Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

PASSING ON THE FAMILY OWNED BUSINESS
(4/1/01)

During the past couple of weeks, I've tried to set out some strategies for passing on a family owned business to family members. This week I want to focus on a technique which might reduce the estate tax bite and help your family hold on to your farm, ranch or business after you're gone.

The strategy I'm going to recommend is one we have been using for many years with Family Limited Partnerships (FLPs) and which we are now applying to Limited Liability Companies (LLCs), as well. It is called "discounting". What that means is that an appraiser can discount the value of your family-owned business because of "lack of marketability" and "lack of control" issues. These discounts can be substantial, and a discount of anywhere from 15% to 40% isn't unusual.

What does the IRS say about this practice of discounting the value of businesses?

You just hit the nail on the head. You all need to be aware that the IRS does not like what we are doing, even though it's common practice among those firms specializing in planning for taxable estates. The IRS routinely challenges these estate plans and although so far the IRS has struck out almost every time it has come to the plate, it keeps on swinging. That means you can expect to incur some additional expense, probably $3,000-5,000 in litigation expenses, before you convince the IRS (and Oklahoma Tax Commission) to accept your Estate Tax Return.

Be aware, also, that just because the Courts have voted in our favor so far, every case is a new time at bat and the worm can turn. Not only that, but Congress could decide to change the law and eradicate all the court precedent we have built up over the years. That would mean all your efforts would be for naught.

So what do you recommend we do--wait to see if the law or court decisions change?

Not at all. I've been doing this for some 27 years and I've learned that Congress talks about changing laws every year, but it rarely does so. I've also been involved in numerous tax audits and Tax Court appeals over that period of time and the Courts seldom abandon an established position to head off in a new direction.

Am I saying you should march blithely down the road without looking back? Not at all. Things change. Nothing is immutable. But if you are working with a reputable estate planner, he or she will notify you if the law or court decisions change and help you to adjust your estate plan accordingly. In the meantime, you should take the law as you find it and seek every legitimate advantage to which you are entitled.

How does this "discounting" procedure work anyway?

It's really pretty simple in concept, even though it may take several documents to get you where you need to be. In our office, we normally start by establishing a revocable trust into which we "pour" all of your assets. We then form an FLP or LLC (sometimes both) and "invest" most of your trust assets in it. In my practice, I usually form a "single-member" LLC which is, by definition, owned 100% by the trust.

After a reasonable period of time, the Trustee of the trust gifts membership interests in the LLC to family members, thereby diluting his or her share of the LLC ownership. We also provide in the LLC Operating Agreement that the Trustee (usually, but not always, the "Manager" of the LLC) cannot make major decisions on behalf of the LLC without the consent of the other "owners" (usually his or her children or other family members). We also include a restriction on the transfer of LLC membership interests. That is, a member cannot willy nilly sell or give away membership interests without complying with the restrictions set forth in the agreement.

Because the majority (but no longer sole) owner of the LLC is restricted in making management decisions and in disposing of LLC ownership or membership interests, the LLC should qualify for "lack of marketability" (you can't just sell it outright) and "lack of control" (you can't dictate actions of the business) discounts.

How can I figure out the amount of the discount I'll receive?
Can I look it up in an IRS Table?

Not this time. The amount of discount is determined individually for each LLC. Normally a CPA will appraise the LLC for a reasonable fee, usually around $2,500-3,000. The size of the discount will depend upon the ownership share of the primary owner, the amount of control he or she has retained, and the restrictions placed on transfer of the ownership interests.

Done correctly, though, the savings that can be obtained by using this procedure can be significant. For example, if you have an LLC with assets of $2 Million but a discounted value of only $1.6 Million (a discount of only 20%), you just saved some $400,000 or more in estate tax. This makes the $10,000 (more or less) paid to set up the estate plan and the additional expense of defending it to the tax authorities almost insignificant. If the value of the LLC is greater or it qualifies for an even larger discount, the savings can grow significantly.

Sometimes we take the plan a step further and use both an FLP and an LLC. The LLC becomes the sole member of the FLP and gifts assets to the family members. How much and when are decisions you need to make after consulting with your estate planning advisor.

Does the IRS "always" disallow returns claiming these discounts?

The IRS and OTC are still challenging every plan they see. If you elect to do this, know in advance that your heirs will have to fight for the discounts. Prepare them in advance so they will be ready for the battle that awaits them.

Nothing is sure in this world except death and taxes. With proper planning, maybe, just maybe, you can make the latter a little less oppressive when the former occurs.

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