BUSINESS ENTITY RESTRUCTURING
USING HOLDING COMPANIES, LLC CONVERSIONS, SPIN-OFFS AND OTHER MEANS TO PROTECT BUSINESS ASSETS, SAVE TAXES AND IMPROVE LEGAL ARRANGEMENTS AMONG OWNERS OF CLOSELY HELD BUSINESSES
1. DEFINITION OF THE FIELD OF BUSINESS ENTITY RESTRUCTURING PRACTICE; THE IMPORTANCE OF THE FIELD *
2. OTHER DEFINITIONS RELEVANT TO BUSINESS ENTITY RESTRUCTURING PRACTICE *
3. THE CHIEF CHARACTERISTICS OF BUSINESS ENTITY RESTRUCTURING PRACTICE *
4. COMMON SITUATIONS CALLING FOR BUSINESS ENTITY RESTRUCTURING *
5. THE ROLE OF TAX AND FINANCIAL PROFESSIONALS IN BUSINESS ENTITY RESTRUCTURING *
6. PRINCIPAL STEPS IN THE BUSINESS ENTITY RESTRUCTURING PROCESS *
7. TYPES OF TAX KNOWLEDGE THAT TAX PROFESSIONALS NEED IN ORDER TO HANDLE TAX ISSUES IN BUSINESS ENTITY RESTRUCTURING *
8. TYPES OF KNOWLEDGE THAT BUSINESS LAWYERS NEED IN ORDER TO HANDLE LEGAL ISSUES IN BUSINESS ENTITY RESTRUCTURING *
9. CHIEF BUSINESS ASSET PROTECTION GUIDELINES RELEVANT TO BUSINESS ENTITY RESTRUCTURING PRACTICE *
10. USE OF CLOSELY HELD INSURANCE COMPANIES BY BUSINESS ENTITIES TO PROTECT ASSETS AND SAVE TAXES *
11. BUSINESS ENTITY RESTRUCTURING COSTS *
- Definition of the field of business entity restructuring practice; the importance of the field
Business entity restructuring is the field of tax and legal practice that seeks to systematically assist owners of existing closely held businesses to identify and implement the tax and legal structures that will be best for these owners for purposes of:
- Lawful tax avoidance;
- Business asset protection; and
- Optimal tax and legal arrangements among the owners.
The owners of a large portion of U.S. privately held businesses – and particularly of growing and successful private businesses – can obtain substantial benefits from altering their tax and legal structures. Indeed, the more successful the business, the greater the likelihood that it has outgrown its original structure.
- Other definitions relevant to business entity restructuring practice
In addition to the definition set forth above, other key definitions and concepts in the field of business entity restructuring practice are as follows:
- Business entity. A business entity is a single business organization with a particular business organization form – e.g., that of a sole proprietorship or an LLC.
- Business organization form. A business organization form is a set of statutory or common law rules governing the formation and legal structure of a business organization.
- Structure. A structure is a set of tax or legal rules.
- Tax structure. The tax structure of a business entity is the set of rules that determines the liability of the entity and its owners for:
- Federal income tax;
- Social Security tax; and
- State taxes.
Tax rules can be imposed by statute, case law or regulations. The tax rules governing a business entity are often determined to a significant degree by its legal structure. E.g., under the Check-the-Box Regulations, a state-law business corporation can be taxed only as a C or S corporation but not as a sole proprietorship or as a partnership under Subchapter K.
- Legal structure. A business entity legal structure consists mainly of three types of rules.
- Business organization law rules. The first type consists of the business organization law rules (e.g., business corporation statutory rules or LLC statutory rules) that govern each of the one or more entities through which a business is conducted;
- Inter-entity relations. The second type consists of the rules imposed by the contractual and other legal arrangements among these entities (in the case of a business that conducts its business through two or more entities).
- Legal rules governing arrangements among business owners. The third type consists of the legal rules governing contractual arrangements among business owners (principally reflected in shareholder agreements, LLC operating agreements and other inter-owner agreements).
- Structure of business entity group. The structure of a business entity group is determined by:
- The number of entities that the owners of a business use to conduct the business (e.g., a parent and two subsidiaries);
- The business organization form of each of these entities; and
- If there are two or more entities in the group, the legal and tax arrangements among these entities.
- Statutory conversion. A statutory conversion is a statutory legal procedure whereby a business entity changes its business organization form to another (e.g., from that of a business corporation to that of an LLC) while remaining the same entity.
- The chief characteristics of business entity restructuring practice
Business entity restructuring practice has three chief characteristics:
- Business entity restructuring practice is multi-disciplinary. Business entity restructuring practice is multi-disciplinary. Among the more important areas of knowledge often relevant in any business entity restructuring project are the following:
- The business of insuring against business risks, including the use of captive insurance companies to insure against these risks;
- Numerous fields of law (see further discussion below); and
- Federal and state income tax law as applicable to the various types of business entities and their owners (see further discussion below).
