Do you have a business idea, and don't know what to do next? Were you recently terminated from your employment and are looking to venture out on your own?
The attorneys at Blahnik, Prchal & Stoll, PLLC can assist you in determining whether to continue on without forming a business entity (as a sole-proprietor), or whether to formalize your new business by creating a Limited Liability Company (LLC), S-Corporation, C-Corporation, Partnership or some other business entity. The following outline will help you with some of the preliminary questions:
- Choosing a Name for your Business
- Preliminary considerations on the preferred type of business entity
- Sole Proprietorships
- General Partnerships
- Limited Liability Companies (LLC)
- Federal Tax I.D. Number (EIN)
- State Tax I.D. Number
I. Choosing a Name for your Business
A. Choosing a name for your business is important and you should not do so hastily. Too often, my clients simply choose the first letters of the last names or first names of the individuals involved in the business (e.g. A & B Builders). I generally advise against this, simply because it is too common of a practice and not distinctive.
In deciding on a name for the business, you should ensure that your chosen name has the following characteristics:
- Indicates your type of business;
- Is easy to remember;
- Is unique and conspicuous to a prospective client/customer;
- Is suitable to your type of business;
- Motivates prospective clients/customers to contact you.
B. Once you have chosen a name, check the availability of the name with the Secretary of State (go to: http://www.sos.state.mn.us/)
C. Remember that certain business entities require specific abbreviations in their names (e.g. “LLC” for limited liability companies and “Inc.” or “Corp.” for Corporations)
D. Do not move forward with anything further with your business until such time that the Secretary of State has accepted and filed your Articles or Certificate of Assumed Name.
E. You cannot simply choose a “fictitious name” (i.e. Betty’s Batter Fried Hotdogs) and start doing business under that name, without filing something with the Secretary of State.
II. Preliminary considerations on the preferred type of business entity
- Tax consequences.
- Limited personal liability.
- Number of individuals who will own the business.
- Formalities necessary to maintain the business entity.
- Flexibility of the business entity.
- Voting power vs.ownership interest
- Ability to transfer property to and from business.
- Deductibility of fringe benefits
III. Sole Proprietorships
A. A sole proprietorship is a business owned by only one individual. If you are generating income by yourself, separate from normal employment, and you do not take formal measures to organize a separate business entity, you are considered a sole proprietorship. You, as the owner, are technically not an employee of the business, but are instead considered “self-employed.” If more than one person owns the business and no business entity has been formed, the business would be considered a general partnership, as discussed below.
Sole proprietorships are not separate entities for tax purposes. The income to an individual with a sole proprietorship is included on Schedule C of that individual’s IRS Form 1040, simply as business income.
Self-employment taxes (FICA – 15.3%) are to be paid upon all earnings from a sole proprietorship in addition to standard income taxes. The owner of a sole proprietorship is personally liable for any debts incurred by the proprietorship.
B. FICA (Federal Insurance Contributions Act) is a term used to designate both the Social Security and Medicare taxes upon earned income. For self-employed individuals, the terms "FICA tax" and "self-employment tax" mean the same thing. The combined FICA rate for both the employer and employee is/was 14.35% in 2017. The FICA tax is upon earned income, not passive income such as dividends, interest, etc. FICA taxes are reported for employees on IRS form 941. For self-employed individuals FICA is reported on Schedule SE to form 1040. Form 941 is filed every quarter and form Schedule SE is only filed once per year.
1. FICA Limits for 2017:
Social Security Tax Rate: 12.4% (both employer and employee's portion)
Social Security: wage base of $127,200. Thus, no Social Security taxes are due for earned income above this amount.
Maximum Social Security Tax: $7,886.40
Medicare Tax Rate: 1.45% (both employer and employee's portion)
Medicare Wage Base: $200,000
C. Necessary Filings for Sole Proprietorships.If the name of the sole proprietorship contains the full first and last name of the individual creating it, then no filings with the Secretary of State are necessary. If the full first and last name of the person are not in the business name, then he/she must file a Certificate of Assumed Name with the Secretary of State.
1. Certificate of Assumed Name
a. After filing, it must be published in a local legal newspaper for two consecutive issues;
b. Is valid for 10 years.
D. Sole proprietorships are a popular alternative because they are easy to form and operate. However, one big disadvantage of a sole proprietorship is that the owner is personally responsible for all of the debts and liabilities of the business. If the proprietorship encounters financial adversity or individuals are harmed by the activities of the proprietorship, the owner's personal assets and the proprietorship’s assets may be used to pay any resulting debts or civil lawsuit judgments.
