Business Start-Up Packet
Step 4: Selecting Your Business Structure
Business activity may be conducted through a variety of organizational structures. An attorney, accountant, financial advisor, tax advisor or banker can suggest which form would be most suitable. One of the primary considerations in selecting a business organization is protection of a business owner from liability. Other considerations are the transferability of ownership rights, the ability to continue as a business in the event of the death or withdrawal of one or more of the owners, the capital needs of the business and tax liabilities.
Note: Legal requirements are determined by the selected business structure. The laws are very specific on the regulations required as you set up your business structure. Legal counsel or the assistance of a professional accountant may be needed. The most common business structures are as follows.
Sole Proprietorship
The single owner of the business is a sole proprietor. The single owner has sole control and responsibility. The sole proprietorship is easily formed, allows important decisions to be made quickly and may enjoy fewer legal restrictions.
The sole proprietorship is the simplest form of organization and the least expensive to establish. There are no statutory requirements unique to this form of organization. The business owner only needs to obtain the necessary business licenses and tax identification numbers, register the business name and begin operations. Many individuals begin their business as a sole proprietorship. As the business expands or more owners are needed for financial or other reasons, a partnership or corporation may be formed.
The sole proprietor is personally liable for the debts of the business, even if those debts exceed the owner’s investments in the business. All of the owner’s assets, both those used in the business and personal property, can be attached by creditors and sold to pay business debts. The sole proprietor may be able to minimize certain risks such as property loss, personal injury or product liability by obtaining adequate insurance.
The sole proprietor has full and complete authority to manage and control the business. There are no partners or shareholders to consult before making decisions. This form of organization gives the proprietor maximum freedom to run the business and respond quickly to day-to-day business needs. The disadvantage of this form is that the sole proprietor, as just one person, will have limited time, energy and expertise to devote to the business. His or her experiences may not provide the breadth of skills and knowledge necessary to deal with all phases of the business. Further, he or she may be unable to leave the business for extended periods of time without jeopardizing its operations. As the business expands, the proprietor may be able to hire managers to perform some of these functions and provide additional expertise, but in the early years of the business, the sole proprietor often will perform many of these tasks alone.
A sole proprietor transfers ownership of the business by transferring the assets of the business to the new owner. The prior proprietorship is terminated and a new proprietorship is established under the new owner. The business entity terminates at the death of the proprietor if the proprietor becomes unable to manage it.
In a sole proprietorship, the taxpayer is the individual business owner. The proprietor is taxed on the entire income from the business, regardless of whether the income is withdrawn for personal use or retained in the business. Income and expenses from the business are reported on a Schedule C or Schedule C-EZ (Form 1040) and any related forms and schedules. The net income or loss from the business is then transferred to the proprietor’s individual Form 1040. The proprietor uses Schedule SE to report net self-employment income for purposes of computing the Social Security and Medicare self-employment tax.
If the business is to operate as a sole proprietorship, the entrepreneur should consider recording a declaration of business name at the local county Register of Deeds office, or by going to www.sdsos.gov and clicking on Fictitious Business Name Registration. State law permits this action and if the business is going to operate under a "fictitious name," it is required.
If the business is simply called the "Acme Company" the business owner must file a sworn declaration stating the names of the owners and participants, their present address, etc. If the business name includes the owner’s last name, the owner may still want to consider filing to be assured of exclusive rights to use that name in that county.
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General Partnership
A partnership is an association of two or more people acting as co-owners of a business for profit. Partnerships have specific attributes, which are defined by statute. All partners in a general partnership share equally in the right, and responsibility, to manage the business, and each partner is responsible for all debts and obligations of the business. Distribution of profits and losses, allocation of management responsibilities, and other issues affecting the partnership usually are defined in a written partnership agreement.
A general partnership is more complex than a sole proprietorship, but involves fewer formalities and legal restrictions than a corporation, or limited liability company. Basic elements of partnership law are established by statute, but most issues can be determined by agreement of the partners. A written partnership agreement is highly recommended, but is not legally required.
In a general partnership, each partner may be personally liable for up to the full amount of debts of the business, even if the debts exceed the owner’s investment in the business. This is because, unless care is taken in the partnership agreement to limit a partner’s authority and potential creditors are notified of the limitation, any partner may bind the partnership. The partner with greater personal assets thus risks losing more than a partner with fewer personal assets. As with a sole proprietorship, many business risks can be lessened by obtaining adequate insurance.
