People often ask me, what are some of the typical business owner’s concerns that I discuss with them regarding their business? In an article by Martin S. Finn, CPA, who mentioned the top ten businesses and estate planning mistakes, I was reminded of the three areas that I typically spend most of my time discussing with owners as mentioned below.
Neglecting to properly structure a business venture to protect personal assets from business creditors. Business owners face risk and the threat of liability from every direction. Some of these risks include business failure, employee torts, product liability, and employee terminations. A business owner can distance himself or herself personally from business risks by forming the proper business entity under which to operate the business.
The several types of possible entities afford different degrees of protection (partnerships, corporations or limited liability companies). Consequently, while no magic bullet will provide all-purpose, one-size-fits-all protection, a business owner can take various measures to afford the best level of protection for his or her business and personal assets.
For businesses owned by more than one individual, neglecting to have an owners’ agreement and a binding buy-sell arrangement (with funding). Much like dewy-eyed lovers forging a romantic relationship, many prospective “partners” in a business have high expectations for the future of that business. The last thing on anyone’s mind is the possibility of business “divorce.” Yet a binding buy-sell agreement is arguably one of the most important documents a multi-owner business entity can have. A “buy-sell” agreement is an agreement between the owners of the business, or among the owners of the business and the entity, to purchase and sell interests of the business at a price set in the agreement on the occurrence of certain future events. Such events may include:
- An offer by an outside party to purchase the owner’s interest.
- Termination of employment.
In addition to defining the events that will result in the buy-out of an owner’s interest, the agreement should define the value to be paid for that interest. Various methods of valuation are available to the business entity. For instance, the agreement may provide that the purchase price is to be set at the annual owners’ meeting. If this method is used, a default method should be selected in the event that the owners cannot agree on a price at the meeting or simply fail to meet to set a price for a period of years. A second valuation option is to use the book value of the interest. Generally, this is not the best method of valuation because book value does not necessarily reflect the true value of the business (e.g., book value does not include goodwill).
Failing to properly plan for family business succession. (Maybe junior wants to run the family dry cleaning business, but maybe he wants to be a forest ranger instead.) In order to avoid this mistake, a family member’s desire to participate in the family business should be evaluated. An effective evaluation process will involve the next generation. A good succession plan will also structure the entity of choice with flexible provisions to serve family needs. Add a system of governing provisions (i.e., checks and balances) to address conflicts before they escalate. In addition, consider creating a “family council” comprised of family members to articulate family expectations for the operating company.
When planning for business succession, an owner should consider types of entities that lend themselves to transfers of entity interests to family members with little or no loss of management or control to the patriarch. Examples of these entities are:
- Family limited partnerships (FLPs).
- Limited liability companies (LLCs).
- Subchapter S corporations (with voting and nonvoting stock interests).
An understanding of estate and gift tax ramifications of gifts of entity interests, such as valuation issues and available discounts, is also crucial. The main goal is to allow the donor to retain control and derive income from the entity, while removing considerable estate value through gifts of interests, or making gifts using the applicable exemption amount ($1 million) or the annual gift tax exclusion amount.