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Why Owning an LLC in Your Own Name May Be a Big Mistake

Business interests are probate assets.  You read that correctly—the lengthy, expensive, contentious, publicly available probate process may involve your limited liability company’s membership interest or corporation’s shares in the event of a major accident or death.  Even some of the most sophisticated business owners do not realize this, resulting in a potentially dangerous planning gap.  One of our goals at Kincaid Business & Entrepreneurial Law, LLC ® is to empower business owners with the knowledge needed to avoid business setbacks.  Creating a plan to avoid the probate court’s involvement in a business is one way we can take that knowledge and implement it for our clients’ benefit.

Businesses are usually owned by individuals.  In the state of Kansas, which requires limited liability companies to file annual reports, a researcher can see the member(s) (a/k/a owner(s)) who own 5% or more of the capital of a company.  In a single-member LLC, the annual report would normally list a member as, for example, “Matthew Kincaid”.  In such case, Matthew Kincaid would be the owner of the limited liability company; in the event of a major accident or his death, a personal representative may have to take his ownership interest through the probate court(s), nixing standard expectations of privacy with respect to the business and potentially posing a security risk concerning proprietary and confidential company information that may be semi-publicly or publicly exposed via a required court filing.

To avoid probate, business owners can work with attorneys to develop a plan that includes the drafting of a revocable living trust agreement.  This technique requires us to know a little bit about trust law, which is set out below.

First, how is it that the use of a revocable living trust avoids probate?  If a revocable living trust is funded with assets—such as a limited liability company membership interest—during an individual’s lifetime, then the assets won’t need to be probated after the individual’s death as the trustee or successor trustee (not the individual) holds title to the trust property.  This will make more sense after we unpack some of the terms below.

The revocable living trust gets its name “revocable” because it can be altered any time during the business owner’s lifetime.  He or she can even revoke the entire trust if desired.  The revocable living trust gets its name “living” because it’s created and managed while the individual is alive and survives the individual upon his or her death, later distributing the assets per the individual’s direction.

A revocable living trust must identify at least three parties: the grantor, the trustee, and the beneficiary.  The grantor (also known as trustor, settlor, or creator) is the person who establishes the trust and is generally the person who provides the funding for the trust.  A trust may have more than one grantor, such as when a husband and wife create a joint trust together.  After the trust is established and all of the assets are properly titled to the trust, the grantors do not need to do anything further, unless they wish to make changes.  To make a change, the grantor(s) would need to sign an amendment; if subsequent changes are desired, it may be appropriate for the trust to be both amended and restated.

The trustee is the party that holds title to the trust property and manages the property according to the terms of the trust.  The grantor often serves as the trustee during his or her lifetime and names another person or an institution, referred to as the successor trustee, to serve as the trustee upon the grantor’s death or in the event the grantor is unable to continue serving for any reason.  During a business owner’s life and while she is in good health, said business owner would be the trustee of her trust, owning and managing the trust’s assets (including the business interest) for her own benefit and with complete control.  While a trust is revocable, the duties of the trustee are owed exclusively to the settlor; in fact, the trustee may even follow a direction of the settlor that is contrary to the terms of the trust.

The beneficiary is the person(s) who receives benefits from the trust. When the revocable living trust is created, the grantors (husband and wife, or individual in the case where the trust is for a single party) are the trust’s current beneficiaries.  Future beneficiaries, such as children, named by the grantors are known as contingent or remainder beneficiaries. As long as the grantors are alive and competent, the beneficiaries can be changed; hence, contingent or remainder beneficiaries may be changed or even taken out of the trust as long as the original grantors who created the trust are living and competent.

Properly creating and funding a trust places the business interest directly into the hands of a trustee, which, if not the grantor or grantors, is a person (usually an attorney or a CPA) or trust company serving in a fiduciary capacity.  This trustee is able to legally perform trust administration services upon the grantor’s death or incapacity outside of the probate court’s supervision, unless the court’s jurisdiction is invoked by an interested person.

