162-Oct. 12 - LLC Course Outline (CO Forum)

Understanding and Drafting
LLC Operating Agreements with WealthDocx
Understanding and Drafting

LLC Operating Agreements with WealthDocx
Part I Introduction 1
1.01 Key Assumptions ......................................................................................................1
1.02 Introduction to LLCs ................................................................................................1
1.03 Important Terminology.............................................................................................2
1.04 ULPA & RULPA......................................................................................................4
1.05 Origins of LLC Law .................................................................................................4
1.06 About Re-ULLCA ....................................................................................................4
1.07 Modification of Tax Laws ........................................................................................5
Part II Essentials of Limited Liability Companies............................................. 8
2.01 Basic Types of LLCs ................................................................................................8
2.02 Basic Management Structures ..................................................................................8
2.03 Special Purpose LLCs...............................................................................................9
2.04 Family LLCs12
2.05 The LLC as a Legal Entity......................................................................................13
2.06 Operational Formalities ..........................................................................................13
2.07 Members in a Limited Liability Companies ...........................................................13
2.08 About Limited Liability ......................................................................................15
2.09 Charging Order Protection......................................................................................15
2.10 How Members Blow Up their Asset Protection under LLCs .................................16
Part III Tax Classification: Choosing how the LLC will be taxed .................. 18
3.01 Disregarded Entity (Sole Proprietorship) Taxation ................................................18
3.02 Partnership (Subchapter K) Taxation .....................................................................19
3.03 S-Corporation (Subchapter S) Taxation .................................................................19
3.04 C-Corporation (Subchapter C) Taxation.................................................................19
3.05 Default Tax Treatment and Electing Out................................................................20
3.06 Social Security tax issues........................................................................................21
3.07 SMLLCs: Sole Proprietorship or Sub-S Taxation? ................................................21
3.08 MMLLCs: Choosing between Sub-S and Partnership Taxation ............................22
3.09 LLC Tax Planning Matrix.......................................................................................24
Part IV Overview of Asset Protection Issues .................................................. 26
4.01 Partnership and LLC Provisions Affecting Asset Protection ............................26
4.02 Tax Consequences to Charging Order Creditor after Foreclosure .........................27
Understanding and Drafting LLC Operating Agreements with WealthDocx
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2011 WealthCounsel, LLC
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4.03
4.04
4.05
4.06
4.07
4.08
4.09
4.10
4.11
Distributions Around a Charging Order? ............................................................27

Other Asset Protection Considerations ...................................................................28
Creditors Rights.....................................................................................................29
General Purpose of Creditors Rights Laws ...........................................................30
Defending entity creation against fraudulent conveyance or transfer claim...........30
Partnership and LLC Defenses Against Bankruptcy ..............................................31
Asset Protection Planning Matrix ...........................................................................32
LLC and partnership Asset Protection Design Features .........................................32
Various Entity Combinations..................................................................................34
Part V Funding the LLC or Partnership ........................................................... 35

5.01 Business Interests....................................................................................................35
5.02 Business Equipment................................................................................................35
5.03 Cash
35
5.04 Installment Notes ....................................................................................................36
5.05 Life Insurance 36
5.06 Marketable Securities .............................................................................................41
5.07 Closely Held Securities...........................................................................................43
5.08 S Corporation Stock ............................................................................................44
5.09 Stock of a Professional Corporation or Professional Association ..........................44
5.10 Tangible Personal Property.....................................................................................45
5.11 Real Estate
45
5.12 Encumbered Property .............................................................................................46
5.13 Residence
46
5.14 Dont Transfer Retirement Accounts to an LLC or partnership!............................47
5.15 Other Assets Warranting Extreme Care..................................................................47
Part VI Family Limited Liability Companies .................................................... 48
6.01 Using FLLCs to accomplish Non-Tax Objectives..................................................48
6.02 Comparison of LLCs to Other Entities ...................................................................50
6.03 Using FLLCs to Reduce Transfer Taxes ................................................................52
Part VII Overview of Valuation Issues ............................................................. 53
7.01 Three Key Concepts of Valuation ..........................................................................53
7.02 Valuation is Focused on the Property that is the Subject of a Transfer..................53
7.03 Determining the Pre-Discount Value......................................................................55
7.04 Determining the Discount .......................................................................................58
7.05 Discount for Lack of Marketability ........................................................................58
7.06 Lack of Control or Minority Interest Discount .......................................................60
7.07 Application of the Discounts ..................................................................................64
7.08 Determining the Premium.......................................................................................64
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7.09
7.10
7.11
7.12
7.13
Control and Annual Gift Exclusions (Hackl) .........................................................66

Chapter Fourteen and FLP and FLLC Valuation ...............................................66
Valuation Discounts and Basis Allocation Problems .............................................76
Planning Suggestions ..............................................................................................76
Valuation Penalties .................................................................................................76
Part VIII Entities as Members or Managers ..................................................... 78

8.01 The Family Limited partnership .............................................................................78
8.02 The Family LLC .....................................................................................................79
8.03 Individuals as General Partners or Managers? .......................................................79
8.04 Corporations as General Members .........................................................................81
8.05 S corporation as Corporate General Partner ...........................................................83
8.06 There are several drawbacks to the use of a corporate General Partner or Manager.83
8.07 Shareholders of the Corporate General Partner or Manager?.................................84
8.08 Irrevocable Management Trust as General Partner or Manager.............................84
8.09 LLC as Manager or General Partner.......................................................................87
8.10 LLC as a Subsidiary Entity. ....................................................................................87
8.11 Who will be the Limited Partners or Non-Manager Members? .............................88
8.12 Avoiding the Strangi II Problem by Using an Independent Special Distribution
Trustee and an Independent Special Distribution Manager...........92
Part IX Considerations in Designing and Creating FLPs or FLLCs.............. 93
9.01 Satisfying the Bona Fide Sale Exception................................................................93
9.02 Avoiding 2036(a)(1) inclusion..............................................................................93
9.03 Avoiding 2036(a)(2) .............................................................................................95
Part X Planning and Drafting Checklists......................................................... 97
10.01 Practical Checklist ................................................................................................97
10.02 Design Checklist .................................................................................................100
Part XI Ethical Considerations in LLC and FLP Planning............................ 101
11.01 Competency of Counsel Standard of Care.......................................................102
11.02 Identifying the Client ..........................................................................................102
11.03 Duty to Inform and Scope of the Representation ...............................................103
11.04 Engagement Letters ............................................................................................103
11.05 Conflicts of Interest ............................................................................................104
11.06 Duty to Not Advise or Assist in Criminal or Fraudulent Activity......................105
11.07 Liability to the Client ..........................................................................................106
11.08 Liability to Third Parties.....................................................................................106
11.09 Criminal Liability ...............................................................................................107
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11.10 Statute of Limitations..........................................................................................107

Part XII Best Jurisdictions for LLC Protection ............................................. 108

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Part I
Introduction
1.01
Key Assumptions
In creating this outline we made several key assumptions that have influenced how we
developed the materials.
First, we assume that attorneys who are in the practice of implementing limited liability
companies and partnerships for business or estate planning purposes will already have a
general understanding of basic estate planning principles, a basic understanding of federal
income, estate and gift tax rules, and an appreciation for the concepts involved in
fiduciary responsibility.
We also assume that most estate planners have had little exposure to most of the
principles and requirements of Subchapter K of the Internal Revenue Code1 (Partnership
taxation), partnership/LLC accounting, or nuances of their own states partnership/LLC
law.
As we prepare all educational materials it is our goal to provide the most current and
correct information as possible. The information in this course and in all ancillary
materials is intended to provide general guidance to attorneys, and where applicable,
CPAs, other advisors, and their clients. But remember that laws frequently change, and
the impact of laws can vary greatly from one jurisdiction to the next, and from one
clients situation to the next. The information provided by this course and contained in
these materials is not intended to serve as legal, accounting, investment, or tax advice.
1.02
Introduction to LLCs
Limited liability companies are creatures of statute that combine many of the features of
partnerships with features generally enjoyed by corporations. LLCs have less stringent
bookkeeping requirements, and provide a measure of creditor protection for all of the
owners. In an ordinary partnership structure, there is a general partner and one or more
limited partners. The general partner is charged with basic management and operations,
and carries liability on behalf of the partnership. Limited partners cannot participate in
management, have much more limited access to the partnership, and only receive
distributions from the partnership when distributions are made.
By contrast, statutory corporations have fairly onerous recordkeeping requirements, and
must either be subject to separate corporation taxation under Subchapter C of the Internal
Revenue Code, or must carefully (and consistently) comply with the much more stringent
Subchapter S taxation rules. As the outline explains below, Subchapter S taxation
1
For purposes of this outline, all references to the Internal Revenue Code or the Code are references to
the Internal Revenue Code of 1986 as amended.
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prevents the corporation from paying income tax at the corporate level (with the
shareholders later being taxed on distributions at their individual income tax rates). In a
Sub-S company all of the tax items pass through to the shareholders and are only taxed at
the individual level. But there are many restrictions and limits imposed for a company to
comply with Subchapter S and take advantage of pass through taxation. On the other
hand, one of the major benefits of corporate structure is that shareholders interests are
insulated from the claims of many creditors.
The LLC combines the asset protection of corporations (and of limited partnership
interests) with the flexibility of partnership-type operations. As we will see, LLCs enjoy a
great deal of flexibility in the choice of tax treatment and in the form of management
structure. They can hold operating businesses, facilitate family gifting, provide protective
structures for important client assets, and otherwise manage significant business
arrangements with a great deal of flexibility and power. But as is often the case in
business and estate planning, the choice of jurisdiction can make a big difference. Some
of the options and structures covered in this outline are not available in all jurisdictions,
and some jurisdictions have laws in place that are prejudiced against certain LLC forms.
Where possible we will highlight those, but its worth bearing in mind that the landscape
continues to change especially where asset protection, valuations, and tax treatment is
concerned.
1.03
Important Terminology
Before we go much further its probably helpful to define some of the more common
terms youll encounter in this outline and in LLC-based planning. This list is far from
exhaustive, but should provide a good start toward becoming conversant in appropriate
terms.
(a)
Act or LLC Act
As used in the outline and unless context clearly provides to the contrary, Act
or LLC Act refers to the state statute that authorizes the creation and operation
of limited liability companies in the jurisdiction.
(b)
Charging Order
The term charging order refers to the relief a judgment creditor can get when
perfecting a claim against an LLC. The nature of charging order relief is that the
creditor steps into the shoes of a member, but only as to distributions and
liabilities; the creditor generally cannot foreclose the claim and seize company
assets. Many states provide that the charging order is the exclusive remedy for
creditors. These states are much more favorable jurisdictions to create and operate
LLCs. Charging order protection is discussed more broadly in 2.09 below.
(c)
FLLC
Family LLC: This is not a different type of LLC; rather, it is simply an LLC that
is specifically intended to hold certain assets of certain family members for
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purposes of facilitating the orderly transfer of those assets to other family

members, or of accomplishing other estate planning objectives.
(d)
Inside Liability
The term inside liability refers to claims that arise against the LLC itself (as an
entity), or that arise among the members inside the LLC.
(e)
MMLLC
Multi-member LLC: an LLC that has more than one member, whether individual
persons, one or more entities, or any combination of individuals and entities.
(f)
Operating agreement
This is the document that memorializes the structure of the LLC, establishes the
management function, determines the rights and responsibilities among the
members, specifies limitations on voting, transfer of interests, and otherwise sets
the ground rules for the operation of the LLC through the companys life. Like a
trust agreement that memorializes the relationship between a grantor/grantor and
trustee, the operating agreement should be reviewed and amended as necessary
over time to ensure that it continues to reflect the wishes of the members. LLC
members have a great deal of freedom to design their operating agreement any
way they wish. Courts generally give deference to the terms of the operating
agreement, favoring the members freedom to contract as they wish.
While an operating agreement isnt mandatory to conduct business as an LLC, its
a really bad idea to try and manage an LLC without one. In the absence of an
operating agreement, the LLC will be managed according to prevailing state law.
The statutory provisions are often more cumbersome and limiting than most
clients prefer.
(g)
Outside Liability
The term outside liability refers to

claims that arise
member by a third party, not from some official act by the LLC.
(h)
against
PLLC
A Professional LLC; that is, an LLC that operates a professional practice such as
accounting, law, architecture, etc. These are not recognized in all states. Some
states that recognize PLLCs do not allow them for specific types of professional
practice.
(i)
Series LLC
This is a specific form of LLC authorized in some states that allows the creation
of separate series inside the LLC. Each series can have uniquely-defined rights,
liabilities, assets, and members, all governed by one operating agreement and all
under one single LLC entity. Some jurisdictions that recognize series LLCs still

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tax them heavily, requiring each series to file and pay franchise tax on each series,
with each series required to file a separate return. (Thanks, California!)
(j)
SMLLC
Single-member LLC: an LLC that has only one member, whether an individual
person or an entity.
1.04
ULPA & RULPA
Limited partnerships and Limited Liability Companies in the United States trace their
history back to an 1822 New York statute written to address a desire of investors to invest
in new businesses without having or incurring the liability of a partner. As time passed,
even though corporations had become a popular form of business organization, states
began to enact statutes permitting the formation of limited partnerships. In 1916 the
National Conference of Commissioners on Uniform Laws (NCCUSL) finalized the first
Uniform Limited Partnership Act (ULPA). Over the next 60 years, all states except
Louisiana adopted ULPA. In 1976 NCCUSL developed a revised ULPA (creatively
referred to as RULPA). ULPA was revised in 1985, and again in 2001.
1.05
Origins of LLC Law
In 1977 the State of Wyoming adopted the first LLC act in the United States. It took until
1987 before other states started to enact LLC acts. Today all fifty states and several
territories have enacted some form of LLC act.
In 1995 NCCUSL finalized the first draft Uniform LLC Act (ULLCA), which was
amended the following year. ULLCA was again revised in 2006 and tagged as ReULLCA. According to NCCUSLs website, Idaho, Wyoming, Nebraska, and Iowa have
enacted Re-ULLCA. At this writing Re-ULLCA legislation is pending in D.C., Indiana,
Utah, and Kansas2.
1.06
About Re-ULLCA
As Re-ULLCA starts circulating through various state legislatures, proponents will point
to several changes revised law would make to the existing uniform LLC law that will
change the way LLCs are formed and operate. We have not studied the issues enough to
form a strong opinion for or against Re-ULLCA, but there are some interesting features
worth highlighting.3
http://www.nccusl.org/LegislativeFactSheet.aspx?title=Limited%20Liability%20Company%20(Revised)
For a more complete list of Re-ULLCAs features, please visit NCCUSLs website:
http://www.nccusl.org/Narrative.aspx?title=Why%20States%20Should%20Adopt%20RULLCA
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(a)
The Operating Agreement
The operating agreement has a more important place under Re-ULLCA. The
operating agreement, and not the articles of organization, will specify whether the
LLC is member- or manager-managed, and the operating agreement will be
binding on the LLC. This applies even to SMLLCs and even if the LLC hasnt
formally adopted the operating agreement.
(b)
LLCs for Any Lawful Purpose
Re-ULLCA makes it explicitly clear that LLCs can operate as not-for-profits, not
merely as for-profit enterprises.
(c)
Increased Management Flexibility
LLCs can have any type of management structure the members want, including a
board of directors-type board to govern. The operating agreement will specify
the management structure.
(d)
Fiduciary Duties of Managers; Liability to Members
Re-ULLCA incorporates the duty of loyalty and the duty of due care for
managers, and includes duty of good faith and fair dealing. The duties may be
modified or limited by the operating agreement, and are similar to the duties for
corporate directors under state law.
(e)
Shelf LLC
An LLC can be formed under Re-ULLCA even if it doesnt yet have a member.
The shelf LLC is formed and then the filing documents may be modified up to
90 days post formation to add members.
(f)
Simplified Charging Order provisions
Re-ULLCA makes it clear that a charging order is the exclusive remedy of a

members creditor. The law also provides rules for foreclosing on a charging
order and makes it clear that a purchaser of a foreclosed interest obtains only
financial rights; they do not become a member by foreclosure.
This is one provision we dont like, as the issue of judicial foreclosure has been
resolved in debtors favor in several jurisdictions. If Re-ULLCA is up for
consideration in your state, work with your legislators to remove judicial
foreclosure of charging orders from the law.
1.07
Modification of Tax Laws
In 1958 the Internal Revenue Code of 1954 was amended by adding Subchapter R and
Subchapter S. Subchapter R allowed partnerships and sole proprietorships to elect to be
taxed like a Subchapter C corporation. It was a total disaster and was soon repealed.
Subchapter S allowed corporations to elect not to be subject to the Section 11 income tax
rates on corporation but instead to have its shareholders taxed similar to a partnership.
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(a)
Income Tax Advantages
With the relative ease and increased frequency of corporate formation after World
War II, investors seemed to favor the corporate form of organization to protect
themselves from personal liability from the operation of these many businesses.
Unfortunately, paying for World War II and the Korean War led to new federal
forms of taxation. The new industrial ventures created in response to the war
effort and pent up peacetime consumer demands provided an easy target for
these new tax revenues. The then prevailing view was that excess profits
needed to be taxed. While this tax was applied to entities such as corporations, the
excess profits tax did not apply to partnerships. partnerships gained in
popularity as a result of this tax disparity.
The economic expansion of the 1970s and 1980s gave rise to expanded uses for
partnerships (because of the flexibility and tax treatment), especially as vehicles
to promote tax shelters and other investments. Because of investor speculation
through partnerships, partnerships became subject to Blue Sky or securities
regulations and registrations. Unfortunately, these so-called tax sheltered
investments resulted in huge losses and partnerships and later, LLCs, fell into
disfavor and suspicion.
(b)
Estate Planning with Family partnerships and Family LLCs

is Born
Before 1987, partnerships and LLCs were not considered to be estate planning
tools. However, RULPA added two new sections that offered a new degree of
protection to the ownership interests in a limited partnership. New Sections 703
and 704 of RULPA limited the enforcement rights of a judgment creditor of a
partner exclusively to a charging order. This change did not go unnoticed by
creditors rights counsel, especially during the Texas oil and real estate
depression of the mid-1980s.
At about the same time, the United States Tax Court issued two landmark
decisions which made partnership/LLC planning highly attractive from the estate
and gift tax planners perspective. Both the Watt4s case and the Harrison5 case
showed that properly structured partnerships and LLCs could be used to transfer
family wealth at substantially reduced values for estate and gift tax purposes.
These cases demonstrated the tax courts recognition that a person could structure
their assets and business affairs in such a way that, for transfer tax purposes, the
value of a limited partnership/LLC interest may not be worth as much as its prorata underlying asset liquidation value. The tax court had acknowledged that the
liquidation value of an interest in an entity was not the true measure of fair market
value, which our system of taxation requires because of the prohibition against the
direct taxation of property under Article I, 9 cl. 3 of the U.S. Constitution.
4
5
Watts vs. Commissioner, 51 T.C.M. 60 (1985)

Harrison vs. Commissioner, 52 T.C.M. 1306 (1987)
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This breakthrough recognition by the tax court is the underpinning for what some
commentators have called the most important planning technique since the
creation of the unlimited marital deduction deferral technique.

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Part II
Essentials of Limited Liability Companies
2.01
Basic Types of LLCs
LLCs will always fall into one of two basic categories: single member LLCs (SMLLCs)
or multi-member LLCs (MMLLCs).
(a)
SMLLC
A single member LLC may be owned by an individual, or by an entity. As we will

discuss in greater detail below, the SMLLC may be taxed as a sole
proprietorship/disregarded entity, an S-corporation, or a C-corporation. It cant be
taxed as a partnership (because there is no other partner).
(b)
MMLLC
A multi-member LLC may be owned by any number (greater than one) of

individuals or entities, and any combination of members or entities. The MMLLC
may be taxed as an S-corporation, a C-corporation, or a partnership. It can only be
taxed as a disregarded entity if there are only two members who are legally
married (as defined under federal law).
2.02
Basic Management Structures
All LLCs will either be managed by one or more of the members (i.e., member
managed) or by one or more managers (i.e., manager managed). The managers need
not be members of the LLC, but they may be. The managers or managing members may
be individuals, or they may be entities who function through a representative, such as the
trustee of a trust that owns LLC interests.
(a)
Managing SMLLCs
The default rules for a single member LLC (owned by an individual, not an
entity) provide that the LLC will be managed by the member. The operating
agreement can certainly provide a different structure, such as management by an
individual or by a managing entity.
We think that it is unwise to rely on the member-management default. It is much
more reliable to draft manager provisions into the operating agreement to help
ensure that there is continuity of management if the member becomes disabled,
dies, or is otherwise unable to act on behalf of the LLC. The manager may be one
or more individuals or entities acting concurrently or consecutively.
When the single member of the LLC is an entity instead of an individual (such as
a trust or another corporate entity), its generally preferable to have a non-member
manager to further insulate the entity member from liability.
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(b)
Managing MMLLCs
By default, a multi-member LLC will have an operating management structure

similar to that of a general partnership. All of the members who will participate in
the LLCs management will essentially operate as the general partner(s) and those
who do not participate in management would operate like limited partners. (The
analogy breaks down, because general partners have joint and several liability; as
discussed above the managers of an LLC do not.)
A preferable model is to have some of the members serve as managing members
to manage the broader operations of the company, with other non-managing
members participating in votes or other company matters beyond the operational
matters.
2.03
Special Purpose LLCs
Since the creation of the LLC in 19776 several states have enacted variations on general
LLC planning. These variations each serve different functions and purposes. The
following is a brief overview of some of the more widely-known LLCs variants.
(a)
Wyoming Close LLCs
In 2000 Wyoming enacted legislation that allows LLC creators to build their
LLCs with significant restrictions. These restrictions often cause the value of the
membership to be deeply discounted for purposes of appraisals. The restrictions
include:
A member may withdraw from the LLC only with the consent of all of the
other members;
Any member who withdraws will not receive return of their capital
contribution unless all the other members consent;
Any member who withdraws can only demand cash to satisfy return of
capital; and
The LLC may only be dissolved by unanimous consent of all the
members.
In addition to the Wyoming Close LLC statute, Wyoming is generally a very
favorable jurisdiction for business formation. If the clients principal office is not
in Wyoming, they must select a registered agent to receive service of process in
the state.7
Wyoming was the first state to enact an LLC: WS 17-15-101

WealthCounsel members Carol Gonnella and Cecil Smith are principals of Teton Agents, Inc.
headquartered in Jackson Hole, WY and offer services as registered agents when appropriate.
(http://tetonagents.com)

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WealthDocx includes an option to create the Wyoming Close LLC and will pull
in the required restrictive language to comply with Wyoming law. If you select
Wyoming as the state of formation, WealthDocx will provide the following
dialog:
(b)
Nevada Restricted LLCs
In 2009 Nevada enacted legislation creating restricted entities, which can be

formed either as LLCs or as LPs (Limited partnerships). Under the statute if an
entity is a restricted entity, the assets inside the entity cannot be accessed during
the term the restriction is in place. The statute provides for a default 10-year lockin period, but the operating agreement can specify any amount of time.
The effect of the lock-in period is that the LLC membership interests are greatly
discounted because of the limited access (on top of the ordinary lack of control,
lack of marketability, and other discounts).
The Articles of Organization for the LLC must specify that it is a restricted entity
to opt into the restricted statute. As mentioned above, the operating agreement can
specify any number of years for the lock-in period. The duration of the lock-in
period substantially drives the valuation discount for the LLC membership
interests.
At this writing, WealthDocx does not include a Nevada Restricted LLC option,
but it should be very easy to modify post document assembly. First, make sure
that the Articles of Organization filed with the Nevada Secretary of State
expressly opt into the restricted LLC statute. Then, simply add a provision in the
operating agreement that reaffirms the opt-in, and specify the lock-in period. (For
ease of administration and valuation, it would likely be best to include that in the
prefatory statements at the beginning the operating agreement.)
(c)
Professional LLCs (PLLCs)
In states that allow PLLCs, generally any practice that requires a license in that
state can be held in a Professional LLC. The result is that the professional practice
can enjoy the many benefits of the LLC structure and still operate the professional
practice lawfully in the jurisdiction.
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Its very important to remember that not all states allow PLLCs. Before you create
one for your client or for your own practice, first verify that your state allows you
to form the PLLC.
(d)
Series LLCs
Nine states (plus Puerto Rico) allow LLCs to divide assets, liabilities, and
members into one or more series, each subject to its own administration, but
covered by a single operating agreement and single legal entity. Each series has a
statutory liability shield that protects the series from claims that arise in another
series.
Each series can have its own members, assets, management and operation
structure, and can operate independent of other series within the LLC. This
structure can be very attractive for clients who have multiple parcels of real estate
and seek to isolate liability from one property to the next without creating a
separate LLC for each property. Each property can simply be assigned to a series
within the LLC, reducing the paperwork and filing fees for the client. But
remember, each series must look, feel, and operate like a separate unit. If the
client fails to properly maintain records for the series and gets sloppy with the
paperwork, it will be fairly easy for a creditor to pierce the inter-series liability
shield and attach the entire LLC. Even if the creditor only gets a charging order, it
would be much better for the client if that charging order applies only to one
series, and not the entire LLC.
Series LLCs are relatively new and as a result, are not fully tested in court. At this
writing we are unaware of any case supporting or refuting inter-series liability
protection either in the LLCs home jurisdiction or in a foreign jurisdiction
(though it seems clear that it would be upheld in the home jurisdiction that
statutorily allows inter-series liability protection).
WealthDocx contains options to create the LLC as a PLLC or as a series LLC:

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Series LLC states & statutes:
2.04
Delaware
DLLC Act 18-215
Illinois
805 ILCS 180/37-40
Iowa
Iowa Code 490A.305
Nevada
Nev. Rev. Stat. 86.296.3
Oklahoma
18 Okla. Stat. 18-2054.4B
Tennessee
Tenn. Code Ann. 48-249-309
Texas
TX Bus. Org. Code 101.601-101.621
Utah
Utah Code Ann. 48-2c-606
Wisconsin
Wis. Stat. 183.0504
Family LLCs
A family LLC (FLLC) is generally an LLC comprised of members who are in the same
family, or comprised of a series of family controlled entities such as trusts, other LLCs,
partnerships, or corporations. FLLCs are generally formed for the purpose of fulfilling
estate planning objectives.
Neither the Internal Revenue Code nor the various state LLC Acts differentiate FLLCs
from any other LLC. But on a practical level there are some very important distinctions
between the operating agreement for a strict business-oriented LLC and the operating
agreement for an FLLC. Some of these distinctions include:
Structure similar to a limited partnership, but with no general partner;
Most or all of the members are family members or family controlled entities;
Complete management and investment control is held by one or more family
members or a family controlled entity serving as the manager;
All of the remaining membership interests are held by family members or family
controlled entities; and
The FLLC operating agreement generally limits transfers of LLC interests to
members of the family or family controlled entities.

