Minnesota Law
Minnesota Small & Privately Held Business Law
Small & Privately Held Business Law
Organization
Sole Proprietorship
The simplest way to own a closely held business is the sole proprietorship, in which the business is owned and controlled by one person who reports the debts and profits of the business on his or her personal income tax return. One person owns, manages, and controls the business. A sole proprietorship may have employees, but only the owner is in charge of the business. The owner receives the business profits and losses. The owner is also personally responsible for any debts the business may incur. Income, expenses, and losses are reported on the business owner's individual tax return.
A sole proprietorship is relatively easy to organize. The business owner is responsible for getting appropriate licenses, if any, and tax identification numbers, and must register the business name. There are no specific state filing requirements for this business option.
The benefits of the sole proprietorship include having complete control over the business, ease of the initial set-up, and having business profits taxed at the individual taxpayer rate, which is lower than the rate charged to corporations. The drawbacks to sole proprietorship include being personally responsible for debts and liabilities of the business. For example, if a business owner has debts that are not being paid, the creditors can reach the personal assets of the business owner, such as a personal checking account, house, or car. A business owner may obtain insurance to minimize this drawback. Other drawbacks include lack of continuity -- when the business owner dies, the business ceases to exist -- and generally not being able to deduct benefits like health, dental, and life insurance on a sole proprietor's income tax return as business expenses.
Partnership
A partnership is formed anytime two or more people who have not filed for incorporation agree to carry on a business together and to share profits and liability. A partnership is relatively easy to form and can be valid even without a written agreement setting forth its terms.
There are two types of partnerships, general and limited. In a general partnership each partner has an equal voice in how the business is run. Minnesota courts have ruled that a partnership can be formed merely by the act of two people running a business together, whether or not they ever had a formal agreement to do so. Usually, however, the partners draw up an agreement that specifies how the partnership will make decisions, when and how the partners can withdraw profits, and how each will be required to make contributions to the business. A chief advantage to forming a general partnership is that it is relatively inexpensive to start, as the agreement need not be filed with any governmental entity. In a general partnership, each partner is equally liable for the agreements and debts of the business.
A limited partnership sets limits on the power of partners to conduct business and affords limited liability to each partner. A limited partner is prohibited from managing or making day-to-day-decisions concerning the business but is shielded from most debts incurred by the company. More legal formalities must be met under this type of arrangement than in a general partnership. In Minnesota, a limited partnership can only be formed in accordance with the Uniform Limited Partnership Act. State and federal tax codes make a number of distinctions between limited and general partnerships. In general, neither kind of partnership has to pay federal income tax, instead, each partner pays tax at the individual tax rates on his or her share of the profits.
Corporation
A corporation differs from a partnership in that it is treated as a separate legal entity in and of itself rather than as a collection of individuals. A corporation is owned by one or more shareholders and must meet certain legal requirements spelled out in its articles of incorporation. The corporation is managed by a board of directors, who are elected from the shareholders of the corporation.
The corporation is taxed as a separate entity, and shareholders are not liable for the corporation's losses nor for any claims against the company. Under both state and federal tax laws, the corporation reports its income, losses, and expenses on a corporate income tax return.
One of the biggest drawbacks to incorporating a business is double taxation. Double taxation occurs because a corporation's income is taxed before dividends are paid to shareholders, but shareholders also have to report the gains as taxable income on their own individual tax returns.
All corporations, whether small or large, are expected to adhere to certain formalities, such as holding regular meetings of the board of directors and of shareholders. However, the small size of most closely held corporations and the tendency for shareholders to take active roles in the operation and management of the corporation often mean that many small and closely held corporations ignore such formalities. The failure to observe corporate formalities can be very unwise.
Sometimes, individuals use the corporate entity to insulate themselves from personal liability and the consequences of their actions. In such cases, when creditors find themselves unable to pursue their claims against closely held corporations, creditors may ask a court to ignore the organization's corporate status and impose liability upon the shareholders. Courts are more likely to take this action, called "piercing the corporate veil," in cases in which shareholders have not regularly conducted the business like a corporation or when the business has a seriously inadequate financial base for operation.
Professional Corporation
Professional corporations are formed by professionals such as doctors, lawyers, and accountants for the purpose of saving money on their taxes through pension plans and deferred-income programs.
A professional corporation is much like any other corporation except that it can be formed by only one person and can engage in only one category of professional service. Also, only other individuals licensed to practice in that particular profession can own shares in such a corporation. The shares cannot be easily transferred. Although forming a professional corporation does not shield the individual from liability for professional malpractice, it can shield an individual from liability for malpractice committed by other persons with whom he or she associates.
Limited Liability Company
As of January 1, 1993, companies in Minnesota have another option for organization. They can organize as a limited liability company, which allows them to take advantage of the favorable tax treatment of a partnership while preserving the limited liability of a corporation. A limited liability company must have at least two members and a limited lifetime, and ownership of the company cannot be transferred freely. This type of company limits the amount an investor in the corporation can lose, either from a lawsuit against the corporation or from other losses. Generally, the amount the investor can lose is limited to the amount he or she invests in the limited liability corporation. In addition, the liability of the corporation itself is limited to the value of its assets. Instead of being taxed as a single organization, the limited liability company is taxed through the income of its owners. All stockholders are allowed to participate in the decision-making process of the company, unlike members of a limited partnership.
Franchise
A franchise is an agreement, sometimes in the form of a contract, that allows the franchisee (the person buying the franchise) to use a marketing system that has been designed by the franchisor (the seller). The business is closely associated with the trademark or commercial identity of the franchisor and the franchisee must pay a fee for the use of the marketing system.
