Formation of a Closely Held Entity (Part 2 of 4)

Jan 10, 2023 | Business Planning, General Estate Planning, IRS / Tax Guidance, T&E Administration

Part 2 of 4 of a deep dive into closely held entities:

“Formation of a Closely Held Entity,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Alvi Aggarwal, ACTEC Fellow from Fairfax, Virginia. Today we’ll dig a bit deeper into closely held entities to understand issues critical to the formation of LLCs and limited partnerships. ACTEC Fellows Miriam Henry of New Orleans and Kevin Matz of New York join us to offer their recommendations. Welcome Miriam and Kevin.

Miriam: Hello and thank you Alvi for getting us started on this topic. We are looking forward to talking with you a bit today about entity formation, which is a key point in any company formation for a family to hold and manage assets together. Whether you’re looking at managing a portfolio of publicly traded securities, real estate, or other family assets.

One place I like to start with my clients is what is the right jurisdiction to form this company in? We’re forming the entity. We get to pick its home state. So, take the time when you get started to look at your state law and consider whether or not that’s the right state for your formation.

Introduction: Entity Planning and Formation

I like to look at three areas. Creditor protection: does your state offer what your clients are looking for as to the protection of their interests in the event something goes sideways or is there another state that’s better for you? How might a dispute be resolved? What do the cases around entities look like in your jurisdiction? Or is there, again, another jurisdiction that could be a better fit? The third topic is, what do the default laws say and indicate about the ability to liquidate the company? Under Internal Revenue Code Section 2704, if you put a restriction in your company document that is stricter than a default state law, it must be ignored for valuation purposes. And we hate to pass up an opportunity to have that asset valued at a lower level for estate tax planning purposes. So, take a look at your state and think first about which state is really the right state to form your company.

Entity Planning and Formation: Membership and Manager Selection

Once we’re looking at formation and getting started on putting together the documentation, the rules of the road are really important for our clients. When I think about these entities, I don’t think about a short-term format, it’s not going to be a short-term venture. Ideally, this company as Kevin will really touch on- is something that will serve a family for several generations and be an asset they go back to and look at and manage and think about over time. And it’s important to get rules in place.

Who will be the manager? How will a manager be selected initially and subsequently? And Kevin will touch a bit more on some of the tax considerations that are important in that. What about transfer restrictions? Your clients will likely want to transfer interests over time. Whether they do that initially or are hold until their death, then transferred. How will new members be admitted? Who should be a permitted transferee? We talk with clients about a pool of people whom you’d want to be able to be admitted automatically as members, but others that you’d want to have some level of approval before admitting.

Both of these topics, manager selection and admission of members, are major decisions for many families and we like to talk about and think about, what are our other major decisions? Are you changing your asset investment and going into a new area of investment? What are the major decisions and how do voters in this entity vote on any particular major decision? I also want to talk to clients about tax distributions. Will the entity guarantee that it will make distributions to its members to cover their taxes? What is the investment policy of the company also and how does that relate to the taxes that people anticipate flowing through to them? Or perhaps, the depreciation or other deductions that are out there.

At these rules of the road, where it intersects with income tax, it’s an important place to involve a client’s CPA in the planning as well, to look at how this works long term with the client’s individual needs. A note here to think too about will the client and any other people who may become members or who are members in the future, like children or grandchildren or trusts, do they participate in this process? If they’re going to be initial owners, yes. And if so, will they have separate representation and involvement of their own CPAs?

Entity Planning and Formation: Planning, Investing and Logistics

Again, a good formation thought process is thinking long term and thinking about the interests, plans, projections, and investments appropriate to the different family members that you anticipate may become or are initially contributing and becoming members. As we get started in forming the company, it’s important that we focus on the actual nitty-gritty logistics. You’ve seen lots of cases in which families have thought about this and gotten started, but not really dotted their i’s, cross their t’s, with things like funding and setting up capital accounts correctly.

Identifying exactly which assets are going in, why those are the appropriate contribution to the company, and then transferring the assets so the title is there and establishing capital accounts for each of the appropriate members. Getting those particulars in place, coordinating with the CPA who will help administer the estate, and administer the LLC going forward are key parts of entity formation. You’ll likely need a tax ID number and minutes from your initial meeting walking through the decision process and the next steps for the members. So, at this point, I’d like to go ahead, Kevin, and turn it over to you to talk a little bit more about how the IRS views the formation of entities and why this particular entity approach may or may not work for different families.

Entity Planning and Formation: Tax and Non-Tax Benefits

Kevin: Well, thank you, Miriam, and hello, everyone. So, planning with closely held entities can provide very significant non-tax and tax benefits to clients. Now, with respect to the non-tax benefits, they can include investment management, such as the establishment of a specific investment strategy including simply to buy and hold the assets that are transferred there. Asset protection, including in the event of divorce. And also, a mechanism to settle disputes among family members such as through arbitration or mediation.

With respect to the tax benefits, this can often arise due to valuation discounts for lack of control and lack of marketability. In connection, the closely held entity interests that are being transferred be it by gift or by sale. But there is importantly, a lot to consider here. And estate planning with closely held interests is not suitable for everyone. There’s a suitability threshold. Now, what do I mean by that? Well, first off on the gift tax side, you’ve got to be careful to steer clear of “indirect gifts.” So, for example, take the facts of the Shepard case.

