Business Succession Planning

A power of attorney is a document in which you give someone else the power to act on your behalf for financial transactions.  Texas, like many states, has adopted a statutory durable power of attorney form.  The form has a laundry list of transactions from which you can pick and choose from, and you can add additional powers as you wish.  The most significant issue to decide is whether to make the power effective immediately or become effective upon disability.  The problem with making the power effective upon disability is that the powerholder will have to prove disability to the third party to whom the power is presented.  Accordingly, I usually recommend that the power of attorney be effective immediately.  Now there have been situations in my career, where husband and wife didn’t trust each other, and were insistent on making the power effective upon disability.  They probably should have come to see a marriage counselor, instead of an estate planning lawyer.

In certain cases, such as where the the client has complicated assets, it is recommended that the client go beyond the statutory form and prepare a power of attorney that addresses specific transactions that might arise in the management of these complicated assets.

Powers of attorney are a simple but important piece of any adult’s personal planning.  Usually used in the case of an illness or travel, they can be a lifesaver in more dire situations.  I remember years ago a client came to me with the follow situation.  Her husband had disappeared (his car was found abandoned on the way to work), but no body was found.  Since he couldn’t be presumed dead under Texas law for four years,  the wife couldn’t sell the family home.  With the husband being the sole provider, she was forced to give up the home in foreclosure.

There are three basic types of intellectual property (IP): copyrights, trademarks and patents.   Copyrights do not protect ideas, but do protect the way those ideas are expressed.  Trademarks protect logos, slogans or other ways a business is identified.  Patents protect inventions.

IP presents unique challenges for estate and business planning.  It is a difficult asset to value.  So before any arrangements are put in place, the client should engage an appraisal firm with IP expertise to assign a fair market value (FMV) for the IP.   Once FMV is known the client can consider estate planning or financial transactions with the IP.  For example, it is not unusual for a client to hold his IP in a separate entity from his business and enter into a license agreement with the business entity.  The license agreement could be challenged as disguised salary if the licensing fee is not at FMV.

Copyrights and trademarks can last a long or indefinite amount of time, although, with respect to trademarks, they must be renewed every ten years.  Patents, on the other hand, have a limited life, typically 20 years.  These differences need to be taken into account when formulating planning ideas. A client with IP consisting largely of patents, for example, could license them to the business to provide retirement income, while the asset depreciates over time reducing his taxable estate.

In addition to the valuation difficulty, IP is an asset class that requires attention.  Filings need to be renewed, and rights need to be defended if challenged.  The client should identify people with knowledge of this area of the law during his life so that the value of the IP can be maintained after his passing.  For example, probate alone will not transfer a patent.  The executor must also file transfer documents with the USPTO.

 

I generally don’t recommend structuring a business as an S corporation.  Unlike LLCs and partnerships, the S corporation rules (i) restrict the number and type of owner, (ii) provide no flexibility in allocating income and loss, (iii) do not allow a step up of the assets at death of the shareholder and (iv) unlike other pass-through entities, the sale of assets and liquidation are both taxable events. This creates a sticky wicket to navigate.

Straight Stock Sale Tax Treatment Unlikely with S Corporations

A business sale can be structured as either a stock sale or a sale of the assets.  Buyers like asset sales because they can pick and choose what they want, and they do not inherit the existing liabilities of the company.  Sellers like stock sales because there is only one taxable event, rather than two.  However, even if an S corporation shareholder is able to negotiate a stock sale, the tax code allows buyer and seller to elect to treat the sale as an asset sale by making a Section 338 election.  Buyers like to do this because it allows them to step up the basis of the assets.  In a simple sale for cash the 338 election often works fine.  Assuming the asset sale results in a taxable gain.  It is passed through to the seller and taxed, and the gain increases his basis in his stock, so the distribution of the sale proceeds, which is deemed a sale, results in no gain because the basis in the stock equals the cash distributed.

Earnouts and Contingent Payments Cause a Sticky Wicket

The problem is that most transactions are not straight stock for cash.  Typically, a portion of the payments are made over time, and, when we introduce the installment sale rules to the mix, we find a huge disparity in tax treatment.  It is possible to have a situation where the seller has a large gain in the year of sale, but not enough cash to pay the tax.  That is a bad situation in its own right, but it can be made downright intolerable later when it turns out the seller reported too much gain in the year of sale, and only has a capital loss in later years that he cannot use.  A lot of these problems can be mitigated by structuring all of the sale consideration as notes, but that introduces business risk to the seller that the notes do not get paid.

Plan Ahead

Given the sticky wicket discussed above, an S corporation shareholder contemplating the sale of his company needs to consult with counsel before he starts the sales process.