- Business entity restructuring practice is systematic. Business entity restructuring practice is systematic – that is:
- It seeks to approach each client’s situation in a rigorous, methodical manner, using comprehensive checklists, forms, and diagrams as key practice tools; and
- It seeks to identify and resolve all possible tax and legal issues relating to all of the client’s tax and legal structures.
- Business entity restructuring practice is proactive. Business entity restructuring practice is proactive. Business entity restructuring practitioners take the initiative to review their clients’ business structures without first being asked to do so by their clients.
- common Situations calling for business entity restructuring
The following are common situations calling for business entity restructuring:
- Conversions of sole proprietorships to single-member LLCs. In order to obtain a liability shield for their owners, many single-owner businesses whose legal structure is that of sole proprietorships should be converted to single-member LLCs.
- Conversions of general partnerships to LLCs or other limited liability entities. In order to obtain a liability shield for their owners, most businesses whose legal structure is that of general partnerships should be restructured as limited liability partnerships, limited partnerships or LLCs.
- Conversions of business corporations to LLCs or limited partnerships. In order to obtain "charging order protections" and other legal advantages, many business corporations should undergo statutory conversions to LLCs or limited partnerships.
- S elections. In order to obtain important federal income tax advantages, many businesses that are taxable as C corporations should elect to be taxable as S corporations.
- Use of holding company/operating company structures. In order to obtain business asset protection, many businesses that hold all of their assets in the same entity that conducts their operations should adopt a holding company/operating company structure; in this structure, they will hold their valuable business assets in one or more holding companies that, in turn, will rent these assets to one or more separate operating companies.
- Use of multiple holding companies. In order to improve business asset protection, many businesses that hold all of their valuable business assets in a single entity should hold these assets in two or more entities.
- Use of multiple operating companies. In order to improve business asset protection, many businesses that conduct all of their business organizations through a single entity should conduct them through two or more entities.
- Use of inter-owner agreements. In order to ensure long-term fairness and harmony among their owners, many multi-owner businesses that have no inter-owner agreements (e.g., shareholder agreements or LLC operating agreements) should adopt these agreements, and many businesses that already have these agreements should update and improve them.
- Conversions of single-member LLCs to multi-member LLCs. In order to obtain or increase business asset protection, many businesses that hold valuable business assets in single-member LLCs should hold them in multi-member LLCs.
- Exploitation of Prop. Reg. §1.1402(a)-2. In order to reduce the Social Security tax liability of owners who are individuals and are active in the business, many businesses, such as LLCs, that are taxable as partnerships but that do not take advantage of the Social Security tax savings available under Internal Revenue Service Prop. Reg. §1.1402(a)-2 should restructure themselves in accordance with this regulation in order to obtain these savings.
- The role of tax and financial professionals in business entity restructuring
CPAs, Enrolled Agents, Certified Financial Planner and other financial professionals normally play a key role in business entity restructuring. To illustrate:
- Client contact. Business lawyers are generally in touch with their clients only occasionally – e.g., when there is a need to draft or review a contract or to deal with a dispute. By contrast, the tax and financial needs of many business owners require regular attention by their CPAs, CFPs and other financial professionals. As a result, these professionals are often better positioned than business lawyers to advise these owners about the potential benefits of business entity restructuring.
- Tax reduction. The principal reason for which many business entities engage in business entity restructuring is to reduce their federal or state tax burdens.
- Tax issues in legal procedures. Finally, many changes of the legal structure of business entities that have purely legal goals – e.g., asset spin-offs – involve serious federal and state tax issues on which the advice and assistance of a financial professional is indispensable.
- PRINCIPAL STEPS IN THE business entity restructuring PROCESS
Tax and legal professionals who are knowledgeable about business entity restructuring practice and who want to help their clients improve their business entity structures should do the following:
- They should review the structure of each of the businesses they serve.
- If they see problems in these structures, they should:
- Advise their clients as to these problems,
- Handle by themselves all problems in their areas of competence; and
- Assist their clients in identifying other professionals who can competently handle all other problems.
- Types of tax knowledge that tax professionals need in order to handle tax issues in business entity restructuring
Tax professionals who engage in business entity restructuring practice need to understand, among other things:
- A solid basic knowledge of sole proprietorship taxation and taxation under Subchapters C, K and S;
- The rules governing taxable spin-offs under IRC Section 1060;
- The rules governing tax-deferred reorganizations under IRC Section 355;
- The rules governing tax-deferred reorganizations under IRC Section 368 (particularly as applicable to entity conversions);
- The rules governing intercompany agreements under IRC Section 482;
- The rules governing the reduction of Social Security taxes of business owners under Subchapter S and Subchapter K (including Prop. Reg. §1.1402(a)-2); and
- The relevant state tax rules in each relevant state.
