Succession Planning and Legal Entity Structures: Ensuring a Smooth Transition

Identifying the right legal / tax entity structure is crucial for any business. Legal entity structuring involves deciding the type of legal entity a business will operate as, such as a sole proprietorship, partnership, corporation, or limited liability company (LLC).

This decision is foundational and impacts various aspects of the business. Each entity type offers unique benefits and drawbacks, so it's important to consider factors like liability, taxation, continuity, ownership eligibility, and future goals. Understanding these structures helps owners make informed decisions that align with their business objectives and risk tolerance. Especially during succession planning or ownership transition, the entity structure may not always be the main focus but plays a key role in the transition process.

One critical reason for choosing the right legal entity is liability protection. Corporations and LLCs generally limit liability to the shareholders, protecting the personal assets of the owners from business debts and legal actions. In contrast, sole proprietors and partners often face unlimited liability, risking personal assets in case of business failure or lawsuits. Correctly structuring the entity helps safeguard personal assets and provides business owners with peace of mind.

For family-owned or small businesses, certain entity structures can facilitate smoother transitions of ownership and management between generations. Properly structuring the entity ensures the business continues to operate successfully after a leadership change. Furthermore, when considering succession planning or selling the business, it's crucial to understand the structuring before engaging in any transition strategy. There are many legal and tax implications that may arise through restructuring or sale. Below are some legal entity structures and identifying marks to assist with your legal structuring process.

• Sole Proprietorship: A business owned and operated by a single individual that is simple to manage often for use by freelancers and small businesses. With minimal regulatory oversight, it is not a separately taxed entity from its owner. Sole proprietorships do make the owner susceptible to unlimited personal liability. Furthermore, continuity of a sole proprietor’s business depends on an owner’s lifespan.
• Partnership: A business owned by two or more individuals that share in the profits and responsibilities of the business. Partnerships can be simple to form and provide pass-through taxation directly to the shareholders. Partnerships do generally impose joint liability for debts and obligations and can also limit liability for transferring ownerships. Partnerships provide its members broad governance capabilities; therefore, the Partnership agreement’s construction is essential for laying the framework should situations arise revolving share transfer, distributions, responsibilities, or duration. Partnerships can take various forms including General Partnership (GP), Limited Partnership (LP), and Limited Liability Partnerships (LLP).
• Limited Liability Companies (LLC): An LLC operates as a separate entity from its owner with discretion as far as how an LLC is taxed. The limited liability character of the entity protects personal assets from business while the flexible framework offers the capability for pass-through taxation and management structure. State regulations vary for LLCs with some taking the position of changes in members requiring the LLC to dissolve or reform.
• S-Corporation: The S-Corporation provides the limited liability and protections of a corporation but is much more suitable for a smaller corporation due to its limitation in number of eligible shareholders (100) and pass-through structure of its income. Generally, an S-Corporation must stick to strict operational requirements and maintain a similar framework as a corporation with a board of directors and articles of incorporation.
• Corporation: A corporation is a legal entity separate from its owners, providing liability protection and potential tax advantages suitable for large businesses. Raising capital is easier through stock sales and the entity is perpetually existent unaffected by ownership changes. A corporation is subject to double taxation and can be significantly more expensive/complex to establish and maintain.

Legal entity structuring is a crucial part of business strategy. It impacts liability protection, tax implications, operational flexibility, and regulatory compliance. Business owners and leaders should carefully evaluate their options, considering their specific goals and circumstances. Consulting with legal and financial professionals can lead to informed decisions that set the company up for long-term success and stability. Prioritizing legal entity structuring helps businesses build a solid foundation for growth and resilience in a constantly changing economic environment. Start early by working with your counsel and accountant to discuss your company’s legal ownership structure and how it aligns with your future goals. Taking these steps early will be advantageous when it comes time for transition.

Choosing the right legal / tax entity structure is crucial for businesses as it impacts liability, taxation, and succession planning. Different structures like sole proprietorships, partnerships, LLCs, and corporations offer unique benefits and risks. Proper structuring protects personal assets and ensures smoother ownership transitions. We’re here to help break this down common entity structures and their implications on succession planning. For companies considering an ESOP (Employee Stock Ownership Plan), understanding these structures is essential to align the ESOP with the overall business strategy and ownership goals.

About the Author:

Andrew Fullenkamp is a Managing Director with Lazear Capital Partners focusing on financial analysis and ESOP transaction structuring for middle-market clients.

Andrew’s previous work experience included tax planning & structuring, capital markets and finance strategy, and multi-billion dollar reorganization initiatives for Fortune 500 companies. He enjoys getting to know his client’s business and striving to help them meet their professional and personal goals while assisting them through every stage of the underlying transaction.

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