IV. General Partnerships
A. A general partnership is a business that is created when two or more persons operate a joint venture together for profit, and have not formally organized the business as a separate business entity (such as a corporation or limited liability company). A partnership does not have to be intended (i.e. you may be involved in a partnership without knowing it). To determine whether a partnership exists, a Court would look to see if the activities being conducted are “considerable, continuous and regular” with some profit motive.
B. Filing Requirements. A general partnership may have a written partnership agreement, but is not required to have one. A written partnership agreement may delineate the obligations, rights and duties of the partners relating to partnership assets, liabilities, income, losses and control of operations. There is no filing requirement with the Secretary of State for general partnerships.
C. Liability. All general partners are “jointly and severally” liable for all partnership debts. This means that each partner can be held liable to third parties for the entire partnership debt and other liabilities. In addition, each partner may hold other partners liable for actions taken in connection with the partnership activities, with some exceptions.
D. Taxes. The general partnership files IRS Form 1065, which is only an information tax return. The partners in a general partnership report their share of the partnership earnings on Schedule K-1. Each partner pays FICA taxes (14.35%) on all of his or her earnings from the partnership, in addition to that partner’s regular marginal tax rate.
E. As an alternate to a general partnership, there are the following less used partnerships:
1. Limited Partnerships
2. Limited Liability Partnerships
3. Limited Liability Limited Partnerships.
V. Limited Liability Companies (LLC)
A. A Limited Liability Company is most often described as a hybrid between a corporation and a partnership.
An LLC provides its owners with limited personal liability protection similar to a corporation. But, it also provides easy management and "pass-through" taxation of profits and losses to its owners similar to a sole proprietorship or partnership, while still maintaining the liability protection of a corporation. With pass-through treatment, the income and loss of the business is not taxed to the entity but is passed through to the owners for them to report on their individual income tax returns. Pass-through tax treatment is desirable for start up businesses because they often generate tax losses during their early years of operation, and the owners can offset these losses against income from other sources. The owners of an LLC are called "members," which are equivalent to "shareholders" of a corporation.
An LLC provides for much more flexibility than a corporation. The members of an LLC may allocate different percentages for voting rights and earnings rights for its members. For example, if someone wanted to invest a large sum of money into an LLC, but the current members did not want this individual to have a large percentage of the voting power in the LLC, the members could agree that the investor would receive (hypothetically) 50% of the profits of the LLC, but would only be entitled to a 25% voting right in the LLC. This is not possible with S-Corporations, which must maintain these two percentages as identical (i.e. the voting percentage must be the same as the interest in profits). With an S-Corporation, all income, loss, and cash flow must be allocated proportionately among shareholders based on their stock ownership.
An LLC is an ideal business entity for holding real estate or other property. This is the case, because property can generally be transferred tax-free by a member to an LLC, and property can generally be withdrawn tax free by a member from an LLC. This is not the case for S-Corporations, where property can generally be transferred tax free to the corporation at the time of its organization, but later transfers may result in the recognition of gain unless they are made by a shareholder who owns 80 percent or more of the stock of the S corporation. Moreover, the withdrawal of property from an S-Corporation by a shareholder will generally be a taxable event, resulting in the recognition of gain or loss by the S-Corporation, regardless of the amount of stock owned by the shareholder.
The amount of losses of a limited liability company or S-Corporation that may be passed through to the entity's members or shareholders and reported on their personal income tax returns is limited to the amount of the tax basis of the members or shareholders in their interests in the business. In computing the tax basis of a limited liability company member, the amount of the limited liability company's indebtedness to banks or other third parties is considered. An S corporation shareholder's basis does not include any amount by reason of indebtedness of the S corporation to persons other than the shareholder. As a result, the losses that may be passed through to the owners in the early years of a business may be greater if the business is organized as a limited liability company rather than as an S corporation.
B. Filing requirements. To create an LLC, an Articles of Organization must be filed with the Secretary of State. Also, the LLC must be renewed every year through the Secretary of State, which may be done “online.” There is no cost to the annual renewal. The LLC “should” also prepare an Operating Agreement to regulate the LLC. However, these documents do not get filed with the Secretary of State.
