Basics of Business Formation

/ June 11, 2014

Chalkboard - iStockMany Minnesota entrepreneurs are well aware that they need to take steps to limit their potential for liability but are unclear about which type of entity is right for them. This post will outline some of the advantages and disadvantages of entity types and some initial first steps in setting one up. This is intended to be an introductory overview and not an exhaustive analysis as there may be more complex tax or other issues pertinent to the business. This will focus on for-profit entities and does not touch on forming a non-profit corporation, public benefit corporation, cooperative, or business trust.

Entity Selection

Unincorporated Entities
Entities can be classified into two categories, those that limit liability and those that don’t. The first category, or unincorporated entities, do not require a filing with the Minnesota Secretary of State’s office to go into effect and have a limited lifespan that is tied to their owners. These include sole proprietorships and general partnerships.

Sole Proprietorship
A sole proprietorship is one of the least expensive and most basic options in which an individual business owner is the business and the business’ taxes pass through to the owner. Some sole proprietors have an assumed name or name that they do business under. So long as the business name contains the individual’s full name within it, a filing with the Minnesota Secretary of State is not required.

General Partnership
Similarly a general partnership can be formed without a formal filing so long as there are two or more partners and they intend to associate to carry on a business for profit. They are also treated as a pass through entity under federal income law and do not require that their assumed name be filed if all the partners’ full names are contained within the name that they’re doing business under. A general partnership may serve as a way to reduce their owners’ overall personal tax liability in the event that the partnership sustains a loss for the year. General partners run the risk of joint and several liability as creditors may opt to collect outstanding debts from either partner or both.

Incorporated Entities
A second category of entities are those that provide limited liability for their owners and require a filing with the Secretary of State’s office. These include various types of partnerships with some form of limited liability, corporations, and limited liability companies.

Limited Partnership, Limited Liability Partnership and Limited Liability Limited Partnership
Limited partnerships provide limited liability for limited partners to the extent of their contributions but not for general partners who possess the authority to conduct business. This entity is used more frequently with passive assets for estate planning purposes but not for operating businesses. Limited liability partnerships provide protection for all partners upon filing with the Secretary of State. Limited liability limited partnerships also provide protection for all partners upon filing and are a way for existing limited partnerships to provide limited liability to general partners. These various forms of partnerships are not recognized in all states and so partners should be cautious when conducting business outside Minnesota.

State law treats corporations the same but under federal tax law, corporations are further divided by subchapters C and S of the tax code. C corps may be publicly traded and are subject to double taxation in that the corporation is first taxed on the income it makes and the shareholders are individually taxed on the dividends distributed to them. The corporation may be taxed at a lower rate than the individual stockholders are depending on their income bracket and this may still make financial sense and as a way for some high net worth shareholders to limit their tax burden. Unlike C corps, S corps aren’t taxed at the entity level as the shareholders pay all the corporation’s income taxes. An S election requires that ownership be limited to a single class of stock with 100 shareholders or less who can’t be non-resident aliens, partnerships, or other corporations.

Limited Liability Company
LLCs may be thought of as a hybrid between a corporation and partnership. They offer the limited liability protection of a corporation while permitting their members to be taxed as a partnership (or sole proprietorship for a single member LLC) or elect to be taxed like a C or S corp. Businesses owners who want to only be taxed once may elect to have their LLC taxed like an S corp as a way to save on payroll taxes. Unlike LLCs, S corp shareholders incur payroll taxes only on the wages they pay themselves but not on distributions. For example, if an S corp makes $80,000 in a year and the two owners each pay themselves a $30,000 salary and $10,000 distribution, the LLC that elected to be taxed as an S Corp would only incur payroll taxes on $60,000 instead of the entire $80,000. S corps must document the reasonableness of compensation which could put the business at risk for an audit as some S corp shareholders have attempted to save on payroll taxes by paying themselves a low salary with much higher corporate distributions. Additionally, S corps may be required to file taxes on a quarterly basis which can be an administrative burden. Owners that want the flexibility to make unequal distributions amongst themselves may prefer an LLC as S Corps are limited to a single class of stock. Thus, the limited liability protection, flexibility, and more simple administration make this entity a popular choice.

Professional Firms
Some professional services which are regulated by the state may opt to further designate themselves as a professional firm as listed under Minn. Stat. § 319B.02 subd. 19 on top of their entity selection.

Formation Actions

Blank Paper & Cup of Coffee - iStockUpon deciding on the type of entity to create, there are additional steps to take in setting it up. First, when selecting the company’s name make sure that it complies with the statutory naming conventions. For example, a partnership can’t have the word ‘corporation’ as part of its name. Another necessary formation activity is obtaining a federal tax identification number (TIN) through the IRS’ website. Also known as an employer identification number (EIN) this will be required for the business to open a bank account though a social security number will suffice for sole proprietorships and single member LLCs . In addition, a state tax identification number may be required for certain taxable sales, services, leases, and entities. The full list for when a state tax id is needed can be found on the Minnesota Depart of Revenue’s website. The business should also make sure that it has the required licenses and permits in order for it to operate.

Formation & Governance Documents

Upon an LLC filing its Articles of Organization or corporation filing its Articles of Incorporation with the Secretary of State, the organizer or incorporator will need to transfer the company to the owners through a written action. These documents should all be contained in the business’ corporate book along with the organizational meeting of the board or a written action in lieu of a first meeting of the board. The business may want to have agreements in place outlining how it will be governed through a Partnership Agreement, Operating Agreement/Member Control Agreement, Corporate Bylaws, or Buy Sell Agreement.

In conclusion, every business is different but this post should serve as a starting point for the basics of forming an entity. Be sure to contact an attorney or other professional to help you figure out the best entity for you.