Non-Tax Factors in Choosing the Correct Entity

Selecting the Entity that is Right for You

In choosing the most appropriate form of organization, the business owner will want to consider a variety of factors, including: complexity and expense of organizing the business; liability of the business owner; distribution of profits and losses; management control and decision making; financing startup and operation of the business; transferability of ownership interest; continuity of the business entity following withdrawal or death of an owner; complexity and expense of terminating or reorganizing the business; extent of governmental regulation, and tax considerations.

These factors should be examined carefully in light of the objectives of the business owner. Competent legal, accounting and tax professionals can provide valuable advice and assistance in selecting the most appropriate form of organization.

As with many business decisions, choosing a form of organization involves weighing the advantages and disadvantages of each alternative before selecting the form most appropriate to the business owner’s situation. No one form of organization will be appropriate to all situations, and as the business expands a change in the form of organization may be necessary. The discussion which follows examines the differences in each of the above factors for proprietorships, partnerships, corporations, and limited liability companies.

Complexity and Expense of Organizing the Business

All businesses, regardless of their form, will encounter certain organizational costs. These costs can include developing a business plan, obtaining necessary licenses and permits, conducting market research studies, acquiring equipment, obtaining the advice of counsel, and other costs.

Sole Proprietorship

The sole proprietorship is the simplest form of organization, and the least expensive to establish. There are no statutory requirements unique to this form of organization. From a regulatory standpoint, the business owner only needs to obtain the necessary business licenses and tax identification numbers, register the business name, and begin operations. Many individuals begin their business as a sole proprietorship. As the business expands or more owners are needed for financial or other reasons, a partnership or corporation may be formed.

Partnership

A general partnership is more complex to organize than a sole proprietorship, but involves fewer formalities and legal restrictions than a limited partnership, corporation, or limited liability company. Basic elements of partnership law are established by statute, but most issues can be determined recommended, but agreement of the partners. A written partnership agreement is highly legally required. The partnership agreement is not required to be filed with any governmental entity. Note that under the Revised Uniform Partnership Act (RUPA) of 1997, Minn. Stat. Chapter 323A, partnerships have the option of filing with the Secretary of State certain statements regarding the authority and liability of partners as well as the status of the partnership.

A limited partnership must meet specific statutory requirements at the time of organization, and the offering of ownership interests in the limited partnership is subject to securities laws. Accordingly, the limited partnership often is more complex and expensive to organize than a general partnership.

Limited Liability Partnership and Limited Liability Limited Partnership

An existing general partnership may elect limited liability partnership status by filing a limited liability partnership registration with the Secretary of State. Such registration is effective for an indefinite period of time. Limited liability limited partnerships are also permitted. Anyone interested in forming an LLP or an LLLP is advised to seek the advice of counsel. Note also under applicable statutes, limited liability status has an indefinite term, although the Secretary of State will revoke LLP or LLLP status if the required annual registration is not filed. Limited liability partnerships and limited liability limited partnerships generally follow the basic partnership or limited partnership law with specific exceptions as provided by law.

Corporation

The corporation is a formal and complex form of organization, and accordingly can be expensive to organize. Procedures and criteria for forming the corporation and for its governance are established by statute. Failure to follow the statutory formalities can result in loss of corporate status and imposition of personal liability on the incorporators or shareholders.

The S corporation faces further complexity in that an election to be taxed as an S corporation for federal tax purposes must be filed with the Internal Revenue Service in a timely fashion. In addition, care must be taken in the transfer of shares not to inadvertently lose S corporation status.

Because of the complexities involved in incorporating, corporations often will make greater use of professional advisers, which will increase costs. Other costs associated with incorporating include filing fees, which are greater for corporations, and the costs associated with tax compliance and preparing various government reports. If the corporation does business in other states, it generally will be required to register to do business in those states, thus further increasing the cost and complexity of incorporation. And, if the corporation will raise capital by selling securities, the compliance costs involved will be substantial.

Minnesota has attempted to simplify the incorporation process by including in the Minnesota Business Corporation Act all of the rules pertaining to the internal governance of the corporation. A corporation that agrees to be governed as specified in the statute need only file standard form articles of incorporation with the Secretary of State. The corporation that wishes to vary the statutory requirements generally must do so in its articles of incorporation. Prior consultation with legal counsel can assist the incorporators in determining which approach is most appropriate for the corporation.

Limited Liability Company

The new Minnesota Revised Uniform Limited Liability Company Act takes a more partnership—like approach to these entities than did the prior Act. Nevertheless, a limited liability company often will combine aspects of both partnerships and corporations. In many cases where the governance and economic rights are simple and allocated among the members equally, one can expect formation to be similar to a corporation in complexity and cost to organize. As with a corporation, the procedures and criteria for forming a limited liability company are specified by statute. Failure to follow the statutory requirements can result in loss of limited liability company status and imposition of personal liability on the organizers and members of the company.

