One of the first questions that entrepreneurs ask when they are thinking about starting a new business is: What type of entity should I form? There are corporations (taxed as either “C” or “S” corporations), limited liability companies (“LLCs”), general and limited partnerships, sole proprietorships, as well as many other types of business organizations. The three main factors to consider when making the selection are as follows: (A) whether the entity offers “limited liability protection”; (B) the organizational structure that must be followed; and (C) how the business will be taxed.
1. Limited Liability Protection
A business entity that offers limited liability protection limits the owners’ risk of loss to the assets that are owned by the organization. In other words, if certain formalities are followed, the business owners cannot be sued personally for the debts of the business.
Historically, people would form certain types of entities that did not offer limited liability protection in order to take advantage of tax benefits. Given the number of options that are now available to entrepreneurs, there is simply no reason to form an entity that does not provide limited liability protection. More specifically, we rarely advise an entrepreneur to engage in business as a sole proprietorship, general partnership, or limited partnership. Corporations and limited liability companies are generally the selections of choice because of their limited liability protection and tax advantages. Therefore, we will only focus on these two entities throughout the remainder of this article.
2. Organizational Structure
Except in certain situations, Michigan law provides that corporations must have shareholders, directors, and officers (e.g. president, vice president, secretary, and treasurer). Shareholders and directors must hold meetings on at least an annual basis and take minutes at these meetings (even if there is only one owner). In short, corporations generally have more “layers” of governance and require the owners to comply with more legal “formalities” as compared to LLCs.
Michigan LLCs are more flexible in terms of governing structure as compared to corporations. The owners are called “members” and can directly make decisions on behalf of the LLC. The members may also delegate their authority to “managers” (who may or may not be owners of the LLC).
In summary, the organizational structure of an LLC is generally preferable to a corporation because of its flexibility. However, the ultimate decision between these two entities often comes down to the tax considerations.
In most instances, corporations elect to be taxed as “S” corporations. This is simply an election that can be made with the IRS. “S” corporations and LLCs are not taxed at the entity level. The tax attributes are “passed through” to the owners and reported on their individual tax returns. However, many people do not understand that corporate income is still subject to the corporate tax rules and LLCs are subject to the partnership tax rules. Therefore, it is imperative that the business owners’ accountant and attorney provide advice on which entity will provide the best probable tax outcome.
In order to make a decision, you must look at the nature of the business itself. Some of the most common considerations are: (1) will the owners be hiring employees; (2) will the business own real estate; (3) will the business have debt owed to lenders; (4) will the business sell services, goods, real estate, and/or investments? The answers to these questions will determine the level of payroll taxes that must be paid, whether you can deduct certain expenses from income, the taxes that must be paid on distributions from the business, as well as many other issues.
Whether a business has one or multiple owners, it is important to choose the proper form of business organization. This can affect your personal liability, how the business must be structured, and the tax implications. A little planning at the outset can create the best possible results throughout the life of the business.