There are a number of reasons that you might want to create an investment vehicle, such as a limited partnership or Limited Liability Company (LLC), to manage your family’s investments. Most commonly, people create these entities in order to maintain control of the family’s investments, pool assets to achieve economies of scale and access to breakpoints, and transfer wealth to children and grandchildren at a discount.

What kind of entity is the best one for making family investments?

There’s no right answer to that question; it depends in large part on your and your family’s goals for your wealth. For a brief overview, please see our WealthFocus on Business Entities. You should consult with your own legal and tax advisors to understand what would work best for your individual situation.

For new entities, we most commonly see families using LLCs, and will use LLCs as the example in the rest of this presentation. But the concepts here work similarly with family limited partnerships or other family entities.

Who has control?

An LLC is governed by an LLC operating agreement, which generally sets out the rules under which the LLC operates. This includes management of the LLC and its assets.

Subject to a different arrangement in the operating agreement, an LLC is usually managed by the “managing member”—that is, one of the members of the LLC who also has control. Usually this is the LLC creator.

Sometimes an LLC is managed by a non-member manager. This is a person who is not a member of the LLC (that is, someone with no economic interest in the LLC) but who is given the authority to manage the LLC. This frequently occurs when the LLC interests are owned entirely by  junior generations (children, grandchildren or trusts for their benefit) while the senior generation (parent) is tasked with managing the LLC.

What are some of the reasons people create family investment entities?

Families create co-investment vehicles for many reasons. Most commonly, families that have an investment entity want to be able to share investments across generations, and parents often want their children to have access to investments in which they wouldn’t be able to participate on their own. Sometimes asset protection is also a motivator for owning family assets through an entity. And quite often, people use entities when they want to take advantage of valuation benefits for non-controlling interests when transferring wealth to their children and other descendants.

How can a family investment entity help when I want to transfer wealth to my children?

Every U.S. citizen and permanent resident has a limited amount of value they can transfer to children or more remote descendants without paying a tax on that transfer. (Transfers between spouses who are U.S. citizens are unlimited.) In 2023, that amount is $12.92 million per person—so a couple can transfer up to $25.84 million to children free of transfer tax. For a more complete discussion of transfer taxes, please see our Wealth Focus on Providing for your loved ones during your lifetime.

When gifts are made, the gift (and therefore the amount of exemption used) is valued as of the date of transfer. So generally parents want to be able to make gifts of assets that are likely to be worth more in the future than they are today.

If parents have an asset that they give to their children, the value of the gift—and therefore the amount of exemption they use—is equal to the value of the asset. If parents have transferred assets to a family LLC and own all the membership interests, they can instead transfer membership interests to their children (or to a trust or trusts for their children’s benefit, in which case the trust(s) would be the recipients of the gifts). How much are non-managing LLC interests worth? Based on principles followed by the IRS, they are generally not worth the full proportionate value of the net assets of the LLC. So if parents have an LLC with $5 million of assets in it and they want to give away 20% of the LLC interests to their children, the fair market value of that gift is probably less than $1 million (20% of $5 million) since a willing buyer would not pay full price for such an asset for the following reasons:

• Lack of control/ minority interest - As we’ve discussed, a non-managing member of an LLC has no control over anything that happens in the LLC. Among other things, the non-managing member has no ability to control:
  •   What the LLC invests in
  •   Whether the LLC makes distributions to its members
  •   If the LLC makes distributions, the size of those distributions
  •   Who manages the LLC (since it’s a minority interest, the minority interest-holder can’t force a vote to change the manager)
• Lack of marketability - Because the LLC is a private, family entity, there is no ready market for interests in it. If you were to be offered an interest in another family’s LLC, you’d want to think about how you might get your money out. Since you can’t effect distributions or investments, you might think about how you could sell the interest. But anyone you sell to is likely to have the same concerns—if you could even find someone who would be interested in purchasing this interest from you.
  

As a result of the lack of control and lack of marketability of a non-managing member, a willing buyer is likely to want to pay less than the proportionate value of the underlying assets in the LLC—in effect, to offer a discounted amount. So for the 20% interest in a $5 million LLC, a hypothetical willing buyer will likely want to pay less than $1 million for that interest. And for gift tax purposes, the amount that the hypothetical buyer would pay becomes the value of the gift.

If the parents hadn’t created the LLC and just owned the $5 million in their names, a gift of 20% would use up $1 million of their exemption. By transferring those assets to an LLC, the parents can give away the same underlying value and use less exemption—leaving more available to shelter other gifts or bequests.

Determining the extent of the minority and marketability discounts generally requires an appraisal of the asset being given away, which can be expensive. However, depending on the value of the assets in the LLC, the gift tax savings can be significant, and families often find those savings well worth the cost of the appraisal and tax compliance. For example, if the combined discount were 40%, a 20% interest in an LLC with $5 million of underlying assets would have a fair market value for gift tax purposes of $600,000—that is, a parent would only use $600,000 of his or her lifetime exemption to transfer that 20% interest to children. If transfer taxes are assessed at a 40% rate, that’s a savings of $160,000 (40% of the $400,000 difference between the underlying net asset value and the appraised fair market value).¹

Valuation discounts are complex and require the assistance of professionals. Talk to your J.P. Morgan Advisor to learn more, and work with your tax and legal advisors if you want to create a family entity.