Using WealthDocx to Draft LLCs by 9I3NA0


									Using WealthDocx to Draft LLCs

          February 2, 2011

     Peter Parenti / Lew Dymond

     Circular 230 Disclaimer
As we prepared these materials, we made every effort
to offer the most current and correct information
possible. The information is intended to provide general
guidance to attorneys, CPAs, advisors, and their clients.

However, laws frequently change, and the impact of
laws can vary greatly depending on the unique facts of
the situation. The information contained in these
materials is not intended to establish a legal
relationship, or to serve as legal, accounting,
investment, or tax advice.

  Business Succession Planning
• Business succession planning is very
  important for the survival of family-owned or
  closely held businesses.
• It is challenging due to complex tax issues,
  the human element (egos, relationships, etc.)
  and managing the operations.
• It can create a deeper relationship with an
  existing client and build one with next the

                   Case Study
The Facts:
Harry, age 62, Wilma, age 58
• Harry – son Steve, from a previous marriage.
• Wilma – daughter Dottie, from a previous marriage.
• Together – minor son Mark
• Harry owns 100% of an S-corporation; current fair market
  value of $10 million. Cash flows very good!
• Significant other assets, including home and other
  investments. Some owned jointly by Harry and Wilma,
  some owned solely by Harry
• $1M/$5M lifetime gift tax exemption still available

       Harry’s Cost of Doing Nothing
• Under the Probate laws of Harry’s state if he does nothing
  and died intestate, the following is the results:
• Wilma gets 50% of Harry’s estate including the business.
• Steve gets 25% of Harry’s estate including the business.
• Mark gets 25% of Harry’s estate including the business,
  except since Mark is a minor Wilma as his Mother would
  control Mark’s 25% until he is age 18. So Wilma would
  control 75% of the business if Harry died intestate.

        Harry’s Planning Objectives
• To have a comprehensive plan to ensure ownership of the
  business will pass to his son Steve. (Steve also wants the
  security of knowing the business will one day become his.)
• To be in control of the timing of the transfer of the business
  to Steve.
• To treat his stepdaughter, Dottie, and their younger son,
  Mark, fairly.
• To have enough cash flow for now and to provide for
  Wilma if he dies first.
• To save estate taxes.

                     Phase 1
Reorganize and Recapitalize the S-Corporation:
• In a tax-free “F type” reorganization
• [IRC§368(a)(1)(F)], convert the S-corporation to a
  limited liability company taxed as an S-
  corporation with voting and non-voting common
• All of the units should be issued to Harry’s personal
  Living Trust.
• Convert 1,000 shares of S-Corp stock into 990 Non-
  Voting LLC Units (99%) and 10 Voting Units (1%).

        WealthDocx™ Options
• Create separate living trusts for Harry
  and Wilma for their respective separate
  property using WealthDocx!

• They could also have a joint living trust
  for any community property or jointly
  owned property.

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• Create LLC taxed as an S-Corporation!
• All membership interests is issued to
  Harry’s personal Living Trust.
• 990 Non-Voting LLC Units (99%) and
  10 Voting Units (1%).

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                     Phase 2
Create Dynasty Trusts
• Establish either three irrevocable separate trusts
  (or one irrevocable trust with separate shares) for
  each child, that is designed so that its income is
  taxable to Harry and then make the initial
  contributions to the trust. (WealthDocx 7 allows you
  to do it either way.)
• Grantor Deemed Owned Trusts (GDOTs) or
  Intentionally Defective Grantor Trusts (IDGTs)
• Include a Toggle On & Off Grantor Trust Provision
  that is provided as an option in WealthDocx

                  Phase 2
Create the Dynasty Trusts:
• Make a $600K gift to Steve’s Trust.
• Allocate GSTT Exclusion to Steve Trust to
  give it a Zero Inclusion Ratio.
• Create Dynasty Trusts for Dottie and Mark to
  possible own Life Insurance Policies on the
  lives Harry and/or Wilma’s.

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                        Phase 3
Sell the 990 Non-Voting Membership Units to
  Steve's Trust with an Installment Note.
• To give Steve ultimate ownership of Harry's business,
  start by selling all of the non-voting membership units to
  the Dynasty Trust for Steve.
• To make a private sale or gift between family members
  of something that does not have an easily known value,
  the IRS requires that a qualified valuation expert to
  determine its fair market value. Harry will need to
  file a 709 Gift Tax Return to report this sale and the
  $600K cash gift to get the SOL running against IRS.

