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.

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.

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.

In addition to the above-listed benefits, taxpayers who file as a couple are also subject to joint and several liability for the payment of tax, including interest and penalties.  Joint and several liability can create an injustice where only one of the spouses is liable for the underlying tax deficiency.  One common situation involves a wife who the IRS claims is liable for additional tax on a joint return due to the illegal activities of her husband.  Prior to 1971, the wife in this example would be held liable for the tax, interest, and resulting penalties even though she had no knowledge of her husband’s illegal activities.

In recognition of this problem, Congress passed Interal Revenue Code Section 6015.  This provision, also known as “innocent spouse” relief, grants a limited release from joint liability under certain circumstances.  Originally narrow in scope, Section 6015 was extensively revised in 1998 to extend protection to a greater number of people.  Under Section 6015(b), relief will be granted if the affected spouse can establish that she did not know of the liability attributable to an erroneous item of her husband.  Equally important, the petitioner for relief must establish that it would be inequitable to be held liable for the deficiency in tax.  In order to apply for innocent spouse relief, the petitioner must elect to apply this provision within two years after the date on which the IRS has instituted collection activities.

Although it may seem like a simple procedure, the above-described provision entails an inquiry which is highly fact specific.  If the IRS is attempting to collect a debt attributed to the illegal acts of your spouse (or former spouse), do not hesitate to contact a tax attorney.

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.

In the District of Minnesota the court will schedule the 341 Meeting of Creditors within one to two days after the petition and schedules are filed. The 341 Meeting of Creditors will usually take place between twenty and thirty days from the date of filing. The 341 Meeting of Creditors is for most debtors the only appearance before a court. At the meeting the debtor will appear before a bankruptcy trustee who will question the debtor concerning the petition and schedules. The debtor’s creditors have the opportunity to come to the meeting and question the debtor, but the likelihood of a creditor making an appearance is quite rare. If the trustee is satisfied with the answers of the debtor, the trustee will close the 341 Meeting of Creditors within a few days.

Once the 341 Meeting of Creditors is closed the debtor enters the final stage of a chapter seven bankruptcy. During the next sixty days the debtor will have to complete a second counseling course. This course will take a minimum of two hours. The debtor must complete this course to receive a discharge. During this time-frame the debtor will also execute any reaffirmation agreements. A reaffirmation agreement is an agreement between the debtor and a creditor where the debtor reassumes a debt that would otherwise be discharged. The most common occurrences where a reaffirmation agreement is used would be with a secured debt such as a vehicle or house. After the sixty day period, the debtor will receive a discharge from most types of debt. Each bankruptcy case filed in Minnesota may deviate from the process listed above to some extent. It is recommend that a debtor contact a Minnesota bankruptcy attorney to assist with this process.

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.

The second hurdle relates to the structure or choice of entity for the business. Depending on the choice made, there will be different tax consequences for the business and individual owners. An attorney will also be able to provide guidance with regard to which entity selection is the best fit based on what type of investing or funding the company is receiving, among other factors.

A third hurdle standing before most small businesses relates to real estate. Many businesses will sign a lease for commercial space, to house their offices or storefront. These leases tend to be drafted by the landlord and contain language that is beneficial to the landlord and may even be detrimental to the tenant. Commercial leases are negotiable and an attorney will be able to provide the landlord with a tenant’s addendum that contains provisions beneficial to the tenant.

Finally, a small business will need the assistance of an attorney to determine the exit strategy for the business. An exit strategy includes the formulation of a plan of how the owners of the business will exit the business either contingent on a planned or unplanned event. A business needs to know what will happen if one owner becomes disabled, dies or just decides it is time to move on. Will the business continue? What happens to that owner’s share of the business? These questions need answers. An attorney will be able to walk you through this process and ensure that all your concerns have been addressed. Remember “You don’t know, what you don’t know.”

Before you hire a bankruptcy attorney, gather up these documents in order to expedite the process.

1. You need your tax returns for the previous two years.  Currently, this means 2009 and 2010 – it is still early in 2012 so you probably have not yet filed your 2011 taxes.  A W-2 will provide supplemental, but not complete, information.
2. If you owe back taxes, have the letters from the IRS and the Minnesota Department of Revenue.
3. You need paystubs for at least the previous 6 months.  From these documents, obtain your average monthly income, gross and net.  Your paystubs would also show any garnishment and child support payment deductions.
4. If you received unemployment benefits for any part of the previous 6 months, print a copy of your benefits statement.  This information may reduce your average monthly income.
5. You need your previous month’s financial statements.  This includes bank accounts as well as retirement accounts.  Each statement will have the account type, account number and balance.
6. If you own real property, have a copy of your property tax statement.  This document has the “fair market value” and the legal description for the property.
7. If you plan to keep your home, have a copy of your mortgage company payment coupon.  This document has the mortgage company name and address, account number and payment amount.  (This item refers to your first, second and any subsequent mortgage-related creditor.)
8. If you own vehicles, have copies of your vehicle registration.  These documents show the lienholder’s name and address, if any, as well as the vehicle type and model.  Also, note the mileage for each vehicle.  With this information, go to the NADA Guides (nadaguides.com) to get its “fair market value.”
9. If you plan to keep your vehicles, have a copy of each car loan payment coupon.  This document has the loan company name and address, account number and payment amount.
10. If you plan to keep your cell phone service, have a copy of the cell phone bill.  This document has the provider’s name and address, account number and payment amount.
11. You need a recent copy of your credit report.  This document will list your creditors and debt information, past and present.  You may even be surprised at the information you find here.
12. You need a list of all your creditors.  List the name, address, account number and debt balance for each.  This list should include your mortgage holders, car loans, credit cards, miscellaneous debts, collection agencies (including letters from lawyers), lawsuits and judgments (pending and final), student loans, the IRS and the Minnesota Department of Revenue, as applicable.  Miscellaneous bills include your medical and dental bills, utility bills and debts from private creditors.
13. The filing fee for Chapter 7 is $306.00.  This is paid directly to the Bankruptcy Court.

