Frequently Asked Questions about Estate Planning, Special Needs Planning, Minnesota Business Law, and Asset Protection Services

A common question we get is whether or not you need to update your will, trust, financial power of attorney, living will or directive or other estate planning documents when you move to another state. In todays’ video, I’m going to answer that question and reveal some things you should be aware of and do when you move to a new state or even just purchase a home in another state.

So here are some things you should be aware of if you are thinking about moving to a new state, or even if you are just thinking about buying a second home in another state. For example, many of my clients have lake homes in WI, or farm land they inherited in Iowa or Nebraska. Many more are buying a second home in FL and becoming snowbirds or are even moving full-time to FL in retirement.

Many states have state-specific powers of attorney.

So as part of your estate plan, you should have an up-to-date financial power of attorney giving a spouse, family member or others the ability to step in and manage your financial affairs in the event you are unable to. If you don’t have one, your family may need to go to Court to get the authority to manage your finances in the event you become incapacitated.

Many states will have a state specific form, For example, both MN and FL have separate power of attorney forms and even differing requirements for their contents and their execution. Many states also require that a financial power of attorney be recorded with either the county or a court.

Probate requirements can vary between states.

One of the biggest misunderstandings I see in the general public when it comes to estate planning is that wills avoid probate. They do not. A will is a set of written instructions to a probate court about how you want probate to occur. So absent something else or additional planning, if you have a will, your family will need to go through probate. And probate costs and timelines vary by state.

So if you are moving from a state where probate can be relatively quick and inexpensive and your currently have a will-based estate plan, but are now moving to a state, like Minnesota or Florida, where probate can be much more time-consuming and expensive, you may want to switch to a trust or other planning tools that would allow your family to avoid probate.

Also, if you own assets in more than one state, and you do not already have a trust, you should consider switching to a trust-based plan. So for example, let’s assume you live in the MN or another state and then buy a home in FL where you plan to spend part of the year. Or you move to FL but keep a home back up north. If you were to pass away, your family would need to open a probate proceeding in your home state to manage assets there. However, that Court will not have jurisdiction over your home and other assets in the other state, only that state’s court does, which means your family will have to open a second, ancillary probate, in that state – which greatly increases the time and expense of managing your affairs. That is why we always suggest clients use a trust-based estate plan whenever they have a home or assets in more than one state as it avoids having to do multiple probates in multiple states.

Estate tax and other tax laws vary by state.

Some states are community property states and some states are separate property states. Some states, like FL, are separate property states but allow a married couple to choose to treat assets as community property and save on taxes. Some states, like MN, have a separate state-level estate tax, whereas some states, like FL, do not have a state-level estate tax. The differing tax laws may require updates to your plan if you own assets in more than one state or move to another state.

Signing Requirements for Estate Planning Documents vary by State.

Some states, like MN, only require you to sign your powers of attorney and trusts in the presence of a notary. Other states, like FL, require that the documents be witnessed as well as notarized.

Homestead Laws Vary By State.

Florida has wonderful homestead protections. However, homestead can be lost if people are not careful. For example, a trust needs to have some specific language in it in order to maintain the homestead protection for any FL real estate transferred to the trust.

The Rules on Protecting Your Home and Life Savings From Long-Term Care and Nursing Home Costs Vary by State.

If you have worked with an attorney to protect your home and life savings from long-term care costs, or need to, you should be aware that the rules and requirements vary a great deal by state and what works in one state may not work in another.

For example, we work with a lot of clients that split their time between MN and FL. We carefully tailor their planning to not only avoid probate, but to minimize taxes and to help them protect their home and life savings in the event they were to need long-term care or nursing home while working within the VERY different rules of each state.

As you can see, whenever you move to a new state, or even if you are just purchasing a home or other assets in another state, it is a good idea to meet with an attorney to review your estate plan to make sure it will work for your family when it is needed.

If you would like to learn more about Why Your Existing Estate Plan  (or lack of one) May Fail Just When Your Family Needs It Most, and How You Can Put a Plan in Place to Make it as Easy and Inexpensive as Possible For Your Family While Protecting Your Assets… I will be hosting a free, online masterclass, where I will be revealing what you need to know about powers of attorney, living wills, health care directives, wills vs. trust, tax minimization strategies, how to protect the assets you leave to your family in the event they get divorced or sued and much more, click here to register for the free msaterclass.

