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A Better Partnership


Jan 2000
January 05, 2000

Closely Held Manufacturers: Have You Selected the Right Entity?

As the owner of an existing business, you may be wondering whether you are operating in the “right” business entity form. The entity selection analysis can be a daunting task even for experienced professional advisors. It generally involves the balancing of tax and business considerations with the business owners’ unique circumstances.

From a business perspective, the primary consideration is that the entity should provide its owners with limited liability protection. Limited liability protection means that the business entity, not its owners, is liable for the entity’s debts and obligations. Secondary business considerations include centralized management, transferability of ownership interests, and the availability of equity financing.

Although death and taxes are inevitable, the business entity should minimize and defer the impact of the later. For federal income tax purposes, business entities can be treated either as taxpaying entities (e.g. corporations) or pass-through entities (e.g. partnerships). Pass-through entities are not separate taxpayers. Income earned or losses incurred by the entity passes through to its owners. The business owners report the entities’ income or loss on their individual federal income tax return.

In contrast, taxpaying entities report and pay tax on any income they earn. Additionally, when the after-tax income is distributed to the entities’ owners, the income is subject to a second round of taxation at the owner’s level. Although there may be special circumstances to the contrary, pass-through entities generally minimize the impact of federal income taxes.

With the adoption of the “check-the-box” regulation, unincorporated entities are permitted to select their tax classification. Eligible multi-owner entities may elect to be taxed as either pass-through or taxpaying entities. Eligible single owner entities may elect to be disregarded for tax purposes or treated as taxpaying entities. Unfortunately, corporations are not given this self-determination option. Unless sub-chapter S status (quasi pass-through taxation) is elected, corporations are taxpaying entities.

Sole Proprietorships

The sole proprietorship entity is a misnomer. In reality, sole proprietorships do not exist for state law or federal income tax purposes. They are the alter egos of their owner. The simplest of the business entities, sole proprietorships, require no legal formalities to form or operate. The business owners are personally liable for the sole proprietorships’ debts and obligations. All items of income and loss are taxable directly to the business owners and reported on their individual tax return.

In general, businesses should not be operated as sole proprietorships. As will be discussed below, single member LLCs offer the benefits of sole proprietorships (simplicity and flexibility) without its disadvantages (unlimited liability).


Corporations are separate legal entities. State law requires compliance with certain legal formalities, e.g. annual shareholder meetings, to maintain corporate status. Corporations provide limited liability protection for their owners (shareholders). Regular or “C” corporations are taxpaying entities separate from their shareholders. Corporations may, however, elect quasi pass-through taxation by electing to be taxed under sub-chapter S of the Internal Revenue Code. Similar to pure pass-through entities, S-corporations, with some exceptions, do not pay federal income tax. Their shareholders report and pay tax on the S-corporations income even if such income is not distributed to the shareholders. Net losses incurred by the S-corporations may be deducted by the shareholders to the extent of basis.

Limited Liability Companies

Limited liability companies (LLCs) are hybrid entities designed to combine the most favorable corporate characteristics (limited liability and centralized management) with the most favorable characteristics of pass-through entities (pass-through tax treatment and flexibility). LLCs posses an inherent flexibility. The owners (members) may contractual agree to vary the Michigan Limited Liability Company Act’s default rules. The members may manage the LLC or elect centralized management. LLCs are generally not subject to the strict formal requirements applicable to corporations, e.g. although recommended, annual meetings of the members or managers are not required. The members are not personally liable for the LLCs’ debts and obligations. In general, multi-member LLCs are taxed as pass-through entities. Single member LLCs are generally taxed as sole proprietorships.

Although LLCs are the equivalent of a business entity’s nirvana, conversion to an LLC must be carefully considered. There may be hidden tax costs. For example, the conversion of a corporation into an LLC is a taxable event for federal income tax purposes. In contrast, unincorporated entities, such as partnerships and sole proprietorships, may convert to an LLC form without fear of taxation on the conversion. Similarly, the conversion of unincorporated entities to corporate form is generally not a taxable event. However, the decision to incorporate should not be taken lightly. Once the corporate form is embraced, it is difficult to change.

In summary, business entity decisions should be based on the business owners’ unique circumstances and goals and only after consultation with a tax professional.

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Because each business situation is different, this information is intended for general information purposes only and is not intended to provide legal advice.

Shoreline Business Monthly

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