CHANGING THE GUARD IN BUSINESS ENTITIES:

Business Succession in Corporations, Partnerships & LLCs

Presented to

UTAH ASSOCIATION OF CPAs

WINTER CONFERENCE

December 14 & 15, 2006

Salt Palace Convention Center

Presented by

BRENT R. ARMSTRONGArmstrong Law Offices, P.C.

50 West 300 South, Suite 150

Salt Lake City, Utah 84101

Tel. 801-359-5511

All happy families are happy in the same way, whereas all

unhappy families are unhappy in their own unique way.

Leo Tolstoy in Anna Karenina

DISASTER WARNING!!!

Without a well-crafted agreement among owners in place at the beginning that covers death, disability and termination of employment of an owner, every entity with multiple owners could encounter financial disaster for one or more owners!

LIGHT-WEIGHT PARTS CORP.

Example 1

Eric met Ed at an industry convention. They had both worked in the specialty parts industry for several years. Ed was 10 years older than Eric. After talking, they decided to start their own parts distribution business, based in Utah.

Example 1

Ed had his lawyer form a Delaware corporation. Since Ed supplied cash to start the business, shares were issued 80% to Ed and 20% to Eric. Ed promised Eric, orally, that ownership would be equalized once business became profitable.

Example 1

There was no buy-sell agreement or shareholders agreement. There were no written employment agreements for either Ed or Eric.

Example 1

Years passed and Light-Weight Parts Corp. became very profitable and both Ed and Eric enjoyed significant 6-figure incomes plus perks and fringes. But, Ed kept delaying on his promise to equalize ownership and refused to reduce his promise to writing.

Example 1

Finally, after 15 years of profitable business, when Eric was 55 years old, Eric demanded that Ed make good on his promise of equal ownership. Ed refused. The dispute became heated.

Example 1

Rather than work out a solution, Ed, as controlling shareholder, caused the Board of Directors to fire Eric. Eric hired lawyers and filed suit.

Example 1

Since Light-Weight Parts Corp. was a Delaware corporation and since the dispute related to ownership of shares in that corporation, the lawsuit had to be filed in Delaware.

Example 1

Eric had to hire lawyers in Delaware – in addition to his Utah lawyers – and all court proceedings were held in Delaware.

Example 1

To find employment, Eric had to move to another state.

Example 1

Delaware law favors controlling shareholders. After battling for many months and spending all of his savings on legal fees, Eric had to give up and settle for what Ed would pay him for his shares – less than 1/10 of their value. A complete disaster for Eric.

EVEN WITH A WRITTEN EVEN WITH A WRITTEN AGREEMENT IN PLACE, AGREEMENT IN PLACE, DISPUTES OFTEN ARISE DISPUTES OFTEN ARISE WHERE AN OWNER’S WHERE AN OWNER’S

EXPECTATION (OR EXPECTATION (OR NEED) IS NOT MET.NEED) IS NOT MET.

HEADLINE: Redstone’s son sues family-run firm

Brent Redstone, 55-year old son of media mogul Sumner Redstone, filed suit to dissolve National Amusements, Inc. – a firm with controlling interests in Viacom and CBS and worth $8 billion – in order to gain control of his 1/6 stake in that company. His shares, received by gift from his father, are restricted by a shareholder agreement from being sold except back to the family at book value (much less than market value).

Feb. 15, 2006 Wall Street Journal

Corporate Dissolution by Court Action

Utah Code Section 16-10a-1430 allows a shareholder to seek court dissolution of a corporation if the directors are deadlocked in management of corporate affairs or the shareholders are deadlocked in voting power for 2 annual meetings or the directors are acting in a manner that is illegal, oppressive or fraudulent.

LLC Dissolution by Court Action

Utah Code Section 48-2c-1210(2) allows an LLC member to seek court dissolution of the LLC if the members are deadlocked in voting power for 6 months.

LP Dissolution by Court Action

Utah Code Section 48-2a-802 allows a partner to seek court dissolution of an LP whenever it is not reasonably practicable to carry on the business in conformity with the partnership agreement.