C. Liability. The members of an LLC are not personally liable for the company’s debts beyond the extent of their investment in the LLC. Further, the members are not personally liable for the acts or omissions, including negligence, of other members or employees of the LLC.
D. Taxes. For tax purposes, the LLC is taxed as a partnership (the LLC files IRS Form 1065, which is only an information tax return. The members of the LLC report their share of the LLC earnings on Schedule K-1), unless an election is made with the IRS to tax the LLC as a corporation (which can be either a C-Corporation or S-Corporation). A “single-member” LLC is considered a “disregarded entity” for tax purposes. For single-member LLCs, no special tax returns need to be filed and all income is reported in the same manner as a sole-proprietorship (on Schedule C of IRS Form 1040).
The following is a “check list” that we use as the necessary steps to complete any new LLC file that we handle:
1. Draft Articles of Organization;
2. Prepare IRS Form SS-4 -Application for EIN (wait until we receive the Certificate of Organization back from the MN Secretary of State before contacting the IRS to obtain the EIN);
3. Draft Operating Agreement; and
4. Prepare (on line) Minnesota Application for Business Registration (MN Dept. of Rev. Form ABR), if necessary.
A corporation is formed through the filing of Articles of Incorporation with the Secretary of State. There is no distinction between an S and C Corporation when you initially file the Articles of Incorporation. To become an S corporation, a corporation must file Form 2553 with the IRS within a certain deadline to qualify for S status. Therefore, the distinction between a C-Corporation and an S-Corporation, is purely the tax differences (the “C” and “S” refer to specific paragraphs within the Internal Revenue Code). If you fail to make a timely S election, the corporation is automatically a C-Corporation.
Form 2553 must be submitted within two months and 15 days after the earliest of the following (but cannot be submitted prior any of the following):
a. Date the corporation first had shareholders;
b. Date the corporation first had assets;
c. Date the corporation began doing business.
To qualify as an S-Corporation, the corporation must meet the following criteria:
1. Has no more than 100 shareholders;
2. Its only shareholders are individuals, estates, certain trusts and certain exempt organizations;
3. Has no nonresident alien shareholders; and
4. Has only one class of stock.
Almost all small businesses electing to be considered an S-Corporation will qualify, based on the above-referenced criteria.
Since an S corporation is organized as a corporation under state law, it must be managed like any other corporation. This means that the shareholders elect directors who are responsible for the management of the corporation, and the directors appoint officers who execute their management directions. The corporate form of management is familiar to many business people but can be considered unduly rigid, particularly in the context of a small business with few shareholders who may prefer to operate the business as a partnership.
Since an S-Corporation may be required to recognize gain on the distribution of property to its shareholders, an S corporation is not a good form of entity for a business that owns real property or other assets that are likely to appreciate. Once such property is transferred to an S corporation, it may be impossible to get it back out without tax cost, which limits the flexibility to change the form of ownership of business assets.
A. Filing requirements. As indicated above, an S-Corporation is created by filing an Articles of Incorporation with the Secretary of State. The S-Corporation must be renewed every year through the Secretary of State, which may be done “online.” There is no cost to the annual renewal. Other documents that should be drafted include:
1. Minutes of First Board of Directors;
2. Minutes of Annual Meeting of Shareholders;
3. Authentication of Record Book and Records;
5. Certificate of Stock.
(None of these additional documents get filed with the Secretary of State).
B. Liability. The shareholders of an S-Corporation are not personally liable for the company’s debts beyond the extent of their investment in the corporation. Further, the shareholders are not personally liable for the acts or omissions, including negligence, of other shareholders or employees of the corporation.
However, be aware of the doctrine of “piercing the corporate veil.” This doctrine provides that if the corporate formalities are not followed (i.e. the required meetings are not held, the owners conduct business in their individual capacities, etc.) that the individuals may be held liable for both debts and other liabilities.
C. Taxes. The S-Corporation files a separate tax return (IRS Form 1120S), but this return is only an information tax return, since there is no corporate level tax. Schedule K-1s are issued to the shareholders. S-Corporations are taxed on income (and losses) like partnerships in that there is no entity level taxation whereas C-Corporations have their income taxed at the corporate level. In regard to employment and unemployment taxes, S and C corporations are treated the same. For both, employment taxes are only paid upon the designated salary of a shareholder and not upon dividends.
S-Corporations have one very important advantage that is enough to cause many businesses to select this form of business organization. The advantage is that a portion of the income of an S corporation may escape employment tax whereas all of the income of a limited liability company, sole-proprietorships and partnerships are often subject to this tax.
