Ep. 15 - Business Succession and Setup

Welcome to the Good Steward Law and Wealth Podcast, where host Ledly Jennings explores law and finance to help listeners become better stewards of their wealth. Each episode covers the latest trends and strategies in estate planning, elder law, investment, and wealth management. Tune in for the knowledge and tools for financial success and security.

Welcome back to the Good Steward Law and Wealth Podcast, and today we are going to talk about business entities and how how to set them up in your estate plan. So, um, we'll start out with talking about the types of entities that a business owner can have. Then we'll get into which one's the best, what are the pros and cons of those. We'll get into the formalities of how you set them up, and then we will talk about how do you pass on your business and what are the methods to do that. So the first thing we'll start with is when you set up a business, what are your options? One is, they call it a sole proprietorship, meaning you have a business that's just in your name. You're running it as an extension of yourself. There's really no business entity. It's just you. The other option you hear about a lot are incorporations. So you see Inc. at the back of business names. That's a corporation. That is one option. Another option is a partnership. It could be a general partnership, a limited partnership, but it's you and partners. It's still in y'all's name and y'all form a partnership, meaning y'all work together. And then the final option we really talk most about is an LLC, also known as a limited liability company. And that is the most common business entity that we see today. And that's changed over the last, I don't even know when it is, since I've been a lawyer, it's been the most common, But it wasn't always that way. That's why you see a lot of older companies set up as corporations. That was originally the most common method because it gives you the asset protection you need. Um, in case, say, if you're a business owner and you're sued, they can't sue you personally. They can only sue the company. So the corporation provides that protection. But over the last several years, the corporations have kind of faded out to where they only, um, use a corporation if it's a large publicly traded company, because mostly corporations have a lot of hoops to jump through. There's a lot of administrative issues. And there's a lot of formalities that have to be followed to have a corporation. So basically, all that to say is the best entity to use nowadays is a limited liability company, an LLC. And the reason for that is it gets all the same protections as a corporation, but, but it's a lot more flexible. You can elect how an LLC is taxed. You can name the types of members in that LLC. You can name multiple members. You can give members different powers, different voting shares. It's very easy to set up. So an LLC has taken over as kind of the main entity that we use today. And I almost always recommend, especially my type of clients, I'm not representing big publicly traded companies. These are business owners., and entrepreneurs. So I recommend an LLC is what they set up. Now I'll preface this. You should almost never have a sole proprietorship as your business entity. It gives you no asset protection. There are really no benefits to it. The, I just can't think of a logical reason why you would want to use a sole proprietorship as your business. Just go ahead and set up an LLC. It's very affordable. So how do you set up an LLC? And this is based off Arkansas law, but you can set up an LLC in other states and they all follow the general same rules with a few variations. But to set up an LLC, you go to the state website, you search the name, you make sure the name you want to use is available. If it is, then you can file— they call it your articles of— well, really just call it articles. Typically you file your articles and that is you saying, you know, the name of the company, company, who the owners are, address, registered agent. You list all that and you pay the filing fee with the state. When you're approved, they will send you a certificate and your articles, and that is your state documents. And then from there, you set up an operating agreement. So basically, this is where the attorney typically is valuable. They come in and create an operating agreement that acts as the bylaws to your company. You know, what, who's in charge, who are the managers, what can you do, what can't you do, what's the purpose of the business. Basically the rules of how you run the business. So once you have the operating agreement, the articles, and the certificate, you set up a bank account. And the bank, it will ask for all those items that I just mentioned. Um, and they may even ask for an EIN. So you will file and get a tax ID, also known as an EIN, with the federal government. And all that is what you use to open a bank account. And once you open the bank account, you're up and running. That is your business. Um, Now I will hit briefly on a new filing requirement with a business entity that not many people know about. It was enacted this year. Anytime you open a business or if you already own a business, you have to file what's called a beneficial owner report. It's through a government agency called FinCEN. And basically you get online, you file, fill out this information to say who are the owners of this company. And it's a new law they enacted to prevent money laundering. So everyone that has a company has to fill this out. If you have an existing company, you have till the end of this year to do it. If you create a new company, you have 30 days to fill it out. So it's not just a one and done. Once you set up your company, there's still things you need to follow. That's why I always recommend calling an attorney to know how to do these things and they will take care of it for you. So you have to fill out Beneficial Owner Report as well. And The details of how you fill that out and, you know, what are the requirements is room for a whole nother episode that we may do eventually. But just know that you have to fill that out. So once it's set up, you