There are multiple types of business entities. All entity types (except sole proprietorships) are separate and distinct entities from their owners. The entity types can vary from state to state, because business entities are statutory (legal) creatures allowed to exist by the state in which they are created. Thus, all business entities (except for sole proprietorships) are subject to state regulation. For example, LAH Law PLC is a Michigan professional limited liability company, which is subject to Michigan law. Whereas, His Business Inc. (my non-profit corporation) is a California non-profit corporation subject to California law.
Business entities can operate in states other than their state of creation, but they must obtain an “Authority to Transact Business” as a “foreign entity” in those states they operate in. This also subjects the entity to that state’s regulations.
In Michigan, the filing fee to create an entity is quite cheap – only $50 (as compared to $800 in California). Legal fees vary from $300 to $1,000 (or more) – based upon the complexity of the entity’s governing documents (see below).Selection Factors
Selection of the proper business entity can be important for several reasons.
- Limited Liability: Many business entity types can protect your personal assets from the claims of the business’ creditors (vendors, bankers, etc.). But, this protection is limited. None of them can protect you if: (a) you are personally responsible for injury to another; (b) you negligently hire or supervise your employees and another person is injured; or (c) you fail to pay payroll or withheld payroll taxes.
- Taxes Advantages: Some entities act as “pass through entities” where the income and deductions pass through to the shareholders. Some entities incur double taxation where the company and the owners pay taxes on the profits.
- Cost to Form & Maintain: Some entities are easy and inexpensive to create and maintain. Some are more expensive. It usually depends upon the complexity of the governing documents.
- Raising Capital: Some entities cannot have new investors. Some have a maximum number of investors. Others are not used because of the awkwardness of handling many investors.
Obviously, we will need to talk through your dreams and plans to select the best entity type for your organization.
Here is a fairly comprehensive list of the entity types:Sole Proprietorship
A Sole Proprietorship is a business owned by only one person (which can include a husband and wife as one person). It has no governing documents. The owner is responsible for all the company’s liabilities (there is no limited liability). It is taxed as a “pass through entity” for IRS purposes, which means it does not have to file an income tax return. Instead, the income and expenses are reported on the owner’s 1040 Schedule C. A Sole Proprietorship is created by filing a DBA (Doing Business As) form with the county clerks in which the Sole Proprietorship does business.Limited Liability Companies (LLC)
The LLC is a recently created entity (first used about 20 years ago). A LLC is owned by “members” – who have limited liability. The LLC is managed either by the members or managers. The governing documents are the Articles of Organization and Operating Agreement. The members all agree to and sign the operating agreement – which can include varying distribution methods (regardless of ownership percentages). Because of this, the LLC offers a great deal of flexibility. For this reason, it has become very popular – and is usually the entity of choice for most small business owners. There are three types of LLC’s:
- Single Member LLC: this LLC has only one member (which can be a husband and wife.) This makes it a “pass through entity” for IRS purposes, which means it does not have to file a LLC income tax return. Instead, the income and expenses can be reported on the member’s 1040 Schedule C.
- Multiple Member LLC: this LLC has more than one member. For tax purposes, it can elect to be treated as either an S corporation or a Partnership. Most choose the S corporation treatment.
- Professional LLC: this LLC is can only be owned by professionals (those who are required to have special licenses, such as attorneys, accountants, engineers, architects, etc.). For tax purposes, it can elect to be treated as either an S corporation or a Partnership. Most choose the S corporation treatment.
- Family LLC: this LLC is and estate planning vehicle created for families to protect their assets from creditors and, in some cases, take advantage of substantial estate and gift tax savings.
LLC’s are created by filing the Articles of Organization with the state.
The corporation has been used for over 500 years. A corporation is owned by “shareholders” – who have limited liability. The corporation is managed by managers. These managers are: (a) Board of Directors; (b) Corporate Officers; and (c) lower level executives and managers. The governing documents are the Articles of Incorporation and Bylaws. Today, it is the most widely used form for larger companies that have large number of shareholders. There are three types of Corporations:
- C Corporation: this is the traditional corporation. Its biggest weakness is that its profits are subject to double taxation: (a) the corporation pays tax on its income: and (b) then the shareholder pays tax on the dividends (the company's profits) they receive. This is the most common entity for large companies with many shareholders. A C corporation can have several classes of stock, such as: (a) common stock; (b) preferred stock; and (c) preferred convertible stock.
