Limited Liability Company
The limited liability company (“LLC”) is a form of business or investment entity ownership, which seeks to provide its owners ("members") with enhanced protection from creditors and, in some cases, substantial estate and gift tax savings.
Just like any LLC, any person may transfer personal investments to a LLC and qualify to receive the same asset protection benefits as a business owner would. This LLC is established just like a regular LLC except that participation is limited to persons related to each other by blood or marriage, creating a special LLC that is considered a family LLC. The family LLC achieves enhanced protection by using a restrictive operating agreement that carefully defines and restricts ownership and transfer rights.
Typically a family LLC would own rental properties, brokerage accounts, and all or a portion of the family business; however, a LLC may own almost anything. An exception is a personal residence, which should be held in trust, and not a business entity, for tax reasons.
The assets you contribute to a LLC benefit from charging order protection. This means that a judgment creditor can obtain a court order that redirects any distributions from you to the creditor. But the manager of the LLC (most likely you or a family member) need not pay out any distributions, which can put you in a much better negotiating position for an out-of-court settlement.
The distinguishing characteristic of a family LLC is a comprehensive operating agreement that carefully defines and restricts the ownership and transfer rights of its members. These restrictions act as the fortress wall to keep creditors in both scenarios from burning down your possessions inside. They discourage a creditor from even attempting to obtain a charging order or to otherwise interfere with your LLC activities. A restrictive operating agreement shields LLC assets by making any involvement with your LLC unattractive to a potential creditor.
You might wonder what types of restrictions are appropriate. One example is that members are prohibited from withdrawing from the company and reacquiring contributions, which could then be seized by a creditor. Another example is that members have no right to participate in management or vote out managers. More examples include prohibitions on members seeking a partition of company assets or dissolving the company without unanimous consent of all members and managers. The result is to limit a creditor's ability to interfere with LLC activities if a charging order is obtained and make an out-of-court settlement more appealing.
The structure of a LLC may be strengthened by gifting or selling membership interests to additional family members either outright or in trust. A multi-member LLC is generally stronger than a single-member LLC, especially in personal bankruptcy. For example, Mom and Dad might gift 10% of their membership interests in equal shares to irrevocable trusts for their two children. Mom and Dad may continue to manage and control all 100% as managers of the LLC and trustees of the irrevocable trusts.
The LLC must be registered in a state with protective laws, such as Wyoming. The most protective state laws provide that a charging order is the only remedy a court can use to seize assets from a LLC. A few states go even further to limit the rights of creditors against a LLC registered in those states. For example, the state of Wyoming blocks creditor access to books and records of the LLC and does not require disclosure of managers or members in Articles of Organization. More importantly perhaps, Wyoming also provides statutory protection for single member LLCs – something other state laws do not. This makes the Wyoming LLC a particularly good choice for ownership of S-Corp stock.
A family LLC may qualify for substantial discounts for estate and gift tax purposes. The term “discount” means that a membership interest will be valued less for tax purposes than the actual value of the underlying assets. A qualified appraisal is needed to substantiate the discount, which is usually for lack of control and lack of marketability. The size of the discount depends on many factors, but may range as high as about 50%.
A family LLC is usually treated as a partnership with flow-through taxation, so income and losses inside the entity are passed through pro rata to the members.
The contribution of business or investment assets to the family LLC is not a taxable event.
There are more costs involved in an LLC, including attorney and registered agent fees, but it is a viable method for asset protection when you are putting over $100,000 of assets into the LLC.