In March, I wrote a post about estate planning for small-business owners. That post discussed the different ways that you, as a small-business owner, might choose to dispose of your small business after your death. Whether you want the business to pass to your children, to go to a business partner, or to be sold, you need to plan well ahead of time.
One part of your planning process should occur very early in the life your business, when you choose what type of business entity to form. In California, two of the most common business-entity choices are a corporation and a limited liability company (LLC). Both options have their own advantages and disadvantages, but in this post, I’m going to consider only one aspect of that choice.
Specifically, what’s the difference between a corporation and an LLC in estate planning?
If you form a corporation for your small business, you will become a shareholder. The corporation will own the business assets (such as inventory and equipment), and you will own shares in the corporation. When you die, your shares are what pass to your heirs or devisees, not the business assets themselves.
Whoever inherits your shares will be entitled to exercise all the rights associated with those shares. So, if the shares entitle their holder to dividends, then the new owners will be entitled to receive those dividends. And if the shares have voting rights, then the new owners will be able to vote on matters subject to shareholder approval.
In short, with a corporation, you can pass on your entire interest in the corporation when you die. This sets corporations apart from LLCs—at least when multiple owners are involved.
Limited Liability Companies
Like corporations, LLCs legally exist as separate entities from their owners, called members. The LLC owns the business property, and the members own membership interests in the LLC. A membership interest entitles a member to vote in the LLC, to receive distributions from the LLC, and to obtain certain information about the LLC.
But unlike with shares in a corporation, you normally can’t transfer your voting rights to another person. To vote, you must be a member, and new members can only be admitted with the consent of all current members.
However, you can transfer one part of your membership interest to another person—the “transferable interest.” A transferable interest entitles its holder to distributions from the LLC. So, if you give your transferable interest to a non-member, that non-member will receive the distributions that would otherwise have gone to you.
When you die, your heirs or devisees receive a transferable interest, not your entire membership interest. If you are the only member in the LLC, you can designate your heirs or devisees to become members after you die. But if the LLC has more than one member, then your heirs or devisees normally can’t become members unless all the other members consent. This could leave your loved ones in a state of limbo—entitled to distributions, but unable to influence business decisions!
Fortunately, what I just said is only a default rule. If you own an LLC with other people, you and the other members can agree to a different rule by including it in your operating agreement. For instance, you could agree that whoever inherits a transferable interest from a member automatically becomes a member. Of course, this requires you to plan!
Most people probably don’t think too much about how choosing between a corporation or LLC for their small business could affect their estate plan. But as this post shows, that choice can have significant consequences for your successors. If you have a small business, or if you’re thinking about forming a new business entity—and especially if you co-own it with others—be sure to talk with your estate planning lawyer about how best to plan for it.