Protect and Defend
Top 10 multi-unit wealth preservation ideas
Over the years, my partners—John Berg and Scott Husaby—and I have been helping franchise clients with business transition issues. The transfer or transition of a business may be one of the most significant financial events of an owner’s life. We thought it would be helpful to address some of the major wealth preservation issues we encounter on a daily basis. The following are our Top 10 multi-unit wealth preservations ideas.
1. Effective Use of Business Entities. Most business owners understand the importance of operating their businesses out of separate legal entities in order to protect their personal assets from their business risks. However, a surprising number of business owners do not understand how important it is to use a different entity for each valuable component of the business, such as separate concepts, owned real estate and possibly even equipment. Using a separate entity for each of these components effectively creates a protective wall around that portion of the business. As a result, the exposure for any liability risk occurring within each entity is limited to the value of the assets within that entity. It is also a good idea to consider setting up a separate management company to manage the business operations and employ key employees that work for more than one company. In addition to providing some potential asset protection, this step also may provide some valuable tax benefits.
2. Business Contingency Planning. One of the most important steps a business owner can take to protect both his family and his business is to engage in business contingency planning. This involves planning to ensure that the business can continue to operate at least on a short-term basis in the event of the owner’s incapacity or death. For businesses owned by more than one individual, most of these issues can be addressed in a shareholder agreement. For wholly owned businesses, however, the owner’s incapacity or death generally has a much more significant impact on the business. Steps need to be taken to address the ownership of the business, retention of key employees, business liquidity and financial resources, and ongoing management of the business during any transition period. While actions taken by a business owner in the business contingency planning area certainly help protect the business in the event of the owner’s incapacity or death, most of these planning ideas also provide an immediate return to the owner as a result of the business being run more effectively and efficiently.
3. Minimize Personal Guarantees. It is an obvious point that no business owner likes signing personal guarantees, but it is surprising how frequently they are provided. Similarly, business owners also frequently pledge or otherwise collateralize their personal assets to secure their business obligations. While personal guarantees may be appropriate and unavoidable in some situations, they should be granted as a last resort. Even if they are granted, the business owner should attempt to cap the liability and negotiate the time period or terms over which the personal guarantee burns off.
4. Choice of Entity. As you structure each portion of your business and significant assets in separate entities, make sure you give sufficient consideration to which type of entity is most advantageous for each situation. Often, the business owner feels that the analysis has been completed when the decision has been made to place a portion of the business or an asset in a separate entity. In many cases the type of entity is an afterthought. No one entity is necessarily the best answer for every situation. We generally start with the assumption that a limited liability company (LLC) is the default choice unless something peculiar in the business operation or type of asset dictates otherwise. Any properly structured entity should provide the liability protection that is required. The primary reasons we prefer LLCs are tax-related. While both LLCs and S Corporations provide flow-through taxation, an S Corporation must generally allocate all items of income, loss, deduction or credit pursuant to the ownership percentages. The LLC, on the other hand, has the ability to specially allocate these items as long as the allocations have substantial economic effect. This provides tremendous flexibility among the ownership group. Another reason we prefer the LLC is because they allow easier flow-through of operating losses. Management companies are sometimes set up in the form of a C Corporation because the management company may manage the potential negative impact of double taxation while enjoying certain tax and employee benefit advantages allowed to C Corporations.
5. Diversify Your Wealth. One of the most common observations we make regarding business owners is that a disproportionate amount of their net worth is tied up in their business. While the situation is likely necessary early in the life of a business, we recommend that over time, business owners find a tax-efficient way to “take some chips off the table” and diversify their wealth. Not only is this good advice from an investment risk standpoint, it also addresses some of the contingency planning issues discussed above. When all of the business owner’s wealth is in the business, the owner’s death or incapacity puts a tremendous amount of stress on the family and the surviving management that is attempting to structure a business succession. There are immediate liquidity problems and any succession plan will likely require a high transfer value that may not be supportable without the owner’s participation in the business. If the owner was able to take some value out of the business, this would provide both immediate liquidity to the family at or prior to the owner’s death or incapacity, and also would reduce the value of the business that needs to be transferred.
6. Determine a Realistic Value of Your Business. Most of the planning issues addressed by business owners (estate planning, succession planning, personal financial planning, etc.) are dependent upon the value attributed to the business. This is particularly true if the majority of the owner’s net worth is tied up in the business. To make sure that this planning satisfies the intended goals, it is critical that an accurate value of the business be obtained. As a general rule, most business owners overvalue their business, which can quickly result in the failure of their personal planning. For example, if the goal is to give the business to one child at the owner’s death and equalize the other children through other estate assets or life insurance, an inaccurate valuation can prevent the “fairness” the owner desired. Buyout obligations under shareholder agreements are often funded by life insurance. At the time of death, it is usually discovered that the amount of insurance may no longer bear any relation to the value of the business. Invest the time and resources necessary to get an accurate snapshot of the value of your business today. You will discover that once you have this baseline established, it is a fairly easy procedure to update your plan for changes in your business or changes in the overall market.
7. Address Family Planning Issues. One of the most serious, yet avoidable, issues we see involves family problems resulting from a business owner’s death. This situation is particularly relevant where the owner has one or more children working in the business. The owner needs to put an effective estate plan in place that specifically addresses how the business will be treated. Nothing can destroy a business faster than finding itself in the middle of a dispute after the owner’s death. While putting together this plan may not be easy because the owner may face difficult issues, the alternative is to pretend the issues do not exist. If you, as the business owner, struggle with putting together a plan to address these family issues, just think how difficult it will be for your family to work through these issues without you.
8. Effective Advisory Team. Good business planning is a multidisciplinary exercise. The process should include input from your accountant, financial advisor and lawyer. You need to make sure you have effective representation in each of these critical areas and you also need to make sure that these advisors work together as a team. While this is important for the effective operation of your business today, it also provides a tremendous benefit in the event of your incapacity or death because you have a team in place that will likely be able to advise your successor on running the business during any transition period. Regular meetings with these advisors will ensure that the owner’s current thoughts on operation and succession issues are known by the advisors and can be implemented if the owner is suddenly out of the picture.
9. Eliminate Probate. Very few business owners give much thought to how probate may impact their business. Probate is the legal process your individually owned assets go through at your death. This public process is intended to make sure that your creditors have access to your assets and that your net estate is distributed pursuant to the terms of your will or law. While this process varies by state, it is not uncommon for assets to be tied up in probate for a period of over one year. Having your business become a probate asset can be a tremendous burden on both your business and your family at the worst possible time. You should put together an estate plan that effectively removes your business ownership interests from this probate process. If you operate a franchised business or have obligations with a third-party lender, this requires a specialized estate plan that can accomplish the probate avoidance goals while not triggering needless personal guarantees and liability exposure for your family.
10. Don’t Delay. Business owners believe they will live forever and nothing will happen. Unfortunately, we know this is not the case; people get sick or injured all the time. Do not push succession/estate planning down the road. You never know how long the road will be.
Dennis L. Monroe is a partner and chairman of Krass Monroe, P.A., a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation based in Minneapolis.