There is very little case law to guide organizational and operational decisions, although Minnesota’s current limited liability company law is modeled on the Revised Uniform Limited Liability Company Act, and the commentary to that may be helpful and can be found on the internet at http://www.iiniform1aws.ore/shared/docs/1imited%201iability%20companv/ii11ca _ final 06rev. df.

In addition, the Minnesota Revised Uniform Limited Liability Company Act contains default rules that will apply in the absence of an agreement by the member (for example, each member has equal management rights and the right to an equal percentage of non-liquidating distributions made by the limited liability company. Members of limited liability companies need to be familiar with these rules. They often will want a formal written agreement where their intentions differ from the law’s default rules. For these and many other reasons, owners of a limited liability company may need to consult often with their professional advisers, increasing their costs.

As is the case for Minnesota corporations, members of a limited liability company may agree to have the company governed by the default provisions of the governing statute — Minn. Stat. Chapter 322C. In that case, standard form articles of organization may be used to organize the company. The law, however, permits the members of these entities to vary many of the default provisions of firm. Stat. Chapter 322C through agreements called “operating agreements”. While it is advisable in most instances to reduce an operating agreement to writing, that is not required. Like a partnership agreement, an operating agreement may be oral, in a record (e.g., in written or electronic format), implied by conduct, or in any combination thereof, as long as it is the agreement of all persons who are members when the agreement is entered into.

Liability of the Business Owners

Sole Proprietorship

The sole proprietor is personally liable for the debts of the business, even if those debts exceed the owner’s investment in the business. All of the owner’s assets — both those used in the business and personal property (subject to certain exemptions) — can be attached by creditors and sold to pay business debts. The sole proprietor may be able to minimize certain risks such as property loss, personal injury or product liability by obtaining adequate insurance.

Partnership

In a non-LLP general partnership, each partner may be personally liable for up to the full amount of the debts of the business, even if the debts exceed the owners’ investment in the business. The partner with greater personal assets thus risks losing more than a partner with fewer personal assets. As with x sole proprietorship, many business risks can be lessened by obtaining adequate insurance.

However, in a Minnesota limited liability partnership, partners are not personally liable for the wrongful acts or omissions in the ordinary course of business of other partners, for the misuse of money or property of anon—partner by another partner, or for the debts or obligations of the partnership, subject to certain exceptions. It is uncertain how this kind of partnership will be treated in other states, although most states have adopted some form of limited liability partnership legislation.

In a limited partnership, so long as the statutory formalities are met and the limited partner is not relied upon by others as a general partner, the limited partner generally is not liable for the obligations of the limited partnership. Thus, the limited partner risks loss only up to the amount of his or her investment. The general partner retains full liability as in any other partnership. In limited liability limited partnerships general partners will enjoy the same protections from liability enjoyed by limited partners or partners of an LLP.

Corporation

The corporation is a separate legal entity, and in most cases is the entity that is liable for the debts of the business. The shareholders generally are exempt from personal liability for those debts and thus risk loss only up to the amount of their investment in the corporation. This is true for both C corporations and the S corporations. It should be noted, however, that in a small, closely held or newly created corporation without an established credit history, some or all of the shareholders may be expected to personally guarantee repayment of certain corporate debts as a condition of obtaining a loan or credit.

Also, under certain circumstances such as fraud or personal wrongdoing, a court may “pierce” the liability shield and hold shareholders personally liable for wrongful acts. Finally, it is possible for courts to “disregard” the corporate entity and make shareholders liable under certain circumstances, especially where the corporation and the shareholders themselves have not respected the corporate entity by commingling corporate funds with those of other persons or having the corporation pay shareholder personal expenses out of corporate assets. See the Withholding Tax Deposit and Filing Requirements information of the Income Tax Withholding section of this Guide for additional information on personal liability for payment of employment taxes.

Limited Liability Company

Liability of the owners of a limited liability company generally is the same as for shareholders of a corporation; that is, absent fraud, personal wrongdoing or disregard of the entity, they generally are not held personally liable for the debts and obligations of the business. They therefore risk loss only up to the amount of their investment. As is the case for corporations, owners of small, closely held, or newly organized limited liability companies may be required to give personal guarantees of repayment to secure financing or credit.

Remember no liability protection for personal act. It is important to note that no entity structure will insulate the owner from liability for his or her own personal acts.


CREDITS: This is an excerpt from A Guide to Starting a Business in Minnesota, provided by the Minnesota Department of Employment and Economic Development, Small Business Assistance Office, Thirty-fourth Edition, January 2016, written by Charles A. Schaffer, Madeline Harris, and Mark Simmer. Copies are available without charge from the Minnesota Department of Employment and Economic Development, Small Business Assistance Office.