There are many different types of business organizations available in the state of Minnesota. This article is meant to give a brief introduction into these organizations, including general information on formation, taxation and liability. It concludes with a chart summarizing the key points of each business entity.
Corporations – S-Corp and C-Corp
A corporation is a separate legal entity in and of itself rather than as a collection of individuals. It is owned by one or more shareholders. The shareholders elect a board of directors which is responsible for management and control of the corporation. Because the corporation is a separate legal entity, it is responsible for the debts and obligations of the business. In most cases, shareholders are insulated from claims against the corporation. An “S corporation” is a corporation that elects to be treated under Subchapter S of the Internal Revenue Code. In most cases, S corporation shareholders, rather than the corporation itself, are taxed on the profits of the corporation. In contrast, a “C corporation” (taxed under Subchapter C of the Internal Revenue Code) is taxed on the profits of the corporation at the corporate tax rate, and any dividends paid to shareholders from after-tax profits are taxed again at the shareholder level at the individual tax rate (often referred to as, “double taxation”). A “C corporation” is a publically held corporation and usually has a large number of individual owners. An “S corporation” is typically a closely held corporation. All of the shareholders must consent to Subchapter S treatment. Further, to be treated as an S-Corp, the corporation:
- Must be a domestic corporation;
- Must not be part of an affiliated group of corporations;
- Must not have more than 35 shareholders;
- Must have only one class of stock;
- Must have only shareholders who are individuals, a decedent’s estate, or one of special class of trusts (not corporations or partnerships); and
- Must have no shareholders who are nonresident aliens.
A corporation provides the most secure shelter from personal liability for the obligations of the business. Furthermore, a corporation is the best business organization to raise significant capital for the operations of the business. Another advantage is the “survivability” of the corporation. Whereas a number of other business organizations do not, or need special language in its formation documents to, survive beyond the life of its owners. Because a corporation is a separate legal entity, it is independent of its owners.
A corporation has many corporate formalities required to put the public on notice that they are dealing with a limited liability entity. Among many others, these formalities include: separate bank accounts between the corporation and its owners; conducting regular meetings of the board of directors and of shareholders; electing directors; and complying with numerous registration, and periodic reporting requirements. Furthermore, if a corporation is publicly traded, a whole plethora of regulations ensue under the SEC and Federal Regulations Acts. A failure to adhere to these corporate formalities may cause a court to ignore the organizations corporate status subjecting the shareholders to personal liability. This is called “piercing the corporate veil”.
Limited Liability Company (LLC)
An LLC may have one or more owners, called “members.” The most common form of an LLC is a business organization that is designed to combine the tax treatment of a sole proprietorship or partnership with the limited liability characteristics of a corporation. This means that the profit or loss of an LLC is passed through to your individual tax return, and taxed at the individual rate. Thus, an LLC member avoids corporate double taxation as well as the higher corporate tax rate on any profits from the LLC. In addition to the taxation benefit, an LLC also offers limited liability to its members’ personal assets. This benefit exists in a limited partnership for the limited partners (who have limited to no managing authority) as well as in a limited liability partnership under certain conditions. Unlike these business organizations an LLC offers unconditioned limited liability for all of its members without the loss of any decision-making authority (subject to the legal doctrine of piercing the corporate veil mentioned below). Since Minnesota has recognized the LLC business organization in 1993, it has become one of the most popular choices for budding entrepreneurs in the state.
The formation and operation of a Minnesota LLC is governed by Minnesota Statutes Chapter 322B. Under Minnesota law, an LLC is formed by filing articles of organization with the Secretary of State and paying the filing fee, which is $160 as of this writing. An LLC must register with the Secretary of State once every year. The articles of organization must include information that satisfies the minimum requirements prescribed by the state. However, the most important function of the articles of organization is to define the infrastructure of the LLC including tax-status election and member responsibilities. For instance in an LLC, governance rights (the right to control the operations of the business) may be separated from ownership rights (the right to share in the increased value of the business). This means that an LLC member may own 50% of the value of an LLC, but have less or more than 50% control of the business as de3termined by LLC documents.
