HOW TO CHOOSE THE FORM OF YOUR NEW BUSINESS
by H. Douglas Shepherd
Purpose
Brandt, Fisher, Alward, and Pezzetti, P.C. has prepared this pamphlet to inform our clients about the different business entities which exist under Michigan law. These business entities, which are described in this pamphlet, include sole proprietorships, general partnerships, limited partnership, limited liability partnerships, corporations (both "C" and Subchapter "S"), and limited liability companies.
Each business entity has its own advantages and disadvantages, and it is our belief that this pamphlet will help you choose the best business to fit your needs.
We believe that a greater understanding of the choices in business entities will make the establishment of their business as easy and uncomplicated as possible. If any questions or problems arise, please do not hesitate to ask questions. We believe that by assisting our clients in making an informed decision regarding the proper business form they will be more prepared and confident in starting their business, thus resulting in a more successful, satisfied and loyal client. Furthermore, it is our belief that an informed decision allows our clients to avoid future problems and more thoroughly understand, and therefore manage, their business. So please we insist that if you have any questions or concerns, please do not hesitate to inquire.
This pamphlet is not intended to be a substitute for legal counsel. The advantages and disadvantages listed for the various types of entities are not an exhaustive list. There may be other advantages and disadvantages. In determining which type of business organization best meets the needs of the proposed business, and to fully understand the legal, business, tax and financial obligations for each type of organization, you should consult with us, your accountant, and other professionals which may be appropriate.
Considerations in Choice of Business Form
-
Desired tax treatment of the entity, its owners and its employees.
- Desirability of a pass-through-type entity.
- State tax law planning and considerations.
- Liability of the owners for the obligations of the entity.
- Ease and expense of forming, organizing and maintaining the entity.
- Legal requirements that the type of business be conducted in a particular form.
- The number of owners of the entity and whether ownership interests are to be transferred frequently.
-
Financing issues:
- Will there be a complex capital structure; is the issuance of different kinds of securities contemplated?
- Is a subsequent public offering of securities contemplated?
- Other requirements which may be imposed by lenders, venture capitalists and other financing sources.
- The clarity of the rules relating to the formation and operation of the entity and the resolution of conflicts among its constituents.
- Estate planning goals.
- Whether the form of the enterprise will need to be subsequently changed.
- Employee compensation issues.
- The extent to which the form of entity is affected by custom or tradition.
Sole Proprietorship
A sole proprietorship is a business that is owned by one individual. Profits are taxed as income to the owner personally and the personal tax rate is usually lower than the corporate tax rate. The owner has complete control over the business but faces unlimited liability for its debts, even if in excess of the amount invested in the business. If the business operates under a name other than the individual’s name, a "Certificate of Persons Conducting Business Under Assumed Name", commonly known as a "DBA" must be filed with the county clerk where the business is located.
| Advantages | Disadvantages |
| Easiest to form | Unlimited liability to owner |
| Low start up costs | Lack of continuity |
| Owner has direct control | Difficult to raise capital |
General Partnership
A general partnership is a legal entity that is jointly owned by two or more persons. Partnerships, like sole proprietorships are subject to relatively little regulation and are fairly easy to establish. The owners are personally responsible for all debts of the business, even debts in excess of the amount they invested in the business. Generally partners enter into a written agreement governing the partnership and an attorney should be consulted to prepare such an agreement. The Agreement, known as a Partnership Agreement, will address potential conflicts before they arise: for example, who will be responsible for performing each task; what consultation is, or is not, needed between partners before major decisions are made; what happens if a partner dies. In Michigan, if partners do not write their own Partnership Agreement, the law defaults to the Uniform Partnership Act to settle disputes and conflicts. A general partnership, like a sole
proprietorship, must register a "Certificate of Co-partnership" or a "Certificate of Persons Conducting Business Under Assumed Name" (DBA) with the county clerk in which the business is located.
| Advantages | Disadvantages |
| Relatively easy to form | Unlimited liability to owners |
| Low start up costs |
Lack of continuity – terminates on death or withdrawal of partner |
|
|
|
| Broader management voice |
Limited Partnership
A limited partnership is a partnership formed by two or more persons under the laws of Michigan and having one or more general partners and one or more limited partners. Like a general partnership, a limited partnership is established by a Partnership Agreement between two or more individuals. The general partner has greater control in some aspects of the partnership; for instance, only a general partner can decide to dissolve a partnership. Limited partners may not participate in management of the partnership or will risk losing their limited partner status. General partners are liable for all the debts and obligations of the partnership, while limited partners are responsible only for the debts and obligations of the amount that they contributed. A limited partnership must have at least one general partner and one limited partner. One person may not form a limited partnership by being designated as the only limited and general partners.