- S Corporation: this is a rather “new” entity as it was created by a change in the tax code in 1958. A corporation must make an “S” election with the IRS to be treated as an S corporation. An S corporation is a “pass through” entity for tax purposes, which eliminates the double taxation of the C corporation. So, its income is not taxed (but a tax return is filed) – instead, the income is passed through to the shareholders who include the income in their tax returns. The other tax advantage is that owners can pay themselves a reasonable salary (which will have employer payroll taxes) and receive profits as a dividend distributions (which do not have payroll taxes). This can save owners significant payroll taxes if their salary is under $120,000. The weaknesses of the S corporation are: (a) it can only have one class of stock; and (b) it can have no more than 100 shareholders. Thus, it is not typically used by large corporations that need more than 100 shareholders.
- Professional Corporation: this corporation can only be owned by professionals (those who are required to have special licenses, such as attorneys, accountants, engineers, architects, etc.). For tax purposes, it can elect to be treated as either an S or C corporation. Most choose the S corporation treatment.
Nonprofit corporations are formed for non-profit purposes (not surprising). The Internal Revenue Code has 29 different types of non-profit corporations. Some of the most commonly known are:
- 501(c)(3) corporation: this includes religious, educational, charitable, scientific, literary, testing for public safety, to foster national or international amateur sports competition, or prevention of cruelty to children or animals organizations.
- 501(c)(4) corporation: this includes civic leagues, social welfare organizations, and local associations of employees.
- 501(c)(5) corporation: labor, agricultural, and horticultural organizations.
- 501(c)(6) corporation: business leagues, chambers of commerce, real estate boards, etc.
A non-profit corporation is created by filing the Articles of Incorporation (for a Non-Profit Corporation) with the state. It can become an IRS recognized non-profit (which allows contributions to it to be deducted from taxable income by the contributor). This is accomplished by filing an Application for Recognition of Exemption with the IRS. This can be a lengthy and somewhat expensive proposition. After obtaining the IRS acceptance, the corporation must then file annual non-profit returns with the IRS (which are more time consuming than income tax returns).Partnerships
Partnerships were used more frequently until the invention of the LLC. Today, they are used infrequently (usually only for certain investment projects). They can be created by written documents or by verbal representations. A partnership is owned by its “partners”. The partnership is managed either by the partners or managers. The governing document is the Partnership Agreement or the Michigan Uniform Partnership Act if there is no written Partnership Agreement. A Partnership Agreement can include varying distribution methods (regardless of ownership percentages). Partnerships are “pass through entities” for tax purposes. So, its income is not taxed (but a tax return is filed) – instead, the income is passed through to the partners who include the income in their tax returns. There are three types of Partnerships:
- General Partnership: is a partnership where all partners are liable for the partnership liabilities. In other words, there is no limited liability. The partnership income is allocated to the partners per their partnership agreement. This partnership is created by filing a “Certificate of Copartnership” or “Certificate of Persons Conducting Business Under Assumed Name” with the county clerks in each the county the partnership is operating.
- Limited Partnership: is a partnership which has a general partner(s) (who is responsible for the partnership liabilities) and a limited partner(s) (who have limited liability). This is created by: (a) filing a “Certificate of Copartnership” or “Certificate of Persons Conducting Business Under Assumed Name” with the county clerk in the county in which the partnership is located; and (b) filing a Certificate of Limited Partnership with the state.
- Limited Liability Partnership: is a partnership where the partners have only limited liability. This is created by: (a) filing a “Certificate of Copartnership” or “Certificate of Persons Conducting Business Under Assumed Name” with the county clerk in the county in which the partnership is located; and (b) filing an “Application To Register A Limited Liability Partnership” with the state.
Small Business Services (click on your area of interest to be taken to that webpage):