have to follow certain formalities to achieve the protections of an LLC. So you have the approval with the state, you have the operating agreement, and you have to maintain that validity with the state. So you have to pay your franchise tax every year. In Arkansas, I can't remember if it's $250 or $350 a year, but it varies by state. Some states are cheaper, some are more expensive, but you pay your yearly tax to stay up to date with the state. And then you need to have annual meetings, really even quarterly, where you keep minutes to show that you are acting as a real company. You're meeting with your shareholders, even if that shareholder is just you or you and your spouse. Y'all need to have a meeting and you need to document it. Minute. Now, why do we have to go through those formalities? Because if you're ever sued for any reason, every attorney will start with trying to— they call it pierce the corporate veil— is show that this entity that you have set up is not a real entity and you're not following the formalities. So they will try to get through the LLC, pierce the veil, and get to you personally. And we don't want that. We— that's why we set up the LLC. We want asset protection. So you want to follow all the formalities so you can show, yes, we set it up the right way. We've maintained it. We have a bank account. Everything we do is through this business, not us personally. And then that's how you get the protection. So there's a lot of formalities that you have to keep each year. And then one other thing I wanted to talk about is the tax election. A benefit of an LLC is you can elect how it's taxed. And you can't always do that with partnerships or with corporations. And by that, I mean, there's a few options on how you tax an LLC. One, it could be a disregarded entity, meaning it's taxed as you personally, same way you file your taxes today. It just taxes through you. Another one is as a partnership. It was taxed just like a partnership. One is as a C corp. So you can tax an LLC as a corporation. Another is as an S corp. So you can tax an LLC as what's called an S corp. And, um, that is room for a whole other episode. There's a lot of benefits of being taxed as an S corp depending on the type of business you run, and it can save you a lot of money. Um, so a lot of people, clients come into me, they have a business, and I'm trying to dig in and figure out how do I pass on this business to their heirs. To do that, I need to know what type of businesses it is. So I say, would you have an LLC? They reply, no, I have an S corp. That is not an accurate statement. So an S corp is a tax election, but your entity needs to actually have a structure to it. And that structure is usually an LLC. Sometimes it's just a sole proprietorship and they are electing to be taxed as an S corp. But you need to know the difference that first you have the entity, you have the structure that owns your business. Which is an LLC, and then you elect the tax election. So try to get clear on that. If you are not sure, ask your CPA, hey, do we just elect this election or do I actually have an LLC set up? And it can vary. So you want to make sure all the formalities are followed so you get the protection that you signed up for. So that's generally how you set up an LLC. Now, how do we pass it on to the next generation? This is a lot of what I do is business succession. So let's start with the premise that there is just one owner, you know, say a husband owns a business and it's his LLC, has no other partners. How does he pass that on to, say, his wife and then his kids? Well, typically when I start talking with a business owner, we usually start with a revocable trust because you can't pass on a business outside of probate unless you have separate agreements in place. And usually if you're the sole business owner, there's no one to pass the business on to because there's no partners in that operating agreement. So what you do is called an assignment of business interest, is you assign your interest to the trust so when you pass away, your trustee can take over and manage the business. Maybe that you want them to keep the business running because your spouse needs that income and relies on that to live her life. Wife. So maybe you leave the business to your son who acts as trustee and manages the company. He runs it, but your wife still gets the benefit from it. Or maybe there's a lot of assets in the business when you die, like equipment, real estate, that kind of thing. So your trustee immediately takes control and can then sell those assets and liquidate the business in a responsible manner. Um, so your wife gets the income and the access to everything to maintain her lifestyle. So basically, when you assign a business to a trust, it just gives you the ability to not interrupt operations of that business. When you pass away, someone can immediately step in as manager. And that's important to do because if you do not have this in place, your business will get stuck in probate. No one is acting as manager and it will just kind of flounder for a little bit and then your spouse and your kids could lose that income that they depend on. So We call it an assignment of business interest. And if you're a business owner, you need one of those and you need a revocable trust and they need to work together. Now let's, let's take that same situation with a single business owner. If they want to pass on their business to their kids, you know, a lot of times I see this a lot with family farms. You have a son that is involved in the business, wants to continue farming, relies on that for his income. But you have a daughter or another child that is not involved in the farming business. They're off doing something else with their career. Most of the time, parents want to provide for each of their kids equally, but they want to make sure the son gets the business. So one instance where we start is evaluating how do we make this equal? Let's say we, you pass away within your trust. It says, I leave my business to my son. And then I leave something of equal value to my other kids. So everyone's treated fairly. They get what they want. Um, and then