Multi-Entity Functionality
In starting a business venture, owner-employees generally will form a single entity such as a corporation or a limited liability company (“LLC”) from which to conduct the business[1]. The most obvious reasoning for the utilization of a legal entity, rather than conducting the business merely as a sole proprietorship, is to negate the need for personal bankruptcies because of the state statutory laws holding only the corporation/LLC liable for business debts and judgments against the business. However, as these entities gain business value with increasing sales, profits, equipment, and assets, each owner must ask the question whether a singular entity structure is still sufficient to meet the tax minimization and asset protection purposes now being addressed by new imperatives that have evolved beyond that which were considered in the embryonic phase long since passed.
Liability: A primary reason of utilizing a multi-entity structure is diversifying liability for its operations or locations. This can be particularly important when more than one line of business is conducted and/or the business has multiple locations. This protection entails multiple issues. For instance, if there’s a major employment lawsuit in one entity, the liability does not impinge upon the other entities, notwithstanding that attorneys willtry to bring all of the entities together. If proper corporate formalities are maintained, the other entities should not be held liable for the issues affecting that one unit entity. For example, if a concrete company conducts both concrete production and concrete pumping (the operations of both will require substantial assets), it may benefit the owner to separate the activities into two corporations. Thus, if there is a judgment relating to the concrete pumping activities, the assets and operations in the concrete manufacturing entity will be protected.
Contractual Relationships: Individuality in contractual relationships is another example such as leases that only bind the single unit operation or store so that adjustments can be made without affecting the other operational and store structures.This creates a buffer as it relates to the lease obligations and the other debtsheld by the remaining entities.
Market Values and Entity Sales: Markets change and so does the value of any operation or store location. Too many owners fail to recognize that though originally forming a business was in part to support their families as an employee by way of salary and fringe benefits, they also became investors in their own business. The rewards for an investor are significantly different that the rewards for an employee, in that an employee’s reward is payroll and benefits whereas an investor’s reward is an increasing business value in their personal financial portfolios.As a result, exit strategy becomes something much more rewarding than simply having a retirement plan which each employee needs to establish. Thus, with more than one marketable operation or
store location, a properly planned exit strategy can have significantly greater value through diversification in entity structuring.
Incentives and Rewards: Separate incentive packages can be established for each operation or site. Owner employers can reward a single well-performing operation or store by providing incentives singularly without the risk of discrimination particularly if these incentives are non-qualified benefits or appreciation rights, stock grants, etc.
Implementation of a Multi-Entity Structure
A multi-entity structure is certainly not a “one size fits all” concept. Instead, once the need for a multi-entity structure is identified, a business owner (or, more appropriately, his or her tax advisors) will need to analyze a multitude of factors to determine the appropriate structure to adopt. Critical factors include the company’s primary lines of business, whether there are multiple, independent lines of business, the amount of equipment and vehicles owned by the business, whether the company holds intellectual property, whether the company holds real estate, the state or states in which the company conducts business, the revenues and profitability of the business, and the owner’s succession and estate planning goals. Depending on these factors, the owner may wish to segregate the company’s operations into two or more entities for asset protection purposes or for succession planning purposes, or may wish to segregate the company’s equipment, vehicles, and real estate from operations. Consideration may also be given to protecting Intellectual Property (“IP”). Large corporations often hold IP in a separate entity, so if there is any major liability issue, the intellectual property can be protected.
Once the desired multi-entity is identified, the next question is the appropriate means to implement the structure with minimal tax consequences. In the adoption of any multi-entity structure, it is likely that equipment, real estate, or vehicles may need to move from one entity to another. Thus, it is imperative to consider both the federal and state income tax consequences of these asset transfers and the state and local sales/use tax consequences of the transfers so that the implementation can be planned in an optimal manner. From both the state and federal perspective, if planned properly, the implementation may qualify as a tax free reorganization as a Type A, Type B, Type C, Type D (“divisive” or “nondivisive”), or Type F reorganization per §368(a)(1) of the Internal Revenue Code. Caution is critical and such a reorganization should not be undertaken without the assistance of a tax advisor with substantial expertise with business reorganizations.
The end result is that in order to protect the investment of any business so that it can evolve, a multi-entity structure is necessary. Conveying that understanding is something that cannot be taken lightly. Further consideration and deliberation requires one vitally important measurement, the value of the business. Each owner should not ignore nor discount this in any manner. The true value is not what appears on the face of a balance sheet but goes into why the business exists at all. It is a breathing and living structure that has layers of value that I will impart with this “You must look within for value,but must look beyond for perspective.” Denis Waitley, 1933, American motivational speaker and writer.
[1] Many states also allow other legal entities including limited partnerships (LPs), limited liability partnerships (LLPs), and limited liability limited partnerships (LLLPs), which also provide varying levels of asset protection.
