Q: What sort of property may be placed into an LLC?

An LLC must contain income-producing or investment property. This might consist of marketable securities, real property, closely-held businesses, investment accounts, etc. Personal use property should not be transferred into an LLC. Assets placed into an LLC for personal use will taint the LLC as viewed by the IRS and the courts (i.e. homes, jewelry, artwork).

Q: For what purpose would an LLC be used?

There are a variety of reasons for using an LLC. Some reasons include providing for continuity of family ownership, consolidating ownership, reducing after-death family controversies over property, protecting assets creditors and divorcing spouses, limiting personal liability, avoiding or decreasing probate and estate administration costs, ensuring the transfer of ownership of property to family members while retaining control, reducing estate or gift taxes, simplifying gifting to family members, promoting and facilitating family communication regarding wealth, family investment philosophies and other family values, maintaining a single portfolio while transferring to multiple beneficiaries, etc.

Q: How much "LLC management pay" should be taken each year? Is it in proportion to the size of the LLC, the complexity of running the LLC, or what? Is it better to take it as a regular paycheck or can it just be taken as a lump here and there? Does a payment have to be made for the proportion owned by the children when a management fee is paid out?

The LLC may indeed pay a management fee. A management fee is not something that would be paid pro rata. It would be paid to the managing members. The LLC should be cautious when paying out management fees however because there is a potential argument that it is an end around actual distributions to the owners. Should the managing members take a management fee equal to the income for the year on an annual basis, it might appear that they never really intended to give the other members an actual asset. This would open the door for the IRS to attack the entity. Therefore, the management fee should be modest, if paid at all. The amount of the fee may vary based on factors such as the income of the LLC and the complexity of running it.

Q: What is the effective tax rate on that distribution (their combined, marginal rate)? Is it separate and away from the actual income earnings of the LLC?

The tax rate on the management fee would be at ordinary income tax rates. In addition, it would be wages subject to FICA and FUTA.

Q: Besides a potentially higher tax rate, what other pitfalls are there here?

If the LLC consistently pays out a management fee to the managing members and does not make distributions to the membership as a whole, there is a possibility that the IRS may not view it as a legitimate business or argue that no transfer of interest was actually made.

Q: What types of distributions can an LLC make? Is it legal for them to take out some "in kind" asset distributions? May a distribution be made in securities or must it be made in cash? When making distributions, do they have to be made in a proportionate amount to all members?

An LLC may make distributions in cash or other types of property (i.e. securities or real property). The owners of the LLC can absolutely take “in kind” asset distributions. However, distributions must be made to all members on a pro rata basis. Otherwise, any non-pro rata distributions would open the entity up to attack by the IRS. The only exception to this is that non-pro rata distributions may be made, but they will subsequently reduce the ownership interest of the member to whom the distribution was made.

Q: When and how often should an LLC make distributions?

There are two schools of thought on the idea of making distribution from the LLC. The first is that a legitimate business takes profits and distributes them to the owners of the business. It may not do this every year or every other year, but on a fairly regular basis when a profit is realized from the business. The second is that pulling money out of the LLC has the effect of decompressing the value of the money, i.e. $100 outside the LLC is worth $100, $100 inside the LLC is only worth $70 and constantly pulling out money for personal costs makes the LLC look less legitimate. If the LLC creators are not in immediate need of a large distribution of money, the former view tends to work better since the IRS may feel that legitimate businesses distribute profits, if there are any. Using this technique, the LLC can make distributions to all members each year to provide them with additional income.

In some situations, if the LLC creators are in need of money, the best course might be to take a large distribution out of the LLC in order to replenish their disposable funds (rather than here and there) and then, with a trimmed down LLC, make a significant gift of membership interest to their beneficiaries.

Q: What are the pitfalls in different types of distributions?

It is probably easier for the LLC to account if assets are sold within the LLC and cash is distributed. It is imperative that the accountant take into consideration the allocation of capital gains to the contributing members for “built in gains” experienced by assets prior to the formation of the LLC.

Q: Do the distributions have to equal the income earned by the LLC?

There is no actual or necessary correlation between taxable income and distributions other than the reasonable practice of making a distribution to cover the owner’s income tax liability resulting from the LLC’s activities.

Q: Are distributions the best way for members to take cash from the LLC?

The best way to distribute funds from an LLC will depend on each particular situation. Each situation requires a different approach. Factors, such as the needs and desires of the managing members and non-managing members, must be considered as well as the LLC purpose, the types of assets, and the annual income.

