The difference has to do with taxes and whether the child gets a Carryover basis or a Step Up in basis? If the property is given during the parent’s lifetime he or she will get the property with the same cost basis that parent had when he or she originally purchased it.

Example: Parent(s) purchased the home for $ 70,000 and the home is now worth today $ 700,000. Child would get your cost basis in the home, the $70,000 (which is the carryover basis). But if he or she wants to turn around and immediately sell the property for $800,000 there will be a capital gains tax on $730,000, (the difference between $800,000 and $70,000.)

Compare if child inherits the home when parent dies, the capital gains tax would be based on the value of the property at time of parent’s death, the $700,000. In other words the child’s basis gets “Stepped Up” to the value at date of death of the parent ( $700,000). Under this scenario the child pays nothing in capital gains tax because there has been no capital gain.

Caveat: Attorney is not a C.P.A. nor a tax specialist rather focuses on estate planning document preparation primarily for Calif. residents. Please consult with your own tax advisor before proceeding with your estate planning calling for transfer of the family residence to your children.

A good example is where there are multiple siblings, and sibling “A” wants to keep the family residence by “buying out” Sibling “B’s” interest. Here are a few suggestions when parents are planning to leave the family residence 50/50 to (2) siblings. First, each sibling should be given a Right of 1st Refusal to buy the property. Second, the trust should be drawn as a “non pro-rata distribution” trust. This entails a couple of points. First the successor trustee must be given broad powers and wide discretion in determining how to divide the estate in equal percentages between the two beneficiaries A and B. A non pro rata trust will enable the successor trustee to sell off other assets in the estate to raise funds to use in order to equalize the distributions. Alternatively it will allow the successor trustee to have the TRUST (not Sibling “A”) obtain a loan. Again providing the successor trustee with additional funds to enable the buy out. The reason sibling “A” should not obtain the loan and instead the Trust, is because if sibling “A” obtains the loan for the purchase, then it is considered a “sibling to sibling” transaction for which there is no exemption upon reassessment of the property. In other words the Trust is the enabler of the transaction by obtaining the loan which sibling “A” takes over with the transfer of the property.

The goal is at the end of the day, that the non-acquiring beneficiary will get cash + other assets equivalent in value to the equity in the home to “equalize the distributions between the parties”. This is key. Beneficiary “A” gets the house and “B”gets the equivalent of the equity ($) that “A” has in the house. It is an equal distribution. Note, party “B” does not get an equal share of the residence. He or she is getting an equal proportion of the entire estate. Further sibling “A” must move into the home and make it that sibling’s primary residence. The sibling who occupies the home ( Sibling “A”) would file for the “Parent-Child exclusion” which is now limited to the first million dollars of value that would be added upon reassessment.

Here are a couple of examples: 1) “The Original Owner Rule.” H & W form an LLC with the intent of buying a rental property and taking ownership in the name of the LLC soon after purchase. Under Rule 462.180 of the Calif. Board of Equalization Rules, if the rental property owner transfers title within a short period of time after the property’s acquisition, the LLC is deemed the original owner. If so, the property may then be reassessed or may NEVER be reassessed! Remember we are not talking about the husband and wife holding title in this illustration, rather we are talking about the LLC and it later transfers a 50% or less interest to another and there is no reassessment.

What if a parent bought a rental property in 2018 for $500,000 and 5 months later created and transferred the property to the LLC. In 2021 the property is reassessed for $1M. The fair market value is then $3M. Parent causes the LLC to transfer 50% of the property to his son and 50% to his daughter.

Result: No reassessment. Why? Because the LLC was the original owner. There is a key footnote to this result. For purposes of estate planning, if parent or parents form a revocable living trust, and transfer the LLC to the trust, the trust should be clear that it is not granting more than 50% or more to any one child otherwise it will trigger a reassessment.

The purpose of the insurance was to be able to use the proceeds to fund a redemption agreement within the corporation. The issue before the court was whether the insurance proceeds increased the estate tax value of the corporation? The I.R.S argued ‘Yes’ and the court agreed.

The case involved two brothers as shareholders of the corporation operating a small building supply company, where each of the brothers had purchased life insurance to enable funding of the purchase of the decedent shareholder’s interest. At issue was whether the insurance proceeds increased the value of the corporation for estate tax purposes as argued by the I. R. S.

The Supreme Court noted that the obligation to redeem shares did not constitute a “liability” of the corporation thereby ascribing a lower estate tax value. The court held that after the death of a shareholder, the value of that person’s shares must reflect the corporation’s fair market value, including insurance proceeds meant to fund a share redemption.

By way of example, suppose Mr. X is a resident of California and does business online out of his condo located in California.

He later forms a Nevada LLC thinking he will be better off tax wise etc.. When one forms an LLC in the state where they reside (California) it is called a “Domestic LLC”. If that LLC later wants to do business in Nevada as an LLC it must register there as a “Foreign LLC.” It is the same LLC, but now registered in two different states.

