Estate planning is important for everyone, but for entrepreneurs and small business owners, who may be heavily involved in the day-to-day operations of the business and may have a significant portion of their assets tied up in the business, a thoughtful estate plan is absolutely necessary.
Estate Planning Essentials
Most people think of estate planning in terms of how their assets will be distributed at death, but business owners should also think of estate planning in terms of how their business will continue (or be wrapped up) in the event that they die or, perhaps more importantly, become disabled. Indeed, the demands of a business do not necessarily halt when the business owner does, and it is critical to put into place a plan that will allow someone else to take over the reins of the business (even if just temporarily) to prevent a collapse of the business altogether.
The first standard estate planning document that every business owner should have is a power of attorney. A power of attorney is a document that authorizes one person (the “agent”) to act on behalf of another person (the “principal”). Every business owner should have in place a power of attorney authorizing an individual familiar with the business to step into the business owner’s shoes in the event of the business owner’s disability to ensure that the business can continue to operate on a day-to-day basis. The power of attorney should authorize the agent to do things like sign payroll checks, complete transactions initiated by the principal, enter into agreements with vendors and access the business’s digital assets (i.e. company e-mail, website, social media). However, a power of attorney is only effective during life; at the moment of the principal’s death, the agent is immediately stripped of all authority under the power of attorney and cannot transact any business on the principal’s behalf.
A revocable trust picks up where the power of attorney leaves off. A revocable trust is a trust that an individual (the “grantor”) creates and funds during her life, and which sets forth provisions for how the trust assets should be handled upon her death. The grantor of a revocable trust is typically the sole trustee and the sole beneficiary of the trust, meaning that, during her life, the grantor has virtually unfettered access to the trust assets and can essentially treat them as if she owns them outright. A revocable trust is also, obviously, revocable, and the grantor can amend or terminate the trust at any time. Upon the grantor’s death, the successor trustee (who is someone the grantor has selected) is instantly vested with authority over the trust assets and can administer them pursuant to the provisions set forth in the trust agreement.
Thus, a revocable trust is like a last will and testament in that it provides for the administration and distribution of one’s assets upon one’s death. But it is unlike a last will and testament in that it avoids the probate process altogether; meaning that, upon the grantor’s death, her successor trustee can act immediately and needn’t wait for a court to admit the last will and testament to probate which, in New York, can take many months and thousands of dollars.
Avoiding probate by means of a revocable trust is of particular value to business owners for several reasons. First, assuming that the business owner has funded the revocable trust with her interest in the business, her successor trustee will be able to seamlessly assume responsibility for the business and ensure that it continues (or is wrapped up) without delay. Second, a revocable trust ensures that private information relating to the business remains private. To be given effect, a last will and testament must be filed with the court, which means that it becomes a publicly available document, and the probate process often requires a very detailed (and, again, public) disclosure of assets. But because a revocable trust is not filed with the court, information relating to the trust’s assets (e.g. the business) are disclosed only to the beneficiaries of the trust.
In addition to planning for the continued administration of the business, business owners must also plan for the financial needs of their families in the event that they die or become disabled. Many business owners invest a significant portion of their personal assets in their businesses, and these assets may not be so easily or expediently pulled out of the business to support the business owner’s family if she is no longer able to provide financial support. Therefore, business owners should consider obtaining disability insurance and/or life insurance to ensure that there are sufficient funds available to provide for their families in the event of their disability or death.
For those business owners who intend for their businesses to live on after their own deaths, succession planning is key. The bones of a succession plan are typically set forth not in the business owner’s personal estate planning documents, but in the operative document of the business; for example, in the bylaws of a corporation, the partnership agreement of an LP or LLP and the operating agreement of an LLC. As a result, all of the owners of the business must be in general agreement as to how the business will be owned upon the death of a current owner.
If the operative document is silent as to ownership of a deceased owner’s share of the company, then the default is that the deceased owner’s share becomes part of the deceased owner’s estate, and passes to the deceased owner’s heirs. Obviously, this may be problematic – not only for the surviving owners who now find themselves in business with someone they had no intention (or possibly desire) of being in business with, but also for the deceased owner’s heirs, who may have preferred to receive the value of the interest in the business, not the interest itself (which may not be marketable).
