Category Archives: Business Planning

Forming a Business in Minnesota: Limited Liability Company (LLC)

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A Minnesota business also may organize as a limited liability company. A limited liability company elects to be treated for tax purposes as a sole proprietorship (disregarded entity), partnership, or corporation. 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, organizers of Minnesota limited liability companies have some flexibility with respect to the federal income tax treatment of such entities due to the Treasury Regulations on entity classification. These Regulations appear in 26 C.F.R. § 301.7701-1 et. seq. A limited liability company with more than one member may choose to be taxed as a partnership or a corporation. In either event, the limited liability company must obtain both federal and state tax identification numbers, even if it has no employees.

A limited liability company with only one member may be taxed as a corporation or as a sole proprietorship. A limited liability company that chooses to be taxed as a sole proprietorship generally does not obtain a federal or state tax identification number unless it has employees in which case it will obtain tax ID numbers and use them to remit unemployment taxes. Business income and losses of the limited liability company that chooses to taxed as a partnership or as a sole proprietorship may be passed through to the owners of the business. The income of a limited liability company that chooses to taxed as a partnership or as a sole proprietorship is included in the taxable income of the member or members and taxed at the owner’s individual tax rate. Like a corporation, a 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. All members of a limited liability company may participate in the active management of the company without risking loss of limited personal liability. It is managed by a board of governors and an active manager.

Forming a Business in Minnesota: Corporations

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A corporation is a separate legal entity from its owners, 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 be subject to 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 return and is taxed on its profits at corporation income tax rates. The Minnesota corporate franchise tax, sometimes called an income tax, is based on the income of a C corporation’s income allocated to Minnesota. Profits are taxed before dividends are paid. The dividends are taxable income to the shareholders. Sometimes this is incorrectly referred to as “double taxation”, when instead it is two separate legal entities 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 S corporation status. The S 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 profits are allocated and taxed to the shareholders at their individual tax rate. Under the Internal Revenue Code, an S corporation may have only one class of stock, 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.

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.

Forming a Business in Minnesota: Sole Proprietor and Partnerships

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Sole Proprietor

In a sole proprietorship, the business is owned controlled by one individual. That person alone receives the profits and bears the losses from the business, and that 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 sale proprietorship (in which case only one of them 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.

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.

Partnership

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. The partners are taxed on their respective share of the partnership’s profits at their individual income tax rates.

Minnesota partnerships are formed and governed only by the Revised Uniform Partnership Act (RUPA), Minn. Stat. § 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.

Starting a Small Business – How to Limit your Liability

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Previously in the Starting a Small Business Series we discussed the importance of limiting your liability as a Minnesota small business owner. In this post we will discuss how small business owners can best limit their liability. The first step to limiting your personal liability is to create a limited liability entity. A local twin cities attorney can help you with that.

Once your company exists, the second step is to create its structure. The most important reason to do this is to avoid personal liability for company debts, also known as “piercing the corporate veil.” In Minnesota, the courts may apply one of three different “tests” to determine whether or not to pierce the veil in any given circumstance.

The Agency Test: under this test a Plaintiff must show that the owner of the business exercised a significant degree of control over the company’s decision making;

The Alter Ego Test: here the court will pierce the veil to prevent fraud, illegality, or injustice, or when not doing so would defeat public policy or shield someone from liability from a crime;

The Instrumentality Test: a Plaintiff must show that the parent company exercises extensive control over the acts of a subsidiary, giving rise to the claim of wrongdoing.

Unfortunately, the courts have done very little to explain these tests. However, the Minnesota Supreme Court did provide a list of factors that they consider when determining whether to look through the limited liability entity. Those factors include: insufficient capitalization for purposes of the corporate undertaking, failure to observe corporate formalities, nonpayment of dividends, insolvency of the debtor corporation at the time of the transaction in question, siphoning of funds by the dominant shareholder, nonfunctioning of other corporate officers and directors, absence of corporate records, and existence of the corporation as merely a façade for individual dealings. To complicate matters further, the Court has said that in addition to a number of the previously mentions factors being present, there also must be an “element of injustice or fundamental unfairness.”

What all of this amounts to for the Minnesota small business owner is that they must not only create their business, but they must observe the organizational formalities imposed by state law. They must do things such as elect directors, adopt bylaws, elect officers, adopt banking resolutions etc. While it may seem silly for a single member business to hold a meeting as the sole member of the board, and then another as sole shareholder (or sole Member if an LLC), this is what is required under Minnesota law for a small business owner to protect themselves from personal liability.

Any twin cites attorney can help the small business navigate these confusing waters, and it is highly recommended that you consult one before moving forward with your business transactions.

Why Small Businesses Need Legal Counsel

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There are many old adages that apply to why a small business needs to consult with and use the services of an attorney. My favorite is “You don’t know what you don’t know!” It is your job as an entrepreneur to focus on what you do best, which would be to run your business. It is the job of the attorney to understand and provide proper guidance regarding the legal hurdles and pitfalls that are waiting for small businesses. Four legal hurdles that small businesses are likely to encounter include the need for contracts, which choice of entity to select, real estate and need for an exit strategy.

At various times, every small business will need to have a contract drafted. An attorney will be able to help the business determine the exact language that should be included in the contract. The types of contracts that may need to be drafted include contracts for customers, clients, suppliers and even co-owners. Continue reading →