Business Entity Types
Choosing the best business entity is an important decision for tax purposes. For most, this can be a daunting task. The following is an overview that can make your decision easier. The formation of your business starts at the state level, followed by the Federal. In Michigan, you can be a sole proprietor, a partnership, a Limited Liability Corporation (LLC), or a Corporation.
Sole Proprietor
The simplest business entity type is Sole Proprietor. You can start operating a business today. Your income and expenses are reported on Schedule C.
You may need to file with your county as a DBA (Doing Business As). You do not need to apply for an Employer Identification Number (EIN) with the IRS unless you plan on hiring employees. If you have employees, you will need to pay employment taxes, unemployment insurance, workers compensation, etc.
The main disadvantage of operating as a Sole Proprietor is separation of liability. There is no separation of liability. You are your company. If your business is sued, you are personally liable. There is no separation to protect your income or assets.
Learn More About Doing Business As (DBA)
Partnership
A partnership is established if you and another person start a business together. You and your partner/partners share in the profits/losses. A partnership is considered a flow through entity. This means the partnership does not get taxed. The income and losses of the partnership are reported on your personal tax return. The partnership does file a tax return to report the profits and losses to be split among the partners.
When it comes to separation of liability, this is dictated by the type of partner you are. There are two types of partners: General Partner and Limited Partner. A partner active in the business is considered a General Partner. A partner that is not actively involved but invests in the business is considered a Limited Partner. The Limited Partner is like a silent investor. If your business is sued, each General Partner is personally liable. The income and personal assets of the General Partners are not protected. The Limited Partner’s liability is capped at their amount of investment in the business.
You do have the option to set up the business as a Limited Partnership. There has to be at least one General Partner and one Limited Partner to set up a Limited Partnership.
Limited Liability Company
A Limited Liability Company (LLC) is formed by filing Articles of Organization with the state. Owners of the LLC are called members. A LLC is separate from its members. If the LLC is properly set up and managed, you will not be personally liable for debts incurred by the LLC. Management of the company can be member managed or manager managed. This will be dictated by the Articles of Organization
Unlike a corporation, an LLC doesn’t have required operating formalities. This makes a LLC easier to maintain compared to a corporation. For example, a corporation must establish a Board of Directors, corporate officers, corporate shareholders, corporate resolutions, and corporate bylaws.
Michigan doesn’t require an operating agreement to be filed for an LLC. However, it’s highly recommended an operating agreement is executed. The operating agreement establishes how the LLC will be managed, the duties of members, distribution of profits and losses, how members are added or terminated, and member’s limitations of liability. The operating agreement is important to preserve liability protection. Learn more about the reasons to set up an LLC or corporation
You Can Decide
- Single Member LLC – You are the only member of the LLC. By default, a Single Member LLC is treated as a disregarded entity (sole proprietor). The income and expenses of a disregarded entity are reported on Schedule C.You can elect to treat a Single Member LLC as a corporation. You can elect to be treated as a Corporation by filing IRS Form 8832. You may elect to be treated as a S-Corporation by filing IRS Form 2553There may be tax advantages for filing this election. There are strategies for minimizing 15.3% self-employment taxes by paying reasonable wages to the owners and distributing profits. Distributed profits are not subject to 15.3% self employment tax.
- Multi-Member LLC – There are at least two members of the LLC. By default, a Multi-Member LLC is treated as a Partnership.The LLC will be required to file Form 1065, Partnership return. A partnership is considered a flow-through entity. Profits and losses of the partnership are reported on the owner’s 1040 tax return. Generally, all profits of a partnership are subject to self-employment taxes. Although, owners considered limited members may not pay self-employment tax on profits.You can elect to treat a Multi-Member LLC as a corporation. You can elect to be treated as a Corporation by filing IRS Form 8832. You may elect to be treated as a S-Corporation by filing IRS Form 2553. Again, there may be tax advantages for filing this election.
It’s important to choose the right business structure. We recommend you review your options with a tax professional before making the decision.
Corporation
A corporation can be started by one or more persons by filing Articles of Incorporation with the state. A corporation starts when the owner/owners have a shareholder meeting electing the Board of Directors. The corporation then needs to be properly set up by establishing Board of Directors, corporate officers, corporate shareholders, corporate resolutions, and corporate bylaws. Typically, you need the help of an attorney to establish a corporation.
A corporation provides separation between you and the business. If the business gets sued, your personal liability is limited to your financial contribution.
There are operating formalities for corporations. The corporation must maintain an accurate record of all board meetings. Corporate funds must not be commingled with personal funds. The Board of Directors must meet annually. The Board of Directors must agree to corporate level contractual agreements.
C Corporation
By default, a corporation is treated as a C Corp for IRS taxes. There is double taxation with C Corp. The C Corp pays taxes on profits earned, tax #1. The C Corp profits are paid to shareholders in the form of dividends. The shareholders then pay taxes on dividends received on their personal tax return, tax #2. Due to increased tax rates over the last few years, there may be tax advantages for establishing a C Corp even with double taxation.
S Corporation
A corporation may qualify to be treated as an S Corp for IRS taxes. There are a few eligibility requirements. An election to be treated as an S Corp must be filed with the IRS. The advantage of an S Corp is the elimination of double taxation. An S Corp is considered a flow-through entity. This means the S Corp is not taxed on the profits. The profits flow-through to the shareholders. The shareholders report the profits on their personal tax return. This results in the profits being taxed once on the shareholders personal tax return. There may be tax advantages for choosing an S Corp compared to other business structures.
The decision for establishing a C or S Corporation is specific to your circumstances. We highly recommend consulting with a tax professional for guidance.
Corporation Operating Formalities
The owners of the corporation are considered shareholders. The Board of Directors is elected by the shareholders. The Board of Directors acts as a governing body and directs the overall direction of the company on behalf of the shareholders. Corporate officers are chosen by the Board of Directors. At a minimum there should be a President, Treasurer, and Secretary. In most states, one person is allowed to hold all of the offices. The president is responsible for the day-to-day operations of the business.
The business must establish corporate bylaws. The bylaws are the internal rules for the corporation. For example, formalizes the date and time for the annual board meeting, the shareholder voting requirements, and description of officer duties.
Failure to maintain operating formalities may result in weakening liability protection.
There are two main types: C Corporation and S Corporation. By default, an incorporated business is set up as a C Corporation. You may elect to be treated as an S Corporation by filing Form 2553. The main disadvantage of a C Corporation is double taxation. The C Corporation pays tax and you personally pay taxes on dividends received by the C Corporation. A S Corporation is considered a flow-through entity. The S Corporation does not pay tax. The profits and losses of the S Corporation are reported on your personal income tax return.