Q: How is an LLC taxed?

The LLC will be taxed as a partnership, unless it elects to be taxed otherwise. Therefore, the LLC itself will not be subject to federal income tax. As a pass-through tax entity, the income tax to the owners is determined on the entity level and passed through to the owners proportionate to their interest in the LLC. The owner’s share of LLC income will be included in his or her individual income and taxed at his or her individual income tax rate. The LLC must file annual partnership tax returns and provide this information to its members. However, if the LLC pays a wage or salary, it will be subject to the associated employment related taxes.

Q: Are distributions taxable? What is the definition of income (dividends, interest, capital gains)?

A distribution is typically a nonevent for income tax consequences since the members have already been taxed on their share of the LLC income.

Q: Are there any income tax benefits associated with forming an LLC?

Income, expenses, credits, and deductions are passed along to the members. This allows income shifting from parents to children, as gifted LLC interests carry with them the responsibility for a proportionate share of the LLC income.

Q: What are the duties and responsibilities of an LLC manager?

The manager is responsible for investing and managing the LLC assets, deciding whether or not to make distributions and what type of distributions should be made, providing annual income tax information to the members (schedule K-1), filing appropriate documents and statements with the Secretary of State, overseeing transfers of LLC interests, making any necessary amendments to the LLC agreement, and filing income tax returns on behalf of the company.

Although the majority of the LLC value may be gifted out, the manager will still largely maintain general control over the LLC assets and management.

Q: In that the purpose of the LLC is to allow creators, over time, to pass along the interests to the children or other beneficiaries at a reduced value, shouldn't they be making these gifts each year? How is this done and what is the recommended amount to gift?

If the intent of the creators of the LLC is to pass ownership interests to the beneficiaries, then they should indeed be gifting membership interests each year. The problem occurs when the LLC creators either do not wish to give up their ownership or they do not wish to distribute any money to their beneficiaries, yet desire to distribute money to themselves. If the LLC creators are focused on avoidance of making distributions to the minority owners of the LLC, we would not recommend additional gifts which would make this issue even more significant. In addition, in order for the gift to be treated as a completed present gift, the beneficiary must be given the right to withdraw the percentage of their capital account associated with that gift. If the creators are concerned that the beneficiary may exercise these withdrawal rights and do not wish to have money taken out of the LLC, we would also recommend holding off on the gifting of additional interests.

In some situations, the best action is to make a large gift of the LLC membership. This would require the proper valuation of the business property, the business itself, and the value of a minority interest. It would also require the payment of some gift tax in any states that have independent gift taxes. Thus, the large gift could result in some gift tax or the use of the gifting members lifetime gift and estate tax exemption but would save the members considerable professional fees for multiple valuations over time.

Q: How do these gifts affect other gifts that are being made?

If there are already other vehicles through which gifts are being made, this should be contemplated before establishing an LLC and before gifting LLC interests. For example, if gifts are being made to an irrevocable life insurance trust to pay life insurance premiums, this will cut into the amount of LLC interests that can be gifted to the beneficiaries of that trust. In the end, there is only so much you can gift away tax free – currently $14,000 whether it is cash or property.

Q: What kind of discounts will the gifted interests receive?

Lack of Marketability Discount (approximately 20%-40%)
Most LLCs are set up for the purpose of maintaining ownership of assets within a family and are therefore structured so that transfer of LLC interests to persons outside the family is restricted or prohibited. In addition, since membership interests are not readily marketable as are typical corporate stocks, they are not easily converted into cash. When compared with publicly-traded stocks (i.e., IBM) or real estate, which are both easily transferable and marketable, LLC interests are much more complicated to transfer and therefore obtain a discount for their lack of marketability.

Minority Interest Discount (approximately 20%-30%)
Since most transferred interests do not carry with them the ability to control the assets or manage the LLC or influence LLC decisions, the value of these interests will be reduced for a lack of control.

Q: How does an LLC protect from creditors?

In many states, a creditor’s sole remedy against a member of the LLC is a charging order against the member’s interest in the LLC, but not its underlying assets. A charging order merely gives the creditor the right to receive distributions that would normally be paid to the member, but not any voting rights. In addition, although the manager does not have to pay out LLC income, an IRS Private Letter Ruling suggests that the creditor will still be responsible for paying any income tax associated with the attached member’s interest and will therefore end up paying tax on phantom income.