What is Dissolution?

“a dissolved [corporation or LLC]…may not carry on any business except that appropriate to liquidate and wind up its…affairs”

Winding Up

The winding up of an LLC is the process of collecting all amounts owed to the LLC, selling the LLC’s assets, paying taxes and debts of the LLC, and distributing all remaining assets to the members according to their interests.

UCA §48-2c-1301

Timeline

Dissolution Winding Up

Termination

WHEN A BUSINESS IS WOUND WHEN A BUSINESS IS WOUND UP, GOODWILL AND OTHER UP, GOODWILL AND OTHER INTANGIBLE VALUE USUALLY INTANGIBLE VALUE USUALLY

DISAPPEARS AND ALL OWNERS DISAPPEARS AND ALL OWNERS GET LESS THAN IF THE GET LESS THAN IF THE

BUSINESS WERE SOLD AS A BUSINESS WERE SOLD AS A VIABLE OPERATING UNIT.VIABLE OPERATING UNIT.

WARNINGWARNING::

SEEKING JUDICIAL SEEKING JUDICIAL DISSOLUTION OF AN ENTITY DISSOLUTION OF AN ENTITY COULD MAKE THE SEEKER COULD MAKE THE SEEKER

SUBJECT TO THE SUBJECT TO THE “BOOMERANG” BUYOUT!!!“BOOMERANG” BUYOUT!!!

Boomerang Buyout

In Utah, shareholder (or member in LLC) who files suit for judicial dissolution of entity is subject to buy-out by entity or other shareholders (members)

for corporations see UCA §16-10a-1434 – for fair value

for LLCs see UCA §48-2c-1214 – for fair market value

Let’s look at an Let’s look at an LLC example – LLC example –

Harry and DavidHarry and David

Example 2

Harry and David are 50/50 members (owners) of a member-managed Utah LLC that has owned a parcel of raw land for over 10 years. The land is now worth $1,000,000.

Example 2

HarryHarry DavidDavid

LLC

(member/managed)

Land worth $1,000,000

50% 50%

Example 2

Harry proposes to sell the land now, but David objects since he wants the LLC to continue to hold the land for several more years. This deadlock has continued more than 6 months.

Example 2

There is no debt in the LLC and the LLC documents do not require the LLC to hold the land for any set period.

Example 2

Harry files suit seeking court dissolution of LLC, in the hope that he can force land to be sold and receive his 50% of sales proceeds.

Example 2

What choices does David have?

-- Choice A

-- Choice B

Example 2Choice A:

David can allow LLC to be dissolved and its affairs wound up – meaning the assets sold, debts paid and the excess distributed to the members.

Example 2

Choice A:

Land sales price $1,000,000Less: sales costs (6%) (60,000)

Surplus to members $ 940,000

Amount to each member = $ 470,000

Example 2

Choice B:

David can assert his right to purchase Harry’s LLC interest at “fair market value”

UCA §48-2c-1214

Example 2

FMV must consider all relevant facts and circumstances and all relevant discounts or premiums.

UCA §48-2c-904

Example 2

Suppose court determines that a value discount of 20% applies to Harry’s LLC interest? What then?

Example 2

Choice B:

Land sales price $1,000,00050% of land value (500,000)

$ 500,000

Less: 20% discount (100,000)

Harry will receive $ 400,000

Example 2

Summary of David’s Choices:

Choice A $470,000

Choice B $400,000

Example 2

What if entity were a corporation instead of an LLC?

Example 2

Where Harry, a shareholder, sues for judicial dissolution, corporation (or David, the other shareholder) has the right to buy Harry’s shares for “fair value” – without any discounts or premiums.

UCA §16-10a-1434

ARE THERE ARE THERE DISSOLUTION DISSOLUTION TRAPS FOR TRAPS FOR

PARTNERSHIPS?PARTNERSHIPS?

Example 3

As part of their estate planning, William and Mary Jones are advised to put assets into a family limited partnership, with themselves as the only general partners, and to make gifts to their children of limited partner interests.

