Why Entreprenuers Should Form Corporations or LLCs

Dec. 29, 2017

The question often comes up: do I really need to form a separate business entity for this business activity?  The idea of forming a business entity – whether a corporation, limited liability company, nonprofit corporation, cooperative, partnership – plagues a lot of entrepreneurs.  Some think the formality of a business entity makes everything more complicated.  And this is just not true.  In many ways, a business entity simplifies activities because it compartmentalizes activities, expenses and income into separate buckets. 

The history of business entities is quite dense and lengthy, literally going back centuries (and I am not kidding).  For purposes of this discussion, I won’t bore you with the details, but if you are ever interested in finding out about it, there are numerous books available. Here is one by Bruce Brown: Astonisher.  As a lawyer, we generally consider the following factors when we discuss the need to the form an entity. 

 

Limited Liability Protection for Owners.

 

The primary reasons to incorporate a business is to separate liabilities of the business from the business owner’s personal assets.  Corporations, limited liability companies (“LLC”), limited liability limited partnerships (“LLLP”) and limited liability partnerships (“LLP”) enable the owners to shield most of a business’s contract and tort liability from their own personal assets.

Generally, shareholders in a corporation, members in an LLC, limited partners in a limited partnership, and the partners in a LLP and LLLP are not personally liable for the debts of the entity and only have risk up to the amount of their investment plus any additional contribution they have contractually obligated themselves to contribute to the entity.

However, the liability protection is not “unlimited.”  An owner can be held liable under the common law concept called “piercing the corporate veil.”  In addition, if the owner has control over the entity’s finances and checkbook, he or she can also be personally liable for the employees’ portion of any FICA and state and federal withholding payroll taxes.

 

Centralized Management

 

An entity can provide centralized management for the business.  Centralized management allows a business owner, when the enterprise becomes large enough, to delegate certain functions away from ownership to a professional team of managers. 

For a corporation, unless the owners have entered into a shareholder control agreement eliminating management by a board of directors or have voted for shareholder management, the Minnesota Statutes, Chapter 302A, the Minnesota Business Corporation Act (“MBCA”) provides for management of a corporation by a board of directors.  Here is a link to the MBCA

 

Unlike a Minnesota corporation, under the Minnesota States, Chapter 322C, the Minnesota Revised Uniform Limited Liability Act (“MRULLA”), a Minnesota LLC formed under the MNRULLA may be managed by a board of governors, by its members, or by its “managers,” which are analogous to a board of directors, shareholders, and officers respectively.  Here is a link to the MRULLA 

For a general partnership and a LLP, management is vested in each general partner unless the partnership has filed a statement of partnership authority limiting a partner’s authority to contract and legally bind the partnership.  For a limited partnership and a LLLP, management is vested in each general partner.

 

Continuity of the Life of the Business

 

Unlike a sole proprietorship or a partnership, a corporation or an LLC can continue its existence indefinitely, unless the articles of incorporation, organization or certificate of limited partnership limits the term of the entity.  Ensuring the business continues to operate without the need to dissolve and wind up the business upon an owner’s death or withdrawal from the business creates goodwill and going concern value for the business and its owners.

 

Transferability of Ownership

 

Unlike a sole proprietorship, the business owned as a corporation, LLC, LP, LLLP, general partnership and LLP is considered separate from its owners.  Thus, the ownership interest in an entity – e.g., a share of stock in a corporation, membership interest in an LLC, partnership interest in a general or limited partnership – is generally considered personal property and can be transferred independent of the business.  Generally, the ownership interest in the entity can be transferred without restriction unless the entity or owners have restricted the transferability in the bylaws, shareholder control agreement, buy-sell agreement, operating agreement, or partnership agreement.  There are also restrictions on the transfer of securities that must be considered.

 

Accommodate Financing Options; Use of Debt and Equity

 

A business can be capitalized either with debt or an ownership interest in the business (equity).  For lenders issuing debt secured against a business’s receivables, personal property and general intangible property, the lender often needs to reference those assets by the owner of the assets.  It is usually easier to secure this type of financing if the business is incorporated, since the lender can reference these assets by the owner rather than having to take physical possession of the assets (the latter of which is usually not practical for the business).

