New York Reserves Right to Subject Real Estate Owned By Single Member LLC to Estate Tax

In a recent New York tax advisory opinion, TSB-A-15(1)M, the Commissioner of Tax and Finance stated that if a single member LLC owns an interest in New York real property, that property can be subject to the New York estate tax upon the death of the sole owner.

In this situation, the Petitioner had set up a single member Delaware LLC to own an interest in New York real estate. The Petitioner then wished to permanently leave New York to live in another jurisdiction.  New York has a state estate tax on real estate but it does not have an estate tax on intangible property.

Typically, an interest in corporation, partnership or trust is considered an interest in intangible property and therefore not subject to New York's estate tax laws.  This raised the question of how to treat the interest in an limited liability company.  An LLC can be taxed as a partnership, a corporation, an S-Corporation or as a disregarded entity.  Single member LLCs are taxed as a disregarded entity unless the taxpayer elects to have it taxed differently.

The rationale behind the opinion in this case is that if the federal government disregards the entity for tax purposes, so should the state of New York.  Accordingly, if you own real property in New York and are not a New York resident, you should speak with your tax advisers about the best way to minimize your estate tax burden.

The nice thing about an LLC is that you can always make an election to have it taxed in a different manner simply by filing a form with the federal government.  By electing to have it taxed as a Corporation or S-Corporation, or by adding your children on as owners of the LLC and having it taxed as a partnership, the LLC will no longer be treated as a disregarded entity.

Business Succession Planning

Some of you may have seen these scary statistics:

According to the U.S. Small Business Administration, 90 percent of the 21 million small businesses in the U.S. are family-owned, but less than one-third of family-run companies succeed into the second generation, while only half of that make it to the third. Most often, the lack of a proper succession planning is to blame.

Proper business succession planning is particularly vital in the Northeast where taxes are so high.

Let's assume that an unmarried NJ decedent (Jane) has a company worth $5,000,000 at the time of her death. Without looking at Jane's other assets, I can tell you that her heirs have a potential federal estate tax liability of close to $1,350,000 plus a NJ Estate Tax liability of almost $400,000 for a total tax liability of close to $1,750,000. If she had no issue or parents living, this would also be subject to a $750,000 New Jersey inheritance tax. These taxes could decimate a small company at a time when the key person involved is not around.

The benefits of proper planning are countless.At a minimum, proper strategy will help you minimize taxes, maximize control and provide a clear path for continuity of the business. Planning an exit strategy is important as soon as you go into a business. This includes planning for death, divorce or a sale upon retirement.

Some popular planning techniques include:

1. Setting up an entity structure (LLC, C Corporation, S Corporation, Partnerships, etc.);
2. Purchasing Life Insurance (combined with Buy-Sell Agreements);
3. Creating agreements limiting control of potential takers to the business;
4. The use of promissory notes;
5. Selling or gifting ownership in the business to family members; and
6. Selling or gifting ownership in the business to other entities or trusts that will benefit family members.

Valuation Discounts

One of the most important aspects of proper planning is gaining the ability to maximize the amount that you can pass down to your heirs through the use of Valuation Discounts.

When a person has a small business, it is often difficult to sell. The IRS recognizes this lack of marketability. Additionally, as many small business owners get on in years, they are not as involved in running the business. The IRS also recognizes this lack of control.

It is not uncommon to have restrictive agreements in place that will allow an owner to pass on his or her interest with a one-third discount for lack of marketability PLUS another one-third discount for lack of control. Discounts are very specific to each business and a proper appraisal is a MUST.

So how does it work?

Let's go back to our example above. Let's assume that Jane has one child, Dave, who is 35 years old and has shown some interest in the business. Ten years ago, Jane sets up an entity, let's say an LLC, with a restrictive operating agreement. As a result, the appraisal comes back and states that there is a 1/3 discount for lack of marketability. Jane can transfer Dave $1,012,000 of this company without any out of pocket gift tax consequences. Without the appraisal, this would result in a transfer of 20% of the company. With the appraisal, Jane could transfer as much as $1,518,000 of the LLC (a little over 30%) without gift taxes. Additionally, Dave could buy another 20% of the company with a promissory note at the lowest rate available for tax purposes. Let's say a ten year note of $666,666 at 6% interest. Finally, Jane is in good health, so for the next 10 years she uses her annual exclusion amount to gift Dave another $12,000 worth of the company annually. (Since annual appraisals would be expensive, let's assume we don't discount this.)

The result is that upon Jane's death 10 years later, her 100% interest in the company, which started at $5,000,000 company, has been reduced as follows:
1) Through the lifetime gift to Dave, her interest is reduced to a 70% interest, worth $3,500,000;
2) Through the promissory note, her interest is reduced just under 50%, with a value of just under $2,500,000.
3) Through the annual gifting, her interest in the business is reduced to $2,380,000.

Upon Jane's death her $2,380,000 interest will receive a 1/3 discount for lack of marketability and another 1/3 discount for lack of control. This will result in a tax valuation of approximately $1,060,000. After we add back in the $666,666 that she received for the 20 interest plus another $220,000 for interest payments, she will pass with a taxable estate of about $1,950,000.

Accordingly, upon Jane's death, her estate will not be subject to any federal estate tax liability. Additionally, the NJ Estate tax liability will be reduced to $96,000. This is a tax savings of over $1,600,000 - which far outweighs the costs involved in such preparation.

Obviously, there are many different ways to structure this type of transaction, but they are usually based upon the same methodology. The numbers and techniques involved will depend upon the individual needs of the client. For example, if Dave were not responsible or had no interest in running the business, Jane could give him his shares in trust. If Jane had a business partner, this structure could be done for each partner and combined with a buy-sell agreement funded by life insurance.

Asset Protect Trusts vs. Family Limited Liability Companies

Occasionally, people who are interested in asset protection ask me what is more appropriate, a trust or some sort of FLC or FLP. Here is my response:

An asset protection trust is more secure than an FLC, but it is also more costly to maintain (high annual fees for an independent trustee) and you give up more control. The more money you have and the more at risk you are for a lawsuit, the more you want to set up a trust. For asset protection trusts to work properly, you must give up almost all decision making power over the assets (to a trusted advisor), and you will become, at best, a discretionary beneficiary of such trust.

A single person FLC does not offer much protection, but certainly some. A two person FLC without an operating agreement offers decent protection from any lawsuit arising out of assets in the FLC, but little protection for misdeeds done outside the FLC. With an operating agreement limiting distributions, you get much more protection and that is why there is more of a setup cost. This structure is good for people who really don’t want to part with their assets and/or think they will need it in the future. These receive more protection over time as the Grantor transfers shares of this down to issue (usually at a discount) because of the lack of marketability and lack of control.

There are many types of Asset Protection Trusts. Inter vivos ones (trusts set up during the Grantor’s life) are invariably more costly than one’s set up on death. Something as simple as a traditional ILIT can make a great Asset Protection Trust, especially if funded with Whole Life Insurance. Self Settled Asset Protection Trusts (where the Grantor is also a beneficiary) are available in a few jurisdictions such as Delaware, Alaska, Nevada and New Hampshire. These are high end domestic asset protection trusts. For even greater protection, we can go offshore.

So, basically, it comes back to what you, the client, is trying to accomplish.