Retired Military Finances 301: How Does Your Limited Liability Company Fit into Your Estate Plan?
Estate Planning Managing Your FinancesBy George Reilly, JD, LL.M (Tax), CFP® [CDR, JAGC, USN (Ret.)]; Reilly Law, PLC
In my estate planning practice, I frequently see clients who have formed one or more Limited Liability Companies (LLCs) to hold title to rental properties or business interests or both. While this can be an excellent idea from an asset protection standpoint, unfortunately there are some serious traps for the unwary. I will discuss a few of the critical ones here, including what happens to your LLC when you become incapacitated or upon your death. But first a refresher on the basics of LLCs.
The first thing to note is that the first L in LLC stands for limited, not no liability. An LLC is formed under the laws of a state, and it doesn’t have to be the state in which you live. There are some very business-friendly states such as Wyoming (the birthplace of the LLC!), Nevada, and Delaware, among others, which are used by many folks to form their LLCs for maximum privacy and protection. An often misunderstood issue for these non-home state LLCs is that you also generally have to register them in your home state or any state in which you are doing business. In the arcane language of LLCs, you register them as a “foreign” LLC and you need a resident Agent for every state in which the LLC is registered. So that gets you started with your LLC. Now what?
Many LLCs are set up as single-member LLCs which poses some risks compared to a partnership entity or multiple member LLC. A single-member LLC is often not really run as a true business and in the event of some claim against the LLC, it is not uncommon for this type of LLC to lose its protections, a result known as “piercing the LLC veil.” Without an LLC’s statutory protections you could face personal liability for a claim against your business.
One way to reduce that possibility for any type of LLC is to no-kidding treat it like a business. Create an LLC Operating Agreement using readily available online resources (or an experienced attorney’s assistance perhaps?) that details how the LLC will, well, operate. Make sure the LLC has its own tax ID number and bank account. If you use personal funds for regular business activities you may as well not even have an LLC. And keep good books and records that show you are running a business.
So that’s a good start to showing you have a true business managed by your LLC. But I like to tell my clients that if they are relying on LLC protections to thwart any claims, they are not approaching that correctly. In my view the LLC statutory protections are your last line of defense against a claim. Your first line of defense should be appropriately underwritten and adequate primary insurance, homeowner’s insurance for rental properties with investment/rental provisions, or errors and omissions or similar insurance for another type of business. If a claim can be satisfied by an insurance payout, then there is no need to rely on the LLC law for protection. The next line of defense, particularly for rental properties, is a sizeable umbrella insurance policy that also covers rental properties. These policies are very low cost compared to the potential payout they can make on your behalf. Between your primary and umbrella insurance policies you should be able to protect your business and personal assets without the need for the LLC’s own protections.
So that gets us to the next LLC issue—what happens to your LLC if/when something happens to you? If you are a single-member LLC, or in a partnership with your spouse that is often viewed as a single-member entity under state law, and you don’t have an operating agreement that says what happens in this kind of situation, the default is that your Durable General Power of Attorney Agent together with your spouse (in a partnership LLC if he or she is also not the Agent) steps into your shoes and operates the LLC. If you don’t have a POA that covers this, then it can be very complicated and may require a Court order of conservatorship. Not something you want at that time.
But if you die, then the POA also dies with you, and cannot be used for any continuity of operations or winddown process. That would be handled by other agents in your estate plan, your Executor for a Will, your Trustee for a Revocable Living Trust, or your Court-appointed Administrator if you have neither a Will nor a Trust (a/k/a intestacy). If your business is relying on these legal procedures to maintain operations, particularly a Will or intestate Estate, that is a recipe for disaster.
There is a better way to handle things and that is to be proactive in your planning. As in many aspects of estate planning, I recommend that with your business interests you take the Stephen Covey approach of beginning with the end in mind. What do you want to happen with your business interests in the event you can no longer run them due to incapacity or death? Do you have a succession plan? Is it written down anywhere? Is it even feasible? In many cases the best way to address business continuity and succession is in the LLC Operating Agreement. This is particularly the case for partnerships or multi-member LLCs, even family LLCs, where the Operating Agreement can set forth rights of purchase requirements, who can succeed to a member’s interests, compensation for shares, among other critical things. If you have a comprehensive Operating Agreement that will generally not require you to address the LLC interests in any detail in your personal estate plan, or to do so only in the nature of a safety net.
But if you don’t have that comprehensive Operating Agreement, you will want to include business continuity and succession provisions in your estate plan, ideally with a Revocable Living Trust instead of a Power of Attorney and Will combination, since the Trust offers legal authority to act continuously while you are alive and well, and if/when you become incapacitated, and seamlessly transitions to your Will substitute upon your death without the need for probate proceedings or Court appointment of an authorized Executor or Administrator.
This last point is a key one in many states since probate generally has a fee or tax associated with it based on the value of assets being administered by the probate court. An LLC, as an intangible asset, does have a value, and may require a formal appraisal be submitted to the Court and have a substantial fee imposed on the process due to the LLC’s value. A properly prepared and funded Trust plan, on the contrary, will avoid probate and eliminate a significant transition cost.
As you can tell, I think the Trust plan is the better choice for business interests in the absence of a comprehensive Operating Agreement that addresses these continuity and succession interests. And the Trust can still serve as a backup, or that safety net I mentioned, in the event that the Operating Agreement is not in effect or is simply not effective to take care of things. The way I recommend an LLC interest be handled with a Trust plan is to not re-title the LLC into the Trust, but rather use a document known as an Assignment of LLC Interest to the Trust. This is a relatively simple document that provides that for estate planning purposes only, an LLC is considered part of the residual Trust property. This permits a Successor Trustee to step into your shoes to manage your interests in the event of incapacity or death, but this Assignment alone does NOT reduce any of the LLC protections or put your other Trust assets at risk—assuming that you are following the earlier guidance on treating it like a business and having your risk management tools in place.
Between the comprehensive Operating Agreement and the association of the LLC with your Trust you will have taken a significant risk off the table for your loved ones should something happen to you. This is truly one of those situations where the old saying “an ounce of prevention is worth a pound of cure” is spot on. Yes, it may cost you a bit to get these things in place, but you can take comfort in knowing that you have made the effort to avoid a potentially costly and complicated situation for your loved ones at what will undoubtedly be an already stressful and emotional time.
Military Finances are Different
A lot of Retired Senior Military Officers and NCOs start consulting businesses when they retire, and the LLC discussion often comes up. Starting a business isn't unique to military retirees. But military and civilian financial and tax issues are often very different from each other. That is why we think that Active and Retired Senior Military Officers and NCOs should work with someone who understands the differences. If you'd like to see how we work with clients just like you, use the button below to schedule a free, initial consultation.
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