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2.05
The LLC as a Legal Entity
Under most state LLC statutes, LLCs are expressly established as separate legal entities,
apart from their interest owners. This is the first step in establishing separation for
purposes of optional tax treatment, valuation adjustments, and perhaps most importantly,
asset protection. As a separate legal entity, the LLC will have its own rights, limitations,
and powers as defined by applicable LLC statutes and as further enumerated in the LLCs
operating agreement.
Unlike partnerships, LLCs as separate legal beings have the ability to own property in the
LLCs separate name. The members have no interest in the underlying property; the
members interests are limited only to the membership interests that they own. Because
the members dont own the underlying assets, the members generally have no liability for
the claims against the LLC. Only LLC assets can be used to satisfy a claim perfected
against the entity.
Finally, because the LLC is a separate legal entity, their operational life is not limited to
the life or lives of the members. If drafted properly, the LLC can continue in perpetuity.
This obviously adds a component of business transition and succession that the attorney
and CPA should discuss with the client.
2.06
Operational Formalities
LLCs are generally not subject to the same operational formalities that corporations must
comply with. In this respect, they are much more akin to partnerships. Corporations are
required to prepare and maintain bylaws, minutes for regularly-scheduled meetings of
directors and shareholders, issue stock certificates to shareholders, etc.
However, clients are unwise to wholly disregard some of the trappings of corporate
paperwork. When a claim against the LLC or its members arises, the creditor will often
seek to pierce the veil and have the court disregard the LLC as a separate legal entity.
Even though the LLC is not bound to the same requirements as corporations for
maintaining books and meetings, the LLC members should be careful to truly treat the
LLC as a business, and document their dealings accordingly. Major decisions affecting
operations or strategy should be documented and preserved in the companys records,
bank accounts must be properly established and carefully managed, etc. In other words,
members must treat the LLC as a business if they expect it to protect them when a claim
arises.
2.07
Members in a Limited Liability Companies
Although most LLCs are comprised of only one class of membership interest, it is
possible to have more than one class of member. The operating agreement can specify
different rights among different classes of members, such as voting rights, management
rights, rights to information, etc.

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(a)
The Manager
All LLCs need some management structure. The Manager controls the day to day
operation of the LLC, and may or may not be a member of the LLC. Unlike a
General Partner in a partnership, the Manager will not have any exposure to the
debts, liabilities, or obligations from the operation and control of the LLC. If the
Manager is a member, he or she can be restricted from resigning or assigning
away their membership interest without the consent of all other members, and
they are entitled to compensation for management of the enterprise.
(b)
Members
Members have no liability that might attach from the operation of the LLC. Nonmanaging members have no right to manage the day-to-day operation of the LLC
and may have restrictions imposed upon their ability to transfer their interest.
However, a total restriction upon a members ability to assign an LLC interest
will constitute an illegal restraint of alienation. Any legally permitted restrictions
placed upon a members interest, including the inability to manage the LLC, may
reduce the value of the members interest for sale or transfer tax purposes. A
member has the right to share in the profits of the LLC and to a return of his or
her capital contribution upon dissolution of the LLC.
(c)
Acquiring a partnership or LLC Interest by Gift or Purchase
In a family LLC, a person will be recognized as a member under the Code if they
own a capital interest in an LLC in which capital is a material income-producing
factor, whether the interest was derived by purchase or gift from another person.8
In the case of any partnership interest created by gift, the distributive share of the
donee under the LLC operating agreement shall be includible in the donees gross
income, except to the extent that such share is determined without allowance of
reasonable compensation for services rendered to the LLC by the donor, and
except to the extent that the portion of such share attributable to donated capital is
proportionately greater than the share of the donor attributable to the donors
capital.9
A purchase of an interest by one family member from another will be considered
to be a gift and fair market value will be considered to be donated capital. The
family of any individual shall include only his spouse, ancestors, and lineal
descendants, and any trusts for the primary benefit of such persons.10
IRC 704(e)
IRC 704(e)(2)
10
IRC 704(e)(3)
9

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2.08
About Limited Liability
Every LLC Act states that members and managers enjoy limited liability. One way or
another, the members exposure for claims is limited to the members assets in the LLC;
the members are not personally liable for the companys liabilities. (Contrast this with a
general partnership, where the general partner has personal liability.)
It may be obvious to attorneys and other professionals, but some clients dont understand
that the LLC itself is not protected from liability. The assets in the LLC are exposed to
claims that arise against the LLC. This is why it is imperative that the LLC contain
adequate assets and liability insurance to cover claims that arise.
2.09
Charging Order Protection
As mentioned above, charging order protection generally limits a creditors relief to a

debtor members share of assets or profits that would be distributable to the member. The
essential protection of a charging order is that the creditor does not get control of the
debtor members non-economic rights, such as voting rights, rights to manage the LLC,
rights to information, or other rights. In other words, the creditor can only receive what
the debtor member would receive in distributions from the company.
Because the creditor does not acquire the debtor members non-economic rights, charging
order protection keeps the creditor from forcing the LLC to liquidate assets to satisfy the
claim. Of nearly equal importance, charging order protection keeps the creditor from
becoming an unwanted substituted member. Charging order protection is unique to LLCs;
most state laws governing corporations have no equivalent. This is one of many reasons
why LLCs have become the preferred entity model for clients with operating businesses.
Whether a SMLLC receives charging order protection is a question that remains
unresolved in many jurisdictions. Considering that the primary purpose of charging order
protection is to protect non-debtor members from claims that arise and are perfected
against a debtor member, the argument for charging order protection when there is only
one member gets somewhat strained. The table of important cases located in the Exhibits
highlights points from Albright and Olmstead, two cases that pierced charging order
protection for SMLLCs. Bear in mind that in neither of the governing jurisdictions
(Albright arose in Colorado; Olmstead in Florida) had a statutory provision that stated
that the charging order is the sole remedy for creditors of the LLC. And Olmstead in
particular had bad facts that just begged the court to find in favor of the plaintiff, the
Federal Trade Commission.
For a quick rundown of the best jurisdictions for LLCs (from an asset protection
perspective), please see the table Best Jurisdictions for LLC Protection at Part XII below.
(a)
Effect of a Charging Order
A charging order functions as a lien against the debtors FLPs & FLLCs interest
and has priority over non-perfected security interests as of the date the charging
order is served. A charging order creditor only acquires the status of an assignee.
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(b)
Four Options of the Court
The UPA (Uniform Partnership Act) applies to partnerships and LLCs insofar as
it is not inconsistent with RULPA. (The same rules also apply to LLCs) Under
UPA 6(2), a court has four discrete remedies.
An Order that charges the partnership/LLC interest of the debtor-partner.
This has the effect of directing that any distributions intended for the
debtor-partner must instead be distributed to the creditor. This is similar to
the concept where funds held by a third party for the debtor-partner could
be diverted.
An Order appointing a receiver. The receivers role would be merely to
receive the moneys due pursuant to the order and to conserve/protect
partnership/LLC property;
An Order of foreclosure selling the debtor-partners interest. The
creditors or purchasers rights are that of a permanent assignee and not
the rights of a substitute partner. The creditor or purchaser continues to be
an assigned even after the judgment is paid or released.
An Order dissolving the partnership/LLC.
Many states have statutorily limited the courts options. See the table Best
Jurisdictions for LLC Protection at Part XII below for a broader discussion of
most favorable jurisdictions. WealthCounsel members can also access the
Leimberg Information Service via the WealthCounsel member web portal and
should search for LISI Asset Protection Newsletter # 154.
2.10
How Members Blow Up their Asset Protection under LLCs
In his treatise11, author John Cunningham highlights several ways that LLC members end
up confounding their own plan, exposing themselves to liability that might otherwise
have been avoided. Its very important that attorneys understand that:
Like any asset protection device, an LLC wont protect the members from claims
that arose before the LLC was formed;
The LLC wont protect members from liability that arises from their own personal
misconduct, including direct actions or omissions, negligence, or tortious or
criminal behavior;
If a creditor is able to pierce the veil of the LLC, a court will hold the members
personally liable for the LLCs claims;
Even though the LLC provides a liability shield, it may not withstand liabilities
arising under state or federal tax, securities, or environmental laws.
11
John M. Cunninghams treatise is titled Drafting Limited Liability Company Operating Agreements
(2010, Aspen Publishers)
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This is not an exhaustive list. Suffice it to say that asset protection is never a sure thing.
Attorneys are wise to counsel their client concerning these and other limitations on
liability protection with LLCs or with other asset protection devices.
Asset protection success depends upon properly maintaining the limited partnership or
LLC. This means that the company must carefully maintain proper formation and filings,
maintain a clear business purpose, and maintain proper operation of the partnership or
LLC in conformity with the partnership or operating agreement.

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Part III
Tax Classification:
Choosing how the LLC will be taxed
WealthDocx gives you the ability to choose how the LLC will be taxed. Although this
course is not a comprehensive comparative study of tax methods, the discussion below
highlights the LLC taxing options in WealthDocx, with a quick overview of some
important decision points. Selecting the right choice of applicable tax regimen is one of
the biggest decisions youll help your clients make as they implement their LLC.
3.01
Disregarded Entity (Sole Proprietorship) Taxation
Quite literally, a sole proprietorship is an entity wholly owned by one individual. As a

result, sole proprietorships are disregarded for tax purposes and pass all tax items (i.e.,
income, capital gains, losses, deductions, credits) through the entity and treat those items
as though they were held individually by the LLC owner. This pass through tax
treatment is a common and often attractive feature of LLC planning. Owners of sole
proprietorships will typically report their business income on Schedule C of their 1040
Income Tax Return.12
An LLC that is wholly owned by a married couple may elect to be treated as a
disregarded entity, meaning that the LLC will be treated as a sole proprietorship for tax
purposes. 13 Disregarded entity/sole proprietorship treatment has some nice benefits:
It avoids double taxation of income and capital gains from the sale of LLC assets
(by contrast, see C-corporation treatment, below);
It allows the LLC owners to use business losses to offset income, reducing their
personal tax liability; and
It provides great flexibility in allowing the LLC owners to use company assets.
Because the LLC is treated as though held by the individual owner, contributions
and distributions of property are not treated as taxable events.
If the single member LLC is wholly owned by a trust, another LLC, or a corporation, the
single member LLC will be treated as a disregarded entity and all tax items will pass
12
Exceptions include: Interest and Ordinary Dividends (Schedule B), Capital Gains and Losses
(Schedule D), Supplemental Income and Loss (Schedule E), and Profit or Loss from Farming
(Schedule F)
13
Because LLC taxation is determined through compliance with the Internal Revenue Code, the Defense
of Marriage Act of 1996 (DOMA) requires that only couples whose marriage meets the federal
definition set forth in DOMA may qualify for disregarded entity taxation in an LLC that is wholly owned
by the married couple. At the time of this writing, LLCs owned by a same-sex married couple will not
qualify for disregarded entity tax status. That couple would likely choose partnership taxation status,
though S-corporation or C-corporation tax treatment would be available as well.
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through to the underlying owner and be taxed at that owners tax rates, unless the owner
chooses an alternate tax treatment option. This is usually a very favorable plan for single
member LLCs.
3.02
Partnership (Subchapter K) Taxation
Partnership, or subchapter K treatment, is founded on the aggregate theory of taxation,

which treats partnerships as a business organization for legal purposes, but for tax
purposes, as merely a collection, or aggregation, of the various partners. Although the
legal concept of aggregate theory for business purposes is obsolete, the principle provides
valuable context in understanding why subchapter K works the way it does.
Like sole proprietorships, partnerships are pass through entities, allowing all tax items to
pass through the entity and be taxed in the hands of the individual partners, and are
generally allocated ratably among the partners in proportion to their ownership interest.
While this statement is generally true, the partners in a partnership-taxed entity may
contractually alter the relationship and the methods by which profits and losses are
allocated among them. This same flexibility does not exist for corporations. Under the
various LLC laws and under IRC 704(b), partners may choose to allocate tax items
(including profits and losses) in any manner in which they agree; the allocation often is
but does not have to be ratable by ownership interest.
In 1987 the IRS issued Rev. Rul. 88-76, which opened up partnership taxation for LLCs
that met certain requirements. (See the discussion on Kintner Regulations at Error!
Reference source not found..) The Treasury issued Regulations to make it much easier
for multi-member LLCs to choose to be treated as partnerships for income tax purposes.
Because the LLC is not separately taxed, capital gains on the sale of LLC assets and LLC
income are only subject to tax at the individual owner level and not double taxed as
they are in C-corporations.
3.03
S-Corporation (Subchapter S) Taxation
S-corporations are also pass through entities, but they have to comply with more rigorous
statutory requirements for that tax treatment. Those additional requirements allow the Scorp to take advantage of some statutory tax benefits not otherwise available to other pass
through entities.
3.04
C-Corporation (Subchapter C) Taxation
C-corporations are not pass-through entities. The tax items of C-corporations are treated
as tax items belonging to the corporation as a separate taxpayer, meaning that income of
the corporation is taxed at the corporate level for the year in which the income is earned.
When the corporation later distributes dividends to the shareholders, those shareholders

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must pay taxes on those distributions for the year in which the distributions are made.
This is generally referred to as double taxation.
Corporations are treated under the so-called entity theory of taxation, meaning that the
corporation is viewed as a legal entity wholly separate from the individuals who own an
interest in the corporation. The corporation is treated as the owner of the corporate
property, and is thus separately taxed on tax items attributable to the entity. When a
shareholder buys an interest in a corporation they do not acquire any interest in the
corporations property; the shareholders interest is in the corporate entity itself and only
has an indirect interest in the corporations assets.
Because the C-corporation is taxed separately as an entity it is seldom the preferred
model for LLCs.
(a)
When C-corporation Treatment Works
If an entity is going to be publicly traded, it must be taxed as a C-corporation

regardless of what type of legal entity it is.14 Also, if the entity owners want clear
tax guidelines on incentives for directors and employees but dont meet the strict
compliance rules of subchapter S, C-corporation treatment is preferable. (It is
unclear whether LLCs can get favorable treatment for fringe benefits when taxed
under subchapter K.15)
3.05
Default Tax Treatment and Electing Out
The Treasury Regulations provide for the procedures necessary to elect desired tax
treatment for the LLC. (See generally Treas. Reg. 301.7701-1 through 301.7701-3.)
Under those laws, the following apply to various LLC formation and taxation options.
(a)
Single Member LLCs
If the LLC is owned by an individual (or is wholly owned by another entity), the
LLC will be treated as a disregarded entity by default under the Check-the-Box
rules. The LLC owner must affirmatively select to be taxed as a C-corporation or
as an S-corporation (assuming they otherwise meet those sub-S requirements).
(b)
Multi-Member LLCs
Under the default Check-the-Box rules, a multi-member LLC will be taxed as a

partnership under subchapter K of the IRC unless the owners affirmatively elect
another form of tax treatment.
(c)
Electing Out of Default Treatment
If the LLC owners/management want to elect out of the default tax position, and
seeks C-corp treatment, the LLC must file IRS Form 8832 within 75 days of
14
IRC 7704
Drafting Limited Liability Company Operating Agreements, John M. Cunningham (2010, Aspen
Publishers), at 4A.02[C]
15

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formation under applicable state law. If the LLC meets the qualification
requirements and the owners want S-corp treatment, the LLC must also file IRS
Form 2553 (in addition to IRS Form 8832) within 75 days of forming the LLC.
3.06
Social Security tax issues
Social Security taxes apply to employment compensation income earned by individual

taxpayers. Social Security taxes do not apply to passive income, like dividends,
interest, capital gains, rent income, or limited partnership income on limited partnership
interests.
Individuals who are employed by others pay Social Security taxes in the form of FICA
withholdings from their paychecks. (The employee pays half and the employer pays half.)
Self-employed individuals pay those Social Security taxes in the form of SelfEmployment Tax (SET). Those self-employed taxpayers often seek planning
opportunities that will reduce their Social Security tax liability.
We strongly encourage estate planning attorneys to work closely with the clients tax
advisors to determine whether it is in the clients overall best financial interest to employ
strategies that would reduce their Social Security tax liability, considering potential
disadvantages such as reduced Social Security payments later in life, or reduced
participation in qualified retirement plans.
3.07
SMLLCs: Sole Proprietorship or Sub-S Taxation?
As we have seen, C-corp taxation is generally unfavorable because of its nature of entitylevel or double taxation. Since partnership taxation treatment requires a partner,
single-member LLCs cant be taxed as a partnership. (In fact, sole proprietorship tax
treatment functions very much like partnership treatment.) So the tax planning issue for
SMLLCs will be whether to treat the LLC as a disregarded entity or a subchapter Scorporation. 16
Sole Prop. / Disregarded Entity
Eligibility
No rules
S-corporation
Only one class of stock; no business
entities as owners; trust limitations (must
be QSST)
16
This matrix was adapted from content in Drafting Limited Liability Company Operating Agreements,
John M. Cunningham (2010, Aspen Publishers), at 4A.06
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Contribution of
property
(at formation)
Putting property in use is not a

contribution; no tax implication.
Contributions are tax-free
Contribution of
property
(post formation)
No adverse tax implication.
Triggers gain to contributor unless they

comply with 50% control rule17
Contribution of
services
Irrelevant for single-owner entities

(category included b/c its relevant for MMLLCs, below)
Special allocations
& distributions

Distributing entity
property
Redemption of
ownership interest
Sale or purchase of
ownership interest
Distributions are tax free

Gain from sale of interest attributable
to ordinary income assets (receivables,
appreciated assets) subject to ordinary
income tax.
Buyer gets inside basis step-up in entity
assets
Entity debt
Owners may include portion of entity

debt in basis of ownership interest.
Restricted interests;
purchase options
3.08
Distribution of property treated as sale to

transferee, resulting in taxable gain.18
Gain from sale of interest always subject

to capital gains tax
No inside basis step-up
Owner may include debt of entity in basis

value only to extent of direct loans to
entity by owner.19

MMLLCs: Choosing between Sub-S and Partnership Taxation
Because C-corp taxation will only be appropriate in very narrow circumstances, the
primary choice of entity taxation for multi-member LLCs will either be partnership
taxation under subchapter K or S-corp taxation. The following table should help you
counsel clients to determine which tax regime is most appropriate for their MMLLC.
Partnership
S-corporation
17
IRC 351(a)
IRC 311, 336
19
IRC 1366(d)(1)(B)
18

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Eligibility
Only narrow limitation for publiclytraded partnerships under IRC 7704;

otherwise no limits on who can be
partner
Only one class of stock; no business

entities as owners; trust limitations (must
be QSST)
Contribution of
property
(at formation)
Pre-contribution gain allocated to

contributor when disposed of by entity,
but depreciation allocated among noncontributing partners;20
No pre-contribution gain rule applies.

Partners who contribute property will
prefer sub-S taxation; partners who do not
will prefer partnership taxation.
Contribution of
property
(post formation)
Post-formation contribution of
appreciated property does not trigger
tax.21
Post-formation contributions taxable

unless immediately after contribution the
contributing owner owns stock possessing
at least 80% of total combined voting
power and at least 80% of all shares.
(80% control rule)22
Contribution of
services
Partnerships may grant profits

interest, a form of equity interest in
partnership. Applies to past or future
services in lieu of cash or property (as
opposed to capital interest infusion of
property).23
Cannot grant profits interest b/c doing

so would create second class of stock
contrary to Sub-S rules.
Special allocations
& distributions
Permitted if allocations have

substantial economic effect.24
All allocations MUST be proportionate to

members respective interests.
Distributing entity
property
Generally not taxable to the entity or

the transferee.25
Distribution of property treated as sale to

transferee, resulting in taxable gain.26
Redemption of
ownership interest
Inside basis step-up (cost basis) in

entity assets for other partners if 754
election is made.27
No inside basis step-up provision
Sale or purchase of
ownership interest
Gain from sale of interest attributable

to ordinary income assets (receivables,
appreciated assets) subject to ordinary
income tax28.
Gain from sale of interest always subject

to capital gains tax
Buyer gets inside basis step-up in entity

assets if 754 election made.29
No inside basis step-up
20
IRC 704(c)(1)(A) pre-contribution gain rule

IRC 721
22
IRC 351(a)
23
Rev. Proc. 93-27, 1993-2 C.B. 343
24
IRC 704(a) and (b)
25
IRC 731(a)
26
IRC 311, 336
27
IRC 734
28
IRC 741, 751
21

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Entity debt
Owners may include portion of entity

debt in basis of ownership interest.30
Owners may include debt of entity in

basis value to extent of direct loans to
entity by each owner.
Restricted interests;
purchase options
May create restricted interests and

options to purchase interests.31
Single class of interest only
Post-formation grants of profits

interests subject to extensive drafting,
unclear law.
Clear rules for restricted stock and stock

options32
3.09
LLC Tax Planning Matrix33
While proper choice of tax treatment for an LLC should be made with the attorney and
CPA working closely with the client, the following matrix can provide a general
overview of some of the decision points to consider when advising the client.
Tax Treatment
Sole Proprietorship
----Disregarded Entity
Subchapter K
(Partnership)
Subchapter S
Key Advantages
Key Disadvantages
Pass-through tax treatment

Flexible use of LLC assets (no tax on
transfers in/out)
No ISOs
No ESOPs
No choice of tax year
Inside basis step-up on 3d-party

acquisition
All net earnings subject to SelfEmployment Tax (SET)

Flexibility in allocating gains & losses
No ISOs
No ESOPs
Distribution of gain or loss property

without recognition of gain or loss
Unexpected income from sale of partnership

interest34
Unexpected gain from sale of interest35
Inside basis step-up if partners buy out

another
Inside basis step-up for partnership
interest transferee
Deemed termination of partnership36

Contribution of encumbered property
affects basis, may trigger gain37
Partners include proportionate share of

non-recourse liabilities in computing basis
Disproportionate distributions trigger

recharacterization, tax consequences38
Potentially complicated tax compliance
Limitations on eligible shareholders

Generally difficult for entities to qualify as
29
IRC 743(b)
IRC 752
31
IRC 704(a)
32
IRC 421
33
This matrix was developed in reliance on data contained in John Cunninghams excellent treatise,
Drafting LLC Operating Agreements, 2010, Aspen Publishers
30
34
35
36
IRC 741, 751

IRC 752(b)
If 50% or more of the partnership is sold or exchanged within any 12-month period. (IRC 708(b)(1)(B))
IRC 752(a)
38
IRC 751(b)
37

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shareholders39
No fringe benefits
Possible to trigger accidental termination of
election by invalid transfer
Less flexibility on choice of tax year
Ability to offer fringe benefits
Choice of tax year
Subchapter C
Transferability of losses if acquired by

another C-corp
Incentive stock options (ISOs),
Employee Stock Ownership Plans (ESOPs)
for employees
Double-taxation
Benefits of pass-through options dont apply
More complicated tax compliance
Fewer options for reducing SET for
owner/employees
39
WealthDocx trusts have options to allow the trust to qualify as an S-Corp shareholder. Its essential to
select those applicable options if the trust is going to own S-Corp shares, or interests in an LLC taxed as an
S-Corp.
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Part IV
Overview of Asset Protection Issues
4.01
Partnership and LLC Provisions Affecting Asset Protection
A creditor has no right to become a substituted partner or member.40 A creditor has no

right to seize assets or to compel liquidation of the partnership.41 A creditor has no rights
over any specific partnership or LLC property.42 A creditor has no right to demand
income from the partnership or LLC43 and no right to demand principal distribution44 or
liquidate.45 The exclusive remedy available to a creditor is a charging order.46
There are many different partnership and LLC provisions that impact on the asset
protection afforded the partners or members interests.
(a)
Voting Provisions
Requiring a high percentage of agreement required for contemplated actions.

Limited Partners should not be allowed to override the General Partner.
(b)
Limitations on Withdrawal of Partners or Members
We generally suggest that the agreement require 100% approval of all General
Partners or Managers and all other Limited Partners or Members.
(c)
Limitations on a Partners or Members Right to Demand

Distributions
No member or partner should be able to demand distributions.

(d)
Limitations on the Transferability of a Partners or Members

Interests
The agreement should not allow the holder of a transferred interest to become a
substitute limited partner or member. Further, there should be no general right to
transfer a membership interest without the approval of all other partners or
members.
(e)
Limitations on Liquidation of the partnership or LLC
The agreement should specify that the partnership or LLC does not terminate
unless by unanimous consent of the partners/members. (A supermajority is
40
RULPA 704. Limitations on rights of Assignee to become substituted partner

RULPA 703. Rights of judgment creditor
42
RULPA 701. Nature of partnership interest the partnership owns all partnership property; the partners
have no rights to partnership property.
43
RULPA 504. Sharing of distributions
44
RULPA 603. Withdrawal from a limited partnership
45
RULPA 801. All partners must agree to dissolve
46
RULPA 703. Rights of judgment creditor
41

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generally okay, but less secure than unanimous action.) The same restriction
should be placed on liquidating partnership/LLC assets.
The agreement should also specify a long partnership or LLC term (50 to 99
years) or even perpetual life.
(f)
General Partner Conversion to Limited Partner where Charging

Order Is Outstanding
Requiring the conversion of a General Partners interest to a Limited Partners

interest if a charging order is entered against the General Partner or if the General
Partner wants to withdraw or resign. CAUTION: this right to convert can conflict
with IRC 2704(a) provisions, discussed in Part VII below.
4.02
Tax Consequences to Charging Order Creditor after Foreclosure
An assignee acquiring substantially all of the dominion and control over the interest of a
limited partner or LLC member is treated as a substituted limited partner or member for
Federal income tax purposes.47
In Evans v. Commr, 447 F2d 547 (7th Cir. 1971), the assignment of partnership/LLC
interest is effective for federal income tax purposes notwithstanding that the assignor, for
state law purposes, remains a partner where consent to transfer was lacking as required
under local law. Rev. Rul. 77-137 suggests that the Charging Order creditor will
effectively receive only a right to receive phantom income.
4.03
Distributions Around a Charging Order?
Some attorneys have speculated that the General Partner or LLC Manager can
discriminate among the Limited Partners or Members by only allowing distributions to
some of the Limited Partners or Members, effectively enabling other members or partners
to benefit from the entity while starving out the creditor. We believe that this would
constitute a breach of the Managers (or GPs) fiduciary duty and would not counsel a
client to do so without prior court approval.
There are a few possible ways to circumvent the fiduciary breach argument, enabling
other members to receive money from the entity when a creditor has a charging order in
place.
(a)
Loans to Members
The operating agreement could arguably contain a provision expressly authorizing

the Manager or GP to make loans to members. The Manager or GP can make a
determination as to whether a loan from the LLC or partnership would be in the
best interests of the entity. The provision might further state that the Manager
47
Rev. Rul. 77-137, 1977-1 CB 178

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could make loans to certain Members, but not to others, and could expressly
prohibit loans to an assignee.
(b)
Distributions for Contributing Members
The operating agreement could include a provision that limits distributions as for
only those partners who have responded to any and all cash calls made by the
General Partner or Manager. Since a creditor holding a charging order would not
be in that class, the creditor would not be entitled to receive any distribution.
(c)
Different Classes of Members/Partners
The operating agreement can also create multiple classes of membership interests
and treat those classes differently. For example, the LLC or partnership might
issue common interests for members who have a higher liability profile, and
preferred interests to members with a lower liability profile. The preferred
interests could then have preferential treatment in distributions from the entity.
Granted, it takes a lot of forethought and a good bit of luck to make it work
sometimes. Also bear in mind that the common interests will likely be valued
lower than the preferred interests.
4.04
Other Asset Protection Considerations
When created for asset protection purposes, partnerships and LLCs are best used in
conjunction with other available asset protection tools and concepts:
(a)
Liability Insurance: The First Line of Defense
Clients should never engage in asset protection estate planning in lieu of

maintaining liability insurance. Liability insurance should be in addition to asset
protection estate planning. Liability insurance is much less complex and typically
less costly.
The advantages of liability coverage include the potential for complete coverage
of any claim, as well as the insurance companys provision of legal representation
in any suit.
The disadvantages of liability coverage include possible insolvency of the carrier,
rising costs of coverage over time, potential unavailability of coverage, such as
where the business activity is particularly risky or is currently the subject of a
pattern of litigation (such as nursing homes), and the failure of insurance carrier to
pay exemplary damages.
(b)
Statutorily Exempt Assets; State Law Issues
The following are examples of property and interests that generally have some
modicum of protection under state law. Bear in mind that the limits and
protections are very much determined on a state-by-state basis.

