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With the (likely *fingers crossed*) repeal of the Federal Estate Tax, asset protection planning is going to be the primary motivation for complex estate planning moving forward. Family Limited Partnerships have been a staple of higher net worth planning for decades, but Family LLCs are on the rise for good reason. There are several advantages to utilizing a Family LLC for your family’s estate and asset protection needs.
A Family LLC is normally formed by the parents of a family who serve as the managing members of the LLC, while the other LLC members are usually the children and, potentially, grandchildren of the family. The LLC membership interests are divided into two separate classes: Class A and Class B. Class A “shares” amount to a small fraction of the ownership interest – maybe 10% – but has full management authority over the LLC. Class B “shares” are purely for economic benefit, having no controlling stake in the LLC. The parents will own the Class A “share” and the majority, if not all, of the Class B “shares” upon formation. Family LLCs are generally used to hold and control family businesses, land holdings, and other investments. You generally do not put personal residences into the LLC. Over time, the parents gift Class B interest to the children and grandchildren. Towards the end of their lives or at their deaths, the parents transfer control to the children by transferring the Class A “shares” to the children.
Assets held in an LLC are generally protected from the creditors of the individual LLC members. This is because of two things: 1) corporate personhood – i.e., the LLC is a separate legal entity and has its own rights under state and federal law, and 2) the individual actions of an LLC member cannot be imputed upon the LLC unless the actions were performed in some sort of employment or agency relationship with the LLC. But, North Carolina’s LLC law takes that one step further: the “Charging Order”.
In North Carolina, if a creditor obtains a judgment against an LLC member, he/she has the option of seeking what’s called a “Charging Order.” This is a court order demanding the LLC to pay any economic benefit that the LLC member would have received to the creditor instead. The creditor essentially steps in front of the LLC member for distributions of income. However, with that economic benefit also comes the tax liability for that benefit. So, if a creditor gets a Charging Order, they have to take the Schedule K-1 that the LLC member would have gotten with it. The main advantage to the LLC and the member is that the parents don’t have to make a distribution of income to the debtor/member unless they want to. But, IRS regulations for LLCs state that the member will be taxed on their respective share of income regardless of whether a distribution is made.
So, for example, if LLC member John defaulted on a credit card and the credit card company got a judgment against him for $50,000, the creditor could get a charging order against John’s economic interest in the LLC. The creditor will stand in front of John for any distribution of income. If John’s share of the income that year is $100,000, but his parents don’t distribute the money to him and instead just hold it aside in the LLC account, the creditor will receive $0 in income and a Schedule K-1 for $100,000 in income. So, the creditor is in a much worse position than when they started. They had a $50,000 debt, but now they also have $100,000 in attributed income without an economic benefit. Lose Lose.
Family LLCs are a great way to pass wealth within families in small increments. Under the current tax law, families will use the annual gift exclusion of $28,000 per married couple to transfer assets to their kids and reduce their estate tax liability later on. By also utilizing a living trust for each of the LLC members, the LLC membership interests would also stay out of probate and keep the family’s financial affairs private. Used together, Family LLCs and living trusts are the gold standard for family wealth protection planning.