How Business Entity Choice Affects Succession Planning in California

Three Scenarios: How Business Entity Choice Affects Succession Planning in California

Estimated reading time: 11 minutes

Any estate with business interests will involve succession planning issues around limited partnerships (LPs), limited liability companies (LLCs), corporations and other business entities. They can come in the form of actual businesses being passed down to an owner’s heirs through share or ownership interest transfers. Depending on the estate’s value, they can also touch upon diverse business entity vehicles for holding a family’s assets, including businesses, real estate and personal property. 

Business succession planning can be fraught with issues and pitfalls that high-net-worth families or business owners must plan around, especially when there are significant changes in leadership and ownership. These challenges could be more pronounced based on a client’s business entity selection choices, especially in California. For example, some California corporations could confront annual registration taxes pegged to annual profits. Other entities may need to plan around California’s unique capital gains tax regime, which can result in significant tax liability for certain transactions when coupled with federal tax obligations.

Because planning for the future is so essential, lawyers should routinely incorporate entity selection discussions into their succession work with clients and ensure they themselves stay informed on relevant California laws and federal regulations. Of course, if clients’ needs change, California rules allow them to convert their businesses and umbrella companies to other entity types (more on that in a bit). But by doing the legwork beforehand and thoroughly understanding California and federal choice of entity ramifications, a law firm will be an asset to clients and develop well-planned succession strategies.

Scenario #1: When an owner’s beneficiaries receive ownership and management interests

Business owners looking to pass along ownership interests in active companies with headquarters or an office presence in California can face many of the same fundamental issues owners in other states confront. Yet a client’s plan for transferring their interests can become less predictable when they stray from traditional distribution approaches or need to accommodate the interests of nonfamilial business partners. Conflict can arise when an owner wants to unequally distribute their business shares to their children and relatives. Roadblocks could also emerge if the entity’s ownership structure involves nonfamily members as key co-owners or buy-sell agreement restrictions.

A partnership contract, corporation’s bylaws or LLC’s operating agreement should cement succession procedures to avoid confusion around how heirs and trusted partners will enjoy the fruits of a client’s ventures. Lawyers should meet with them regularly to determine whether estate and business document changes would be necessary to satisfy their evolving succession plans. Attorneys should also collaborate with their clients to locate and incorporate the following into will documentation to clarify confusion around intended distributions and succession strategies: 

1. Management and ownership transfer provisions from the company’s formation and management documents. 

2. Assignment or recorded transfers of interests to the client’s revocable trust.

3. Gifts of interest in the business to family members or others.

Clients’ interests will vary depending on their plans and how well they trust their heirs, requiring lawyers to consider different succession strategies. It may be easier for some clients to sell their businesses entirely and distribute sale profits to their beneficiaries. The downside to this approach is that any sale of a business for profit will likely trigger long-term capital gains taxes from the federal government and California capital gains taxes. Unlike the federal tax code, California’s tax code makes no distinction between long-term and short-term capital gains when calculating taxes — all are subject to the same state income rates, which can be as high as $106,869.53 plus 13.3% (including 1% mental health service tax in Rev & T C §17043[a]) for taxable income over $1,000,000. In other cases, transitioning engaged family members into management roles and gifting passive ownership interests to other heirs could satisfy all beneficiaries and avoid potential power struggles.

However, simpler is also often better — especially if clients want their beneficiaries to enjoy steady income streams from their companies equally. As our trusts & estates guides detail, the most basic corporation, partnership, or LLC structure for succession planning purposes is one in which all the shareholders, partners or members have an interest in the profits and losses in proportion to the value each of them contributes to the entity. 

Scenario #2: When an owner’s heirs are not interested in taking over the business or want to reduce their involvement 

A client’s succession planning picture can also become convoluted if none of the owner’s heirs are interested in taking over business operations or if some want to continue working as employees but gradually transition out of their roles. In this scenario, clients could explore alternative California business entity structures to streamline successions. 