If a business is organized as an S-Corporation, it may be possible to avoid some of the self-employment tax cost. Income of an S-Corporation is not subject to self-employment tax in the hands of its shareholders, but amounts paid out by the S-Corporation as compensation to its shareholders are subject to employment taxes.
The tax savings result from the fact that employment tax is only imposed on amounts paid out by an S-Corporation as compensation. This means that S-Corporation income that is retained as working capital, is used to acquire capital assets, or is paid out as dividends escapes employment tax (14.35%). This can provide substantial tax savings, and for some businesses, this savings is enough to outweigh all of the advantages of a limited liability company.
The following is a “check list” that we use as the necessary steps to complete any new S-Corporation file that we handle:
1. Draft Articles of Incorporation;
2. Prepare IRS Form SS-4 – Application for EIN (wait until we receive the Certificate of Incorporation back from the MN Secretary of State before contacting the IRS to obtain the EIN);
3. Prepare IRS Form 2553 – Election by a Small Business Corporation. Form 2553 must be submitted within 2 months and 15 days of the earliest of the following (but cannot be submitted prior any of the following):
4. Date the corporation first had shareholders;
5. Date the corporation first had assets;
6. Date the corporation began doing business.
7. Draft Minutes of First Board of Directors;
8. Draft Minutes of Annual Meeting of Shareholders;
9. Draft Authentication of Record Book and Records;
10. Prepare By-Laws;
11. Prepare Certificate of Stock;
12. Prepare (on line) Minnesota Application for Business Registration (MN Dept. of Rev. Form ABR) if necessary.
A. A C-Corporation is created the same way as an S-Corporation, without the subsequent filing of IRS Form 2553 as provided above.
A corporation is a separate legal entity that can shield the owners from personal liability and company debt. As a separate entity, it can buy real estate, enter into contracts, sue and be sued completely separate from its owners.
A corporation is set up in this structure:
1. Shareholders own the stock of the corporation.
2. Shareholders elect Directors (known as the "Board of Directors").
3. Directors appoint Officers (President, Secretary, Treasurer, etc.).
Officers run the company (day-to-day operations).In many cases (especially during the startup phase), one person will be the 100% owner of the stock, therefore that person will elect the directors (usually yourself) and then appoint yourself as an officer (or all the officers: CEO, Treasurer, Secretary).
B. Filing requirements. A C-Corporation is created in the same manner as an S-Corporation, by filing an Articles of Incorporation with the Secretary of State. The C-Corporation must be renewed every year through the Secretary of State, which may be done “online.” There is no cost to the annual renewal.
Same as an S-Corporation, other documents that should be drafted include:
Minutes of First Board of Directors;
Minutes of Annual Meeting of Shareholders;
Authentication of Record Book and Records;
Certificate of Stock.
None of these additional documents get filed with the Secretary of State.
C. Liability. The shareholders of an C-Corporation are not personally liable for the company’s debts beyond the extent of their investment in the corporation. Further, the shareholders are not personally liable for the acts or omissions, including negligence, of other shareholders or employees of the corporation.
Similar to S-Corporations, be aware of the doctrine of “piercing the corporate veil,” which is discussed at further length below.
D. Taxes. The C-Corporation files a separate tax return (IRS Form 1120). Unlike, S-Corporations, a C-Corporation is taxed as a separate entity (at the corporate level). The initial tax rate on the first $50,000.00 of income to a C-Corporation is currently 15%. However, most small C-Corporations can structure themselves so that little, to no income exists at the expiration of the tax-year, so that there is no tax at the corporate level. A C-Corporation can elect a tax-year, ending in a month other than December.
As indicated above, employment and unemployment taxes, for S and C corporations are treated the same. For both, employment taxes are only paid upon the designated salary of a shareholder and not upon dividends.
E. Advantages of a C-Corporation. One of the larger advantages for a C-Corporation over an S-Corporation, or other business entity is the ability of a C-Corporation to deduct certain fringe benefits to its shareholders and employees. Such deductions, include:
- Qualifying health insurance coverage;
- Cafeteria plans;
- Group term-life lnsurance;
- Certain meals and lodging; and
- Qualified transportation expenses.