Example 3

William and Mary follow that advice and formed the Jones Family Limited Partnership – with a term of 30 years. They make annual gifts to their children for several years.

Example 3

After 7 years,William dies, leaving Mary as only general partner.

Example 3

No changes are made in governing documents for Jones Family Limited Partnership to provide for a successor general partner.

Example 3

After 4 more years, Mary dies, leaving Jones Family Limited Partnership with no general partner.

Example 3

Limited partners cannot agree on who should be successor general partner.

Result: LP dissolves

Example 3

Utah Code §48-2a-801 provides:

A limited partnership is dissolved and its affairs shall be wound up upon…[the death of a general partner] unless…

there is at least one other general partner and…the partnership agreement permit[s] the…partnership to be carried on by the remaining general partner, or

Example 3

[continuation of §48-2a-801]

within 90 days after [the death of the last general partner], all partners agree in writing to continue…the partnership and to the appointment of one or more…general partners.

Example 3

As part of winding up of Jones Family Limited Partnership, its assets are sold (before the time planned) and the proceeds distributed to partners.

Example 3

The Jones Family Limited Partnership only lasted 11 years, not 30 years.

LET’S LOOK AT LET’S LOOK AT ANOTHER ANOTHER

PARTNERSHIP EXAMPLEPARTNERSHIP EXAMPLE

Example 4

Von owns a 20% interest as a partner in a ranch general partnership that conducts its ranch business in a state with the Revised Uniform Partnership Act (RUPA).

Example 4

Partnership has a value of $6,000,000, consisting of land, equipment and livestock.

Example 4

Due to changes in his family’s needs, Von withdraws from partnership to pursue another job and gives notice of such withdrawal to partnership.

Example 4

Since partnership agreement does not specify any term for partnership’s existence, partnership is an “at-will” partnership under RUPA.

RUPA §101(8)

Example 4

Von’s withdrawal from partnership causes partnership to dissolve under RUPA §101(8):

A partnership is dissolved, and its business must be wound up…in a partnership at will [upon] the partnership’s having notice from a partner…of that partner’s express will to withdraw.

Example 4

Result: Von’s withdrawal from partnership causes partnership to dissolve and entitles Von to be paid for the “fair value” of his partnership interest – 20% of $6,000,000 or $1,200,000.

CONSEQUENCES OF NOT HAVING A BUY-SELL AGREEMENT/SUCCESSION PLAN

Minority owner has no market for his shares Minority owner has no employment security Future owners not determined No planned buyer for majority’s shares Possible dissolution of entity Increased uncertainty for all owners and their

heirs Fertile field for disputes

POSSIBLE TRIGGERING EVENTS IN BUY-SELL AGREEMENTS

Death Termination of employment Permanent disability Divorce Retirement Non-approved transfer

POSSIBLE ISSUES IN SUCCESSION PLANNING

Family system vs.business system Family financial planning Role permutations -- owner vs. non-owner;

employee vs. non-employee; family vs. non-family

Goal definition Exit strategies Management succession Sibling rivalries Financial conflicts

POSSIBLE ISSUES IN SUCCESSION PLANNING – cont’d

Hidden agendas Succession fantasies Emotional impacts Personalities Control conflicts Queen-bee syndrome In-laws Taxes Timing and transition Updating

WHO SHOULD WHO SHOULD ASSIST IN ASSIST IN

DESIGNING AND DESIGNING AND PREPARING PREPARING

SUCCESSION PLANS?SUCCESSION PLANS?

ETHICAL ISSUES IN PREPARING SUCCESSION PLANS

Multiple owners represented by one lawyer

Potential conflicts of interest Confidentiality Informed client consent Withdrawal of representation Facilitation

IN SUCCESSION PLANNING, ONE

SIZE DOES NOT FIT ALL.

HEADLINE:Ranch Operator Shoots Brothers

Over Inheritance

J, a long-time rancher in MMM County, shot and killed his two brothers who had traveled to the ranch to finalize inheritance from their father’s estate. J then took his own life. Their father had left the ranch in equal shares among his 5 children, without any special consideration for J who alone had cared for the ranch and livestock for over 20 years.