And if you’d like to learn how you can protect your home and life savings from long-term care and nursing home costs, download my free Guide, “Save My Home: How to Protect Your Home and Life Savings from Long-Term Care and Nursing Home Costs” by clicking here.

Or call us today at (763) 420-5087 in the Minnesota office or at (941) 909-4644 in the Florida office to schedule a consultation.

Your individual retirement account "IRA" may be one of the most valuable assets you own. In order to decide who you should name as the beneficary of your IRA, you need to weight the tax consequences along with the need for protecting the IRA from potential future creditors.

If your children are minors, the decision is simple. Minor children cannot inherit so you should set up a trust to own and manage your assets, including your IRA, until your children are old enough to responsibly manage the money you leave for them.

If your children are adults, the quesiton becomes more complicated. If you name your adult children as the beneficiaries of your IRA, they can, under current law, continue to strecth the IRA over their lifetimes. There are significant tax adantages to doing this. However, they are not required to and could just cash it out. Also, under a new ruling by the U.S. Supreme Court which you can read about by clicking here, inherited IRAs are subject to creditors claims. 

So if you have any concerns about your children's financial management skills or the possibility that they may be subject to creditor's claims in the future, you should consider naming a trust as the beneficiary of your IRA. A properly prepared trust can provide significant tax advantages as well as protecting the IRA from potential creditor's claims of your children. 

To learn more about protecting the money you leave for your children from divorce and creditor's claims, click here.

A qualfied personal residence trust is an advanced estate planning technique that can reduce your state and federal estate taxes by removing the value of your home from your estate.

A qualified personal residence trust is an irrevocable trust that is set up to own your home for a period of time, usually ten to fifteen years. After the time specified passes, the home is transferred out of the trust and to the benficiaries of the trust - usually your children. You continue to live in your home while it is owned by the trust. Once your home is transferred out of your trust to the beneficiaries, you can continue to live in your home but must now pay fair market value rent to the owners of the home - again, usually your children.

By utilizing this advanced estate planning technique, you remove the value of your home from your estate for estate tax purposes. If the value of your home is $1 million, you have effectively removed $1 million from your taxable estate.

To learn more about qualified personal residence trusts, click here.

If you are interested in gifting stocks, bonds, money, real estate, business interests or other assets to one or more children or grandchildren then you are on the correct page.

In January of 2013 the gifting rules changed.

Gifting can be more complicated than you might think.   For example, there are different rules for gift taxes than there are for the nursing home gift rules under medicaid.  So use the information here as a guide and get good information from an estate and gift tax adviser based on your personal and specific information.

Gifting in 2013:

Annual gift tax exclusion - inflation adjusted to $14,000.00 per person. This amount can be given to a child, grandchild and or their spouses. Furthermore, if you are married each spouse can gift this amount to each desired recipient. This means that a married couple can together gift $28,000.000 per year.

If one spouse has greater assets be sure to ask your adviser about split gifts and whether or not you need to file a gift tax return.

Lifetime Exclusion (unified credit): In addition to the annual gift tax exclusion, each person now also has a $5,250,000.00 lifetime credit which can be used to make gifts to children and grandchildren and/or their spouses.You will be required to file a 709 gift tax return when making gifts larger than the $14,000.00 per year annual gift tax amount but you can use your lifetime credit.

Note:  Gifts of hard to value assets such as real estate or business interests may require an appraisal. If you are considering a lifetime gift, you may require the advice of legal counsel.
 

Gifting can radically reduce taxes in certain circumstances and may also need to be coordinated with changes in your wills, trusts, and beneficiary designations.  The advice of counsel can therefore be both valuable and can save you and your heirs from later problems that might cost much more to correct.

Chuck Roulet

(763) 420-5087

The unlimited marital deduction allows a married couple to pass an unlimited amount of money, estate tax free, to a surviving spouse. As an example, assume Steve and Carrie are married and Steve passes away with an estate worth $7 million and a federal estate tax exemption of $5 million. In the absence of the unlimited marital deduction, Steve could only pass $5 million dollars estate tax free to Carrie. His estate would pay tax on the balance of $2 million. At a tax rate of 40%, that would be $800,000 in federal estate tax. With the unlimited marital deduction, Steve can pass his entire estate, tax free, to Carrie.

