Scalability Is an Issue in S-Corp Succession Plans

The founding principal in an architectural firm had, over the years, sold a small percentage of ownership to his second-in-command, a person several years his junior, with the understanding that he might eventually purchase more shares. In time, the firm identified another potential owner. He was hired with the express understanding that he would be able to purchase shares pending a one-year trial period. As the year was coming to an end, many issues were left unresolved. No valuation formula had been agreed to by the founder and the candidate, nor had there been any discussion with the second-in-command relative to a new valuation and its impact on his shares. Moreover, the founder had made a decision as part of his personal succession plan to begin a process of divesting his shares to new shareholders as able candidates were identified and invited to join the practice. A scalable and equitable valuation and stock transfer procedure was needed, along with updates to all the corporate documentation. In addition, provisions needed to be made for nonarchitects (designers and specialty engineers) who could not, under American Institute of Architects (AIA) rules, participate in direct ownership of an architectural firm. Finally, options governing the sale of additional shares to current shareholders and potential dilution issues needed to be addressed. Within a year, these programs were in place just in time for the acquisition of a competing firm and the absorption of a new equity owner in the company.

Subchapter C Corporation

The C-Corp is the organizational structure most adaptable to growth. For principals wishing to give the firm maximum advantage in managing rapid growth, attracting investors, providing incentives to key employees, possibly forming an Employee Stock Ownership Plan (ESOP), or wanting to go pub-lic,1 this is the structure to adopt. There are no limitations on the number of shareholders or subsidiaries, and there is ample case law to provide guidance in protecting both majority and minority shareholders.2 Despite the normalization of corporate law across America, both Delaware and Nevada still enjoy reputations as corporate havens for maximum legal flexibility.

C-Corps provide maximum tax benefit for employee benefits with up to $50,000 in individual benefits deductible. Various classes of stock can be issued on terms favorable to even the pickiest institutional investor or venture capitalist, including provisions for preferred stock options and preferential liquidation rights. The form is also the best choice for owners considering ownership succession.

The biggest downside is the double taxation issue. Unlike other forms of organizational structure, the C-Corp is a taxable entity-which means owners pay taxes at both the corporate and personal level. Similarly, losses do not

pass through to the individual investors. Many professional services firms address these challenges by managing the bottom line, but this practice has limitations, and principals must be careful not to run afoul of IRS rules restricting, and possibly penalizing, this practice when taken to excess (using excessive compensation guidelines and personal holding company penalties as their tools).

An additional challenge also being seen more today has emerged as some attorneys have initiated novel (fraudulent conveyance) strategies to pierce the corporate veil. Actions usually follow Racketeer Influenced and Corrupt Organizations (RICO) or Employee Retirement Income Security (ERISA) violations, charges of corporate fraud or malfeasance on the part of key shareholders or officers, are related to creditor disputes, and/or are the product of equitable distribution actions in marital dissolutions. Because fraud statutes are often very broad, some plaintiff attorneys use the statutes to discover hidden assets or challenge valuation approaches.

Advantages

1. The C-Corp has maximum flexibility for growth and expansion.

2. Liability protection and regulations as in the corporate form apply.

3. Companies can convert from S-Corp and LLC.

4. Number of shareholders or subsidiaries are not limited.

5. There are no limitations on who may own shares.

6. Multiple classes of stock and other securities are allowed, along with flexible rights and preferences.

7. This form is not restricted to small business companies.

8. Ample case law exists to defend rights of all involved parties.

9. This is the most attractive form for institutional investors.

10. Stock options are available for employees.

11. Maximum employee benefit deductibility is provided.

12. The C-Corp is the best structure for eventual IPO and/or succession strategy.

Disadvantages

1. There is a potential for double taxation (on corporate income and dividend income).

2. Corporate income and loss cannot be used on a personal level.

3. C-Corp structure requires more formality to be in conformance with legal requirements (failure to conform may become problematic if firm leaders are challenged by dissident shareholders, creditors, estranged spouses or disaffected employees). Conformance requires regular board and shareholder meetings, preparation and maintenance of formal corporate minutes, maintaining records of resolutions, and

some arms length restraint regarding personal distributions to key shareholders.

4. There are limits on the amount of earnings that can be retained in closely held companies as well as limits on executive compensation levels (before unreasonable compensation and personal holding company penalties are pursued).

Equity and Compensation

It sometimes appears that there are nearly an infinite number of ways to divide equity and establish creative compensation plans. The most popular and accepted plans separate equity and return on equity from job performance. Firms that fail to make this separation and/or cloud compensation issues often experience high turnover and spotty overall firm performance.

Equity

Equity can be allocated in many ways. It can be gifted or awarded, purchased or sold, earned or inherited. Provided the firm has taken the time to establish an ongoing valuation procedure and engages in strategic planning, most processes proceed slowly and peacefully.

The most basic need when dealing with equity in the firm is to determine if those who currently own it want to retain it, give or gift it to a relative, use it to retain the best firm talent, sell it to an individual, or even dispose of it by initiating an ESOP.

With the largest shareholders intent in mind and a valuation formula in place, serious consideration can be given to how best to use expanded equity participation as a strategic tool.

In increasing the pool of shareholders, the leadership should always be sure to restrict the shareholders ability to freely resell firm shares. The firm should have the right of first refusal for all outstanding shares at the time of a shareholders separation or death (shares are often repurchased over a period of time-often 5 years for a friendly parting and 7 to 10 years when asked to leave). This is usually accomplished by adding a legend to each stock certificate detailing the procedure for selling shares.

Stock can be gifted, earned, or awarded based on the operational performance or profitability of the firm and the roles played in achieving those results by those being gifted. So called sweat equity programs are defined within this scope and represent a way to acquire excellent talent at what amounts to discounted prices. All stock awards should be commensurate with results over and above a predetermined base level of performance. Shares to be allocated to new and prospective owners in such programs are