In this example, Mr. X is illegally doing business in California. Why? Because he formed an LLC in Nevada while a resident of California and while doing business in California through an unregistered Nevada LLC. Technically Mr. X should have registered the Nevada LLC in California as a” foreign entity”. Now what? Mr. X will incur fines and penalties unless he registers his Nevada LLC in California as a foreign LLC!

Net Result: Mr. X may have the equivalent of two LLCs to maintain in terms annual fees and paperwork in both states. Between added fees and costs, Mr. X may have shot himself in the foot losing much of the benefits he was hoping for in forming a Nevada LLC.

It is important to remember that Mr. X may have no office in California and no employees in California, but is still considered “doing business” in California running his business from home.

The other thing is California has very strict tax laws relative to other jurisdictions. That means in addition to the costs incurred to form the Nevada LLC, he may also have to contend with the California Secretary of State and the Franchise Tax Board with regard to taxes.

Also if Mr. X was looking for certain legal benefits by having a Nevada LLC, courts have discretion to decide which state law to apply to a given situation in court Again, since Mr. X resides in California and is doing business in California, it is possible a court could decide Nevada law does not apply! So Mr.X loses the benefits associated with a Nevada LLC.

Moral of the Story: If you are thinking about where to form your business entity, especially if it is to be a state outside of where you are doing business already, consult with a corporation/LLC attorney in your locale first.

One example to illustrate the point: Suppose parents purchased a rental property in the 1950’s for $50,000 and the assessed value under prop 19 is now more than $1M. That means the child is inheriting a property with no Exclusion (because it is a rental property) and with a reassessed value of over $1M. Because of the significant tax increase the child will be forced to decide whether to keep or sell the property given the absurdly high tax obligation.

1) trustee has committed a breach of trust 2) trustee is insolvent and/or unfit to administer the trust 3) where lack of cooperation between co-trustees impairs trust administration 4) trustee fails or declines to act 5) trustee’s compensation is deemed excessive

6) trustee has serious mental capacity issues 7) trustee is unable to resist fraud or undue influence.

Removal usually is accomplished by the settlor’s notice (if settlor is still alive) to the trustee to step down or notice from the beneficiaries. If that doesn’t work the beneficiaries would need to petition the court for an order.

Typically, the major factors that a business owner would want to consider include: 1) which entity is the easiest to form? 2) the number of owners the business will have 3) what type of management and control is desired for the business 4) what will be the degree of authority the owners and management will have to bind the entity 5) the owner’s liability for business obligations 6) the desire for easy transferability of the owners’ interest in the business 7) various tax considerations and 8) the ease of dissolving the entity should an owner want out.

Digging Deeper:

1. An S- Corporation. If properly formed AND properly maintained, the S-corp will shield owners from personal liability for the debts of the business. The S-corp. however requires more maintenance than an LLC. Separate books and records must be maintained by the S- corp and must be continually updated as the business incurs more transactions. Regular meetings must be held by the Directors of the corporation each time a business transaction is contemplated and must be voted upon by the Directors. There must be written meeting minutes documenting what transpired at each meeting. An S-corp cannot have a nonresident alien hold shares. In an S-corp. and the total number of shareholders is limited to 100. Also an S-corporation must maintain a sufficient amount of working capital which depending upon the type of busienss involved may be thousands of dollars.
2. California LLC: This type of entity generally provides more flexability to the owners in terms of operating style. The LLC can delegate the day to day operations to one or more managers. The regularity of holding meetings as with an S-corp. are not as rigid. Still for major business decisions it is a good idea for the members to document the decisons made by the LLC’s member/owners. An LLC requires an Operating Agreement. This document is essential for documenting how the LLC will operate. It can be as complex or as simplified as desired depending on the number of members and the nature of the business. For example a one member LLC will likley have less requirements in terms of operation compared to a multi member LLC. A multi member Opearing Agreement should contain provisions regarding a member’s departure from the LLC including any buy out provisons by the other members. This would not be the case with a single member LLC.

Flexabilty:

An LLC is easier to operate provided the Operating Agreement has provisions which address the particular issue. For example, the LLC can operated by its member-owners serving as managers or persons appointed as managers who may or may not necessarily be member- owners. Of course where spouses are involved, including same sex partners, who are member-owners, they can appoint one member to be the manager or appoint both members to operate the business as its mangers.

Transferring a member’s interest is easy relatively provided the Operating Agreement allows one to transfer. A transfer can even be restricted to the monetary value of the membership while the original member retains voting and management rights. A member’s interest can also be held by a Revocable Living Trust so that at death of the member, the interest passes via the member’s estate plan along with any other assets thereby avoiding probate.

Because of the flexability of an LLC, built into the terms of the Operating Agreement, an LLC has the distinct advantage when it comes to holding and selling investment real estate.