Some prognosticators have predicted that by the year 2000 more than one-half of all retail stores in America will be franchises. There is generally less of a financial risk associated with the purchase of a franchise because the marketing strategy has proven successful in the past. It is often easier for a franchise to obtain financing than it is for another independent business, even if both want financing for the same reason.
While a franchise fee does not guarantee success in business, the purchaser of a franchise can usually expect some help, services, and support from the franchisor. Among other things, the purchaser might receive help choosing a site for the business in the form of feasibility studies of the location and the demographics of the area where he or she hopes to locate the business. A franchisee might also expect to receive help in negotiating a lease for the business and financial assistance with the start-up and initial operating costs. Finally, a franchisor often provides a franchisee with training, support, advertising, product discounts, and further assistance.
In Minnesota, there are three specific elements that must be present with a franchise: a fee, a name, and a community of interest. Any offer that meets this definition may be subject to regulations found in the Minnesota Franchise Act. A franchise must be registered with the Minnesota Department of Commerce before any sales are made. In addition, certain fees are owed, such as a $400 application fee and several additional filing fees.
There are some exemptions to registration and a wide variety of state regulations with which franchises must comply. Copies of the Minnesota Franchise Act, the rules of the Department of Commerce, and the Uniform Franchise Offering Circular (a form of franchise guidelines accepted in almost every state) are all available from the State of Minnesota Bookstore.
Buying or Selling a Closely Held Business
Transferability
The ease of transferability of ownership varies depending on the way a business is organized. The assets of a sole proprietorship are easy to transfer. A sole proprietorship can be sold by selling all the assets of the business to another person, who then becomes the new sole proprietor of the business. A partnership is not easily transferable. Unless otherwise specified, no person can become a partner unless all of the other partners agree. Thus, if a partner sells his or her share in the business to someone who is not already a partner, the purchaser does not then become a partner but merely earns the profits that the seller otherwise would have received. To avoid this situation, most partnership agreements specify the conditions under which partnership status can be transferred. Sometimes partners have buy-sell agreements between themselves that obligate remaining partners to buy out the interest of a partner who wants to sell his or her interest. Buy-sell agreements can be mandatory, that is, requiring remaining partners to buy out a departing partner, or optional, giving the remaining partner or partners the right of first refusal should one partner want to sell his or her interest.
Shares in a corporation are usually the easiest to transfer because, by definition, a corporation is made up of shareholders who may transfer ownership of their shares to others. However, in the case of small and closely held corporations, there may not be much of a market for shares that are not publicly traded. Other shareholders may want to prevent the frequent sale of shares by strictly limiting such sales in their articles of incorporation. Members of limited liability companies can sell their rights to share in the profits and losses of the company unless there is an agreement to the contrary. As with a partnership, the rights to participate in the decision making of the company cannot be sold unless all of the members agree.
Non-Compete Agreements
Usually when a business is sold, the buyer wants the seller to agree not to compete with the business being sold. Non-compete agreements are enforceable in Minnesota so long as they are reasonable in geographic scope and duration. Non-compete agreements are especially important in the context of small and closely held companies because often goodwill and name recognition are the most significant items the buyer is paying for. Without an effective non-compete agreement, the seller might set up a new business in direct competition with the old one and transfer the loyalty of longtime customers to the new enterprise. A buyer may want to get non-compete agreements from the seller's spouse and children or anyone else who worked closely with the seller in operating the business and who might go into competition with the buyer.
Consulting Agreements
Another common component of an agreement to sell a closely held business is a consulting agreement. Often, the advice of the former business owner is a valuable asset for a new owner during a transitional period. The former owner can give advice on how business has been conducted, where supplies are kept, how to operate machinery, working effectively with suppliers, and generally keeping customers happy. Both parties to the agreement need to be clear on the extent and duration of the consulting arrangement. The advice of an attorney can be especially helpful when drafting a consulting agreement because the seller may be able to realize certain tax advantages by re-characterizing a portion of the purchase price as a consulting fee.
Business Succession
In a sole proprietorship, the business ceases to exist when the proprietor dies. In a general partnership, the business can be continued after one of the partners dies, but the remaining partners have to pay the beneficiary of the deceased partner the fair market value of his or her partnership. If a partner in a limited partnership dies, his or her ownership in the corporation may be inherited and all attendant rights exercised by the new owner.
Because a corporation is a freestanding legal entity, the death of an owner technically has no effect on the operation of the business. Many smaller corporations, however, take out life insurance policies on certain key employees, such as the founder or CEO of the business. The shares held by those persons may be transferred to descendants or, by previous agreement, to remaining key individuals.
In a limited liability company, the company dissolves unless there was prior agreement to continue in the event of a death. Also, if the remaining members of a company with more than one remaining member unanimously consent to continue operations, the company may do so.
Because interests in a small and closely held business often lack liquidity and can be difficult to evaluate, they can be difficult to transfer before or after the death of the owner. Estate planning concerns for owners of small and closely held businesses are addressed in the Trusts & Estate Planning Law Chapter.
Resources
Minnesota Department of Revenue, Minnesota Business Assistance Group, Mail Station 5555, St. Paul, MN 55146-5555, (612) 296-6181 or 1-800-657-3777.
Minnesota Secretary of State, 180 State Office Building, 100 Constitution Avenue, St. Paul, MN 55155-1299, (612) 296-2803.
Small Business Administration, 610C Butler Square Building, 100 Sixth Street North, Minneapolis, MN 55403, (612) 370-2324.
Minnesota Small Business Assistance Office, 500 Metro Square, 121 Seventh Place East, St. Paul, MN 55101-2146, (612) 296-3871 or 1-800-657-3858 (free pamphlet: A Guide to Starting a Business in Minnesota (3d ed. 1995)).