Until fairly recently, there were no good alternatives available to woodland owning families who, after years of effort now find themselves having to leave forests – and forest management plans – to children. Thankfully there is now a perfect alternative to maintain management traditions, kept lands intact and in the family, while also removing the burden of ownership from any one heir.
In this issue we describe the limited liability Company (llC), the ease with which it is formed, and why it is perfectly suited to passing forests within the family. Also covered is the process of ‘vesting’ children with ownership interests in the family forest without losing control, and the tax benefits to those who handle transfers correctly. In the next issue we describe important elements of the Operating Agreement, which is the equivalent of a contract between the members of an llC and the ‘Constitution’ that describes its purpose and governance, even its succession years in the future when it comes time to re-evaluate the goals and objectives of the family forest. [Parts 1 & 2 are combined here]
Forest owners who want to keep ecosystems intact and in the family have four options: family partnership, closely-held S-corporation, a qualified trust for conservation purposes or a limited liability company. Of the four, the simplest to set up and easiest to manage is also the most flexible alternative: a limited liability company, or llC. One of the useful features of an llC – especially as it relates to long-term management of forests – is that profit motive is irrelevant. Thus, the family forest llC can be dedicated to any purpose; investment, business, conservation or – best of all – any combination of motives. llCs provide the liability protection of a corporation, pass-through taxation aspects of a partnership, and the essential ability to restrict ownership in the family forest that a closely-held S-corporation provides. Plus, an essential added benefit, crucial to an entity that must add members at the same rate that families grow: there are no limitations on the number of members an llC can have. The individuals that form the lCC, also known as “founders,” have the choice of restricting the number of members (the concept of ‘members’ to an llC is exactly the same as ‘shares’ to a corporation), allowing fractional membership, forming more than one class of membership, or allowing membership to grow with the family.
Every state in the U.S. now has an llC statute, and for reasons mentioned above, it has become a very popular way to organize businesses, non- profits and other circumstances where people come together to make something happen. When that “something” is long-term management of forests, the llC can allow family members to be the recipients of both tangible and intangible forest benefits but without forcing any one family member to dedicate his or her life to “carrying on Dad’s legacy.” It is this perception that often causes current owners to rethink the wisdom of dedicating one child with the ‘golden brick,’ who must then sink or swim while attempting to keep the forest afloat. And when a forest is the principal asset, other children are apt to feel cheated, even though the son or daughter who accepted the responsibility would gladly pass it off. By forming an llC, the ‘golden brick’ resides with the ‘company’ leaving children to enjoy the benefits of forests without the hassles; or to get involved if they are so inclined. It sounds too good to be true, but it is not, so long as the founders give careful thought to language in the llC’s ‘operating agreement.’
There are two parts to an llC; one public, the other private. The public document is known as the ‘articles of organization,’ and it includes such information as: name (which must include the letters ‘llC’ or ‘lC’ to publicly declare the nature of the company), the state law that governs the few statutory requirements of the llC, the physical location of it’s offices, the name and location for the agent of process (if the llC is ever ‘served’ with legal papers, who is the lucky person willing to accept them?), and the llC’s fiscal year.
The articles of organization include two important questions, the answers to which are especially significant for woodland owning families: 1) Is this a term llC, or an at-will company?, and 2) Is this a member-managed or a manager-managed llC?. By default, most states will assume an llC is ‘at-will’ and that it is managed by members. But an llC established for the purposes of maintaining a forest management legacy and for keeping forest lands intact will want to designate the company a ‘term’ llC of 100 to 150 years or more. Although this may sound somewhat drastic, the operating agreement, discussed below, can specify conditions the members can use to shorten the llC if absolutely necessary, and/or to establish a new term upon expiration of the old one.
The second question is a little more difficult to answer initially, because chances are the founders are already adequate managers and, therefore, have no reason to relinquish those responsibilities. Nevertheless, they will want to address the issue of future management in the operating agreement, possibly by designating a trusted consulting forester or property manager to serve as ‘manager’ after the founders have passed away. As a general rule, it is a good idea to place management decision-making in the hands of one person rather than in the hands of a committee – for obvious reasons. But, to avoid the risk of a manager run amuck, the operating agreement should also spell out a series of checks and balances to impeach a manager for cause. Those checks and balances are usually spelled out in the operating agreement, discussed below.
After completing the single-page articles of organization, the founders sign and date it (including their mailing address, E-mail and day-time phone numbers, just in case there are questions). With the required filing fees, the package is then submitted to the Secretary of State. Within a few weeks the founders should receive notification that the llC is formed. After that, two things need to happen: 1) The founders need to draft an operating agreement that explains the purpose of the llC, the relationship of members to it, and important matters of governance. 2) Once the operating agreement is finalized, or nearly so, the founders can initiate transfer of title in forest lands to the llC either directly, or as a trust of the llC. But, no one should ever take the process of title transfers lightly, so it is at this stage where good legal advice – from an attorney who has had experience with llCs – is essential.
