INTRODUCTION
Are you starting a business in Michigan?
Fantastic! You're about to join a vibrant entrepreneurial community in the Great Lakes State. But before you dive into the world of product launches, marketing campaigns, and customer satisfaction, a critical first step needs your attention - choosing the right legal entity for your business.
This decision is not just about ticking a box on a registration form. The choice of your business structure - be it a sole proprietorship, partnership, corporation, or limited liability company (LLC) - is far-reaching. It may not be the most exciting part of launching a business, and it can't compare with the thrill of your first sale or the joy of opening day, but it is as significant, if not more so.
Why is it so important?
Because the legal entity you choose can substantially affect various aspects of your business. From determining your degree of personal liability to influencing your tax liabilities and even dictating the everyday workings of your venture, this choice sets the tone for many fundamental business dynamics. Therefore, it is essential to have a comprehensive understanding of your options.
This blog post includes a comprehensive discussion of the different types of Michigan business entities, debunking the legal jargon and presenting clear, concise information that is easy to understand.
Disclaimer: The information provided in this blog post is intended for informational purposes only and does not constitute legal advice. Interacting with this content does not establish an attorney-client relationship with the author or the publisher. Please seek the advice of a qualified attorney in your jurisdiction for any legal decisions.
BACKGROUND AND GENERAL CONSIDERATIONS
Michigan offers a variety of business entity forms. These include the sole proprietorship, C corporation, S corporation, LLC, limited liability partnership, general partnership, and limited partnership. The best fit for your business will largely depend on your specific liability and risk management needs, the number of owners, tax implications, and your preference for a formal or flexible business structure.
To help you make an informed decision, an experienced business attorney can guide you through the process of selecting the most suitable entity form and structure for your business. This attorney can also help you understand the management structure, potential for limited liability, allocations of profits and losses, tax consequences, and formation expenses associated with each business entity form.
To give you a more concrete understanding, let's delve into a brief description of each business entity form available in Michigan.
1.) Sole Proprietorship
A sole proprietorship is the simplest business entity, and it is automatically established if you're running a business by yourself without any legal registration. In Michigan, there is no requirement to file formation documents with the Department of Licensing and Regulatory Affairs (LARA) for this type of entity.
As a sole proprietor, you are the sole owner of the business, meaning all profits are directly yours. This setup allows for straightforward taxation as the business income and expenses are simply included on your personal tax return.
However, there's a significant downside to this simplicity: personal liability. As a sole proprietor, there is no legal distinction between you as an individual and your business. If your business incurs debts, or if it's sued, your personal assets—like your home, car, and savings—can be at risk. Creditors can go after your personal property to satisfy the business's debts.
Additionally, sole proprietorships can also face challenges in raising business capital, as banks and investors often see them as riskier than registered business entities.
A sole proprietorship can be a good choice for low-risk businesses and entrepreneurs who want to test their business idea before forming a more formal business. However, it's always essential to evaluate the potential risks and benefits carefully, considering factors such as potential liability, tax implications, and funding needs.
2.) Corporation
The process of forming a corporation involves filing articles of incorporation with LARA accompanied by the appropriate fee. To maintain its existence, the corporation is also required to pay an annual fee to LARA.
Legally treated as a separate entity, a corporation has its own rights, privileges, and liabilities, distinct from its owners, who are referred to as shareholders. This separation provides what is commonly known as the "corporate veil," protecting shareholders from personal liability for corporate debts and obligations, assuming the corporation is properly formed, adequately capitalized, and its formalities are observed.
However, this protection is not absolute. If shareholders personally guarantee the corporation's debts or if courts "pierce the corporate veil" due to fraudulent or improper actions (like commingling of personal and business funds, failure to maintain proper corporate records, etc.), then shareholders may be held personally liable.
A corporation can have multiple shareholders, or it could be entirely owned by a single individual. Whether a corporation has one shareholder or many, it must comply with certain formalities. These may include holding regular meetings, maintaining separate financial records, and filing separate tax returns.