If you would like to learn how you can avoid or minimize estate taxes and pass along more to your heirs, give us a call today at (763) 420-5087.

Portability of the federal estate tax exemption between married couples means that upon the passing of the first spouse, if the value of their estate does not require the use of their entire federal estate tax exemption, then the amount of the exemption that was not used can be used upon the passing of the surviving spouse. In simple terms, it means that married couples can easily double the amount of their estate that escapes federal estate taxes.

An example of portability may help. Assume Steve and Carrie are married, own all their assets jointly, and have a combined estate worth $8,000,000. Let us also assume that the federal estate tax exemption in effect at Steve’s passing is $5,250,000.

If portability were not in effect and Steve passed away first, here is what would happen. Steve could pass his entire estate, estate tax free, to Carrie pursuant to the unlimited marital deduction. However, when Carrie passes away, only $5,250,000 is exempt from federal estate tax. That would leave $2,750,000 subject to the estate tax.  At a federal estate tax rate of 40%, $1,100,000 in federal estate taxes would be due upon Carrie’s passing.

With portability in effect, Carrie could use Steve’s $5,250,000 exemption as well as her own and double the amount not subject to estate tax to $10.5 million. With a total estate of $8,000,000, the estate would not be subject to federal estate tax and would save $1,100,000.

If you would like to learn how you can avoid or minimize estate taxes and pass along more to your heirs, give us a call today at (763) 420-5087.

Portability allows married couples to easily double the amount of their estate that escapes federal estate tax. Assume for example that Steve and Carrie are married, own everything jointly, and have a combined estate of $2,000,000. If Steve were to pass away first, using the unlimited marital deduction, he can transfer everything to Carrie and no estate tax is due upon his passing. However, when Carrie passes away, her entire estate is now $2,000,000. With only a $1,000,000 exemption in Minnesota, under current rates, Carrie’s estate would pay approximately $99,600 in Minnesota estate tax. If Minnesota had portability, Carrie could have used Steve’s $1 million exemption, in addition to hers, and no estate tax would have been due. The bad news is that Minnesota does not have portability. The good news is that with advance planning, Steve and Carrie can still avoid the Minnesota estate tax and pass an additional $99,600 to their heirs.

If you would like to learn how you can avoid or minimize estate taxes and pass along more to your heirs, visit our video page by clicking here.

An irrevocable life insurance trust, also known by the acronym "ILIT", is an advanced estate planning tool that can be used to minimize or avoid estate taxes. Many people purchase life insurance to help take care of their family after their passing. However, most are not aware that their family may not receive all of the proceeds. That is because life insurance proceeds are included in your estate for estate tax purposes. By creating an ILIT, you can protect the proceeds from estate taxes and take care of your family at the same time. For more information on ILITs, click here.

Estate plans come in a wide range of quality. Some are very basic form documents that leave big holes open. Sometimes clients are given a will when a trust would have been better, or a trust when a will would have been better, because they did not get the proper advice regarding the benefits and disadvantages of each one. 

I have had multiple clients ask me to review the plans created by other offices. These clients thought that they had a trust that would allow their estate to avoid probate, when in fact they actually just had a will. These clients had asked for a trust and were told they had a trust, only to find out after my review that they had a will with a testamentary trust that only goes into effect after their death and does not avoid probate.

I have had clients come to me with plans that do not protect the money their children inherit from full public disclosure of the assets/liabilities, from potential claims of a child's ex-spouse, or from their children's creditors.

In short, to answer the question, "Can I just do my own estate plan myself?", I often mention that some of my estate planning clients include lawyers who practice in other areas. These attorneys are aware of the intricacies that estate plans can contain. They ask me to do their plan because they believe that using an online provider or doing it themselves would leave too many holes in their estate plan.

 

Business owners often hear about certain benefits of incorporating in "incorporation-friendly" states like Delaware, Alaska, or Nevada and wonder if incorporating in one of these states would be right for them. Most of the clients I see would not benefit under this arrangement, because they are headquartered in Minnesota and most of  their business is conducted in the Minnesota.  Typically, they would still have to follow Minnesota law, unless they leaned heavily on accountants and lawyers to try to set up a really complicated arrangement. If they were to incorporate in Delaware, the registration, upkeep, accounting and legal fees would generally offset any potential advantages. We find that incorporating in another state is just not a cost-effective option for many small businesses who do most of their business in Minnesota.

