Discount for Lack of Marketability and Control in a New York Family LLC

One of the best ways to shield your investment assets form creditors and leave more of your assets to your children is to form a New York family LLC or a New York Family limited partnership (LLP). Creditors can only collect against your limited partnership interest. However, by transferring a portion of your interest to a trust for the benefit of your children, you can shield your assets further and take advantage of the discount for marketability strategy.

You can use gift a portion of your partnership interest in the family limited partnership to your children every year. An appraiser can be hired to give you an opinion of value of your partnership interest by discounting the value of your partnership interest for lack of marketability and control. This means that you reduce your lifetime gift tax exemption, and you avoid paying taxes on the gift.

The federal lifetime per person gift tax exemption is $1,000,000. Under the federal gift tax laws, a person can gift $13,000 per year without running into the exemption, or $26,000 for a married couple. This means you can gift each of your children $26,000 tax free every year without wasting your $1,000,000 lifetime per person gift tax. Because of the marketability discount, the $13,000 per year gift will carry more value then discount-free gift.

Making a decision about the best way to gift your assets to your children should be discussed with a New York probate and estate planning attorney. An attorney can review your financial situation and help you with your estate planning strategies.

What the Two Discounts Actually Mean

The "discount for lack of marketability" (DLOM) and the "discount for lack of control" (DLOC, often called a minority interest discount) are two separate valuation adjustments. They are commonly used together when transferring interests in a family LLC or family limited partnership, and together they can substantially reduce the gift or estate tax value of a transfer.

The discount for lack of marketability recognizes that an interest in a closely held family entity cannot be sold quickly the way a publicly traded share can. There is no ready market for it. A potential buyer would demand a price reduction in exchange for accepting an illiquid asset that cannot be easily resold. Appraisers typically support this discount with academic studies that compare the prices of restricted shares (which cannot be freely traded) to the prices of freely tradable shares of the same company. Depending on the company and the restrictions involved, the DLOM is often in the range of 15 to 35 percent.

The discount for lack of control recognizes that a minority owner cannot make the decisions a majority owner can make. The minority interest cannot force a distribution, cannot decide when to sell the business, cannot remove the manager, and cannot change the operating agreement. A buyer of a minority interest would pay less than a proportionate share of the entity's value to reflect this powerlessness. The DLOC is often in the range of 10 to 25 percent, depending on the rights the minority interest holder has under the operating agreement.

Applied together, these discounts can cut the gift tax value of a transferred interest by 30 to 50 percent. A $100,000 proportionate interest may have a gift tax value of $50,000 to $70,000 after the discounts.

How the Family LLC Structure Supports the Discounts

The discounts are not automatic. They depend on the actual restrictions in the operating agreement and the actual control rights of the interest being transferred. To support the DLOM, the operating agreement should:

• Restrict transfers of membership interests to outside parties.
• Require the consent of the manager (or the other members) before any transfer.
• Include a right of first refusal in favor of the LLC and the other members.
• Provide for buyout terms that are formula-driven rather than fair market.

To support the DLOC, the interests being transferred should be true minority interests with no special voting rights and no ability to force distributions. If the transferor retains a controlling interest and the children receive nonvoting interests, the case for the discount is much stronger.

Annual Exclusion Gifts and the Lifetime Exemption

The numbers in the original paragraphs above reflect the law as it stood years ago. The federal lifetime gift and estate tax exemption is now several million dollars per person and is indexed for inflation, and the federal annual exclusion is set each year by the IRS and currently allows tax-free gifts on the order of $19,000 per donee per year, or roughly twice that for spouses electing to gift-split. New York does not impose a state-level gift tax, but it does have its own estate tax with a much lower exemption than the federal estate tax. A coordinated gifting program through a family LLC can take advantage of the federal annual exclusion every year and use the lifetime exemption when larger transfers make sense.

Section 2704 and the Limits on Family Discounts

Internal Revenue Code Section 2704 places limits on discounts that can be claimed for transfers among family members in certain entities. In 2016, the IRS proposed regulations that would have substantially narrowed the availability of valuation discounts for family LLCs and family limited partnerships. Those regulations were withdrawn in 2017 and have not been finalized, but the IRS has continued to challenge aggressive discount claims on audit. The best protection is a well-drafted operating agreement that imposes restrictions which are common in non-family arms-length deals, a qualified appraisal from a credentialed appraiser, and adequate disclosure on the gift tax return so that the statute of limitations starts to run.

Adequate Disclosure on the Gift Tax Return

To start the three-year statute of limitations on the IRS's ability to challenge the value of a gift, the gift must be "adequately disclosed" on a timely filed gift tax return (Form 709). Adequate disclosure means providing a description of the transferred property, the date of the transfer, the identity of the donee, the relationship of the donee to the donor, the basis of the transferor in the property, the fair market value of the transferred property, and a copy of the appraisal. Without adequate disclosure, the IRS can challenge the value of the gift at any time, even decades later when it shows up in the donor's estate.

Common Mistakes That Defeat the Discount

• Treating the LLC like a personal piggy bank. Personal expenses paid from the LLC's accounts undermine the case that the LLC is a real business entity.
• Skipping the appraisal. Discounts claimed without a qualified appraisal are routinely disallowed.
• Failing to follow the operating agreement. If the members do not actually observe the transfer restrictions, the IRS will argue that the restrictions are illusory.
• Retaining controls that should have been given up. If the donor continues to control distributions and management even after the transfer, the IRS may include the transferred interest back in the donor's estate under Section 2036.
• Last-minute deathbed transfers. Transfers made shortly before death are particularly vulnerable to challenge.

Combining Family LLCs With Grantor Trusts

A common advanced planning technique pairs a family LLC with an intentionally defective grantor trust (IDGT). The donor sells discounted interests in the LLC to the IDGT in exchange for a promissory note carrying interest at the applicable federal rate. The sale is not a taxable event between the donor and the grantor trust for income tax purposes (because they are treated as the same taxpayer), and the appreciation on the LLC interests above the AFR effectively moves out of the donor's estate. When done correctly, this technique can transfer significant wealth to the next generation at a fraction of the gift tax cost.

Why Coordination Among Attorney, CPA, and Appraiser Matters

A family LLC planning engagement requires coordination among the estate planning attorney, the family's CPA, and a qualified business appraiser. The attorney drafts the operating agreement and the trust documents. The CPA handles the gift tax return and ongoing tax compliance. The appraiser provides the valuation opinion and supports the discount on audit. When the three professionals are not on the same page, the plan tends to unravel under IRS scrutiny.

Asset Protection Benefits Beyond Tax

The same family LLC structure that supports gift tax discounts also offers meaningful asset protection benefits. Under New York law, a creditor of a member of an LLC generally cannot reach into the LLC and force a distribution. The creditor's only direct remedy is a charging order, which intercepts distributions if and when the LLC makes them. Because the manager controls whether and when to distribute, a properly structured family LLC can make a member's interest an extremely unattractive target for creditors.

Speak With a New York Estate Planning Attorney

Making a decision about the best way to gift your assets to your children should be discussed with a New York probate and estate planning attorney. An attorney can review your financial situation, coordinate with your other advisors, and help you structure a family LLC plan that will withstand scrutiny.

If you wish to speak to a New York estate attorney, call the Law Offices of Albert Goodwin at (212) 233-1233 or email [email protected].