| Advantages | Disadvantages |
| Limited liability to limited partners | Lack of management voice for limited partners |
| Investment by limited partners is a potential source of venture capital | Unlimited liability to general partners |
| No management responsibility for limited partner |
Limited Liability Partnership
A limited liability partnership is a business entity that is formed by two or more persons. The owners of the partnership are personally liable for all debts of the business, except those debts resulting from acts committed by another partner or a representative of the partnership not working under the supervision or direction of the partner at the time the acts resulting in liability occurred. The joint and several liability of partners for debts and obligations of the partnership arising from other causes is not limited. A partnership which has filed a "Certificate of Co-partnership" or a "Certificate of Persons Conducting Business Under Assumed Name" with the county clerk of the counties in which the business is to be located may register the partnership as a limited liability partnership by filing with the State.
| Advantages | Disadvantages |
| Some limited liability to partners | Some liability for partnership debts and general liability for own acts |
| Relatively easy to form | Lack of continuity – terminates on death or withdrawal of partner |
| Low start up cost | Divides authority among copartners |
| Partner can provide additional capital |
"C" Corporation
A "C" Corporation is a legal entity made up of persons who have received a charter legally recognizing the corporation as a separate entity having its own rights, privileges and liabilities apart from those of the individuals forming the corporation. It is the most complex form of business organization and is comprised of three groups of people; shareholders, directors, and officers. The corporation can own assets, borrow money and perform business functions without directly involving the owners of the corporation. Corporate entities are subject to "double taxation" when the corporation is taxed and when passed through as shareholder dividends. However, corporations have the advantage of limited liability (but not total protection) from lawsuits. In order to form either a profit or nonprofit corporation, "Articles of Incorporation" must be filed with the State. Governance of the corporation is prescribed by law, bylaws of the corporation and the resolutions and decisions of its shareholders or members.
| Advantages |
Disadvantages |
| Ownership easily transferable | May be more expensive to organize |
| Limited liability for owners | More extensive record keeping |
| Continuous Existence | Limitations regarding number and types of shareholders |
| No limitations regarding number and types of shareholders. | Corporate veil can be pierced (See Below) |
Subchapter "S" Corporation
A special section of the Internal Revenue Code permits a corporation to be taxed as a partnership or sole proprietorship, with the profits taxed at the individual rather than corporate rate. Because of the flow through taxation, an "S" Corporation is not subject to "Double Taxation". To qualify as an "S" Corporation, a business may not have more than 75 shareholders and shareholders may only be U.S. citizens, resident aliens, estates, qualified retirement plans, Section 501(c)(3) charitable entities, and certain trusts.
| Advantages | Disadvantages |
| Pass through taxation | May be more expensive to organize |
| Ownership easily transferable | More extensive record keeping |
| Limited liability for owners | Limitations regarding number and types of shareholders |
| Continuous Existence | Shareholders pay income tax on earnings even if undistributed |
| Profits passed through to shareholders are not subject to self-employment tax. | Less flexibility in choose a tax year. |
| Generally, fringe benefits are not tax free to shareholders. |
Limited Liability Companies
A limited liability company is a business formed by at least one member. It is a business entity separate from its members and liability is limited to the financial contribution made by the member. The members are the owners of the company. The management of the company is carried out by its members, unless the Articles of Organization provide for management by managers. Governance is set forth by the Articles of Organization or Operating Agreement. A limited liability company is formed by filing the Articles of Organization with the State.
| Advantages | Disadvantages |
| Easy to form | New body of law |
| Low start up cost | Piercing corporate veil may apply to LLCs as well as corporations (See below) |
| Broader Management Base | Members pay self-employment taxes on all income of the Company |
| Limited liability to members | Generally, fringe benefits are not tax free tomembers. |
Subchapter "S" Corporations v. LLCs
The Subchapter "S" Corporation and the LLC share many similar characteristics. At times a particular situation reveals an obvious entity choice. However, often the decision rests on very subtle, often tax related, issues. Some of these issues are briefly discussed below, but a tax professional such as your accountant should make the final determination regarding what entity is right for your business situation.
