Letter to Professor John Robinson

Jupiter 2 Spacecraft
En route from Alpha Centauri
RE: Business Structuring

Dear Professor Robinson:

I understand that you, Mrs. Robinson and the children are headed back to Earth in your Jupiter 2 spaceship after three years of cheesy intergalactic wandering on black and white TV and a 1998 movie remake (sans, in the movie, the aluminum foil costumes and June Lockhart). Now that the plastic action figures from your 1998 movie remake are showing up in dollar stores, you’ve decided to use your intergalactic contacts and technology to “launch” a new career as an entrepreneur. Specifically, you have indicated that you anticipate purchasing equipment and hiring employees for several operating businesses. You also hope to pursue some potentially valuable patent opportunities.

You indicate that you are in the market for an attorney to assist you in organizing these ventures. To allow you to assess which attorney or law firm may be best for you, you’ve asked several law firms to lay out some likely recommendations for structuring ownership and compensation. My firm’s response is set forth below.

Structuring business ventures involves consideration of:

(i) tax minimization,
(ii) asset protection,
(iii) succession planning, and
(iv) compensation

(i) Tax minimization. Generally you should hold depreciable assets in pass-through entities, such as a limited liability company or, in some cases, an S-corp, so that you can use the depreciation deductions generated by those assets to offset income from other sources. (There are some limitations on this principle. Sometimes, you’ll just want to hold
those assets in the name of your operating business.)

As if the federal tax issues weren’t sufficiently dense, there are also state taxation issues that affect how to structure the relationship between an entity that owns depreciable assets and an operating entity. For example, some states may attempt to tax “lease” payments made to an equipment-owning entity by an operating entity. Also, since you anticipate operating in more than one state, you have to structure ownership to minimize taxation of your income by different states.

Intellectual property, whether it’s a patent or simply business good will, is also a capital asset. Ownership structure for intellectual property should take into account the possibility that the property may at some point be sold. You want to be in a position to sell the asset without double taxation. That rules out a C-corp. In addition, you want to be in a position to take advantage of the tax-free reorganization rules, whereby instead of receiving cash for the assets you receive stock in the acquiring company. Because Ccorps aren’t a good idea, it’s likely that an S-corp will prove the best choice.

Entity planning aimed at tax minimization is highly fact specific. We will need to do a tax projection based on costs and projected income from any venture before deciding on the entity or entities to use.

(ii) Asset Protection. An important part of asset protection involves segregating separate lines of business in separate entities. Single member limited liability companies offer some attractive planning opportunities in this regard. Because it is treated for asset protection and liability shield purposes as a separate entity, and yet doesn’t complicate things tax-wise, some companies with multiple lines of business are putting each business line in a separate single member liability company. In other words, a holding company structure. Because you need not file a federal tax return for a single member limited liability company, this allows for sophisticated asset protection strategies without complicating your bookkeeping and tax compliance burden.

Asset protection also means protecting your business assets from your personal creditors. It’s tougher for a creditor to grab an interest in an limited liability company than it is to get control of stock in a corporation. Consequently, as a starting point, you might, from the standpoint of asset protection, prefer limited liability companies over corporations (either S-corps or C-corps). You’ve got to take care, however, not to position yourself unfairly vis a vis personal creditors. (Many — though not all — off-shore asset protection gambits are fraudulent). All the same, there is lots we can do, depending on the choices you make in terms of tax minimization and depending on your family situation.

(iii) Succession Planning. Asset protection is related to succession planning, in that in the event of your disability or death, it is important to your family, to your employees and to those that do business with you that you provide for a responsible person or parties to make decisions on behalf of the business.

I would recommend succession planning provisions which authorize a group of disinterested advisers and business associates to take control of your companies if you die or become disabled. The group would function like a board of directors, but would be directed to follow your stated intentions. This might entail, by way of example, selling your business to your managers or employees, providing time for one or more of your young adult children to grow into a management position or finding a buyer. The idea is to insure stability and retain value until whatever succession plan you select is carried out.

You should consider buying life insurance, to supply additional working capital for the company if you die unexpectedly. The money also may become important if your succession documents contemplate a buyout by other shareholders or by employees. Sometimes the insurance should be bought by the company and sometimes by the
owners. It depends.

Another aspect of succession planning may involve gifting some ownership interests to family members, either outright, through a family limited partnership or in trust. This depends on your retirement plans and the age and maturity of your children. There are also so called “estate freeze” strategies that allow the anticipated appreciation in the value of a company to accrue to your children, rather than to you. This is important if your net worth is likely to be in the millions of dollars at your death. These estate planning strategies would, however, be less important if you were younger, say in your thirties.