F. Additional facts, information, pros and cons of corporations are as follows:
Operating a corporation involves at the minimum holding a yearly Directors and Shareholders meeting (the location is determined by you and the expenses are deductible), keeping written minutes of major company decisions and maintaining general corporate compliance as dictated by the Corporate Bylaws.
The limited liability and tax benefits of doing business in the corporate form result from the corporation's being treated as a separate entity. To obtain these benefits, it is important that the corporation be operated as an entity separate from its shareholders, directors, and officers. In order to do this, you must understand the role of each of the persons involved in the operation of the corporation and must comply with certain formalities in operating the corporation.
It is critical that you recognize the corporation as a separate entity and treat it as such. Under no circumstances should corporate and personal funds, assets, or accounts be mixed. Corporate funds should not be used to pay personal expenses, to make personal investments, or for any other purposes not related to the corporation's business. Corporate assets should be distributed to shareholders only in the form of compensation, dividends, or other distributions specifically approved in advance by the board of directors.
The corporation should also be held out to third parties as a separate entity. All business of the corporation should be conducted in the name of the corporation, and the name of the corporation should be used on all agreements, contracts, leases, orders, and other arrangements entered into by the corporation. It should also be used on all products, signs, advertisements, correspondence, business cards, telephone directory listings, and similar items. The corporation should carry its own insurance and will be required to file its own income and employment tax returns.
The corporation can only act through individuals. However, when acting for the corporation, remember that you are acting as a representative of the corporation, and not in your individual capacity. When signing documents, make it clear that you are acting in a representative capacity for the corporation. For example, all documents signed on behalf of the corporation by its president should be signed, "[Name of Corporation] by [Name of President], President." If you fail to make your representative capacity clear, you run the risk of
incurring personal liability for the obligations of the corporation (under the doctrine of “piercing the corporate veil.”).
The shareholders, directors, and officers of the corporation all have their own roles and functions. It is important that these roles be kept separate and respected. This is particularly crucial in the case of a closely held corporation such as yours where the same individuals function in several different capacities.
The shareholders own the corporation. However, the shareholders are not partners in a partnership, and they neither own the business (which is owned by the corporation) nor manage the business (which is the function of the board of directors and officers). The shareholders own stock in the corporation and have a voice in the management of the corporation since they elect the directors of the corporation and participate in certain major decisions, such as sale of substantially all of the assets of the corporation and amendment of its articles of incorporation. If the corporation's existence is to be respected, it is important that the shareholders' activities are limited to their proper role.
The shareholders must act as a group. Actions are taken at meetings, or by written consents signed by all shareholders, through the adoption of formal resolutions. A formal written record of all actions taken by the shareholders should be maintained in the corporation's minute book. Shareholder meetings should be held at least once a year for the purpose of electing directors. Special meetings may be required if additional matters requiring shareholder approval arise.
The board of directors of the corporation is responsible for the management of the corporation. The board of directors establishes policy, which is carried out on a day-to-day basis by the officers of the corporation. The board of directors elects, and can remove, the officers. The board of directors also makes all major decisions relating to the management of the corporation, including the compensation paid to employees, issuance of stock, approval of important contracts, borrowing of money, purchase of equipment and property, and the payment of dividends.
The board of directors must act as a group. Actions are taken at meetings, or by written consents signed by all directors, through the adoption of formal resolutions. A formal written record of all actions of the board of directors should be maintained in the corporation's minute book.
The board of directors should meet at least once a year for the purpose of electing officers and dealing with such things as the compensation of shareholder employees. However, special meetings may be required from time to time throughout the year as major issues arise that require the attention of the board of directors.
The officers are employees of the corporation and are responsible for conducting the day to day business activities of the corporation. The business is to be conducted in accordance with policies established by the board of directors, and authorization must be obtained from the board of directors for major corporate transactions. The scope of authority and the functions and responsibilities of the various officers are set forth in the bylaws of the corporation.
Because a corporation is a separate entity in which individuals may play a variety of roles, certain formalities are prescribed for corporate actions. Complying with these formalities is important to have the corporation recognized as a separate entity and to avoid personal liability for the obligations and liabilities of the corporation. The bylaws of the corporation provide a guide to compliance with proper corporate formalities. In addition, proper and complete records must be maintained by the corporation.
VIII. Federal Tax I.D. Number (EIN)
- Who must file
- Who may file
- Requirements for form
- Form attached hereto.
IX. State Tax I.D. Number
- Who must file
- Who may file
- Requirements for form
- Form attached hereto