TRUSTS WITH APPRECIATED REAL ESTATE SHOULD CONSIDER
USING AN LLC AS AN INVESTMENT
USING AN LLC AS AN INVESTMENT ENTITY
I. TAX PROBLEM
The real estate held by the Smith Irrevocable Trust and the Jones Residuary Trust has a combined fair market value of approximately $10M and a combined adjusted basis of approximately $2.6M. Upon distribution of the Trusts assets, there will be no basis step-up and the beneficiaries will receive their pro-rata share of the $2.6M basis.
Problems may arise if the real estate is subsequently sold. U.S. persons who are married and who hold the real estate until death will be entitled to a marital deduction and will receive a basis step-up at death. The foreign beneficiaries will have a taxable transaction if they transfer their interests to a foreign entity or sell the real estate during their lives. In addition, the foreign beneficiaries will have a large estate tax if they die owning U.S. real property.
The Trusts should place their real estate assets into a Limited Liability Company (LLC) and receive membership interests in proportion to the value of the real estate contributed to the LLC. Bank of Krypton should be the manager of the LLC. When the Trusts liquidate and distribute the LLC interests to the beneficiaries, those interests will be comprised of membership interests in an LLC and not undivided individual ownership interests in the real estate assets themselves. This will allow the LLC to manage the real estate assets in one entity, in much the same manner as the Trusts are currently managing those assets.
A. The Perils of Individual Ownership of Undivided Real Estate Interests as Tenants in Common.
Absent an LLC (or similar structure), each beneficiary will own an undivided pro-rata share of each asset in his or her individual name as tenants in common.
1. Tenants in common have the right to partition and sell property by filing a lawsuit.
2. Creditors of a tenant in common (including tax authorities) may seize and sell (or become the owner of) the property interest held as a tenant in common.
3. A tenant in common may become personally liable for any tort claims occurring with respect to the property (including hazardous waste claims).
4. If a tenant in common dies, a probate in the county in which the property is located is necessary.
5. There is no continuity of management or control with respect to property held by tenants in common, absent an express agreement among all tenants in common.
B. The Advantages to Using an LLC to Manage the Real Estate
In contrast to a distribution of an interest directly to each beneficiary as a tenant in common, placing the real estate into a Limited Liability Company (LLC) offers the following advantages:
1. Continuity of management and professional management. Essentially, the same management will continue to occur. Income and expenses will be distributed to the members on a pro-rata basis or special allocations can be made, subject to the applicable rules regarding substantial economic effect of special allocations. Also, the LLC should contain sufficient liquid assets to cover the outstanding liabilities on the real estate and any refundable security deposits owed to the tenants.
2. Rights of members to sell, encumber or assign their respective interests may be restricted by agreement.
3. Rights of members to partition and sell the properties or to receive an undivided interest in the properties may be eliminated.
4. Individuals will not own the properties directly, therefore, they will not have personal liability for any potential hazardous substance or other contract or tort claims with respect to the properties.
5. Lower value of interest for estate tax purposes since a greater minority discount will apply if property is owned in an LLC rather than by individuals.
6. Use of agreements to purchase each others interests, such as a first right of refusal or repurchase agreements at a substantial (50%) discount, are available to the members. Ability to sell the interest or pass it on to the members heirs.
7. Estate planning opportunities: An LLC, unlike an S corporation, can have foreign members and revocable trusts can be members.
8. Advantageous Proposition 13 rules: If an individual owning an undivided interest in land sells that interest, Proposition 13 will apply. Proposition 13 will apply to an LLC only if there is a change in ownership, (a greater than 50% shift) among the members.
9. There will not be a local probate. Undivided interests in land held individually are subject to probate in the county in which the land is located.
10. For non-resident aliens, there could be advantages to owning land in an LLC if the LLC interest, in turn, is owned by a foreign corporation. Land held individually by a foreign person which is then transferred to an entity located outside the U.S. requires the filing of a tax return and reporting of any gain arising from the transaction.
11. Use of an LLC can provide for redemptions of membership interests with liquid assets, if both the stock and land are held in the LLC. This could permit certain tax advantages to the foreign beneficiaries, since the sale of stock by a foreign person (who is not a U.S. resident and who does not reside in the U.S. for more than 182 days in the year of sale) is a tax-free event. The sale of U.S. real property by a foreign person, however, is subject to tax.
12. Annual gift tax exclusion: Both foreign and U.S. members of an LLC are entitled to the annual gift tax exclusion of $10,000 per year per beneficiary. It is much easier from an administrative standpoint to make gifts of an LLC membership interest, rather than gifts of an undivided interest in land, since no deeds must be filed and recorded, and the change in ownership is recorded within the LLC. Also, the gifts would enjoy a larger minority discount factor when compared to a direct gift of land.
C. The Disadvantages to Using an LLC
1. There is the expense of forming the LLC and maintaining it, and the expense of hiring Bank of Krypton to manage the real estate operations.
2. Owning a membership interest in an LLC, rather than an outright undivided ownership interest in property, will cause a loss of certain individual rights that may affect the real property. Individuals have the power to force the sale of property held as tenants in common. The limitations on members imposed by an LLC operating agreement (an operating agreement is similar to a partnership agreement) translate into legally enforceable restrictions that could impact the minority of members, should a disagreement develop among the members.
3. There would also be a loss of the power to affect the management of the properties held in the LLC. Members will vote as though they were limited partners rather than as direct owners of the properties, and unless the majority agreed to a particular action, individual members could not compel a particular course of action.
D. Planning Opportunities for Foreign Members of the LLC
A properly structured LLC may allow for the redemption of the foreign members interests through the distribution of stock, rather than undivided interests in real property, with the following results:
1. The foreign persons could sell the stock without payment of a capital gain. The proceeds could then be placed into a foreign corporation and the foreign corporation could then reinvest as a member of the LLC (or as a lender as discussed below).
2. In this manner, the foreign person would have converted a potential capital gain tax into a tax-free event, and would have eliminated any estate tax on the LLC membership interest.
3. The foreign person (acting through the foreign corporation) could also avoid any withholding tax on payments made by the LLC, if the new investment was structured as a loan (under the portfolio interest exception to withholding), rather than as a direct membership interest. Under the portfolio interest exception, in general, if a lender owns less than 10% of the company and the borrower is a foreign person or entity, interest paid to the lender is not subject to withholding. Therefore, the interest is received tax-free by the lender, but the LLC still obtains the interest paid deduction for U.S. income tax purposes.
4. In conclusion, it is possible to structure an LLC agreement so that a foreign person could: (i) reduce U.S. income tax liability with respect to the sale of his or her LLC membership interest; (2) reduce U.S. estate taxes; and (3) receive a tax-free stream of income from the LLC.
|| [Tax Class] | [Hot Topics] | [Estate Planning] | [Employee Stock Options] | [Tax & Trust Scams] | [Foreign Taxes] | [Tax Columns] | [Tax Publications] | [Tax Hound] | [Interactice Apps] | [Cyber Surfing] ||
|All contents copyright © 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.|