Business Entities for Estate Planners: Preview and Introduction
Deciphering the alphabet soup of business arrangements
Table of Contents
Intro and Video
Wealth transfer professionals of all stripes often find themselves assisting clients who have interests in business entities. And while there is a ton of information out there on the nuances of wills and trusts, there is a surprising dearth of basics when it comes to business entities themselves. The now-defunct (as least with respect to domestic entities) Corporate Transparency Act brought some principles of entity formation and governance into focus, but not necessarily with a frame of comprehensive understanding.
Familiarity with the principles of business entities can also vary between practitioners. Even if you are familiar, a refresher can be helpful. So, even if the subject matter seems light at first, don’t be discouraged from reading further.
To start, let’s consider the core purposes of a business entity. While there are several reasons beyond these for creating a business entity, the following tend to be the significant drivers of formation:
To conduct an active business for purposes of generating profit;
To hold investments and non-business assets, short-term or long-term, for management purposes whether or not there is a profit-seeking motive; and
To protect the personal assets of owners of the entity from claims against the business entity, and vice versa.
Again, I remind you that these are not all-inclusive. But, these principles can perhaps be illustrated by comparison to the most basic form of business – the sole proprietorship. Many businesses were traditionally formed as sole proprietorships, which is a bit of a self-explanatory name in that it describes the ownership situation of one owner. In a sole proprietorship, that one owner directly holds title to all assets used in the business.
Of course, this represents a challenge. Let’s say the sole proprietor has a long-standing employee who wishes to have an ownership stake in the business. In this situation, there is no real “equity” to give to the long-standing employee – instead, the sole proprietor must essentially give the employee a tenant-in-common ownership interest in each of the business assets. While this does not seem impossible in theory, keep in mind that a business does not just consist of assets. It also consists of liabilities. The true difficulty lies in having the new employee assume a portion of the business liabilities as well, as this must be done on a per-contract basis. Many business contracts have restrictions on assignment or assumption which must be worked around, and a transfer of business assets itself may violate some of the covenants of such contracts.
Let’s contrast this with a situation where instead of transferring ownership to an employee, one wishes to take on outside capital investment. If the sole proprietor preferred having an investor to obtaining a loan from a bank, for example (which would be limited based on the income of the sole proprietor), they would run into the same challenges on asset ownership as highlighted above. But, there would be an additional challenge inherent in such a structure – again we cannot ignore business liabilities, but an outside investor likely would not wish to take on the business liabilities. In this light, we see the same challenge in transferring ownership of assets without also breaching covenants or forcing liability on the investor.
Finally, let’s say the sole proprietor wishes to engage in estate planning. As they examine the possibility of administration of their estate at death, they encounter the headache of requiring an executor to marshall and manage each business asset and liability (intermixed with all other personal assets of the sole proprietor) while either transferring ownership piecemeal or navigating a sale and winding down of the business. Likewise, use of a revocable trust might help avoid probate but still imposes the same asset-by-asset management on a successor trustee.
Obviously these outcomes are simplified for purposes of illustration and may not represent common business realities, but the underlying point is that business entities were developed to avoid this outcome. The idea is that the entity itself can own business assets and liabilities, creating greater ease of transfer along with consolidated ownership and management.
Of course, as highlighted above, running a business is only one common purpose in creating a business entity. This ease of transfer and consolidated management can make the “business” entity structure seem enticing in non-business scenarios. This is where our other two purposes – holding assets for investment/management purposes, or creditor protection, come into play. Increasingly, successful families with complex wealth holdings are utilizing business entities for non-business purposes. In this vein, it may even be the case that one business entity holds an interest in another business entity.
Which brings us to the first point in a business entity – how do we classify ownership?
Debt Versus Equity
Many entity ownership structures break down interests by classifying them between two extremes. On one side, you might have debt – which is not direct ownership, but could lead to ownership of an interest in the entity or its underlying assets if the debt is not satisfied. The other side is equity, which represents true ownership in the entity itself. In some cases, debt interests may be convertible into equity, but that is a subject for another time.
Circling back to the key differences, one of the basic principles of accounting is that the balance sheet always reflects the following outcome:
Assets = liabilities + equity
This accounting equation, which is the fundamental starting point of all accounting classes, reflects the dynamic that an equity interest reflects indirect ownership in assets of the business entity by value, but net of liabilities. This can be reflected in two other extremes – creation of the business entity, versus termination of the business entity.
When a business entity is formed, the equity interest is its own form of asset recognized by state law (which some nuances for partnerships, as we will later discuss). But, getting equity usually involves some form of exchange – usually for the initial assets transferred to the business entity. So, for example, a sole proprietor creating a business entity would transfer ownership of the business assets in exchange for 100% of the equity interests in the business entity. Liabilities would also need to be transferred and assumed or, as is more common, the sole proprietor may need to remain on the hook for those liabilities at least temporarily. For now however, for the sake of simplicity, we will assume there are no business liabilities or contracts.
This would lead us to an equal equation by value, of assets = equity. The assets contributed to the business are often considered capital. (Note that services can also be contributed for equity in lieu of capital, but this is a subject for later.)