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(1)
Homestead Exemptions
Homestead exemptions vary from state to state. Attorneys should be

familiar with the scope and limitations of homestead exemptions in their
own states and the states where their clients reside to make sure that the
clients take maximum advantage of those protections.
(2)
Life Insurance Cash Value
The cash value of life insurance is generally protected from creditors.

(3)
Wages & Salaries
Some states do not allow wages or salaries of employees to be garnished.

Other states cap the allowed garnishment of wages or salaries.
(4)
Retirement Plans
Generally, qualified retirement plans are exempt from creditors. This often
includes qualified pensions, qualified profit sharing [401(k)], qualified
defined benefit plans, qualified target benefit plans, and IRAs.
(c)
Separate Property Trusts
Many practitioners create separate trusts for each spouse to own the respective
FLLC interest of the spouses as the respective separate property of the spouse.
Its important to properly schedule each spouses separate trust on a property
agreement identifying the trust as separate property. In community property
states, those trusts should also be listed as separate property on any partition
agreement.
As a result, if one spouse is sued the creditor of that spouse cannot obtain a
charging order against the other spouses partnership or LLC interest.
4.05
Creditors Rights
The genesis of creditors rights is found in the Statute of Elizabeth (13 Eliz. Ch. 5
(1571)). The penalty was forfeiture of value and imprisonment. In the U.S., each state has
adopted either the Statute of Elizabeth as part of the common law; the Uniform
Fraudulent Conveyances Act or the Uniform Fraudulent Transfers Act, or a variation of
one of these.48 The essential remedy allows a court to set aside the transfer of assets that
were found to be fraudulently transferred.
Creditors rights laws are designed to protect present creditors and future known creditors
against transfers made with the intent to hinder, delay, or defraud them.
48
Other relevant laws impacting creditors rights include Comprehensive Thrift and Bank Fraud
Prosecution and Taxpayer Recovery Act of 1990 (Title XXVII, Crime Control Act of 1990); Money
Laundering Control Act (18 USC 1956-1957); Anti-Money Laundering Act of 1992; Federal Debt
Collection Procedures Act of 1990 (28 USC 3001-3307); and the Racketeer Influenced and Corrupt
Organizations (RICO) Act
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(a)
Future Unknown Creditors
Future but unknown creditors must generally show actual fraud to void a transfer.
It is okay to have a protection motive as to these creditors.49
In Hurlbert v. Shackleton, 1st DCA, No. 89-2283 (April 18, 1990), a Florida
doctor sought to cover all the bases as he couldnt get malpractice insurance.
Dr. Shackleton made transfers in 1983 and a claim was made in 1984. Judgment
was entered in 1986 in favor of Dr. Shackleton. The court found that at the time of
the transfer, Hurlbert was not a present creditor or a subsequent creditor but was
in fact an unknown future creditor. The appellate court reversed and remanded on
finding of whether there was or was not actual fraudulent intent at the time of
transfer. The appellate court probably should have affirmed without comment.
4.06
General Purpose of Creditors Rights Laws
In general, creditors rights laws are designed to address the situation where there is a
transfer for less than full and adequate consideration of assets that are not otherwise
exempt from attachment by creditors, and after the transfer, the transferor has insufficient
non-exempt assets with which to satisfy his or her liabilities.
4.07
Defending entity creation against fraudulent conveyance or

transfer claim
A frequent claim made by a creditor is that a debtor created a limited partnership or LLC
as a means of hindering, delaying or defrauding the creditor. However, your client can
defeat that accusation by properly structuring their plan.
(a)
Equivalent Value Received
In creating a limited partnership or LLC, each partner or member receives limited

FLPs & FLLCs interests or having a reasonably equivalent value in exchange for
transfer of asset.
(b)
Adequate Liability Insurance
If the contributing debtor has adequate liability insurance to satisfy the claim of
the creditor, there should be no colorable claim of a fraudulent transfer. This
defense is frequently employed in the case of limited partnership and LLC
planning for professionals who have higher liability profiles, like doctors.
49
See Oberst v. Oberst, 91 B.R. 97, L.Rep. P. 72, 462 (U.S. Bankruptcy Court, C.D. California (1988)
(police officer and wife bought farm; general concern about possible liability at the time), and Wantulok et
al. v. Wantulok, 214 P.2d 477 (1950) (concern about liabilities arising from adult daughters illness led to
grant of mortgage).
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(c)
Partnership/LLC Interests Have Value
A debtor contributing assets to a partnership or LLC may not be insolvent after

the transfer of assets. Entity interests have an ascertainable value and a creditor
can still enjoy the economic benefit by virtue of a charging order. Under UFTA,
case law suggests this will be answered on a case-by-case basis. In Commissioner
v. Culburtsson, 337 U.S. 733 (1949), the court set forth the all facts and
circumstances test and, in addition, establishes the good faith and business
purpose standards.
(d)
Other Assets Remain
The debtor contributing assets to a limited partnership or LLC may have other
assets with which to satisfy any claims. It is very important to not structure the
plan in such a way as to try and make your client totally judgment proof.
(e)
Economic Hardship
A final defense is that it would work an economic hardship on innocent partners

or members to interrupt the functioning of the partnership or LLC in favor of an
unrelated third party creditor.
4.08
Partnership and LLC Defenses Against Bankruptcy
Generally, a bankruptcy trustee has no right to seize partnership or LLC assets as a result
of an individual limited partner or member filing bankruptcy. The terms of the
partnership or LLC weigh heavily in this area.
The creditor can only receive the debtor-partners/members interest, an assignees right
to receive that share of profits and distributions.50 A bankruptcy trustee is treated the
same as an assignee and has no right to withdraw or demand assets. The creditor also has
no rights to vote on partnership or LLC issues and decisions.
The partnership or LLC agreement can specify that all distributions are to be made in the
discretion of the General Partner or Manager. Note that a bankruptcy trustee may attack
the general partner/manager under its fiduciary capacity to act in the best interests of the
partners/members, and seek judicial dissolution if the general partner/manager
discriminates against a particular partner/member such as the bankruptcy trustee standing
in the shoes of the debtor limited partner/member.
If the GP is bankrupt, it may cause dissolution of the partnership.51 This is one of many
reasons why it is generally best to use an entity as the general partner.
50
51
RULPA 702
See UPA 31 (5) and 38; RULPA 402(4), (5), 801 and 804
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Asset Protection Planning Matrix52
4.09
Claims Brought
Against
Spouse 1 Risk
Person or Entity
Personal Risk
(own exempt Assets)
Person or Entity
Personal Risk
(own 50% of estate)
Personal Risk
(own 50% of estate)
Same Tools
Indiv. vs.
Entity
No Risk
(retain CP)
No Risk
(retain CP)
Joint RLT, FLPs, LLCs & FLLC,

Entity GP; Corp or LLC
4.10
Spouse 2 Risk
Asset Protection Tools
No Risk
Partition Property; Sep. RLTs;
(own non-exempt assets, LLC-Owned Corps; FLPs, LLCs
home, etc.)
w/ Entity GP (LLC, Corp, BT)
LLC and partnership Asset Protection Design Features
This section highlights some of the most preferred asset protection-oriented design
features commonly used in LLCs and LPs (whether for business purposes or estate
planning purposes.
(a)
Use an Entity Manager or GP
With the advent of the Check the Box Regulations it is now possible to design
LLCs and partnerships to possess three of the desirable corporate characteristics:
Limited liability;
Centralized management; and Continuity of life.
We usually want to negate the fourth corporate characteristic of free
transferability of interest.
With the check-the-box regulations in place, we can design partnerships and
LLCs to have a limited liability entity as the Manager. Therefore, if a creditor
were to have a claim against the partnership or LLC, the creditor can only look to
the assets of the entity and the managing/GP entity, and not to the assets of the
members.
Since none of the members serve as GP, the members are totally shielded from
the entitys liabilities so long as a member does not co-sign or guarantee any of
the entitys obligations. But if a limited partner gets involved with the business
52
Abbreviations: Indiv. = Individual; RLT = Revocable Living Trust; RMT = Revocable Management
Trust; IMT = Irrevocable Management Trust; BT = Business Trust; FLPs, LLCs & FLLC = Family Limited
Liability Companies; LLC = LLC; GP = General Partner; CP = Community Property
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operations of the partnership they can be elevated to the status of general

partner.53 RULPA 303(b) sets out a list of various acts that limited partners may
engage in without causing them to be elevated to GP status. This list is very broad
and can be made even broader by the partnership agreement.
(b)
Assignee does not automatically become Substitute Partner
RULPA 704 provides that the transferee of a partnership interest will not have
the status of a substitute partner, but that of an assignee only, unless and until all
partners consent. RULPA 702 provides that an assignee of a partnership interest
does not have the right to become a partner or to exercise any partner rights or
powers. The assignee is only entitled to be allocated the assignor partners share
of tax items.54 Until an assignee becomes a substitute partner, the assignor partner
continues to be a partner and retains the power to exercise any rights or powers of
the partners interest.
RULPA 703 provides that a judgment creditor of a partner has only the rights of
an assignee. Accordingly, in those signatory states where the charging order is the
exclusive remedy, the adverse tax consequences of Rev. Rule 77-137 will apply.
We believe that the best practice is to have the partnership-taxed entity agreement
echo the provision of RULPA 702-704.
(c)
Mandatory Additional Capital Contributions
The operating agreement can give the manager the power to make mandatory
capital calls from all members. Any member who fails to pay the cash call will
not be entitled to have his share of the income distributed to him. If a creditor
obtains a charging order, if neither the debtor member nor the creditor satisfies the
cash call, the manager may suspend distribution to the debtor member and the
creditor, while continuing to pay out distributions to the other members.
Note that the managers power to demand additional capital contributions can
further strengthen arguments for valuation discounts.
(d)
Redemption of Interest Seized or Subject to Charging Order
The operating agreement may include provisions allowing the manager to redeem
the interest of any member whose interest is seized or subject to a charging order.
This feature should be designed to allow the manager to call or redeem the debtor
members interest at a price which is the lesser of the indebtedness owed or the
fair market value of the partnership interest. The provision could further provide
that the payment could be made with no down payment required and a long term,
low interest rate unsecured promissory note. The promissory note may then be
offered by the debtor member to the creditor as payment towards the indebtedness
owed.
53
54
ULPA 303(a)
IRC 704(a)
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(e)
Two Classes of Limited Liability Companies Interests
As mentioned at 4.03(c) above, the agreement can create a common class of

interest for those members who have the highest potential for liability exposure,
and a preferred class of interest for those members who have a lower risk profile
(such as a spouses trust or a childrens trust). The preferred class would receive
preferential distributions, even if a creditor has a charging order against a
common interest member.
If a preferred class of member should find itself in litigation and a threat exists
that a charging order may be eminent, then at the joint option of the manager and
the affected preferred member, the preferred members interest may be converted
into a common interest.55
4.11
Various Entity Combinations
Robust asset protection can be achieved through the use of multiple partnerships, LLCs,
or other entities, each designed to own different types of assets, or groups of assets. It is
somewhat common for some entities to control tangible assets, while others hold real
property, and still others hold higher-liability assets (automobiles, boats, ATVs, etc.)
Practitioners will also layer various entities, creating one or more entities that own
other entities, which ultimately own the property.
55
We believe that this strategy does not violate IRC 2701. That Section is directed towards the reverse of
this strategy where the senior generation receives preferred interests to freeze growth, and the junior
generation receives common interests to gain all the potential for growth. In this asset protection strategy,
the senior family members usually have the liability exposure and as such, will receive the common
interest.
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Part V
Funding the LLC or Partnership
General Note: Check to see if your state requires the name of a General Partner,
Manager, or a Member to be reflected on the title to an asset rather than just the name of
the entity.
5.01
Business Interests
An ongoing business can be contributed to an LLC or partnership. Under the partnership

rules of Code 704(e), capital must generally be material income-producing. In the
alternative, a subsidiary LLC or partnership may be formed, followed by a transfer of the
business interest to the subsidiary entity, or the GP or any Member may create a whollyowned LLC to own and operate the business as a subsidiary company, which will be
disregarded for federal tax purposes (taxed as a disregarded entity/sole proprietorship).
Consider segregating the assets and equipment of the business from the operating entity,
such as by forming an asset and equipment leasing company to further insulate assets and
operations from creditors and to increase planning flexibility for the client.
Transfer occurs by a bill of sale or assignment of corporate stock (a stock power), or
assignment of interest. Make sure to comply with any transfer restrictions contained in
the operational documents of the business being transferred.
5.02
Business Equipment
Contribution of business equipment to a partnership or LLC avoids seizure of the

equipment in the case of a judgment against the operating company. Equipment can be
leased to the operating company for fair rental value. The client should be certain to make
all lease payments on a timely basis and for fair rental value. As mentioned above,
segregating equipment provides an additional layer of asset protection to the LLC plan,
and lends further evidence for business purpose to a FLLC structure.
Business equipment and assets are conveyed by a bill of sale or an assignment.
5.03
Cash
Cash is a safe asset to contribute to a limited partnership or LLC because cash is not a
liability producing asset.
Existing cash accounts should be retitled into the name of the partnership or LLC. Take
care to ensure that the correct tax identification number is noted on the new account
application and that only proper parties are authorized signors on the account.

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5.04
Installment Notes
Third party promissory notes are generally desirable assets for LPs or LLCs and generate
consistent cash flow.
(a)
Gain Recognition Potential
There are no tax issues if the installment note is not a tax deferred IRC 453
installment note. If the note is a 453 tax deferred installment note, the transfer of
the note to the partnership or LLC is generally not a taxable disposition of the
instrument. IRC 721 provides that no gain or loss is recognizable on the transfer
of assets to a partnership.56 However, any future gift, sale, or exchange of the
partnership or membership interest can be a taxable disposition to the extent of
the deferred gain.
To the extent that deferred gain is capital gain (as contrasted with ordinary
income), the installment note is not considered an unrealized receivable.57
However, 751 is not applicable to gifts of partnership or LLC interests, so there
should be no gain or loss should result on sale or gift of an interest under a tight
reading of the statute. But see: Rev. Rul 60-352, 1960-2 C.B. 208 and Tennyson
vs. United States, 76-1 U.S.T.C. 83,573 (1976, W.D. Ark.). In each of those
cases a partner required to report the partners share of capital gain attributable to
installment notes held by the partnership).
Disposition of a partnership interest or LLC membership interest is viewed as a
disposition of installment obligations. The payment of the income tax by the
transferor is not a gift to the other partners.
Installment Notes are conveyed by assignment, accompanied by the transfer of the lien, if
any, that secures the note. Be careful to make sure and give proper notice of the lien
transfer as may be required by the terms of the note.
5.05
Life Insurance
LLC- or partnership-owned life insurance provides a viable alternative to an irrevocable

life insurance trust when there are concerns about the ability of the owner to survive the
transfer of the policy by more than three years58 or when the insured is in questionable
heath giving rise to concerns about the proper value of the policy for gift tax purposes.
Additionally, LLCs and partnerships are more flexible than an irrevocable life insurance
trust. LLCs and partnerships may be a better fit for the investment features of many
modern life insurance policies, and they are considered to be less susceptible to
legislative extinction than ILITs.
56
Treas. Reg. 1.453-9(c)(2)

Treas. Reg. 1.751-1(c)
58
IRC 2035
57

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(a)
Technical Issues
There are several technical issues that the practitioner must address when
contemplating partnership owned life insurance:
Should we be concerned about the proceeds from the insurance policy
owned by the LP or LLC being taxable as ordinary income?
Will policy proceeds payable to the LP or LLC be included in the estate of
the insured partner?
Does an LP or LLC designed solely or primarily to own life insurance
have a sufficient business purpose?
How can we use the annual exclusion to purchase life insurance owned in
an LP or LLC?
What effect do the death proceeds of life insurance owned by the LP or
LLC have on the surviving partners basis?
(b)
Income Taxation of Life Insurance
The general rule is that life insurance proceeds paid by reason of the death of the
insured are not included in the gross income of the person receiving the death
benefit.59
(1)
Transfers for Value: The Exception to the General Rule,

and Exceptions to the Exception
Life insurance proceeds are included in gross income if the policy had
been transferred for value (i.e., sold after policy placement to the ultimate
policy owner).60 Gross income will include the total proceeds less the
value paid for the policy, EXCEPT the following transfers, even though
for value, will not cause the proceeds to be included in gross income,
under IRC 101(a)(2)(B):
Transfers by gift, e.g., gifts to life insurance trusts or other third
parties;
Transfers to the Insured;
Transfers to a partner of the insured or to a partnership in which
the insured is a partner;
Transfers to a corporation in which the insured is a shareholder or
officer. (Note: transfers to a fellow shareholder do not fall within
this exception.)
59
60
IRC 101(a)(1)
IRC 101(a)(2)
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(c)
Estate Taxation of Life Insurance
The value of life insurance proceeds are includable in the value the insureds
gross estate if the insured possessed any incidents of ownership or if the proceeds
are payable to, or for the benefit of, the insureds estate.61 The value of life
insurance proceeds are also included in the value of the insureds gross estate if
any incident of ownership of the policy was previously owned by the decedent but
was transferred by the decedent without consideration within three years of
death.62
(1)
Incidents of Ownership
Incidents of ownership under Treas. Reg. 20.2042-1(c)(2) include any

rights to the economic benefits of the policy, including:
The power to surrender or cancel the policy;
The power to change the beneficiary;
The power to assign the policy;
The power to revoke an assignment;
The power to pledge the policy for a loan or to obtain from the
insurer a loan against the surrender value of the policy; and
A reversionary interest in the policy.
Payment of premiums by the insured on a policy will not cause policy
proceeds to be includible in the insureds gross estate.63
In the corporate context, under IRC 2042 and Treas. Reg. 20.2042- 1
(c)(6), the value of insurance proceeds will not be included in the
insureds gross estate even if the decedent was a controlling shareholder,
provided the policy proceeds are payable to or for the benefit of the
corporation. Significantly, the courts have extended the 2042 regulations
into the partnership context as well. In the Estate of Frank H. Knipp, 25
T.C. 153 (1955) acq. in result, 1059-1C.B. 4, the insured was a 40%
general partner in a partnership that owned life insurance. The tax court
held that the life insurance proceeds were not included in the value of the
partners gross estate since the value of his partnership interest, augmented
by the partnerships receipt of insurance proceeds, was included in the
value of his gross estate.
The Internal Revenue Service acquiesced in Revenue Ruling 83-147,
1983-2C.B.158. The reasoning applies to LPs & LLCs. To include the
insurance proceeds in the value of the gross estate under IRC 2042 would
61
IRC 2042
IRC 2035
63
Rev. Rul. 71-497
62

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result in an unwarranted double inclusion. The value of insured

partners pro rata share of the insurance will come in under Section 2033.
(2)
Payable to or For the Benefit of the Estate
Insurance is payable for the benefit of the decedents estate if the

beneficiary is under a legal obligation to utilize the insurance proceeds to
pay the decedents taxes, debts or costs of the administration of the
estate.64 This will cause inclusion in the insureds gross estate.
(3)
Transfers Within Three Years
As previously stated, life insurance proceeds are also included in the value
of the gross estate if any incident of ownership of the policy was
transferred by the decedent without consideration within three years of
death.65 An exception to IRC 2035 is a transfer for full and adequate
consideration in money or moneys worth. Also as previously noted, a sale
to a partner of the insured is an exception to the transfer for value rule of
IRC 101(a)(2). Subsequent gifts of discounted partnership or LLC
interests will reduce the size and value of the insureds estate for IRC
2033 purposes.
(d)
Practical Suggestion: Create an Asset Mix
If the LP or LLC owns life insurance, it is a very good idea for the entity to own
other investment assets and have other business purposes to substantiate the
business purpose of the entity for state law and federal tax law purposes.
In summary, as long as the death benefit is payable to or for the benefit of the
limited partnership/LLC, and the entity is not obligated to make any payments
chargeable against the decedents estate, then the insurance proceeds will not be
included in the insureds taxable estate.
(e)
Using Annual Gift Tax Exclusion to Pay Premiums on EntityOwned Insurance
Gifts of cash directly to children or to trusts for their benefit which are, in turn,
contributed to a partnership or LLC that owns life insurance in one method of
using the annual gift tax exclusion amount to pay premiums on entity-owned life
insurance. This approach provides no leveraging of the gift through discounts
and places the premiums at risk, subject to the childs frailties. This approach
however is convenient and always qualifies for the annual exclusion.
(1)
Pay Premium Gifts to LLC
Perhaps a better approach is for the insured to make contributions to the

partnership LLC, which are then used to pay premiums. The insured then
makes gifts of partnership or LLC interests to the children or to trusts for
64
65
Treas. Reg. 20.2042-1(b)(1)

IRC 2035
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their benefit. This approach makes the most tax sense, as the gifts can be
leveraged by the discount allowed the partnership or LLC for the interests
in the entity.
This approach also avoids placing cash into the childrens hands. But, this
approach requires special drafting and accounting and is therefore
somewhat administratively more demanding. Special drafting and working
with a good team of professionals can make this approach easy and
effective for the client. See TAM 9131006 in which the gift of a limited
partnership/LLC interest was held to be a present interest gift. But see
Hackl, discussed at 6.03 below.
(2)
Capital Account Crummey Powers
Capital Account withdrawal rights can provide an alternative means of

utilizing the gift tax annual exclusion for the proceeds used to purchase
partnership- or LLC-owned life insurance. This approach looks a lot like
ILIT Crummey powers.
To be effective in the partnership or LLC context, you must manually
draft withdrawal right language into the capital account provisions in the
partnership or operating agreement. The language should read very similar
to demand provisions in an ILIT.
The transfer of a life insurance policy, even with a substantial cash value,
and the payment of future premiums, should not be a taxable gift if the
transferors capital account is increased by the value of the policy or the
cash contributed to pay the premiums.
(3)
Pay Premiums from Adequate Reserves
If the partnership or LLC has other assets that can provide substantial
income to pay the premiums on the life insurance policy, there may be no
need to contribute cash to pay the premiums.
Note: Under IRC 677, the grantor is income taxable on any income of a
trust which is used to pay premiums on life insurance insuring the life of
the grantor. But such a payment of income tax is not considered a gift and
as such reduces the grantors estate.
(f)
Impact of Death Benefit on the Basis of the Surviving Members
IRC 264 disallows any deduction under IRC 162 or IRC 212 for the payment
of life insurance premiums. Therefore any income used to pay for life insurance
premiums will be taxed to the partners.
IRC 705(a)(1)(B) and Treas. Reg. 1.705-(a)(2)(ii) provides that a partners
basis is increased by the receipt of tax exempt income such as municipal bond
interest or life insurance proceeds. If this was not that case, then upon the sale of a
partnership or LLC interest or upon liquidation of a partnership-taxed entity, the
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gain realized would be increased due to a lower basis, which, in effect, would
result in taxation of tax exempt income.
(g)
Method of Transfer
Transferring a life insurance policy to a partnership or LLC is accomplished by

completing both an absolute assignment form and a change of beneficiary
designation form. Note: Some companies forms cause an automatic change of
beneficiary designation whenever there is a change of ownership. Each
companys forms are different so make sure that both ownership and beneficiary
are changed.
5.06
Marketable Securities
(a)
General
IRC 761(a) and 7701(a)(2) and Regs. 301.7701-3(a) define a partnership to

include any financial operation or venture. IRC 761(a) specifically permits an
unincorporated association to elect out of partnership classification if it is availed
of for investment purposes only and not for the active conduct of a trade or
business. If the partners do not elect out, the entity is a partnership so long as it is
not an estate, trust or corporation. Investment activities alone are sufficient for
partnership classification, however, Rev. Rul, 75-523 and Rev. Rul. 75-525
recognized investment clubs as partnerships.
(b)
Uruguay Round (GATT) Agreements Act of 1994
GATT adds IRC 731 and 737(e), which generally require the recognition of
gain on distribution of appreciated marketable securities to a partner from the
partnership.
(c)
Technical Advice Memorandum 200212006
FACTS: A taxpayer and her two children established a limited partnership

initially funding the partnership with cash and marketable securities. Thereafter,
the taxpayer transferred municipal bonds to the partnership and filed a gift tax
return reporting the transfer of the bonds to the children as the donees. She took a
45% valuation discount on the bonds, treating the bonds as having been first
transferred to the partnership to claim that the real transfer was of partnership
equity, not the bonds. National Office treats the transaction as a transfer of the
bonds, not partnership equity interests.66
Per Gibbs and Schwartzman:
We believe the outcome to be correct. Causation: Pilot Error! Dont
expect the Service to take this position if the partnership is properly
funded and if gifts are made of partnership equity sometime after the
66
See J. C. Shepherd v. Commissioner, 115 T.C. 30 (October 26, 2000).