All partners share equally in the right, and responsibility, to manage and control the business. The partnership agreement may centralize some management decisions in a small group of partners, but all partners continue to share ultimate responsibility for these decisions. The right to share equally in decisions can make the decision making process cumbersome, and the risk of major disagreements can impair effective operation of the business. An advantage of the partnership that is not present in a sole proprietorship is that the partnership, with its several owners, can bring a broader range of skills, abilities and resources to the business. The owners’ combined experiences can also promote more informed decision making. In addition, the workload can be shared to lessen the physical and other demands on the individual owners.
The transfer of a partner’s economic interest in a partnership is determined by the partnership agreement or by statute if there is no partnership agreement. Unless permitted by the partnership agreement, no person may become a partner without consent of all the other partners. If a partner attempts to transfer his or her interest in the partnership without such an agreement, the transferee does not become a partner but instead becomes entitled to receive profits which the transferring partner otherwise would receive. A properly drawn partnership agreement will address the conditions under which an ownership interest may be transferred, and the consequences to the transferee and the partnership. General partnerships do not automatically cease to exist when a partner dies or otherwise withdraws from a partnership. The partnership continues, unless certain other events occur.
The partnership itself is not a taxable entity. The partnership serves as a conduit through which income, deductions and credits are passed through to the individual partners. Each partner is taxed on his or her share as defined in the partnership agreement. All income of the partnership is taxed to the partners, whether or not it is actually distributed. The partnership itself files an information return which reports partnership income and distributions to the partner. The partnership files Form 1065, which is an information return. No tax is paid by the partnership with this return. Other forms and schedules may be required, including Schedule K and K-1. Individual partners use Schedule E (Form 1040) which is prepared with information from their Schedule K-1 of Form 1065, to report their distributive share of partnership income, deductions, credits and losses on their individual Form 1040. Schedule SE (Form 1040) is used to compute Social Security and Medicare self employment tax.
One or more individuals may register a General Partnership Statement of Authority with the Office of the Secretary of State. A statement of authority cost $100. This should be done at the Capitol Building, Suite 204, Pierre, S.D. 57501, (605) 773-4845 or go to www.sdsos.gov.
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Limited Liability Partnership (LLP)
Limited liability partnerships are more closely regulated than general partnerships, permitting investors to become silent or limited partners without assuming unlimited liability. In a LLP, the personal assets of the partners are shielded against liabilities incurred by the partnership in tort and contract situations. This is different from a general partnership, in which partners may be personally liable up to an unlimited extent for the debts and obligations of the partnership.
An existing general partnership may elect LLP status by filing a LLP registration with the South Dakota Secretary of State Office. Such registration is effective for an indefinite period of time. It is recommended to seek advice of counsel when forming an LLP. The Secretary of State’s Office will revoke the LLP if the required annual report is not filed.
A limited partnership is a type of partnership in which the limited partners share in the partnership’s liability only up to the amount of their investment in the limited partnership. By statute, the limited partnership must have at least one general partner and one limited partner. The general partner has the right and responsibility to control the limited partnership, and is responsible for the debts and obligations of the limited partnership. The limited partner, in exchange for limited liability, is usually not involved in the day-to-day management and control of the business. Limited partnerships must be established in compliance with statutory requirements, and the tax and securities laws. Because of their complex nature, limited partnerships should not be undertaken without competent professional advice.
A limited partnership must meet specific statutory requirements at the time of organization, and the offering of ownership interests in the limited partnership is subject to tax and securities laws. Accordingly, the limited partnership will be more complex and expensive to organize than a general partnership.
In a limited partnership, so long as the statutory formalities are met and the limited partnership is not relied upon by others as a general partner, the limited partner generally is not liable for the obligations of the limited partnership. Thus the limited partner risks loss only up to the amount of his or her investment.
A limited partnership does not terminate when a limited partner dies or becomes disabled. The limited partner’s interest may be assigned, and if the limited partner dies, his or her legal representative may exercise all the partner’s rights for purposes of settling the estate.
South Dakota has adopted the Uniform Limited Partnership Act. One or more individuals may form a domestic LLP or limited partnerships with the Office of the Secretary of State. The Certificate of Limited Partnerships and the Statement of Qualification cost $100 each. An annual report with a $30 filing fee is due each year on the anniversary date for LLP's only (Partnerships do not file annual reports). These forms can be obtained from the Office of the Secretary of State at the Capitol Building, Suite 204, Pierre, S.D. 57501, (605) 773-4845 or go to www.sdsos.gov and click on Corporations, then click on Forms.
