My practice is pretty evenly divided between commercial law, property law, and estate planning and administration. So I’m excited that today’s article combines all three with a rarely asked, but important question: What happens to your business when you die?
To explain what happens, let’s start with the default (and least advisable) circumstance: Your business is a sole proprietorship and you die without a will.*
The Default Scenario
When you do business as a sole proprietorship, your business assets and your personal assets are not distinguished. So, when you die, all your assets are subject to the jurisdiction of the probate process, which means a personal representative (often a family member) will have to be appointed to take possession of your business property. If creditors have claims against you, the personal representative may have to pay those claims out of the assets of your estate. If necessary to pay claims, the personal representative may be required to sell real and personal property.
So what happens to your actual business? Meaning, the operations—the goings on. Does everything just stop and the business get liquidated? There are many reasons why this could be undesirable: income from the business may be a necessary, or more convenient, means of satisfying creditors’ claims; you may have intended to pass down the family farm to your children; the maintenance of other valuable assets may require income from the business—Many, many reasons.
Ark. Code Ann. § 28-49-112 gives personal representatives a limited authorization to continue to run the business, but this procedure is not without potential problems. First, not every personal representative is competent to run a business—let alone your business. Second, eventually your business assets, which in a sole proprietorship are indistinguishable from your personal assets, may be divided up among your heirs in ways that may not make sense for the business. The Arkansas Inheritance Code of 1969, Ark. Code Ann. § 28-9-201 et seq., governs the disposition of a deceased’s assets that are not directed by a will. If you have children, your business assets would go to your children in equal shares. If you have a deceased child who was survived by a grandchild, that grandchild would take the share that your child would have taken (or, in the case of a minor, the grandchild’s guardian). You can probably can see how arbitrary these default dispositions are.
But that’s not all.
To satisfy the value of the shares owed to your heirs, circumstances may require the personal representative to liquidate certain business assets, despite their importance to the business’s ability to make a profit. In other words, profitability—the thing that may be most valuable to your children—may be made impossible because of the Probate Code’s requirement that assets be passed on to somebody. The nature of every profitable business is that its value outweighs the sum of its individual assets. This value is always lost when a business is liquidated.
This is why you need an estate plan, and why your estate plan must include your business.
The first fundamental problem with the default circumstance I mentioned is the fact that it is a sole proprietorship. There is never a good reason to do business as a sole proprietor. First, your personal creditors can satisfy their claims against you out of your business assets. Second, had you instead done business as an LLC, your heirs would inherit not the assets themselves but your shares in the business. And by “business”, I mean the WHOLE business, including its operation.
The second fundamental problem involves the disposition itself. Let’s suppose you carried on your solely owned business as an S Corporation or an LLC, and you died without a will and with three children. Unless your operating agreement said otherwise, your three children would be made the owners of your business. Is that what you want? Maybe, but maybe not. Most business owners, if they want the business operations to continue, want their children to receive either (1) a share of the continuing income of the business, or (2) a share of the sale of the business. Few business owners, however, want their children to inherit the actual management of the business. Some business owners have little management of the business. However, for those business owner who actively manage their business, this can be a real burden to pass on.
With these problems highlighted, the following are a few scenarios you might encounter and how I would recommend handling them.
“I have a wife and a four-year-old daughter. Three business partners and I jointly own XYZ LLC, which owns several restaurant franchises throughout Arkansas. XYZ is a manager-managed LLC. We hire store manager employees to run our restaurants, but the owners manage the major business decisions. After I die, I would like my wife to continue receiving my share of dividends from the LLC. In the event that my wife dies, I would like my child to get the money, but only after she turns 21.”
While there are several ways to accomplish your objectives, I recommend drafting a provision in your will to direct your shares to a testamentary trust. A testamentary trust is a trust that comes into force only upon the death of the testator. Once in the trust, the trustee whom you appoint will be required to distribute the trust funds to your wife and child as directed in the trust agreement. Further, the trustee can hold all funds for your daughter until she turns 21 (or 31, 41, or whenever you think your daughter will be mature enough to handle money).
Three things in particular make the use of a trust extremely convenient. First, trusts can receive and distribute income and assets from other sources such as, for example, your life insurance policy. Second, you can draft the trust agreement to give the trustee authority to sell your shares of the company. If your business partners refuse to issue dividends for an extended time, the trustee may decide that the shares are more valuable to be sold. Third, owners of an LLC are responsible for their share of income taxes regardless of whether distributions are made to the owners. In the event that your business partners vote against making distributions, the trust would be liable for the income taxes, not your wife and daughter.
Most LLC operating agreements consider your ownership interest in trust to be an “assignment” and most operating agreements do not give assignees rights of management and voting. In this situation, this is probably fine because the stores are managed by employees and the LLC itself would be managed by three other partners. The trust would be considered a “member” rather than a “manager.”
“I’m a widow and solely own a custom crafts store. I take specialty orders and make all the crafts by hand. I don’t recall ever creating an LLC or a corporation. I have five grandchildren. My oldest granddaughter, Ophelia, age 21, wants to come work for me after she finishes art school. If she comes to work for me, I would like after I die for her to own the business. If she changes her mind, I would like my business sold and my grandchildren to split the proceeds. Well, except Ralphie. He never comes to visit me. He just plays on his computer all day.”
First, if you have never registered with the Secretary of State, you are a sole proprietorship. I wrote an article about choosing a business entity, and based on what I wrote there, I recommend an LLC. Unless your business is wildly profitable, you probably won’t save taxes by registering an S Corporation.
Second, I recommend putting your shares in the LLC into an inter vivos trust. An inter vivos trust is a trust created during the lifetime of the person who created the trust (in legal parlance, we call this person the “settlor”). By having the shares in the trust during your lifetime, they are technically not owned by you, but by the trust. Thus, when you die, the shares are not part of your estate. Because trustees are constrained by trust agreements, many business partners feel uncomfortable when the trust owns part of the business, especially when the trustee has voting power. However, because you solely own your business, you don’t have to worry about this.
The trust agreement can quite flexibly direct that business profits go to your granddaughter for as long as she manages the business, but that the business be liquidated in the event that she chooses not to manage the business (because she got better job offers in New York City).
Ralphie will get nothing.
* NEVER do business as a sole proprietorship, and NEVER own a business (or anything substantial) without having a will.