Equity involves selling ownership in a business.  Sometimes equity better meets the needs of the business, especially in start-up businesses, since few lenders will lend to a business with little or no history.  Instead, forming an entity to own the assets and raising capital through the sale of equity in the business causes little disruption to the business operations. 

 

Provide Tax Benefits to the Business, its Employees and Owners

Corporations, LLCs, partnerships and its owners and employees are taxed differently under the tax laws, which results in tax benefits differing depending on the type of entity chosen.

Differences in tax rates to an entity and its owners can create substantial tax savings on business profits, depending on which entity is created.  In a C Corporation, the corporation pays tax on its profits, but the shareholders do not pay taxes until a dividend is distributed.  When considering a C Corporation both corporate tax rate as well as the tax rate on dividends needs to be considered.  In contrast, the business profits on an S Corporation, LLC or partnership are not taxed at the entity level, but the owners are taxed on the profits based on the owner’s federal income tax rate up to the maximum personal tax rate.

 

Issuing equity to employees in exchange for services rendered is taxed differently depending on the type of entity chosen.  Employees that are issued stock options and warrants with transferability and vesting subject to risk of forfeiture provisions usually are not currently taxed on the difference between the amount paid and the fair market value of the option or warrant when granted.  When the transferability or other restrictions lapse and the options or warrants become vested, however, the employees are taxed on the then fair market value of the option or warrant (less any price paid for the option or warrant).  In contrast, in an LLC or partnership, the entity can issue a “profits interest” and the employee is not taxed on the increased value when granted nor taxed upon vesting.  A profits interest means the employee is only entitled to future profits of the entity and not any of the current capital that the entity may own.

 

The various entities also tax employee-owners differently on the fringe benefits the entity may grant to the employee.

 

Accommodate Management and Employee’s Concerns

 

If the owners of a business want to keep a management team together, issuing restricted equity can provide a means to ensure long-term longevity of the business management team.  It is easier to do this if the business is incorporated as one of the various incorporated entities.

Often management and employees become concerned if the business will be sold and potential buyers of a business may want to ensure that the business employees remain after a sale to ensure no disruption in business operations.  In some circumstances, this can be accomplished by giving the management and employees options to purchase some or all of the business in the event of a sale or change in control of the owners of a business.  Accomplishing the legal safeguards for these arrangements is easier if the business is incorporated in one of the various entities, since it is easier to transfer stock, membership interests or partnership interests than assets of a business.

 

Entity Overview

Unincorporated Business Entities

 

Sole Proprietorship.  A sole proprietorship is a business owned by only one individual.  The owner is technically not an employee of the business, but is rather considered to be “self-employed.”  The owner may have employees working in the business, but those employees are not owners.  If more than one person owns the business and no entity has been formed, the business is owned by a general partnership.  A sole proprietorship is not a separate entity for tax or state legal purposes.  In most states, if a sole proprietor uses his or her surname in the business title, there is no state-filing requirement.  However, in some states a fictitious or assumed business name filing (“doing business as” or “d/b/a” for short) is required.

 

General Partnerships.  A general partnership is created when two or more persons carry on an activity as co-owners for profit, whether or not the persons intend to form a partnership.  Co-ownership of property alone does not establish a general partnership.  Usually the courts look to see if the activities being conducted are “considerable, continuous and regular” with some profit motive.  There is no requirement that a general partnership file a certificate with the Secretary of State for the start of its legal existence.  While a general partnership may own personal and real property in the name of the partnership and sue and be sued into its own name, it is not a separate legal entity for all purposes.  For example, the general partnership is not a separate legal entity for state liability purposes and in certain cases, for federal tax purposes.  Like a corporation, LLC, and LP, a general partnership is liable for its own debts and obligations.  Unlike those entities, however, all of the partners are jointly and severally liable for the debts and obligations of a general partnership.

 

Incorporated Business Entities

 

C Corporation.  The corporation is created under state law, whereas the “C” is the tax term for how the corporation is taxed for federal income tax purposes.  A C Corporation is treated as a separate entity for federal and state tax purposes and the shareholders are only taxed on the income of the Corporation when a dividend is declared and distributed to them.

