Business owners have long sought the advantages of incorporation, including personal liability protection, while avoiding what is often a significant income tax drawback of incorporation, double taxation of income (once when the corporation is taxed for the income and once when shareholders are taxed for the distribution of this income as dividends).  Current federal law generally permits pass-through entities to avoid this double taxation of income.  Income earned by these entities is permitted to “pass-through” to its owners and is taxed a single time to the owners of the business.  Pass-through entities generally include corporations that make an S corporation election under federal law, as well as sole proprietorships, partnerships, and limited liability companies.

Under the federal Tax Cuts & Jobs Act, as introduced, the House of Representatives Ways and Means Committee majority tax staff indicates that active owners or shareholders of pass-through entities would generally be permitted to have a portion of their net income from the pass-through entity treated as “business income” subject to preferential income tax rates ranging from 9% to 25% when fully implemented, verses regular income tax rates ranging from 12% to 39.6%.  These active owners or shareholders of pass-through entities would generally be permitted to have 30% of their net business income subject to these more favorable rates as “business income.”

However, under the federal Tax Cuts & Jobs Act, as introduced, personal service businesses in such fields as engineering, law, financial services, accounting, performing arts or consulting would generally not qualify to have any net business income taxed at the more favorable rates as “business income,” except to the degree it was claimed under a formula based on the business’ actual capital investments.

In addition, unlike business owners actively participating in the business, all net income derived from a passive business activity would be eligible to be taxed as “business income” at the preferential income tax rates of 9% to 25% when fully implemented.

[Legal advice not only involves an understanding of the law, but the application of the law to a particular set of circumstances or facts.  Typically blog posts are imperfect tools to address the subtlety and exceptions of the law that may apply in particular situations.  As a result, the information in this blog post does not represent legal advice.  If you are in a situation where you need or desire legal advice, we would be happy to help.  Call 608-358-9413 to set-up a no-charge initial consultation.]

It can be common (and certainly understandable) for both business owners and their accountants to primarily focus on minimizing taxes when deciding in what form to do business and whether or not to make an S corporation election with the IRS.  An important advantage to an S Corporation election can be the avoidance of double taxation of income (once when the corporation is taxed for this income and once when shareholders are taxed for the distribution of this income as dividends), while still retaining other benefits of incorporation.

However, when considering whether or not to make an S Corporation election to avoid the double taxation of income, business owners may also wish to consider the restrictions on debt and ownership of S Corporation shares imposed by the federal government, and the implications of these restrictions for raising the necessary financing for their business.

S corporations may not have more than one class of stock.  This limitation, for example, will preclude the creation of a second class of preferred stock which may limit the options for certain businesses to raise capital.  [Remember that preferred stock generally entitles the holder to a fixed dividend, the payment of which takes priority over any dividends paid to holders of common stock.]

S corporations generally may not have more than 100 shareholders, only certain types of qualifying trusts may hold S corporation stock, nonresident aliens may not be shareholders, and other corporations and partnerships may also not be shareholders.  These ownership restrictions may limit the ability of certain businesses to raise the necessary equity capital they need, either in the short- or long-term.

Finally, in enforcing the requirement that S corporations may only have one class of stock, the federal government places restrictions on the types of debt that may be incurred by an S corporation.  S corporations are only permitted to have what is referred to as “straight debt.”  Straight debt means a written, unconditional promise to pay a fixed amount of money on demand or on a specified date provided that: (a) the interest rate and/or payment dates are not dependent on business profits or the discretion of the borrower; (b) the debt cannot be converted to stock; and (c) the creditor is generally an individual, an estate, a qualifying trust, or a person who is actively and regularly engaged in loaning out money.  Again, these straight debt restrictions may limit the options of certain businesses to generate the financing they need.

Take the time to understand what form of doing business is right for your venture, including whether the benefits of any S corporation election outweigh the imposed restrictions.  Do you want to know more about estate planning considerations when deciding on an S corporation election with the IRS?  Consider the following two additional posts: (a) Contemplating S Corporation Status?  Consider Estate Planning Flexibility and Restrictions on Ownership; and (b) Contemplating S Corporation Status?  Consider Estate Planning Flexibility and Preferred Stock Limitations.

[Legal advice not only involves an understanding of the law, but the application of the law to a particular set of circumstances or facts.  Typically blog posts are imperfect tools to address the subtlety and exceptions of the law that may apply in particular situations.  As a result, the information in this blog post does not represent legal advice.  If you are in a situation where you need or desire legal advice, we would be happy to help.  Check out our Contact Us page, and feel free to set-up a no-charge initial consultation.]

It can be tempting to avoid the work of developing an operating agreement with your other contemplated business partners and “just get started.”  However, a lot of future conflicts can be avoided and the foundation for a long and successful partnership can be laid if business partners have the foresight to work through issues upfront.  How much should each partner contribute in the way of capital and services?  What will be the initial capital needs of the company?  What are the specific services that a partner will be required to contribute on a one-time and on an ongoing basis?  What are the remedies for the other partners if a partner defaults on providing the capital or services he or she promised?  What are the rights or obligations of partners to buyout the interests of a departing partner?  How will the purchase price of a departing partner’s interest be determined?  What rights does a departing partner have to sell his or her business interest to a non-partner or to pass his or her interest on to his or her heirs?  Will a business partner be subject to a noncompete agreement if he or she leaves?  What rights does a departing business partner have to the company’s intellectual property after he or she leaves?  Can all business partners bind the company or will day-to-day management of the company be delegated to one partner or a subset of partners?  What level of profits will each partner receive in return for his or her contribution of capital and services?  What happens if the company runs short of money?  Can partners require each other to make additional capital contributions to the company to give the company a chance to succeed if the company runs short of cash?  What rights do the partners have to a return of capital if a partner departs the company or the company dissolves?  What are the various default provisions that govern the operation of the type of business entity that has been selected (for example corporation, limited liability company or limited liability partnership)?  Will these default provisions work well for your business venture or do they need to be modified?  The operating agreement is the mechanism by which you and your business partners can change the application of these default rules to your business and address the other issues identified above.

How can I form a business corporation, a limited liability company, or a nonstock, not-for-profit corporation in Wisconsin?  How can I form a limited partnership or a limited liability partnership under Wisconsin law?  Can I just form my business entity and forget it?

There has been an ongoing expansion in the law over time as to the types of business and nonprofit entities that may be formed.  In order to provide flexibility as to how these organizations are formed and operate, the statutes are filled with default rules that often may be modified to address your situation and your particular needs.  However, the law governing these different entity types varies, and depending on your situation and your goals one may be a better fit than another.  The goals in entity formation include: (a) identifying the entity type that is the right fit for your situation and goals: (b) modifying the default rules to address your formation and organizational needs; (c) addressing the rights and responsibilities of the various entity stakeholders, including owners and key employees; (d) developing organizational procedures and processes to address and resolve disputes between owners and leaders in the entity; (e) defining rights and processes to provide for the orderly sale and transfer of ownership interests (this is particularly important with small businesses as the most important market for small business ownership interests are often the co-owners of the business); and (f) addressing tax issues that may be affected by your entity selection.

Articles of Incorporation or Organization may be filed for a business corporation, a limited liability company, or a nonstock, not-for-profit corporation with the Wisconsin Department of Financial Institutions.  Likewise, a certificate of domestic limited partnership or the registration of a limited liability partnership may be filed with the Wisconsin Department of Financial Institutions.   What staff at the Wisconsin Department of Financial Institutions cannot do is to provide you legal advice to assist you in working through the issues identified above.