| We have all heard the old adage that it isn't wise to put all of your eggs in one basket. But does this saying apply to the world of business ownership? Specifically, is it a valid warning or just a worn-out cliché? In the areas of retaining corporate identity and branding, it seems to make sense for owners to concentrate all of their business effort and ownership in one entity, rather than creating multiple entities. However, from a tax, liability, income distribution and, ultimately, exit planning perspective, concentrating all of a company's wealth and assets in one entity can actually create more harm than good. For instance, operating a business as a single entity can:
Make it easier for future creditors to attack and attach to all of an owner's business assets
Result in unnecessary income taxation and avoidable estate taxation
Complicate, not facilitate, key employee incentive planning
Consequently, delay an owner's exit from the business
If using multiple entities solves the problems listed above, then why aren't more business owners creating separate business entities? For one, most business owners are so wrapped up in the day-to-day responsibilities of running a business that the concept of creating multiple business entities to establish a positive tax planning, continuity planning and asset protection planning environment may never cross their minds. That is, unless they have a trained exit planning advisor who understands that shifting from a single business entity to multiple parallel entities can provide significant benefits to business owners.
Particularly, the strategy of creating multiple entities can be most effective in situations where business owners want to provide income to young children, deduct premiums for long term care insurance, wind down a C Corporation, pay for life insurance funding and distribute proceeds under a multi-owner buy-sell agreement, include employees in ownership of new or discrete aspects of the business, and provide liability protection to the core business.
This series of articles will provide an overview of how multiple business entities can serve multiple purposes for your business owner clients, as well as discuss when it is appropriate for advisors to recommend this type of planning technique. The remainder of this article will specifically discuss the scenarios in which multiple entities can be a favorable solution for owners who are interested in minimizing taxes while obtaining long term care insurance; need a structure where tax efficiently provides a stream of income to their children; and are concerned with protecting the core business from liabilities caused by business operations.
Scenario No. 1: C Corporation including LTCI
I've met few business owners who believe they should pay more taxes every year. However, most are frustrated with the inability to engage in meaningful tax planning that reduces the annual tax bite. This scenario fits the bill for those types of owners who are interested in minimizing taxes, as well as need long term care insurance (LTCI). The typical companies that this planning is appropriate for include S Corporations or other pass-through entities that can't deduct long-term care insurance premiums with separate business and income streams that can be segregated in a new entity. Examples of these companies may include software companies with training activities, a consulting business with hardware sales, truck leasing companies with a service and repair element, and management services companies with several small project-based divisions.
If you have clients that fall within the parameters of this scenario, the next step is to ask the following questions to uncover the specifics of your clients' situations:
In discussing your financial needs, to what extent are you concerned about nursing home expenses and similar health issues?
What arrangements have you made for possible health issues in the future?
Has anyone walked you through the purpose and structure of LTCI? The tax consequences?
A separate C Corporation that operates a separate and marginally profitable aspect of the existing business can use its income to fund premiums for a long term care insurance policy. These premiums are deductible to the corporation when paid by a C corporation, but not when paid by a pass-through entity such as an S Corporation. The tax savings from the deductibility of the premiums often exceeds the cost and administrative effort involved in creating and operating a separate entity. The C Corporation must be engaged in a valid business activity so it is important to conduct a careful analysis before choosing this strategy.
Scenario No. 2: S Corporation or LLC to provide children with income
A common objective of many business owners with children is to provide a stream of income to their kids, especially if the children are near college age (i.e., old enough to be somewhat responsible and young enough to not have substantial income). Many owners also want to transfer wealth from their estates to their children while indefinitely controlling the timing and the amount of the wealth being transferred. A multiple entity solution can allow these owners to not only achieve these objectives, but also minimize total tax dollars in the process.
To do so, you can help owners create a separate pass-through entity, such as a limited liability corporation, or LLC, to own income-producing assets (such as an equipment LLC, or a real estate LLC) and gift a minority interest in that LLC, either directly to the owner's children or to trusts created for their benefit. The LLC can then lease the land to the business operating entity, thereby insulating the land from the operational risks of the business. The LLC and the business can enter into a long-term lease, thus providing income to the LLC.
If you have clients that fall within the parameters of this scenario, the next step is to ask the following initial questions to uncover the specifics of your clients' situations:
What income level and/or asset value is appropriate to shift to children?
