By Ryan Snow, JD
Effective estate planning often involves planning for the succession and transfer of a client’s business operations and business assets. Business planning becomes critically important when a large portion of the value of the client’s estate is derived from their ownership of a business. Estate planners may need to consider whether a transfer of a business interest is permitted, if obtaining the consent of the other business owners is required, or whether there are other legal constraints or obligations related to ownership of the business and its assets.
Navigating a client’s business organizational documents is the key to understanding their company’s formation, governance, and day-to-day operations. This article is intended to equip estate planners with the background they need to confidently and competently review these critical business documents. This foundational overview identifies 10 concepts you must understand when navigating transactions or providing recommendations related to a client’s business. Collaboration with an experienced business attorney is also encouraged when complex business planning is required.
#1 Entity Type and Tax Classification
One of the most common issues in business entity formation discussions is failing to differentiate between a business’s state law entity type and its federal tax classification.
State law determines the types of business entities that can be formed. The most common state law entity formation types are limited liability company (LLC), corporation, and partnership. The LLC is currently the most commonly formed entity type. However, there are a myriad of other less frequently used state law entity types that can also be formed. Some examples are the limited or general partnership, limited liability partnership, limited liability limited partnership, nonprofit corporation, and B corporation.
These state law entity structures are not the same as the entity’s federal tax election. Under Internal Revenue Service (IRS) regulations, there are four main federal tax election options: partnership, S corporation, C corporation, and disregarded entity. The type of state law entity structure and the number of owners dictate which federal tax election options are available to the various state law entities. For example, a single-member LLC will be taxed by default as a disregarded entity (meaning that it is disregarded as separate from its owners for federal income tax purposes), or it can elect to be taxed as an S corporation or a C corporation. An LLC with at least two members will be taxed as a partnership by default, or it can elect to be taxed as an S corporation or C corporation. Likewise, a corporation will be taxed as a C corporation by default, or it can elect to be taxed as an S corporation.
The types of documents filed to form the state law entities are commonly known as articles, certificates, or statements (e.g., articles of incorporation for a corporation or certificate of organization for an LLC). The required title of an entity formation document varies by state and is determined by applicable state law. However, the federal tax election either occurs by default, or an election can be made using the applicable IRS forms. For example, the S corporation election is made by filing IRS Form 2553, and an LLC can elect to be taxed as a C corporation by filing IRS Form 8832.
One of the most common mistakes related to entity types occurs when someone describes an entity as an S corporation without additional reference to whether the actual state law entity type is an LLC or a corporation. Likewise, someone might refer to their entity as being a C corporation, without understanding that both an LLC and a corporation can use the federal tax election status of a C corporation.
#2 Management Structure
Understanding an entity’s management structure is critical for identifying who has authority and control over the day-to-day decision-making for the business. Management structure provisions are most commonly contained in operating agreements, bylaws, partnership agreements, and shareholder agreements.
The management structure can vary based on the entity type. A corporation typically requires that its shareholders elect a board of directors to oversee the affairs of the business, and the board of directors then elects or appoints company officers (e.g., president, treasurer, secretary) to manage the day-to-day operations of the company. An LLC has a broader spectrum of management structure options. These typically include management by its members, one or more managers, or a board of managers.
Management of an LLC by its members (often referred to as a member-managed LLC) could include management authority by all members equally, or it might provide for management by one or more specific members referred to as managing members. The term managing members is not to be confused with the second type of LLC management structure, which provides for management by a manager (often referred to as a manager-managed LLC). A manager-managed LLC could include management by a single manager who may or may not be a member of the LLC. It could also provide for management by multiple managers. Using multiple managers is also the underlying functionality of the third variation for LLC management structure; however, it is typically accomplished by using a board of managers, which more closely resembles the corporate management model of having an internal board of directors and two or more officers.
If an entity’s management structure allows for management by one or more members or managers, additional concepts to understand for succession planning might include the method for selecting and removing managers, the affirmative duties and limitations on the managers’ or officers’ authority, any approvals required by the members or shareholders, the type of approvals required for certain actions, the extent or limitation of fiduciary duties, the extent of information that should be provided to the members or shareholders, and the extent of any management liability or indemnification that might be provided.
#3 Equity Structure
A business can choose from a variety of equity structure options. However, the type of state law entity that is formed and the type of federal tax election that is made may substantially limit those options. In general, an entity’s equity structure can have different types of voting interests and different types of economic interests. Equity structure provisions are most commonly contained in operating agreements, partnership agreements, shareholder agreements, and a corporation’s minutes and resolutions.
An entity can have multiple classes of interest or a single class of interest. A common family business succession planning scenario often involves a business owner who wants family members to participate in the ownership but not the control of the business. This is accomplished through an entity with a single class of equity interest that characterizes some of those equity interests as having voting rights and others as being nonvoting interests. The nonvoting interests are typically held by the children, and the voting interests are held by the parent. On the other hand, an operating business with unrelated owners might have a single class of interest with equal economic rights and equal voting rights. That business could instead choose to have multiple classes of interests in order to adequately compensate owners contributing capital to the business.
For succession planning purposes, there can also be classes of equity interests designed to provide preferential or priority rights to certain owners when it comes to profit distribution, liquidation, or a general return of capital. Interests in a corporation are characterized as shares of stock, while an LLC can generally characterize its equity interests as either a percentage of the total interests or as units of interest similar to the corporate stock model. An LLC or corporation that elects to be taxed as an S corporation is limited to having a single class of equity interest in order to meet the IRS requirements for S corporation election, although it can still elect to have voting and nonvoting equity interests.
#4 Transfer Restrictions
When reviewing an entity’s governing documents, it is important to understand the rights and obligations related to an equity owner’s ability to transfer their equity interest. An entity’s equity interests might be completely free from any transfer restrictions, or they may have many restrictions and obligations that must be considered and addressed when an owner desires to transfer an equity interest, whether voluntarily or involuntarily. Transfer restriction provisions are most common with LLCs and closely held corporations and are generally found in operating agreements, partnership agreements, shareholder agreements, and buy-sell agreements.
Buy-sell provisions are a common method for both restricting the transfer of equity interests and committing the equity interests to certain obligations. Buy-sell provisions may be found in a stand-alone buy-sell agreement, but they are most often incorporated into another agreement, such as an operating agreement or shareholder agreement. These provisions can prescribe what happens to equity interests in a number of scenarios, including if an owner dies, quits, retires, becomes disabled, gets divorced, goes bankrupt, or loses their license.
Other common transfer restrictions include requiring consent from the other owners, managers, or directors; granting the entity or the other owners a right of first refusal prior to allowing a transfer; the ability of majority owners to require minority owners to sell when the majority ownership interest is being sold (commonly referred to as drag-along rights); the ability of minority owners to participate in a sale of the majority owners’ interest (commonly referred to as tag-along rights); and preemptive rights granting the existing equity owners a preferential right to acquire any new equity interests issued by the company.
For succession planning purposes, all of these transfer restrictions require further analysis and understanding of the specific circumstances that might trigger a specific restriction; the methodology for determining pricing, funding, and payment for a transfer; the specific rights or obligations of the entity and the other equity interest owners, including whether all of the equity owners will have the same rights to participate in any buy-sell transaction; and the effect of an invalid or unauthorized transfer.
#5 Profit Distributions
A company’s profits might be distributed to the equity owners in several different ways: on an equal basis, based on the type of equity interest that is held, or on some form of non pro rata basis determined by certain parameters as specified in the company’s documentation. The organizational documents commonly clarify how the owners will participate in distributions and who will . . .
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