Now that we have at least a basic understanding of trust law, let’s explore the connection between it and business interests.  One respected authority has stated that LLC owners should hold their ownership interests through revocable trusts rather than in their individual capacities: “In states where LLC membership rights are subject to probate, parties who are individuals should often hold their memberships through revocable trusts or through other arrangements that protect those memberships from probate administration in those states.”  John M. Cunningham & Vernon R. Proctor, Drafting Limited Liability Company Operating Agreements, 14-5 (Supp. 2014).  Other sources similarly state as follows: the living trust “is the ideal way to own…LLC membership interests”.  Christopher R. Jarvis & David B. Mandell, Wealth Protection, 166 (2003).  “[S]ome commentators propose a revocable trust structure in which the individual owns the SMLLC membership interest as the trustee of a revocable grantor trust.  In this scenario, at the death of the individual, the successor-trustee now controls both the membership interest and the entity.  This solution undoubtedly works and, in some situations, may be optimal—particularly when other estate planning reasons make a trust advisable.”  F. Philip Manns, Jr. & Timothy M. Todd, Issues Arising Upon the Death of the Sole Member of a Single-Member LLC, 99 Marq. L. Rev. 725, 738 (2016).

The benefits of this form of business ownership have been plainly and succinctly stated: “If you operate a business, your trust can become effective during your incapacity or immediately upon your death, and your trustee can be authorized to immediately start managing your business affairs.  With probate, your business may languish for weeks or months while your heirs petition the court to appoint somebody to manage your interests.”  Aaron Larson, Wills & Trusts Kit For Dummies, 155 (2008).

Before transferring an LLC interest to a trust, an attorney will first review the LLC’s operating agreement, buy-sell agreement, and/or succession plan for transfer restrictions (a/k/a restrictions on transfer).  If no transfer restrictions exist, and S corporation issues are appropriately evaluated, the attorney will prepare an assignment agreement that transfers the LLC interest to the trust and declares that the new transferee (the trustee of the trust) agrees to become a party to the LLC’s operating agreement as a member and to be bound by all of the provisions thereof.  With a multi-member LLC, the transfer of an LLC interest usually requires the consent of the other member or members on either a unanimous or majority basis.  This is for good reason, too, as the other member or members will want to know that the transferring member will be the initial trustee of the trust and will also want to evaluate whether they want to do business at some potential point in the future with the successor trustee of the trust or the trust’s beneficiaries.

An assignment and acceptance transferring an LLC interest to a trustee of a trust is not without traps for the unwary.  Besides S corporation, member consent, and member continuity issues, others abound.  Operating agreements, which often contain buy-sell clauses, are often written for individuals, not trusts.  For example, if the members of the LLC want a person’s disability or death to trigger a buyout, and one member of the LLC is a trustee of a trust (to be followed by a successor trustee in the event of an applicable incident), then written portions of an operating agreement pertaining to death and disability wouldn’t apply equally among human beings, who have natural expiration dates, and an entity-like structure that has superhuman qualities.  Significant amendments to the operating agreement would be in order to ensure that its provisions apply equally to trusts and individuals.  If the LLC is in the business of performing professional services requiring licensure for ownership (e.g., a law firm) and the subject trust is joint, care must be taken upon allocating the membership interest to the “professional” spouse’s share and only allowing the professional spouse to be trustee of that share.  As another example of a trap, but certainly not completing the list, third parties (such as lenders, investors, etc.) may not be accustomed to seeing trusts as members of LLCs and even less accustomed to reviewing copies of relevant trust agreements.

The most common device used for transferring ownership of a business on the death of an owner is the buy-sell agreement.  American Bar Association, Guide to Wills and Estates, 199 (4th ed. 2012).  Such an agreement provides that the remaining owners of the business will purchase the interest of the deceased owner, leaving the deceased owner’s relatives with the proceeds of the sale.  Id. at 199-200.  Buy-sell provisions can be applicable in other circumstances besides death, such as disability, retirement, or bankruptcy.  Id. at 202.  Both the For Dummies series and the Idiot’s Guides series make clear that every small business with two or more owners should have a buy-sell agreement.  See, e.g., Aaron Larson, Wills & Trusts Kit For Dummies, 59 (2008) (“Every small business with more than one owner should have a buy-sell agreement addressing the right to purchase shares from a partner who wants to leave the business, or from a partner who becomes incapacitated or dies.”); Stephen Maple, Estate Planning, 70 (5th ed. 2016) (“Every partnership, LLC, and multishareholder corporation should have a buy-sell agreement.”).

Considering that a business is often an individual’s most significant asset, continued smooth operation and minimal (if any) involvement of the probate courts deserves prioritizing.  The proper use and funding of a revocable living trust is one mechanism to reduce risk and keep the government from interfering with an entrepreneur’s private affairs.  Here at Kincaid Business & Entrepreneurial Law, LLC ®, we enjoy working with business owners and entrepreneurs to properly structure their businesses and minimize unanticipated consequences stemming from failures to plan.  Please contact us at 913-735-7707 if we can be of service to you or your business.

Matthew T. Kincaid

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