An LLC is the most flexible business organization with regard to management and ownership. To properly outline the direction and boundaries of these areas, non-compulsory documents are highly recommended, such as an operating agreement and a member control agreement. A member control agreement is similar in function to a corporation’s shareholder agreement, whereas an operating agreement is similar in function to a corporation’s bylaws. Without these documents, the members of an LLC are subject to the default provisions in Minnesota statutory law, which will most likely govern over the operation of the LLC in a manner different than what its members desire. These agreements are fact-specific to the circumstances of each limited liability company, and limited liability company members should consult with legal counsel in creating or signing such agreements. If you would like help with your LLC, call us at (612) 355-2200.
A sole proprietorship is a one-person business that is not registered with the state as a corporation or a limited liability company (LLC). It is the default business form. It is the easiest type of business entity to form and maintain. In fact, it’s so easy to form and maintain that you may already own one without knowing it. For instance, if you independently contract a service for compensation, or get paid exclusively on commission, you are already a sole proprietor. There may be some local registration, license and/or permit requirements to make your business legitimate; however, in practice, businesses that are small enough will get away with ignoring these requirements. Keep in mind that if you choose to ignore these requirements, such as: local registration; obtaining an EIN from the IRS (if you have employees); and obtaining proper licensing and zoning permits; you are subjecting yourself to possible liability in the form of back taxes and other penalties.
A sole proprietor can and will be held personally liable for any business-related obligations, such as business debts, business related lawsuits, or defaults on a debt. The sole proprietorship offers the individual no liability protection. On the flip-side of that coin, the sole proprietor keeps all of the business profits as personal income.
Just as the sole proprietorship offers no protection from liability, it also offers no specific tax benefit. In the eyes of the law, a sole proprietorship is not legally separate from the person who owns it. This means that any income or loss from the business is reported directly on your individual income tax return – IRS Form 1040, with Schedule C attached. In addition, a sole proprietor will have to pay “self-employment” tax, which consists of contributions to Social Security and Medicare, and pay estimated taxes throughout the year. Typical business deductions such as health, dental, and life insurance for the sole proprietor may not generally be deducted either.
Partnerships – General and Limited
A General Partnership is much like a Sole Proprietorship, except it requires two or more owners. Under Minnesota Statutes (323A.0202(a)), “The association of two or more persons to carry on as co-owners a business for profit, forms a partnership, whether or not the persons intend to form a partnership.” This means that it is possible, just like a sole proprietorship, to be in a general partnership without even knowing or desiring it, and without a written agreement setting forth its terms. The major distinction between a general partnership and a sole proprietorship is the existence of a relationship between co-owners.
It is imperative (but not required by law) that general partners draw up a partnership agreement and other partnership documents, to define the relationship between the partners at every stage of the business (formation, operation and dissolution). This includes managing authority, authority to bind the partnership, and how to withdraw profits from and make contributions to the partnership, among other things. Most often, general partners get into legal disputes with each other where no agreements have been executed which define exit strategies, succession ownership or partner buy-outs. It is difficult for general partners to recognize potential areas of disagreement they may encounter in the future, which generally leads to conflict between the partners.
According to Minnesota statutory law and absent a partnership agreement, in a general partnership each partner has an equal voice in how the business is run and an equal share in the profits and losses. Just like a sole proprietor, a general partner’s personal assets are subject to the liability of business obligations. Even more significant, anything that one partner does affects all of the partners. That means each partner is personally responsible for all obligations of the partnership even if that obligation was entered into solely by the other general partner on behalf of the partnership. If it is not apparent already, one can see many areas of potential conflict between general partners absent a partnership agreement. If you need legal contracts to govern your business, contact us at (612) 355-2200.
A general partner faces tax liabilities identical to that of a sole proprietor. Each general partner is personally taxed on his or her share of partnership profits.
