When investing time and money in establishing a business, whether it is a sole proprietorship, or some form of partnership, corporation, or limited liability company, the business’s legal structure can have major implications on how the business operates, how it’s taxed, and how ownership and control may be transferred. When your goal is to establish a business that can operate sustainably across generations, implementing succession planning early in the business’s life can facilitate the transition process when the time comes for retirement or upon an untimely death. In this article, we will provide an overview of the options to organize a business and consider how succession planning for each type of entity may facilitate transition of control and ownership of the business at retirement or death.
An immediate and complete transfer of ownership and management of the business is often not the best way to ensure a smooth transition that best serves the business, its customers, clients, employees, and the current and prospective owners. Therefore, a business ownership structure that facilitates a gradual transition of ownership between the current and future owners and separates ownership and control of the business’s daily operations will often be the better option for the succession of the business. This can allow for a new owner to purchase ownership of the business in stages and allow the current owner/manager to transfer degrees of control of the business when he/she thinks the time is right.
Common forms of business ownership, and how they do or don’t facilitate succession planning, include:
Sole proprietorship: In a sole proprietorship, the owner directly owns the business and its assets. The revenue and expenses of the business are taxed as a part of the owner’s 1040 income tax return. Sole proprietor ownership does not provide a means of partially transferring ownership of the business, or transfer control of the business while retaining ownership.
Partnership: A partnership allows for multiple owners, but does not provide any protection to the partners for the business liabilities. A partnership files a 1065 income tax return, and issues a K-1 to each owner that allocates the business’s profits or losses in proportion to each partner’s share of ownership. While a partnership does allow for a gradual transition of ownership by selling ownership gradually, all partners are liable for the debts of the partnership. It does not allow for the formal transfer of control of business. While the incumbent owner may informally defer to the new owner in the operations of the business, the incumbent retains the right to control in proportion to their ownership, which may create an undesirable situation for the new owner, and leaves the incumbent liable for the actions of the new owner. A partnership may also register as a Limited Liability Partnership (LLP), which would shield the partners from being personally liable for the debts of the business.
LP: A Limited Partnership (LP) allows for some partners, designated as Limited Partners, to financially invest in a business without control over the operations of the business, but also without liability for the business’s debts, while other partners, designated as General Partners, are responsible for operation of the business and are liable for the business’s debts. While many common goals for succession planning may be accomplished within an LP, the decision to establish an LP would generally be driven by the needs of investors in the business.
Corporation: A corporation features ownership by shareholders who select a Board of Directors, which in turn selects and oversees officers responsible for the daily operations of the business. A corporation can either be taxed as a “C-Corp,” which directly pays taxes on its profits, or as an “S-Corp,” where profits and losses are taxed proportionally to shareholders. Shareholders and officers are not personally liable for the debts of the corporation. Ownership of a corporation can be transferred gradually by selling shares in stages. Control of the corporation can also be transferred gradually by assigning the new owner increasing duties as an officer, while retaining control of the board of directors for as long as the incumbent owner holds a majority of the voting shares issued by the corporation.
LLC: Limited Liability Companies are a flexible ownership structure that allows the owners to select aspects of governance and taxation from the entities discussed above. An LLC with a single owner, referred to as a member, may operate and be taxed like a sole proprietorship. With multiple members, an LLC may operate, and be taxed, like a partnership with the members directly controlling operations by operating as a “member managed” LLC, or may operate in a manner similar to a corporation, with the members overseeing an appointed manager who handles daily operations, by operating as a “manager managed” LLC. The benefits and disadvantages of an LLC for succession planning depend on how the owners establish the LLC as discussed above.
Succession planning should be considered early in a business’s life. The choices made early in a business’s life, especially with choices related to taxation, may be costly and difficult, if not impossible, to reverse. The attorneys at Plager, Krug, Bauer, Rudolph & Stodden, Ltd. have extensive experience in business planning and establishing business entities, and are available to assist in determining the best business structure for you.