One of the fundamental initial decisions a new business owner faces is choosing the form of organization for the business. Generally speaking, a person should consider himself or herself to be “in business” once they have begun the operation of an activity for which they expect to be paid.
This is true whether that person terminates other employment (such as a job that brings a paycheck), or intends to operate that business on a seasonal or short—term basis. For most businesses, the choices are:
In a sole proprietorship, the business is owned and controlled by one individual. This person alone receives the profits and bears the losses from the business, and this person alone is responsible for the debts and obligations of the business.
Income and expenses of the business are reported on the proprietor’s individual income tax return, and profits are taxed at the proprietor’s individual income tax rate. If a husband and wife wish to own a business together, they must either form a partnership, corporation, or limited liability company (in order to have each of them be an owner of the business) or a sole proprietorship (in which case only one of them will be an owner of the business).
A married couple who jointly operate an unincorporated business and who file a joint federal income tax return may have a qualified joint venture and can elect not to be treated as a partnership for federal tax purposes provided that the husband and wife are the only members of the joint venture and that both husband and wife materially participate in the running of the business. In this case each spouse will report his or her share as a sole proprietorship.
A general partnership is a business owned by two or more persons who associate to carry on the business as a partnership. Partnerships have specific attributes, which are defined by statute. All partners in a general partnership share equally in the right, and responsibility, to manage the business, and each partner is responsible for all the debts and obligations of the business.
Distribution of profits and losses, allocation of management responsibilities, and other issues affecting the partnership usually are defined in a written partnership agreement. Income and expenses of the partnership are reported on federal and state “information” tax returns, which are filed by the partnership. These include Schedules K—1 which are used to report to the partner’s respective shares of partnership taxable income. The partners then report this income on their separate tax returns along with their other income and pay tax at their applicable income tax rates.
Minnesota partnerships are formed and governed only by the Revised Uniform Partnership Act (RUPA), firm. Stat. Chapter 323A. Partnerships formed under former partnership law are now subject to this chapter. If you were formed under former laws and have not yet consulted with an attorney about the changes in partnership law, you are encouraged to do so immediately.
A limited partnership is a type of partnership in which the limited partners share in the partnership’s liability only up to the amount of their investment in the limited partnership. By statute, the limited partnership must have at least one general partner and one limited partner. The general partner has the right and responsibility to control the limited partnership, and is responsible for the debts and obligations of the limited partnership.
In Minnesota, a limited partner may participate in the management and control of the limited partnership without losing limited liability protection, but does not have the power to act for or bind the limited partnership (unless this is provided for in a separate agreement). Limited partnerships must be established in compliance with statutory requirements, including requirements of tax and securities laws. Because of their complex nature, limited partnerships should not be undertaken without competent professional advice.
A general partnership may register as a limited liability partnership (LLP) by filing a limited liability partnership registration. In limited liability partnerships, the personal assets of the partners are shielded against liabilities incurred by the partnership in tort or contract situations. This is different from a non-LLP general partnership, in which partners may be personally liable to an unlimited extent for the debts and obligations of the partnership. It should be noted that limited liability partnerships are a relatively new type of entity and certain aspects, such as tax aspects, of such entities are not yet fully developed or understood.
Limited liability partnership status affords protection to the individual partner from liability for partnership obligations in tort and contract. An LLP files with the Secretary of State an annual report. There is a one—year grace period for retroactive reinstatement after revocation of LLP status for failure to file the annual report.
Limited liability partnerships must have a name that includes one of the following: “Registered Limited Liability Partnership,” “Limited Liability Partnership,” “R.L.L.P.,” “L.L.P.,” “RELP,“ or “LLP. This should be used by the partnership in transactions with third parties so that they are aware of the partnership’s status.
Minnesota law also allows a limited partnership to elect limited liability status under Minn. Stat. Chapter 321 by so designating this status in its certificate of limited partnership. This extends limited liability protection to both general and limited partners. This type of limited partnership is called a limited liability limited partnership. Limited liability limited partnerships are discussed below.
Care should be taken in naming a limited liability limited partnership; the name must contain the phrase “limited liability limited partnership” or the abbreviation “LLLP” or “L.L.L.P.”, which must be part of the name, and must not otherwise contain the abbreviation “L.P.” or “LP.”
A corporation is a separate legal entity that is owned by one or more shareholders. The corporation must be established in compliance with the statutory requirements of the state of incorporation. The shareholders elect a board of directors which has responsibility for management and control of the corporation. Because the corporation is a separate legal entity, the corporation is responsible for the debts and obligations of the business. In most cases, shareholders are insulated from claims against the corporation.
