Each of the common entity types (including sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, S corporations, and C corporations) comes with its own set of benefits and downfalls. The pros and cons vary depending, among other concerns, on whether you’re starting a small/family-sized business with limited foreseeable partners, or if you want to have the ability to seamlessly add on a large number of shareholders down the line to raise capital. If the former applies to you, then you should consider going the limited liability company (“LLC”) route. In this article, we discuss this, and other benefits and considerations related to starting an LLC in Michigan.
Creating an LLC in Michigan: Key Benefits
Protection from Personal Liability
Before LLCs were available, owner liability protection was reserved for C Corporations. This was less than favorable, as all income earned by these entities is taxed at the corporate level, and then again at the individual level when they pass profits on to owners through dividends. However, in 1977, regulations allowing the formation of limited liability companies were passed. They allowed business owners to limit the risk that their personal assets would be jeopardized in the event of a lawsuit, while only subjecting income to taxation once, at the individual level. While there are situations in which an LLC cannot protect an owner’s personal assets, more often than not they limit the assets creditors may lay claim on to the business’ assets. This is why many entities will use “holding companies” as part of a tiered partnership strategy – the HoldCo owns certain more valuable assets, such as a building, and income from the operating entity is passed through the HoldCo down to the owners. This reduces the value of the assets in the operating entity subject to seizure, should any issues arise. Before settling on forming an LLC in Michigan, make sure you understand what situations it will and will not protect you in.
Flexibility in Taxation
Another key benefit to an LLC business structure is that it allows you to take advantage of its flexible taxation. By default, a single-member LLC is taxed as a sole proprietorship. This type of entity is not separate from the individual; revenue and expenses are reported on Schedule C with the owner’s 1040, with the net income being subject to self-employment tax. The default taxation of a multi-member LLC is as a partnership; revenue and expenses are reported on Form 1065, which then passes a K-1 to partners so that income or losses are accounted for on their separate personal returns. If neither of these options suits, an LLC may elect to be taxed as an S Corporation or a C Corporation using Form 8832, Entity Classification Election. Similar to a partnership, an S Corporation passes a K-1 to its owners (called “members”), but it is subject to different rules around who may be an owner, how many owners are allowed, how income and losses must be reported to owners and how many classes of stock are allowed. A C Corporation status is generally not preferred, as income is subject to double taxation, but may be beneficial in certain situations. When deciding which form to choose, it is best to research all available options and consider whether it may be worth consulting with an accountant.
Preferential Tax Opportunities
Not only does the LLC business structure allow for increased flexibility in taxation, but it also opens the door to a number of tax-saving opportunities. If taxing an LLC as a sole proprietorship, a partnership, or an S Corporation, losses the entity incurs pass through to the owners. While this is true for a sole proprietorship or partnership that is not incorporated, a sole proprietorship with recurring losses is often seen as a hobby in the eyes of the IRS, and hobby losses are not deductible. C Corporations, on the other hand, do not allow for the deduction of current year losses by owners at all. Instead, the entity’s taxable income is reduced to zero, and the additional loss is carried forward to offset 80% of future years’ income.
Another opportunity afforded by LLCs is the concept of a “reasonable salary” for S Corporations. Take a moment to dig out your most recent W-2 – boxes 4 and 6 contain Social Security and Medicare taxes withheld at 6.2% and 1.45%, respectively. The total tax rates are actually double these amounts, but your employer is required to pay the other half for you. However, if you are the employer, you are responsible for paying this other portion (deemed “self-employment tax”), which can drastically increase your tax liability. When organized as a partnership or an unincorporated sole proprietorship, all active income passes through to the owner(s) as earned income subject to self-employment tax. However, S Corporations are allowed to pay their owners “reasonable salaries” based on the amount of work they are putting into managing the business. This essentially allows the taxpayer to only claim a portion of their total business profits as active income subject to self-employment tax, while the rest is passed to the owner through a K-1 and subject only to federal income tax. S Corporations are not standalone entity types, but rather a tax status LLCs may elect; in other words, an S Corporation cannot be formed without first creating an LLC.
Ability to Raise Capital
Say you’ve been operating a baking business out of your house. It’s a small operation, so the need for a formal entity setup was unnecessary. However, you’ve decided you’d like to expand your business by obtaining a small space in town and hiring 1-2 employees. At this point, you need funding, but a traditional bank loan requires a time-consuming amount of paperwork and doesn’t provide you with any guidance in the process. This is an example of a situation in which starting an LLC in Michigan may be a preferential route. A sole proprietorship may only have one owner; by transitioning the business to an LLC, the owner may bring on one or multiple investors who can earn a percentage of the company’s profits and contribute some of their time and expertise, without taking part in the day-to-day operations. Moreover, this avoids the time and cost involved in traditional financing and provides all owners with (now more necessary) liability protection.
If nothing else, upgrading your business to an LLC is likely to improve your reputation in the market. While the process to create a Michigan LLC is simpler than one may think (as discussed in our other article here), investors and potential partners alike respect the investment and effort necessary to obtain the designation.
If you’ve kept reading to this point, it’s safe to assume you’re contemplating starting a Michigan LLC. While information surrounding the benefits and process are readily available, it takes more than a Google search to understand the best route for your unique situation. We recommend discussing your options with a CPA who can help you understand all relevant considerations. If you would like to book a free consultation with us, you can fill out an inquiry here.