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DISCLAIMER: The information provided is not, and should not be considered legal advice. All information provided is only informational and should be verified by a law practitioner whenever possible. The reader should NOT consider this website information to be an invitation for an attorney-client relationship. When confronted with legal issues contact an experienced attorney in your state who specializes in the area of law most directly called into question by your particular situation.

CHARGING ORDERS: OUTSIDE-IN V. INSIDE-OUT ASSET PROTECTION

Since 1994, when the Beverly-Killea Limited Liability Company Act was adopted by the California legislature, LLCs have quickly become the entity of choice for most entrepreneurs. In addition to shielding their owners (i.e., members) from entity-level liabilities ("inside-out protection"), LLCs also offer the managerial flexibility and pass-through taxation of partnerships. However, to what extent can assets held by the LLC be protected from lawsuits and claims of the members? Specifically, when a member is involved in an unrelated lawsuit (i.e., a lawsuit that is not related to the business or actions of the LLC), how does this event affect the LLC and the remaining members? As we will see, a properly structured LLC can offer members with "outside-in protection", that is, protection of the LLC assets and business from the claims of a member's creditors.

To better understand the concept of "outside-in protection," it is best if one compared the consequences of operating in the LLC form with those of operating in a corporate and partnership format.

Briefly, a charging order is an affirmative, but temporary, creditor remedy (i.e., it is actually sought by the creditor). Generally, a creditor is required to first obtain a judgment against a partner. Next, the creditor petitions for a charging order which is an action against the partner's distributional interest partnership. The creditor is only entitled to distributed profits. The debtor retains his partnership interest and is taxable on his pro rata share of partnership income. The partnership is directed to distribute all profits due to the debtor-partner to the creditor. However, if the other partners decide not to distribute profits of the partnership, nothing is due to the debtor partner and the creditor cannot compel a distribution. Therefore, the creditor may seek to foreclose on the debtor's partnership interest whereby the creditor ordinarily becomes the owner of the partner's transferable interest. The creditor may then attempt to sell the interest to an outside buyer in order to recoup some of his costs. Nevertheless, if the partnership has relatively few partners or is controlled by relatives or friends of the debtor, the creditor attempting to sell the foreclosed interest may not be able to obtain a desired purchase price for the interest in the partnership.

In reality, although some regard the charging order limitation as a form of "asset protection", the limitation may be best described best as "creditor frustration" simply because a creditor may not be willing to invest significant resources (i.e., litigation costs) in order to obtain something of relatively insignificant value (i.e., debtor's transferable interest in the partnership).

In California, the charging order limitation has been extended to LLCs. Under California law, the charging order constitutes a lien on a debtor's transferable membership interest. Whether a membership interest is assignable depends on the provisions of the operating agreement (which may specify that a new member may be accepted by all or significant portion of the members) or, in the alternative, provisions of state law applicable to LLCs. If a well-drafted operating agreement restricts the transferability of the interest, or couples such transferability with buy/sell or redemption provisions (for nominal amount), the charging order remedy may be of little or no value to an outside creditor.

It is important to note that creditors of single-member LLC investors might not be limited to the charging order remedy. From a policy point of view, charging orders have been adopted in order to protect solvent partners (or members). In a single-member LLC, this concern is non-existent. Nevertheless, the presence of at least one unrelated capital-interest holding member may be sufficient, in some circumstances, to make the charging order remedy applicable to the LLC.

In sum, properly-structured charging order protected entities (e.g. LLCs) protect the investment of the original members, and their ability to manage their own business. Thus, the charging order concept is simply another factor that must be considered when structuring a California business entity.

BUSINESS SUCCESSION PLANNING

A vast number of business owners spend years, if not decades, building, growing and developing their business. Thus, it is not unreasonable to assume that under most circumstances the small business is the owner. The owner alone makes key decisions, deals with major customers or interacts with important suppliers. However, as the business owner nears retirement s/he is faced with a number of difficult questions: who will control/operate the business as the current owner enters a new phase of his/her life? Will this responsibility be entrusted to an heir or will it be outsourced to a professional manager? If the former, how does one choose among the various heirs? Lastly, and perhaps most importantly, how can the business owner maintain financial security throughout this important transition? Needless to say, answering these can be quite overwhelming for a large number of small business owners. As a result, business succession planning is too often banished to the back of the mind to the detriment of the business owner, the business entity as well as successive generations.