For more information on legislation of limited partnerships go to www.sdsos.gov then click on Corporations, then click on SDCL 48-7.
For more information on legislation of limited liability partnerships go to www.sdsos.gov then click on Corporations, then click on SDCL 48-7A.
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Business Corporation
A corporation is a more complex form of business organization. A corporation is a legal entity and exists apart from its owners or shareholders. As a separate entity, it has its own rights, privileges and liabilities apart from the individuals. The corporation must be established in compliance with the statutory requirements of the state of incorporation. The shareholders elect a board of directors which has the responsibility for management and control of the corporation. Because the corporation is a separate legal entity, the corporation is responsible for the debts and obligations of the business. In most cases, shareholders are insulated from claims against the corporation.
Because of the complexities involved in incorporating, corporations often will make greater use of professional advisors, which will increase costs. Other costs associated with incorporating include filing fees, which are greater for corporations, and the costs associated with tax compliance and preparing various government reports. If the corporation does business in other states, it generally will be required to register to do business in those states, thus further increasing the cost and complexity of incorporation.
The corporation, in most cases, is the entity that is liable for the debts of the business. The shareholders generally are exempt from personal liability for those debts and thus risk loss only up to the amount of their investment in the corporation. It should be noted, however, that in a small, closely held or newly created corporation without an established credit history, some or all of the shareholders may be expected to personally guarantee repayment of certain corporate debts as a condition of obtaining a loan or credit. Also, under certain circumstances such as fraud or personal wrongdoing, shareholders may be held partially liable for wrongful acts. Finally, it is possible for courts to “disregard” the corporate entity and make shareholders liable under certain circumstances.
The rules for corporate decision making are established by statute, but many rules may be modified by the articles of incorporation or bylaws. Shareholders elect the board of directors, which in turn manages the operations of the business. The corporation also must have one or more natural persons exercising the functions of chief executive and chief financial officer. Except in very small corporations in which the shareholders are also the directors, shareholders as a group generally will not directly participate in management decisions. This concentration of decision making in a relatively few individuals promote flexibility in decision making, but also result in overruling of minority interests or in some cases manipulation or exploitation of minority shareholders. To resolve this problem, corporations may adopt provisions in the articles of incorporation or bylaws to give minority shareholders a stronger voice in management decisions. Decision making authority also may be delegated by the shareholders and/or directors to hired managers, who may or may not be shareholders. This delegation further removes decision making authority from the shareholders. Like a partnership, the corporation can draw on the skills and expertise of more than one individual in running the business. This can broaden the base of information for decision making and reduce workload demands on individual managers.
A corporation is a separate legal and taxable entity. For tax purposes, the corporation may be a “C corporation” or it may be treated as an “S corporation”. In a C corporation, the corporation itself pays tax on corporate profits. After taxes are paid, remaining corporate profits may be distributed to shareholders in the form of dividends. The shareholders are then taxed in a manner similar to a partnership; that is, the income, deductions and credits of the corporation are passed though to shareholders and are taxed to shareholders at their individual tax rates.
Ownership in a corporation is transferred by sale of stock. A change in ownership does not affect the existence of the corporate entity. Technically, shares of stock in a corporation are freely transferable. As a practical matter, however, the market may be limited for shares of stock in a small corporation that is not publicly traded. In addition, shareholders in a new venture often will want to prevent unrestricted transfer of shares and thus may provide in the articles of incorporation or bylaws for transfer restrictions or buy-sell and redemption agreements, further limiting transferability.
Since a corporation is a separate legal entity, the death, disability or withdrawal of an owner has no legal effect on the business entity’s existence. As a practical matter, however, many small businesses depend heavily on the efforts of one or two individuals, and the death or disability of one of those key individuals can seriously impair the economic viability of the business. For this reason, a small business corporation, like a partnership, often will obtain life insurance on key shareholder-employees. The articles of incorporation may provide for share purchase agreements or other restrictions on the transferability of stock in order to retain control of the firm by the remaining key individuals.
C Corporation
A C corporation reports its income, deductions and credits, and computes its tax, on Form 1120 or Form 1120-A. Supporting forms and schedules may be required. If the corporation issues dividends, it must annually send its shareholders Form 1099-DIV, stating the amount of dividends paid. A copy also is filed with the IRS. The shareholder reports dividends received from the corporation on his or her individual Form 1040.
