By Leo J. Cushing
Limited liability companies clearly are the entity of choice, particularly in cases where holding real estate is involved. By way of background, Massachusetts first introduced limited liability companies in 1996. As a result of a 2003 amendment, single member LLCs became permissible.
Single member and multi-member LLCs are clearly superior to other entity choices, including S corporations, Massachusetts Business Trusts and nominee or “realty” trusts. For example, contributions of appreciated property to limited liability companies are income tax free. More importantly, distributions of appreciated property from an LLC to its owners are generally income tax free. This is a particularly significant benefit, inasmuch as a distribution of appreciated property from an S corporation will be a taxable event.
Liability and Income Tax Advantages
By statute, each member of an LLC has limited liability. A single member LLC does not file a separate income tax return. Rather, all items of income, expenses, deductions, and credit are reported to the owner on the individual income tax return for both federal and state purposes.
In cases in which there are multiple properties, it is common to form a parent LLC and have each of the separate properties owned by a separate LLC. Each separate title-holding LLC will be owned by the parent LLC. The separate, single purpose LLCs, which own separate properties, are single member LLCs that do not have a separate income tax filing obligation. Of course, each LLC must pay the $500 annual filing fee.
Tax Filing Obligations
All income will be reported on the parent LLC and, in such a case, if the parent LLC is a single member LLC, all items of income, expense, deduction, and credit will be reported on the individual’s owns personal income tax return. Multi-member LLCs are treated as partnerships. No income taxes are paid at the entity level. All items of income, expense, deduction and credit will pass through to the members and will be taxed in accordance with the partnership rules of Subchapter K of the Internal Revenue Code.
Gifting of LLC Membership Interests
LLCs are used extensively for estate planning. In a typical case, a senior family member will form an LLC and contribute substantial real estate holdings to it. Thereafter, the senior family member will transfer by gift LLC membership interests. These may be voting or nonvoting and could represent a small or significant portion of the LLC-using non-voting shares. To the extent that the membership interest transferred is either a minority interest or non-voting shares, the gift tax value of the interest will be discounted. This is because the interest is nonvoting and nontransferable.
In the case of Pierre v. Commissioner, 133 T.C. 2 (2009), the IRS argued unsuccessfully that the LLC should be disregarded and that the transfer of a membership interest was essentially a distribution of the underlying asset to the transferor, a gift by the transfer or to the transferee with a recontribution of that asset by the transferee, and, as a result, no discount would be allowed. This was rejected by the Tax Court.
Limited liability companies are also useful to minimize Massachusetts estate taxes in connection with a change in domicile. Massachusetts residents are subject to an estate tax that can be as high as 16%. For this reason, many Massachusetts residents consider changing their domicile to Florida, New Hampshire or some other state that does not have a state death tax.
Aside from the need to comply with the various regulations in terms of changing voting registration, driver’s license, physicians, and the like, it is also important to deal with Massachusetts real estate that the taxpayer may own. The reason for this is that nonresidents are subject to the Massachusetts estate tax based on a formula.
The computation involves first computing the amount of the state death tax that otherwise would be due if the Florida resident was a Massachusetts resident, and then multiplying that amount by a fraction, the numerator of which is Massachusetts real estate and other tangible personal property located in Massachusetts with the denominator being the decedent’s adjusted gross estate. G.L. c. 65C, § 4(g).
If we assume that a single taxpayer dies with an estate of $5,000,000, which would be nontaxable to a Florida resident, and we assume that 50% of the property is Massachusetts real estate, then the Commonwealth of Massachusetts would be entitled to $195,800, computed as follows:
Total tax due assuming decedent was $2,500,000
a Massachusetts resident: $391,600 x $5,000,000 = $195,800
If the Massachusetts property was transferred to an LLC in connection with a change in domicile, even if the LLC is owned by the Florida resident, the numerator would be zero since the LLC is an intangible and not real estate. See Estate of Nielson v. Commissioner, Docket No. F232365; (Appellate Tax Bd. Feb. 15, 2001) (stating that partnership interest not taxable, but interest in realty trust taxable for Massachusetts estate tax purposes).
This planning opportunity has been addressed by a number of states, most recently New York. In an advisory opinion, the New York State Department of Taxation and Finance concluded that real estate owned by a single member LLC will not be considered an intangible unless it elects to be taxed as a corporation.
It is likely that other states will follow suit but not likely in Massachusetts because the LLC statute provides that an LLC interest is personal property and a member has no interest in specific LLC property. Also, this issue was addressed in a DOR regulation, 830 Code Mass. Regs § 65C.2.1, which was repealed in its entirety as being obsolete in 2014.
Avoiding Excise Stamp Taxes
General Laws c. 64D, § 1, imposes as stamp/excise tax on the sale of real estate; the amount is $4.56 per $1,000 of sale price and is payable by the seller. Massachusetts has not taken the position that a single member LLC is a property interest, at least for purposes of imposing the $4.56 per $1,000 stamp tax. In theory, then, this would permit a taxpayer to transfer their property to a single member LLC and then sell the membership interest to avoid paying the $4.56 per $1,000. See DOR Directive 95-5 (a sale of benefits interest in a Massachusetts nominee trust is subject to the stamp tax).
Single Member LLC and Asset Protection
One important asset protection benefit to an LLC is the statutorily-limited remedy of a creditor to a so-called charging order. See G.L. c. 156C, § 40. Generally, this means that unlike an interest in another type of entity, the interest cannot be taken to satisfy a judgment creditor. A word of caution: this benefit does not exist in the case of a single member LLC.
This article only scratches the surface of the complex and vexing issue, not yet settled in all jurisdictions, on whether a single member LLC is an intangible or an interest in real estate. However, it is widely recognized that for holding title to real estate, the limited liability company has supplanted all other entities.
The founding partner in the Waltham-based firm of Cushing & Dolan P.C., Leo Cushing has written and lectured extensively on all aspects of taxation and estate planning. He also co-chairs REBA’s estate planning, trusts and estate administration committee. Leo can be contacted by email at firstname.lastname@example.org.