                        Phase 3
• First, the balance sheet assets owned by the business
  are valued.
• Second a business evaluation of the ownership interest is
• When the valuation adjustments for lack of control and
  lack of liquidity or marketability are made for the non-
  voting interests in an LLC, it is not uncommon that the
  cumulative effect is to depress the fair market value by a
  significant amount (ie. 40% or $6K per unit = $5,940,000 )
• Voting units will have a premium value to reflect the
  control value. ($12K per unit X 10 units = $120,000)

                      Phase 3
• Harry sells his 990 non-voting units for $5,940,000 to
  the Dynasty Trust for Steve using a 20-year
  installment note, payable annually. Make sure the
  note is similar to one used for unrelated parties.
• Based on the value and terms of the note, the trust
  will pay Harry $447,197 every year for 20 years.
• There is no "bright line" test for what is a
  commercially reasonable loan-to-value ratio. Many
  practitioners use 10%, but some are more comfortable
  at 20%. Still others are OK with 0% to 9%.

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  Why did we reorganize the corporation into an LLC?
• The non-tax reason that the S-corporation was reorganized into
  an LLC taxed as an S-corporation is that corporate stock is freely
  transferability and as such it is very easy for a judgment creditor
  to foreclose on corporate stock and become a shareholder.
• On the other hand, LLC membership interest is not transferable
  without the consent of all members.
• LLC offers much greater asset protection from creditors - since
  many states limit a creditor’s remedy to only a charging
  order on distributions to LLC members.
• In state where foreclosure of an LLC membership interest is
  allowed, the creditor can never become a substitute member and
  will only remain as a mere assignee without the ability to vote on
  admission of new members or the liquidation of the LLC.

  Why did we reorganize the corporation into an LLC?
• In most states, the ownership percentage required for
  shareholders voting on liquidating a corporation will range from
  51% to 80%. In other word a majority vote of less than 100%.
• Whereas the ownership percentage required for liquidating an
  LLCs, in most states, is a majority vote of 100% of the member.
• As a statutory corporation, if a judgment creditor forecloses on
  enough shares of stock that would allow the creditor to liquidate
  the corporation, the creditor would be able to prevail upon the
  assets of the corporation.
• Whereas with an LLC the creditor can never become a member
  and as such the creditor can never vote on the liquidation of the
  LLC or to force distributions.

• Harry owns 10 voting units, which gives him
  100% control of the business and 1% of the
• The Dynasty Trust for Steve owns 990 non-
  voting units, which gives it no control over the
  business and 99% of the equity.
• The Dynasty Trust also has $600,000 in cash
  that Harry gifted to it as seed capital.

            Income Tax Reporting
• Harry is the deemed "owner" of Dynasty Trust for Steve
  for purposes of reporting trust income.
• No interest income is recognized on the installment
  note payments. No Interest deduction is allowed to the
• Thus Dynasty Trust for Steve does not have to file a Form
  1041 fiduciary income tax return.
• US Corporate Income Tax Return (1120S & K-1) is filed,
  for reporting the LLC’s income tax information to be
  reported by Harry as the Trust's deemed owner, for
  reporting on his personal Form 1040, Schedule E income
  tax return.

      Income Tax Effect of Sale of
          Membership Units
• Harry's sale of LLC units to the Dynasty Trust for
  Steve is a "non-recognition" event.
• Because Harry is the deemed owner of the Trust for
  income tax purposes, it is treated as a sale by Harry
  to himself.
• Thus no gain or loss is recognized on the sale of
  the 990 Non-Voting units and no income is
  recognized on any of the installment note payments
  to Harry.

   “Pass Through” Dynasty Trust Income:
• Income from the LLC will be allocated to the unit
  holders based on their unit ownership percentages.
• Let's assume the business has $500,000 in net income:
• Harry owns 10 voting units, which is equal to 1% of the
  equity. Therefore, Harry will be allocated $5,000 in
  1120S, Sch. K-1 income.
• The Dynasty Trust for Steve owns 990 non-voting
  units, which is equal to 99% of the equity.
• Therefore Harry, on behalf of the Trust, will be allocated
  $495,000 on a 2nd 1120S, Sch. K-1 income.