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transfer of new property is made to the partnership. Always adjust capital

account percentages after a non-proportional transfer of property is made
to or from the partnership. The partnership (or LLC) agreement for an
investment holding company should require that the adjustment be made
to percentages of ownership at any time disproportionate contributions or
disproportionate distributions are made.
(d)
Securities Practice Pointers
Securities, like other property, have a basis. If an IRC 754 election to step-up
basis is not made for shares held by a partnership at the death of a partner, shares
previously gifted remain at the original cost basis.67 This can necessitate tracking
of basis on individual stocks for each individual partner, a major headache where
there are numerous stocks and/or partners.
Possible Fix: Redeem gifted shares as of date of death. Publicly traded securities
are already subject to discount (the trading price). Securities can, in some
instances be further discounted as discussed in Part VII below).
(e)
Recognition of Gain
Generally, a contribution of publicly traded securities is tax free under IRC

721(a). However, attention must be paid to the anti-diversification rules of IRC
731(b) and 351(e).
CAVEAT: The controlled corporation investment company rules of IRC
351(e) and 721(b) pre-empt the IRC 721(a) non-recognition rules if, after
exchange, 80% of the value in the partnership assets, excluding cash and
nonconvertible debt obligations, are held for investment in readily marketable
stocks or securities. The problem occurs most often when non-identical assets are
contributed by different partners that have substantial value, causing
diversification that in turn triggers recognition. It is not a problem in cases where,
for example, grandkids make nominal initial capital contribution as limited
partners.
The Service does not want the creation of family mutual funds that would
permit diversification yet avoid current taxation. Cf. PLR dated August 17,
1993 (holding that where three family members form a partnership, each
transferring cash, but one also contributing securities and interests in FLPs &
FLLCs in exchange for partnership interests, 721(b) would not apply because the
cash contributed by the other two partners was less than 1% of the value of all
transferred assets). This PLR is probably superseded since cash is now considered
a security for 351(e) and 72 1(b) purposes.
67
IRC 1012
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(f)
Method of Transfer
In the case of a brokerage account, contribution to an LLC or a limited

partnership is achieved by changing the registration on the account. If securities
are held in certificate form, contribution is achieved by reregistering the securities
in the name of the partnership or LLC, which generally requires a signature
guarantee.
Planning Tip: Any time securities are placed in the mail insurance should be
taken out equal to 2% of the value of the securities, being the transactional fee
charged by stock transfer agents to replace lost or stolen certificates.
Recommending to the clients that they contribute their stocks held in certificate
form to their brokerage account so that the financial advisor can handle the
retitling makes your job easier and is a nice gesture to the financial advisor
because it increases the money under the advisors management for which he/she
will (hopefully) be thankful.
5.07
Closely Held Securities

(a)
Closely Held C Corporation Stock
First, check Buy-Sell agreements and bylaws. Look for restrictions or covenants
that could cause problems. Assuming that transfer to a partnership or LLC is
permitted, make certain that any rights of first refusal have been complied with
and that proper notices have been provided.
(1)
Possible Estate Inclusion under IRC 2036(b)(1)
The potential of estate inclusion exists if the transferor of the stock is the
general partner or controls the general partner entity at death. Direct or
indirect retention of voting rights in transferred stock of a controlled
corporation (generally the ownership of 20% or more of the stock) could
be considered to be retained enjoyment of transferred property. If the
General Partner is an entity with control spread across the entity, this can
be avoided.
Also, the LLC or partnership could specify that all partners will retain the
right to vote the stock of the corporation in proportion to their partnership
or LLC interest at the time of contribution of the stock to the entity. This
should avoid a problem to the extent of future gifts of entity interests.68
Alternatively, the corporation could re-capitalize into voting and nonvoting stock and only the non-voting stock is transferred to the LLC or
partnership.
68
See PLR 9346003 for some favorable language. WealthDocx has an option for this.
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(b)
CAVEAT
IRC 1244 stock-The tax favorable treatment of 1244 stock is lost when closely
held stock is transferred other than by death.
(c)
Method of Transfer
Contribution of closely held stock is achieved by assignment (a stock power),

again after properly complying with any requirements that may exist in the
bylaws. If stock certificates have actually been issued, a new certificate should be
issued in the name of the partnership or LLC.
5.08
S Corporation Stock
Warning! A partnership is not a permitted S shareholder. Conveying stock in an S

corporation to a partnership will terminate the S election for all shareholders, causing the
corporation to be taxed both at the corporate level and at the shareholder level.as a C
corporation. Subchapter S stock should not be contributed unless the conversion to a C
corp is intended.
But an LLC that is 100% owned by one permitted S shareholder can own S corp stock.
Spouses owning 100% of an LLC as community property are considered one owner of
the LLC.
Note: An alternative planning opportunity exists for the S corporation to contribute its
assets to the partnership. While a partnership cannot own S corporation stock, an S
corporation can be a partner in a partnership, or a member in an LLC.
5.09
Stock of a Professional Corporation or Professional Association
Contribution of professional corporation stock to anyone other than a licensed

professional carries potential violation of state licensing laws. In the case of a
professional services corporation, contribution to a partnership or LLC can be seen as a
potential threat to that partnership or LLC if the transfer is seen as a mere assignment of
income.69 Services rendered, or to be rendered, are not equivalent to the definition of
property in a partnership context. Services contributed to the partnership are
compensation and are conceptually treated as ordinary income to the party making the
contribution, in the amount of the capital interest received.
But if past services are exchanged for an interest in anticipated profits in the partnership
or LLC, the profits are taxable when received. If the partnership or LLC interest
belonging to the service-rendering partner/member is non-transferable or subject to a
substantial risk of forfeiture, IRC 83 will postpone recognition until the restriction and
risk lapses.
69
Treas. Reg. 1.704-1(e)(1)(iv)

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5.10
Tangible Personal Property
Tangible personal property is not usually the best type of asset to contribute to an LLC or
a limited partnership with the possible exception of business tangible personal property,
(e.g., telecommunication equipment, computers, furniture). Another exception may be
titled personal property such as an automobile, an airplane or a yacht either of which is
being chartered when not used by the owner. (Bear in mind that these high-liability assets
may produce inside liabilities to the partnership or LLC.)
In the case of personal property contributed to an LLC or a partnership, be careful to
document the entitys business purpose. Moreover, if the assets are going to continue to
be used by the contributing partner or member, that individual should enter into a lease
with the owning entity to better defend against an argument of inclusion in the
individuals estate under IRC 2036.
An Assignment or Bill of Sale is used to convey title to tangible personal property to a
partnership or LLC, together with proper registration for any titled tangible property. The
Assignment or Bill of Sale should adequately identify the property, including model
numbers, serial numbers, vehicle identification numbers, production date stamps, etc. It
may be a good idea to add photographs or digital images to the file as well.
5.11
Real Estate
Some special issues arise when contemplating the contribution of real estate to a
partnership or LLC.
(a)
CERCLA Liability
One potential problem associated with contributing real estate to an LLC or a

limited partnership has to do with the potential CERCLA liability for contributing
environmentally contaminated property. If environmentally contaminated
property is acquired by an LLC or a partnership, the entity is generally not liable
for the contamination and cleanup unless the deed provides that the grantee
accepts the property in its contaminated condition.70
Environmental concerns do help make the case for an entity General Partner or
Manager, especially to the extent the real property is in use in agriculture or other
industry that tends to generate waste. Cadillac Fairview/California Inc. v. Dow
Chemical Company, 21 E.L.R. 1108 (D.C. Ca. 1985). Potential piercing of
corporate (or LLC) veil with liability resting with controlling shareholder. United
States v. Northeastern Pharmaceutical and Chemical Company, Inc., 579 F.Supp.
823 (W.D. Mo. 1984). Also, it may constitute a fraud on creditors. Shapoff v.
Scull, 222 Cal. App. 3d 1457, (1990); look at capitalization of entity general
partner as a possible determinant.
70
42 U.S.C. 9601 et seq.

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It may also be wise to create multiple layers of entities as briefly described in 4.11
above to help keep contaminated property separate from uncontaminated
property. Doing so will prevent the contaminated property from creating liability
for the entity holding the uncontaminated property.
(b)
Retained Interests
The most common pitfall in the retained interest area occurs when clients
contribute personal use assets to the LLC or partnership, such as a vacation home
and then the home is used by the contributing partner without paying adequate
rent. Courts have traditionally found those kinds of retentions to cause inclusion
under Section 2036.
(c)
Potential Property Tax Assessment/Reassessment
Attorneys should be aware of the impact of special assessment or reassessment

laws like Californias Propositions 13 and 58, which cause reassessment of
property for property tax purposes when certain transfers are made. This subject is
beyond the scope of our outline, but this issue can potentially cost clients
thousands of dollars if their transfer triggers reassessment under applicable local
laws.
5.12
Encumbered Property
Transferring property encumbered by a mortgage, lien, or other indebtedness can cause

some particularly sticky issues. In the case of recourse debt, transferring the property to a
partnership or LLC may produce adverse gift tax and income tax consequences when the
entity interests are later gifted to others.
In the case of nonrecourse debt (against property used to collateralize the debt), the client
should get consent from the lender before making the transfer. Failure to do so may
trigger the due-on-sale/due-on-transfer provision accelerating debt repayment. (It should
go without saying that any permission should be received in writing.)
Transfers of property encumbered in excess of basis to the partnership or LLC will likely
trigger tax liability on the gain to the transferor.
5.13
Residence
Contribution of the residence also falls into the potential retained interest category
unless the contributing partner/member executes a proper lease with the entity.
Additionally, rent paid for the personal use of the residence will be income taxable to the
entity and will not be tax deductible to the client.
The contribution of the residence also potentially results in the loss of the state homestead
exemption, as well as the IRC 120 $250,000/$500,000 capital gain exclusion. It may
also trigger the loss of mortgage interest deduction of IRC 163(h), and the potential loss
of business interest deduction under IRC 162.
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If asset protection of the residence is the goal sought to be achieved by contributing the
residence to an LLC or a limited partnership, a possible alternative is to have the client
contribute the residence to the LLC or partnership but reserve a life estate. Doing so
limits the extent and value of the interest retained, also making the retained interest less
attractive to a potential creditor.
Real estate is conveyed by a warranty deed or special warranty deed and should be
properly recorded. Note: the LLC or partnership should be added as a named insured on
any casualty insurance and, if possible, the LLC or partnership should be added as a
named insured on any title insurance policies.
5.14
Dont Transfer Retirement Accounts to an LLC or partnership!
IRAs, tax-deferred annuities, and any other tax qualified plans should not be transferred
to an LLC or partnership. Doing so will immediately accelerate the income tax liability
on that asset.
5.15
Other Assets Warranting Extreme Care
Some assets are worthy of a high degree of caution because the assets either have a high
tendency to cause inside liability for the partnership or entity that owns the asset.
Examples can include airplanes, watercraft, and automobiles, but can also include lowerrent rental real estate, general partnership interests, and other high-exposure items.
Consider putting high-risk assets in their own entity, and transfer that entity into the
partnership or LLC (Continuing our layering theme discussed briefly at 4.114.11
above.) Wrapping those assets in a subsidiary entity helps compartmentalize liabilities. In
jurisdictions that allow series LLCs, those can be good options as well.71
71
See the discussion on series LLCs at 2.03(d), above.

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Part VI
Family Limited Liability Companies
6.01
Using FLLCs to accomplish Non-Tax Objectives
It is very important to establish the non-tax business objectives for estate planning with a
family LLC. In doing so, we should ask ourselves, Would we create this structure even
if the use of the family LLC was tax neutral? The following are some of the more
frequently expressed non-tax planning objectives associated with the implementation of a
family LLC:
(a)
Asset Protection
The family LLC may offer a high degree of creditor and other economic
predator protection for the family.
(b)
Financial Tutelage
Clients fear that substantial transfers of wealth to their issue will prevent or delay
their children from being productive people. Trust-based plans have been able to
formulate incentive provisions for beneficiaries after the matriarch or patriarch
of the family has died. A family LLC-based plan may permit the head of the
family to implement a business structure which controls the involvement of other
family members in a direct and meaningful way.
(c)
Maintain Control and Lifestyle While Engaging in Meaningful

Estate Planning
Some clients delay engaging in meaningful estate planning out of fear that they
will lose control of their wealth and the lifestyle they enjoy. A family LLC,
correctly organized, can allow the older, wealthier generation to substantially
control the assets contributed to the LLC and the distributable cash flow generated
by those assets.
(d)
Income Shifting Within the Family
Spreading income generated by invested assets to more family members can

significantly reduce total income tax liability for that income.
(e)
Creating a Positive Lifetime Spin on Family Wealth
When parents involve children as member in business limited liability companies,

the parents, and not a third party trustee, are able to influence desired behavior by
children by linking partnership/LLC distributions with stated incentives or
initiatives. If a parent continues as the Manager (or controls the Management
entity), the parent can reduce cash flow to a child who is a problem or who is
exhibiting trust baby tendencies.

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The Manager may decide that the establishment of reserves with, or the
reinvestment of, LLC income in new investments or in improvements to LLC
assets, is in the best interest of the entire LLC.
(f)
Consolidating Family Assets to Centralize Management
Consolidating assets offers certain cost advantages, such as reduced accounting

costs, reduced brokerage commissions, and expanded investment opportunities.
(g)
Consolidation of Family Assets into a Single Economic Unit
The family can achieve a measure of synergy by consolidating the family asset
base into a single economic unit. In other words, the sum of the parts is not equal
to the value of the whole. The King Ranch in Texas is a classic example (family
members own shares in the entity instead of acreage, livestock, implements, feed,
etc.).
(h)
Control Over Ownership of Interests
Consolidated wealth is also regulated by family members. The LLC operating

agreement can require that any disputes over interests in LLC-owned assets be
arbitrated privately. Distributions of income can be restricted or protected from
errant family members or spouses. Further, the operating agreement can adopt the
English Rule, requiring that the loser of any dispute pay all costs of arbitration
or litigation.
(i)
Efficient Wealth Transfer Opportunities
Partnership and LLC interests are personal property, easily transferable by gift.
An interest in an FLP/FLLC that owns only real estate is still considered personal
property and is as easily gifted as any other personal property represented in
certificate form. (Compare this with the complexity of transferring undivided
interests in real estate outside of a FLP/FLLC!)
(j)
Divorce Protection
An FLP/FLLC can protect family wealth from failed marriages of family

members. Pre- and Post-Nuptial agreements may be distasteful or impractical. A
gifted entity interest is separate property and can be designed with a built-in buysell agreement prohibiting the transfer of the interest to the departing spouse of a
child/member. Because the ownership of the FLP/FLLC interest is by law passive
in nature, there is little risk that these interests can be found to be marital or
community property.
(k)
Flexibility
Unlike an irrevocable trust, the operating agreement of an FLP/FLLC is flexible

document; the members can vote to amend it.

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(l)
Encouraging Family Unity
FLPs or FLLCs can institutionalize family communication on family business

or financial matters.
6.02
Comparison of LLCs to Other Entities
The following is a very general comparison of LLCs (taxed as a partnership) and other
types of entities.
(a)
LLCs vs. General partnership
In General partnership, all the partners have unlimited exposure for partnership
debts, liabilities and obligations. In LLCs, members enjoy the benefit of limited
exposure to liability. A members exposure for LLC debts extends only to the
extent of their interest in the LLC.
In General partnership, all partners are legally entitled to participate in the
management of the partnership. In an LLC, only the manager(s) have the legal
right to participate in the management of the LLC.
(b)
LLCs vs. S Corporation
As an estate-planning tool, an S corporation is less flexible for making intrafamily transfers of real estate or other highly leveraged investments into and out
of the S corporation. Statutory restrictions on who may be a shareholder also limit
the flexibility of the S Corporation in intra-family transactions, leveraged gifting
opportunities, estate freezes, or basis increases.
An S corporation shareholder has less asset protection than an LLC member.
Creditors of an S corporation shareholder may levy upon the shareholders shares
of stock and acquire ownership. As we have seen, creditors of an LLC member
can be restricted to a charging order.
(c)
LLCs vs. C Corporation
As we discussed in Part III above, C Corporations are subject to double taxation

during operation and upon liquidation, while LLCs can be taxed as pass-through
entities.72 Unlike with a C Corporation, an LLC can offer disproportionate
allocations of income and loss between partners provided the allocations have
substantial economic effect.73
The C corporation may also be subject to the accumulated earnings tax, personal
holding company tax or constructive dividend problem. The LLC is not affected
by these concerns.
72
IRC 336 Repeal of General Utilities Doctrine

IRC 704(a), (b). Substantial economic effect essentially means that a tax item may be
disproportionately allocated to a member if member bears an equivalent economic burden.
73

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In addition, IRC 351(a) provides that, No gain or loss shall be recognized if

property is transferred to a corporation by one or more persons solely in exchange
for stock in such corporation and immediately after the exchange such person or
persons are in control (as defined in section 368(c)) of the corporation. (80%
control of all classes of stock outstanding).
On the other hand, IRC 721(a) provides: No gain or loss shall be recognized to
a partnership or to any of its partners in the case of a contribution of property to
the partnership in exchange for an interest in the partnership. In other words,
there is no 80% control requirement after the exchange in IRC 721(a).
(d)
FLLCs vs. FLPs
As we have seen, an LLC may be managed either by its members or by a

manager. Like a corporation, it affords limited liability to all members, even a
member serving as a manager. Unlike corporate stock in the hands of a
stockholder, and similar to a limited partnership, a members interest generally is
not subject to seizure by the members creditor.
But a family limited partnership must have at least one general partner, who has
some asset protection exposure. The GP interest also commands a premium for
valuation purposes because the GP has broader control than the LP interest
holders. (Granted, the retained GP interest is usually very small.) The
client/parent can form and manage the LLC even without retaining any ownership
rights, without the liability that attaches to General Partners, and without the
premium that a GP interest commands.
Some states tax LLCs differently than LPs. For example, California imposes a tax
on gross receipts of LLCs and imposes no such tax on LPs.
Also, recall that comparatively few states have adopted a form of the Uniform
Limited Liability Company Act. Some state LLC statutes do not require a 100%
vote to liquidate the LLC. If the LLC operating agreement is more restrictive than
the enabling statute, an applicable restriction is created which may cause
problems under IRC 2704(b). Applicable restrictions are ignored for valuation
discount purposes.
The lack of uniformity among state laws also impacts asset protection and the
scope of creditors remedies. (Please see the matrix titled Best Jurisdictions for
LLC Planning at Part XII below.)
LLCs have similar design difficulties and advantages of FLPs & FLLCs,
depending on the state law variations made to the Revised Uniform Limited
partnership Act (RULPA) or Uniform Limited Partnership Act (ULPA), and
depending on whether the state has adopted ULLCA.

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6.03
Using FLLCs to Reduce Transfer Taxes
FLLCs can reduce transfer tax liability through valuation adjustments (discounts). Those
adjustments are driven by the impact of the operating agreements restrictions on transfer
and other rights, driving down the value of the underlying assets in the entity. The subject
of valuation is discussed in greater detail in Part VII below. Using an FLLC will reduce
the overall size of the clients estate by operation of the discounted values, and through
leveraged sales or gifts of membership interests to other family members.
A gift of a partnership/LLC interest may qualify as a present interest gift for annual gift
tax exclusion purposes. See PLR 9131006, in which limited partnership interests were
held to qualify for the annual gift tax exclusion where distributions to limited partners
were subject to a fiduciary duty by the general partner. By contrast, the IRS recently
prevailed in Hackl74 where the donees of LLC interests in an LLC could not transfer their
interests without the consent of the manager, who also had complete discretion over
distributions to members.
While other tools like ILITs focus on how to pay the estate tax as cost efficiently as
possible, FLLCs can actually reduce overall transfer tax liability and efficiently transfer
great wealth.
74
Hackl v. Commissioner, 118 T.C. No. 14 affd Nos. 02-3093 and 02-3094 (9th Cir. July 11, 2003)
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Part VII
Overview of Valuation Issues
7.01
Three Key Concepts of Valuation
Valuation for transfer tax purposes is based on three fundamental principles.

(a)
Hypothetical Willing Buyer, Willing Seller
For estate or gift taxation purposes, all property is valued using the hypothetical
situation of an arms length transaction between a willing buyer and a willing
seller, neither of whom is acting under any compulsion to buy or sell, and each of
whom has reasonable knowledge of all relevant facts.75 A cynic once described
this as the price that would be paid by a greedy lawyer and a zealous IRS agent,
neither of whom have had any real world business experience.
(b)
Gift Taxes and Value Received
Gift taxes are imposed only on what is received by the transferee.76

(c)
Estate Taxes and Value Held
Estate taxes are imposed on what was held by the decedent at the time of his death
and passed to his estate, not on what was transferred to his beneficiaries.77
7.02
Valuation is Focused on the Property that is the Subject of a

Transfer
The US Constitution, Article 1, Section 9, Clause 3 prohibits the direct taxation of

property. So in order to pass Constitutional muster the gift tax and the estate tax are an
excise tax on the right to transfer property by gift or at death. These taxes are not levied
on the property being transferred but on the value of the property being transferred.
Rev. Rul. 59-60 initially described the procedure to be followed in valuing property for
gift or estate tax purposes. Rev. Rul. 83-120 significantly expanded and refined the
factors addressed in 59-60. The value of lifetime gifts and bequests at death are measured
by the same standard.78 Accordingly, the value of the transfer is the value of the
property which is actually transferred as contrasted with the interest held by the decedent
before death or the interest held by the legatee after death.79
75
See Regulations 20.2031-1(b), 20.2031-3, 25.2512-1, United States v. Cartwright, 411 U.S. 546
(1973)
76
Estate of Chenowith v. Commissioner, 88 T.C. 1577 (1982)
77
Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981)
78
IRC 2033(a), 25 12(a)
79
See: Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981)
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(a)
The Objective Hypothetical Buyer and Seller
Value is determined by an objective standard determined from the point of view

of a hypothetical seller and a hypothetical buyer. PLR 9432001 offers that
valuation for estate tax purposes is to be measured by the interest that passes as
contrasted with the interest held by the decedent immediately before death or the
interest held by the legatee after death. The willing seller cannot be identified
with the decedent before death, nor can the willing buyer be identified with the
legatee after death.
Example. A parent owns 51% of a partnership and transfers a 2% interest
in the partnership to daughter. The value of the transfer is the value of the
2% interest transferred, not the value of the decrease in value of
transferors interest (which would be significant because of loss of
control). See also, Propstra v. U.S., 680 F.2d 1248 (9th Cir. 1982); Estate
of Woodbury Andrews, 79 TC 938 (1982).
(b)
The Life and Death of Family Attribution
For years the IRS had taken the position that in a family setting there was a unity
of interests and therefore, transfers within a family required attributing one
family members interests with another. However, the IRS was consistently
unsuccessful in promoting that idea, and, after several defeats promulgated Rev.
Rul 93-12, 1993-1 C.B. 202 finally taking the position that family attribution will
not be a factor used when valuing closely held entity equity interests. This
Revenue Ruling specifically revoked Rev. Rul. 81-253 and specifically approved
the result in Bright, cited supra.
(c)
The Swing Vote Theory
Even after the apparent death of the family attribution doctrine, the IRS in TAM
9436005 signaled a willingness to assert the theory that a swing vote factor may
apply to increase value of minority interests. This swing vote theory had been
recognized previously in Estate of Winkler v. Commissioner, 57 T.C.M. (CCH)
373 (1989). In Winkler, the decedent held only 10% of the voting stock, but the
tax court held that the decedents block of stock had swing vote characteristics
and therefore was subject to a 10% premium rather than a minority discount.
Example: Donor gifted 30% of corp. stock to each of 3 children, as well as
5% to spouse, keeping 5% for himself (more than the donor kept in Rev.
Rul. 93-12). IRS determined that any willing buyer of any 30% interest
would take into account that his 30% could be the swing vote and thus
be more valuable when combined with another minority interest large
enough to create a control block.
(d)
The Planners Objective in Engineering Valuation Outcomes
Simply stated, the objective of valuation adjustments, indeed, the tax objective of
FLP and FLLC planning is to permit the limited partner or members interests to
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be valued for their distributable cash flow value (sometimes expressed as the
going concern value) rather than the liquidation value of the underlying
assets. The manner in which this is accomplished involves creating a structure to
which a business appraiser can properly apply either percentage discounts or
from which he or she can determine a capitalization rate in order to
approximate what an investors return on invested capital might bring in that
particular enterprise.
In either case, the adjusted value reflects true economic value as opposed to
pro- rational (liquidation value) value of the underlying assets. Stated another
way, The sum of the parts is not always as great as the whole.
7.03
Determining the Pre-Discount Value

(a)
How Value is Determined
In determining value, the Treasury Regulations for both estate and gift transfer
taxes require that the fair market value of a business interest be determined on the
basis of all relevant factors, including a fair appraisal of all the business assets and
the demonstrated earning capacity of the business.80 The best evidence of value
would be previous arms length sales of the entire partnership or LLC interest or
of partial interests. However, since that rarely occurs, the appropriate starting
point is the determination of the value of the entire partnership or LLC on a prediscounted basis.
The pre-discounted value is typically determined based on the going concern
value or the net asset value or perhaps a combination of both. Courts have
favored a valuation that uses a combination of both analyses. Ward v. Commr, 87
T.C. 78 (1986). In Ward, the court explained that,
[w]here there is an ongoing business...courts generally have refused to
treat either asset value or earnings power as the sole criterion in
determining stock value...
The degree to which the corporation is actively engaged in producing income
rather than merely holding property for investment should influence the weight to
be given to earnings power as opposed to net asset value.81 Generally, the IRS
takes the position that the appropriate valuation approach is the one that produces
the highest value.
(b)
Going Concern Value
The going concern value of a partnership or LLC is determined by capitalizing its

past and projected net earnings. This approach properly recognizes that because
the partners or members do not have the ability to unilaterally liquidate the
80
81
Treas. Reg. 20.2031-3 (1992), 25.2512-(3)(a) (1958)

Ward, 87 T.C. at 102.
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limited partnership or LLC, the only value to them in currently owning a

partnership or LLC interest is their right to receive the distribution of earnings,
which is often substantially less than the net asset value of the partnership or
LLC.82
The Watts case is one of the most dramatic illustrations of the difference between
the going concern value and the liquidation value. The parties in that case
generally agreed that the liquidation value of the decedents 15% interest was
$20,000,000 and the going concern value of that same interest was $3,933,181
before the application of any valuation discounts to the decedents minority
interest.
The Eleventh Circuit, finding for the taxpayer, held that because the death of the
partner did not cause the partnership to dissolve, but instead, the partnership
continued under the partnership agreement and state law, the partnership was
properly valued on the basis of its going concern and not its liquidation value. The
court concluded that because, under all the facts of the case, there was no
reasonable prospect of the partnership being liquidated, the liquidation value of
the partnership was irrelevant. See also:
Harwood v.Commr 82 T.C.235 (1984) where the court rejected the going
concern approach because the business of the partnership consisted solely
of acquiring timber for the use of its affiliated companies. Consequently,
the partnerships real value was tied directly to the current value and
expected future value of its timber holdings.
Estate of Curry v. United States 706 F.2d 1424 (7th Cir. 1983) where the
court concluded that the power to liquidate does not necessarily result in
the conclusion that liquidation value should govern since liquidation could
not occur because the majority shareholders had a fiduciary duty to protect
the interests of the minority shareholders.
So the nature of the underlying partnership or LLC assets and the business
conducted by the partnership or LLC will determine which valuation method the
courts will accept to determine value.
(c)
Tiered Discounts and Premiums
The first step in valuing a partnership or LLC interest is the determination of the
assets the partnership or LLC holds. In making that determination, we must
decide if the underlying assets themselves should be discounted from their
apparent face value. If the partnership or LLC owns a partial interest in real estate
or a partial interest in another partnership or LLC, the same valuation principles
that apply to determining the value of partnership interest should apply to
determining the value of the underlying partnership assets.
82
See Estate of Gallo v. Commr, 50 T.C.M. (CCH) 470 (1985) and Watts v. Commr, 823 f.2nd 483 (11th
Cir 1987)
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(d)
Restricted Securities Discount
The discount should not exceed the cost of registering and selling the stock.83
In the Estate of Gilford v. Commissioner 88 T.C.38 (1987) the court allowed a
33% discount for a block of stock that could not be sold without registration.
(e)
Portfolio Discount
If the partnership or LLC owns a large amount of a single asset, courts recognize
a discount for having a non-diversified portfolio.84
(f)
Blockage and Absorption Discounts
The Treasury Regulations expressly recognize a discount for the time frame that
the market would require to absorb a large block of stock.85 The same reasoning
can apply to real estate. See Carr v. Commissioner 49 T.C.M. (CCH) 507 (1985)
in which the court found that a 30% discount was appropriate when valuing a
large block of lots.
(g)
Fractional Interest Discount
A number of cases have recognized that significant discounts should be applied to

partial interests in real estate. See Propstra v. United States 680 F 2d 1248 (9th
Cir. 1982) 15% discount; Estate of Anderson v. Commr, 56 T.C. M. (CCH) 78
(1988) 20% discount; and Estate of Della van Loben Sels v. Commr 52 T.C.M.
(CCH) 731 (1986). 60% discount.
(h)
Promissory Notes
The face value of a promissory note is rarely indicative of its real value.
Fractional ownership of the note, the quality of the collateral that secures the note,
the interest rate and other factors affect its marketability. Accordingly, significant
discounts may be applied in valuing these interests. See Smith v. U.S. 923 F. Supp
896 (S.D. Miss. 1996); Hoffman v. Commissioner, T.C. Memo. 2001-109 citing
Treas. Reg. 20.2031-4 which provides that the burden of proof is on the taxpayer
to prove that a promissory note is not worth its face amount plus accrued interest,
but nonetheless found that the burden of proof had been met and applied
substantial discounts to the promissory notes.
(i)
Built-in Capital Gains
A number of cases have held that with the repeal of the General Utilities doctrine,
the built-in capital gains inside C corporations is a relevant factor to consider
when valuing the stock of the corporation.86 However, the tax court has denied
83
Estate of Piper v. Commissioner 72 T.C.1062 (1979)

See Estate of Barudin v. Commr, T. C. Memo 1996-335. See also Piper, supra, in which the court,
analogizing to closed end mutual funds, recognized a 17% discount for relatively unattractive portfolios.
85
See Treas. Reg. 20.2031-2(e) (1992)
86
See Estate of Davis v. Commissioner, 110 T.C. No. 35; Estate of Simplot v. Commr, 112 T.C.13 (1999)
revd on other grounds, 87 AFTR 2d Par.2001-923 (9th Cir. 2001); Estate of Borgatello v. Commr, T.C.
84

