Structure family business wisely to aid succession

Business owners have a lot to think about: product and service development, human resources, marketing, and sales. Maintaining the right business entity structure may not be high on the list and, even when it is addressed, may not be something to which business owners devote a lot of future-oriented thought. But choices business owners make about the structure of their businesses could have important consequences down the road.

In particular, when mature owners decide to retire, there could be complications as they try to pass their companies, parts of their companies, or the business value of them on to their children. All individuals impacted by a family business transition should consider the opportunities and challenges related to entity structure, how owners can overcome them, and the best ways to avoid them in the first place.

The benefit of thinking ahead

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The following client example illustrates how the choice of entity structure can have a real impact on succession:

The founder of a company had two children, both of whom had aptitude for and interest in the business. Upon becoming shareholders in the company, the children, then in their early 20s, received dividends equal to those received by the founder. For the founder, the value of his dividends were needed to cover taxes, while, for the children, only half of the value was needed for taxes. Thus, the children ended up with large amounts of cash much earlier than the founder expected or would have chosen.

This situation resulted from having an S-corporation structure, which requires that distributions be paid out on a pro-rata basis. While a partnership structure would have allowed more flexibility in how distributions were paid, the founder didn’t know what the future held when setting up the business. Because the business transition had been put into motion before the structure could be changed, it was critically important that the children received professional advice on wealth management to ensure they managed the distributions wisely.

Another factor strategic owners should consider ahead of time is future company control as in this example:

A couple that founded a company was ready to start thinking about retirement and wanted to transition value to their children yet continue to maintain control over the company. The solution was to set up voting and nonvoting stock; the children got the financial benefits of nonvoting stock, while the couple maintained control with voting stock.

While most situations can be similarly resolved, it is ideal to initially set up a structure that covers likely future scenarios.

Advice for business owners

This means business owners are faced with a challenge not only at startup, but also at various decision points afterward. When thinking about the future of a business, owners should ask themselves some fundamental questions about their visions:

• Do I eventually want the company to go public?

• Will I be trying to raise money for the business?

• Will I want to distribute shares/ownership to family or nonfamily members?

If the answer to all of these questions is “no,” then an S-corporation arrangement may be the best entity structure. Although it can be less flexible, it’s very simple to operate tax wise, and there may be no reason for business owners to subject themselves to the potential complexities of a partnership. However, a partnership may be a better alternative and may make life easier down the road if these scenarios are likely to come up and if flexibility is important.

Once the appropriate entity structure is in place, business owners should review it upon any of the following events:

• When the company is looking for financing.

• When the company is considering acquisition to grow.

• When the company expands into a new geographic location (especially overseas).

• When the company is going through a difficult time.

• When owners want to retire or transition.

Determination of entity structure might not be top of mind for entrepreneurs and executives with rapidly growing family businesses. However, because of possible future repercussions, it’s something company leaders should take the time to consider regularly. In particular, when owners plan to pass the business on to the next generation, the company’s structure could limit how it gets done. There’s no one right structure for every company, so business owners should think carefully about the future and examine options for the best ways to accomplish their business and personal goals.

The important thing to remember is that it’s never too late to address this issue, and there are always solutions available.

Mike Grell and Brent Hendricks are partners with EKS&H. Contact Grell at 970-282-5400 or mgrell@eksh.com.