Family company not always smart
Consider a client, living in Alaska, with three adult children. The client has never made a taxable gift, and her only asset is a share of stock. Although she purchased the stock for $100,000, it is now worth $675,000. The client forms an LLC and contributes the $675,000 of stock to the LLC.
Initially the client is the only member of the LLC, so she does not recognize gain when she contributes the stock to the LLC. Also, because the client is the sole member of the LLC, the LLC is ignored for federal income tax purposes. In other words, the LLC is disregarded as an entity separate from its owner. Later, when the client brings her children in as members, the LLC is then, absent an election, treated as a partnership for federal income tax purposes.
The client, over the balance of her lifetime, gives her children interests in the LLC totaling 13.3 percent per child. At all points in time the LLC’s only asset is the stock, worth $675,000.
At the time of the client’s death, her only asset is the remaining 60 percent interest in the LLC. Under her will or revocable living trust, the client gives this remaining property to her children in equal shares; so each child owns one-third of the LLC. The LLC’s only asset is the stock, which is still worth $675,000.
If the client had not formed the LLC and instead had continued to own the stock until her death, under current law her children’s tax basis in the stock would have been stepped-up to $675,000. So the children could then have sold the stock for as much as $675,000 at absolutely no tax cost.
A consequence of the client’s giving through the LLC is that the donees will have basis substantially less than $675,000. In other words, if the LLC sells the stock for $675,000, there will be taxable gain.
Specifically, under current law the tax-basis analysis is as follows:
First: The client’s basis in the stock is her cost of $100,000. When she contributes the stock to the LLC in return for 100 percent of the LLC interests, the LLC takes a carry-over basis of $100,000 in the stock. The client receives a basis of $100,000 in her LLC interests. Although the LLC is initially disregarded as an entity separate from its sole owner, the LLC becomes a partnership for federal income tax purposes on the day the LLC has two or more members.
Second: At the time of her death, the client owns 60 percent of the LLC interests. Although the LLC owns stock worth $675,000, the value of 60 percent of the LLC interests is less than 60 percent of $675,000, or $405,000. The valuation expert assisting with the client’s estate believes the value of 60 percent of the LLC interests was roughly $364,500 on the date of the client’s death. Thus the children receive a stepped-up basis of $364,500 in the LLC interests they inherit from their mother.
Third: The children now own 100 percent of the LLC and their basis in those interests is $404,500 (i.e., $40,000 carryover basis plus $364,500 stepped-up basis).
Fourth: If the LLC sells the stock for $675,000, it will have taxable gain of $270,500 ($675,000 sale proceeds minus $404,500 basis equals $270,500). Assuming an applicable capital gain rate of 20 percent, the LLC members would owe $54,100 in tax.
Again, if the client had not formed the LLC and had owned the stock until her death, under current law her children’s basis in the stock would have been stepped-up to $675,000. So the children could then have sold the stock for as much as $675,000 without incurring any tax, a savings of $54,100 under the facts of this case.
The upshot is that LLCs or Limited Partnerships could increase taxes down the road. This consequence needs to be figured into the analysis of whether the advantages of a family business entity outweigh the disadvantages.
Steven T. O’Hara is a shareholder in the Anchorage law firm of Bankston, Gronning, O’Hara, Sedor, Mills, Givens & Heaphey, P.C. This article is Copyright 2001 by Steven T. O’Hara and is used by permission.