Module 4 — Business Succession Plans

There are many ways to establish and own a business entity. Each form of ownership has differing advantages and drawbacks, both during the owner’s lifetime and upon death. From a legal point of view, there are three basic categories of businesses: sole proprietorships, partnerships, and corporations. Some of these basic categories can be subdivided further according to various tax or legal aspects.

As the name implies, a sole proprietorship is owned by one individual. There is no legal distinction between the business operation and the owner — the law holds a sole proprietor personally liable for all actions of the business. Any debts or other obligations of the business are legal obligations of the owner. This is the concept of general liability and can be a serious drawback.

Offsetting this disadvantage, the IRS does not impose a separate tax on business profits — the proprietor reports business profits (or losses) as personal income on his or her own tax return. No special documents are necessary to form a sole proprietorship, although the business must comply with all government regulations, including any licensing and bonding requirements. Of all business forms, the sole proprietorship is by far the simplest to start. Approximately three-quarters of all U.S. businesses are sole proprietorships.

From an estate planning perspective, a sole proprietorship is treated the same as the owner’s other property. The proprietor’s taxable and probate estate will include business property as well as personal assets. As part of the probate estate, the business transfers to heirs by the terms of the owner’s will.

Estate Planning for Sole Proprietors

A sole proprietor must ensure that the will considers the unique nature of the business — including providing the executor with adequate powers to operate and dispose of the business. Generally, the probate court does not grant these powers unless the will explicitly provides for them. Without special provisions, the personal representative must discontinue the business immediately, complete any unfinished work, and wind up the business’s affairs. A sole proprietor dying intestate subjects the estate to even more severe constraints.

Even if the executor is granted power to continue operations, the executor is personally liable for any losses arising from continued operations. Without a carefully crafted succession plan, the odds of the family successfully operating the business are slim. The sole proprietor faces three alternatives to forced liquidation:

• Selling the business to others — an orderly, pre-planned sale to an outside buyer or key employee at a fair price
• Orderly liquidation — winding down on the owner’s own terms rather than under court supervision, preserving more value
• Retaining the business within the family — transferring the business to family members with the skills and desire to continue it

Any of these options is preferable to a forced liquidation under court supervision. The factors influencing the proprietor’s choice are discussed in greater detail later in this module.

A partnership is the result of a voluntary agreement between two or more persons whose goal is to establish a business and profit collectively and individually. A partnership agreement details the rights and responsibilities of each partner, including the division of business profits. Like sole proprietorships, partnerships do not enjoy a separate legal existence — the law views a partnership as a direct extension of the individual partners.

Business profit (or loss) is split among the partners and reported as personal income on their individual tax returns. The IRS does not impose a business-level tax on partnership profits, but requires the partnership to file an informational return (Form 1065) disclosing each partner’s distributive share. Partners must report their share of profits as taxable income whether or not the partnership actually distributes the cash.

General vs. Limited Partnerships

In a general partnership, all partners are jointly and severally liable for the actions of the business — each partner is fully liable for the entire debts of the business (not just their proportionate share). All general partners have a voice in supervising the enterprise. No formal documents need be filed with the state to form a general partnership.

A limited partnership divides owners into two categories. General partners supervise operations and assume general liability. Limited partners act mainly as investors (the proverbial “silent partners”) — they have no voice in management and consequently are not held responsible for the business’s actions beyond the capital they contributed. This is the concept of limited liability. Formal documents must be filed with the state to form a limited partnership. Most limited partnerships are investment vehicles for real estate or other assets.

A critical distinguishing characteristic of partnerships: a general partnership automatically terminates upon the death of a partner as a matter of law. The surviving partners may choose to form a new partnership to continue the business, but the automatic legal termination is a serious estate planning consideration. All partnerships should have a business continuation plan before any partner’s death. Each individual partner should consider not only the effects of his or her own death, but also the possible death of each co-owner.

Estate Planning for Partnerships

Of all business organizations, partnerships are the most problematic for estate planners. When a partner dies, the partnership must cease — no one can be forced to accept someone else as a partner, nor can the heirs be forced to become partners. Without a formal continuation plan, any surviving partners become liquidating trustees with fiduciary responsibility to complete work in progress, collect receivables, liquidate assets, pay debts, and distribute the deceased partner’s share to the estate.

There are four alternatives to forced liquidation, each with distinct advantages and drawbacks:

Estate planning for partners must address two possibilities: what happens if the client dies first, and what happens if the client survives a co-owner. Both scenarios require advance planning.

