An LLC Case Study February 22, 2011 Peter J. Parenti, JD, LLM (Taxation) Matthew T. McClintock, JD 1

Circular 230 Disclaimer As we prepared these materials, we made every effort to offer the most current and correct information possible. The information is intended to provide general guidance to attorneys, CPAs, advisors, and their clients. However, laws frequently change, and the impact of laws can vary greatly depending on the unique facts of the situation. The information contained in these materials is not intended to establish a legal relationship, or to serve as legal, accounting, investment, or tax advice. 2

Business Succession Planning Very important for the survival of family-owned or closely held business Challenges: –Complex tax issues –The “human element” (egos, relationships, etc.) –Managing operations Opportunity for deeper relationship with existing client; build relationship with next the generation of owners 3

Case Study The Facts: Harry, age 62, Wilma, age 58 Harry – son Steve, from a previous marriage. Wilma – daughter Dottie, from a previous marriage. Together – minor son Mark. Harry owns 100% of an S-corporation; current fair market value of $10 million. Cash flows very good! Significant other assets: home, other investments. Some owned jointly by Harry and Wilma, some owned solely by Harry. $1M/$5M lifetime gift / estate tax exemptions still available. 4

Harry’s Cost of Doing Nothing If Harry dies intestate, assume: Wilma gets 50% of Harry’s estate including the business Steve gets 25% of Harry’s estate including the business Mark gets 25% of Harry’s estate including the business, BUT! since Mark is a minor, Wilma will control Mark’s 25% until he is age 18. So Wilma would control 75% of the business if Harry died intestate 5

Harry’s Planning Objectives Have comprehensive plan to ensure ownership of the business will pass to his son Steve. –(Steve also wants the security of knowing the business will one day become his.) Control of the timing of the transfer of the business to Steve Treat his stepdaughter, Dottie, and their younger son, Mark, fairly. Keep enough cash flow and to provide for Wilma if he dies first Minimize estate taxes. 6

Phase 1 7 Reorganize and Recapitalize the S-Corporation: In a tax-free “F type” reorganization [IRC § 368(a)(1)(F)], convert S-corp to an LLC taxed as S-corp with voting and non-voting common units. Transfer all LLC interests to Harry’s Living Trust. Convert 1,000 shares of S-Corp stock into 990 Non- Voting LLC Units (99%) and 10 Voting Units (1%).

Drafting Options Create separate living trusts for Harry and Wilma for their respective separate property They could also have a joint living trust for any community property or jointly owned property. 8

Drafting Options Create LLC taxed as an S-Corporation! All membership interests are issued to Harry’s personal Living Trust. 990 Non-Voting LLC Units (99%) and 10 Voting Units (1%). 9

Phase 2 Create Dynasty Trusts Establish 3 irrevocable trusts, one for each child (or one irrevocable trust with 3 separate shares; (WealthDocx 7 allows you to do it either way.) Each trust should be income-taxable to Harry. –Grantor Deemed Owned Trusts (GDOTs) or Intentionally Defective Grantor Trusts (IDGTs) –Include a “Toggle” provision to turn grantor trust status off or on as needed –Make sure trusts are designed to own life insurance on Harry’s life Harry then makes initial gifts to the trust(s) 10

Phase 2 Create the Dynasty Trusts: Make a $600K gift to Steve’s Trust. Allocate GSTT Exclusion to Steve’s Trust to give it a Zero Inclusion Ratio. Create Dynasty Trusts for Dottie and Mark to possibly buy Life Insurance Policies on Harry and/or Wilma 11

Phase 3 Sell 990 Non-Voting LLC interests to Steve's Trust with Installment Note To give Steve ultimate ownership of Harry's business, sell all non-voting LLC interests to Steve’s Dynasty Trust NOTE: To make a private sale or gift between family members of something that does not have an easily known value, the IRS requires that a qualified valuation expert to determine fair market value. –Harry must file a 709 Gift Tax Return to report sale and the $600K cash gift to start SOL on the IRS 12

Phase 3 First, balance sheet assets owned by the business are valued Second, a business evaluation of the ownership interest is performed After valuation adjustments are made for non-voting LLC interests (lack of control, lack of liquidity, lack of marketability) the cumulative effect often reduces the fair market value by a significant amount (e.g., 40% or $6K per unit = $5,940,000 ) Voting units will have a premium value to reflect the control value ($12K per unit X 10 units = $120,000) 13

Phase 3 Harry sells his 990 non-voting units for $5,940,000 to the Dynasty Trust for Steve using a 20-year installment note, payable annually. (Make sure the note is similar to one used for unrelated parties.) Based on the value and terms of the note, the trust will pay Harry $447,197 every year for 20 years. –NOTE: There is no "bright line" test for what is a commercially reasonable loan-to-value ratio. Many practitioners use 10%, but some are more comfortable at 20%. Still others are OK with 0% to 9%. 14

Why reorganize the corporation to an LLC? Corporate stock is freely transferable; judgment creditor can foreclose on stock and become a shareholder. LLC membership interest is not transferable without the consent of all members. LLC offers much greater asset protection from creditors: many states limit a creditor’s remedy to a “charging order” on distributions to LLC members. In states where foreclosure of LLC membership interest is allowed, creditor can never become a substitute member; only gains status as “assignee” with no ability to vote on admission of new members or the liquidation of the LLC. 15

In most states, the ownership percentage required for shareholders voting on liquidating a corporation will range from 51% to 80%. (Less than 100%) In most states, a vote of 100% of LLC interests is required to liquidate an LLC. If judgment creditor forecloses on enough shares of corporate stock, he can liquidate the corporation and take assets to satisfy claim With an LLC, creditor never becomes a member and will never be able to force distributions or liquidation 16 Why reorganize the corporation to an LLC?