During what time period should children receive income?
Will income to children be unequal? If so, is this a problem?
The ownership interest would be gifted to the children, applying standard minority and lack of marketability discounts as applicable. This technique removes that share of the property from the owner's estate and, more importantly, removes the future appreciation in the value of that property from the owner's estate. Just as importantly, the income attainable to the LLC interests owned by the children (or their trusts) would be taxed to the children (if at least 18 years old in 2007 and older in future years) at their individual, and hopefully lower, tax rates. Parents who manage the LLC can time asset
acquisition and disposal, manage income levels in the LLC, and direct distributions from the LLC on a schedule that coincides with tuition payments, the purchase of a car or other major expenses.
Note: The rules related to passive income earned by children that determine whether the income will be taxed at the child's rate or the parents' rate are changing and should be reviewed carefully in each unique planning situation.
Scenario No. 3: Protecting the core business from liabilities caused by business operations
One of the first questions that business owners ask when advisors mention the use of multiple entities to limit liability exposure is, "Why do I need to create multiple entities to protect my assets? I already have all of my business interests in a corporation (or other entity) that provides liability protection. Doesn't that protect me and my business?" The short answer is yes and no.
While putting all of an owner's assets in a limited liability entity such as an LLC or corporation can provide personal liability protection to the business owner, there still is one important exception: If the owner is responsible for the event leading to the liability (as is often the case in smaller businesses) the fact that the company is a limited liability entity doesn't protect the owner from personal liability.
Furthermore, there is little asset protection for the owner or the business if a creditor is successful in its action against the company. Since the bulk of most business owners' wealth is in the assets of their companies, a successful creditor attack against the company can wipe out the majority of most owners' wealth by wiping out the value of the ownership interest in the business. A valuable asset inside the entity, such as a valuable contract, cannot be shielded from liability created by the owner or another asset in the company (such as equipment).
In situations such as these, creating multiple entities can be a viable and relatively straightforward solution. If one entity is attacked successfully by creditors, its assets will disappear. But if properly planned, the bulk of the overall assets, contained in the other entities, will survive intact. For example, a multiple entity plan can be favorable for a company with several retail locations, each of which have their own exposure to operational liabilities such as employee-based law suits or customer-based law suits. By creating a separate legal entity for each location, the liabilities of that location will more likely be confined to the assets of the particular location and entity. However, if a business owner runs a business with just one location, his or her ownership interests would be better protected if he or she separated the real estate (or perhaps the equipment used in the business) from the operations.
If you have clients that fall within the parameters of this scenario, the next step is to ask the following initial questions to uncover the specifics of your clients' situations:
How are projects and tasks of the business organized?
How are customers categorized?
What assets are most valuable?
What aspect of the business or element of a project creates the most risk to the company?
One common planning technique is to transfer hard assets (such as real estate, equipment and inventory) into an LLC (similar to the second scenario in which the LLC is owned solely by the business owner and his or her family) and the operations in a separate entity (such as an S Corporation or LLC). Once again, valuable hard assets will tend to be protected from the liabilities of the business operation.
Conclusion
As you can see, with a bit of planning, it is relatively straightforward to implement a multiple entity strategy that accomplishes the following:
Minimizes taxes while obtaining long term care insurance with tax-deductible premiums
Tax-efficiently provides wealth or a stream of income to an owner's children
Protects the core business or assets from liabilities caused by business operations
John H. Brown is the president of Business Enterprise Institute, Inc., the only single source of education, marketing support, and plan design for advisors of business owners. BEI teaches professionals in a variety of disciplines (accounting, law, business consulting, valuation, banking, insurance and financial planning) how to use Exit Planning to attract and keep high-caliber business owners in their practices. Brown is also a founder of the Denver law firm of Minor & Brown, P.C. Brown began his practice as an estate planner, but over the last 30 years he has represented hundreds of business owners as they work to orchestrate successful exits from their companies. As president of BEI, Brown has taught thousands of advisors how to solve their clients' most pressing problem: how to exit their companies in style.
Brown is the author of two books and numerous articles in the areas of estate and exit planning. His first book was published by the American Management Association in 1990 and focused on:
1. Creating and preserving business wealth;
2. Transferring business value to others profitably; and
3. Integrating business ownership with personal financial, tax and estate planning objectives.
http://www.exitplanningforadvisors.com
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