The C corporation’s taxable income and tax are determined prior to distribution of profits to shareholders. Profits which are distributed to shareholders in the form of dividends are then taxable to the shareholders at their individual income tax rate. Thus these dividends are subject to double taxation; once on the corporation’s income tax return and once on the individual shareholder’s income tax return. In addition, the dividends are taxed to the shareholders as ordinary income: capital gains, charitable contributions and other income and deduction items do not retain their character when passed to shareholders in the form of dividends. Similarly, individual shareholders do not share a corporation’s losses for tax purposes.
The C corporations offer some opportunity for tax planning in that dividends may be accumulated by the corporation rather than paid to shareholders, thus postponing double taxation. However, IRS regulations limit the amount of accumulated earnings that may be retained by the corporation. An accumulated earnings tax may be imposed on excessive accumulated earnings. Because all income of the sole proprietorship, partnership and S corporation is taxable to the owners whether or not it is distributed, these entities are not subject to the accumulated earnings tax. The C corporation may pay a salary to owner-employees. Salaries are deductible by the corporation and thus are not included in the corporation’s taxable income. However, the IRS may treat as dividends excessive salaries that appear designed to avoid double taxation.
S Corporation
An S corporation files Form 1120S and supporting forms and schedules, including Schedules K and K-1. The S corporation generally is not separately taxed. Individual shareholders report their share of the S corporation’s income, deductions and credits on their individual Form 1040, using information contained on the Schedule K-1.
The S corporation is a conduit through which the firm’s income and deductions flow to the shareholder. Income items and deductions generally retain their character when passed through to shareholders, although special reporting rules apply and the opportunity to fully claim a share of the S corporation’s losses may be limited. Unlike a partnership, allocations to S corporation shareholders must be in proportion to their shareholdings. Thus this form of organization may offer less attractive tax planning opportunities.
A shareholder’s pro rata share of S corporation income and deductions is combined with income and losses from other sources and reported on the shareholder’s individual income tax return. The total taxable income is taxed at individual income tax rates applicable to shareholder’s tax bracket.
One or more individuals may form a South Dakota corporation by filing articles of incorporation with the Office of the Secretary of State. South Dakota law does not require a resident incorporator or director, but every corporation must maintain a resident registered agent. The filing fee in $125 to form a South Dakota Corporation, $550 for Application for Certificate of Authority. An annual report with a $30 filing fee is due each year on the anniversary date of incorporation. The forms for Articles of Incorporation and application for Certificate of Authority may be obtained from the Office of the Secretary of State, Corporate Division, Capital Building Suite 204, Pierre, SD 57501, (605) 773-4845 or go to www.sdsos.gov and click on Corporations, then click on Forms.
For more information on legislation of corporations go to www.sdsos.gov and click on Corporations, then click on SDCL-47.
OR
Go to www.sdsos.gov and click on Corporations, then click on Corporations, then click on Domestic Business Corporation Booklet.
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Limited Liability Company (LLC)
The Limited Liability Company is a form of business organization that is designed to combine the tax treatment of a partnership with the limited liability characteristics of a corporation. A LLC may have one or more members which may choose to be taxed as partnerships or corporations. Business income and losses of the LLC that choose to be taxed as a partnership or as a sole proprietorship may be passed through to the owners of the business. A LLC that chooses to be taxed as a partnership or as a sole proprietorship is not taxed at the entity level, eliminating the double taxation of profits that occurs with a C corporation. Income is then taxed at the owner’s individual tax rate. Like a corporation, liability for business debts and obligations generally rests with the entity rather than with individual owners. A LLC is not subject to many of the restrictions that apply to S corporations. Unlike a limited partnership, all members of a LLC may participate in the active management of the company without risking loss of limited personal liability.
An LLC can be expected to be similar to a corporation in complexity and cost to organize. As with a corporation, the procedures and criteria for forming a LLC are specified by statute. There is very little case law to guide organizational and operational decisions although the LLC law is modeled on the business corporation law. For this reason, owners of a LLC may need to consult often with their professional advisors, increasing their costs.
Liability of the owners generally is the same as for shareholders of a corporation; that is, absent fraud, personal wrongdoing or disregard of the entity, they generally are not held personally liable for the debts and obligations of the business. They therefore risk loss only up to the amount of their investment. As is the case for corporations, owners of small, closely held, or newly organized LLCs may be required to give personal guarantees of repayment to secure financing or credit.
Like a corporation, a LLC has centralized management. By statute, a limited liability company is managed by or under the direction of a board of governors, comprised of one or more individuals. In addition, the LLC must have one or more individuals exercising the functions of chief manager and treasurer. Additional managers and agents may be appointed by the board. The LLC act also authorizes members of the LLC to make management decisions under certain circumstances. As with a corporation, many of the rules governing the management of the LLC are specified in the articles of organization, by-laws or the LLC statute.