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discounts for built-in gains when valuing limited partnership interests reasoning
that a Code 754 election would correct any built-in gains disparity.87 But other
cases indicate that the tax court has shown some willingness to allow the built-in
gains inside a partnership to be considered.88
7.04
Determining the Discount
Once the underlying assets in the partnership or LLC have been properly valued, the next
step in the valuation process is to determine the nature of the interest that is being
transferred. As we mentioned previously, a transfer for estate tax purposes focuses on the
property that passed to the decedents estate and not on what was received by the
decedents beneficiaries. So, while the decedents interests in the partnership or LLC may
be aggregated for estate tax purposes, if the same interests in the entity were transferred
to the same beneficiaries through lifetime gifts, the focus would not be on what the donor
held, but instead on the value of the interests transferred to each donee.89
We note also that while the Internal Revenue Service has conceded the application of the
family attribution doctrine, they will likely aggregate multiple interests in the same
partnership or LLC held by the same partner or member.90
7.05
Discount for Lack of Marketability
If an asset is less attractive and more difficult to sell than publicly traded stock, a
discount for its relative lack of marketability may be available to adjust its value for
transfer tax purposes. If a limited partner or member wanted to get out of the partnership
or LLC, who would buy their interest? An interest in a closely held enterprise is less
attractive and more difficult to sell than a publicly traded interest. The lack of
marketability discount acknowledges the economic reality of the inherent inflexibility of
getting into and out of investments where there is no ready market.
Discounts are not automatic and must be established by empirical data and appraisal. In
order to determine the value of an ownership interest, the value of the entity, i.e., the
partnership or LLC as a whole must be determined. (The discount is available for both
majority and minority interests.91)
Memo 2000-264 (2000); Estate of Jameson v. Commr, 2001 AFTR 2d Par 2001-3253 (5th Cir 2001);
Estate of Welch v. Commr 85 AFTR 2d Par.2000-534 (6th Cir.2000)
87
Estate of Jones II v. Commissioner, 116 T.C. No. 11 (2001)
88
Estate of Dailey v. Commissioner T.C. Memo 2001-263 (2001)
89
Chenoweth v. Commr 88 T.C. 1577 (1987)
90
See Estate of Lee v. Commissioner 69 T.C. 860 (1978).
91
Estate of Mazcy v. Commissioner, 28 T.C.M. (CCH) 783 (1969), revd on other grounds, 441 F.2d 192
(5th Cir. 1971). Estate of Folks v. Commissioner, 43 T.C.M. (CCH) 427 (1982) [40% discount allowed in
closely held real estate investment company where decedent owned 62% of stock]
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The IRSs Valuation Guide for Income, Estate and Gift Taxes (U.S. Government Printing
Office) discusses this discount and how IRS agents and appeals officers are to treat
claimed discounts:
Lack of marketability is defined as: the absence of a ready or existing market for
the sale or purchase of the securities being valued Investors prefer an asset which
is easy to sell, that is, liquid. An interest in a closely held business is not liquid in
comparison to most other investments.
...The most effective way to deal with arguments that marketability reduces the
value of the stock is to indicate that you have taken it into consideration in your
overall appraisal of the stock and for that reason you have applied a conservative
capitalization rate or weighted certain of the other factors from a conservative
standpoint to give effect to this marketability factor.
In Estate of Ford, 66 T.C.M. 1507 (1993) decedent owned 92% of a corporation and the
court still allowed 10% discount for lack of marketability. In Estate of Bennett, 65
T.C.M. 1816 (1993) tax court allowed 15% lack of marketability discount is real estate
management firm that was 100% by decedent.
The costs of liquidation alone of the corporate form must be taken into account. The court
in Estate of Curry v. United States, 706 F.2d 1424 7th Cir. (1983), rejected the argument
that the majority shareholder may liquidate. The Court found that the fiduciary duties of
the controlling shareholder restrained the majority interests from liquidating without
regard to the minority interests. Discounts have also been held to apply to assignee
interests in general partnerships.92 Taken together, this line of cases demonstrates that
there is a quantifiable discount for lack of marketability.
There are three generally accepted methods to quantify this discount.
Studies relating to the sales of restricted shares of publicly traded companies are
compared to the sales of unrestricted shares of the same companies. The SEC did
a study in 1971: Institutional Investor Study Report, H.R. Doc. No. 92-64, 92nd
Cong. Pages 2444-2456 (1971);
Sales of closely held company shares are compared to the prices of subsequent
initial public offerings of the same companys shares; and
Projected estimated costs of making a public offering are calculated.
NOTE: the IRS Valuation Guide, supra, leads an Appeals Officer to make a
determination on the lack of marketability discount using the following factors:
Restrictions imposed by the corporation or partnership/LLC;
Restrictions imposed by State or Federal law;
Costs to sell the stock (Partnership/LLC interest);
Brokers commissions for the sale of the entire business when sold locally;
92
Adams v. United States, 218 F3rd 383 (5th Cir 1971)

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Registration and distribution costs;

Underwriters commissions; and
Comparison of market prices of publicly owned companies in a similar business.
The IRS Valuation Guide indicates that Because a lack of marketability discount is
based on lack of liquidity, the Courts generally allow the discount without regard to the
percentage ownership of the stock. IRS Valuation Guide, supra, page 9-4, citing Estate
of Andrews, 79 T.C. 938. Even controlling shares in a non-public corporation suffer
from the lack of marketability because of the absence of a ready private placement
market and the fact that flotation costs would have to be incurred if the corporation were
to publicly offer its stock....
Where the lack of marketability discount has been recognized by the courts it is usually a
substantial discount.93
Several recent cases indicate that the courts continue to recognize the validity of this
discount. A few examples:
Peracchio v. Commissioner, T.C. Memo 2003-280 (September 25th , 2003) (25%
marketability discount and 6% minority discount);
Lappo v. Commissioner T. C. Memo 2003-259(September 3rd, 2003) (24%
marketability discount and 15% minority discount);
Estate of Godley v. Commissioner, T.C. 2000-242 (2000); (20% marketability
discount); Estate of Strangi v. Commissioner 115 T.C. No 35 (2000) (31%
discount);
Estate of Hoffman v. Commissioner T.C. Memo 2001-109 (2001) (35% lack of
marketability discount and an additional 18% minority interest discount);
Knight v. Commissioner 115 T.C. No. 36 (2000) (15% discount);
See also Estate of Jones II v. Commissioner, supra, where the court valued two
separate partnership interests, one which had the power to cause the dissolution of
the partnership and one which did not. The court applied a 7% marketability
discount to both interests and an additional secondary market discount for the
interests that lacked the ability to dissolve the partnership.
7.06
Lack of Control or Minority Interest Discount
The lack of control or minority interest discount is distinct from a marketability

discount. The minority interest discount is applied when the owner of the interest does
not have managerial control over the entity. We must also consider that the individuals
interest cannot be sold if transfer rights are restricted. Liquidation value has little
93
See Arneson, Now marketability discounts should exceed 50%, 59 Taxes 25 (1981); Moore, Valuation
Revisited, 126 Trusts & Estates (February, 1987).
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meaning to an individual investor if owner cannot compel or vote to force liquidation. A

proper analysis of value would consider comparable sales. However, there usually are no
comparable sales.
The IRS Valuation Guide indicates that a minority interest in a corporation is the
ownership of an amount of stock which does not enable the holder to exercise control.
The lack of control feature of a minority interest makes it less attractive to investors, who
are not necessarily willing to pay the allocable value of the stock. The reduction for what
a willing buyer would pay for an interest with no control is called a minority discount.
While the Guide specifically mentions corporations, the same concepts presumably apply
to partnership and LLC interest valuations. This discount addresses the economic reality
of not having control of the day-to-day management of the entity. It also addresses the
inability of a minority interest holder to force a liquidation of the entity to get at the core
assets. Minority interest holders lack certain important powers:
They lack control over issues of entity business policy;
They lack control to force distributions/payment of dividends; and
They lack the ability to affect executive compensation.94
How much ownership interest is needed to have control? The transfer of the first 49% of
an entity will generally constitute the transfer of minority interests and will be valued at
less than the full value of the underlying assets in the entity. Transfer of the next 2% of
the entity also be valued at a minority interest and will reduce the transferors interest in
the entity below 50%. The IRS Valuation Guide indicates also that You should be aware
that a numerical minority or majority interest may not represent actual control. State law
or the articles of incorporation may require a specific percentage to make decisions or
compel liquidation. An individual who owns a numerical minority, may, based on the
particular facts, be exercising actual control and making all the decisions.
What happens when partnership or LLC interests or stock is given away? Where the tax
court has found that a transaction was structured solely to attain a minority discount for
the tax benefits that created, the discount was disallowed.95 In Murphy, the Decedent,
Mrs. Murphy, was Chairman of the Board, her son was president and her daughter was
vice-president, both before and after transfer. Testimony in tax court indicated sole
purpose of the transfer was to obtain a minority discount for the stock at her death.
The decedents accountant periodically advised her to reduce her stock ownership below
50%. Eighteen days before her death she made gifts of .88% of her stock to each of her
two children, resulting in her ownership of 49.65% at her death. The tax court recognized
that this was an extreme case and did not have general application to many minority
discount cases. The tax court in effect applied pre-1981 ERTA IRC 2035 (gifts within 3
years of death) thinking. It is instructive to recognize that a transfer made solely to
94
95
See: Regs. 20.2031-2(e) and 25.25 12-2(e) and (f)

Estate of Murphy, 60 T.C.M. 645
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achieve a numerical minority without relinquishing any actual control will cause a
disallowance of the minority interest discount.
The tax court found that a decedents lifetime transfers of limited partnership interests in
three FLPs were subject to inclusion in her estate under IRC 2036(a)( 1), since the
decedent did not deposit partnership income into the partnership accounts.96 Rather,
partnership income was commingled with the decedents income from other sources in
her personal checking account. The decedents children also testified that the parties
intention was for Mrs. Murphy to continue to manage partnership assets as she had prior
to the establishment of the FLPs. It also appears that distributions of partnership income
were never made to partners other than the decedent.
The Schauerhamer case97 presaged a number of more recent similar cases that apply
I.R.C. 2036(a)(1) to conclude that the full value of the FLPs assets should be included in
the decedents estate because of an implied agreement to return the economic benefit to
the decedent. The IRS has had considerable recent success with this approach which we
discuss at greater length later in this outline.
The minority interest discount is not automatic. The court will look for economic
substance to a transaction (or business purpose aside from the tax consequences). The
Heppenstall case98 involved a donor who owned 2,310 of the 4,233 outstanding shares of
Heppenstall Co. The donor gave 300 shares each to his wife and three children, thus
giving up controlling interest in the entity. The court held the gifts were gifts of minority
interests: ...[donor] did lose, or surrender, his control over the company, but he did not
convey that control to any one of the donees or to all of them jointly.
In Knott v. Commissioner, 54 T.C.M. 1249 (1987) where the tax court rejected the IRSs
attempt to assert the finding of family attribution principle in the context of a family
partnership and allowed a 30% discount in valuation based on illiquidity and lack of
control based on the hypothetical willing buyer/willing seller principle.99
If there is evidence of a prior agreement concerning the future of transferred interests
between donor and donee, the discount will be disallowed. See: Driver v. United States,
1976-2 U.S.T.C. (CCH) 13,155 (D.C. Wisconsin 1976); Blanchard v. United States, 291
F.Supp. 348 68-2 U.S.T.C. (CCH) 12,567 (D.C. Iowa 1968).
If there is any evidence of family discord, it should be highlighted in the appraisal report
for the transaction. As discussed above, Rev. Rul 93-12 suggests IRS acquiescence on tax
court insistence that there is no family attribution on valuation of closely held business
96
Another example of bad facts making bad law!

Estate of Dorothy Morganson Schauerhamer v. Commissioner, TCM 1997-242 (May 28, 1997)
98
Estate of Heppenstall v. Commissioner, 8 T.C.M. (CCH) 136 (1949)
99
See also, Ward v. Commissioner, 87 T.C.M. 78 (1986) 33 1/3% discount on gifts of non-controlling
shares to children where parents controlled corporation before band after transfer; Carr v. Commissioner,
49 T.C.M. 507 (1985) 25% discount allowed even though family controlled 100% of corporation before
and after transfers; Harwood v. Commissioner, 82 T.C. 239 (1984), affd, 786 F.2d 1174 (9th Cir. 1986),
cert denied, 479 U.S. 1007 (1986) (50% discount allowed on value of a family partnership interest
transferred by gift to taxpayers children based in large part on minority attribute.)
97

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interests. However, as the IRS Valuation Guide suggests, and PLR 9436005 confirms, the
swing vote theory may continue to be an attack point for IRS on the allowance of
minority discounts in valuing family held, closely held business interest.
(a)
Assignee Status
The law of every state we know about provides that the transfer of every limited
partnership or LLC interest is the transfer of only an assignee interest in the
partnership or LLC unless additional action is taken by the partners or members to
admit the transferee as a full partner or member. As an assignee, the recipient of
the transferred interest has no status as a partner or member until partner or
member status is conferred upon the assignee as provided under state law or by
the terms of the partnership/LLC or operating agreement.
While we are confident that our position here represents the current state of the
law, the tax court has, on occasions, refused to value interests as assignee interests
where taxpayers did not take steps to transfer mere assignee interests. In Kerr v.
Commissioner, the court concluded that the family had previously ignored the
formalities required by the partnership agreement and found that the interests
conveyed were in fact partnership interests even though the other family member
partners had not formally voted to admit the transferees as partners.100
In Estate of Nowell v. Commr, the court valued limited partnership interests as
assignee interests where admission required the consent of a general partner but
valued the general partner interests as partnership interests because the agreement
permitted transfers of general partner interests between general partners without
another partners consent.101
This concept is particularly important when a decedent has an ownership interest
in the partnership or LLC that exceeds 50% and may have the ability to control
the entity. If the interest the decedent owns is merely an assignee interest, the
estate should be entitled to both a lack of marketability and lack of control
discount because the transferor partner or member could not convey rights to a
transferee other than assignee rights.
(b)
Discount for Loss of a Key Person
Courts have occasionally recognized a discount for the loss of a key person in the
business. United States v. Land, 303 F.2d 170 (5th Cir. 1962); Estate of Rodriguez,
56 T.C.M. (CCH) 1033 (1989); See also Revenue Ruling 59-60 which explains
that in valuing the stock of a closely held business, the loss of a key person may
have a depressing effect upon the value of the business.102
100
Kerr v. Commissioner 113 T.C. No. 30 (1999)

Estate of Nowell v. Commr, T.C. Memo 1999-15 (1999)
102
Rev. Rul. 59-60, 4.02(b), 1959-1 C.B. 237
101

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7.07
Application of the Discounts
When both minority and marketability discounts are available and taken, they are not
added together. The minority interest discount is placed on top of the lack of
marketability discount. That computation is shown clearly in Lippo and Peracchio, supra.
Example: a 30% lack of marketability discount and a 30% minority interest
discount = 49% total discount. Discounts are taken serially (100% - 30% = 70%,
70% x 30% = 21%, 70% - 21% = 49%). Minority Interest discount (lack of
control) is taken first; Lack of Marketability is taken on net after the lack of
control discount.
Even a limited partner or member that owned all of the interests does not have the ability
to control the long-range managerial decisions of the partnership or LLC enterprise; the
ability to affect future earning or the ability to establish executive compensation of the
General Partner or Manager. The limited partner or member does not have the ability to
control or significantly influence efforts for growth potential. When an ownership interest
lacks the ability to exercise control over the operations and destiny of an enterprise, that
interest is worth significantly less than its liquidation value.
Rev. Rul. 93-12 acknowledges that an aggregation of ownership interests within a family
does not alter the willing buyer/willing seller valuation rules; i.e., a control premium
cannot be attributed to family held interests simply because of family aggregation.
7.08
Determining the Premium
On occasion, some courts have found that values should be adjusted upward from their
pre-discount value if control value exists. The issue of control premiums occurs most
frequently in corporations, but sometimes general partners of partnerships have the same
kinds of powers and may therefore subject their general partnership interests to an
upward valuation adjustment.
If a limited partnership or LLC is properly designed, there should never be an occasion in
which a control premium is applied to the entity interests. If the limited partner or
member owns 99% of the partnership or LLC interests, that partner or member can still
only convey an assignee interest, so no control premium should ever be applied.
(a)
The Control Premium
Control premiums do not attach merely because an interest is a general

partnership interest. The interest must be the type of interest that permits the
interest holder to ...unilaterally direct corporate action, select management,
decide the amount of distribution, rearrange the corporations capital structure and
decide whether to liquidate, merge, or sell assets.103
Applying the Newhouse analysis to a limited partnership context would mean that
a control premium would only attach if the holder of the general partner interest
103
Estate of Newhouse v. Commissioner, 94 T.C. 193 (1990)

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could unilaterally act on behalf of the partnership. If there are multiple general
partners, and none of them hold more than a 50% interest, then none of the
general partners interests would be subject to a control premium. If the premium
applies, it is generally expressed as a percentage over what would have been
received for the same shares if they had been sold as minority interests.104
Usually, practitioners want to avoid the application of a control premium.
However, there are situations in which the application of a control premium can
be advantageous. For example, in Chenoweth, the taxpayer successfully sought to
have a control premium applied in order to increase the marital deduction.105
In the context of a limited partnership or LLC, some conclusions can be drawn.
First, a control premium will only apply if the recipient of the general partner
interest holds more than 50% of all the general partnership interests. Second, the
control premium will be mitigated by discounts for lack of marketability and the
existence of fiduciary obligations owed by the general partner to the other
partners.
(b)
Implied Control
In Strangi, supra, the court applied a curious concept described as implied

control. In Strangi, the decedent owned 47% of the corporate general partner of
the partnership. While concluding that the partnership was validly formed, that
there was no gift on formation and that Chapter 14 would not cause the
partnership to be ignored, the court chose to believe that the decedent had not
given up real control of the partnership. Key to this finding was the fact that the
taxpayers valuation expert failed to value the decedents minority interest in the
general partner.106
(c)
Mitigation of Control
Control premiums will usually be mitigated by state law unless the partnership or
LLC operating agreement is drafted in such a way as to override the default
provisions of state law. In most cases, state law and the partnership or LLC
operating agreement will not allow the general partner or manager to
automatically confer FLPs & FLLCs status, so the control premium will be
104
Estate of Salsbury v. Commr 34 T.C.M. (CCH) 1441 (1975) (applying a 38% premium to reflect that
the controlling shareholder could elect the entire board of directors). See also Estate of Feldmar v.
Commissioner 56 T.C.M. (CCH) 118 (1988) (applying a 15% control premium for controlling corporate
stock, but offsetting it by a discount for the loss of a key person); Estate of Oman v. Commissioner, 53
T.C.M. (CCH) 52 (1987) (applying a 20% control premium to stock in a closely held corporation); but see
Estate of Lee v. Commissioner, 69 T.C. 860 (1978) in which the court refused to apply a control premium
to an 80% block of stock that was held by the decedent and her husband as community property.
105
Estate of Chenoweth v. Commissioner 88 T.C. 1577 (1987)
106
See also Godley v. Commr, supra, in which the court refused to find a minority discount for a 50%
general partnership interest without any analysis of whether or not the interest transferred was an assignee
interest.
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mitigated by the transferees assignee status. See the discussion of this issue in
Nowell v. Commr, supra.
In addition, the general partner will almost always owe a fiduciary duty to the
other partners that will also mitigate the value of the general partners control
premium. The IRS has ruled that because the decedent general partner occupied a
fiduciary position with respect to the other partners and could not distribute or
withhold distributions or otherwise manage the entity for purposes unrelated to
the conduct of the business, the limited partner interest would not be included in
the decedents gross estate under Section 2036(a)(2).107 However, the Strangi II
holding substantially erodes that notion at least in those situations in which the
person in the fiduciary position holds almost all of the limited partnership/LLC
interests as well.108
7.09
Control and Annual Gift Exclusions (Hackl)
The issue of value and control premium has also arisen in the context of the
determination of whether a gift of a limited partnership or LLC interest qualifies for the
annual gift exclusion under Code 2503(b). Generally, the Internal Revenue Service has
concluded that when the general partner has a fiduciary duty to the limited partners, the
general partner cannot manipulate the entity so effectively as to render the limited
partners interest valueless.109
But in the Hackl case110 the court found that the terms of the operating agreement of an
Indiana LLC were so restrictive that the interests conveyed to the donees were so lacking
in economic benefit they did not qualify as present interest gifts. The holding in this case
appears to turn more on the particularly severe restrictions on transfer rather than on
fiduciary duty issues.
7.10
Chapter Fourteen and FLP and FLLC Valuation
Chapter 14 was added to the Internal Revenue Code to combat what Congress perceived
to be manipulation of values in transfers of family-owned business and investment
organizations. Chapter Fourteen added 2701-2704. Three of those sections, 2701,
2703 and 2704 relate only to transfers of ownership between family members. They do
not affect any other type of transaction.
(a)
Section 2701
Section 2701 is a gift tax valuation rule that was designed to combat the
preferred equity freeze, the freezing technique that, before the enactment of
107
Priv. Ltr. Rul 9131006 (Apr. 30, 1991)

Estate of Strangi v. Commissioner, T.C. Memo 2003-145 (2003)
109
See Technical Advice Memorandum 9131006
110
Hackl v. Commissioner, T.C. 118 T. C. No. 14 (2002), Affd. Nos 02-3092 and 02-3094 (7th Cir. July 11,
2003)
108

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Chapter Fourteen, permitted corporations to recapitalize, creating two separate

classes of stock common and preferred. Preferred stock was assigned a par
value equal to its present value and could be called by the corporation at that par
value. As a result, the common stock had no value.
While the preferred stock had all of the value at the point of recapitalization, it
could not grow beyond the par value. So preferred stocks value was frozen and
all future growth of the corporation occurred with the common stock. Typically in
this arrangement the senior generation would take back the preferred stock
interest and then gift the younger generation was given the common stock.
Although the common stock was worth essentially nothing at the time, it carried
with it all the growth opportunity. In this way, significant value could be shifted
with little or no gift tax cost.
(1)
Application to partnerships and LLC
General and limited partnership interests and LLC interests are not treated
as being two classes of equity, and therefore, Chapter Fourteen does not
affect the valuation of straightforward general and limited partnership and
LLC interests. Regulation 25.2701-(c)(3) provides that non-lapsing
differences with respect to management and limitations on liability do not
create separate classes of interests. Also, non-lapsing provisions regarding
compliance with partnership/LLC tax allocation under 704(b) and 704(c)
do not create two classes of interests.
Regulation 25.2701-2(b)(4)(iii) provides that a guaranteed payment
provision qualifying under 707(c) in an FLLC may escape 2701
valuation rules if the payment is fixed specific as to amount definite as to
time of payment.
Estate planning and business-oriented LLCs should ordinarily be
structured with only one class of interests to avoid 2701 application.
Avoidance of 2701 application allows the willing buyer/willing seller
test to apply to transfers of interests. Rather than the willing
buyer/willing seller valuation, 2701 creates a subtraction method for
valuing gifts made by older generation member. The usual result is the
reduction of the value of the retained portion to zero, making the entire
gift taxable. This is why compliance with 2701 is so very important.
So, 2701 applies when:
Both before and after the gift, the donor had an interest in the
business enterprise (Partnership/LLC); and
The donor retained the right to receive payments from the business
enterprise (Partnership/LLC) which are not based upon the
remaining percentage of ownership held by donor (the Qualified
Interest).
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(2)
Outline of Statutory Prerequisites of IRC 2701
IRC 2701 requires that all of the following conditions be present before
the normal valuation rules under Chapter 12 are ignored and the valuation
rules of IRC 2701 are applied to certain of a transferors rights in his
retained assets in order to determine the value of transferred assets:
Corporate Asset Test: The transferred asset must be an interest in
a corporation or an interest in a partnership (including LLCs);111
Transferee Non-Marketable Asset Test: The transferred asset
must be an asset for which market quotations are not readily
available on an established securities market;112
Transfer Test: The asset must be transferred or deem to be
transferred;113
Family Member Transferee Test: The asset must be transferred
to or for the benefit of a member of the transferors family;114
Retention Test: After the transfer of the interest in the corporation
or partnership/LLC, the transferor or an applicable family member
must retain an interest in the corporation or partnership/LLC;115
Control Test: After the transfer of the stock or partnership/LLC
interest, the transferor and/or applicable family members are in
control of the corporation or partnership/LLC;116
Transferor Non-Marketable Asset Test: The transferors
retained asset in the corporation or partnership/LLC in which the
transferor has made a transfer of an interest must be an asset in
which market quotations are not readily available as of the date of
the transfer;117
Same Class Test: At least part of the transferors retained interest
in the corporation or partnership/LLC must be an interest which is
not in the same class as the transferred interest;118
Proportional Test: At least part of the transferors retained
interest in the corporation or partnership/LLC must be an interest
111
See IRC2701 (a)( 1)

Id.
113
See IRC 2701 (a)(1), 2701(d)(4), 2701(e)(3)(A), and 2701(e)(5)
114
See IRC 2701(a)(1), 2701(e)(1)
115
See IRC 2701 (a)( 1)
116
See IRC 2701(1)(a), 2701(b)(1)(A), 2701(b)(2) and 2701(e)(3)
117
See IRC 2701 (a)(2)(A)
118
See IRC 2701(a)(2)(B)
112

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that is not proportionately the same as the transferred interest

without regard to non-lapsing differences in voting power;119
Potential Valuation Abuse Rights Test: There exist at least some
rights in the transferors retained interest in the corporation that are
either distribution rights or liquidation, put call, or conversions
rights;120
Equity Distribution Rights Test: If a retained distribution right
exists, at least part of the transferors retained distribution rights
must constitute a right to distributions from corporate stock or a
partnership/LLC interest;121
Preferred Distribution Rights Test: If a retained distribution
right exists, at least part of the transferors retained distribution
rights must constitute a right to distributions from a senior equity
interest (i.e., the transferor must have retained preferred stock, or
in the case of a partnership/LLC, a partnership/LLC interest under
which the rights as to income and capital are senior to the rights of
all other classes of equity interest);122
Guaranteed Distribution Rights Test: If a retained distribution
right exists, at least part of the transferors retained distribution
rights must constitute distribution rights that are not guaranteed
payments under IRC 707(c) of a fixed amount;123
Valuation Manipulative Liquidation Right Test: If retained
liquidation, put, call or conversion rights exist, the exercise or nonexercise of at least some of the transferors retained liquidation,
put, call or conversion rights must affect the value of the
transferred interest;124
Fixed Liquidation Right Test: If retained liquidation, put, call or
conversion rights exist, at least some of the transferors retained
liquidation, put, call or conversion rights in his retained asset must
not be exercised at a specific time and at a specific amount;125
Fixed Convertibility Right Test: If a retained conversion right
exists, at least part of the transferors retained conversion rights are
not rights to convert into a fixed number (or fixed percentage) of
119
See IRC 2701 (a)(2)(C)

See IRC 2701 (b)(1)(A), (B)
121
See IRC 2701 (c)(1)(A)
122
See IRC 2701(c)(1)(B)(i) and 2701 (a)(4)(B)
123
See IRC 2701 (c)(1 )(B)(iii)
124
See IRC 2701(c)(2)(A)
125
See IRC 2701 (c)(2)(B)(i)
120

