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Feb 2005
14
February 14, 2005

What Businesses Should Know About -- Business Entities

What form of entity is right for your business? Of course, the tried and true corporate and partnership forms remain available, but what are LLCs and LLPs? You may even come across entities called PCs or PLLCs. This article identifies the basic business forms and highlights some of the important features and drawbacks of each.

Corporations, the Veterans

The corporate form has been available to business operators for centuries. The traditional attraction of the corporate form is limited liability. Basically, that means its owners (shareholders) are not responsible for the debts and liabilities of the corporation. Corporations are familiar to most people, which makes transacting business through them easier. Though familiar to most, the corporate structure is somewhat inflexible, generally requiring a board of directors and certain specific officers be appointed. Annual shareholder meetings are another component of the formality imposed on the structure.

Corporations are either C corporations or S corporations. It is important to remember that the C-S distinction is a tax distinction only. The essential elements of the corporate form described above hold true for both types. The C and S identifiers correspond to Subchapters of the federal tax code that govern them. A C corporation is the traditional type of corporation. Nearly every large public company in America is a C corporation. Under Subchapter C of the federal tax code, a C corporation is treated as a separate person whose income is subject to tax. Further, when money or property come out of the corporation to shareholders in the form of dividends, the shareholders also must pay tax on the dividends. This results in the so-called "double tax." On the other hand, the federal tax code allows certain advantages to C corporations that can be important in some circumstances.

S corporations are governed by Subchapter S of the federal tax code. To be an S corporation, the shareholders and corporation must timely file an S election with the IRS. There are restrictions on the number of shareholders that an S corporation may have (up to 75) and the types of shareholders it may have. For example, an S corporation may not generally be owned in whole or in part by foreign persons or by certain entities such as C corporations, partnerships or LLCs. On the positive side, however, S corporations, as entities, are not required to pay federal income tax on their income. Instead, income passes through to the shareholders who are taxed on it, thus avoiding the double tax.

Limited Liability Companies, the Newcomers

In 1993, Michigan passed its limited liability company statute allowing for the creation of Michigan LLCs. Since that time, LLCs have become the prevalent choice of entity. The Michigan Department of Consumer and Industry Services (which manages filings for corporations, LLCs, and most other entities) reports that LLCs are currently being formed more than any other entity. Despite their recent popularity, however, LLCs are not the right choice for every business enterprise.

LLCs allow for great flexibility in management structure. LLCs can be formed with a board of managers and subordinate (but executive) employees who are often given officer titles -- like president, treasurer, etc., thus making the LLC resemble the corporate structure. On the other hand, LLCs can be given a very simple management structure so that they are managed by their owners (called members) like a simple partnership. LLCs do share the principal benefit of corporations, i.e., limited liability for their owners. The flexibility in management structure allows for less formality than corporations if desired. For example, no annual meeting of members is required.

This flexibility, however, can cause the entity to be less attractive to venture capitalists or for businesses planning to "go public." Both venture capitalists and the public markets prefer a standardized securities product with well-understood tax rules, like that offered by the corporate form. Another potential advantage of corporations over LLCs comes in the area of executive incentive compensation plans, such as stock option and restricted stock plans. In the corporate setting, the taxation and operation of such compensation plans are fairly standardized and well understood. Given the LLC's flexibility and tax attributes, preparing and operating such plans in LLCs can be more cumbersome.

Just as owners of an LLC have flexibility in organizing their management structure, the federal tax code gives them some flexibility in determining how they wish their entity to be taxed. In most cases, an LLC will be taxed as a partnership under Subchapter K of the federal tax code. This means that income and loss of the company flow through to the owners, in a manner similar to an S corporation (although the two are not subject to all of the same tax rules). Of course, this pass-through taxation eliminates the "double tax." However, partnership taxation can be quite complicated and is not always intuitive to persons not working in the area on a day-to-day basis. Persons working with LLCs that are taxed as partnerships need to be familiar with the tax concepts of capital accounts, allocations of profits and losses, and other matters so that unexpected tax consequences do not occur. If owners of an LLC would prefer not to be subject to partnership tax rules, they may choose to have the LLC treated as a C corporation for federal tax purposes. To do so, they simply file an election form on a timely basis with the IRS.

Partnerships, Several Varieties

There are three types of partnerships available in Michigan: general partnerships, limited partnerships, and limited liability partnerships (LLPs). General partnerships and LLPs are closely related. A general partnership is formed when two or more persons come together to further a business purpose. As a technical matter, no filing is required to create the entity, although a filing is commonly done in the county where the business is located. LLPs are simply a garden variety general partnership that has been registered by an appropriate filing with the state. While general partnerships do not afford any liability protection to their partners (that means partners have personal liability for the debts and obligations of the partnership), LLPs enjoy the advantage of shielding their partners from obligations arising from the acts of another partner in the course of partnership business. This is the chief reason to use the LLP form, as opposed to a simple general partnership. The LLP form does not shield a partner from his or her own actions in the course of partnership business or the actions of those under his or her supervision or control.

Limited partnerships are a more complicated form of partnership that is not often used today. Generally, LLCs can do all that limited partnerships could do and are better in certain regards. In the limited partnership form, partners are either limited partners or general partners. Limited partners generally have liability protection in the same way that shareholders or members have liability protection in corporations and LLCs. However, the general partner of a limited partnership has full personal liability for the debts and obligations of the partnership, just as general partners in a general partnership. Taxation of limited partnerships, general partnerships, and LLPs is generally subject to the same partnership tax rules described above with regard to LLCs.

Professional Entities

Professionals such as accountants, doctors, architects, and others wishing to form a business entity to render professional services are required to conduct business through a general partnership, an LLP, a professional corporation (PC), or a professional limited liability company (PLLC). These entities generally share the same benefits and drawbacks as their nonprofessionalized forms. However, they will generally be subject to additional rules limiting transfers of ownership interests to other professionals and providing that traditional malpractice liability of professionals is not altered by the fact that services are rendered through an entity which otherwise has a liability shield.

How do you pick? Picking the right form of business entity for your enterprise will require careful thought and a weighing of your goals and plans for the business. The information above represents a very basic description of the advantages and disadvantages of the various business forms. There are a number of other distinctions that could be important in various circumstances. Spending a little time and effort up front to pick the right form of entity at the outset can lead to great savings and less effort later. Switching midstream is usually possible, but often has tax and perhaps other consequences that may not be desirable.

If you have questions about choice of entity issues, please feel free to contact Loren Andrulis at 616.752.2182 or your WN&J attorney.

 

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