For business who will be operating in multiple states, the option to incorporate in a "business-friendly" state like Delaware, Alaska, or Nevada becomes a more viable option.

If you have questions about whether incorporating in a "business-friendly" state is right for you, please contact our office. 

Most states have laws which allow pet owners to include provisions in their wills that provide for their pets after their death.

Only four states do not have laws allowing pet ownders to provide for their pets in their wills as of this writing. Minnesota is one of the four states. That means that Minnesotans cannot reliably provide for their pets in their wills. Instead, Minnesotans need to use standalone pet trusts or other arrangements to provide for their pets after their death.

Even for states that do have laws that make it easy for pet owners to provide for their pets in their wills, standalone pet trusts are generally preferable to wills for two reasons:

1) Wills go through probate, which means that a court has to review the will before ownership of your pet is determined. Standalone pet trusts do not go through probate and so your wishes for your pet can be carried out much faster.

2) Courts have the ability to change the amount pet owners leave behind for their pets in their wills. Courts cannot change amounts that pet owners have established in standalone pet trusts.

3) When pet owners provide for their pets through a provision in their wills, they cannot direct how money left behind for the pet should be spent and generally cannot leave any enforceable instructions for their pet's care. 

Often people refer to a Special Needs Trust and a Supplemental Needs Trust interchangeably. Actually, they are two distinct types of trusts.

A Special Needs Trust is usually funded with someone's own money for their personal benefit. For example, someone who becomes disabled would create a Special Needs Trust to set aside their own funds to supplement government benefits.

A Supplemental Needs Trust is usually funded with money from a 3rd party, such as a parent of grandparent. For example, a parent or grandchild may set aside funds for their child or grandchild.

Parents of a special needs child would create a Supplemental Needs Trust. The purpose of a Supplemental Needs Trust is to provide assets to supplement the needs of your disabled or special needs child. In the absence of this type of planning, any money you leave for your child could cause them to lose much needed government benefits. They would have to burn through the assets you've left for them before being able to reapply for government benefits. 

By creating a properly set up and manage Supplemental Needs Trust, the money you leave for your child can be used to supplement rather than replace any government benefits they are getting or may get in the future. 

The top question weighing on the minds of many parents with a special needs child is, "What will happen to my child after I am gone?" Parents worry that after they are gone, their child's quality of life may not remain as strong. At Roulet Law Firm, one of the options we recomment to clients with special needs children is the use of a Supplemental Needs Trust, which does not threaten the elibility for government benefits like Medicaid and SSI, and still allows the child to receive additional funds to supplement government benefits.

If you have minor children, one option to consider in your estate plan is when and how your children receive the money you leave for them.

If a parent dies without a will or a trust in place, a judge would decide who would be their guardian and how much of your assets would go to them. Most likely, the judge would decree that your children would receive their entire inheritance at the age of 18.

When you create a will or a trust, you get to decide who would be their guardians. You would get to decide if they would get everything outright at age 18, or if certain life events would trigger releasing some of the funds, like graduating from college, turning 25, having children, etc.

With a will, all this information would be public, exposing your children to anyone who reviews probate proceedings with less than honorable intentions.

A properly drafted trust keeps this information private and allows your estate to avoid the time-consuming probate process.

Yes, there are multiple ways to avoid or reduce estate taxes, commonly referred to as the “death tax”. In Minnesota, estates smaller than $1 million dollars, including life insurance, are not subject to the death tax. Estates larger than $1 million dollars, including the value of life insurance, are subject to the death tax. One simple way to double the $1 million dollar exemption is if you are married and use a special kind of trust. However, few people take advantage of this. If you would like to avoid or reduce the death tax, give us call at 763-420-5087 to schedule a free consultation to discuss protecting what matters most to you.

The short answer is yes. However, they may not go to the people and in the manner you prefer. If you pass away without a written estate plan (known as “intestate”), the State of Minnesota will decide who is in charge of your affairs, who should receive your assets, in what amounts and in what manner. This process is known as probate. None of these may be what you would have wanted or intended.