(iv) Compensation Strategies. Of all the professional advice you get from your lawyer, your accountant and your other advisers, none will have a greater impact on your company than advice relating to compensation. First, this is how you get money from your company to live. Second, this is how you build personal net worth that is going to grow fast and be there when you retire. Third, this is how you attract and retain the kind of employees — rank and file as well as management — who will enhance growth, stability and profitability.

Regarding your own compensation package, as a majority owner, your best bet for maximizing qualified benefits is to use a C-corp. Regarding building personal net worth, choice of entity is less important than choice of retirement and/or deferred compensation plan.

If it is possible to capture the essence of your strategy in this area, it is to shove as much money as you can into either or both of qualified retirement plans and insurance policies. Why? Each is exempt from the claims of creditors (mostly) and each allows “tax free inside buildup”. Tax free inside buildup means that the profit and income from the assets held in the plan or policy are not subject to taxation, so the assets grow much (very much) faster. If you want to consider purchasing insurance, so-called “split dollar” plans allow you to finance the purchase with company dollars, with much of the policy value (before and after death) inuring to you personally. Split dollar life insurance is less complicated than it sounds.

Regarding attracting and retaining good employees, I understand that not many of your rank and file employees are likely to be interested in a retirement plan. Because participation among lower paid employees will be relatively low, it is tough to simply opt for the most obvious off-the-shelf retirement choices. Consequently, to make the best qualified plan choices, you can’t do without a “fee for service” compensation and benefits consultant.

Attracting and retaining management level employees requires a system of incentive compensation that both rewards production and ties executives to the firm. As to the reward part, I find that most people will take money over the opportunity to own a small piece of a privately held venture.

As to tying the executive to the firm, you should consider deferring part of the incentive, be it in the form of money or ownership. For example, you may want to offer a generous commission structure to your sales people, but only pay it out two-thirds or four-fifths in the year the sales occur, with the balance paid ratably over three years.

If you do decide to issue shares to employees, or options to purchase shares, this works best with a corporation, either a C-corp or an S-corp, rather than with a limited liability company. The rules for issuing ownership interests in limited liability companies are not as clear, and, some would say, more complicated from a bookkeeping standpoint.

To summarize:

You will want to use multiple entities to take advantage of tax minimization strategies and to allow mid-course corrections in how you allocate income and opportunities between your various ventures.

You will want to use limited liability companies for depreciable assets (unless some technical rules indicate otherwise).

You will want to use either a C-corp or an S-corp for the operating businesses that may be salable down the road, since only a corporation can take advantage of the tax-free reorganization rules.

In the case of a salable business, as between an S-corp and a C-corp, the S-corp is superior, since if, instead of doing a tax-free reorganization (you won’t know until you are actually negotiating the deal), you sell the assets for cash, there is only one level of tax (where there would be two if the assets were sold for cash by a C-corp). This would likely apply to patents as well.

There is a slight advantage for an owner to be employed by a C-corp rather than an S-corp, since the fringe benefits you receive from a C-corp are cheaper tax-wise. (On the other hand, if the IRS says you’ve paid yourself excessive compensation from a C-corp, you and the corporation will each pay taxes (likely at the maximum marginal rate) on the
same income.)

You have lots of choices in terms of providing incentive compensation to employees, some of which should involve deferred vesting.

Multiple entities and the use of qualified retirement plans and insurance policies all further your interest in asset protection. (With insurance policies, watch for excessive fees.)

You’ve got significant multi-state taxation issues. Using multiple entities will facilitate tax minimization strategies at the state level.

Is all this clear so far? Many business owners are lost in their own space when it comes to achieving the optimal mix. The reality is that it is intensely fact specific, you face tough trade-offs at every turn, and the facts and law keep changing.

Permit me in closing to point out a consideration other than professional competence in deciding on a law firm. Small and medium sized firms are full of attorneys who are refugees from large institutional firms and who therefore have similar training and experience to large firm attorneys. While large firms do great work, there is a fair chance at a large firm that you will be dealing with a junior attorney or attorneys assigned by the senior partner. You will, as has happened to you in the past, get lost.

When you hire a lawyer who has big firm experience but who now practices in a smaller firm, you will be dealing with the boss. Trust me, it’s a difference that matters. Privately held businesses without a large legal budget can’t effectively access the expertise found in large law firms, because attorneys in large firms specialize. You need a big matter to justify paying more than one attorney. Star Wars you are not. You’re not even Star Trek. Sorry. Also, don’t get sold on a large firm’s specialty departments. They will do that work for you for the same hourly rate whether or not you are a regular client.

Kind regards,

David Borinsky

P.S. While your 1998 movie had great special effects, I really missed June Lockhart and the aluminum foil.
© Maryland Gazette. Reprinted with permission

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