  “Pass Through” Dynasty Trust Income
• Because the Dynasty Trusts are structured as grantor
  trusts for income tax purposes, Harry must pay the
  income tax attributable to all of the income, including
  the S-corporation income that is allocated to the trust
  for Steve.
• Harry's payment of the trusts' income tax is not an
  additional gift to the trusts, so every year Harry is
  transferring, gift tax free, additional estate assets to
  the trusts for the three children.

  How the Dynasty Trust Makes the Required
              Note Payments

• LLC will have $500,000 per year of cash flow for
  distribute to its unit holders:
   – Steve's Dynasty Trust gets a cash distribution of
     $495,000 ($500,000 x 99% = $495,000).
   – At the end of year one it will have $1,095,000 in
     cash ($495,000 from the LLC and the $600,000
     that was gifted to it as seed capital).
   – The trustee can thus easily make the $447,197
     note payment to Harry.

  How the Dynasty Trust Makes the Required
              Note Payments
• LLC will have $500,000 per year of cash flow
  to distribute to its unit holders:
   – If the company does not generate enough
     income to pay the note, take the same
     approach as if a borrower can't repay a
     bank loan. Options would include (1)
     deferring payment until such time as the
     business recovers or (2) renegotiating the
     term or interest rate of the note.

          Results After Year One
At the end of the first year, the note has been reduced
to $5,745,847 and the Dynasty Trust has a cash
balance of $647,803.
The trustee of the Dynasty Trust could use this cash to:
1) Invest and save. (Income taxes on the earnings
   would be taxed to Harry.)
2) Make distributions to Steve as the trust beneficiary.
   (Distributions would be gift tax-free.)
3) Buy and pay for life insurance on Harry's life.

          Results After Year One
• Harry has received $5,000 from the LLC and
  $447,197 from the note payment, for a total of
  $452,197 in income.
• Harry will pay income taxes on the full $500,000
  amount of S-Corp income (via 1120S K-1).
• A higher income tax rate would mean less income,
  but there may be other sources of income: company
  salary as well as compensation as a Director.
• If no further cash flow is needed? We could
  reduce Harry’s salary from the LLC. This would save
  payroll tax and would give the business more cash

                 When Harry Dies
• If Harry has consumed or gifted the net after the tax note
  payments that he receives from Steve's Dynasty Trust, at most
  only the unpaid balance of the note will be included in the
  value of his taxable estate. (The FMV of the Note)
• Dynasty Trust for Steve is GSTT "exempt“.
• Dynasty Trusts established for Dottie and Mark would get Life
  Insurance Proceeds Income, Estate & GSTT “exempt” .
• Harry’s personal living trust should leave the 10 voting units
  (1%) to Steve’s Dynasty Trust.
• Steve's Trusts would own 100% of the business and the other
  children's GSTT exempt trusts would own cash.
• Wilma will continue to receive the remaining note payments for
  her support.

              Estate Tax Results
1. Harry has removed $10,600,000 of appreciating
   assets from the value of his gross estate that, at his
   death, which would have been subject to estate tax.
   Unless the Congress acts quickly, the top rate after
   the catch-up tax will be 55% in 2013.
2. Harry has received an asset (the self-amortizing
  note) that is based on a discounted asset value, that
  is both frozen and declining in value over the 20-year
  note amortization term).

                Estate Tax Results
3. If Harry does not accumulate the note payments, then at
   the end of the note term (20 years), he will have totally
   removed the $10,600,000 (plus all future appreciation on
   this amount) from his gross estate without making a
   taxable gift other than the initial $600,000 seed capital gift.

4. The assets of the three Trusts are in a generation skipping
   tax-exempt trusts that can include asset protection
   features. These three trust assets are not included in the
   children's or grandchildren's gross estates at their
   respective deaths.

   Goals and Objectives Achieved
• Steve would receive 100% of the
  business without having to buy Harry
• Harry controlled the timing of the
  business transfer.
• Harry provided for his other children and
  his wife, Wilma.
• Harry saved substantial estate taxes.


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