Choosing the Form of Business Organization: Tax and Non-Tax Considerations
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 or not 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).
Effective with tax years beginning after December 31, 2006, 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. 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), Minnesota Statutes, 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.
Limited Liability Partnership
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 up 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.
There is an additional provision (Minnesota Statutes section 322A.88) allowing a limited partnership to elect limited liability partnership status under Chapter 323A. This allows for limited liability protection for both general and limited partners and this type of partnership is called a limited liability limited partnership. Limited liability limited partnerships are discussed below.
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. 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.
Note that a limited partnership is governed by Chapter 323A for certain matters not addressed by Chapter 322A. Chapter 322A was repealed effective June 1, 2007.
As mentioned above, limited partnerships, just like general partnerships, may elect limited liability partnership status under Chapter 323A of Minnesota Statutes. A limited partnership that does so is known as a limited liability limited partnership. In other words, a limited liability limited partnership (L.L.L.P.) is a limited partnership because it has a certificate of limited partnership on file with the Secretary of State’s Office (pursuant to Chapter 322A, the Minnesota Statute dealing with limited partnerships) and it has also filed, pursuant to Minnesota Statutes section 322A.88, a Statement of Qualification as a limited liability partnership. In all instances, however, the partnership remains a limited partnership governed by Chapter 322A (except to the extent that Chapter 323A addresses certain matters that Chapter 322A does not), and must meet all the requirements that limited partnerships must meet.
Care should be taken in naming a limited liability limited partnership; the name must contain either, the words “limited partnership, limited liability partnership” (or the abbreviation “L.P., L.L.P.” or the words “limited liability limited partnership” (or the abbreviation “L.L.L.P.”).
It is important to note that if a limited liability limited partnership chooses the L.L.L.P. designation, that partnership should also use that designation in its name as listed on its certificate of limited partnership. There are two reasons for this. First, without doing so, the Secretary of State’s office might not accept the partnership’s Statement of Qualification, because it is not clear that the entities are one and the same. Second, there could be questions about what standard of personal liability to apply to the partnership and the partners, and what entity is responsible for the partnership’s actions, because the partnership’s filings with the Secretary of State’s office are inconsistent.
A corporation is a separate legal entity. It 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, as a separate legal entity, is also a separate taxable entity. The corporation may be taxed under Subchapter C of the Internal Revenue Code (a “C corporation”) or 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 corporation income tax is sometimes called a corporate franchise tax. Profits are taxed before dividends are paid. Dividends are taxed to shareholders, who report them as income, resulting in “double taxation” of profits which are paid as dividends. If the corporation meets the statutory requirements for S corporation status, the shareholders may elect to be taxed as an S corporation. 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. 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. S corporations are described in more detail in later sections of this Guide.
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. The closely held corporation can provide many of the advantages of incorporation, such as limited liability for shareholders and S corporation status for tax purposes (if an S corporation election is made under the Internal Revenue Code) while retaining many of the simplified, less formal operating procedures of sole proprietorships and partnerships. 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.
Limited Liability Company
A Minnesota business also may organize as a limited liability company. A limited liability company is a form of business organization that is designed to combine the tax treatment of a partnership with the limited liability characteristics of a 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.
Limited liability companies with more than one member, like partnerships and limited partnerships, may choose to be taxed as partnerships or corporations. (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 with one member that chooses to be taxed as a sole proprietorship generally does not obtain a federal or state tax identification number unless it has employees 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 be taxed as a partnership or as a sole proprietorship may be passed through to the owners of the business. A limited liability company that chooses to be taxed as a partnership or as a sole proprietorship is not taxed at the entity level, eliminating the double taxation of profits that occurs with a C corporation. Income is then taxed at the owners’ individual tax rate. Like a corporation, liability for business debts and obligations generally rests with the entity rather than with individual owners. A limited liability company is not subject to many of the restrictions that apply to S corporations. Unlike a limited partnership, 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.
Other Forms of Organization
Other forms of organization available to Minnesota businesses include professional organizations, cooperative associations, business trusts, and certain variations of these forms of organization. These types of organizations are established and regulated by statute and involve complex legal, financial and accounting issues. Organizing under any of these forms should not be attempted without competent professional advice. Because of their highly specialized nature, these forms of organization are not addressed in detail in this Guide.
Changing the Form of Organization
Note that although the discussion in the above paragraphs is also applicable when changing the form of business organization, (e.g., when converting a sole proprietorship to a corporation), a business owner is strongly urged to seek professional assistance when doing so, because unintended consequences may result. As an example, contracts entered into by the business may or may not be assignable to the new entity; also, there may be a tax cost to changing the form of organization, such as when an S corporation becomes a C corporation. Minnesota Statutes [302A.681] authorizes conversions in either direction between corporations and limited liability companies. That section requires the converting organization to adopt a plan of conversion which must be approved by a majority of the board of directors or board of governors. Upon approval, articles of conversion are drafted and filed with the Secretary of State who issues a certificate of conversion and a certificate of incorporation or certificate of organization. There are similar requirements for the conversion or merger of partnerships and for the conversion of limited liability companies.
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, Twenty-eighth Edition, January 2010, 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.
This is also part of a series of articles on How to Pick the Right Business Entity Type. These articles help you select the right business type for your circumstances.