A Limited Partnership, unlike a general partnership, is required to file with the State. It consists of an association of individuals, some of whom participate in the day to day operations of the business (general partners) and others who do not (limited partners). Those who do not participate are typically the ones who provided the financing for the business. An LP must have at least one limited partner and at least one general partner. In addition, ownership interests of the partners cannot be freely transferred or sold without filing additional documents with the state and perhaps subject to additional limitations placed into partnership agreements. The most important distinction between an LP and a general partnership is that an LP sets limits on the power of partners to conduct business and affords limited liability to each limited partner (general partners have the same amount of liability as do partners in a general partnership).
A limited partner is prohibited from managing or making day-to-day-decisions concerning the business but is shielded from most debts incurred by the business. A limited partner is liable for business obligations only up to the amount of investment he or she put into the business. This means that a limited partner’s personal assets are not typically at risk. More legal formalities must be met under this type of arrangement than in a general partnership. In Minnesota, a limited partnership can only be formed in accordance with the Uniform Limited Partnership Act. State and federal tax codes make a number of distinctions between limited and general partnerships. In general, neither kind of partnership has to pay federal income tax, instead, each partner pays tax at the individual tax rates on his or her share of the profits.
Limited Liability Partnership (LLP)
An LLP is a fairly new business entity and is governed in the state of Minnesota by the Uniform Partnership Act of 1994. To change an existing partnership to an LLP, one must file a statement of qualification with the State.
An LLP is a general partnership with limited exposure to personal liability for business obligations. However, an LLP does not exempt general partners from personal liability in all circumstances. An inquiry into whether personal liability is attached to particular business obligations is very fact specific. Remember that in a general partnership, the general partners are personally liable for the business obligations incurred by any other general partner on behalf of the partnership. This is called vicarious liability. In Minnesota, an LLP affords protection to the personal assets of general partners from vicarious liability for malpractice claims in both tort and contract as well as non-malpractice torts and other contractual liabilities. An LLP does not protect a general partner from personal liability for his or her own negligence or malfeasance. In addition, most LLP statutes provide that LLP partners are liable for the negligence, wrongful acts and misconduct of any person under the LLP partner’s “direct supervision and control.”
Many judicial caveats arise under an LLP, which can mostly be attributed to the underdeveloped jurisprudence of LLP’s. The original purpose of the LLP was to protect general partners engaging in a professional activity from personal liability for the acts of another within the partnership, which is a great benefit. However, the extent of that protection ranges from state to state and case to case depending on a number of variables. For more information regarding LLP’s, call us at (612) 355-2200.
An LLP is generally taxed like a general partnership for federal income tax purposes. However, with more complex LLP’s, more complex tax implications arise.
Limited Liability Limited Partnership (LLLP)
An LLLP extends the liability protections of an LLP to the general partners in a limited partnership. Minnesota is one of twenty-two states that have LLLP enabling statutes.
Professional corporations are formed by professionals such as doctors, lawyers, and accountants for the purpose of saving money on their taxes through pension plans and deferred-income programs.
A professional corporation is much like any other corporation except that it can be formed by only one person and can engage in only one category of professional service. Also, only other individuals licensed to practice in that particular profession can own shares in such a corporation. The shares cannot be easily transferred. Although forming a professional corporation does not shield the individual from liability for professional malpractice, it can shield an individual from liability for malpractice committed by other persons with whom he or she associates.
Piercing the Corporate Veil
Piercing the corporate veil is when a limited liability entity loses its limited liability status subjecting the private owners / shareholders to personal liability for the organizations obligations. Courts will do this for a variety of reasons.
In Minnesota and Wisconsin, piercing the corporate veil is extremely rare. The Court will analyze the shareholders’ relationship to the corporation. Some questions that a court may ask include:
- Was there sufficient capitalization to carry on the corporate business?
- Did the shareholder follow corporate formalities such as conducting regular meetings, electing directors, and keeping separate accounts?
- Have proceeds of the corporation been siphoned off to shareholders?
There are numerous risks associated with forming a corporation. It is always wise to seek legal advice.