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Restructuring company ownership while maintaining control
One of the greatest fears an owner of a closely held business can have is losing control. Control consists not only of ownership but management of the company, including making critical decisions on its future. As a result, the stock of most closely held companies remains in the name of the current owner or founder. Owners may be unaware of the fact that a significant portion of a company can be transferred to the next generation without the current owner losing control.
Companies grow in size, owners grow older and possibly outside investors acquire an equity interest in the business. Many owners are told they need to maintain at least 51% of the stock in order to maintain control of the company, but this is a false assumption. There are several ways in which a current owner can transfer significantly more than a 49% share to their children so the next generation, employees or third-party investors can acquire ownership. At the same time, the estate tax can be significantly reduced.
Voting and nonvoting stock
Let’s assume a current owner owns 100% of the common stock of a company and would like to give shares of stock to children who are either working for the company or not employed at the company and therefore would be considered passive investors. Whether it’s a corporation, limited liability company, limited liability partnership or other legal entity, there are tax planning techniques that allow the owner to transfer more than 90% of the equity in the entity while still retaining total control of the business.
One planning option is to create two different classes of stock, voting and nonvoting stock. The voting stock controls the election of directors, officers and any major corporate decisions such as selling substantially all of the assets, merging the company, selling all or substantially all of the company stock, etc. The nonvoting stock only have a passive investment to receive their proportionate shareholder shares (nonvoting shares over total voting and nonvoting shares) of profits or dividends.
The voting and nonvoting stock technique can be very helpful when some children of the family are actively involved in the company and others are not. This technique allows the children who have a better understanding of the company’s operation to control the management and, at the same time, allows the non-employed children a percentage ownership. However, there needs to be a safeguard put into place to protect the nonvoting shareholders’ interests to prevent the voting shareholders/employees from taking excessive compensation which reduces the profits or distributions.
The voting and nonvoting stock plan can be applied to situations where there is one or more owners. Assuming there are two unrelated, yet equal owners, the stock of the two equal owners can be reorganized for each of the owners to receive an equal amount of voting shares and nonvoting shares. They then are allowed to transfer their shares to their children, spouse, etc. By properly drafting bylaws and shareholder agreements, each family can transfer their 50% ownership (voting and nonvoting) shares to their children and the company can then continue with the two-family ownership.
Preferred stock/life insurance option
Another planning option is to issue the non-employed children preferred stock. The preferred stock has a priority of being repaid if there is a liquidation or dissolution of the business. With a fixed annual return, the preferred stock provides a steady flow of income. The preferred stock could be cumulative or noncumulative. If it’s cumulative, the preferred stockholder is entitled ever year to receive a fixed returned (for example 8%). If the company would skip a year of paying the 8%, the 8% would roll over and be added to the second year’s 8% (or a 16%) return. If the preferred stock is noncumulative there would be no distribution and no carryover to the following year.
Another planning option instead of issuing preferred stock is for parents to purchase a life insurance policy on their lives. The insurance proceeds would be used to compensate non-employed children in lieu of ownership of stock by redeeming the nonvoting shares or simply giving the children the insurance proceeds instead of owning any stock at all.
Control of a closely held company can be maintained while at the same time transferring a significant portion of the equity to the next generation and transfer a considerable amount of assets out of the current owner’s estate. Drafting such a plan requires detailed corporate documents and sophisticated income and estate tax planning.
Client alert authored by: Terrell J. Isselhard (312 855 4624), Principal.
This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.