Editor’s Note: Stuart B. Dorsett is the head of the Trusts and Estates Practice Group at Ward and Smith, P.A.
When business owners engage in business succession planning, they typically focus on only two things: (i) minimizing estate and gift taxes on the transfer of equity ownership in the business and related assets to children and grandchildren; and (ii) selecting and grooming a successor manager. Obviously, these are the critical components of a successful plan of succession, but too frequently another critical component – asset protection – is overlooked. The transfer of a business to a younger generation presents the unique opportunity to preserve the family’s business assets against outside claims. A few of the ways to achieve this asset protection are summarized below:
Use Limited Liability Companies to Protect Against “Inside Liabilities” and “Outside Liabilities”
A limited liability company (“LLC”) combines the best attributes of corporations and partnerships, including the ability to segregate managerial control from equity ownership, the ability to achieve partnership income taxation status, and tremendous flexibility in structuring the allocation of the entity’s economic benefits. In addition, LLCs offer unparalleled asset protection.
First, an LLC protects the other assets of the LLC owners (known as “members”) from exposure to liabilities incurred by the LLC itself. For example, if an individual is injured on property owned by an LLC, that individual may have a claim against the LLC and its assets, but, barring something unusual about the matter, will not have a claim against the members of the LLC or their other assets. The LLC prevents these “inside liabilities” from affecting “outside assets” of the outside members.
Second, an LLC protects the LLC’s “inside assets” from being adversely affected by liabilities incurred by the LLC members. For example, if an LLC member injures an individual, that individual might have a claim against the LLC member, but again, barring something unusual about the matter, will not have a claim against the LLC’s assets. Thus, “outside liabilities” do not bleed through the LLC to affect “inside assets.”
These attributes are not unique to LLCs. For example, a corporation offers the same protection. However, an LLC offers one attribute that is not shared by a corporation – the protection of an owner’s interest in the entity from third party claims. If a judgment is entered against a shareholder in a corporation, that shareholder’s stock is subject to attachment by the shareholder’s creditor. That creditor may cause the sale of the stock and might itself acquire the stock in such a sale, thereby becoming a shareholder and being able to vote the share’s interest. In contrast, a judgment creditor of an LLC member has only the right to obtain a so called “charging order” against the member’s LLC membership interest, which essentially gives the creditor only the ability to receive distributions, if any, made to that LLC member. The creditor cannot cause a sale of the LLC membership interest, the creditor cannot vote the LLC interest, and the creditor cannot cause the liquidation of the LLC.
Accordingly, whenever possible, a business should be conducted using an LLC, and all assets used in connection with it should be owned by the LLC or another LLC. For example, if the business leases real estate from the business owner, the business should be conducted as an LLC and the real estate should be transferred to another LLC. Not only does an LLC offer significant protection against third party claims, but it also offers a convenient way to transfer ownership of those assets to family members, often at a discounted value for gift and estate tax purposes.
Use “Spend Thrift” Trusts in lieu of Outright Distributions of Business Assets
If a business owner transfers assets outright to a child, those assets are exposed to a variety of liabilities that might be incurred by the child. The assets would be subject to attachment by a judgment creditor of the child, they would be controlled by a bankruptcy court in the event of the child’s bankruptcy, and, in some cases, they might be subject, in whole or in part, to an order of equitable distribution in the event of the child’s divorce.
In contrast, assets passing into a “spend thrift” or “discretionary” trust for the benefit of the child should be sheltered from all such claims. Under the North Carolina Uniform Trust Code, the trust is completely protected from any third party claims (other than a claim for child support).
Moreover, the child may be given broad authority over, and access to, the trust assets without undermining the protected nature of the assets. For example, the child may be named as the trustee of the trust, thereby granting the child managerial control over the underlying assets. The child also may be the sole or primary beneficiary of the trust, thereby providing the child with the beneficial enjoyment of the trust assets. This is true even if the child serves as his or her own trustee, so long as distributions to the child are limited to those necessary for “health,” “education,” “support,” or “maintenance” – broad standards which may not limit the child’s use of the funds in any meaningful way. Finally, the child may be given a testamentary power of appointment – that is, the power to direct the disposition of the trust assets at the child’s death by the child’s own will. In a sense, such a trust gives the child all of the “good” aspects of ownership, without any of the “bad” aspects of ownership.
Protect Non-Management Children from the Bad Business Decisions of Their Management Siblings
In most cases, managerial control of a family business and related assets should be vested in one child. However, other children who are equity owners of the business, but who are not active in its management, will have their share of the family fortune exposed to the bad business decisions of their sibling who is running the business. Accordingly, it is important to provide the non management children with an exit strategy.
Frequently, such an exit strategy involves the ability to “cash out” of the business. For example, the parent who established the business might impose on the children a buy sell agreement which gives the non management children a “put” – i.e., the right to require the manager child to purchase the non-management children’s ownership interests. Such a put might require the non management children to accept a discounted price for their interests and it might allow the manager child to pay for the interests over a period of time. By the same token, the manager child probably should be given a “call” – i.e., the right to require the non-management children to sell their interests to the manager child. To minimize the chance for abuse of this right, the call option might require the payment of a premium price and might require cash at closing. Ideally, these rights will never be exercised, but often the existence of an “escape hatch” reduces tension among the family members.
If possible, the business owner should never put children in this position. Assuming there are sufficient assets outside of the family business, the owner might equalize the children’s interests in the estate by allocating non business assets to the non management children and allocating the business assets to the manager child. If the non management children must be allocated some of the business assets, perhaps they could be allocated non operating assets, such as real estate leased to the company. Life insurance is often a great vehicle for resolving this problem, because life insurance proceeds can be a great source for an equalizing distribution to the non management children.
The primary objective of any business succession plan must be the tax efficient transfer of ownership interests and the identification and training of a successor manager. Nonetheless, it is easy to graft onto that business succession plan several asset protection techniques that can shelter the family business assets from outside claims against the business owner’s children and grandchildren. Protecting the family business from unexpected third party claims may be critical to ensuring the long term viability of the business.
© 2010, Ward and Smith, P.A.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Stuart B. Dorsett practices in the Trusts and Estates Practice Group where he concentrates his practice in estate planning, estate administration, business succession planning, and asset protection planning. Comments or questions may be sent to email@example.com.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.