Deciding how to structure your family business often comes down to what will save you the most in current taxes. With a business owned by multiple family members, however, there are other considerations with longer-range impact. In fact, your business structure could affect whether or not your family can remain in business for generations to come.
It’s widely reported by sources like the Harvard Business Review that only 10 percent of family businesses survive to the third generation. Choosing a wise business structure as part of your success planning can help your family beat these odds. How? By protecting your assets from one of the most common threats to a family businesses: personal bankruptcy.
Businesses that are co-owned by two or more family members usually become Corporations, Limited Liability Companies (LLCs) or Limited Partnerships (LPs). These entities offer very different protection from an owner’s personal bankruptcy. In fact, the differences in the asset protection of Corporations versus LLC/LPs when it comes to bankruptcy can be quite shocking. Without proper planning, one family member’s financial crisis could threaten the future of even the strongest family business.
Corporations and Personal Bankruptcy
When a co-owner of a Corporation owes creditors, those creditors cannot take assets from a debtor’s corporation. That’s great news, right? Not necessarily. What a creditor can do instead is obtain ownership of the debtor’s stock in the business, essentially becoming a co-owner. What’s more, a debtor with more than 51 percent ownership is essentially handing the corporation over to the creditor for likely liquidation. In a scenario that’s increasingly common, the creditor is an ex-spouse (you can imagine how this may complicate the issue).
If the creditor owns less than 50 percent, you can still have major problems. The majority owner(s) now have a fiduciary duty to the minority owner(s). So, you see, a seemingly air-tight asset protection plan involving a corporate structure could devastate a family business under ripe conditions.
LLCs/LPs and Personal Bankruptcy
Under an LLC and LP, creditors cannot acquire the debtor’s interest in the company no matter how much the debtor owes. When bankruptcy is filed for an LLC in Texas, the judgment is handed down in the form of a “charging order.” This charging order allows creditors to put a lien on an LLC or LP member’s distributions until the debt is satisfied. In other words, the debtor’s distributions go directly to the creditor until there’s no more debt. This protects the other members of the LLC or LP from involuntarily losing a portion of business (or the business altogether) to the creditor. What’s more – as a partner in an LP or LLC taxed as a partnership – the creditor is now subject to federal income taxes, which could complicate matters on the creditor’s end.
Using Your Crystal Ball
You can’t predict with certainty what storms your family business will need to weather in the future. But by factoring in your family, your industry and your assets, you can better plan for possible risks—like a family member’s personal bankruptcy—that could shatter the legacy you’ve built.
What is certain is that you can’t wait for a problem to restructure a business. Once a family member is being pursued by a creditor, it’s too late to make changes. Smart planning is the best protection. Contact us if you have specific questions on how your own business structure may stand up to future family pressures. Please note: We are not lawyers and this does not constitute legal advice. Please contact a lawyer to discuss a particular legal situation.
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