Consider the following example:
The year is 1968 and (in the fictional world of “Mad Men”) Sterling Cooper & Partners has opened its doors for business.
The founding partners of Sterling Cooper are Ted Chaough, Jim Cutler, Don Draper, Roger Sterling, Pete Campbell and Joan Holloway. Assume that Sterling Cooper is a New York limited partnership, that each partner owns an equal 1/6 partnership interest and that the partnership agreement is silent on the issue of what happens upon the death of a partner.
Tragically, before the first anniversary of Sterling Cooper, Don Draper and Roger Sterling are killed in a car accident on their way to schmooze a new client. Neither Don nor Roger had a last will and testament at the time of his death, so New York law determines how their respective assets are distributed.
Under New York law, Don’s estranged wife and former secretary, Megan, will inherit the first $50,000 of Don’s assets, plus one-half of the remaining assets, while Don’s three children from his marriage to his first wife, Betty, will inherit the balance. Don’s sole assets were his NYC apartment (which had only $50,000 in equity) and his interest in Sterling Cooper. Megan sells the apartment for the $50,000 cash, and she and the children split the partnership interest equally, with Megan becoming a 1/12 partner and the children each becoming a 1/36 partner. However, because the children are minors, they cannot legally own the partnership interests, so legal title to their interests vests in their legal guardian – Betty.
As a result, Don’s estranged wife and his ex-wife join Sterling Cooper as partners.
Furthermore, because Roger was unmarried at the time of his death, under New York law his entire estate, including his interest in Sterling Cooper, will pass to his children. Roger has an adult daughter, Margaret, from his first marriage, and a minor son, Kevin, from a prior affair with Joan. By 1968, Margaret has joined a cult, which takes possession of her 1/12 partnership interest, and Joan (as guardian) takes legal title to Kevin’s 1/12 partnership interest.
As a result, Margaret’s cult joins Sterling Cooper as a partner, and Joan effectively becomes the majority partner, with her 1/6 and Kevin’s 1/12.
Undoubtedly, the remaining partners of Sterling Cooper never intended to enter into business with Don’s estranged wife and ex-wife, or a cult. And they likely never intended that any one founding partner would have a greater say than the rest. But without a succession plan in place, they are stuck with that outcome. Moreover, Don’s and Roger’s heirs may well have preferred to receive the cash value of their inherited interests in the business, but without necessary liquidity – and the consent of the other partners – they may also be stuck as unlikely partners.
A common succession plan often utilized by businesses to avoid these problems is the buy-sell agreement. A buy-sell agreement provides, generally, that upon the death of a member, the remaining members will buy back the member’s interest and pay the purchase price to the deceased member’s estate or heirs. These agreements typically set forth the price to be paid (or the method by which the price will be assessed) as well as the time period for payment. Buy-sell agreements thus provide necessary clarity – the members know how much liquidity they will have to raise over a certain time period (and can plan accordingly, for example, by purchasing term life insurance policies on the lives of the members, the proceeds of which will be used to buy back the member’s interest) and the deceased member’s estate and heirs know how much money will be coming into the estate and when.
Another common succession plan utilized by businesses (particularly family businesses) is the designation of specific individuals who will inherit the interest. This strategy helps to ensure that the business continues with only those individuals who are capable of (and interested in) continuing the business. The trick to this plan is determining the value of the interest (particularly of a closely held company), so that the business owner can accurately apportion her estate assets among her heirs.
While estate and succession planning are clearly important, the value of simply being organized cannot be overstated. In order to ensure that the business can be properly administered (either by winding up or transitioning to the next generation), the business owner must ensure that others can access all of the key information relating to the business. Furthermore, it is important that the business owner’s family members and co-owners and/or successors are aware of the business owner’s general plan for how the business should be handled in the event of the business owner’s death so that there are no surprises and so that all that needs to be done can be done efficiently and effectively.