The dad transfers real estate and publicly traded securities to an entity on day one and very shortly thereafter, or maybe even simultaneously, gives percentage interest in the entity to son one and son two. The IRS could easily say that what dad has really done here, via a series of steps is to make gifts, so the assets transfer to the entity and not the entity’s interests to his children. And therefore, valuation discounts for lack of control, lack of marketability, with respect to the entity interests, probably won’t be available.

Entity Planning and Formation: Estate Tax and Valuation Discounts

Now, what about the estate tax? Turning to the estate tax, there is a very significant concern that without proper planning and, importantly, a willingness of the client to step back from a control position, particularly in respect to such matters as participating in distribution and liquidation decisions for the entity, the entity wrapper may be disregarded by the IRS with claim valuation discounts disallowed. Now, the IRS’s chief weapon in challenging valuation discounts for lack of control and lack of marketability, is Section 2036 of the Internal Revenue Code. And the IRS’s position there has been emboldened in light of its success in the 2017 full tax court decision of the Estate of Powell, which itself came on the heels of earlier IRS victories in the Strangi and Turner cases.

Now, in the estate of Powell, the decedent’s ownership of a limited partnership interest – I emphasize limited partnership interest – which simply entitled her to participate in the decision of whether to liquidate the entity in conjunction with other partners. Not alone, but in conjunction with other partners, was itself enough to trigger an estate tax inclusion of the underlying family entity assets at their fair market value at depth without valuation discounts under Section 2036(a)(2) of the Internal Revenue Code, as a retained right to designate who can enjoy the transferred assets.

Now, importantly in the Powell case, the executor did not argue that the bona fide sale, the full and adequate consideration, and money and money’s worth exception of Section 2036 should apply to prevent the application of Section 2036. Now, the bona fide sale exception, in general, requires showing that there is a substantial non-tax purpose for creating and transferring assets to the family entity and that any entity owner capital accounts have been properly credited. Basically, the client should treat and respect the entity as the business entity that it is, which could potentially mean in the entity formation context we have here, having negotiations with other partners or members and preferably, if feasible, having separate counsel for the various owners.

Now, sometimes clients are unwilling to do that, however, and want to continue to participate in entity distribution and liquidation decisions. And sometimes moreover, even reach into the entity and treat it – and the entity assets – as if it were his or her alter ego. In that context, Section 2036(a)(1) bad facts case. And then the clients will sometimes ask, “well, what’s the worst thing that can happen here? Isn’t this really all: nothing ventured, nothing gained?” The answer to that question, unfortunately, is often no.

Entity Planning and Formation: Relevant Estate Planning Court Decisions

First, where a senior family member has engaged in estate planning with family entities and both spouses are living, as illustrated in the Turner case from 2012 where Section 2036 applies, it can accelerate estate tax in the first spouse’s death even where the will contains a reduce to zero value reduction formula. What is that you may ask. Well, why is that, you may ask rather. Well, the answer to that is because under Section 2056 of the Internal Revenue Code, the value reduction provisions, you only get a marital deduction for a property that passes to the surviving spouse or marital deduction trust.

If, in contrast, you gift away the entity interest, say to other family members or irrevocable grantor trust for the benefit of multiple family members, Section 2036 then applies on death, and you then have a so-called “phantom asset” for estate tax purposes that may potentially be incapable of passing in such form to the surviving spouse or marital deduction trust. So, the unhappy result is there can be an acceleration of estate tax in the first spouse’s death, even with a reduced to zero estate tax formula on the first spouse’s death under the terms of the will.

Entity Planning and Formation: Estate Tax

Second, there’s a potential for double inclusion of estate tax due to the application of Section 2043 of the Internal Revenue Code. As it’s discussed in the estate of Powell case and then further elaborated on in the Estate of Moore case. Now, these cases state that where Section 2036 applies, the proper analysis under Section 2043 is to include the decedent’s gross estate both the date of death value of the entity interest – let’s call it limited partnership interests under Section 2033 – and the underlying property, again at date of death value, under Section 2036 at the date of death. And then subtract from that the value of the property transferred to the closely held entity as of the date of transfer. Not date of death, but as of the date of transfer.

This means that if there’s appreciation in value from date of transfer to date of death, that gap can create a double inclusion for estate tax purposes. When you combine that with the entity interests that are themselves included – limited partnership interests or LLC membership interests included under Section 2033. Moreover, as Miriam alluded, there could be adverse income tax consequences depending upon the circumstances in part to a reduction in the extent of the step up in basis for the transferred assets, among other intricacies.

So, in sum, estate planning with family entities is potentially not a nothing ventured, nothing gained proposition. And the client, unfortunately, can sometimes be rendered worse off by engaging in such planning than doing nothing at all and that needs to be discussed with the client. That concludes my remarks. Thank you.

Alvi:  Thank you Miriam and Kevin for highlighting those important considerations in the formation of a closely held entity. Stay tuned for the next podcast, the Administration of a Closely Held Entity.

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