When you start a new business, thinking ahead to what would happen if an owner leaves the business might be the furthest thing from your mind. But it’s important to plan for the death, disability, or any departure of a business owner. This sort of planning is called “business continuity” or “business succession” planning, and if you don’t do it, the laws of your state might do it for you.
Each state’s business laws contain default provisions governing what happens when an owner dies, becomes incapacitated, retires, or otherwise withdraws from the business. Business continuity planning allows you to change these outcomes, and can also address what happens to an ownership interest if an owner files for bankruptcy or gets divorced and needs to consider the business interest when dividing marital property. For example, state law might provide that, absent an ownership agreement to the contrary, an LLC or a partnership automatically terminates upon the death or withdrawal of an LLC member or a partner.
However, business owners can agree to avoid or modify these default outcomes, and can prevent ownership interests from being transferred in a divorce or bankruptcy. The legal agreement that owners use is called a “buy-sell agreement” or a “buyout agreement”.
Buy-Sell Agreements
A buy-sell agreement can be between shareholders of a corporation, partners of a partnership, LLC members, or a key employee and a sole proprietor. The agreement obligates the remaining business owners, key employees, or the business itself to purchase the interest of the deceased or withdrawing owner. The buy-sell agreement can establish when a deceased or withdrawing owner’s interest must be bought out, who can buy-out the interest, the price to be paid (or a method for determining that price), and the other terms of the transfer—for example, whether the purchase price will be paid in a lump-sum payment or in installments over time.
It’s best to have a buy-sell agreement in place early in the company’s life, preferably when the business is first organized. This can avoid innumerable headaches and costly disputes later on. For an in-depth explanation of buy-sell agreements, see Nolo's Business Buyout Agreements.
The way that owners can provide for business continuity planning depends on the type of legal entity they have chosen for their business–corporation, LLC, general partnership, or sole proprietorship. The discussions below explain how planning can be done in each type of business.
Continuity of Corporations
A corporation, though made up of individuals, is a separate legal entity, apart from the owners . It can continue indefinitely until the owners or the state decide otherwise. Its existence is not affected by the death, withdrawal, or incapacity of its shareholders, officers, or directors. Moreover, the transfer of a corporation’s shares from one person to another does not affect its existence. This stability has always been one of the great advantages of the corporate form.
However, a corporation doesn’t have to exist forever. Its shareholders can voluntarily decide to dissolve it. In some cases, the directors may dissolve a corporation—for example, if it goes out of business or is bankrupt. A corporation may also be involuntarily dissolved upon court order if minority shareholders are mistreated; or if it fails to pay its debts, commits fraud or other illegal acts, or fails to pay taxes or make required corporate filings.
Although corporations can last forever, human shareholders don’t. Sooner or later, the shareholders typically want to dispose of their interests. The shareholders of small corporations whose shares are not readily saleable to the public, often enter into shareholder buy-sell agreements, that require the other shareholders to buy a departing shareholder’s shares under specified circumstances, such as death or disability.
Continuity of Limited Liability Companies
Many limited liability companies (LLCs) have multiple owners (called members). Others have only one owner-member—these are called single-member LLCs (SMLLCs). Here’s what happens to these LLCs upon the death or withdrawal of owners or an owner:
- Multi-member LLCs. In most states, the death or withdrawal of an LLC member in a multi-member LLC will result in dissolution of the LLC, unless:
- at least one other member remains and the LLC operating agreement permits continuation of the business, or
- the remaining LLC members unanimously agree in writing within 90 days of the death or withdrawal of a member to continue the business and elect a new LLC member to run the LLC business, if necessary.
If owners/members want to vary these rules, they should sign an LLC owner buy-sell agreement.
- Single-member LLCs. In some states, an SMLLC must dissolve when the owner dies or becomes incapacitated. In other states, the sole member’s heir or legal representative has the option of continuing the LLC. In either case, it’s wise for the owner of an SMLLC to have a written operating agreement that includes a provision appointing a successor in the event of the member’s death or incapacity.
Continuity of Sole Proprietorships
Unlike a corporation or LLC, a sole proprietorship is not a legal entity separate from its owner. Instead, the proprietor personally owns all the business assets. Thus, a sole proprietorship has no continuity of life. It automatically terminates by law upon the sole proprietor’s death or disability.
If the proprietor dies, the business assets, if any, will go to the late sole proprietor’s legal heirs. The heirs can sell the business as a going concern, or sell the individual assets on a piecemeal basis. However, it can be difficult to sell a sole proprietorship, because potential buyers fear that key employees will not remain after the owner’s death. Moreover, the loss of the sole proprietor’s personal services, often a major contributor to the value of the business, will often depress its sale value. Instead of selling the business, one or more heirs can continue to operate it. A single heir who takes over the business thereby creates a new sole proprietorship; when multiple heirs carry on, they will need to choose among the available business entity types.
A sole proprietor can plan for his or her death or withdrawal from the business by entering into a buy-sell agreement with employees, relatives, or others who agree to take over the business when the proprietor is no longer able or chooses not to run it.
Continuity of Partnerships
A general partnership is made up of two or more people, each of whom is responsible for the partnership’s legal obligations. A limited partnership includes both limited and general partners, with only the general partners being liable for the debts of the partnership. In many states, a general or limited partnership automatically dissolves when a partner dies, becomes incapacitated, goes bankrupt, or resigns from the partnership. Technically, this means the people involved are no longer partners. They have two alternatives.
- They can accept the dissolution, wind up the partnership’s business, and terminate the partnership. Winding up a partnership means paying the debts of the business and distributing any remaining assets to the partners.
- Alternatively, the remaining partners can continue the partnership business despite the dissolution. In effect, although the original partnership has been dissolved by law, the remaining owners can create a new partnership to carry on the business. The new partnership may consist of the former partners plus a new partner who has purchased the partnership interest of the withdrawing or deceased former partner, or the remaining partners may themselves purchase the interest.
In other states, a partnership does not automatically dissolve when a partner leaves. Instead, state partnership law permits the partnership to buy out the interest of a partner who leaves, without dissolving the partnership. But if they choose not to do so, the partnership dissolves.
The best practice is for the partners to decide ahead of time what they will do if one or more partners dies or withdraws, by entering into a partnership buy-sell agreement. The agreement can be included at the outset as part of the partnership agreement, or in a separate agreement that the partners agree to when they form the partnership or later. A limited partnership will always have a partnership agreement
Business Succession Planning and Estate Planning
For many small business owners, their ownership in their business is a significant asset and might account for a substantial portion of their net worth. For such owners, business succession planning and personal estate planning should be done in harmony. For more information on integrated estate and business succession planning, see Estate and Business Succession Planning for Small Business Owners.