The legal structure of your family business need not be permanent. You can change the structure to meet the needs of your evolving family business. Your business’ legal structure plays a role in determining your tax rates, governance and filing requirements, liability protections, transitions to the next generation, and more. As your family business grows, and its unique needs change over time, it’s worthwhile to take some time with your attorney to consider whether a change in business entity type might better align your business’ interests with your family’s priorities.
This is the first of several periodic articles on converting the form of your family business entity to suit your current and future needs. The articles will provide an overview of the factors you should consider when deciding whether and how to convert your family business from one legal structure to another.
The articles will focus on the factors to evaluate when considering entity conversion in California, and the business and legal implications of certain entity types. We begin by explaining entity conversion and the key reasons you may wish to change the form of your family business. In future articles, we will describe other possible conversion options including through dissolutions, reformations, mergers, and statutory conversions.
How is My Business Organized Now?
If you have started a business, but have not taken the time to complete any of the formal steps needed to select the right type of entity for your business, you will likely be deemed to have one of two types of entities: (1) a sole proprietorship, if there is one of you, or (2) a partnership, if there are two or more of you.
A sole proprietorship can only exist where there is a single owner of the business. You and the business are the same. A partnership, on the other hand, will exist by operation of law whenever there are two or more individuals who own the business. As your family business grows and prospers you may wish to convert your sole proprietorship to a corporation or your partnership to a limited liability company (“LLC”).
What Is Entity Conversion?
A business entity conversion is a legal process established by the legislature in a statute by which you can change the form of your existing business from one type of entity to another. For instance, you can change a partnership to an LLC or an LLC to a corporation. In some instances, you can do so in reverse.
Most of the time your business will change from a relatively simple organizational structure – like a partnership – to a more complex structure – like an LLC or corporation. A “converting entity” refers to your family business prior to conversion, and the “converted entity” refers to your family business after a conversion is complete.
What are Some Reasons to Change the Form of Your Business?
Changing the form of your family business is sometimes advisable as the business grows and your family’s needs change. Some of the key reasons to change the form of your family business are reducing tax burdens, formalizing the business entity’s governance requirements, protecting against personal liability, and accommodating changes among the family members responsible for running the enterprise.
Minimizing the Tax Burdens on You and Your Company
Tax requirements differ depending on how your family business is legally structured. Your business entity form determines, at least in part, your tax rates and paperwork obligations. The business entity you choose should help separate your personal and business income.
- Sole proprietors classify their business income as personal income and are taxed at only one level.
- C-corporation income is taxed at two levels; first as business income, and then, if distributed to its shareholders, as personal income.
- S-corporation income is taxed one level, passing through the corporate enterprise and falling first and finally on the shareholders’ individual tax returns.
- Limited liability company income can be taxed at either one or two levels, depending on the tax election made by the managing members.
The tax consequences of changing the form of your business entity are fact-specific and will likely have a significant economic impact on your company’s and your co-owner’s tax returns. When and if you decide to change the form of your family business, it’s important to work with competent legal counsel and qualified tax accountants to ensure you complete all of the legal work properly, and you prepare and file all the required tax forms with the appropriate taxing authorities timely.
Formalizing the Corporate Governance Requirements
The statutes and regulations in effect in California that apply to the different types of business entities your family business can assume – or convert to – are crucially important to determining which type of entity is most appropriate for your business.
Depending on how the organizational documents of a limited liability company are drafted, the members or managers of the company may or may not owe fiduciary duties of loyalty and care to the company and all of its members.
The officers and directors of a California corporation will, in almost every instance, owe such fiduciary duties to the corporation and its shareholders, and will be unable to waive those duties by contract (e.g., bylaws).
The creation of, or conversion to, a limited liability company or corporation involves the preparation and adoption of several important contractual documents that will govern the management of those types of companies, and explicitly state who has the authority to act (or not act) on behalf of the company.
You should work with competent legal counsel to make sure the existing form of your family business provides you and your co-owners with the legal protections and management flexibility to grow your business in a manner that protects and suits your family’s needs.
Protecting Against Personal Liability
Reducing the risk of personal liability while running a family business becomes increasingly important as the business grows because the risks associated with running the enterprise increase in both scope and number as your customers, vendors and employees increase and change. Some forms of legal entity offer significantly more protection against personal liability than others.
While owners of sole proprietorships and partnerships are personally liable for all of the obligations of their businesses, LLCs and corporations offer significant protection against personal liability for any of the debts, obligations or wrongful actions of the company or corporation and any of its managers, directors, officers or representatives in the course of running the business. When run properly, while the assets of an LLC or corporation may be at risk from mismanagement, missed business opportunities or broader economic downturns, the personal assets of the LLC’s members or corporation’s shareholders will be protected.
Accommodating Generational Changes in Management and Ownership
As the years pass, and your family business grows, the founding generation will inevitably wish to pass day-to-day management, and ultimately ownership of the business, from the founding generation to the next generation. That can be tricky for a number of reasons.
A family limited partnership (“FLP”) offers a form of business entity that is uniquely structured to allow for a relatively smooth transition in management and ownership of your family business from one generation to the next. In a typical FLP, parents transfer assets to the partnership in exchange for general and limited partnership shares. They retain their general partnership shares, and the limited partnership shares are distributed among the children and grandchildren. Because an FLP is a separate legal entity once assets are properly transferred to the FLP’s ownership they become property of the FLP. This effectively places the assets outside the reach of potential creditors of the individuals who owned the assets prior to transferring them to the FLP.
An FLP is run in accordance with its partnership agreement which means general partners retain control over the FLP’s assets. Because the partnership agreement can be amended the FLP retains a measure of flexibility for its general partners. Transferring assets to an FLP removes them from the general partners’ estates, which effectively reduces their estates’ size and lowers the estate tax burden.
An FLP allows individuals to distribute their wealth to heirs through limited partnership shares. The value of such shares is less than that of the assets held by the FLP because their appraised value is discounted due to factors like limited marketability. Once assets are transferred to the FLP, the general partners can take advantage of the annual gift tax exclusion to implement a gradual transfer of the FLP’s interests to their children and grandchildren. So long as the value of the limited partnership shares falls under the annual gift tax exclusion threshold the distributions will not be subject to gift taxes.
As a limited partnership, the FLP is taxed as a pass-through entity. This means the FLP is not subject to taxes itself. Instead its profits and losses are passed to the general and limited partners in proportions equal to their interest in the FLP.
The FLP takes advantage of the typically lower tax brackets of its limited partners. For example, a child who is attending college will likely be in a lower tax bracket than their parents and will pay a lower income tax. FLPs are complicated so it is important to work with competent legal counsel when you organize or reorganize such an enterprise.
Conclusion
As your family business grows it may make sense to consider changing its structure. Many small family businesses start as sole proprietorships or partnerships, but as they grow and prosper a more complex legal entity might become beneficial and help to facilitate the long-term success of your family’s business from one generation to the next.
Contact Finkel Law Group for Assistance With Your Family Business
Finkel Law Group, with offices in San Francisco and Oakland, has provided business counsel to many different types of business enterprises, including family businesses, in many different types of industries for more than 25 years. We have the knowledge and experience to help your company navigate the delicate legal and family issues associated with starting and growing a family owned business, and ensuring it succeeds from one generation to the next.
When you need intelligent, insightful, conscientious and cost-effective legal counsel to assist you with managing and planning for the future of your business enterprise, please contact us at (415) 252-9600, (510) 344-6601, or info@finkellawgroup.com to speak with one of our attorneys about your matter.