The stock corporation arose in 16th century Europe as a way to raise capital to explore the New World. Among the earliest were the Dutch East India Company and the Hudson Bay Company. These ventures needed more capital than individuals, families, or partnerships could provide. Governments granted charters to sell shares to investors. The great distinction between partnerships and corporations rests in the corporation’s separate legal existence.

Once chartered, the corporation becomes a separate legal entity: shareholders enjoy limited liability and supervise the business through a Board of Directors. As a separate legal body, the corporation is subject to taxation — it pays corporate tax on its profits. If the Board declares a dividend, those distributions are taxable again on the shareholder’s individual return: the notorious double taxation of corporate profits. Additional disadvantages include formal filings and bookkeeping requirements to maintain the corporate charter.

From an estate planning perspective, a corporation offers a critical advantage: a corporation’s existence is unaffected by an owner’s death. No special legal arrangements are necessary simply to keep the business operating. However, in closely held corporations, business continuation plans remain a practical necessity.

Shareholder Rights

Shareholders enjoy certain rights granted by the corporate charter, including:

• Dividends, if declared by the Board
• Inspection of the company’s books and records
• Voting for directors and important corporate matters (usually reserved for common shareholders)
• Free transferability of ownership
• Limited liability regarding the debts and obligations of the corporation

These rights apply to shareholders of both publicly traded and closely held corporations, but in closely held companies they take on different — and usually more limited — dimensions.

Dividends

In many closely held companies, shareholders are also employees. The owner’s compensation more likely results from salary than dividends — salary compensates for the owner’s productive participation, and payroll is tax-deductible while dividend payments are not. Most closely held corporations pay little or no dividends. This is a critical estate planning consideration: upon the owner’s death, the salary income ceases, leaving heirs with little or no current income from the business. Many heirs cannot understand why the business’s income has “dried up.”

Free Transfer of Ownership

Shareholders have a general right to sell, give, or transfer their stock. In closely held companies, shareholders may enter into contracts limiting the sale of shares — imposing holding periods, rights of first refusal, or other restrictions. Even without contractual restrictions, closely held shares are typically very unmarketable. Finding a purchaser and establishing a proper valuation is difficult, especially for a minority interest.

Limited Liability

While shareholders of corporations enjoy limited liability, officers and directors do not. In most closely held companies, shareholders are also officers or directors. Furthermore, creditors frequently require shareholders to personally co-sign for the company’s debts. In practice, the shareholder’s “limited” liability is often not very limited.

Voting Rights

In closely held corporations, the right to vote shares is critical. The shareholder is usually a key member of the management team. Whether a shareholder has the votes to effect a change has a great deal to do with the value of those shares. Majority ownership interests in a closely held corporation are significantly more valuable than minority positions — a fundamental valuation principle explored later in this module.

Taxation of Corporations

C corporations pay corporate tax on business profits before distributing earnings to shareholders, who then pay personal income tax on dividends — double taxation. Under certain conditions, a corporation may elect to be taxed as an S corporation (named after Subchapter S of the Internal Revenue Code), avoiding the corporate-level tax. S corporation requirements:

• No more than 100 shareholders
• All shareholders must be individual U.S. citizens or residents (another corporation or foreign investor may not hold shares)
• Must be chartered in the U.S.
• May issue only one class of stock
• May not receive more than 25% of gross revenues from passive investment income (rents, royalties)

All shareholders must consent and sign the S election. Once filed, the election continues until terminated voluntarily or involuntarily (by violating any condition above). In an S corporation, taxable income from operations is divided among shareholders, who pay tax at their individual rates — much like a partnership, though S corporations (unlike partnerships) cannot distribute capital losses to owners. A recently developed alternative, the limited liability company (LLC), offers many of the same benefits as an S corporation with greater flexibility.

Estate Planning in Closely Held Corporations

Unlike partnerships, corporations do not face automatic dissolution when an owner dies. Yet for closely held corporations, the practical implications are similar. The heirs need cash to settle the estate, while surviving owners want to continue without interference. Without a formal continuation plan, the corporation continues with the heirs as part owners — which can create serious problems.

Upon the death of a shareholder, a closely held business loses a key member of its management team. Disruption of management and uncertainty about continuation can cause problems with employees, suppliers, customers, and lenders — seriously depressing the value of the business and affecting the financial condition of heirs and other shareholders alike.

The consequences differ based on whether the heirs inherit a majority or minority interest:

Closely held corporations face many of the same considerations as partnerships. As with partnerships, buy-sell arrangements can overcome many complications caused by a shareholder’s death. These arrangements are explored in greater detail later in this module.