The forest land is also appraised at the time of transfer so the founding members can use IRS tax- exempt gift rules to vest children into ownership interests in the llC over time. Under current rules, a husband and wife (or other qualified couple) can give tax-exempt gifts of up to $24,000 per child per year ($12,000 per qualified spouse). And, when the terms of a gift are controlled by a charter, IRS also allows parents to ‘discount’ the gift for its lack of marketability. In other words, parents can give each child, say, $30,000 of an undivided interest in forest land to create a $24,000 gift for tax purposes (by discounting the gift 20 percent due to the limitations imposed on the gift the llC operating agreement). An ‘undivided interest’ in assets is the same thing as ‘shares’ in a corporation.
The operating agreement is a proprietary document of the llC, which means that it is private to all except the members (same as ‘shareholders’ in a corporation) and it does not need to be filed with the state. There are, however, some necessary requirements implicit to the llC that the operating agreement can not obviate. For example, members have rights to see the books and records of the company; all members have a duty of loyalty and care to one another and to the purpose of the llC, and members are obliged to act in good faith and deal fairly. Statutory requirements vary by state, and some allow more freedom than others. For this reason, prospective founders many want to read up on llCs and choose to organize in a state that offers the best set of conditions for a company whose purpose is to manage forest lands and keep them intact for many, many years. As of this writing, there are nearly 300 titles of books in print that come up with a keyword search on ‘limited liability companies,’ so there is no shortage of expertise on the subject.
When the purpose of an llC is to pass forest lands within the family and to create a management structure that allows goals and objectives established under the current forest management plan to be maintained until the plan says it is time to act, organization and wording of the operating agreement are crucial to long-term success. Here are some of the elements a family will want to include in an operating agreement:
- A strong opening paragraph that clearly describes the purpose of the llC: to pass forest lands within the family – intact – for the llC’s term and longer; to manage long-term timber investment values; to create and maintain wildlife habitats (for named species); to provide opportunity for recreational purposes (either reserved for the family, or for townspeople by including a clause that allows public access to forest lands for stated recreational purposes in exchange for an agreement from the town to lower property taxes). The opening paragraph sets the tone for the rest of the agreement and so it is essential that it explain why the founders set up the llC in the first place.
- The operating agreement should describe a legislative structure that puts most of the decision-making power into the hands of a relatively few members, or in the hands of a manager. For example, any child or grand-child is automatically a ‘member’ of the llC, but their ability to ‘vote’ is vested to them as they acquire a financial interest in the company. It is the equivalent of having more than one class of stock; and the highest class has voting rights to select a ‘board,’ and then the board appoints a set of ‘directors,’ who are actually charged with making decisions.
- The above is a description of a “member managed” llC. Here is another: Governing members can be divided into three functions: administrative, judicial, and legislative (sound familiar?). The administrative arm makes day- to-day management decisions. But for some decisions that require drastic measures (such as effecting a ‘reproduction treatment,’ or installation of an expensive road), there must be a vote of the membership. Discrepancies are sent to the judicial board charged with making a decision that the members agree to accept. There are many different alternatives to create a reasonable management structure for a ‘member-managed’ llC, but the goal of any structure should be to further the original cause of the llC while installing necessary checks and balances.
- If the operating agreement is amended to put a manager in charge (a consulting forester, for example), the manager is a fiduciary of the llC; the equivalent of a ‘trustee’ to a trust. Even with a manager-managed structure, the members should retain the power to impeach a manager, as described above. In fact, the operating agreement can spell out conditions that cause an automatic impeachment. And the agreement should also describe the process of appointing a new manager.
- Generally, the members of an llC are the owners and income and expenses are passed directly to them for tax purposes, unless the operating agreement describes a different method. Given a marginal return on forest investments in some parts of the country, the agreement may want to specify periodic pay-outs of “profits” rather than annual payouts. Income can be distributed to members (or in trust for children), much as dividends are paid by a corporation. Given a choice, people will choose simplicity over almost any alternative, allowing them more time to enjoy forests, and less effort spent worrying about the business.
- The operating agreement should restrict membership to children who are direct descendants of the founders. In fact, prospective spouses should agree to waive any rights to the family llC as a potential marital asset in the case of divorce. If a future family member wants out of the llC, the agreement describes how that member’s shares are purchased, and if the member’s offspring are eligible to buy back in to the llC. The operating agreement can also grant a non-voting membership to any direct descendent, but each generation must choose one family member to obtain a voting interest.
At the end of a ‘term,’ the operating agreement should spell out the process voting members will use to establish a new term, or to dissolve the llC for cause. Since dissolution of the llC involves land, legal advice is absolutely essential. The founders may want to think about local conditions 150 years from now that might prompt them to encourage members to dissolve, or to create a new term. Finally, the operating agreement should also include a copy of the management plan, and make reference to it in virtually every clause. Future llC members should never lose sight of the original purpose that caused the founders to take the steps they did to ensure that forests are kept intact and in the family. If the family votes to dissolve the llC, the original agreement could specify that the land is to be given to a local land trust or some other qualified entity that is willing to continue managing the forest for generations to come.
McEvoy, T.J. 2003. Sustainable Family Forests:
The Benefits of an LLC - Parts I & 2. Farming
The Journal of Northeastern Agriculture. Vol. 6,
Nos. 9 & 10 – September & October Issues. pp49
– 58. [Updated to Fall 2006]