Determine a business structure
Generally speaking, the simplest and least costly form of business organization is the “sole proprietorship”. A sole proprietor owns all of its assets and is entitled to all of the profits but is personally responsible for all the debts.
If the business has more than one owner, a partnership might be considered. Each partner isresponsible for the debts of the partnership. This is a more risky way to organize your business because every time one partner takes on a responsibility, the other is legally responsible.
If it is a risky business where you could be sued, a corporation is usually the structure of choice. Corporationsprovide limited liability. If estate planning is an objective, a corporation allows the next generation of your family to participate in the business while providing mechanisms for ensuring the founders maintain control.
The parent starting the business usually providesmost, if not all, of the needed capital. It is different in a non-family relationship. Here partners or shareholders are expected to advance funds in accordance with their proportionate ownership of the business. What is required must be addressed in any partnership or shareholder agreement. It becomes very important when personal bank guarantees from the owners are required.
Be very careful when signing a joint and several bank guarantee and carefully assess the danger of its being called by the lender. CAUTION: The term “jointly and severally” means that the bank can go after either one or more of the owners.
Shareholders and Partnership agreements
Usually the primary object of having such an agreement is to ensure that a dispute will not destroy the business.
The following is a partial checklist of items which are typically considered in a shareholder or partnership agreement.
Most agreements address management issues. The family may agree that they require professional managers and, if so, details of this consensus should be built into thedocument. The terms of such an engagement and the amount of remuneration must also be determined and put in the agreement.
Financing and distribution of profit
In many family businesses, the parents have provided the start-up capitalization and also additional funds. The agreement might have a provision that the other shareholders or partners will be required to contribute apro rata share. Alternatively, it could provide for a repayment mechanism to pay out the parents’ investmentover a period of time, ahead of distributions of profit.
The family might also look to a bank to fund the business. Financial institutions normally require a personal guarantee from the owners. The agreement will need to deal with whether all the shareholders or partners must provide such a guarantee. As previously noted, if the financial institution requires unlimited joint and several guarantees, provision could be included to provide that each shareholder or partner will indemnify the others in the event that any of them must pay more than his or her pro rata share based on their percentage ownership of the business.
Restrictions on transfers
Restrictions on the transfer of shares or partnership interests will ensure that the business continues to be controlled by the family.
There could, however, be an exemption for transfers to affiliated or related entities such as trusts or corporations. This will permit some flexibility in estate planning.
Some provision must be included to deal with a potential claim against the business or a family member who owns an interest as a result of a marital breakdown.Example – a buy-out by the other owner at a fixed price might be used to keep the price at a reasonable amount.
A buy-sell or “shotgun” agreement can be included in shareholders/partnership agreements. This can be used in a dispute when the owners are unable to agree on a particular course of action or decision and one party is prepared to risk being a seller by invoking a buy-sell provision.
In a family business it is not always desirable to have disputes resolved by a shotgun provision which could end ongoing relationships between the parties. Alternatively, provisions for mandatory mediation or other type of alternative dispute mechanism could resolve disputes in a less confrontational manner.
Death or disability of a shareholder/partner
In a non-family business, the death of a shareholder or partner or the disability of a shareholder or partners will typically be dealt with by a buyout by the remaining owners. In a family enterprise, the parent who started the business may not want his or her ownership portion to be subject to a buyout on death, but rather may want these shares or portion of the partnership to flow to his or her children by virtue of a Will. Alternatively, as part of an estate plan, a freeze can be considered.
Use of an estate freeze
Assuming a parent owns common shares in the capital stock of a family-owned business corporation, a typical estate freeze plan would exchange the parent’s common shares for preference shares of a set value in the capital stock of the corporation. These would be redeemable at the option of the parent for the value of the common shares he or she previously owned. Usually the preference shares will be voting to ensure that the parent retains control of the corporation in the interim.
The exchange of the parent’s common shares willtake place on a tax-free rollover basis pursuant to the provisions of the Income Tax Act.
As a result, all existing growth in the family-ownedsmall business corporation as of the date the estate plan is implemented is frozen in the value of the preference shares. The common shares owned by the children, or a trust, if one is used, will benefit from future growth in the corporation.
© The foregoing provides only an overview and does not constitute legal advice. You are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained in the context of your own particular circumstances.