Three Partners, One Retirement, and a Liability Wake-Up Call
Harper Ridge Landscaping has operated for 11 years as a general partnership owned equally by Dana, Miguel, and Priya. Revenue last year was $1.4 million with net income of $180,000, split equally among the three. The firm owns trucks and skid steers and leases a yard; it carries $250,000 of equipment debt personally guaranteed by all three partners. In March a company truck ran a red light and struck a parked car. The insurer paid that claim, but Dana's attorney warns that a future judgment could reach the partners' personal savings. Dana, 63, plans to retire in 20 months and wants cash for her interest. Miguel and Priya want to admit Ramon, the operations manager, as a one-third owner. Their banker says the equipment loan can be refinanced in the company's name only if the business is a separate legal entity and the owners sign a buy-sell agreement.
1. Recommend an ownership structure for the business and justify it against the partners' liability, tax, and financing constraints.
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Three options are realistic: stay a general partnership, convert to an LLC, or incorporate as an S corporation.
Staying put fails two tests. A general partnership is not a separate legal person, so each partner remains personally liable for the truck accident and for the $250,000 debt. It also does not satisfy the banker, and it terminates on a partner's withdrawal or death unless the agreement says otherwise - a real risk with Dana leaving.
An S corporation would create the liability shield, but it restricts who can hold shares, permits only one class of stock (awkward if Ramon buys in on a vesting schedule), and requires formal payroll. Its advantage is that distributions escape FICA, which at $180,000 of income might save roughly $8,000–$12,000 a year against added payroll and filing cost.
An LLC is the best fit now. It is a separate legal entity, so the banker's condition is met and the owners' homes are shielded absent personal guarantees or fraud. With multiple members it is taxed as a partnership by default: income is taxed once, allocations are flexible in the operating agreement, and Ramon can be admitted as a member with a profits interest without breaking a one-class-of-stock rule. The cost is that members' distributive shares are generally subject to self-employment tax.
Recommendation: convert to an LLC now, adopt a written operating agreement, and revisit an S election once Ramon is fully admitted and payroll systems exist.
2. Propose how Dana's exit and Ramon's entry should be structured and funded, including valuation and the key terms of a buy-sell agreement.
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Valuation. Net income of $180,000 is not a clean number: Dana's duties will be partly absorbed by Ramon, so normalize earnings by adding back her compensation and subtracting a market salary for her replacement. Assume adjusted earnings near $200,000. Apply a multiple appropriate to a small, owner-dependent service firm - commonly 2.5x to 4x adjusted earnings - giving roughly $500,000–$800,000 of enterprise value. Because Dana's one-third interest is a minority stake in a private business, apply a marketability and minority discount, perhaps 15–25 percent. Agree on the formula now and attach it to the agreement so no later negotiation is needed.
Mechanism. Choose an entity redemption (the LLC buys Dana's interest) or a cross-purchase (Miguel and Priya buy it). Redemption is simpler administratively; a cross-purchase gives the buyers basis step-up. Either way, pair it with mandatory buy-sell triggers: death, disability, retirement, divorce, bankruptcy, and attempted sale to an outsider.
Funding. Fund the death and disability triggers with term life and disability policies owned by the entity or cross-owned. Fund Dana's retirement with a promissory note - say 20 percent down and the balance over five years at a market rate - because the business will not have $600,000 of cash. Secure the note with a lien on the purchased interest and require the remaining owners to guarantee it.
Ramon's entry. Have him buy in at the same per-unit value, with a vesting schedule and a capital contribution, plus a restrictive covenant and a right of first refusal on any later transfer.