Generally, all business entities in Minnesota can be organized into two large groups: incorporated business entities and unincorporated business entities. The first group mainly consists of corporations, limited liability companies (“LLC”), limited liability limited partnerships (“LLLP”), limited liability partnerships (“LLP”) and business trusts. If the incorporated entity operates in certain professions, the business title of such entity often includes an extra “P” for “professional” (for example: PLLC). Incorporated entities are organized by registering with the State of Minnesota; in addition, there is usually a maintenance requirement which consists of annual filings with the State. Furthermore, additional documentation, such as buy-sell agreements, bylaws, operating agreement, and partnership agreement, may be required to organize the relations between business owners and managers. Since incorporated entities are treated as separate entities, there are also numerous legal and tax implications associated with a particular choice of incorporation.
The unincorporated business entities mainly include sole proprietorships and general partnerships. Unlike the incorporated entities, unincorporated businesses usually do not require any type of registration with the state and often (in the case of sole proprietorships, always) avoid any complications associated with being treated as separate legal entities.
Given the accounting and legal complications and expenses of money and/or time associated with additional paperwork, what are the main reasons for business owners to incorporate, i.e. why go through all these troubles? Answering this question is precisely the objective of this essay. In this article, I will detail the top five powerful incentives which account for why most successful businesses seek incorporation.
1. Limited Liability Protection for Owners
Probably the most common incentive for business incorporation is protection of the owner’s assets. As a consequence of incorporation of a business, business owners are not personally liable for business debts and only have risk up to the amount of their investment and additional contributions they may have contractually obligated themselves to contribute to the entity. Thus, under the limited liability protection doctrine, liabilities of the business are separated from the owner’s personal assets.
Remember, however, that the limited protection is not absolute. A business owner may still be liable under the common law concept known as “piercing the corporate veil” (a common-law doctrine which removes the limited liability protection in certain circumstances). Furthermore, there are additional statutory provisions which may encroach on the limited liability protection (such as personal liability for the employees’ portion of FICA and withholding payroll taxes).
Finally, it must be remembered that an incorporated business will not provide limited liability protection from professional liability. For example, lawyers and doctors cannot protect themselves against professional liability by incorporating their business. The incorporation, however, can usually shield professionals from debts and obligations of the business itself.
2. Flexible Ownership Structure
The second reason for business incorporation is flexibility in structuring business ownership, especially transferability of ownership. In order to understand this superiority of the incorporated entity over unincorporated one, one must remembered that, unlike a sole proprietorship, an incorporated entity is considered to be separate from its owners. Therefore, the ownership interest in an incorporated entity is generally considered as personal property and can be transferred independent of the business. The same analysis applies to general partnerships, but such partnerships usually do not have the features, such as different classes of stocks or stock compensation options, enjoyed by the incorporated entities.
The transfer of the ownership interest in an incorporated entity may be restricted by the owners themselves by using bylaws, shareholder control agreements, buy-sell agreements, operating agreements, member control agreements, partnership agreements, et cetera.
3. Business Tax Planning
Incorporation of a business may be one of the best ways to reduce or defer taxes. The primary reason for this is the fact that the State of Minnesota and the federal government tax each business entity differently. Moreover, there are great differences with respect to the types of taxes and tax rates imposed on an entity and its owners. Structuring compensation differently (for example, issuing equity to employees in exchange for services rendered) may produce a completely different end-of-year tax bill. Some business entities may even choose their own tax year different from the usual calendar year used by a solo proprietorship. With careful tax planning, a business owner may greatly reduce his tax burden, thereby increasing his profits and competitiveness of his business.
In addition to the pure business tax planning, incorporation of a business can be a great tool for estate planning.
4. Superior Options for Attracting Investors
It is much easier for an incorporated entity to attract investors and secure business financing. This is usually the case because an incorporated entity can be capitalized either with debt or an ownership interest in the entity (equity), and the business owners can simply sell equity to raise capital and attract investors. Thus, investors become co-owners of the business without having to going through the process of constant re-titling of the assets (as would usually happen in a sole proprietorship). Obviously, the limited liability protection and the flexible ownership structure are two other very important factor in attracting investors.
5. Continuity of Life of a Business Entity
In a general partnership or a sole proprietorship, a death of an owner or a partner’s withdrawal from business will lead to the dissolution and the winding up of the business. Unlike unincorporated entities, however, the incorporated businesses can continue their existence indefinitely, unless the organizational documents specifically limit the term of the entity. This continuity of life creates goodwill value for the business and its owners, and it is very important to the stability of the business.
Incorporation of a business can be very important to business success. Except for professional liability, the owner’s personal assets are separated from the debts and obligations of the business. Incorporation can help a business to attract investors through its flexible ownership structure and assured continuity. Finally, incorporation of a business can create tremendous opportunities for business tax planning, reducing the tax burden and promoting the competitiveness of the business.
Obviously, these five factors are not the only reasons for business incorporation. They are, however, the most common and the most powerful ones. You should remember though, that, once the decision to incorporate your business is made, the next step is to decide which particular entity best fits your situation. The choice of entity should be made a business and tax attorney, who will choose the right entity for you through analysis of the combination of business and tax factors. Sherayzen Law Office can help you make this choice, draft and file the necessary documents, and create the right legal structure for your business entity so that you can concentrate on working toward your business success.