The 2016 California Worker Cooperative Act (AB 816) introduced some employee-owned ownership models that could help with these transitions, especially for family members who want to remain long-term employees. Worker cooperatives can designate themselves as “cooperative corporations” in their articles of incorporation or organization and can pursue any of the following entity structures:

1. Worker cooperatives, where employees fully own and govern the company after paying a small equity buy-in.

2. Employee ownership trusts (EOTs), perpetual trusts that allow companies to remain employee-owned in perpetuity. EOTs give employees a percentage of profits and grant them some governance rights, although a management team can still operate the company.

3. Employee stock ownership plans (ESOPs), in which a company-created trust purchases a company with a loan collateralized by employee shares. Employees can receive their vested shares upon termination of their employment or retirement.

Ultimately, attorneys should walk business owners through the benefits and drawbacks of these structures to assess whether they would be worth considering. Setting up and selling a business to a trust under the ESOP model, for example, could allow owners and their families to avoid hefty federal capital gains if certain conditions are met. Once the ESOP owns the company, employee shareholders could convert the organization into an S Corporation and realize substantial tax benefits on the company’s profits. However, the ESOP approach may not be ideal for unprofitable companies or for businesses with single owners who want to enjoy full company control during their lifetimes. 

Attorneys in these situations must fully understand a client’s succession planning motivations and priorities and assess whether these types of alternative entity structures would better meet the client’s objectives than traditional planning vehicles such as trusts, partnerships and LLCs. 

Scenario #3: When a client establishes an umbrella business entity to hold their business and personal assets

For many estates, it is easier to pool assets into standalone business entities for family members to access and inherit. As a result, it may make sense for some families — especially those with a net worth of more than $15 million — to create separate umbrella companies for holding these assets and distribute profits to offspring. 

However, how families structure their entities can raise management and tax liability questions. It does not help that the Internal Revenue Service (IRS) often scrutinizes business entities more heavily than other succession planning vehicles, as the government agency considers succession strategies using business entities as an aggressive form of estate planning that requires more supervision. 

Fortunately, California is among several states that do not have an estate or inheritance tax for clients to plan around. Nevertheless, attorneys must tread carefully with their clients, ensuring they account for various federal and state-level questions that could impact their business succession planning outcomes.

California-specific fees for S corporations and LLCs

Regardless of whether a business entity has generated profit, it must remit mandatory annual fees to California’s tax authorities. LLCs and S corporations must pay a minimum “franchise fee” of $800 annually. However, for any business entity that elects S-corporation status, the annual tax bumps up to 1.5% of the entity’s annual earnings. As a result, a family business planning vehicle that generates $20 million in profits would have to cough up a $300,000 tax payment.

While the franchise tax takes up a relatively small portion of the estate’s profits, it can be a significant cost when paired with the legal, accounting, appraisal and management fees required to operate the entity. Unsurprisingly, most high-net-worth families in California save on these fees by starting a family LP or family LLC, which do not involve comparatively extensive tax obligations. Both entity structures offer pass-through taxation benefits that sidestep ever-costly double taxation and minimize regulatory expense costs. However, as CEB’s trusts & estates guides detail, other business entity vehicles could be reasonable depending on the client’s objectives.

Unique tax situations tied to entity selection and ownership transfers

Depending on the type of umbrella entity a client selects, unique federal taxation issues could impact how significantly the estate and its heirs are taxed over ownership interest transfers. For instance, LLC-organized estates should watch out for restrictions around the gifting exclusion in IRC §2503(b), which permits a $17,000 annual exclusion credit for gifts. While this credit can significantly reduce an estate’s tax burden, LLC ownership interest grants may or may not qualify depending on how estate planning and corporate lawyers organize them. The U.S. Tax Court has held that LLC ownership interest gifts may not be eligible for the exclusion if LLC managers must approve those transfers and the original owners could not prove their recipients would receive steady income. Christine M. Hackl (2002) 118 T.C. 279, aff’d (7th Cir. 2003) 335 F.3d 664. On the other hand, the court inferred that gifts of LLC interests could qualify if the LLC generates income, some portion of that income would flow steadily to gift recipients, and those income portions could be readily identified and quantified. Estate of George H. Wimmer, T.C. Memo 2012-157.