you kind of figure out, well, how do you value the business? There's a lot of options for that. You can say, hire an independent business appraiser to say, hey, this is worth $1 million. My son gets this value of $1 million. My daughter gets life insurance or a retirement account of that equal value. Whatever's left, they split it equally. You can hire a business appraiser, or you can just name a value on that business each year, or you can say, let's look at the last 3 years of revenue and get a multiple of that to decide how we value the business. But there, it gives you a lot of options to, within a trust, once your business is assigned to that trust, of how you distribute things fairly and equally. Now, let's talk about about another scenario where you own a business with a partner. So, you have another partner, not in the family, just a business partner. Y'all came together, y'all chose to be business partners, you trusted each other, you saw value in each other, so you chose to be business partners. What you didn't choose is to be partners with each other's spouses. And why is that, that a concern? Well, if one business owner passes away, His spouse would, without an estate plan in place that says otherwise, his spouse would inherit his interest. So all of a sudden you've got Business Owner 2 that is now partners with Business Owner 1's spouse, and that is not what they signed up for. Or even spouse, it could be kids. So a lot of times we start talking about what is called a buy-sell agreement when you have partners. I think every business owner needs to have a succession plan in place. And if you have partners, that can usually be some sort of buy-sell agreement. So what is a buy-sell agreement? Well, it's an agreement for one partner to buy, one partner to sell, and vice versa. They each agree to buy and sell their shares if something happens to the other. Um, practically speaking, say owner one passes away, they have a buy-sell agreement in place, meaning owner two pays owner one's estate a certain amount and buys out the business. So, owner 2, the survivor, owns the business wholly. Owner 1 gets cash, meaning the spouse gets enough cash to maintain their lifestyle and can walk away clean and clear of the business. The other owner owns it by themselves. So, a lot of times that's what you want, especially if there's no kids that are involved in the management and step up. You want to make it clean, clear, and laid out. And buy-sell agreements can happen upon different occurrences. One obviously is death. So, if one owner passes away. Another is disability. If they are disabled for a long time, can no longer contribute to the business, they need to be bought out. Or retirement. Let's start with death. So, we mentioned how it works, but how is it funded? So, how does the business get the money to buy out the other owner? The best way, if you plan ahead while owners are young and healthy, is life insurance. You get a life insurance in place that is paid for by the business. Let's just say the policy is $2 million and we'll ballpark it, say you have $2 million on each person or the survivor of them. And let's say the business is worth $4 million. So, when one owner passes away, his half is worth $2 million. So, they take those life insurance proceeds, buy out the other owner's share, And the new owner owns it solely. So, it's funded by life insurance that was paid for by the company. Neither party is technically out of pocket for it. It's all paid for by the company. Um, there's tax benefits with that, but it's clean and clear. Now, sometimes people wait too late or maybe it's just not— their health isn't in a good, uh, situation where they can qualify for good life insurance at a good rate. Um, so then we start talking about other options., you can buy out each other over a period of time, meaning the business just pays out a certain amount each year until that valuation is bought out. Or maybe they have to go to a bank and get a loan and buy out the survivor. Um, so those are options too. In those instances, we want to think about how do you value the business? Most commonly what I do is you look at the last 3 years of financials. And pick a multiple of revenue. So that's how you agree on the value. So you're not, if you die after a really good year or a really bad year, your spouse is typically fairly compensated because you're looking at the last 3 years. That's what I do a lot of times. And I've had this in place for clients too upon retirement. I have a business that was, you know, maybe there's 6 owners. One of them, a few of them are active in the business. One decides he wants to retire. How does he get bought out of the business? We look at that last 3-year multiple. That's pretty common too. So the business can keep running, the other owner can retire and get out of the business. Same with disability, all that. So a buy-sell agreement is a great method to have in place if what you're wanting is clean and clear. If not, you can assign different interests to a trust. Maybe you do have a partner, but your son wants to take over your share of the business. As long as the other partner agrees to that, we can put that in the bylaws that that's okay. That a trust can inherit interest and management can pass on within a certain number of people or certain family members. So the takeaways for all this is set up an LLC for your business, follow all the formalities, get it set up right. And then once you have it set up right, make sure you have a succession plan in place. Come talk to me. We can bounce around the different ideas of the best methods. There's all kinds of methods, like we mentioned the trust, the buy-sell agreement. Even within operating agreements, you can facilitate succession. So there's a lot of options that just depend on the type of business you're in. And the main thing is it's important to have a succession plan in place. So that's been another episode of the Good Steward Law and Wealth Podcast, where we believe everything is a gift and it is our duty to do the best with what we've been given and be good stewards of our wealth.

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