Chapter 2: Choosing the Right Business Entity ^[1]

I.   Overview

§2.1   When asked to assist a client in the start-up of a business venture, the initial decision the practitioner must make is the type of entity to form for the client to hold the assets and operate the business. The practitioner must choose among the many different types of entities available, such as a C corporation, an S corporation, a limited liability company (LLC), a limited liability partnership (LLP), a general partnership, or a limited partnership. In deciding which entity to choose, the practitioner must first ask themselves the following questions:

1. Are the owners of the entity individuals or other entities?
2. Will the owners be actively involved in the business?
3. What are the projections for the profitability and long-term growth of the business?
4. What are the owners contributing to the capital of the business?
5. How will the entity be managed?
6. Is limited liability important to the owners?
7. What are the owners’ concerns about how they are to receive the profits of the business, and what are the tax consequences on the business and owners?
8. What are the plans for a sale of the company? Is the company to eventually go public? Is the business one that the owners desire to give to family members?

Clients have great flexibility in choosing an entity that will fit their needs. They may choose an entity that provides liability protection to themselves, such as a corporation or an LLC or as limited partners in a limited partnership. If they have concerns regarding structuring distributions and returns, most entities, except an S corporation, will allow them to craft customary provisions regarding preferred and/or disproportionate returns. Some entities are put into place for the purpose of passing on an enterprise to the owners’ heirs. In this regard, the clients need to look at the effect of contributing the enterprise property to a new entity and how the clients can maintain control while giving up equity in the business. On the other hand, there are instances where a business enterprise is to be structured with the express intent of readying an enterprise for future sale. In such a case, the practitioner must ascertain the effect of a sale or dissolution on the owners and the entity even before the entity is formed.

In the initial interview, the practitioner must elicit the predictions and anticipations of the prospective entity owners so that the proper entity selection structure can be made. Although businesses evolve and owners’ desires and plans may change, a careful analysis at the outset can make a substantial difference in meeting the clients’ expectations of their future enterprise. Exhibit 2.1 compares various legal and tax aspects for the different types of entities.

II.   Formation

A. Type and Number of Owners

§2.2   The type of entity desired might be limited by the individuals or entities that are to be the owners. Some entities have no restrictions on the number and type of owners while other entities have strict limitations that must be complied with to make the election valid.

C corporations and LLCs have no minimum or maximum number of shareholders or owners that may have an equity interest in them. Partnerships require that there be at least two partners and, in the case of a limited partnership, one of the partners must be a general partner and one of the partners must be a limited partner. MCL 449.1101. S corporations must not have more than 100 shareholders. IRC 1361(b)(1)(A).

S corporations can have only the following types of shareholders:

1. Individuals. IRC 1361(b)(1)(B). Spouses are counted as one shareholder for purposes of the 100-shareholder rule, and family members who have a common ancestor not more than six generations removed may elect to be treated as one shareholder for purposes of the 100-shareholder rule. IRC 1361(c)(1). Nonresident aliens are not permitted to be shareholders. IRC 1361(b)(1)(C).
2. Certain retirement plans. IRC 1361(b)(1)(B), (c)(6). Each such plan is counted as one shareholder for purposes of the 100-shareholder rule. IRC 1361(c)(6)(A).
3. Tax exempt organizations under IRC 501(c)(3). IRC 1361(b)(1)(B), (c)(6). Each such plan or organization is counted as one shareholder for purposes of the 100-shareholder rule. IRC 1361(b)(1), (c)(6).
4. Grantor trusts. IRC 1361(c)(2)(A)(i)–(iii).
5. Voting trusts. IRC 1361(c)(2)(A)(iv).
6. Qualified subchapter S trusts. IRC 1361(d). Each income beneficiary and potential income beneficiary of such trust is treated as one separate shareholder for purposes of the 100-shareholder rule. Id.
7. Electing small business trusts (ESBTs). Accumulation and discretionary trusts are permitted to be shareholders if they elect to be an ESBT, as long as all of the following requirements are met:
   1. all of the beneficiaries of the trust must be specifically included in IRC 1361(e)(1)(A) and not specifically excluded under IRC 1361(e)(1)(B);
   2. there cannot be any interests in the ESBT that may be acquired by purchase; and
   3. the ESBT must have filed a written election with the Internal Revenue Service (IRS).
      
      IRC 1361(e)(1).
8. Another subchapter S corporation. S corporations may own 100 percent of the shares of a qualified subchapter S subsidiary (QSub). IRC 1361(b)(3). The following requirements must be met to be considered a QSub:
   1. the subsidiary must be a domestic corporation;
   2. the subsidiary must be otherwise eligible to be an S corporation;
   3. the subsidiary must be 100 percent owned by its S corporation parent; and
   4. the parent S corporation must have properly elected to treat such subsidiary as a QSub.
      
      IRC 1361(b)(3)(B).
9. Domestic building and loan associations, mutual savings banks, and certain cooperative banks with shares organized on a nonprofit basis. IRC 1361(b)(2), (c)(6).
10. Each shareholder must be a U.S. citizen or resident alien. IRC 1361(b)(1)(C).

B. State of Formation

§2.3   Many times the practitioner will be faced with a client who has heard that forming an entity in Delaware or Nevada will give their entity the most favorable treatment. Indeed, Delaware has a long-established body of law developed over the years that favors corporations. Consequently, the Delaware court systems presumably are more experienced regarding corporate law. Nevada has also become a desirable state in which to incorporate because of some favorable provisions in its business statute for owners, such as the lack of a requirement for annual shareholder meetings. In attempts to attract business, other states may also begin to provide favorable ownership or governance treatment or reduce filing fees or franchise taxes. Before choosing a state of formation, the practitioner should review the following issues.

In most instances, filing in the state where the business or owners are located may be the best alternative, and forming a closely held Michigan business with Michigan owners in Michigan may be the right choice. The following are some of the benefits of forming an entity in Michigan:

1. Formation in another state may result in additional fees such as out-of-state counsel and the cost of a registered resident agent for service of process within the other state.
2. Formation in another state may not generally reduce taxes. For example, the initial franchise tax for forming a corporation in Michigan for authorized stock fewer than 60,000 shares is fairly low. See MCL 450.2062. Although the cost in Michigan is higher for authorized stock over 60,000 shares, filing in another state does not necessarily avoid imposition of the Michigan tax. Additionally, in several other states, including Delaware, corporations must pay annual franchise taxes.
3. Formation in another state may also make unavailable the federal intrastate offering exemption provided for in section 3(a)(11) of the Securities Act of 1933. 15 USC 77c(a)(11); SEC Rule 147, 17 CFR 230.147. See also §3.38. For example, this exemption from registration is useful in selling shares in Michigan where circumstances make other federal exemptions difficult to rely on. To qualify for the intrastate offering exemption, the corporation issuer must be both a resident and doing business in the same state as all of the offerees and purchasers. If incorporated in another state, this exemption will not be available to the corporation seeking Michigan shareholders.
4. Additionally, an entity formed in another state may find itself subject to the jurisdiction and service of process in that state and, therefore, can be sued there even if it does not do business there.
5. Delaware has a counterpart to Chapter 7A of the Michigan Business Corporation Act (MBCA), MCL 450.1775 et seq. (regulation of business combinations).

Although statutory revisions over the past several years have narrowed the differences in substantive corporate law between the states, there remain variations in filing fees, reporting requirements, and notice provisions. Accordingly, the familiarity with Michigan requirements and the other potential pitfalls of incorporating or organizing out of state make Michigan, in many instances, the desirable state of formation for closely held Michigan businesses with Michigan owners.