Why not convert?

Cynthia E. Brazzil
January 28, 2008 — 1,652 views  
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If you are starting a new business or just making a passive investment, selecting the proper legal structure is critical.  If you already have a business or investment with others, you should review the business form you are using on a regular basis to determine whether it is still the best choice.

Should you operate as a sole proprietorship, a partnership or form a limited liability company?  Should you incorporate?  And if you do, should you elect “S” corporation status?

Each business entity has advantages and disadvantages.  No one form is right for every situation, and no initial choice remains right as a business grows or circumstances change.  The form of business entity that you choose can make a difference in the taxes you pay, the costs of doing business, and the amount of paperwork required, as well as in your exposure to personal liability.

The simplest form of business organization is the sole proprietorship, i.e., Jane Doe d/b/a Speedy Printing.  As such, Jane Doe is personally liable for the debts of the business and Jane reports the profits/losses of her business on her personal tax return.  Typically, a sole proprietorship is the least complicated and usually the least expensive way to set up and run a business.

Limited liability is available for Jane under Michigan law.  By filing “Articles of Organization and Certificate of Conversion” with the state of Michigan, Jane can “convert” her simple sole proprietorship into a limited liability company.  The new limited liability company protects Jane’s assets from seizure by creditors (beyond her investment in the entity) but allows Jane to have the identical tax treatment.  Jane would report the profits/losses of her business on her personal tax return (Schedule C).  With such a minimum amount of work required in exchange for a potentially significant amount of liability protection, there is simply no reason why all sole proprietorships shouldn’t convert to limited liability companies.

Some of the other business entity forms to choose from are:

1. A General Co-Partnership must have at least two partners and generally pays no income tax itself.  The income or losses are passed through to the partners who report them on their own individual tax returns.  The major drawback is that the partners have unlimited personal liability, as well as liability for the actions of every other partner.

2. In a Limited Partnership, there are two classes of partners.  The general partners run the business and have substantially the same liability exposure as partners in a general co-partnership.  Limited partners do not take part in the business and are generally liable only to the extent of their investment.

3. A “regular” or “C” Corporation files its own tax return and pays its own income tax.  This can lead to the major drawback of business profits being taxed twice, once at the corporate level and again at the shareholder level, if paid out as dividends or liquidating distributions.  The complexity of rules and regulations governing corporate operations, including the tax laws is another drawback.

4. An “S” Corporation passes through its profits or losses to its shareholders, who then report their pro rata share of income, losses and credits on their individual tax returns.  The double taxation that regular corporations face is avoided with an S Corporation.

5. A Personal Service Corporation (“PC”) is a special kind of corporation that has professional employee-owners performing services in the fields of health, law, engineering, architecture, accounting, etc.  This entity allows professionals to incorporate without limiting their personal malpractice exposure.  However, unlike a partnership of professionals, in a PC, fellow shareholders are not personally liable for the malpractice of each other.  There are also tax consequences.

6. Limited Liability Partnerships are simply garden variety general co-partnerships in which the partners can shield themselves from the negligence, wrongful acts, omissions, misconduct or malpractice of another partner, employee, agent or representative.

For further information regarding these matters, please contact Ms. Brazzil at 248.740.5667 or [email protected].

Cynthia E. Brazzil