Self Employment Tax Issues – Self Employment Tax Issues - In general, in a Subchapter "S" Corporation, a shareholder/employee can receive reasonable compensation from the Corporation for services performed. Any profits earned by the Corporation are passed to the shareholder and are taxable for income tax purposes, but not for self-employment tax purposes. Conversely, in a limited liability company, a member/employee’s compensation from the Company for services performed and any profits earned by the Company (even if not distributed to the member) are taxable to the member for income tax purposes and for self-employment tax purposes. In 2004, the self-employment tax rate is 15.3% on the first $87,900.00 earned per year. The self-employment tax consists of two parts, a 12.4% social security tax and a 2.9% Medicare tax. The 12.4% social security tax applies for the first $87,900.00 earned, while the Medicare tax applies to all earnings. Thus, only the Medicare tax portion applies to a member’s earnings over $87,900.00 per year.
Company Size and Owners – Subchapter "S" Corporations may not have more than 75 shareholders. Joint owners each count as one shareholder unless they are married to each other. Furthermore, shareholders of a Subchapter "S" can only be U.S. citizens, resident aliens, estates, qualified retirement plans, Section 501(c)(3) charitable entities, and certain trusts.
Limitations on the Type of Business – A Subchapter "S" Corporation can not be an insurance company, domestic international sales corporation, or non-qualifying financial institution.
History – Compared to LLCs, Corporations have extensive litigation history. Corporate case law and principles are well developed. In Corporations legal issues with respect to various conflicts have a small degree of uncertainty. LLCs on the other hand carry a greater degree of risk and uncertainty.
Basis Tax Advantage of LLCs - "S" Corporation shareholders and LLC members may deduct company losses on their individual tax returns to the extent of their "basis." A Member in an LLC, however, may increase his or her basis of membership interests when the LLC borrows money. S Corporation shareholders may not increase the basis of their stock when the corporation borrows money. An S Corporation shareholder may only increase his basis by making a direct loan to the corporation.
How to prevent "piercing of the corporate veil"
Although infrequently invoked, there exists an equitable doctrine called "piercing the corporate veil" (The issue has not yet been fully litigated, but most believe the doctrine will apply to LLCs as well). Generally, Michigan courts treat corporations as entirely separate entities from the shareholders, and thus, the courts will only "pierce the corporate veil" in order to prevent injustice or fraud. While there is not a single rule that delineates when a corporate entity should be disregarded, Michigan courts have used the following standard for piercing the corporate veil:
- The corporate entity must be a mere instrumentality of another entity or individual.
- The corporate entity must be used to commit a fraud or wrong.
- There must have been unjust loss or injury to the plaintiff.
Note: The courts have ruled that the disregard of corporate formalities alone is not sufficient to justify piercing the corporate veil.
The following is a non exhaustive list of potential behavior or actions that may risk the piercing of the corporate veil:
- Commingling of funds and other assets
- Failure to segregate funds of the separate entities
- The unauthorized diversion of corporate funds or assets to other than corporate uses
- Treatment by an individual of the assets of the corporation as his or her own
- Failure to obtain authority to issue or subscribe to shares
- Failure to maintain minutes or adequate corporate records
- The confusion of the records of the separate entities
- Identification of the equitable owners thereof with the domination and control of the two entities
- Identification of the directors and officers of the two entities
- Failure to adequately capitalize a corporation
- Use of a corporation as a mere shell or sham, instrumentality or conduit for a single venture or the business of an individual or another corporation
- Failure to maintain separate books
- Concealment and misrepresentation of the identity of the responsible ownership, management and financial interest or concealment of personal business activities
- Disregard of legal formalities and the failure to maintain arms-length relationships among related entities
- Use of the corporate entity to procure labor, services or merchandise for another person or entity
- Diversion of assets from a corporation by or to a stockholder or other person or entity, to the detriment of creditors, or the manipulation of assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another
- The use of the corporation to support fraud or illegality
- Formation and use of a corporation to transfer to it the existing liability of another person or entity
©BRANDT, FISHER, ALWARD & PEZZETTI, P.C.
****This pamphlet is meant strictly for informational purposes only. Nothing contained in this pamphlet should be construed as legal advice.