- Types of knowledge that business lawyers need in order to handle legal issues in business entity restructuring
These lawyers need to be familiar with, among other things:
- Business risk law – i.e., the laws of negligence, intellectual property and other areas of law to the extent that a knowledge of this law enables lawyers to identify the legal risks of businesses;
- Fraudulent transfer law;
- The law of creditors’ rights and related fields of law (such as federal bankruptcy law and Article 9 of the Uniform Commercial Code);
- Veil piercing law;
- The statutory business organization law governing all of the main types of legal entities, including sole proprietorships, business corporations, LLCs, and general and limited partnerships;
- Substantive law and practical techniques necessary for the drafting of documents (e.g., shareholder and director resolutions) necessary to authorize and implement business entity restructurings;
- Substantive law and practical techniques necessary for the drafting of intercompany contractual arrangements governing legal relations among the entities in business entity groups, including, for example, real property and equipment leasing agreements, license agreements, promissory notes, and security agreements;
- The business organization law and other law governing agreements among business owners, such as shareholder agreements and LLC operating agreements; and
- State statutory merger and conversion law.
- CHIEF Business asset protection guidelines RELEVANT TO business entity restructuring practice
The following are the 10 principal guidelines that should be followed by business owners who wish to maximize the legal protection available to their business assets:
- Avoid asset protection arrangements that violate fraudulent transfer law. Before they do any business asset protection, these owners should make sure that their business asset protection plan does not violate fraudulent transfer law.
- Make a complete inventory of your business assets. Obviously, business owners cannot make appropriate arrangements to protect assets that they don’t know they have. Often overlooked assets include the value of goodwill inherent in business names and the value of workforces in place.
- Make a complete inventory of your business and legal risks. Obviously, business owners cannot protect against risks of which they are unaware. Often overlooked risks include those inherent in poorly drafted contractual arrangements with customers, suppliers and insurers.
- Use a holding company/operating company structure. As indicated above, business owners who own single-entity businesses should split their businesses into one or more holding companies and one or more operating companies, should hold their business assets in their holding companies; and should lease, license and lend these assets to their operating companies under written intercompany agreements.
- However, these owners should consider having their holding companies sell their inventory to their operating company under written sales agreements and promissory notes; using security agreements to make the inventory the collateral for the notes; and filing financial statements with the Secretary of State to "perfect" their interest in this collateral.
- Through spin-offs or other means, put each egg of substantial value in a separate basket. Business owners should consider placing each business asset of substantial value in a separate holding company.
- Use LLCs. In most states, business owners should not use state-law business corporations or other non-LLCs as their business entities; rather, they should use LLCs and should make statutory conversions of non-LLC entities to LLCs. (Note, however, that in a few states, including California, Florida, Florida, Pennsylvania, and Texas, limited partnerships may be preferable to LLCs in certain situations).
- Take full advantage of intellectual property law to protect your intellectual property assets. Business owners should make full use of intellectual property law (e.g., patent law, trademark law, copyright law and trade secret law) to protect valuable intellectual property assets.
- Structure each of your business entities to avoid veil piercing and reverse veil -piercing. Business owners should structure their business books, records and operations to avoid veil piercing and reverse veil-piercing.
- Protect your holding company from your operating company. Business owners should use carefully drafted rules of intercompany governance to protect their holding companies from risks arising from actions of their operating companies.
- Use written intercompany agreements. For both legal and tax reasons, business owners should document the relations between their holding companies and their operating companies in written intercompany agreements that contain arm’s-length terms; and they should make sure that all entities in their business groups comply with the terms of these agreements.
- Use of closely held insurance companies by business ENTITIES to protect assets and save taxes
For businesses with substantial financial resources, closely held insurance companies ("CHICs") can be useful means to save taxes (because of the ability of insurance companies to deduct their reserves) and to protect cash.
- Business entity restructuring costs
The costs, including professional fees, that are likely to be incurred by a business whose owners implement a comprehensive plan of business entity restructuring will vary greatly with the size and complexity of the business, the extent of the required restructuring and many other factors. However, these costs are likely to amount, at a minimum, to several thousand dollars and sometimes to much greater amounts. Understandably, business owners are reluctant to incur these costs unless they are convinced that the value of the restructuring in question will justify them. Often, however, the tax savings alone of a well-designed restructuring will justify the costs of the restructuring within one or two years after its completion. Furthermore, fiduciary considerations will often lead corporate directors and persons with similar responsibilities in non-corporate entities to implement restructuring plans even when a strict cost-benefit analysis does not mandate them.
C:\J2\JMC website - 1-9-05 ff\Outlne - business entity restructuring - 3-2-05.doc