Donnelly Ritigstein on closely held businesses advantages and traps

The closely held business: Advantages and traps for the unwary and how to resolve them

Thought Leadership on Closely Held Business Law presented by Donnelly Ritigstein.

By default, the standard form of business chosen by the vast majority of people is the closely held business. A closely held business is a private company that is owned by a (relatively) small group of people. As opposed to a public company, which is traded on a stock-exchange, the closely held business allows business owners to take advantage of the corporate veil protections afforded to public companies without all of the hullabaloo of exchange filings. These advantages are myriad; however, just because it is not public, does not mean that the closely held business is not immune from problems and concerns. Nor does it mean that careful planning can prevent many problems from cropping up in the first place.

ADVANTAGES

Ownership transfers are restricted

One of the special features of a closely held corporation is a restriction on ownership transfers. A closely held corporation, be definition can’t go public. That is to say, shareholders are not allowed to sell their shares on a stock exchange. This type of restriction on the transferability of ownership makes the closely held corporation particularly useful for family businesses and estate planning. The transferability of interests in the closely held company is acknowledged by most state laws and the IRS, however more often than not closely held business owners never institute many of the benefits bestowed by statute to deal with transferability of member’s interests.

Management issues can be settled by agreement

Partnership or shareholder agreements are commonly used to set up management procedures in closely held companies. These agreements also restrict sale of the company’s interests to outside parties absent consent of the remaining members and set forth procedures for dealing with disputes within the company. In virtually all instances, judicial intervention of the arrangements between members of a closely held company will not be interfered with if met at arm’s length by the members and the arrangements do not violate any corporate enabling statutes in each state.

Minority shareholders have rights

State laws protect minority shareholders in closely held companies. Most state laws allow minority shareholders to bring claims of oppression, fraud, mismanagement, and unfair dealings to court for a judge to decide the issue if the shareholders can’t agree. Unfortunately as often as these laws are utilized as a shield to protect disenfranchised company owners, they can also be used as a sword to allow unscrupulous partners to bully the other company owners.

Taxation is malleable

There are many possible entity types that a closely held company can take, including sole proprietorships, partnerships, “C” corporations, “S” corporations, and limited liability companies. Currently, the two most common choices for closely held businesses are S- corporations and LLCs. There are many factors to consider when choosing one form of business. S corporations, partnerships and LLCs provide limited liability to their shareholders/members. The ownership units in each are generally transferable, subject to any restrictions the owners agree upon. Further, for the most part, both are “pass-through” entities for tax purposes, meaning that the entity itself does not pay income tax; rather, the income of the entity passes through to the shareholders/members who pay tax on the entity’s income. C corporations are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal income which makes many closely-held business owners eschew the C-Corporation. However, C-corporations also may have unlimited stock holders, can attract a large pool of talent and may take advantage of several tax incentives not granted to LLCs, S-Corps or partnerships.

HOW DO I AVOID TRAPS?

Plan for amendments to the operating agreement.

An operating agreement is a living contractual agreement just like the business. As a business continues to grow, expand and/or, for lack of a better word, live, closely held company owners must document these changes. Meet regularly, utilize resolutions for major decisions of the company and whenever necessary, always-always-always document changes to the operating/shareholder/partnership agreement.

Engage in contingency planning

Closely held business owners should hire counsel to deal with planning for the contingencies of life events of the members before they occur. Common life events that are not planned for but can have radical effects on the company are:

  1. Death or disability of a member.
  2. Dealing with the children of members. Some members may want to bring their children on board or pass their interest to them upon their death or disability.
  3. The effect of divorce on a member’s interest.
  4. The amount of time or devotion required by a member to the business.

The vast majority of these events can be addressed in the operating agreement of the company or in buy-sell agreements.

Engage in valuation planning

Litigating the value of a business is arguably the most expensive aspect of a closely held company break-up. As such, while not addressing the perceived unpleasantness of such a discussion may be the easy way out, company owners must build into their agreements a way to value the interests of the owners. This would include either hiring an appraiser or a set formula for valuation into its agreement. If the company is doing either very well or very poorly compared to previous years, coming up with a new valuation is a requirement as an ongoing matter.

Stay on top of your taxes

Although taxation is malleable, it cannot be done willy-nilly. For example, while an LLC or S-corporation can elect to be taxed as a C-corporation without tax consequence, the reverse is not true and once the C-corporation election is made a closely held company cannot thereafter generally elect to be taxed as a partnership or S-Corporation without significant tax consequences. Additionally, if a closely held company elects to be taxed as an S-Corporation, it runs the risk of failing to meet the S-Corp limitations and being taxed as a C-corporations (called “blowing the S-Corp election”). This could have significant tax consequences on the shareholders. As such, it is critical for closely held business owners to work with their accountants and attorneys annually to ensure tax structures are being maintained.

Corporate trappings must be maintained.

Regardless of the entity chosen for the closely held business, the trappings of the corporate structure must always be maintained. Books and records must be maintained separately for the entity, agreements with outside parties must be executed in the name of the company and not the individual members, and taxes and worker’s compensation insurance must be paid and maintained. In S and C Corporations, meetings of the company should be held at least annually, with corporate minutes and resolutions made. If the company and the members fail to maintain the separate nature and existence of the company it will probably be disregarded in lawsuits and contracts thereby exposing the members to personal liability for debts and obligations of the company.

Don’t be penny-wise and pound foolish

Spending money on attorneys and accountants to review documents and tax filings prior to execution is much cheaper than litigating them after the fact. It can be especially tough to swallow fees paid to an attorney for negotiating a deal that has fallen through but sometimes the old adage applies- the most important deal in your filing cabinet is the one you never made.

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Brian Donnelly is managing member of Donnelly Ritigstein, LLC, a boutique law firm focusing its practice in Business and Estate law. Brian is an AV Preeminent rated attorney on Martidale Hubbel and is listed in the Bar Register or Preeminent Attorneys,