As a family business owner, you might be less formal about agreements with affiliated parties than you are with unrelated third parties. That is understandable because you rely upon the commonality of ownership, management, or family ties among affiliated parties to resolve any points of uncertainty that might arise about these business relationships. However, you should consider adopting formal written contracts for your affiliated party agreements because they can provide many valuable benefits.
What are affiliated party agreements?
For purposes of this discussion, "affiliated parties" include (a) members of your family and any trusts for their benefit, (b) the primary business entities owned by your family members and their trusts, (c) subsidiaries of your family business entities, and (d) any other business entities owned by your family members and their trusts.
"Affiliated party agreements" are agreements or understandings about ongoing business relationships between or among various affiliated parties, including business relationships between your family-owned company and the company's own subsidiaries.
Examples of affiliated party agreements include the following:
◊ Your family business employs a family member.
◊ Your family business leases equipment or real estate from family members or from a business entity owned by family members.
◊ One business entity owned by your family members provides management or executive services to another entity owned by your family members, including, perhaps, family-office services.
◊ Money is loaned between your business and a family member.
What are the benefits of written contracts for affiliates?
Written contracts for business relationships between parties that are affiliated with your family business can provide immediate benefits, long-term benefits, and some benefits that may be important in the case of certain crucial contingencies. The benefits, include the following:
● Superior business relationships.
The process of planning, discussing, and reviewing a written contract for a business relationship between affiliates will cause you and other family decision makers to be more thoughtful and purposeful about these arrangements. The process might lead you to adopt better business practices in these arrangements, such as greater efficiency, better communication, or a higher standard of accountability. If you involve your tax advisor, which you should do, you may discover potential tax savings in how these arrangements are structured or priced.
The process of formalizing these contracts may lead to discussions about family objectives and a better understanding of how different family members define fairness. The process might help you refine elements of your family's business succession plan and may prompt senior family members to update related elements of their retirement planning.
● Clarity and expectations.
A written contract will clarify what is expected of the affiliated parties in their business relationships and the consideration they will receive. The terms of the contract will set expectations realistically and reliably. This in turn will help family members better manage their own financial affairs and feel safer in committing their efforts and resources to the family enterprise.
● Durability.
A written contract will help affiliates' business relationships endure despite changing circumstances, including the exit of senior family members and the transition of family business management and control. Many oral agreements can be canceled at will by one party without clear recourse for the other party. In contrast, a written contract can bind the parties for a term of multiple years, with provisions for automatic renewals.
A written contract also can bind a party's successors, including involuntary successors. For example, if you loan funds to a family business entity that subsequently is forced into bankruptcy, you are much more likely to recover some of the amount owing to you if the debt is evidenced by a written promissory note or other loan document.
● Enforceability and alternative dispute resolution.
Oral business agreements are not enforceable in some circumstances, or they are difficult to enforce if there is no reliable evidence of the terms of the agreement. In contrast, a written contract is easier to enforce because the contract itself is the best evidence of the agreement and commitment on both sides. In addition, a written contract can require the parties (in most cases) to submit contract disputes to mediation or binding arbitration and thus avoid public litigation.
● Defense to piercing the corporate veil.
Usually, the owner of a limited liability business entity, such as a corporation or LLC, is not liable for the entity's obligations. Sometimes, however, a creditor of a limited liability business entity will try to force the entity's owner to pay the entity's obligations under a theory of "piercing the corporate veil." Courts might be willing to pierce the corporate veil if they conclude that the business entity was a sham or that the entity and its owner are not separate and distinct.
A written contract for business relationships between the business entity and its owner and other affiliates can be evidence that the parties are separate entities, especially if the parties structure their cash flow in accordance with the terms of the contract. Thus, written contracts among affiliates can be an effective defense against owner liability for obligations of the family business or its subsidiaries.
I hope these comments will help you consider adopting written contracts for your affiliated party business relationships.
Gregory Monday
9/14/2020