Case Study: Transferring LLC Interests to the Family

April 13, 2006

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John owns a limited liability company (LLC) with a value of $600,000 (value of assets less liabilities). He wants to avoid the estate tax, as he knows the value of his business, and his other assets, will steadily increase above his exemption amount. John owns 100 percent of the business, represented by ownership of one share as a member/manager, and nine shares as a member/non-manager.

John transfers the nine member/non-manager shares to his children as a gift. Because this represents nine of the ten outstanding shares, or 90 percent ownership in the business, the transfer should be valued at $540,000 ($600,000 x 90 percent), and would reduce John's exemption by this amount.

However, because of discounting, due to a lack of control and marketability, the interest would only be valued at $378,000, if a 30 percent discount were applied ($540,000 x 70 percent). This discounted amount is what counts against your estate and gift lifetime exemptions. Thus, John will have preserved $162,000 of his exemption, which could be used to make future tax-free transfers of business interests to the family. He accomplished this even though, in reality, he transferred 90 percent of his business to his children.

In addition, 90 percent (the children's ownership share) of the future appreciation in the value of the business, which John projects will be quite substantial, will be attributed to the children. In other words, nearly all of the future appreciation in value will be passed on to the children free of estate taxes. John will not have to be concerned about paying hundreds of thousands of dollars in estate taxes when passing this value onto the children.

Note that, in practice, as much as 99 percent of the business can be transferred in this way to the next generation, without a loss of control.

Note, too, that it would be important to form the LLC in a state that protects the business owner's interest against the claims of his personal creditors, and that allows for the complete elimination of voting rights for certain membership interests, such as those held by members who are not managers. For example, Delaware is one state where both of these objectives can be accomplished.

Now let's assume John owns an LLC with a value of $600,000, but does not want to reduce his $1 million exemption when he transfers the interests to his children. The discounted value of the interests he plans to transfer is $378,000 (90 percent of the business is $540,000, then $540,000 x 70 percent = the discounted interests).

If John and his spouse join in making the gifts, and they have four children, it will take less than five years to complete the transfers, using only the $11,000 annual gift tax exclusion and, thus, preserving the entire $1 million exemption ($22,000 x four donees = $88,000 per year that may be transferred under the exclusion; at that rate, in five years, they could transfer $440,000 ($88,000 x five years).