Articles & White Papers
LEGAL ISSUES FOR FAMILY BUSINESSES
by James A. Castleman, Esq.
In the early 1900’s, my grandfather started a small scrap metal business. Eventually, my uncle, then my father went into the business, while their four brothers and sisters went off and did other things. Despite the lack of any formal business agreement, when my grandfather died in the late 1950’s, the business passed smoothly to my uncle and my father. Their siblings realized that this was my grandfather’s wish, that my uncle and father had contributed significantly to the development of the business, and none of them had any interest in the business.
In the late 1970’s, my father developed a serious illness, and on the advice of his attorney, insisted that a formal partnership agreement be drawn between him and my uncle, so that my mother would be protected if my father were to die. The next year, when it was my uncle that unexpectedly died, both my father and my uncle’s widow breathed a sigh of relief that my father had insisted on that agreement. The business was smoothly taken over by my father, and my aunt was assured of a fair, structured payment for my uncle’s interest. Both my father and my aunt openly let it be known that there probably would have been a bitter battle and possibly extended litigation, if that agreement had not been drawn.
People who are in business with members of their family tend to be much more lax in formally setting down their business relationship than people that are in business with strangers or friends. After all, who can you trust, if you cannot trust your family? As with people in love that may be faced with the prospect of a prenuptial agreement, families faced with setting down their business relationship on paper often feel that having to do so will spoil the relationship. But family business members that do not formalize their relationship run huge risks, as I can attest to the by the fees I have earned over the years in litigating family business disputes.
If you are in a family business, please consider addressing the following issues formally and in writing:
1. Who is actually in the business? Who started the business? Was it a joint effort? Is the son who came into a business started by his father a partner of the father or just an employee? If a wife helps out with her husband’s business, what is her ownership interest in the business? Is it the husband’s business, or are they partners? What if two brothers started a business, but now both of their wives and some of their children are involved in the business? Who has what responsibilities, who actually owns part of the business, and who gets what if somebody dies?
These questions all seem basic, but they are not always easily answered. The person that started the business may think that he is the sole owner. But, his sons who have been working in the business for twenty-five years may believe that they now own the business. If two brothers started a business and now both of their wives help out in the office, if one of the brothers dies his widow may believe that now she is a partner. These issues must be addressed, and there must be an agreement as to what the business relationship is.
2. What is the appropriate business entity for your family business? If a father has started a business, and his two sons have recently started working in the business, perhaps the business is still a sole proprietorship, and the sons are merely employees. If it is agreed, however, that the sons contributed significantly to the business, and that they are truly part owners, perhaps a partnership exists. Without a written agreement, no one knows for certain. Be aware that partnership interests do not have to be equal, and that they can change as each partner’s responsibilities and contributions change.
Perhaps a corporation or a limited liability company may be appropriate. These types of entities are more formal and may involve higher administrative costs to operate. On the other hand, both corporations and LLC’s provide much greater flexibility in defining ownership interests, responsibility, and control. Each may have particular tax advantages, depending on the size of the business, revenues that are generated, and the particular tax situation of the individual owners. Each of these entities can be used to financially reward those people most involved in the business, while retaining control in those who may have started the business and may have the best management expertise.
Aside from protecting individual owners from personal liability to creditors, important aspects of corporations and LLC’s are the flexibility they allow in passing on ownership interests in the business. A sole proprietorship or partnership dissolves when an owner or partner dies. Corporations and LLC’s may continue to carry on. Further, these entities allow for planned transfers of control, with partial stock interests or LLC membership interests being given or sold to family members that become more involved in the business. They allow flexibility for passing on a business from one generation to another, or from one family member that wants to ease his way out of the business to another family member that wants to become more involved.
Corporations are the traditional formal business entity, and the laws that govern them have been around and have been fine tuned for many years. While LLC’s are a relatively recent development, they often provide more flexibility in defining ownership interests, particularly if the choice is between an LLC and a so-called “S” corporation, which can only have one class of stock.
3. Who owns what and who controls what? No matter what type of business entity you have, you should set out what your ownership interests are and how much control each person has.
