trust in their estate plans – various powers may be added to trusts that cause greater estate inclusion and/or reduce valuation discounts, especially for so called “AB” trusts for surviving spouses (see our 90-minute educational program on The “OBIT” or Optimal Basis Increase Trust). These solutions may enable vastly increased basis for beneficiaries, reducing later income tax to them through increased depreciation or reduced capital gains and net investment income tax.

Make sure your entire wealth management team is on the same page when orchestrating your LLC planning. Very often, a business attorney creates one or more LLCs, an estate attorney creates the trust and different accountants do the personal and business tax returns. These issues are easily overlooked among the various advisors, who may all see a different part of the elephant. This is certainly true for asset protection and tax planning for LLC interests, and at no time more than now, after the recent changes in income tax, Medicare surtax and estate tax threaten to snare any missteps in planning.


EdwinMorrowEdwin Morrow, J.D., LL.M., MBA, CFP®, RFC® is a manager of Wealth Strategies at Key Private Bank.  Ed works with Key Private Bank financial advisory and trust teams, both local and nationwide, assisting with in-depth reviews of high net worth clients’ estate, trust, asset protection and tax planning in order to better preserve, protect and transfer their wealth in a tax efficient manner.  Prior to joining Key Bank in 2005, Ed was in private law practice in Cincinnati, Ohio, concentrating in taxation, probate, estate and business planning.

Ed can be reached by phone (937) 285-5343 or by e-mail at


Image courtesy of Stuart Miles /

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