Most states have used a standard for trust investments which has been called the “Prudent Person Rule” and which will apply, except as may otherwise be directed by the trust instrument. Since this rule is the heart of all investment judgments, it is quoted here at length from a typical statute.
The Prudent Person Rule: In acquiring, investing, reinvesting, exchanging, retaining, selling, and managing property for the benefit of others fiduciaries shall be required to have in mind the responsibilities which are attached to such offices, the size, nature, and needs of the estates entrusted to their care, and shall exercise the judgment and care under the circumstances then prevailing, which men of prudence, discretion and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to permanent disposition of their funds, considering the probable income as well as the probable safety of their funds, considering the probable income as well as the probable safety of their capital. Within the limits of the foregoing standard, fiduciaries are authorized to acquire and retain every kind of property, real, personal, and mixed, and every kind of investment, specifically including, but not by way of limitation, bonds, debentures and other corporate obligations, stocks, preferred or common, securities of any open-end or closed-end management type investment company or investment trust, and participation in common trust funds, that men of prudence, discretion, and intelligence would acquire or retain for their own account.
What does this mean for you? Clearly this rule gives the Managing Member the power to invest LLC assets in the kinds of property in which men of prudence and caution would invest their own money. It imposes on the Managing Member the standards of investment that a prudent investor would follow considering all the circumstances involved. Learn more about forming a Wyoming Limited Liability Corporation here.
The Managing Member should:
Consider diversifying the assets of the LLC among many types of investments such as stocks, bonds, mortgages, etc.
Consider diversifying among various industries with LLC stock holdings.
Consider current income as well as long-term capital appreciation and balance the interests of the beneficiaries of LLCU interests.
Seek professional guidance both for initial investment and for continuing review of investments held if the Managing Member is in need of such assistance.
The Managing Member should not:
Speculate with LLC assets.
Lend LLC assets without adequate security, or engage in other forms of self-dealing.
Continue to hold an investment that no longer meets the “prudent man” standards.
Continue to hold assets transferred to the LLC without an independent investigation of their quality as LLC investments.
Delegate investment decisions to others. The LLC agreement instrument may enlarge or limit investment powers, but you should always keep in mind the Prudent Person Rule quoted above.
Important Note about Prudent Person Rule: In many states, the Prudent Person Rule applies to the entire investment portfolio. This may or may not be the same as the business judgment rule that is generally applied to decision-makers in business entities. When juries make decisions on these cases, they may consider the entire investment portfolio performance, but if they find one investment that does not meet the Prudent Person Rule, the jury may find the Trustee liable. Generally there is a higher standard for Trustees than for other fiduciaries such as agents, business managers, general members, etc.
Transfer of Specific Assets to the LLC
Investment assets should go into the LLC. These assets include:
Investment real estate;
Stocks, bonds, mutual funds, money market accounts, and CDs;
Business interests like shares of a closely held corporation (but not shares of an S corporation), partnership interests, and Limited Liability Company membership interests (be sure to check partnership, LLC, shareholder, and other agreements that might restrict the transferability of closely held business interests);
Notes receivable, and mortgages and trust deeds given as security for notes; and
Life insurance not owned by irrevocable gifting trusts or irrevocable life insurance trusts.
Assets That Should Not Be Transferred to the LLC
A homestead should normally be kept out of the LLC because of the tax advantages available to owners of a homestead residence (the homestead exemption for property taxes). If the homestead is transferred into the LLC, fair market rent must be paid to the LLC. Also, in many states, there are homestead exemptions that protect part or all of a personal residence from creditor claims. These exemptions may be large or relatively inconsequential, depending on state law.
There are some situations where you might want the homestead to go into the LLC. If the home value is high, the loss of the homestead exemption might cost considerably less in the long run when compared to any estate tax savings. Also, if the creators of the LLC don’t mind paying rent (which could further reduce their taxable estate), then putting the homestead in the LLC could work. Generally however, it is best to leave the homestead out of the LLC.
Non-business tangible personal use personal property, like furniture, jewelry, collectibles, and the like should be kept out of the LLC. Since most clients prefer to continue to use their personal property, they should keep it out of the LLC in order to avoid having to rent it from the LLC.
Cars and other motor vehicles that are used for personal use should also be kept out of the LLC. A motor vehicle can produce tremendous personal liability for the owner of the vehicle if an auto accident happens. By keeping vehicles out of an LLC, our clients avoid having to rent the vehicles from the LLC, and also protect the LLC itself from incurring liabilities that can exist for owners of motor vehicles.
Annuities, IRAs, and other qualified retirement plan funds, should be kept out of the LLC since these items must be personally owned for certain tax purposes. Transfer of these assets to an LLC would result in adverse immediate income taxes. However, there are often ways to incorporate those assets into LLC planning.
Obtaining Distributions from the LLC
There are four ways to obtain cash from an LLC.
- First, the managers of the general member can be paid management fees for managing the LLC. If the general member is an entity, the entity can use the management fee to pay salaries to its managers.
- Second, distributions (of income) may be declared. When distributions are declared, all limited members receive a pro rata share of the distributions.
- Third, the LLC can make loans, at market interest rates, to the limited members or to the general member. The note signed upon the creation of a loan, and any unpaid interest, is a legitimate debt for the taxable estate of the borrower if the loan is not paid back prior to death. Such outstanding loans can reduce the estate tax of the borrower.
- Fourth, when distributions are paid, limited members could use the distributions to purchase more LLC units from the founders of the LLC should they desire to sell some of their LLC units. Since these sales are at the fair market value (FMV) of the LLC units, this sale will get more LLC units out of the founders’ taxable estate, provide a source of cash to the founders, and allow the founders to “freeze” the value of their taxable estate to some degree.