If you pass away without a written estate plan, assets will only be distributed after the Court appoints a personal representative and only in connection with a formal probate proceeding. The personal representative can be anyone with an interest in your affairs. Although a family member is most likely to be appointed, your bank, credit card company or others could petition the court to be appointed. Also, a family member who you would not want to act as your personal representative could also petition the Court. If you have minor children, the Court will appoint a guardian for the children and a conservator to manage their assets and they will most likely receive those assets outright and unprotected at the age of 18. If your children are not minors, they will receive an outright distribution of their share of your estate unprotected and regardless of whether or not they have the ability to manage what they receive from you. If you have a child or grandchild with a disability, their inheritance from you could cause them to lose needed government benefits. In the event you are married at the time of your passing and have children from a prior relationship, a portion of your estate will be given to your spouse and another portion will be immediately given to your children.

In short, if you pass away without a written estate plan, the State of Minnesota has a plan for you. It is known as probate. The probate court will decide who is in charge of your affairs, who receives your assets, when they receive those assets, the process takes on average 12-16 months, costs on average 3%-5% or more of your estate, and is completely public. Whether you choose to use a will or a trust as your written plan, dying without a written estate plan should be avoided if it all possible.

It is personal preference. We take the time to explain all of the options to our clients and help them choose which plan best meets their unique needs and goals. A will requires a probate proceeding to administer your estate upon your passing. Probate is time consuming (approximately 12-16 months in Minnesota), can be expensive (averages 3%-5% of the value of the gross estate), and is completely public. A properly crafted and funded trust avoids the probate process. We explain the differences this way: a will is cheaper and easier on the front end but far more expensive and difficult to administer at the back-end due to probate; a trust is more expensive and a bit more work to do at the front but much cheaper and easier for the family in the long run.

Never, ever do this! If you put your children’s names on your home, bank accounts and other assets, you’ve given them a share of the asset. If you give them a gift over $13,000 per year per person, you will have a gift tax problem.

You have also given away a valuable tax advantage. Let’s assume you give them a stock when it is worth $10,000 that you bought for $100. They will pay taxes on the $9,900 difference. If you had given them the same stock upon your passing, there would be no tax due because of the differences in what is called carry-over versus step-up basis.

If your children were to have a creditor’s claim against them, the creditor could attach your assets because your children’s names are on them. That means you could lose stocks, savings, etc. to your children’s creditors.

If you put your children’s names on the title to your home, you have huge potential problems for you and your children. If you sell the home, you and your spouse will have the capital gains exemption for the sale of your primary residence but your children will NOT. That means they will have to pay the capital gains tax. Also, if one of your children gets divorced, it is possible that their soon to be ex-spouse could sue for the sale of the home if there are insufficient other assets to pay them out. Yes, you read that correctly, you children’s soon-to-be ex-spouse has an ownership interest in your home even if it is only your child’s name on the title with you. That is because Minnesota law gives spouses a marital interest in real property even if their name is not on title to the home.

To illustrate this point, I once had a client come to me for legal help. After his wife’s passing, his previous attorney advised him to put his children’s names on his home, bank accounts, brokerage accounts and other assets. Unfortunately, his daughter became disabled and  applied for government benefits. Her ownership interest in her father’s assets disqualified her for the help she needed. To further complicate the matter, his son’s broker had invested with Tom Petters. Even though the client’s son knew nothing about the investments his broker made on his behalf, his father’s assets were now fair game for the government officials looking to recover assets – my client’s entire life savings were at risk simply because his son’s name was on them. When I explained all of this to him, he could not understand why his previous attorney had advised him to do this. I told him, I couldn’t understand it either.

The Corporation as an Entity.

A corporation is an entity. A corporation exists separate from its owner(s). A corporation can sue and be sued. A corporation has its own “social security number” in the form of its Employer Identification Number or EIN.

Corporate Structure

A corporation is owned by its shareholders. If you own stock in any corporation, you are an owner of that corporation. The shareholders elect the Board of Directors. The Board of Directors is in turn responsible for running the corporation on behalf of the shareholder-owners. The Board of Directors then elects and oversees the officers of the corporation that are responsible for the day-to-day operation of the corporation subject to the oversight of the Board of Directors.

Federal Insurance Contributions Act (FICA) Taxes

FICA is used to provide for the federal system of old age, survivors, disability and hospital insurance. The first three of these is funded by the Social Security system. Hospital insurance is funded by a Medicare tax. Both the corporation as employer and the employee(s), are required to pay FICA taxes on income earned as an employee of the corporation. The FICA tax rate is 7.65%. The breakdown of the 7.65% is 6.2% for the Social Security portion (old age, survivors and disability or OASDI) and 1.45% for the Medicare portion.