Potential tax liabilities also extend to how well estate and tax attorneys organize the family business entity’s ownership holdings. Ideally, attorneys should ensure any income from the decedent’s ventures flows tax-efficiently into the family’s holding company but not put the estate at risk for legal claims and tax burdens stemming from an affiliated company’s activities. However, the entire estate’s taxable value can increase by listing the estate as an “owner” of one of the decedent’s businesses.

Consider an estate that holds interests in a “controlled corporation” — a corporation owned by another business entity. Often, an estate will transfer right-to-vote shares of these controlled corporations to children and relatives for their benefit. Since the Internal Revenue Code (IRC) considers the direct or indirect retention of right-to-vote shares of a controlled corporation transferred by a deceased individual to be “a retention of enjoyment of the transferred shares,” they are included in the decedent’s taxable gross estate value for federal tax purposes. IRC §2036(b)(1). By increasing the estate’s overall value, beneficiaries would pay more in taxes to the federal government — all because of how the decedent and their attorneys set up the controlled corporation’s ownership structure.

While we won’t dive deeper into the weeds here (CEB’s estate planning resources do just that), the main takeaway is that practitioners should stay on top of ever-evolving U.S. Tax Court case law and work with their clients to organize transfers and business entity ownership structures to preserve generational wealth. Governing documents for closely held corporations, LPs, LLCs and tenants-in-common agreements can help lawyers see how clients structure their business assets, identify tax-saving opportunities and transfer clause modification options. The CEB’s Drafting California Revocable Trusts and other estate planning guides address some essential considerations and tips that any lawyer should consider when advising clients on how to best organize their assets — and the entities they create to hold them. 

Changing business structure to meet succession goals 

Estate planning lawyers should help clients develop succession plans that require minimal changes over time. However, if a client’s initial entity preferences no longer meet their succession planning objectives, California rules make it flexible in many cases for clients to modify their corporate structure with minimal paperwork and nominal fees.

This is possible because California allows for “conversion” (i.e., a change) to another entity in certain circumstances. A corporation could become an LP, for example, if that provides a better structure for succession planning. The California Secretary of State’s office outlines the following scenarios where conversion, also known as “domestication” in some jurisdictions, is permitted: 

1. A domestic California stock corporation wants to convert to a different California business entity.

2. A California LLC, LP or general partnership (GP) wants to convert to a different California or foreign business entity.

3. A foreign business entity wants to convert to a California corporation, LLC, LP or registered GP, so long as the conversion is permitted under the laws of the foreign business entity’s original jurisdiction.

Of course, lawyers will need to review business entity paperwork to ensure their clients have the authority to initiate conversions or otherwise advise them on how they can proceed in light of relevant bylaws or operating and partnership agreement restrictions. However, it’s nice to know that owners have options — even if it means “moving” the entity into or out of California. 

Staying on top of California business succession planning issues 

Despite the challenges associated with conducting business in California, stakeholders and their families may find maintaining a presence in the Golden State vital to their business growth and generational wealth plans. As with any state, lawyers who develop business succession plans must tailor them around the state’s unique regulations, including entity structuring and ownership transfer laws.

For lawyers unfamiliar with California’s business rules or those who want to stay on top of the state’s emerging regulatory developments, CEB’s extensive resources and DailyNews service can help you stay abreast of important California laws, best practices and proposed legislation. 

With more than 75 years of experience educating the legal community on California regulatory developments, CEB can be any law firm’s trusted copilot in understanding and planning around California’s complex nuances. The CEB’s curated array of news alerts, online treatises and regulatory resources will help ensure any lawyer fully understands the rules of the road and guide their clients to successful outcomes. 

Learn more about how CEB can help you develop robust succession planning strategies for your clients.