Briefly, business succession planning ("BSP") is the orderly process through which control of a closely-held business is passed to others. As the family business represents a highly undiversified investment, the primary goal is to transfer ownership of this unique asset, in the most tax-advantageous manner, while maintaining personal financial security. In effect, BSP is an overlap between estate planning and business planning. When these matters are handled by two sets of lawyers who do not communicate with each other the result may be confusion through lack of coordination, severe tax consequences and the creation of conflicts between family members and/or unrelated co-owners.

How does one begin the process of business succession planning?

Ordinarily, BSP begins by fleshing out the business owner's desires and objectives. This is usually done by getting the business owner to answer a few basic questions including:

• Where does the business owner see himself in 5-10 years? In the office? Deep-sea fishing off Cabo San Lucas?
• What characteristics make the business a success? Is the business on the upswing or downswing (e.g. CD stores, video game arcades)?
• What is the business worth now and what is it worth without the particular owner?
• What are the objectives for the owner, family and employees?
  - In the future, what role will the business owner have in the business?
  - Is the business owner emotionally ready to turn over operational control to another generation?
  - Does the owner view employment of family members in the business as a right or a privilege?
• What are the current and future sources of income for the business owner and spouse?
• How is cash being currently drawn out of the business: salary v. dividend?
• Who will control the day-to-day operations of the business? What are their strengths and weaknesses?
• How will the non-active family members receive income from the business? Will this create a conflict with active family members who want to see income being reinvested?
• Which roles will be filled by outsiders?
• Who will have an ownership interest in the business?
• Will equal treatment of family members have a detrimental effect on the well-being of the business?
• Etc.

Tips for effective business succession planning

1) Start early. A sudden loss of leadership can have profound repercussions. Furthermore, much like estate planning, BSP is a process, not a single event. The earlier one starts planning the more effective the transition (from a business as well as a tax point of view). For example, tax-benefits of strategies such as the formation of family limited partnerships are severely reduced if engaged in late in the business owner's life.

2) Coordinate estate planning documents with business succession documents. For example, does the buy/sell agreement permit the funding of a QTIP trust for the benefit of a surviving spouse? Does the buy/sell agreement prohibit lifetime or testamentary gifts to descendants?

3) Provide cash flow to the surviving spouse. If the business owner has been taking income from the business in the form of compensation, will the surviving spouse be entitled to income when the business owner dies? How will the earnings of the business reach the surviving spouse? How can the business owner make be assured that stock will be voted in favor of a dividend?

4) Insure the buy/sell agreement. An "insured buy/sell agreement" is a buy-sell agreement under which the purchase obligation at the death or disability of an owner is funded, wholly or partially, by an insurance contract insuring the business owner. The insurance policy is owned by and payable to the purchaser - whether the entity or remaining co-owners - thereby providing liquidity in the event of death or disability.

5) Don't ignore family dynamics/harmony. Consider whether family members who are inexperienced or unemployable in the outside world should be given executive positions or whether non-voting interests are a better alternative. Sometimes "fairness" is superior to "equality".

Business succession planning is a topic of growing importance

In the summer of 2007, Massachusetts Mutual Life Insurance Company underwrote the 7th in a series of surveys monitoring trends in family business since 1993. In October 2007, the results of the 2007 American Family Business Survey were released to the public. Here are some interesting statistics:

• Within 10 years, 40.3% of business owners expect to retire;
  - Of these, 45.5% of those expecting to retire in 5 years have selected a successor;
  - 29% of those expecting to retire between 6 and 11 years have selected a successor;
• 31.4% of business owners have no estate plan beyond a will. Furthermore, only 53.5% have a good understanding of estate taxes that could be due upon their death. The lack of a good understanding of wealth transfer taxes usually brings about an excessive tax burden to heirs and, as a consequence, the business' failure.

Furthermore, a survey conducted by Laird Norton Tyee, a Seattle-based wealth management firm, uncovered the following statistics:

• Nearly 60% of majority shareholders in family businesses are 55 years or older.
  - Nearly 30% are 65 or older.
• Less than 30% of the business owners surveyed have succession plans and fewer than 40% have a successor in line.
• Nearly 64% of respondents don't require that family members have qualifications or related experience, and 25% think that the next generation is not competent to assume leadership roles.
• 93% have little or no income diversification. That is, if the business fails upon transfer, very little is passed on to the inactive spouse or next generation.