It is important to note that FICA taxes are paid by BOTH the corporation and the employee at the rate of 7.65%. Thus, the actual FICA tax rate is 15.3%. So, if you are the owner/shareholder of your own corporation, as well as the employee of your corporation, your income you’re your corporation will be subject to a 15.3% FICA tax. It should be noted that there are limits on the amount of OASDI taxes. However, that is beyond the scope of the discussion here. For now, you simply need to understand what FICA taxes are, the FICA tax rate and that they are paid by both the corporation and the employee(s) of the corporation.

Unemployment Insurance

Another tax that must be understood by all owners of corporations is the unemployment tax. IRS regulations require that all corporations have at least one employee. For most small business owner, they will end up being shareholder/owner, director, officer and employee of the corporation they own. Many states will require the owner of the corporation to carry unemployment insurance for the employee(s) of the corporation even if the only employee of the corporation is its owner. Even if the state of incorporation does not require unemployment insurance, the federal government will. What the small business owner needs to understand is that they will need to pay for unemployment insurance for themselves as the employee of their corporation. However, because they are the sole owner of the corporation, they cannot collect unemployment should the corporation they own ever fail and they find themselves without an income from their corporation.

C Corporations and S Corporations

A corporation can either be a “C” corporation or an “S” corporation. “C” and “S” refer to the subchapters of the Internal Revenue Code that govern the tax treatment of the two. All corporations are subchapter C corporations by default; when a corporation is formed it is a C corporation unless the shareholders of the corporation choose to be an S corporation instead by electing to become an S corporation in their minutes and filing the required form with the Internal Revenue Service. There are very significant differences between them.

 S Corporations

An S corporation avoids the “double taxation” of a C corporation, but there are a number of rules that must be followed before a corporation can become an S corporation. For instance, an S corporation can have no more than 100 shareholders, and each shareholder must be an individual who is either a United States citizen or a Permanent Resident Alien.

The Corporation as an Entity.

A corporation is an entity. A corporation exists separate from its owner(s). A corporation can sue and be sued. A corporation has its own “social security number” in the form of its Employer Identification Number or EIN.

Corporate Structure

A corporation is owned by its shareholders. If you own stock in any corporation, you are an owner of that corporation. The shareholders elect the Board of Directors. The Board of Directors is in turn responsible for running the corporation on behalf of the shareholder-owners. The Board of Directors then elects and oversees the officers of the corporation that are responsible for the day-to-day operation of the corporation subject to the oversight of the Board of Directors.

Federal Insurance Contributions Act (FICA) Taxes

FICA is used to provide for the federal system of old age, survivors, disability and hospital insurance. The first three of these is funded by the Social Security system. Hospital insurance is funded by a Medicare tax. Both the corporation as employer and the employee(s), are required to pay FICA taxes on income earned as an employee of the corporation. The FICA tax rate is 7.65%. The breakdown of the 7.65% is 6.2% for the Social Security portion (old age, survivors and disability or OASDI) and 1.45% for the Medicare portion.

It is important to note that FICA taxes are paid by BOTH the corporation and the employee at the rate of 7.65%. Thus, the actual FICA tax rate is 15.3%. So, if you are the owner/shareholder of your own corporation, as well as the employee of your corporation, your income you’re your corporation will be subject to a 15.3% FICA tax. It should be noted that there are limits on the amount of OASDI taxes. However, that is beyond the scope of the discussion here. For now, you simply need to understand what FICA taxes are, the FICA tax rate and that they are paid by both the corporation and the employee(s) of the corporation.

Unemployment Insurance

Another tax that must be understood by all owners of corporations is the unemployment tax. IRS regulations require that all corporations have at least one employee. For most small business owner, they will end up being shareholder/owner, director, officer and employee of the corporation they own. Many states will require the owner of the corporation to carry unemployment insurance for the employee(s) of the corporation even if the only employee of the corporation is its owner. Even if the state of incorporation does not require unemployment insurance, the federal government will. What the small business owner needs to understand is that they will need to pay for unemployment insurance for themselves as the employee of their corporation. However, because they are the sole owner of the corporation, they cannot collect unemployment should the corporation they own ever fail and they find themselves without an income from their corporation.