During the lifecycle of the business entity, there may be profits generated. There also may be assets available for use by business owners. As a default, these net profits (and more rarely, use) get shared by equity owners in proportion to their overall ownership in the business entity. So, if there is one owner, they get 100% of the benefits generated by the entity. If there are two or more owners, by default, they would share benefits based on their percent of the overall equity ownership. Again, this is oversimplified, as this default treatment can (and often is) changed using complex equity ownership structures by class. And, keep in mind that profits usually first go to the payment of short-term and long-term liabilities – including interest accruing on debt – and may then be further retained by the business entity as a reserve for ongoing business maintenance and expansion.
Speaking of class of ownership, the other extreme mentioned previously – termination of the business entity – brings us back to our accounting equation of assets = liabilities + equity. When a business entity is terminated, its assets may or may not be sold (often called liquidation of the business entity). But the elimination of the business entity itself – often called dissolution - means we must convert the entity’s ownership of assets back into direct ownership. The hallmark of equity ownership is that you have the right to the assets, or liquidation proceeds, of the business entity if and when it is dissolved.
There is, however, a priority of state-law rights since liabilities are part of our equation. Following basic algebra, we can switch up our equation to be the following:
Equity = assets – liabilities
This means the amounts received by equity owners in an entity on dissolution will be net of liabilities. In other words, creditors of the business entity get paid first. This brings us full circle back to the question of debt versus equity. We don’t have to have debt, but if we do, it gets priority upon liquidation and dissolution of the business entity.
Interest in the Entity, and Classes
When we see the term interest in the context of describing ownership, this usually refers to equity ownership in the business entity itself. It does not mean the interest inherent in debt, as a cost of borrowing money. Distinguishing these two terms is important.
And as mentioned above, equity ownership can come in different classes. These classes can be reflected in different ways, but the common distinguishing characteristics are:
Priority in distributions of net profits,
Priority in distribution of assets or liquidation proceeds on liquidation and/or dissolution of the business entity; and/or
Rights to participate in the management of the business entity, at least on a day-to-day basis and sometimes even for higher-level decisions.
These priorities are often, but not always, described in order of priority using terms such as senior equity versus junior equity, or preference in terms of voting rights and distributions of profits and/or assets on dissolution or liquidation. Liquidation is highlighted in isolation here, because it may be the case that the business entity continues without dissolving but that the net proceeds of liquidation of core asset holdings get distributed to certain equity owners (as might be common in a hedge fund, or a real estate development project, for example).
Of course, however, liabilities of the business entity usually get satisfied before distribution to equity owners – even those holding classes of interests having distribution preferences. On that note, what happens if the liabilities are greater than the remaining assets of the business entity? And, might this treatment highlight a trade-off for some of the preferences of senior equity?
Equity Owner Liability
A common issue and concern with a business entity is whether the equity owners are on the hook if the liabilities of the business entity are greater than its assets. This might be the case if significant debts (and interest charges on that debt) are accrued beyond the assets and earnings of the business entity itself. It might also be the case if, for example, the business entity itself gets sued and incurs a court judgment (which itself becomes a liability of the business entity). This creates a shortfall which, if we keep our accounting equation constant, essentially reflects negative equity:
Assets = Liabilities + (negative equity)
If an equity owner is liable for this shortfall in business assets reflected in negative equity, they would have to satisfy the shortfall from their own assets. This is a risk many equity owners are not willing to take, at least without commensurate reward – a dynamic that will later be illustrated when we further discuss classes of ownership. Sometimes, this reward is reflected simply in the (sometimes sole) right to participate in the management of the business entity itself. Other times, there might be a greater preference as pertains to the net profits and liquidation proceeds of the business entity.
Many, but not all, equity ownership interests in a business entity create what is known as limited liability. Simply put, this means that an equity owner having limited liability is not at risk of satisfying negative equity from the entity owner’s personally-owned assets. This risk is then shifted to anyone holding debt owed by the business entity as a cost of extending credit. Of course, this risk is sometimes shifted back to some equity owners outside of the entity ownership structure by asking them to either pledge their personal assets as collateral for a loan to the business entity, or to personally guarantee the debts and liabilities of the business entity.
As we go along, we will further explore these dynamics. For now, however, it is important to note that limited liability is not absolute. Not all forms of business entity recognize limited liability, and among those that do, this limited liability can be lost if the business entity’s formal asset ownership and governance structure is not respected (in a process we will come to know as piercing the veil of limited liability). There may also be reverse limited liability concerns, whereby a business entity’s assets might get applied to satisfy the debts and liabilities of an equity owner in situations where the transfer of capital to the business entity by the owner frustrates a creditor’s efforts to collect on a debt.
Key Takeaways
There are several important elements of business entities to consider, but before previewing the upcoming articles in this series let’s take a look at what we have covered so far:
Business entities can streamline situations where ownership and management of business, investment, or personal use assets by multiple individuals would be burdensome.
Using our basic accounting equation of assets = liabilities + equity, we can see the key differences between debt and equity highlighted on the left side of the equation with equity ownership of the assets and net profits of the business entity taking a back seat to debt.
Multiple classes of ownership can be used to create different priorities, after debts and liabilities are taken into account, to the net profits and liquidation proceeds of the business entity.
While many equity ownership interests grant limited liability in a situation where the liabilities of a business entity exceed its debts, this is not a universal outcome. Some types or classes of equity ownership, as a trade-off for distribution or management preferences, may take away liability protection. In addition, some lending or contractual arrangements may bypass this structure by asking equity owners to pledge or guarantee payment by the business entity if the business entity is not able to satisfy its liabilities in full.
Coming up in this article series, we will start exploring some of the various forms of business entities, their tax nuances, governance structures, and other key principles.