Membership rights in a LLC consist of financial rights and governance rights. Financial rights are the rights to share in the profits, losses and distributions of the LLC. Governance rights are the rights to vote and to manage the business. Unless the articles of organization or operating agreement provide otherwise, a member may assign or transfer financial rights. Such a transfer gives the transferee all the rights to profits and distributions that the transferor had. The transfer does not create membership rights in the transferee, nor can the transfer allow the transferee to directly or indirectly exercise governance rights. Governance rights can only be transferred if all members give their written consent. The articles of organization may provide for less-than-unanimous consent.
For LLCs the termination of membership of a particular member is an event of dissolution only to the extent specified in the articles of organization or in a member control agreement, or if the membership of the last member terminates and no new members are admitted within 180 days of that termination. Otherwise, the termination of a member’s interest does not affect the existence of the LLC.
One or more individuals may form a South Dakota LLC by filing articles of organization with the Office of the Secretary of State. The filing fee is $125. An annual report with a $50 filing fee is due each year on the anniversary date of organization. The forms for Articles of Incorporation and application for Certificate of Authority may be obtained from the Office of the Secretary of State, Capital Building Suite 204, Pierre, SD 57501, (605) 773-4845 or go to www.sdsos.gov and click on Corporations, then click on Forms.
For more information on legislation of a Limited Liability Company go to www.sdsos.gov and click on Corporations, then click on SDCL 47-34A.
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Nonprofit Corporation
A nonprofit corporation is created to help people achieve a common purpose. It is an organizing structure useful to small and large-scale activities, involving only a few people or many hundreds of people. It provides a useful and inexpensive structure for the enterprise of groups of all sizes, from community campaigns or events to perpetual and diverse activities by hundreds and thousands of people. A nonprofit corporation may be formed in South Dakota for any lawful purpose, but not for financial profit. It does not require large sums of money and it can be prepared initially by following a few simple rules: 1. It may not have shareholders or pay dividends. 2. It may compensate members, officers and trustees (in reasonable amounts) for services rendered.
Special Note: Nonprofit incorporation status does not guarantee that your organization will be granted tax-exempt status, nor does it ensure that your contributors can deduct their gifts from reported personal income. Nonprofit incorporation is generally a prerequisite to applying to the Internal Revenue Service for preferential tax status, under IRS Code section 501(c)(3). To apply for exempt status contact the IRS for the necessary application forms.
Three or more individuals may form a South Dakota nonprofit corporation by filing articles of incorporation with the Office of the Secretary of State. The filing fee is $25. An annual report with a $10 filing fee is due each year on the anniversary date of incorporation. The forms for Articles of Incorporation may be obtained from the Office of the Secretary of State, Capital Building Suite 204, Pierre, SD 57501, (605) 773-4845 or go to www.sdsos.gov and click on Corporations, then click on Forms.
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Cooperative
A cooperative is a form of business organization in which the business is owned and controlled by those who use its services, rather than to generate profit for investors. A cooperative may be organized as a legal entity or it may be an unincorporated association. Some of the more common purposes for which cooperatives are formed are:
• To supply members with agricultural production components such as fuels,
fertilizers, feed and chemicals.
• To provide members with an organizational structure for jointly handling and
marketing their products.
• To provide service to members, like housing, electricity, telephone, insurance
and health care.
Cooperatives have several features that distinguish them from for-profit business corporations. These include control of the cooperative by user-owners, services provided at cost and limited return on equity capital. An annual report with a $30 filing fee is due each year on the anniversary of incorporation. For more information, contact the Office of the Secretary of State, Capital Building Suite 204, Pierre, SD 57501, (605) 773-4845 or go to www.sdsos.gov and click on Corporations, then click on Forms.
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Federal Identification Number
If your business is a partnership or corporation (with or without employees), or a sole proprietorship with employees, one of the first things you must do is obtain a federal identification number for federal purposes.
To obtain a federal identification number, you must file Form SS-4, Application for Employer Identification Number, with the Internal Revenue Service. This form can be downloaded from the IRS Web site at www.irs.gov, click on Businesses, then click on Small Bus/Self-Employed under Contents, then click on Online Application – Employer Identification Number (EID). Or you can have a Form SS-4 sent to you by calling the IRS at 1-800-829-4933.
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