It is worth noting here that because a corporation is an entity separate from its owners, if the owner (and/or members of the owner’s family) performs services for the corporation, these persons are considered to be employees of the corporation. Thus, the corporation will be required to comply with most of the laws and regulations and reporting requirements applicable to employers.
The corporation may be taxed under Subchapter C of the Internal Revenue Code (a “C corporation”) or the provisions of Subchapter S of the Code (an “S corporation”). Minnesota tax laws provide for comparable treatment.
A C corporation reports its income and expenses on a corporation income tax returns and is taxed on its profits at corporate income tax rates. The Minnesota corporate franchise tax, sometimes called an income tax, is based on the portion of a C corporation’s income that is allocated to Minnesota. Profits are taxed without regard to payment of dividends, which generally are not deductible. Dividends paid to shareholders are taxable income to them. This is sometimes referred to as “double taxation” because this effectively taxes operating income twice, once to the corporation and then again when distributed to the owners, although it actually is two separate taxpayers being taxed on their separate income.
An S corporation election may be made by the shareholders of the corporation if the corporation meets the statutory requirements for 5 corporation status. An S corporation that has not previously been taxed as a C corporation is taxed in much the same manner as a partnership, i.e., the S corporation files an information return to report its income and expenses, but it generally is not separately taxed. Income and expenses of the S corporation “flow through” to the shareholders in proportion to their shareholdings, and then are taxed to them at their individual rates. Under the Internal Revenue Code, an S corporation may have only one class of stock (i.e., “common” stock, although voting differences are permitted), no more than 100 shareholders, and no shareholders that are nonresident aliens or non-individuals (e.g., corporations, partnerships, limited liability companies) except for certain estates, trusts, and certain tax exempt entities. The federal 2004 American Jobs Creation act allows an S corporation to treat shareholders within six generations of one family as one shareholder thus allowing family business S corporations to distribute shares to family members of existing shareholders without those new shareholders being counted as new shareholders against the 100 shareholder limit. S corporations are described in more detail in later sections of this Guide. (If the shareholders of an existing C corporation elect to have it taxed as an S corporation additional rules as well as corporate level taxes may come into play. Any such change in tax status should be discussed in advance with a competent tax advisor.)
A closely held corporation is any corporation whose shares are held by a relatively small number of shareholders. The Minnesota Business Corporation Act defines a closely held corporation as one which does not have more than 35 shareholders. Most closely held corporations are relatively small business enterprises, in which all shareholders tend to be active in the management of the business. Some states provide a separate, less formal, less restrictive set of laws for closely-held corporations. Minnesota does not. In Minnesota, the business corporation law is geared to small corporations, so a separate law is not necessary, and all corporations operate under one law.
A Minnesota business also may organize as a limited liability company. A limited liability company may have one or more members. As described further in the section on tax considerations in choosing the form of organization, under Treasury Regulations regarding entity classification the members of limited liability companies have some flexibility with respect to the federal income tax treatment of their entities. Under these rules a limited liability company with more than one member will be taxed as a partnership unless it elects to be taxed as a corporation and a limited liability company with only one member will be taxed as a sole proprietorship (a “disregarded entity”) unless it elects to be taxed as a corporation. The applicable regulations appear in 26 C.F.R. § 301.7701—1, et. seq.
A limited liability company that is taxed as a partnership or as a corporation must obtain its own tax ID numbers. A limited liability company with only one member that is taxed as a sole proprietorship generally does not need to obtain separate federal or state tax identification numbers unless it has employees or pays federal excise taxes, in which case it will obtain tax ID numbers and use them to remit employment taxes or pay excise taxes.
Business income and losses of a limited liability company that is taxed as a partnership or as a sole proprietorship are passed through to the members, included in their taxable income, and taxed at each member’s income tax rate. As with a corporation, liability for business debts and obligations generally rests with the entity rather than with the individual owners. A limited liability company is not subject to many of the restrictions that apply to S corporations (unless it elects to be taxed as a corporation and wishes to be taxed as an S corporation). All members of a limited liability company may participate in the active management of the company without risking loss of limited personal liability. Minnesota adopted a new Limited Liability Company Act (Minn. Stat. Chapter 322C) that became effective August 1, 2015. Minnesota limited liability companies formed on or after that date are subject to the new act, and may be managed by the members, by a board of governors, or by a manager.
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.