The governance structure of a corporation is typically arranged in three distinct tiers:
a.) Shareholders:
As the owners of the corporation, shareholders principally elect the board of directors. Additionally, they cast their vote on pivotal corporate matters, such as mergers, acquisitions, or company dissolution. Shareholder rights often derive from the state law (in this context, Michigan law) as well as the stipulations set forth in the corporation's bylaws.
b.) Board of Directors:
The board is elected by the shareholders to supervise the broader strategic direction of the corporation. They are tasked with crucial decisions like appointing officers, forming strategic objectives, and sanctioning annual budgets. The corporation's bylaws typically outline the board's rights and responsibilities.
c.) Officers:
Tasked with the day-to-day management of the corporation, officers generally hold positions such as CEO, CFO, and COO, and are hired by the board of directors. The corporation's bylaws ordinarily specify the responsibilities and duties of each officer role.
Due to its tri-level governance structure and legally required formalities, a corporation may be more complex and costly to set up than other business structures.
The IRS defaults to characterizing corporations as C corporations.
A C corporation pays taxes on its retained earnings at special corporate tax rates. Additionally, the corporation distributes profits to shareholders as dividends, which are then taxed on the shareholders' personal income tax returns, leading to what many term as "double taxation." However, some small corporations and LLCs may elect to be treated as Subchapter S corporations.
S corporations are not taxed at the corporate level. Instead, the income passes through to individual shareholders or members, who report this income on their personal tax returns, eliminating the issue of "double taxation." To qualify for Subchapter S status, businesses must meet specific requirements, including having 100 or fewer shareholders or members.
3.) Limited Liability Company
The process of forming a limited liability company (LLC) requires filing the Articles of Organization with LARA. This involves a filing fee and necessitates the provision of basic business details such as the company's name, its purpose, and the names of the members.
An LLC has become a popular choice among small business owners in Michigan, offering an optimal blend of flexibility, liability protection, and favorable taxation conditions.
When you establish an LLC in Michigan, the law typically offers you protection in the form of limited personal liability, similar to what you'd expect from a corporation. This crucial feature generally ensures that the LLC's owners, also known as members, are not personally held accountable for the company's debts and liabilities. This fosters a significant division between business and personal finances, thus providing a protective shield for the members' personal assets.
However, it's important to note that, akin to a corporation, there are circumstances where this liability protection might not hold. Instances such as personal guarantees for business debts, tortious acts committed by a member, piercing the corporate veil due to failure in maintaining the LLC as a separate entity, or certain unpaid taxes could potentially make members personally liable.
An LLC can include a variety of membership structures. From a single individual (single-member LLC) to multiple individuals (multi-member LLC), and even other business entities, the number and type of members can be highly flexible, making it a suitable choice for a wide range of businesses. However, the structure and number of members can affect the company's tax status, so it's important to carefully consider this aspect.
One of the standout advantages of an LLC is the provision for pass-through taxation. Unlike C corporations, which are subject to "double taxation" (where corporate profits are taxed and the dividends distributed to shareholders are taxed again), LLCs bypass this issue. In an LLC, profits or losses are reported directly on the members' personal tax returns, effectively avoiding the need for corporate taxes.
However, it's noteworthy that an LLC can elect to be treated as an S Corporation for tax purposes. This election can sometimes result in tax savings, but it requires meeting specific IRS criteria and additional tax filing requirements.
Though not legally mandated in Michigan, it is strongly recommended for LLCs to have an operating agreement. This pivotal document delineates the management structure, operating procedures, and financial arrangements of the LLC, serving as a comprehensive guide for conducting business and helping prevent potential disputes among members. This agreement can also help to uphold your limited liability by demonstrating that your LLC functions as a distinct business entity.
4.) Limited Liability Partnership
A limited liability partnership (LLP) is a distinct business structure that provides each partner with limited personal liability for the business's debts and actions. This means that each partner is not personally responsible for the misconduct or negligence of another partner. This level of liability protection is a departure from a general partnership, where each partner has unlimited liability and is jointly and severally liable for the partnership's debts and legal obligations.
LLPs are a preferred choice for groups of professionals like lawyers, accountants, architects, and engineers. These professions often require a high degree of trust and liability protection given the nature of their work and the risk associated with potential malpractice or negligence claims.
To establish an LLP in Michigan, you are required to file an application with LARA. This application process includes providing necessary details about your partnership, such as the name of your LLP, the address of its principal office, the names and addresses of all the partners, and a statement that your partnership elects to be an LLP.