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shares of the same class of stock as the transferred stock (there

exist similar rules for partnerships/LLCs);126and
Grandfathered Freeze Test: If the freeze occurred before
October 8, 1990, the new valuation rules of IRC 2701 will not
apply.
(3)
Special Classes of Interest for Asset Protection Purpose
Creating voting and non-voting partnership/LLC interest or creating a

preferred and common partnership/LLC interest where the older
generation receives the voting and/or the common interest and the younger
generation receives the non-voting and/or preferred interest will not
violate the abuse that 2701 was enacted to stop.
(b)
Section 2702
This is a gift tax valuation statute. For purposes of determining whether

transferring interest in a trust to or for the benefit of a member of the transferors
family is a gift (and the value of such transfer), IRC 2702 provides special rules
for determining the value of such trust retained by the transferor or any applicable
family member. IRC 2702 does not apply to corporations or partnership/LLCs.
Section 2702 applies to gifts made via non-charitable split interest trusts.
Grantor Retained Annuity Trusts (GRATs)
Grantor Retained Unitrusts (GRUTs)
Grantor Retained Income Trusts (GRITs)
Qualified Personal Residence Trusts (QPRTs)
The application of 2702 requires the use of the subtraction method of
valuation to determine present interest (Section 7520 tables) of the qualified
interest retained by donor/grantor.
Section 2702 drastically limits the use of GRITs. A GRIT is a trust where the
grantor transfers property to the trust and retains all of the income only from the
trust for a period of years. Prior to Chapter 14 GRITs were used to make gifts of
non-income producing property to the GRIT and the grantor retained all of the
non-existing income for a period of years to reduce the value of the gift for gift
tax purposes. A QPRT is a type of permitted GRIT. Tangible non-depreciable
assets GRIT are also a type of permitted GRIT by 2702.
(c)
Section 2703
2703 governs buy-sell agreements and leases between family members. It

provides that The value of any property shall be determined without regard to
any restriction on the right to sell or use property unless the terms [of the
126
See IRC 2701 (c)(2)(C)

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restriction] are comparable to similar arrangements entered into by persons in an

arms length transaction. Three tests are applied to make that determination:
(1)
Business Purpose Test
Is the restriction on the use or transfer of the property a bona fide

business arrangement?
(2)
Testamentary Tax Avoidance Device Test
Is the restriction or the agreement a device to transfer property to the

decedents family for less than full and adequate consideration?
(3)
Comparability of Price Test
Are the terms of the restriction or agreement the kind of terms that would
be reached in an arms length transaction between unrelated individuals?
Regs. 25.2703-1 requires that for estate, gift and generation skipping tax
purposes, the value of any property is determined without regard to any
right or restriction related to the property. Common restrictions found in
commercial FLPs & FLLCs that satisfy the comparability test
include:
Right of first refusal
Restrictions on ability to pledge partnership/LLC interests
Requiring partnership/LLC interest to be subject to a buy-out in the
event of default
If the restrictions and price are similar to those which would be reached
between unrelated parties, 2703 presents no problem with structuring and
planning a Family Limited Liability Companies. However, the IRS
indicated that 2703 would be applied to disallow valuation discounts
claimed by an estate where the transfers of limited partnership/LLC
interests were truly made in contemplation of death.
(d)
Technical Advice Memorandum (PLR 9719006)
In a Technical Advice Memorandum dated March 1, 1997, (Released as PLR

9719006) the IRS addressed valuation issues that arose from transfers made under
a power of attorney while the transferor was either on or had been removed from
life support. In fact, the transferor died only two days following the
consummation of a series of transactions including the transfer of substantial real
estate and marketable securities from the transferors living trust to a Family
Limited partnership in exchange for a 98% limited partnership interest.
Following the establishment of the Family Limited partnership, the transferors
children (who were trustees of the living trust) sold 30% limited partnership
interests to themselves in exchange for thirty-year notes. The result of this series
of transactions was the purported inclusion in the decedents estate of only a 37%
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Limited partnership interest, which was valued by the estate subject to a 48%
valuation discount.
The IRS contended that the series of transactions represented a single
testamentary transaction [citing Estate of Murphy v. Commissioner, 60 TCM 645
(1990)], since the decedents children would be in the same position following the
transactions as they would have been had the LLC creation/sale of partnership
interests not taken place. The IRS argument ignores the fact that the children had
substantially different rights as partners than as holders of undivided interests in
real property and other assets (such as the right to compel partition of property).
The IRS also contended that 2703(a)(2) precludes the use of valuation discounts,
suggesting that 2703 was applicable to the formation of an entity rather than to
an agreement.
(e)
Current IRS Position and Recent Cases
For several years and notwithstanding the clear language in the legislative history
to the contrary, the IRS continued to assert the position that 2703 required that
the formation of a family limited partnership and subsequent transfer of assets to
the partnership be disregarded for gift and estate tax valuation purposes.127 The
IRS also asserted in Technical Advice memorandum 9842003 that the transfer of
assets to a partnership resulted in a gift to the other partners.128
However, the courts have consistently rejected those arguments. Church v.
United States, 85 AFTR 2d Par. 2000-428 (W.D. Texas 2000), affd in an
unpublished opinion, 88 AFTR 2d Par. 2001-5142 (5th Cir. 2001). In Church, the
court concluded that the partnership was valid under Texas law and the subject
partnership interest, not the contributed property, should be valued. The court also
specifically rejected the notion that Mrs. Church had made gifts to other partners
upon the contribution of her property to the partnership. (The IRSs Gift on
Formation argument). Significantly, the court reached this result even though the
partnership was not technically formed or funded at the time of Mrs. Churchs
death. The tax court has found under one set of facts that the contribution of assets
by the taxpayer to that was allocated to the capital account of the taxpayers son
did create an indirect gift. However, the fact pattern in that case did produce a real
economic shift in wealth from the taxpayer to the taxpayers son.129
The more recent cases continue to recognize that it is the partnership interest
rather than the contributed property that must be valued.130
(f)
Some Additional Observations on Section 2703
Reference to decedent in the second requirement is probably an error since IRC

2703 could also apply to inter vivos situations.
127
See Tech. Adv. Mem. 9725002 (Mar. 3, 1997)

TAM 9842003 (July 2, 1998).
129
Shepherd v. Commr 115 T.C. No. 30 (2000).
130
Strangi, Knight, Jones II, all cited supra.
128

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What constitutes a member of the decedents family in the second requirement

is not defined. The Technical Corrections Act of 1991 would have changed the
reference to members of the decedents family to natural objects of the bounty of
the transferor.
The regulations provide that a buy-sell agreement is considered to meet the
requirements of IRC 2703 if more than 50% of the property subject to the right
or restriction is owned either directly or indirectly by individuals who are not
members of the transferors family.131 The regulations define family to include
those persons who are family under Reg. 25.2701-2(b)(5) and any other
individual who is a natural object of the transferors bounty.
A perpetual restriction on the use of real property that qualifies for a deduction
under IRC 170(h) will not be treated as a right or restriction under IRC 2703.
The third requirement under Paragraph B is not found in present law. The
taxpayer must be able to demonstrate that the agreement is one that would have
been obtained at an arms-length bargain. That burden is not met simply by
showing certain comparables, but requires demonstration of a general practice of
unrelated parties. Expert testimony can provide evidence of that practice. The
regulations provide that the evidence of the general business practice of unrelated
parties under negotiated agreements in the same business is not met by showing
isolated comparables.132
(g)
Section 2704(a): Lapsing Voting or Liquidation Rights
Two sections in Section 2704 present concern for the FLP and FLLC designer.
The first deals with lapsing rights.
(1)
Definition of Lapsing Rights
Transfers of interests in a family controlled partnership/LLC or

corporation which has voting or liquidation restrictions which lapse will
be valued as if the lapse did not occur. A lapse of a voting or liquidation
right is defined as follows:
A lapse of a voting or liquidation right occurs at the time a
presently exercisable right is restricted or eliminated. Generally, a
transfer of an interest conferring a right is not a lapse of that right
because the rights with respect to the interest are not restricted or
eliminated.133
Thus, the transfer of a minority interest in a corporation or
partnership/LLC by the controlling shareholder or partner is not a lapse of
voting rights, even if the transfer results in the transferors loss of voting
control (with the exception noted below). Even if a transferors liquidation
131
Reg. 25.2703-1(b)(3)
See Reg. 25.2703-1(b)(4)(ii)
133
Reg. 25.2704-1(c)
132

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control lapses, the Service recognizes that the dominant Congressional

intent was to preserve fractionalization discounts.
(2)
Application of Section 2704(a)
IRC 2704(a) will apply if the following prerequisites are present:

There is a lapse of a voting or liquidation right in a corporation or
partnership/LLC (Treasury may also expand this requirement to
include other rights similar to voting and liquidation rights);
The individual (the statute significantly does not use the word
transferor) holding the right immediately before the lapse and a
member or members of such individuals family hold, both before
and after the lapse, control of the entity;
If the elements described in Paragraph above are present, the lapse will be
treated as a transfer.
The measure of that transfer is the excess, if any, of:
1) the value of all interests in the entity held by the individual
before the lapse, over
2) the value of such interests immediately after the lapse.
Thus, in order for 2704 (a) to apply, the family must control entity both
before and after the lapse. The holder/owner of the lapsed interest will
be deemed to have made a transfer by gift (or will have the value subject
to the lapse included in his/her gross estate) in an amount equal to the
excess of all interests in the entity held immediately before the lapse over
the value of the interest immediately after the lapse.
The effect is to disregard the lapse and treat the transferred interest as if no
lapse occurred. Upon a lapse during lifetime, a gift is deemed to occur
even though no actual transfer has occurred.
(3)
What are Voting Rights?
A voting right is a right to vote on a matter with respect to the entity (i.e.,
the partnership/LLC). A liquidation right is a right to compel the entity to
acquire all or a part of the holders equity interest. A power to compel by
reason of aggregate voting power is a liquidation right, not a voting right.
If the restriction on the liquidation of the business lapses after the transfer
of an interest, or, if a family member or members together can remove the
restriction that prevents liquidation, then an appraiser must ignore the
restriction for valuation purposes. A voting right or liquidation might be
conferred by state law, corporate charter, or bylaws or an agreement, such
as a partnership/LLC agreement. A transfer of an interest that results in the

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lapse of a liquidation right is not subject to 2704(a) if the rights

connected to the transferred interest are not restricted or eliminated.
Example: Parent owns 70% interest in family controlled entity.
Entity can be liquidated with 66 2/3% vote of ownership interests.
Father gifts 10% interest to children. Parent no longer has
liquidation power - lapse of aggregated voting right to liquidation.
This transfer is not subject to 2704(a) because the rights associated or
connected to the transferred interests has not been restricted or eliminated.
The voting rights of the gifted interests are the same voting rights in the
hands of parent. Lapsing powers will exist when a partner is given the
right to liquidate the FLP or FLLC upon the occurrence of certain events
or at-will. If a partner (for example, a general partner) can withdraw from
the FLP or FLLC and his general partner interests (which contain voting
powers) are converted to limited partners interests (which lack those
voting powers), a lapse will have occurred which will be subject to
2704(a). Because these issues are driven entirely by state law, state law
must be taken into account in designing the entity.
(h)
2704(b): Applicable Restrictions
The second section of Section 2704 deals with Applicable Restrictions. The
Treasury regulations define applicable restriction as follows:
An applicable restriction is a limitation on the ability to liquidate the
entity (in whole or in part) that is more restrictive than the limitations that
would apply under the state law generally applicable to the entity in the
absence of the restriction.134
and
A restriction with respect to which either of the following applies:
The restriction lapses after a transfer to a family member;
or,
The transferor or any member of the transferors family, either
alone or collectively, has the right after such transfer to remove, in
whole or in part, the liquidation restriction.
However, even if the restriction meets the above tests that restriction will
not be governed by IRC 2704(b) if it arises as part of any financing or
equity participation entered into by the corporation or partnership/LLC
with a person who is unrelated, as long as the restriction is commercially
reasonable or is imposed or required to be imposed by any federal or state
law. So, if a third party lends money to the entity (or takes an equity
134
Reg. 25.2704-2(b)
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position as part of the financing) and requires that if a family member

transfers its interests, the acquiring transferee will not have a vote in the
enterprise, such a restriction will not constitute an applicable
restriction.
The regulations also add the additional exception that any option, right to
use property, or agreement that is subject to IRC 2703 is not an
applicable restriction.135
(i)
Disregarding Applicable Restrictions
A restriction categorized as an applicable restriction will be disregarded in

determining the value of the transferred interest if there is a transfer of an interest
in a corporation or partnership/LLC to a member of the transferors family, and
the members of the transferors family control the entity.
(j)
Effect or Impact of Disregarding an Applicable Restriction
If an applicable restriction is disregarded, the transferred interest that formerly

was subject to the restriction is valued as if the restriction does not exist and as if
the rights of the transferor are determined under state law.136
7.11
Valuation Discounts and Basis Allocation Problems
Valuation discounts produce a lower income tax basis under 1014. Careful planning is
required to determine whether discounts should be structured (or claimed) in the first
estate or the second estate. Should the entity ownership be divided equally between
spouses, or should one spouse own all of the interests? Its not merely an issue of when
the 1014 basis occurs; its also a question of how much basis will be available.
7.12
Planning Suggestions
In most instances, FLPs should be designed so that they do not terminate at the death of a
general partner. Generally, they should be designed to exist for a set term of years. The
transfer of an interest should only convey an assignee interest. That will generally be
the case under state law automatically unless specific action is taken to convey a fully
admitted partnership or LLC interest. It is possible to structure assets so that the valuation
of assets will be determined under the distributable cash flow method, and 2704 is not
violated. Design of the entity under state law is the key to successful implementation.
7.13
Valuation Penalties
Two valuation penalties may apply when a partnership or LLC interest is valued:
135
136
See Reg. 25.2704-2(b)

See Proposed Reg. 25.2704-2(c)
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(a)
Substantial Overstatement of Valuation
This penalty applies if a substantial valuation overstatement exists if the value

or adjusted basis of any property claimed on a return is 200% or more of the
correct value or adjusted basis, and only if the underpayment of tax attributable
to a valuation overstatement exceeds $5,000.
The amount of the penalty is 20% of the underpayment if the value or adjusted
basis is 200% or more, but less than 400% of the correct value or adjusted
basis.137
(b)
Estate or Gift Tax Understatement
The taxpayer is subject to this penalty if the value of the property that is reported
on the return is 50% or less of the correct value.138
Penalty is 20% of tax in normal cases. Penalty doubled to 40% if valuations are
claimed that exceed 400% of actual value, or only 25% or less of the correct
value is reported for estate and gift valuation.
137
138
6662(b)(3), 662 (f) and 6662 (h)

6662(b)(5), 6662(g) and 6662 (h)
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Part VIII
Entities as Members or Managers
8.01
The Family Limited partnership
The Limited partnership itself is a legal entity that may own assets and carry on business
or investment operations for profit. A Limited partnership is a partnership with two
classes of partners: General Partners and Limited Partners. General Partners manage and
control all of the business operations of the partnership and have full responsibility for all
debts, liabilities and obligations of the partnership. In other words, the General Partner
has what is referred to as unlimited liability. A General Partner will usually receive a fee
for management services. The Limited Partners have no control over the business
operations of the partnership and have voting rights limited to such issues as the
admission of new partners, or on the dissolution and liquidation of the entity. Limited
Partners have limited or no responsibility for the debts, liabilities and obligations of the
partnership beyond the amount of their investment in the partnership. The Limited
Partners therefore enjoy what is referred to as limited liability.
Since only the General Partner of the Limited partnership controls the day-to-day
operation and management of the Limited partnership, regardless of the General Partners
percentage of ownership, it is not necessary for the General Partner to have a large
ownership interest in the partnership. Unlike corporations, where more than 50%
ownership is required for control, a greater than 50% partnership interest is not required
in order to control the partnership entity.
A General Partner who owns as little as a 1% General partnership interest (or even less)
can nonetheless have 100% control of the partnership operations and management. If we
were to compare the control of the partnership/LLC to the control of a corporation, the
General Partner would be like a shareholder who owns all the voting stock of a
corporation, whereas the Limited Partners would be like the non-voting stockholders of a
corporation.
Generally, if any of the Limited Partners ever become involved with the day-to-day
operations of the Limited partnership, the law can treat those Limited Partners as General
Partners, and they, too, will have unlimited liability for all, debts, liabilities and
obligations of the partnership. The exposure of the Limited Partners to unlimited liability
is just the opposite of what is desired in the designing of a Limited partnership.
A Family Limited partnership (FLP) is a Limited partnership where the General and
the Limited Partners are family members or family-controlled entities such as
corporations, Limited Liability Companies or trusts. Therefore, only certain family
members or family-controlled entities will own and control the FLP. This result can only
be achieved by giving serious thought to the design of the FLP.

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8.02
The Family LLC
The LLC (LLC) is also a legal entity that may own assets and carry on business or
investment operations for profit. An LLC may be managed by its Members or managed
by one or more Managers. An LLC that is Member-managed will have what is referred to
as decentralized management. An LLC that is Manager-managed will have what is
referred to as centralized management. The Manager of an LLC may be a Member or a
non-Member. The Manager will manage and control all of the business operations of the
LLC. Unlike the General Partner of the Limited partnership, the LLC Manger, as a
general rule, will not have any responsibility for the debts, liabilities and obligations of
the LLC. Similar to the General Partner, though, the Manager will usually receive a fee
for management services. The non-Manager Members will typically have no control of
the business operations of the LLC, but only have limited voting rights such as on the
admission of new Members, or the dissolution and liquidation of the LLC. Both Members
and Managers will have no responsibility for debts, liabilities and obligations of the LLC
beyond the amount of their investment in the LLC. The LLC Members therefore also
enjoy what is referred to as limited liability.
A Family LLC (FLLC) is an LLC where the Managers and the Members are family
members or family-controlled entities such as corporations, Limited Liability Companies
or trusts.
The FLLC may be designed as a Member-managed LLC or as a Manager-managed LLC.
The Managers of the FLLC may be a Member or a non-Member. Regardless of the
Managers ownership interest, the Managers will control the day-to-day operations of the
FLLC. Therefore, the FLLC will usually be designed as a Manager-managed LLC so that
the control of the FLLC will be centralized in certain family Members or familycontrolled entities. Either management arrangement will not expose the Members or
Managers of the FLLC to the debts, liabilities or obligations of the FLLC.
So, in a way, the FLLC is less complicated than the FLP. However, we do not have
nearly as much case law as we have for FLPs & FLLCs.
The key question to be answered and the key focus of this chapter therefore is
Who, or what kind of an entity, should be considered for the General Partner or
the Limited Partners of the FLP or the Manager or the Members of the FLLC?
We will explore the various choices of persons or entities and their implications.
8.03
Individuals as General Partners or Managers?
An individual can be a General Partner or Manager, or, several individuals together can
be the General Partners or Managers. As General Partner(s) or Manager(s), he/she/or they
will control the FLP or FLLC. It is recommended that if individuals are serving as
General Partners or Managers that several individuals should be named and several lines
of successors should be named in the partnership agreement or operating agreement and
the Certificate of Limited partnership or the Articles of Organization.
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An obvious shortcoming to having an individual as a General Partner is the individuals

personal exposure to unlimited, joint and several responsibility for all of the debts,
liabilities and obligations of the partnership/LLC. Whether or not this is an unmanageable
problem depends upon the nature of the assets of the Limited partnership/LLC.
For example, if the Limited partnership/LLC owns assets such as rental real estate, rental
automobiles or any other kind of asset that could potentially cause a personal injury, the
liability exposure of the General Partner or General Partners can be substantial.
On the other hand, if the Limited partnership/LLC merely owns intangible assets, such as
stocks, bonds, mutual funds, savings accounts, certificates of deposit, money market
accounts or funds, the liability exposure of the General Partner is virtually nonexistent.
Intangible assets are non-liability producing assets. You never hear of lawsuits that are
filed because someone slipped and fell over a stock certificate or that a certificate of
deposit caused a fire. Therefore, the General Partner will not have exposure to liability to
third parties merely because of the partnership/LLCs ownership of these intangible
assets. When an FLP owns only intangible assets, the General Partners liability exposure
will usually be limited to contractual obligations or for debts incurred upon borrowed
funds or other credit arrangements.
The Manager of the FLLC will not, as a general rule, have exposure for the debts,
liabilities or obligations of the FLLC regardless of the assets owned by the FLLC.
An additional problem that occurs when an individual is a General Partner or Manager is
that an individual can die or become incompetent, insolvent or bankrupt. Most state
versions of the Uniform Limited Partnership Act or the Revised Uniform Limited
partnership Act provide that a Limited partnership will terminate upon the death,
incompetency, insolvency, or bankruptcy or insanity of any or all the General Partners,
unless the Limited partnership agreement provides for immediate replacement of the
General Partner or all partners give their written consent to reconstitute the
partnership/LLC and replace the General Partner within 90 days after the event of
withdrawal by the previous General Partners (RULPA 402 & 801). This risk of
premature termination may reduce the valuation discount of an FLP interest.
If partnership interest or LLC membership interest is held in the name of an individual
and the individual dies or becomes incapacitated, the partnership interest or LLC
membership interest will go through the probate process. This could expose the
partnership interest or LLC membership interest to the claims of probate creditors.
Furthermore, IRC Section 708(b)(1)(A) &(B) provides that if the partnership/LLC ceases
to do business or is terminates under state law or if within any rolling 12-month period
there is a sale or exchange of 50% or more of the total interest in capital and profits of a
partnership/LLC, the partnership/LLC will be considered terminated for tax purposes.
Therefore, if a partnership/LLC is considered terminated for state law purposes it could
also be considered to have been terminated for income tax purposes if any individual who
is a General Partner or LLC Manager dies or becomes incompetent or if he or she owned
50% or more of the partnership/LLC interest and a sale or exchange occurred within
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any rolling 12-month period. The consequences of such an inadvertent termination for tax
purposes would mean a closure of the partnership/LLCs tax year and the termination of
any tax elections, such as an IRC Section 754 election. The new partnership/LLC would
have to hold new elections all over again.
For all of the above reasons, it is usually not recommended that, in the design of the FLP
or FLLC, individuals ever be named as the General Partners of the FLP or the Managers
of the FLLC.
8.04
Corporations as General Members
A corporation can be a general partner of a limited partnership/LLC. In fact, many of our

clients choose a corporation (or an LLC) to serve as the general partner of their FLPs,
LLCs & FLLC. Unlike individuals, corporations are artificial legal entities with perpetual
existence. As such, they are not subject to the human frailties of death or disability. For
this reason, a corporate general partner or manager can provide an FLP or FLLC with
continuity of life.
(a)
Opportunities with Management Fees
The General Partner of an FLP or Manager of the LLC is entitled to receive a

management fee for services rendered in the course of managing the Limited
partnership or LLC. The payment of a management fee can open the door for a
number of planning opportunities when a corporation is a General Partner or
Manager. They are:
Compensation can be paid to officers and employees of the corporation. A
corporation can only act through its directors, officers and employees. When a
corporate General Partner or Manager is used for an FLP or FLLC, family
members can serve as the directors, officers and employees of the corporation
and, as such, can receive compensation, like salaries or commissions, for such
services. As long as the salary or commission is reasonable, the corporation may
deduct the cost of such compensation, as an ordinary and necessary business
expense and the officer or employee will include such compensation in his or her
gross income. This can result in splitting the corporate income between family
members. If some family members are in lower tax brackets than other family
members, this income-splitting can result in substantial income tax savings. A
Limited Partners involvement as an officer, director, employee or
shareholder of the corporate General Partner will not convert him or her
into a General Partner for liability purposes.
Directors Fees. As Members of the Board of Directors, family members may
also be paid director fees. Again, these fees must be reasonable to be deducted as
ordinary and necessary business expenses and the family members must include
the directors fees in their gross income.

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Fringe Benefits provided to Officers and Employees. Furthermore, the

corporation can provide income tax deductible fringe benefits to officers and
employees, such as medical, health and accident insurance, medical
reimbursements to cover health insurance deductibles or exclusions, disability
insurance, cafeteria benefit plans and, most importantly, it can provide retirement
plans such as defined contribution pensions, profit sharing--401(k) plans, Section
419 welfare benefit trusts, and defined benefit pension plans.
(b)
Controlling the Corporate General Partner
As previously mentioned, control of a corporation ordinarily requires ownership

of more than 50% of the shares.
However, owning a majority interest is not the best way to control the corporate
General Partner or Manager. If a shareholder is sued, a creditor can levy upon the
shareholders share of stock to satisfy the creditors judgment, and thus, the
control of the corporate General Partner or Manager can end up in the hands of an
adverse party.
If an undesirable person gains control of the corporate General Partner or
Manager, this undesirable person will also gain control of the FLP or FLLC. This
result can be devastating. Therefore, our experience suggests that the best way to
insure family control of the corporate General Partner or Manager is to have all of
the family member shareholders enter into a voting agreement.
Voting trusts are not recommended because the corporate laws of many states
limit the number of years that a voting trust may exist. There are no such limits,
however, to voting agreements.
A voting agreement is an agreement between the shareholders that they will vote
their stock each year to elect certain individuals to the Board of Directors. This
agreement ensures that regardless of the percentage of stock ownership of a
particular shareholder, the shareholders have contractually agreed to elect certain
individuals to the Board of Directors. A judgment creditor of any of the
shareholders may be able to gain control of a judgment debtors shares, but the
voting agreement will control how the remaining family shareholders will vote
the majority of the stock of the corporate General Partner or Manager.
The Board of Directors elected by the majority of shares under the voting
agreement will control the corporation by appointing or electing the officers that
run the corporation. The FLP or FLLC is, therefore, controlled and operated by
the officers of the corporate General Partner or Manager who were appointed or
elected by family member directors.
We regularly suggest that our client own a very small percentage of the stock in
the corporate General Partner or Manager. With a shareholder agreement
guaranteeing the clients election to the Board of Directors each year, the
percentage ownership of stock in the corporate General Partner or Manager is
unimportant. Other family members will own the balance of the corporate stock.
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[Note: The Strangi II holding, discussed later, casts some doubt on this approach,
but a solution will also be discussed.]
Our strategy here is to maintain control of the corporation in the event that a
creditor, or even the IRS, should levy upon the clients stock. The levy will not
result in loss of control because the stock levied upon is a small minority interest.
Under the voting agreement, our client is still going to be elected to the Board of
Directors, year after year. Thus, it is not unusual for our clients to own a very
small percentage (e.g., 1%) of the stock of the corporate General Partner or
Manager and for the corporate General Partner to own a very small percentage of
the FLP. The corporate LLC Manager, on the other hand, does not have to own
any of the FLLC.
8.05
S corporation as Corporate General Partner
The corporate general partner or manager may also be an S corporation. As an S

corporation, the problem with double taxation of a C-corporation is eliminated.
(a)
Advantages of an S Corporation
With an S corporation there is generally no taxation at the entity or corporate

level. Each shareholder will include in its, his or her gross income or deduct from
its, his or her gross income a pro rata share of the S corporations income or
losses based upon the percentage ownership of stock owned and the number of
days in the tax year that percentage of stock was owned.
(b)
Disadvantages of an S Corporation
The major disadvantage of an S corporation serving as a General Partner or

Manager is that under the S corporation rules, certain persons or entities cannot be
shareholders. Only United States citizens or resident individuals, estates, grantor
trusts, electing small business trusts, IRC 501(c)(3) charities and special
qualified S corporation type trusts (QSST) may be shareholders.
In addition, there are some special tax rules that limit the deductibility of fringe
benefits enjoyed by employee-stockholders who own more than 2% of the S
corporation stock.
For these reasons an S corporation may not be the appropriate choice of entity to
serve as general partner. (IRC 1372)
8.06
There are several drawbacks to the use of a corporate General

Partner or Manager.
(a)
It makes the FLPs, LLCs & FLLCs structure more complicated.
Since we are creating two new entities, we have to draft, execute, and file the
paperwork for both. We have to obtain a corporate charter, from the state of origin
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and a certificate of authority, from any other state that it operates in, for the
corporate General Partner or Manager and a Limited partnership or LLC charter
for the FLP or FLLC. We have to obtain an IRS taxpayer identification number
for both entities and both entities must file tax returns each year.
The Limited partnership or LLC that is taxed as a partnership/LLC must file an
IRS Form 1065, U.S. partnership/LLC Income Tax Return, and the corporate
General Partner must file an IRS Form 1120 or 1120S, U.S. Corporate Income
Tax Return, annually.
(b)
Corporate formalities must be observed.
One of the advantages that a trust, or an FLPs & FLLCs has over a corporation is
that the strict formalities of a corporation are not required to be followed by a
trust or an FLPs & FLLCs. With a corporate General Partner or Manager, our
clients are required to observe those strict corporate formalities again. Corporate
bylaws must be adopted, observed and maintained. Annual minutes of shareholder
meetings electing the directors must be maintained. Annual minutes of the Board
of Directors meeting electing the chairperson of the board and the officers must
be maintained. Special minutes, of any special Board of Directors meeting,
authorizing the directors and officers to perform acts outside of the ordinary
course of business must be maintained as well.
If the corporate formalities are not observed, creditors of the corporation or even
creditors of shareholders, directors or officers can file suits seeking to pierce the
corporate veil and, as such, break through the corporation or even break up the
corporation, and by so doing, gain control of the FLP or FLLC.
8.07
Shareholders of the Corporate General Partner or Manager?
Revocable living trusts are excellent estate planning vehicles and offer many
advantages. For example, we generally use living trusts as the shareholders who will own
the shares of stock in the corporate General Partner or Manager. In estate planning, a
living trust shareholder offers more continuity over an individual shareholder. If an
individual shareholder should die, the shares owned by that individual would become a
part of his or her death probate estate. If an individual shareholder should become
incompetent, the shares owned by that individual would become part of his or her
guardianship or conservatorship probate estate.
8.08
Irrevocable Management Trust as General Partner or Manager
A management trust will usually be a grantor trust that is created by the client as the
grantor. The trust may be revocable or irrevocable. As noted, our client will be the
grantor and will control and dictate the terms in the trust. Our client may serve as trustee,
and may choose to have other family members serve as co-trustees. As trustees, they will

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manage and control the administration of the management trust. Most importantly, our
client will not be a beneficiary of the trust and will have no beneficial interest in the trust.
In an irrevocable management trust, it is important that the grantor have no beneficial
interest in the trust. The beneficiary of the management trust will usually be the clients
spouse, children or other family members. Structured in this way, the management trust
will act as a valid spendthrift trust with all the creditor protections afforded to the trust
beneficiaries under the trust law.
The management trust should include a solid spendthrift provision. Because the
protection varies from state to state, its often a good idea to situs the trust in a state that
affords asset protection, even to self-settled trusts.
While the grantor can be a trustee, it is very important that the grantor-trustee or anyone
related or subordinate to the Grantor does not have the power to make distributions from
the management trust or from the FLP or FLLC. Instead, the trust should have a special
independent distribution trustee who has the power to make distributions from the trust or
from the FLP or FLLC.
(a)
Advantages of the Management Trust
There are several advantages in using a management trust as a General Partner.