Succession planning, including selling or gifting business interests, dealing equitably with children, developing management successors, retaining key employees, estate planning for the owner, and contingency planning for the owner's death or disability is a constant topic of discussion. If you own a business and want to preserve the benefits that it has provided for you and ensure that the same benefits continue to be provided to your family, consider giving BSP some thought.

BUSINESS EXIT STRATEGIES

Perhaps you started a business with a few of your closest friends. In order to save on the start-up costs you decided to employ the services of an online incorporation business such as Legalzoom or Bizfilings. Although the business may be going well for now, ask yourself this: would you ever walk into a building not knowing whether you'll ever be able to exit? If your answer is "no", why would you ever invest in a business without knowing whether you'll ever be able to walk away from the investment? What if, in the lifecycle of your business, you get to a "it's not you, it's me"-moment? Wouldn't it be nice to know that you can split up on amicable terms?

The point of this article is that unless viable exit strategies are examined and agreed upon early, a business co-owner may find it difficult or impossible to walk away from the investment on favorable terms.

First, the law:

Co-venturers have four basic choices for structuring their business: general partnership; limited partnership, limited liability company and the corporation. Limited liability partnerships are available for a limited group of professionals and will not be a topic of discussion.

• General Partnerships: under California law, a partner who withdraws (the actual term used is "dissociates") from the partnership is entitled, unless otherwise provided in the partnership agreement, to a buy-out of his partnership interest, except where the dissociation occurs within 90 days prior to the dissolution of the partnership. The buy-out price is determined by assuming either a liquidation sale of the partnership's assets or a sale of the business as a going concern on the date of withdrawal.
• Limited Partnerships: - General Partner: assuming that the general partner is allowed to withdraw (per the limited partnership agreement), unless otherwise provided in the agreement, the general effect of withdrawal is that the general partner becomes a limited partner. - Limited Partner: assuming that the limited partner is allowed to withdraw (per the limited partnership agreement), unless otherwise provided in the agreement, on withdrawal the limited partner is entitled to receive any distribution to which he or she may be entitled under the partnership agreement. In addition, within a reasonable time after withdrawal, the limited partner is also entitled to receive the fair value of his or her interest in the partnership.
  - NOTE: The California law governing limited partnerships is subject to change as of January 2008. For limited partnerships organized after that date (or for all partnerships after January 2010) the new provisions do not entitle a withdrawing limited partner to a return of his investment. This is a substantial shift from present law which is certain to catch a number of LP investors by surprise.
• Limited Liability Company: assuming that the member is allowed to withdraw from the LLC (per the operating agreement), unless otherwise provided in the agreement, the member will not be entitled to payment for the member's interest in the company.
  - NOTE: Typical operating agreements provide that a member has the right to withdraw. Don't read terms into this provision which aren't there. Unless the operating agreement specifies that the withdrawing member is entitled to a buy-out of his interest, no such right is granted by virtue of this provision.
• Corporation: a corporate shareholder is not entitled to have his investment purchased either by the corporation or the remaining shareholder.

Second, the pitfalls:

Even if the default provisions under California law entitle a withdrawing investor to have his/her investment purchased, either by the entity or by the remaining investors, a number of issues are left unanswered, for example:

1) How does one determine the liquidation value of assets or value of the business as a going concern?

2) Who makes this determination?

3) What is a "reasonable time" for return of a limited partner's investment?

4) Which funds are to be used for purchasing a withdrawing partner's interest? The entity's? The remaining partners'?

5) What if some investors desire to buy-out the withdrawing investor's interest, but others do not? How does this effect the control and viability of the business?

6) What are the tax implications of a purchase of an investor's interest by the entity v. the remaining investors?

7) How does the exit strategy that you think you may have fit in with your estate plan?

8) Etc.

Conclusion

Parties involved in a closely-held business entity should not fail to include exit strategies in their venture agreements. Significant litigation fees can be saved by simply including concise buy-out provisions as part of the investment. Furthermore, as operating businesses are usually worth more than the liquidated value sum of their parts, the withdrawing investors can be assured that s/he will realize the maximum financial benefit of his/her interest upon withdrawal.