LLPs should have a well-drafted partnership agreement in place. While not legally required, a partnership agreement is beneficial as it provides clarity about the LLP's management structure, the partners' roles and responsibilities, profit-sharing mechanisms, dispute resolution methods, and procedures for adding or removing partners. It aids in preventing misunderstandings and disputes among the partners.
5.) General Partnership
A general partnership is a relatively simple and straightforward business structure where two or more individuals collectively operate a business for profit. This form of business organization is typically suited to small businesses with shared ownership and decision-making.
One of the defining features of a general partnership is its ease of formation. Unlike other business entities such as LLCs or corporations, there is no requirement to formally register a general partnership with the state of Michigan. However, it's a good practice to have a written partnership agreement that clearly lays out the terms and conditions of the partnership.
The partnership agreement is a crucial document that typically outlines the roles and responsibilities of each partner, the distribution of profits and losses, the procedure for dispute resolution, the process for admitting new partners, and the protocols for dissolving the partnership. Although it's not legally required, drafting this agreement can provide clarity and help prevent future disputes among partners.
In a general partnership, each partner shares in the management of the business and can make decisions on behalf of the partnership. This aspect of shared authority requires a high degree of trust and cooperation among the partners.
However, this structure also means that each partner is personally liable for the business's debts and obligations. This is a significant risk, as personal assets could potentially be used to cover the partnership's liabilities. This differs from entities such as LLCs or corporations, where owners typically have the opportunity to enjoy limited personal liability.
For taxation purposes, a general partnership follows a pass-through taxation structure, meaning the partnership itself does not pay income tax. Instead, profits and losses are reported on the individual tax returns of the partners.
It's important to note that a general partnership, by default, ceases to exist upon the death or withdrawal of a partner unless otherwise stipulated in the partnership agreement. Therefore, provisions for such eventualities should be included in the partnership agreement to ensure business continuity.
6.) Limited Partnership
To establish a limited partnership (LP) in Michigan, a certificate of limited partnership must be filed with LARA. There's a filing fee associated with this process. This certificate typically includes information such as the partnership's name, the names and addresses of the partners, and the nature of its business.
An LP is a unique form of business organization that includes at least one general partner and one limited partner. This partnership model is particularly advantageous in certain business scenarios, often used when an investor wishes to financially back a business without getting involved in its daily operations.
In an LP, the roles and responsibilities of the partners vary significantly. The general partner, who could be an individual or an entity, assumes full responsibility for the partnership's operations and management. They bear unlimited personal liability, meaning that if the partnership cannot meet its obligations, the general partner's personal assets may be at risk. This responsibility comes with the benefit of being able to make binding decisions for the business and oversee its regular management.
Conversely, the limited partner primarily serves as an investor and does not participate in the day-to-day operations or management decisions of the partnership. Their liability is limited to the extent of their investment in the partnership. This means that a limited partner's personal assets are generally not at risk if the partnership fails or incurs debt beyond its ability to pay. However, if a limited partner becomes overly involved in management, they risk losing this liability protection.
Although not legally required, it's highly advisable for the partners to draft a thorough partnership agreement. This vital document outlines the roles, responsibilities, and profit-sharing among the partners. It details the protocol for dispute resolution, changes in partnership structure, and procedures for dissolution of the partnership. Having such an agreement can prevent future conflicts and ensure smooth operation of the business.
CONCLUSION
Selecting the right business entity form is a pivotal decision in setting up your business in Michigan. By understanding each option and its implications, you can choose a structure that aligns best with your business objectives and operational style.
Given the complexity of these matters, it's advisable to consult with a business attorney, CPA, and a financial advisor before making your decision. They can provide you with personalized advice based on your specific business model, financial situation, and long-term goals.
Keep in mind that the business entity form you choose isn't set in stone. As your business grows and evolves, you may find that a different structure better suits your needs. For instance, you might start as a sole proprietorship and later transition to an LLC or corporation. It's important to periodically re-evaluate your business structure to ensure it remains the best fit.
If you require legal assistance with forming your business, we invite you to contact us today. Our team is prepared to help you navigate the complexities of business formation, providing personalized guidance tailored to your specific needs. With Dawisha Law, PLLC, you're not just getting legal support; you're gaining a partner dedicated to helping you achieve your business goals. Let us help you pave the way to a successful, legally sound business. Reach out today and let's start building your future together.
DeLone Dawisha
Principal and Founder
Dawisha Law, PLLC
248-904-5123