C Corporations and S Corporations

A corporation can either be a “C” corporation or an “S” corporation. “C” and “S” refer to the subchapters of the Internal Revenue Code that govern the tax treatment of the two. All corporations are subchapter C corporations by default; when a corporation is formed it is a C corporation unless the shareholders of the corporation choose to be an S corporation instead by electing to become an S corporation in their minutes and filing the required form with the Internal Revenue Service. There are very significant differences between them.

C Corporations

Let’s examine a C corporation against our three criteria for a business: 1) Limited liability; 2) Tax efficiency; and 3) Operating efficiency.

Limited Liability. A corporation has a limited liability shield. If the corporation is properly incorporated and properly maintained, creditors of the corporation can only attach assets owned by the corporation; the assets of the officers, shareholders and directors are safe. However, if the corporation is not properly incorporated or fails to meet certain operating requirements, a potential creditor may “pierce the corporate veil” and attach the assets of the officers, shareholders or directors. Some reasons courts may allow creditors to pierce include lack of corporate formalities (e.g. failure to hold meetings of directors and/or shareholders), mixing business and personal funds, entering into agreements in one’s own name versus the name of the corporation, failing to identify the corporation as a corporation to the public and lack of capitalization.

As an example, let's say that Sally and Janet have started making and selling quilts together. If Janet drove out to a quilting show and got in an accident, Sally could be held jointly liable with her depending on the form of entity they chose. If they had chosen a partnership, Sally could be held liable with Janet.

On the other hand, choosing a C corporation would provide limited liability protection for both Sally and Janet. That is to say, assuming the corporation is properly formed and properly maintained, a potential creditor could only attach assets owned by the corporation. A creditor could not attach Sally and Janet’s personal assets. However, there are also tax and operating efficiency considerations.

Tax Efficiency. A C corporation, unlike a S corporations, LLCS, and partnership, pays its own separate taxes. At the end of its tax year, a C corporation reports its profits to the Internal Revenue Service on Form 1120. The corporation then pays taxes on those profits at the rate as determined by the bracket the profits put it into; just like you. Then, if the corporation pays a dividend to its shareholders, the shareholder is responsible for reporting the dividend on the shareholder’s individual tax return and paying taxes on the dividend earnings. As a result, profits of a C corporation are subject to double taxation. That is, the profits are taxed the first time when the corporation reports its income and pays its taxes on that income and then the profits are taxed a second time when they are paid to the shareholders of the corporation and reported on the shareholder’s tax return. The double-taxation of profits of a C corporation is one of the biggest drawbacks to its use. That being said, there are ways of “zeroing out” the profits of the C corporation so as not to pay the double tax. There are also some significant tax planning opportunities available to the C corporation.

Dividends paid to shareholders must be in directly proportional to the percentage ownership of the corporation. So, if two shareholders own the corporation 50/50, the dividends paid must be 50/50. If the two shareholders own the corporation 80/20, the dividends paid must be 80/20.

Internal Revenue Service rules also require all corporations to have at least one employee. For most small businesses, that means that the owner MUST be an employee of their corporation. If there is more than one owner/shareholder, at LEAST ONE, but NOT all, of the owners/shareholders MUST be an employee of the corporation. The employee(s) of the corporation must be paid a salary in the form of “W-2” income. That means income from the corporation paid to the employee as an employee of the corporation gets reported on form W-2. The income is also subject to Federal Insurance Contributions Act (FICA) taxes.

Operating Efficiency. Unlike partnerships, a C corporation is a perpetual entity; it exists until it is dissolved. Dissolution of the corporation occurs when the shareholders of the corporation choose to dissolve or by operation of law (e.g. the corporation does something requiring it to be dissolved such a result of a court action, or fails to do something which dissolves it such as failing to make an annual filing).

Corporations are creatures of statute. State laws mandate the structure and operating structure of corporations. Thus, in order to start a corporation, a filing must be made with the appropriate government agency in the state in which the corporation will exist and all state requirements as to the structure and operations of the corporation must be met. In addition, most states also require annual filings and still others will require yearly filing fees to maintain the corporation. Exhibit A has an alphabetical listing of the websites for each state’s office that handles business incorporations.

Summary. A C corporation is attractive because of the limited liability protection it affords. However, administrative and compliance can be large. Lastly, profits of a C corporation are subject to double-taxation unless the owners choose to “zero-out” the profits of the corporation by paying all profits out as W-2 income to its employee(s).

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