(1)
Control
The client maintains control of the FLP or FLLC by controlling the trust
as the trustee of a trust that has creditor spendthrift protection.
(2)
Privacy
A trust is a very private entity and does not require a state charter, unlike a
corporation, which must get a charter from the state of its origin.
(3)
Informality
The formalities of a corporation need not be observed; therefore, the trust

is much less complicated. Since the corporate formality requirements are
not applicable to a trust, the principle of piercing the corporate veil by
creditors is not applicable either.
(4)
Continuity of Life
Since a trust is an artificial entity, a trust does not have to end on the death
or disability of its grantor, trustees or beneficiaries. Thus, there is no loss
of continuity when a trust is used as a General Partner or Manager.
(5)
Management Fee
The management trust can collect a management fee for its services as
General Partner or Manager and the special independent distribution
trustee can distribute the fee income to its beneficiaries according to the
terms of the trust or to the trustees as a trustees fee..
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(6)
No Tax Returns Need Be Filed Yearly
The irrevocable management trust does not have its own taxpayer
identification number and does not file an IRS Form 1041, U.S. Fiduciary
Income Tax Return, each year. It is an Intentionally-Defective Grantor
Trust or IDGT and under Treasury Reg. 1.671-4(b)(2), no special tax
return needs to be filed, and under Treasury Reg. 301.6109-1(a)(2), no
special tax ID number is needed either. The trust must use the Grantors
taxpayer number.
(b)
Disadvantages of the Management Trust

(1)
No Employee Compensation nor Fringe Benefits
Since a trust does not normally have employees, the payment of salaries to
family members and the various employer provided fringe benefits that we
talked about with the corporate General Partner or Manager are not
available in this situation.
(2)
Irrevocability
Since the Trust is irrevocable it lacks flexibility in that it cannot be

amended and modified or repealed. But, a protector could be named and
given the right to make certain changes in the trust, or an independent
trustee could have the power to decant the trust.
(c)
The Revocable Management Trust
The Revocable Management Trust will have all of the advantages and
disadvantages as stated above, except:
(1)
Advantages of the Revocable Management Trust
It is more flexible since it can be amended, modified, and revoked. The

revocable management trust will typically be designed with the grantor as
a trustee and a beneficiary. As a rule, we recommend the revocable
management trust where simplicity is called for.
No annual tax return will be required as provided by Treasury Regulation
1.671-4(b). The trust should use the tax identification number of the
grantor. See Treasury Regulation 301.6109-1(a)(2).
(2)
Disadvantages of the Revocable Management Trust
The value of the trust is included in the grantors gross estate for estate tax
purposes. It lacks spendthrift protection from creditors.

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8.09
LLC as Manager or General Partner
LLCs provide significant flexibility while affording superior asset protection to

individual or corporate General Partners. As discussed above, an LLC may be taxed as a
sole proprietorship, partnership, C corporation or S corporation.
The operating agreement should be drafted to include a perpetual life provision, so that
the death, disability, or insolvency of a Member does not inadvertently terminate the
LLC. If the LLC does not have a perpetual life, the inadvertent termination of the
manager LLC can cause the inadvertent termination of the underlying entity (that is,
the entity managed by the LLC). Unless specifically allowed by the state LLC statute, the
adding of a perpetual life provision into the operating agreement is probably an
applicable restriction under 2704(b) that will be ignored for valuation discount purposes.
However, the LLCs General Partner interest in the FLP is usually small enough that
reduction of the valuation discount will not be significantly impacted. If the Members of
the LLC are non-individual entities such as trusts, the need for a perpetual life provision
in the LLCs articles of organization or operating agreement can be rendered
unnecessary. This can also be easily avoided by situsing the LLC in a jurisdiction that
allows perpetual existence.
8.10
LLC as a Subsidiary Entity.
LLCs are frequently used as a subsidiary of the FLP or FLLC. If, for example, we would
like our clients FLP or FLLC to own only intangible assets, such as, cash, stocks, bonds
and mutual funds, but my client also owns what we refer to as hot assets (any type of
assets that could potentially be involved in a personal injury lawsuit, such as real estate or
automobiles), then we will put these hot assets into one or more subsidiary LLCs or if
appropriate, in a single LLC that isolates the liabilities associated with particular assets
from the other assets of the LLC (the series LLC). Series LLCs are now recognized in
Delaware, Oklahoma, Nevada, Texas and soon in Illinois.
These hot asset LLCs will usually be owned 100% by the FLP or FLLP. (However, in
those states that do not recognize the one Member LLC, the FLP or FLLC will own 99%
of the Membership interest in the subsidiary LLC and the remaining 1% owned by a trust,
such as my clients childrens trust.) Thus, we have converted our clients interest in
these hot assets to an interest in an intangible asset (LLC Membership interest). Using
this technique, we accomplish our objective of having only intangible assets owned by
my clients FLP.
The subsidiary LLC can be ignored for federal tax status purposes by checking box 2c on
IRS Form 8832, so long as 100% of the LLC Membership interest is owned by the FLP
or FLLC. This means that the subsidiary LLC will not have to file a tax return, and
instead, all of its tax attributes (income, gains, losses, deductions, credits, etc.) will be
reported on the parent FLPs or FLLCs IRS Form 1065 U. S. partnership tax return.
Therefore, we can now obtain limited liability protection, without the burden and expense

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of another return. However, some states [e.g. Texas] assess a franchise tax in the nature
of a disguised income tax on LLCs. Generally, FLLCs are avoided in these states.
8.11
Who will be the Limited Partners or Non-Manager Members?
Limited partners or Members can be individual family members. In fact, most of the
various state versions of the Revised Uniform Limited Liability Companies Act allow the
general partners to also own a limited partnership interest.
In our practice, though, we rarely create FLPs or FLLCs with Limited Partners or
Members that are individuals. We almost always create various types of trusts that will be
the Limited Partners or Members.
As advocates of the revocable living trust, we prefer that clients not own assets in a form
which could become subject to a death probate or a living probate (guardianship or
conservatorship) in the event that our clients, or members of their families, should die or
becoming mentally disabled.
(a)
The Revocable Living Trust
For an unmarried client, we generally use a revocable living trust. For married
clients we will, on occasion, use a joint revocable living trust to own the limited
partnership interest or LLC membership interest. However, if either spouse has
any degree of potential creditor exposure, we will invariably partition or convert
any community property into separate property, and then create separate
revocable living trusts to own the respective limited partnership interest or LLC
membership interest of each spouse as that spouses separate property. This will
help insulate the creditor exposure of one spouse from the other spouse and viceversa.
On some occasions, we have clients whose creditor exposure is virtually
nonexistent. Usually these clients are ones who own only cash and marketable
securities and no real estate other than perhaps their homes. Usually these clients
will be retired, and so they no longer have any personal trade, business or
professional liability exposure.
When both spouses fit that description, we may suggest a joint revocable living
trust provided that they own the majority of their assets jointly or as community
property. As a general rule, separate trusts for each spouse are preferred.
(b)
The Irrevocable Trust
As to other family members, such as children, we generally use irrevocable trusts

created by the parent clients as Grantors for the benefit of their children as
beneficiaries. This is true regardless of the ages of our clients children.
The irrevocable trust allows the parents, as Grantors, to control the trust and
protect their children through carefully drafted instructions to the trustees of the
trust. Through the spendthrift protection provisions of the trust, the parent as
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grantors can protect the beneficial interest of their children from both creditor
lawsuits and divorce lawsuits. Furthermore, the parents can design the trusts to
last for the childs life with generation-skipping tax features so that upon the
death of the child a remainder interest passes to the childs children instead of the
childs surviving spouse. This can help assure that FLP or FLLC s interest will
stay in the family. If the FLP or FLLC s interest is allowed to pass outright to the
child it would be wishful thinking to think that upon the childs death, the
deceased childs surviving spouse would not remarry and leave the FLP or FLLC
s interest to his or her new spouse (who we refer to as the replacement spouse of a
surviving son-in-law or daughter-in-law).
In order to remove the assets of the childrens trust from the parents gross estate
for estate tax purposes, neither parent may serve as trustee if the childrens trust
owns other assets in addition to the FLP or FLLC interest. This is of very little
consequence when the FLP or FLLC owns and controls the actual assets that are
in the FLP or FLLC. The childrens trust owns only an intangible asset, a limited
partnership interest or LLC membership interest, that carries with it no voting or
control rights in the FLP or FLLC. On the other hand, as we explained earlier
when discussing the management trust, if the childrens trust only owns a limited
partnership interest in one or more FLP or FLLC, the parent or parents may serve
as Trustees. However, if the parent or parents are serving as trustees, there are
limitations that must be observed in designing such a trust. The parent or parents
as grantors-trustees may not retain any IRC Section 2036(a) or IRC Section 2038
powers to alter any beneficiarys interest in the trust or to spray or sprinkle
principal or income of the trust.
In our experience, most clients who would make gifts of actual assets to their
childrens trust, a trust that they cannot be trustee of, usually have reservations
about doing so, or experience distress and regret over their loss of control over the
actual assets given to their childrens trust. This is so even if the original
motivation was estate size reduction. We refer to this as the donors remorse
syndrome.
It is a wholly different situation when our clients give a FLP interest or FLLC
membership interest to their childrens trust since there is absolutely no loss of
control. The actual assets remain safe and sound in the FLP or FLLC under the
control and management of the entity general partners controlled by the parents.
Since the parents no longer own the limited partnership interest or FLLC
membership interest given to the childrens trust, the limited partnership interest
given is no longer part of the parents estate for estate tax purposes. This
particular planning technique is one of the primary reasons that the FLP or FLLC
s has become a very popular planning tool. The IRS has issued several rulings
confirming this outcome, specifically, Private Letter Rulings 93-10039 and 9415007. The national office of the IRS issued a Technical Advice Memorandum
TAM 9131006 (4/30/91) that confirms that a general partner can retain
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investment and distribution power and control over the partnership/ assets without
subjecting the limited partnership interests of other limited partners to be included
in the gross estate of the general partner.
TAM 9131006 also confirmed that gifts of limited partnership interest also
qualify as gifts of present interests for purposes of the $13,000 annual exclusion
rule of IRC Section 2503. See, however, Hackl v. Commissioner which reaches
the conclusion that an operating agreement in an LLC can be drafted so
restrictively that the gifted interests will have so insubstantial a value as to not
qualify as present interest when gifted. Hackl v. Commissioner 118 T.C. No. 14
(March 27, 2002). Affd Nos. 02-3093 and 02-3094 (9th Cir. July 11, 2003). The
reasoning of Hackl could readily apply to FLPs & FLLCs as well as LLCs.
(c)
The Grantor Retained Annuity Trust (GRAT) or A Grantor

Retained Unitrust (GRUT)
A (GRAT) or a GRUT is often used in FLPs, LLCs & FLLC estate planning for
high net worth individuals and their families. If for example, a limited partnership
interest is given to a GRAT, the Grantor retains the right to the income stream in
the form of an annuity from the limited partnership interest for the term of the
GRAT. When the GRAT ends, then the limited partnership interest can pass to the
remainder beneficiary (usually other family members) either outright or in trust. A
GRAT or a GRUT allows even a greater discount for purposes of making gifts of
limited partnership interest or LLC membership interests.
A further discussion of GRATs is beyond the scope of this outline.
(d)
The Charitable Remainder Trust (CRT)
Using a CRT as a limited partner works very much like using a GRAT as
discussed above expect at the end of the CRT term (usually the death of the
grantor) the Limited partnership interest will pass to the remainder beneficiaries
which are one or more IRC 501(c)(3) tax exempt organizations. If a CRT is a
limited partner or member, it is very important that the assets of the FLP or FLLC
s be restricted to passive investment assets (assets that produce passive income
such as interest, dividends, rents and royalties) and not own any unincorporated
businesses. Otherwise, the CRT could become taxable on all of its income under
the unrelated business taxable income rules (UBTI) of IRC 511 and 512.
Another effective technique is to create an FLP or FLLC with a taxable entity as
the 1% general partner and a Net Income With Makeup Charitable Remainder
Unitrust (NIMCRUT) as the 99% limited partner. The 1% general partner can
control the distribution of income to the 99% limited partner NIMCRUT.
Since the FLP or FLLCs is not a tax paying entity and since the NIMCRUT is a
tax-exempt entity, neither entity pays tax on 99% on the FLP or FLLCs income.
The income can grow tax free in the FLP or FLLC s.

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Thus, when our client wants income from the NIMCRUT, he or she, as the
controller of the 1% general partner, can turn the distribution spigot and distribute
income to the 99% limited partner NIMCRUT. A CRT does not have distributable
income unless and until it has cash.
A further discussion of CRTs is also beyond the scope of this outline.
(e)
The Offshore Trust and The Alaska or Delaware or Nevada Asset

Protection Trust
For those individuals who choose to create offshore trust planning, the limited
partnership interest or LLC membership interest of the domestic FLP or FLLC
can be held by their offshore trust or an Alaska or Delaware or Nevada Asset
Protection Trust. This enhances the asset protection offered by an FLP or FLLCs
as well as by the offshore trust or an Alaska or Delaware or Nevada Asset
Protection Trust. A further discussion of these planning options is also beyond the
scope of this outline. We do understand that a few other state have recently
adopted statutes which would allow the same results.
(f)
An Intentionally-Defective Grantor Trust (IDGT)
An Intentionally-Defective Grantor Trust (IDGT) is a trust which is designed as

an irrevocable trust that avoids inclusion in the Grantors estate for estate tax
purposes, but is intentionally designed to cause the Grantor to be taxable on the
income of the trust, even though the income cannot be distributed to the Grantor
but to other persons who are in fact the income beneficiaries of the trust. This is
usually accomplished through the reservation of an IRC 675 power under the
Internal Revenue Code Grantor Trust Rules, which will cause the Grantor to be
income taxed on the income of the trust, but which will not cause the assets of the
trust to be included in the Grantors gross estate for estate tax purposes. If an
IDGT is a limited partner or member of an FLP or FLLC, the limited partnership
interest or LLC membership interest of the trust will not be included in the
Grantors estate, but the Grantor will pay all income taxes allocable to the trust.
Each time the Grantor pays the income tax on the trust, the Grantors estate is
reduced by the income tax paid at no gift tax cost to the Grantor. The effect is that
the trust assets will grow undiminished by income tax almost as if the trust
income was tax-free.
If a Grantor transfers FLP or FLLC interest to an IDGT, any transaction between
the Grantor and the IDGT are ignored for income tax purposes [see Rev. Rul. 8513, Treas. Reg. 1.671 -4(b)(2) Treas. Reg. 301.6109-1 (a)(2)]. Usually the FLP
or FLLC interest is sold by the Grantor to the IDGT and the sale does not trigger
any capital gain or loss recognition by the Grantor. The IDGT will usually give
the Grantor a promissory note secured only by the FLP or FLLC interest. Since
the transaction is a sale, there is no gift tax incurred as long as the sale is for full
and adequate consideration. Upon the Grantors death the value of the note is
included in the value of the Grantors estate and not the value of the FLPs, LLCs
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& FLLC interest. Thus, the value of the note is frozen since notes usually decline
in value as they are paid off. The IDGT transaction with an FLP or LLC is an
excellent estate freezing transaction. It should be noted that the IRS does not
necessarily agree with the foregoing analysis. The IRS has assessed a substantial
gift tax deficiency in at least one case that utilized the sale of limited partnership
interests to an IDGT, though the case has not yet come to trial in the tax court.
The IRS position in that case (Karmazin v. Commissioner) is notable because the
Service has contended that the promissory note executed by the IDGT should be
subject to Chapter 14 of the Code and the net result of such treatment would be to
cause the entire value of the sold limited partnership interests to be deemed to
be a gift by the seller.
(g)
Other Entities
Any other form of legal entity can be a Limited Partner or members (e.g., LLPs.
Corporations and even other Limited Liability Companies).
8.12
Avoiding the Strangi II Problem by Using an Independent Special

Distribution Trustee and an Independent Special Distribution
Manager.
In the second review of the U.S. Tax Court case of Strangi vs. Commissioner (as affirmed
by the 5th Circuit Court of Appeals), U.S. Tax Court Justice Cohen included the full value
of all of the assets of the FLP, in the value of Mr. Strangis gross estate for federal estate
tax purposes, under IRC 2036(a)(2). Justice Cohen ruled that Mr. Stangis FLP was
designed in such a way that he retained the right, either alone or in conjunction with
another person (his son-in-law), to designate the person or persons who shall possess or
enjoy the property of or the income from the FLP as provided by IRC 2036(a)(2).
To avoid this harsh result, the use of an independent special distribution trustee or an
independent special distribution manager is recommended. If the general partner of the
FLP or manager of an FLLC is a management trust, then an independent special
distribution trustee of the management trust will hold: (1) the exclusive power to make
distributions from the trust and from the FLP or FLLC; (2) the exclusive power to vote
the general partner interest or Management LLC interest on the liquidation of the FLP
and (3) the exclusive power to vote any corporate stock owned by the FLP or FLLC. If
the general partner of the FLP is an LLC, then an independent special distribution
manager will hold these exclusive powers. Likewise when creating an FLLC, an
independent special distribution trustee of the management trust that is the LLC manager
or the person or entity that is the independent special distribution manager will have these
exclusive powers. Justice Cohen seemed to be saying that Mr. Strangis FLP fail to come
under the 1972 U.S. Supreme Court decision of Byrum vs. Commissioner because Mr.
Strangi or his son-in-law held these various powers.

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Part IX
Considerations in Designing
and Creating FLPs or FLLCs
Given the anxiety caused by recent IRS success with the 2036 arguments, it is useful for
us to consider in one section of this outline what steps we can take to best insulate our
clients partnership or LLC entity from this kind of attack.
9.01
Satisfying the Bona Fide Sale Exception
The most recent cases focus on the bona fide sale exception more than the subsections of
2036. Because success in satisfying this exception essentially eliminates the need to be
concerned about the (a)(1) and (a)(2) provisions, we suggest that every new entity be
formed in a way that satisfies the following two requirements:
The partnership or LLC transaction should include an actual business or,
alternatively, a pooling of assets;
The formalities of formation, funding and operation must be scrupulously
followed.
However, because these bona fide business purposes will almost always be viewed in
hindsight, it continues to be useful to parse the formation through the checklists provided
in the next two sections, because a failure to satisfy one or more of these requirements
will most likely be viewed as evidence of a lack of a bona fide business purpose.
9.02
Avoiding 2036(a)(1) inclusion
Practitioners who have implemented FLP and FLLC strategies for their clients but who
have not taken an active role in monitoring the administration of those limited entities
should see these cases as a wakeup call. This should also serve as motivation to
implement an annual or semi-annual review program.
Consistent themes emerge after a reading of all these cases to which planners should be
attentive.
Planning discussions should include (and memorialize in writing to the client) the
absence of any definitive access to assets contributed by partners or members. Not
all of the clients assets should be contributed to the FLP or FLLC; the client
should maintain sufficient assets to sustain his or her lifestyle for an extended
period of time. This includes sufficient assets to sustain the clients normal
lifestyle and any anticipated estate tax and estate administration expenses.
The entity should not make capital distributions to the client if at all possible,
particularly during the first several years of the partnership or LLC. Additionally,
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requests for distributions should not be met in every instance. Some authors
believe that the entity should expressly prohibit distributions to the client
Consider bifurcating the partnership or LLC. Distributions would continue to be
made from one of the partnerships or LLC, and the 2036(a)(1) issue would be
essentially conceded. Distributions would cease entirely from the other
partnership or LLC.
Assets contributed to a FLP or FLLC should be formally retitled in the name of
the FLP or FLLC.
Personal use assets such as personal residences or vacation property should
generally not be contributed to a partnership or LLC. If they are contributed, it is
important to calculate and actually pay reasonable rent on the property. Clients
should be sure and pay rents promptly when due.
If the client holds promissory notes for which the client does not intend to begin
any enforcement actions for failure to pay, the promissory notes should not be
contributed to the partnership or LLC.
A separate taxpayer identification number should be acquired contemporaneous
with the creation of the FLP or FLLC.
A partnership or LLC checking account should be established into which all
partnership or LLC income is deposited and out of which all partnership or LLC
expenses are paid. There should be no commingling of personal and partnership
or LLC income.
Only those persons authorized to act on behalf of the general partner or manager
entity should have authority to act on behalf of the partnership or LLC.
For those clients who have already established a limited partnership or LLC,
corrective measures can and should be taken while the client is still alive. If those
corrective measures take place within three years of the clients death, the IRS
certainly has an argument for inclusion based on the theory that the decedent
possessed a 2036(a)(1) right which was subsequently transferred within three
years of death, thus causing inclusion under 2035.
Regular maintenance meetings can be very effective to make sure the partnership
or LLC administration does not succumb to an IRS challenge based on 2036(a).
The clients CPA and other trusted advisors should participate in the meeting to
ensure proper accounting for the entity and maintenance of capital accounts.
It may be that the most extreme conclusions in the tax courts opinion in Strangi will
ultimately be rejected, but until that happens it is important for practitioners to at least
consider restructuring existing partnership/LLCs to address those issues.

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9.03
Avoiding 2036(a)(2)
As we have seen, we must also be careful to avoid estate inclusion for FLP or FLLC
interests under IRC 2036(a)(2). We believe that there are several strategies that can
help.
(a)
Avoid having founder retain GP interest or Management powers

from initial formation
This is the most conservative approach, but to make this work, the partnership or
LLC would also need to be structured so that the founder would also not have the
ability to vote on distribution or liquidation matters or vote on any amendment
that could confer those powers.
(b)
Have the other family members contribute assets to entity
In several places in its opinion, the Strangi Court expressed the notion that the
fiduciary duty that would ordinarily have worked to circumscribe Mr. Strangis
rights did not, in this case, interpose any genuine fiduciary impediments
because the decedent himself owned a 99% interest. But if other partners
contributed their own assets to the entity, that fiduciary duty would become more
genuine. Note that if the assets contributed by the younger generation came from
gifts from the founder, the IRS could successfully argue that the step-transaction
doctrine applied, preventing the actual pooling of assets to avoid 2036(a)(2).
(c)
Corporate trustee of trust that holds interests
We believe that a court would have a great deal of difficulty finding that no
meaningful fiduciary duty existed if an outside professional trustee is holding the
interests.
(d)
No right to vote on liquidation or distribution
This solution should solve the retention of rights problem, assuming that the
client will agree to the planning. In this solution, the FLP or FLLC is formed ab
initio so that the limited partner or members (at least the senior family member
that contributes the larger portion of assets) does not possess any right to vote on
distribution or liquidation matters. With this approach, even if death were to occur
within three years of the partnership or LLC formation, 2035 should not apply
since the decedent never held the voting rights.
(e)
Married clients: one spouse contributes assets, the other

receives the entity interests
This solution takes advantage of the marital deduction to preclude the IRS from
asserting the gift on formation and 2036(a)(2) arguments. When the spouse
that contributed the assets dies, the decedent will have never held any voting
rights with respect to any partnership or LLC interests. When the non-contributing
spouse dies, 2036(a)(2) should not apply because that spouse never made a
transfer.
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(f)
Unmarried clients: Gift tax defective trust as GP and no voting

rights
If a client has no spouse, or if the client is married and is reluctant to give up

control to a spouse, that client could form a partnership or LLC by contributing
assets in exchange for limited partnership interest or LLC membership interests
that do not have certain voting rights. An incomplete gift trust would be
designated as the owner of the general partner. The client would not be the trustee
of that trust, but could, if properly drafted, hold the right to remove and replace
the trustee with another trustee that is not related or subordinate to the founder.
(g)
Defective gift trust owns interests, founder owns direct interest

in GP or Management entity
This approach would allow the founder to have more direct control over the
operation of the enterprise, and the 2036(a)(2) inclusion should only apply to the
extent of the general partnerships small percentage interest in the partnership.

