Family Business Entities: Preserving Wealth and Minimizing Taxes

• Publication year: 2003
• Pages: 11

32 Colo.Law. 11 Colorado Lawyer 2003.

2003, November, Pg. 11. Family Business Entities: Preserving Wealth and Minimizing Taxes

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11

Vol. 32, No. 11, Pg. 11

The Colorado Lawyer
November 2003
Vol. 32, No. 11 [Page 11]

Articles

Family Business Entities: Preserving Wealth and Minimizing Taxes
by Allen Sparkman

Allen Sparkman is a partner in the Denver/Boulder firm of Sparkman · Shaffer · Perlick LLP - (303) 449-6543, sparkman @sspattorneys.com. Sparkman is Secretary/Treasurer of the CBA Business Law Section and is a member of the Business Advisory Committee of the Colorado Secretary of State

A client or client's advisor may ask an attorney whether the client should establish a family limited partnership ("FLP"). For business, tax, and estate planning purposes, this article examines what can be accomplished with an FLP. Practitioners need to know about FLPs in order to recognize situations in which one might be appropriate

Although the term "FLP" refers to a family limited partnership, sometimes the person using the term really has in mind a family limited liability company ("FLLC"). Also, attorneys may search in vain in Colorado limited partnerships ("LPs") and limited liability companies ("LLCs") statutes for any provision relating to an FLP or FLLC.1 Examining the FLP concept requires an analysis of entity selection factors in the family context. From a family's perspective, entity selection often attempts to achieve several goals, including minimizing taxes, achieving limited liability, and preserving the value of a business or investment for the family

An examination of all of the myriad legal problems facing family businesses would require a lengthy treatise.2 However, this article intends to cover most of the important factors in choosing the type of entity when the client's goals are primarily wealth preservation (including estate planning), or family succession, with respect to investment assets or real estate that may or may not be used in an active business. Except as specifically noted, only Colorado entities are discussed.

This article first describes the formational and operational aspects of the entities that may be employed to achieve the goals of wealth preservation or family succession. Following an examination of the income tax differences among the various forms of entities, the article notes certain creditor protection characteristics. Finally, the article surveys the use of family business entities to reduce federal estate and gift taxes.

OVERVIEW OF POSSIBLE

ENTITIES

Although a family business entity is likely to be a corporation, LP, or LLC, a family instead might use a general partnership or limited partnership association ("LPA").3 Until a few years ago, achieving the goals of minimizing taxes and limited liability usually resulted in the use of a corporation (in the case of an active business) or an LP (in the case of investment property). The corporation should elect to be taxed as an S corporation, described below, to avoid double income taxation.4 The LP should be organized with a corporate general partner so that no individual would have personal liability for the entity's obligations, and the LP should be structured carefully so as to ensure classification as a partnership for federal income tax purposes.

The enactment of Colorado statutes permitting the registration of general partnerships as "limited liability partnerships" ("LLPs") and LPs as limited liability limited partnerships ("LLLPs") enables all partners, general or limited, to avoid unlimited liability for the obligations of the partnership.5 In addition, the promulgation of "check-the-box" regulations6 by the Internal Revenue Service ("IRS") eliminated previously applicable complex rules for avoiding classification of a partnership or LLC as a corporation for tax purposes.

Now, under these regulations, unless the taxpayer elects otherwise, any domestic unincorporated entity with more than one owner will be treated as a partnership for federal tax purposes, and any single-owner unincorporated entity will be disregarded for federal tax purposes. The same treatment applies for Colorado income tax purposes.7 Any Colorado entity a family is likely to use to achieve wealth preservation or family succession goals - corporation, LLC, LP, or general partnership or LPA - can achieve one level of income taxation and limited liability for all owners.

Other entities, such as cooperatives or professional entities, either could not, or are not likely to, be used for family estate planning, wealth preservation, or family succession planning purposes. Accordingly, they are not discussed in this article.8

Corporations

Corporations are the most common form of entity, but, as discussed below, corporations are not chosen for family business purposes as often as are LPs and LLCs.9 A corporation is formed under the Colorado Business Corporation Act ("CBCA") by the delivery of articles of incorporation to the Secretary of State for filing.10 The same form of corporation will be formed under the CBCA whether the corporation will be a C or an S corporation for income tax purposes.

The articles of incorporation usually contain only the few provisions required by the CBCA, such as the name of the corporation, names and addresses of the incorporators and registered agent, principal office information, and minimal provisions regarding the corporation's capital structure.11 The basic rules governing the election and term of office of the directors and officers, shareholder meetings, and shareholder voting typically are set forth in the corporation's bylaws instead of in its articles of incorporation, although the articles also could contain such other information.12

A shareholder of a corporation has no management rights as a shareholder. The CBCA contemplates that the business of a corporation will be managed by its board of directors.13 Directors are elected by the shareholders.14 Unless denied by the articles, cumulative voting applies to shareholder elections of directors.15

The CBCA provides that directors are to act either through actual meetings or by unanimous written consent.16 However, in the case of closely held corporations in situations in which the directors personally and directly conduct the business, informal action may be valid if consistent with the customs and practices of the corporation (but is not recommended).17 Unless there are contrary provisions in the articles of incorporation or bylaws, the owner of one-half plus one (51 percent) of the issued and outstanding shares of a corporation has the power to control the corporation by electing all directors and approving major corporate transactions.18

The shareholders of a family corporation also often enter into agreements such as shareholder agreements, buy-sell agreements, and voting trusts or voting agreements. A shareholder agreement may restrict the transfer of shares to a divorcing spouse, may provide price and payment terms for any purchase of stock, may provide for voting and management rights, and may include restrictions on transfer of shares to protect S corporation status. Buy-sell agreements are similar to shareholder agreements except that they generally cover only transfers of shares. Voting trusts and voting agreements are mechanisms whereby one shareholder may transfer the right to vote his or her shares to a trustee or to another shareholder.19

Limited Liability
Companies ("LLCs")

An LLC is formed by delivering articles of organization to the Secretary of State for filing.20 The owners of an LLC are known as "members." Colorado law permits single-member LLCs; accordingly, an LLC, like a corporation, may have only one owner.21 LLCs may be either member-managed or manager-managed. This choice must be specified in the articles of organization.22 The statute contemplates that the articles of organization of an LLC will contain only other basic information, such as the LLC's name, principal office, and registered agent information.23 The specifics of the members' intentions will be set forth in the operating agreement.

Every LLC has an operating agreement because the statute supplies one if the members do not adopt one; that is, the Colorado Limited Liability Company Act ("Colorado LLC Act") provides rules for the allocation of profits,24 member meetings and voting,25 duties of the managers,26 and dissolution,27 among other things. With only a few exceptions,28 the members may adopt an operating agreement that varies any of the statutory rules. In some situations, the statute permits variation from the default rule only in a written operating agreement.29 The parties to an LLC operating agreement have tremendous flexibility in defining the duties and responsibilities of the managers and members and in providing other rules for the operation of the company.30

An LLC that is managed by its members will have more of a partnership feel than an LLC managed by one or more managers, especially if the managers include non-members. An LLC may have any number of classes of members. The membership classes may have different rights to income, distributions, or capital appreciation,31 as well as different voting rights.32

If an LLC is manager-managed, a member may have few management rights other than the right to vote for a manager. In an FLLC, the manager often will be named in the operating agreement and may not be removed except by a super-majority vote. Unless varied by the operating agreement, members of an LLC vote per capita.33 However, it is common for voting to be by economic interest.

The operating agreement for an FLLC likely will contain...