Again, bankruptcy is personal.  Depending on your assets and liabilities and your personal circumstances, you may need additional documents that are not listed here.  Review the bankruptcy forms to determine what other requirements apply to you.

The ownership restrictions for an S-Corp. are much more substantial than those of an LLC.  Pursuant to IRS code section 1362, an S-Corp. cannot have more than 100 shareholders. While this provision is very limiting, it does allow for a family to count as one shareholder. S-Corps. also have a limitation on who can be a shareholder. A shareholder must be either US citizens or resident aliens. What this means is that no corporations or LLCs may be a shareholder of an S-Corp. Finally, an S-Corp. may only have one class of stock.  However, the S-Corp. can differentiate whether the shareholders are able to have voting rights in that one class of stock.

In contrast, ownership restrictions for an LLC are nearly nonexistent. In a limited liability company the owners are called members rather than shareholders. An LLC is unlimited in the number of members allowed to participate. Like an S-Corp., members of an LLC can be US citizens and resident aliens, however additional entities such as a corporation, LLC and any individual person regardless US resident status are also permitted to be members.

The next difference between an S-Corp. and an LLC relates to the treatment of self-employment tax. With regard to the LLC the treatment is straight forward. The member of an LLC must pay self-employment tax on all net income generated by the LLC. This amount is currently 13.3%.

The self-employment tax treatment of an S-Corp. is more complex than that of an LLC. If the shareholder of an S-Corp. works for the corporation the shareholder will be paid a reasonable salary set by the corporation for the work performed by the shareholder. The shareholder will pay self-employment tax on their portion of income that is derived from the reasonable salary. The remaining income distributed to the shareholder and will be taxed as ordinary income.

The final difference addressed in this post relates to the permissible behavior with regard to the distributions of profits and losses. With an S-Corp. there are no special allocations of profit and losses for shareholders. Corporate profits and losses must be split up proportionately to the percentage of shares owned by each shareholder. On the other hand an LLC has the ability to decide what percentage of the LLC’s profits and losses each owner will be given regardless of a members ownership share in the LLC.

Determine Ownership
Operational Control
Succession Planning
Protecting Limited Liability of Single Member LLCs

While they can, and usually do address more, these four will be covered below, as they are necessary components to most LLCs.

Determining Ownership

The LLC’s Member Control Agreement details how much ownership in the company each member has. Many companies choose to have ownership be proportional to the capital investment of the members. For example if Member A invests $1,000 and Member B invests $2,000, then B will have twice as many shares as A.

However, one need not necessarily allocate ownership in proportion to capital contributions. What’s known as a “passive investor” might contribute the majority of the capital initially, while a member that actively manages the company will own shares in excess of his capital contributions. It is for this reason that LLCs, unlike corporations, also do not require that a member’s voting rights be equal to that of their ownership stake. Any combination can be chosen by the members.

Operational Control

Not only does the Member Control Agreement control the ownership of shares in the LLC, it also spells out how voting operates. You could choose to have one share equal one vote. Or, the Member Control Agreement could give each member an equal say regardless of the number of shares held.

The agreement will also spell out what constitutes a majority for making major decisions affecting your company. You will want to spell this out because often major decisions need to be made.

Succession Planning

No one wants to think about this when starting their company, but what happens if a member dies or retires? The Member Control Agreement can provide, for example, that the remaining members are allowed the first opportunity to buy the leaving member’s shares. LLCs can protect assets by removing the voting power of shares taken involuntarily from a member. This is an advanced topic and you should consult an attorney on how to use LLCs for asset protection.

In addition to members leaving the LLC, the member control should spell out how new members are added. Often LLCs will choose that it take a unanimous vote rather than a simple majority to add a member.

Protecting Limited Liability of Single Member LLCs

Some people believe that if you’re a single member LLC, there is no need for a Member Control Agreement. After all, the Member Control Agreement is essentially a contract among members as to how they’ll run the company. However, a Member Control Agreement is useful because it can help preserve your company’s limited liability status. If you operate your single member LLC without a Member Control Agreement, then your business begins to look very similar to a sole proprietorship.

The danger there is that if that happens, a judge could pierce your corporate veil (protection) under the “alter ego” theory, saying that your LLC and you as an individual are actually one and the same. With a formal Member Control Agreement, you make it clear that you as an individual and the LLC are two separate entities.