 

S Corporation.  An S Corporation is an incorporated entity that has elected to be taxed under Subchapter S of the Internal Revenue Code by filing Form 2553 with the IRS. An S Corporation pays no entity level tax. If qualified, the IRS will grant the election and after the effective date of the election, the Corporation no longer pays any income tax.  There are, however, certain exceptions for S Corporations that were previously C Corporations that had appreciated assets at the time the S election was made.  Although an S Corporation generally does not pay any tax, it still must file an annual information tax return with the IRS and report each shareholder’s pro rata share of profits and losses on a Schedule K-1.  Only the shareholders are liable for paying the tax earned on profits from an S Corporation.

 

Note: For state law purposes, both a C and S corporation are formed and operate in the same manner.  The difference between the two “entities” is one of taxation not formation. 

 

Limited Liability Company (“LLC”).  An LLC offers its owners limited liability protection similar to a corporation.  It also provides enough flexibility that the entity can be operated similar to a corporation or a partnership by using a contract between the owners and/or management.  For tax purposes, the LLC is taxed as a partnership unless an election is made with the IRS to tax the LLC as a C corporation or an S corporation.  An LLC that is taxed as a partnership pays no entity level tax.  Rather, the income of the LLC is taxed at each of the owner’s applicable income tax rate. For a Minnesota LLC, income is allocated equally among members (per capita).

 

Limited Partnership (“LP”).  An LP is a partnership that has both general partners and limited partners.  The general partners have the authority to conduct the regular operations of the business, but have unlimited liability for the debts and obligations of the limited partnership.  In contrast, the limited partners generally only have liability to the extent of their contribution plus any additional contributions they contractually agreed to pay in the future.  The LP is a popular entity choice for estate planning purposes and passively holding assets.  It is not often used for operating a business since the LLC provides more flexibility and better liability protection for its owners and managers.  Note:  No filing is required to create an LP but an agreement amongst the general partners and the limited partners is required.

 

Limited Liability Partnership (“LLP”).  An LLP is a general partnership, except that all of the partners are shielded from future liability for the partnership’s debts and obligations.  An LLP is created when a statement of qualification is filed with the Secretary of State.  See Minn. Stat. § 323A.1001.  The partners are still jointly and severally liable for the debts or obligations, if any, that arose before filing the statement of qualification. 

 

Limited Liability Limited Partnership (“LLLP”).  An LLLP is a limited partnership, except that the general partners are shielded from future liability for the partnership’s debts and obligations.  An LLLP is created when a certificate of limited partnership is filed with the Secretary of State.  The LLLP provides limited liability protection to all partners, including the general partners.

 

Business Trust.  The Minnesota Business Trust Act, found in Chapter 318 of the Minnesota Statutes, creates the legal entity known as a business trust.  All of the owners of a business trust have limited liability similar to a corporation, LLC, LLP and LLLP.  The Business Trust is not a common form of entity these days since the other types of incorporated entities provide more flexibility.

 

Overlays:  Professional Firms or Public Benefit Corporations.

 

A for-profit enterprise can also to add additional functionality and governance protections by electing in its formation documents to also be governed by one Minnesota’s overlay statutes: the Minnesota Professional Firms Act found in Chapter 319B or the Minnesota Public Benefit Corporation Act found in Chapter 304A. 

 

Professional Firms.  To be a professional firm its owners must be engaged in providing professional services such as medical care, dentistry, engineering, architecture, accounting or any other professional services listed in Minn. Stat. § 319B.02, subd. 19.  A corporation that is a professional firm is subject to both Chapter 302A and 319B. A limited liability company that is a professional firm is subject to both 322C and 319B.  A limited liability partnership that is a professional firm is subject to either 321or 323A and 319B. 

 

Pubic Benefit Corporations.  A public benefit corporation is a 302A business corporation that has elected to add to its general business purpose one or more social purposes that are at least co-equal with the general business purpose.  Minn. Stat. § 304A.104.  A corporation that is a public benefit corporation is subject to both 302A and 304A.  Public benefit corporation elections is only available to 302A corporations. 

 


Written By:
Kimberly Lowe

For almost 20 years Kim Lowe has lawyered from the trenches. Kim lawyers from experience, using her knowledge of the law and understanding of how both for-profit and nonprofit business enterprises operate.

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