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Part X
Planning and Drafting Checklists
Before you engage the clients and begin drafting, here are some key ideas to keep in
mind to help you plan appropriately for the clients. The first section in this Part addresses
some of the practical considerations in planning and in determining if FLP or FLLC
planning is appropriate for your client. If you decide that it is appropriate, the drafting
checklist in the next section will help guide you through the actual design and
implementation process.
10.01
Practical Checklist
FLP and FLLC planning is not appropriate for all clients. There are several factors that
should raise caution flags. This does not always mean that the plan should not be
implemented. It does mean that these cases will present a more visible signature on the
IRS radar as targets for challenge. The IRS has labored with constricted resources in
recent years, so it is reasonable to expect that the cases chosen for audit will be those
most likely to yield additional revenue to the government. These are those cases:
(a)
Relatively Small Estate
If the clients estate is relatively small it may be difficult to move enough assets
into the entity and retain sufficient assets outside the entity to support the clients
lifestyle. In addition, the reduced step-up in basis resulting from the discounted
value of the entity interests may well outweigh the estate tax savings.
(b)
Old and Ill Clients
If the client is extremely old or in ill health, especially if the entity was formed by
an agent under a power of attorney, the IRS will be more likely to target the plan
for audit. More so if the founders illness requires that entity funds be spent for
the founders care.
(c)
Intent to Unwind Soon After Death
If your clients intend to unwind the partnership or LLC soon after the founder
dies, this will indicate that the entity was only formed to obtain a tax benefit.
(d)
Cash or Marketable Securities Only
The reality is that a partnership or LLC holding only cash or marketable securities
has a higher audit profile, especially if there is no change to the investment
strategy after the entity is formed. Cases such as Kelley also teach us that these
entities sometimes work well.

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(e)
Document bona fide business purpose and follow through
This approach is not robotic or hyper technical, so success here depends on the
facts and circumstances of each case. As planners, we have the responsibility to
manage the client discussion to make certain our clients interests are properly
served.
(f)
Make sure reasons for forming entity are credible
Put the non-tax reasons for the plan in writing. The correspondence with the client
should discuss these reasons, and the partnership or LLC operating agreement
should indicate what those reasons are. Make sure that these reasons are not
comprised of a long list of standard language, but that they accurately reflect the
motivating factors guiding the clients toward the plan.
(g)
Dont rely on asset protection as a business purpose unless a

real risk exists
Arguably, asset protection could be the legitimate business purpose for every
partnership or LLC, but courts have been reluctant to accept that when there is no
legitimate risk to the founder. When real estate is a significant asset in the entity,
asset protection is a credible need. The same is true for a securities partnership or
LLC created by a professional in a high-risk profession.
(h)
Avoid letters or memos indicating a tax-driven purpose
If your written client communications become part of the audit process (which
you must assume it will, notwithstanding the application of any privilege), these
letters and memos must emphasize the nontax business purposes. Fortunately,
practitioners have complete control over this part of the process.
(i)
Counsel clients to avoid statements inconsistent with the

entitys stated purpose
Practitioners do not have control over what clients and their families say, and the
case law demonstrates the damage that can be done.
(j)
Proactively manage post-formation activity
The post-formation actions of the partners should be consistent with the non-tax
purposes expressed in the pre-formation communication and in the partnership or
LLC operating agreement. For example, if the agreement provides that one of the
purposes of the of the entity is to engage the family in consolidated management
of family assets, counsel the clients and ensure that the family indeed manages the
property consistent with the stated objectives.
(k)
Dont fumble the formation formalities!
There are some elements of the entity formation that you truly can control, so
mistakes here are difficult to explain. These issues include:

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Failure to seek input from potential partners prior to executing the

partnership LLC operating agreement;
Delay in registering the entity with the Secretary of State;
Delay or failure in transferring assets to the entity;
Failure to properly credit capital accounts based on contributions;
Failure to acquire a new Taxpayer Identification Number for the entity;
Failure to establish an operating account to avoid commingling assets or
income with personal assets or income; and
Failure to advise clients to properly represent assets to third parties, (e.g.,
that they no longer own the assets themselves but instead own a
partnership or LLC interest).
(l)
Consider having someone besides founder control the entity
If the entity is formed for a bona fide business purpose, the parenthetical
exception in 2036 should apply. Consequently, a partner contributing the bulk of
the value of the partnership or LLC interests should be able to continue to control
the entity after its formation. But retained control seems to increase the audit
profile of the transaction. When clients are willing to do so, transferring control to
others will provide a more helpful fact pattern.
(m) Make sure founder keeps sufficient assets out of the entity to
maintain their lifestyle.
If a partner is too dependent on distributions from the entity they will have a hard
time withstanding a 2036(a) attack. The logic of the courts position on this point
still eludes us. Most of the clients we know who invest their assets assume that
they will be able to benefit financially from those assets to maintain their lifestyle.
These cases, however, seem to suggest that our clients should be prepared to
forego benefits of the partnership/LLC investment for an indefinite period of time.
This factor appears often enough in the case law that we should take it seriously
and develop and document a financial analysis of the clients lifestyle needs to
make certain that enough assets remain outside the entity to support their needs.
(n)
Do not waive fiduciary duties
In an effort to limit their personal exposure for decisions, general partners or

managers often attempt to dilute the applicable state law fiduciary duties owed to
the partnership or LLC and to the other partners or members. If the bona fide sale
exception does not apply, waiving fiduciary duties will almost certainly trigger
2036(a) inclusion for the general partners interests.
(o)
Have genuine diversity of investors in the entity
On remand to the tax court, Judge Cohen in Strangi suggested in dicta that if there
had been a meaningful pooling of assets, the outcome of the case would have
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been different. Although both Kimbell and Bongard question the significance of
this factor, we believe that contributions to the entity from multiple family
members, an independent trustee as trustee of a limited partner, and outside
investors can be helpful factors.
(p)
Encourage ALL Members to negotiate the terms of the entity
Evidence of authentic pre-formation negotiation or authentic conflict between

family members played out in the partnership/LLC formation will be helpful in
satisfying that higher standard.
(q)
Change investments after formation
Many partnerships and LLCs are created for the express purpose of managing
investments. But if no material change is made in the pre-formation asset mix, the
legitimacy of the objective is suspect and courts have found that to be significant.
The clients financial advisor should be engaged to create an investment policy
statement for the entity, and the investments should be materially different from
the pre-formation asset mix. Then, the investment policy statement should be
followed. If the investment purpose is to ensure that the founders investment
philosophy does not change, there should be a very good reason why there is no
change.
(r)
Manage distributions correctly
As obvious as this one seems, failure to make proportionate distributions is a

frequent mistake clients make. Disproportionate distributions are often made to
the founding partner, especially to pay for the partners medical needs. In
addition, clients quite often do not maintain separate books and records and
separate bank accounts for the entity. We advise clients to imagine that they have
skeptical outside investors who will hold them to account for how the entity is
managed.
10.02
Design Checklist
The WealthDocx Advanced Library contains a Design Checklist. While no checklist

can be exhaustive, the checklist included in the system helps remind the drafting attorney
of many of the issues that can be easily overlooked. A copy of that checklist is included
in the exhibits to this outline.

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Part XI
Ethical Considerations in LLC and FLP Planning
Practitioners face ethical hurdles in every estate planning engagement. Who is the client? Do
I have a conflict of interest? Have I adequately defined the scope of the engagement? Have I
fully and fairly disclosed all material facts? Have I adequately explained the pros and cons of
my recommendations so that the client can make an informed decision? Every LLC and limited
partnership planning engagement carries with it an element of asset protection planning, even if
that protection is not one of the clients planning goals and even if it is not intended. Therefore,
an important additional ethical consideration in the LLC and partnership planning context is the
avoidance of fraudulent conduct. In addition, anytime property of any kind is transferred to and a
limited partnership or LLC, the rights of the contributing partners or members are altered in ways
that usually reduce the limited partners or members rights with respect to the contributed
assets. While contributing partners or members may be anxious to accomplish the other results of
planningreducing potential gift or estate taxes, for examplethese contributing partners or
members may not fully realize how their rights will be altered when their individual property
interest is converted to a partnership or LLC interest. These are not merely theoretical issues, but
rather are issues that must be considered and discussed before rights have been irretrievably
surrendered.
The primary purpose of the Model Rules of Professional Conduct is to set standards to regulate
the conduct of attorneys, the violation of which may result in disciplinary action by the state bar,
civil liability and, potentially, criminal prosecution. Because of the severity of the consequences
that may stem from an ethical violation, attorneys who practice in the area of LLC, partnership
and asset protection planning should be intimately familiar with the particular rules of
professional conduct adopted by the state in which the attorney is practicing139, and have access
to additional resources. State specific resources may provide the best guidance on ethical issues,
such as the California State Bars Compendium of Professional Responsibility for California
practitioners, but another excellent treatise to which a practitioner should have access is Peter
Speros Asset Protection, Legal Planning and Strategies.140 Much of the discussion of ethics in
this section is covered in his materials in greater detail.
Because the Model Rules of Professional Conduct are more easily read in the context of a
personal injury law practice, the American College of Trust and Estate Counsel (ACTEC) has
produced its own commentaries to give guidance on the Model Rules in the context of an estate
planning practice. The ACTEC Commentaries are extraordinarily helpful and also freely
available on the web at http://www.actec.org/pubInfoArk/comm/toc.html.
139
In 2002, the American Bar Association amended many of the Model Rules of Professional Conduct. Caution
should be exercised in determining which version of the Model Rules applies in the particular state in which a
lawyer is practicing. It should be further understood that states virtually never adopt Model Rules without
modification and so a close reading of the applicable rules is warranted
140
Peter Spero, Asset Protection: Legal Planning, Strategies, and Forms, 2.04[1] (Warren, Gorham & Lamont
2003)
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11.01
Competency of Counsel Standard of Care
A fundamental issue in every engagement is the determination of the competency of the attorney
to render the advice needed. Rule 1.1 of the Model Rules of Professional Conduct states:
A lawyer shall provide competent representation to a client. Competent representation
requires the legal knowledge, skill, thoroughness and preparation reasonably necessary
for the representation.
The comment to Model Rule 1.1 states that in determining if a lawyer has the requisite
knowledge and skill, consideration is given to factors such as:
The relative complexity and specialized nature of the matter;
The lawyers experience;
The lawyers training and experience in the specific area involved;
The preparation and study given the matter by the lawyer; and
Whether it is feasible to refer the matter to, or associate with, a lawyer competent in the
particular area.
The comments specifically note that an attorney may accept representation in an area even in the
absence of the requisite skill and knowledge where the lawyer can achieve the requisite skill and
knowledge through preparation. If co-counsel is to be engaged, issues of confidentiality should
be addressed prior to the engagement.141
In his treatise on the subject of asset protection, Peter Spero states:
Attorneys are generally not liable for an error in judgment on an unsettled matters of the
law, even if other reasonably prudent attorneys would have acted otherwise. Attorneys
are, however, charged with knowing matters that are characterized as settled
propositions of law, and they have a duty to use standard research techniques and are to
have the knowledge they would gain thereby. (citations omitted)142
If an attorney holds himself out as specializing in an area of the law, the attorney must exercise
the knowledge and skill of other specialists in the same field.
11.02
Identifying the Client
A great deal of caution should be exercised in determining the identity of the client in an LLC, a
limited partnership or asset protection engagement. Engagement letters should clearly set forth
the identity of the client, and may also set forth who is not the client. An attorney owes certain
duties to his or her clients, including the duty to communicate to the client whatever information
is acquired with respect to the subject matter involved in a transaction. Failing to clearly
establish the identity of the client can lead to inadvertent violations of the duties owed to the
client.
141
See Model Rules of Profl Conduct R. 1.6

Peter Spero, Asset Protection: Legal Planning, Strategies, and Forms, 2.04[1] (Warren, Gorham & Lamont
2003)
142

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In Buehler v. Sbardellati143, an attorney performed services in connection with a limited

partnership that was being formed by two clients to own real estate in Texas. The investment
failed and the client who was a limited partner was found liable on a personal guaranty to the
lender who had financed the purchase of the property. The limited partner sued the attorney for
professional negligence and breach of fiduciary duty. The trial court entered a judgment for the
attorney after the jury entered a special verdict finding that the attorney was not negligent. The
judgment was upheld by the appellate court which found that there was no concurrent
representation adverse to a present client because the evidence showed that the attorney
represented the partnership and not the individual partners.
11.03
Duty to Inform and Scope of the Representation
Asset protection planning is an emerging area of the law and as a result, there are few cases
dealing with the duty to inform. However, given the plethora of available resources on asset
protection, the frequency of presentations locally by experts on the subject, and what could
easily be characterized as a growing public awareness of runaway juries in tort cases, it may well
be that asset protection planning now comprises part of the knowledge and skill which other
members of the profession possess sufficient to give rise to an action for malpractice for failing
to disclose.144
The failure to advise on the area of asset protection planning may create more liability than
advising on asset protection only to have the asset protection planning fail. The best defense is to
either raise the issue or specifically exclude asset protection planning from the engagement letter.
Some states do not require engagement letters although a cautious practitioner will use them to
prevent misunderstandings and to protect the lawyer (and the client) at some later date when
memories are not as clear as they were at the time of the engagement.
11.04
Engagement Letters
Whether or not required under the applicable rules of professional conduct, before undertaking
services in connection with the formation and/or operation of an LLC or a limited partnership, an
attorney should have a written engagement letter, signed by the client or clients. Such
engagement letter should, among other things, set forth:
The identity of the client;
The services to be provided by counsel;
The services that will not be provided by counsel
The fee arrangement, including how fees are to be paid and what fees are reimbursable to
the client in the event that the client elects not to proceed with the formation of the
limited partnership after services have commenced; and
A description of the other types of costs that will likely be incurred, whether the attorney
will advance such costs and the clients obligation to reimburse such costs.
143
(1995) 34 Cal.App.4th 1527, 41 Cal.Rptr. 104

See Peter Spero, How to Arrange a Clients Property for Asset Protection, ESTATE PLANNING, July/August 1995,
at 227
144

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11.05
Conflicts of Interest
Rule 1.7 of the Model Rules of Professional Conduct, along with 1.8 and 1.9, both of which are
more narrow in scope, speaks to the issue of conflicts of interest.
A lawyer shall not represent a client if the representation of that client will be directly
adverse to another client, unless:
The lawyer reasonably believes the representation will not adversely affect the
relationship with the other client; and
Each client consents after consultation.
A lawyer shall not represent a client if the representation of that client may be materially
limited by the lawyers responsibilities to another client or to a third person, or by the
lawyers own interests, unless
The lawyer reasonably believes the representation will not be adversely affected;
and
The client consents after consultation. When representation of multiple clients in a
single matter is undertaken, the consultation shall include an explanation of the
implications of the common representation and the advantages and risks
involved.145
Any waiver of a conflict should advise the clients as to the nature of the conflict, the attorneys
duty to inform each client of communications received from either client, and what actions must
be taken in the event of an impermissible conflict.
The determination of a conflict and its impact on the attorneys ability to adequately represent
his clients is not a determination made at the outset of the engagement and then forgotten. A
conflict that was once considered tolerable by the practitioner may, during the course of the
engagement, ripen into a conflict that mandates withdrawal. Consideration should be given at the
outset to the likelihood of such a ripening.146
An LLC or a limited partnership will involve multiple parties between whom conflicts and
misunderstandings can arise because of the choices and elections that must be made in the
formation and operation of the partnership. Conflicts can, for example, arise in the valuation of a
partners or members interest on the partners or members withdrawal or death, the limitations
to be placed on the transferability of a partners members interest or the rights, if any, of the
limited partners or members to change or remove a general partner or manager. If representing
multiple clients, even if they are husband and wife, the attorney must know when the
engagement can be accepted and what action must be taken if a conflict subsequently arises.
ACTEC Commentary to Model Rule 1.7 notes:
It is often appropriate for a lawyer to represent more than one member of the same
family in connection with their estate plans, more than one beneficiary with common
interests in an estate or trust administration matter, co-fiduciaries of an estate or trust, or
more than one of the investors in a closely held business. (citation omitted) In some
instances the clients may actually be better served by such a representation, which can
145
146
Model Rules of Profl Conduct R. 1.7(a)

See ACTEC Commentary to Model Rule of Profl Conduct 1.7
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result in more economical and better coordinated estate plans prepared by counsel who
has a better overall understanding of all the relevant family and property considerations.
An attorney can represent an individual partner or member as well as the partnership or LLC as
an entity, subject to the rules on conflicts of interest. If the partnerships LLCs consent to this
dual representation is required, such consent must be given by other than the individual or
constituent who is to be represented, or by shareholders or organization members. The attorney
should set forth and explain the proposed limited partnership or LLC and the purpose for its
formation in the engagement letter or in a separate writing incorporated into the engagement
letter. This can serve as evidence that the waivers of conflict were informed, as well as the scope
of the services you have agreed to provide for the fees set forth in the engagement letter.
11.06
Duty to Not Advise or Assist in Criminal or Fraudulent Activity
Rule 1.2(d) of the Model Rules states:

A lawyer shall not counsel a client to engage, or assist a client, in conduct the lawyer
knows is criminal or fraudulent, but a lawyer may discuss the legal consequences of any
proposed course of conduct with a client and may counsel or assist a client to make a
good faith effort to determine the validity, scope, meaning or application of the law.
The rule makes clear that the attorney may counsel the client on the legal consequences of any
proposed course of conduct even if that conduct were fraudulent or criminal, but may not assist
them in implementing such a course if the result is illegal or fraudulent.
Extreme caution should be exercised in addressing such issues because civil as well as criminal
penalties may be imposed not just upon the client, but upon counsel as well. It is therefore
crucial that the practitioner perform adequate due diligence into the particular facts of each case,
attempt to ascertain the clients true objectives in planning, and determine if it will be
permissible to continue the representation. Identification and documentation of the clients
representations as well as the attorneys representations are crucial to the success of the planning
and in defending the role of the attorney. The documentation may be used to defend the lawyer
without an ethical breach of the attorney-client privilege.147 (Again, a more thorough discussion
of this issue appears in Peter Speros treatise.)
WealthDocx contains a model Affidavit of Solvency. We believe that it is a good practice to
insist that every client complete this affidavit and provide it to counsel in connection with the
creation of any kind of business entity in which the transfer of property to the entity could be
considered a fraudulent transfer. While this affidavit will not absolve an attorney if the attorney
had actual knowledge of an outstanding claim that was omitted from the affidavit, this practice
should provide additional protection to both the client and the attorney by insuring that any
outstanding claims are considered before property transfers are made.
Perhaps the best test is the Smell Test. If it smells, check it out further or let the case pass
without engagement.
147
Am. Jur. 2d Witness 337, 344-345 (1992)

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11.07
Liability to the Client
In addition to the potential disciplinary action for violating one of the ethical rules, an attorney
may also be liable to the client in a claim for malpractice. A claim for malpractice is a tort claim
and generally contains the elements of:
The existence of a duty;
A breach of that duty;
Proximate cause between the breach of the duty and the resulting injury; and
Damages resulting from the breach.
In the area of asset protection planning, an attorney is generally not liable to the client if the
planning fails as long as the planning was implemented competently. (Note that the attorney may
still, however, be subject to disciplinary action, criminal prosecution, or liability to third parties
(see 2 below)). Several equitable doctrines, such as unclean hands, should preclude recourse
against the attorney for a failed asset protection plan.
If sued by the client for malpractice, the attorney is not bound by the attorney-client privilege.
Further, the attorney-client privilege may be waived if the client draws into question the legality
of specific recommendations made or advice given by the lawyer.
11.08
Liability to Third Parties
Where it is known that third parties will be impacted by the attorneys advice (such as where the
client owes a fiduciary duty to third parties in the clients capacity as general partner of a
partnership, for example), the cautious practitioner may choose to inform the third parties of the
identity of the client and that the practitioner specifically does not represent the third parties.
Identifying a particular party as expressly not being a client does not preclude liability to that
party. While privity of contract once precluded liability as to non-clients,148 a number of
jurisdictions have established exceptions to the privity rule to allow suits by non-clients. The
California Supreme Court, in Biakanja v. Irving (1958) 49 Cal.2d 647, 320 P.2d 16, set forth a
balancing test to determine when a plaintiff, despite the absence of privity, can recover for
professional negligence. In this case, a will prepared by a notary that left the decedents property
to the plaintiff was denied probate because it was not properly attested. The court held that the
determination of whether a defendant in any specific case is liable to a plaintiff not in privity of
contract with the plaintiff involves the balancing of many factors, including the:
Extent to which the transaction was intended to affect the plaintiff;
Foreseeability of harm to the plaintiff;
Degree of certainty that the plaintiff suffered injury;
Closeness of the connection between the defendants conduct and the injury suffered by
plaintiff;
Moral blame attached to the defendants conduct; and
148
See Natl Bank v. Ward, 100 U.S. 195 (1830)

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Policy for preventing future harm.

Theories of liability to third parties are generally based upon either conspiracy or aiding and
abetting. Again, damages are always a requirement in maintaining an action in tort for either
conspiracy or aiding and abetting. Punitive damages may be granted for committing fraud149 and
sanctions granted against an attorney who assists debtors in engaging in fraudulent activity.150
11.09
Criminal Liability
It is a crime to fraudulently conceal or transfer assets in a bankruptcy context.151 A client may be

criminally liable for concealing assets from the IRS, as may the clients professional advisors.152
Prosecution may be under either a fraud theory or as an aider and abettor,153 or under the
money laundering statute through the use of proceeds obtained as a result of bankruptcy fraud.154
In accordance with ABA Formal Opinion 92-366 (Aug. 8, 1992), if an attorney believes his or
her services are being used to perpetrate a fraud, the attorney must withdraw. The lawyers
ability to disaffirm the work product used to perpetrate the fraud depends on whether the fraud
has terminated.
11.10
Statute of Limitations
A significant consideration in evaluating a potential ethical breach and the corresponding
liability of the attorney is the relevant statute of limitations period. A detailed discussion
of this area is beyond the scope of this presentation although the attorney should be aware
that tolling provisions in the statute could result in significant time passing from the time
the services provided by the attorney before a malpractice action based on those actions
would be barred.
149
16 Am. Jur. 2d Conspiracy 71 (1979)

See In re Coones Ranch, Inc., 7 F.3d 219 (9th Cir. 1997)
151
18 U.S.C. 2, 152
152
See United States v. Wilson, 113 F.3d 228 (4th Cir. 1997), cert. denied, (attorney convicted for assisting in
concealment of assets from IRS), and United States v. Noske, 117 F.3d 1053 (8th Cir. 1997), cert. denied, 118 S.Ct.
315 (financial advisor convicted for attempting to assist clients in concealing assets from IRS).
153
18 U.S.C. 2. See also United States v. Knoll, 16 F.3d 1313, (2nd Cir. 1994)
154
18 U.S.C. 1956; United States v. Ward, 197 F.3d 1076 (1 1th Cir. 1999)
150

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Part XII
Best Jurisdictions for LLC Protection
This matrix highlights the most debtor-friendly jurisdictions for forming LLCs. The table below
ranks the jurisdictions in order of strength of charging order protection. While South Dakota
ranks highest, any of the top three tiers should be considered strong LLC states. If asset
protection is a client priority, seek to create the LLC in a state somewhere in one of these
jurisdictions.155
Rank
155
State
Statute
Case Cite
Notes
South Dakota
S.D. Codified Laws

47-34A-504
SD expressly prohibits broad charging orders,

which would otherwise dramatically limit the
LLCs operations, and also expressly prohibit
various equitable remedies for creditors
Alaska
Alaska Stat. 10.50.380
Prohibits broad charging orders; silent on

equitable remedies
Delaware
Del. Code 6 18-703
Silent on broad charging orders; prohibits

equitable remedies
Georgia
Ga. Code Ann. 14-11504(b)

equitable remedies
New Jersey
N.J. Stat. 42:2B-45

equitable remedies
Texas
Tex. Bus. Orgs. Code

101.112
Expressly prohibits judicial foreclosure; prohibits

equitable remedies
Virginia
Va. Code 13.1-1041.1
Silent on broad charging orders; prohibits

equitable remedies
Wyoming
Wyo. Stat. 17-29-503(g)

equitable remedies
Alabama
Ala. Code 10-12-35
Arizona
Ariz. Rev. Stat. 29-655
Indiana156
Ind. Code 23-18-6-7
Minnesota
Minn. Stat. Ann.
These third tier jurisdictions are silent on broad

charging orders, and they are either silent or they
permit equitable remedies to reach the entity
assets.
Examples of equitable remedies include
constructive or resulting trust arguments, alter ego
arguments, or reverse veil piercing, in which an
This matrix was adapted in part from information in LISI Asset Protection Newsletter #154

Page 108
All rights reserved
Minnesota
322B.32
Nevada
Nev. Rev. Stat. 86.401
North Carolina
N.C. Gen. Stat. 57C-503; Herring v. Keasler,

563 S.E. 2d 614 (N.C.
App. 2002)
North Dakota
N.D. Cent. Code 10-3234
Oklahoma
Okla. Stat. tit. 18 2034
Tennessee
Tenn. Code 48-218-105
LLC member seeks to set aside the LLC
156
Indiana is probably a sole remedy state. The issue was not fully settled in Brant v. Killrich, 835 N.E. 2d 582 (Ind.
App. Ct. 2005)
Page 109
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Understanding and Drafting

LLC Operating Agreements with WealthDocx

Understanding and Drafting

Distributions Around a Charging Order? ............................................................27

Part V Funding the LLC or Partnership ........................................................... 35

Control and Annual Gift Exclusions (Hackl) .........................................................66

Part VIII Entities as Members or Managers ..................................................... 78

11.10 Statute of Limitations..........................................................................................107

Understanding and Drafting LLC Operating Agreements with WealthDocx

Act or LLC Act

purposes of facilitating the orderly transfer of those assets to other family

The term outside liability refers to

Understanding and Drafting LLC Operating Agreements with WealthDocx

ULPA & RULPA

Origins of LLC Law

The Operating Agreement

LLCs for Any Lawful Purpose

Increased Management Flexibility

Fiduciary Duties of Managers; Liability to Members

Simplified Charging Order provisions

Re-ULLCA makes it clear that a charging order is the exclusive remedy of a

Modification of Tax Laws

Income Tax Advantages

Estate Planning with Family partnerships and Family LLCs

Watts vs. Commissioner, 51 T.C.M. 60 (1985)

Understanding and Drafting LLC Operating Agreements with WealthDocx

Basic Types of LLCs

A single member LLC may be owned by an individual, or by an entity. As we will

A multi-member LLC may be owned by any number (greater than one) of

Basic Management Structures

By default, a multi-member LLC will have an operating management structure

Special Purpose LLCs

Wyoming Close LLCs

Wyoming was the first state to enact an LLC: WS 17-15-101

Understanding and Drafting LLC Operating Agreements with WealthDocx

Nevada Restricted LLCs

In 2009 Nevada enacted legislation creating restricted entities, which can be

Professional LLCs (PLLCs)

Understanding and Drafting LLC Operating Agreements with WealthDocx

Series LLC states & statutes:

DLLC Act 18-215

805 ILCS 180/37-40

Iowa Code 490A.305

Nev. Rev. Stat. 86.296.3

18 Okla. Stat. 18-2054.4B

Tenn. Code Ann. 48-249-309

TX Bus. Org. Code 101.601-101.621

Utah Code Ann. 48-2c-606

Wis. Stat. 183.0504

Understanding and Drafting LLC Operating Agreements with WealthDocx

The LLC as a Legal Entity

Members in a Limited Liability Companies

Understanding and Drafting LLC Operating Agreements with WealthDocx

Acquiring a partnership or LLC Interest by Gift or Purchase

Understanding and Drafting LLC Operating Agreements with WealthDocx

About Limited Liability

Charging Order Protection

As mentioned above, charging order protection generally limits a creditors relief to a

Effect of a Charging Order

Four Options of the Court

How Members Blow Up their Asset Protection under LLCs

Understanding and Drafting LLC Operating Agreements with WealthDocx

Disregarded Entity (Sole Proprietorship) Taxation

Quite literally, a sole proprietorship is an entity wholly owned by one individual. As a