Outcome Harry owns 10 voting units = 100% control of the business and 1% of the equity. The Dynasty Trust for Steve owns 990 non- voting units = no control over the business and 99% of the equity. The Dynasty Trust also has $600,000 in cash that Harry gifted to it as seed capital –This cash gets invested, and income, gains, & losses are taxed to Harry. 17

Income Tax Reporting Harry is the deemed "owner" of Dynasty Trust for Steve for purposes of reporting trust income. No interest income is recognized on the installment note payments; No Interest deduction is allowed to the Trust. –Dynasty Trust for Steve does not file Form 1041 fiduciary income tax return. US Corporate Income Tax Return (1120S & K-1) is filed, reporting LLC income tax. Harry is reported as Trust's deemed owner; income reported on Harry’s 1040, Schedule E 18

Income Tax Effect of Sale of Membership Units Harry's sale of LLC units to the Dynasty Trust for Steve is a "non-recognition" event. Because Harry is the deemed owner of the Trust for income tax purposes, it is treated as a sale by Harry to himself. Thus no gain or loss is recognized on the sale of the 990 Non-Voting units and no income is recognized on any of the installment note payments to Harry. 19

“Pass Through” Dynasty Trust Income: Income from the LLC will be allocated to the unit holders based on their unit ownership percentages. Assume business has $500,000 in net income: –Harry owns 10 voting units, equal to 1% of the equity. Therefore, Harry will be allocated $5,000 in 1120S, Sched. K-1 income. –The Dynasty Trust for Steve owns 990 non-voting units, which is equal to 99% of the equity. Therefore Harry, on behalf of the Trust, will be allocated $495,000 on a 2 nd 1120S, Sch. K-1 income. 20

“Pass Through” Dynasty Trust Income Because the Dynasty Trusts are grantor trusts for income tax purposes, Harry must pay the income tax on all income, including the S-corporation income that is allocated to the trust for Steve. Harry's payment of trusts’ tax liability is not an additional gift to the trusts (it’s his liability), so every year Harry is effectively transferring additional estate assets to the trusts for the children without additional transfer tax. 21

How the Dynasty Trust Pays the Note LLC generates $500,000 per year of cash flow to distribute to interest holders: –Steve's Dynasty Trust gets a cash distribution of $495,000 ($500,000 x 99% = $495,000). –At the end of year one it will have $1,095,000 in cash ($495,000 from the LLC and the $600,000 that was gifted to it as seed capital) –Trustee uses this to pay note obligation 22

If the company does not generate enough income to pay the note, take the same approach as if a borrower can't repay a bank loan. –Defer payment until business recovers, or –Renegotiate term or interest rate 23 How the Dynasty Trust Pays the Note

Results After Year One At the end of the first year, the note has been reduced to $5,745,847 and Dynasty Trust has a cash balance of $647,803. Trustee of the Dynasty Trust could use this cash to: –Invest and save. (Income taxes on the earnings would be taxed to Harry.) –Make distributions to Steve as the trust beneficiary. (Distributions would be gift tax-free) –Buy and pay for life insurance on Harry's life 24

Results After Year One Harry has received $5,000 from the LLC and $447,197 from the note payment, for a total of $452,197 in income. Harry pays income taxes on the full $500,000 amount of S-Corp income (via 1120S K-1). Higher income tax rate = less net income, but there may be other sources of income: company salary, compensation as a Director. If no further cash flow is needed, reduce Harry’s salary from the LLC. (Reduces payroll tax, increases company cash flow. 25

When Harry Dies... If Harry has consumed or gifted the net after the tax note payments from Steve's Dynasty Trust, at most only the unpaid balance of the note is included in the value of his taxable estate. (The FMV of the Note) Dynasty Trust for Steve is GSTT “exempt.” Dynasty Trusts established for Dottie and Mark would get Life Insurance Proceeds Income, Estate, & GSTT “exempt.” Harry’s personal living trust should leave the 10 voting units (1%) to Steve’s Dynasty Trust. Steve's Trusts would own 100% of the business and the other children's GSTT exempt trusts would own cash. Wilma will continue to receive the remaining note payments for her support. 26

Estate Tax Results 1.Harry has removed $10,600,000 of appreciating assets from the value of his gross estate that would have been subject to estate tax. Unless the Congress acts quickly, the top rate after the catch- up tax will be 55% in Harry has received an asset (the self-amortizing note) based on a discounted asset value, that is both frozen and declining in value over the 20-year note amortization term). 27

Estate Tax Results 3. If Harry does not accumulate the note payments, then at the end of the note term (20 years), he will have totally removed the $10,600,000 (plus all future appreciation on this amount) from his gross estate without making a taxable gift other than the initial $600,000 seed capital gift. 4. Assuming Harry & Wilma made additional lifetime gifts to the trusts for Dottie and Mark, that money would have been invested and growing free of estate and GSTT tax. 28

Estate Tax Results 5. The assets of the three Trusts are in generation skipping tax-exempt trusts that can include asset protection features. Because the gifts are completed gifts to the irrevocable trusts, and because the trusts are GSTT exempt, the trusts’ assets are not included in the children's or grandchildren's gross estates at their respective deaths. 29

Goals and Objectives Achieved Steve will receive 100% of the business without having to buy Harry out. Harry controls the timing of the business transfer. Harry provides for his other children and his wife, Wilma. Harry saves substantial estate taxes. 30

Questions? 31