Are you equal owners of the business? Did each of you put in the same money into the business? Does each of you spend as much time in the business? If the business were to be sold, would each person in the business get an equal percentage of the sale proceeds? If one person contributed more money or assets to the business than another, was it an actual contribution, or was it a loan? What did the person get in exchange for that contribution? These are all issues that should be addressed in your agreement with your other family members.
And, just because someone may have an equal or greater ownership interest in a business, does that person have an equal or greater right of control? Perhaps one member has contributed greater financial assets, but another member actually runs the day to day operation of the business. Does the person who contributed more want more say in overall control, to protect his financial investment? Does the person who runs the day to day operation want more control, because of his expertise and dependence on the business? Does a father want to hand over control to his sons, but still retain a greater ownership interest in the value of the business? Or, does a father want to be able to ease into retirement, while taking out a greater percentage of the profit, and leaving more control in the younger generation that is now bearing the primary responsibility for the operation of the business?
4. Who is to be responsible for what? Is a person with greater business acumen going to be running the front office of the business, while a family member with greater technical knowledge going to be the one responsible for making sure that the company’s products or services are properly delivered? Is one person better dealing with customers, while another is better dealing with tools? Does one family member want to plan for expansion and want to work as many hours as it takes to accomplish that, while another family member just wants to make sure he has a secure 9 to 5 job? Who is going to be responsible for keeping the books of the entity, filing tax returns, and dealing with outside professionals? These are issues that should be sorted out and written down, as well.
5. What happens if someone dies, retires, or becomes disabled? This becomes a sudden major problem for many businesses. Brothers who may have gotten along famously for 30 years may find themselves in a terrible situation when one has an unfortunate illness that suddenly makes it impossible for him to continue in the business. Families that once seemed inseparable all of a sudden break apart when the founding member of the business retires or dies, and the other people involved in the business no longer can agree on anything.
Ideally, all of these issues should be addressed in an agreement between the owners of the business. A way of valuing the business must be agreed upon, either as a fixed amount, by some agreed upon formula, or by some by orderly arbitration process. Agreement should be reached as to how (or if) payment is to be made to a business owner that retires, dies or becomes disabled, for his interest in the business. Is payment to be a lump sum? Is it to be payable over several years? Has insurance been purchased to fund the buy out?
Does a retiring business owner, or the estate of a deceased business owner have the right to sell that person’s interest in the business to anyone that they wish? Do the other owners, or does the business itself, have the right or obligation to buy that person’s interest in the business? Does an owner that dies have the right to leave his interest in the business to his surviving spouse or his children? Does it make a difference if any of those people are also in the business?
6. How are disputes resolved? If one of the family members disagrees with another member in the business, is there any way to peacefully resolve the dispute? The family business agreement can set out certain rules or presumptions that will govern the resolution of disputes. If there are unequal business ownership interests, perhaps there are ways to force a vote on certain issues. On the other hand, perhaps minority owners are protected from majority votes that would be unfair. Generally in Massachusetts, majority owners owe a fiduciary duty of “utmost good faith and loyalty” to minority owners, so that majority owners cannot act arbitrarily to the detriment of the minority owners. By agreement, however this can be changed. Perhaps there are certain issues in which a simple majority will control and others in which a three-quarters or unanimous vote is required.
If there is an ultimate impasse, or just a desire for one owner to get of the business, are there ways to resolve this, or to protect the interests of the other owners, or, in special circumstances to force the liquidation of the business? When is it just no longer worth continuing the business, and who can make that decision?
A significant portion of the country’s economy is driven by family owned businesses. And, the combinations of types of family ownership interests that exist are unlimited. No matter what the situation is, however, all family owned businesses require as much formality in their operation as any other type of business, no matter how owned. When you are in business with other family members, there is a tendency to rely on trust. But reliance on that type of trust, without putting understandings down in writing can be extremely dangerous. No matter how small or large or complex your business is, and no matter how much you trust your other family business owner members, and no matter how good your relationship may be with them, it is imperative that you address all of the issues raised in this article, and that you do it in writing.
James A. Castleman is a managing member of the law firm of Paster, Rice & Castleman, LLC, in Quincy, Massachusetts.