What are the benefits and risks associated with incorporating as an LLC, another corporate form, and remaining unincorporated?

Author: LegalEase Solutions

QUESTION PRESENTED 

What are the benefits and risks associated with incorporating as an LLC, another corporate form, and remaining unincorporated? 

SHORT ANSWER 

Generally, with regard to a Limited Liability Company, the member or manager, or both, will not become personally liable for the acts, debts, or obligations of the limited liability company. But when a contract is made on behalf of the company, the member may be personally liable for the acts or debts. Benefits kept apart, the limited liability company has the obligation to file tax returns and pay tax obligations which are determined on the basis of the number of members forming the LLC. At the same time, while filing the documents, the documents had to be submitted to the administrator with prescribed fee as per the statute.

In case of a limited partnership, the limited partner is not liable for the obligations of a limited partnership corporation unless that member is a general partner. Likewise in case of limited liability partnership, the owners shall be personally liable for all debts of the business except for the debts made by another partner. In addition to that, in such corporations, each partner must include his or her share of the partnership’s income or loss on his or her tax return.

Similarly, in case of an unincorporated entity, the individual members of unincorporated associations would become personally liable for the contracts and undertakings of the association and have no corporate shell to protect their personal assets.

Alternatively, the nonprofit corporation is such organization that the Internal Revenue Service recognizes as tax exempt. This is one of the major advantages of forming a nonprofit organization. But the law restricts such corporation from usage of its profits for non-charitable purposes and for payment of salary or wages. Instead it must be solely used for the maintenance, expansion, or operation of the lawful activities of the corporation. Also, in case of nonprofit corporations, the statute permits the members to amend and adopt by-laws for the purpose of corporation and also permits the inclusion of a provision in the articles of incorporation that eliminates or limits a director’s or volunteer officer’s liability to the corporation.

Because ‘Lake Street’ receives a very small profit and is apprehensive about the exposure if filed as an unincorporated association, incorporating the entity as nonprofit corporations would be appropriate.

RESEARCH FINDINGS

Limited Liability Company

A business entity formed by an organizer who may or may not be a member forms a limited liability company. Such business entity’s liability is limited to the financial contribution made by the member and is separate from its members. The members being the owners carry out the management of the company. The Articles of Organization or operating agreement set forth the governance of the company.

The state of Michigan has enacted the Limited Liability Company Act to provide for the organization and regulation of limited liability companies; to prescribe their duties, rights, powers, immunities, and liabilities; to prescribe the powers and duties of certain state departments and agencies; and to provide for penalties and remedies.

The Limited Liability Company Act “clearly and specifically provides for the time that a limited liability company comes into existence and has powers to contract.”

Duray Dev, LLC v Perrin, 288 Mich App 143, 156; 792 NW2d 749, 758 (2010). Notably, the Act also states that, “[a] limited liability company may be formed under this act for any lawful purpose for which a domestic corporation or a domestic partnership could be formed, except as otherwise provided by law.” Id. at 759.

Pros

In a limited liability company, under sec. 450.4501 of the Act, a member or manager, or both is not liable for the acts, debts, or obligations of the limited liability company.

Also another provision of the Act provides that:

Sec. 408. (1) A limited liability company may indemnify and hold harmless a manager from and against any and all losses, expenses, claims, and demands sustained by reason of any acts or omissions or alleged acts or omissions as a manager, including judgments, settlements, penalties, fines, or expenses incurred in a proceeding to which the person is a party or threatened to be made a party because he or she is or was a manager, to the extent provided for in an operating agreement or in a contract with the person, or to the fullest extent permitted by agency law subject to any restriction in an operating agreement or contract, except that the company may not indemnify any person for conduct described in section 407(a), (b), or (c).

(2) A limited liability company may purchase and maintain insurance on behalf of a manager against any liability or expense asserted against or incurred by him or her in any such capacity or arising out of his or her status as a manager, whether or not the company could indemnify him or her against liability.

M.C.L.A. § 450.4408

“Once a limited liability company comes into existence, limited liability applies, and a member or manager is not liable for the acts, debts, or obligations of the company.” Duray Dev, LLC v Perrin, 288 Mich App 143, 151; 792 NW2d 749, 755 (2010). In contrast, “a person who signs a contract on behalf of a company that is not yet in existence generally becomes personally liable on that contract.” Id.

Also the statute states that:

Sec. 501.

(2) Unless otherwise provided by law or in an operating agreement, a person who is a member or manager, or both, of a limited liability company is not liable for the acts, debts, or obligations of the company.

M.C.L.A. § 450.4501

Sec. 504. A membership interest is personal property. A member has no interest in specific limited liability company property.

M.C.L.A. § 450.4504 

In short “[a] limited liability company is a form of hybrid business entity that offers all of its members limited liability as if they were shareholders of a corporation but treats the entity and its members as a partnership for tax purposes.” Dawson v. DeLisle, No. 283195, 2009 WL 2168887, at *3 (Mich. Ct. App. July 21, 2009). “It is defined in Michigan’s Limited Liability Company Act (LLCA), MCL450.4101 et seq., as an entity that is an unincorporated membership organization formed under this act.” Id.

Cons

Generally “[u]nder the LLCA, members have no interest in specific limited liability company property. But they do have a limited statutory right to file an action in circuit court against managers and members. Members may also serve as managers of the limited liability company.” Dawson v. DeLisle, No. 283195, 2009 WL 2168887, at *3 (Mich. Ct. App. July 21, 2009). However, “Limited liability companies involve fiduciary relationships.” Id at *4.

“When a fiduciary relationship exists, the fiduciary has a duty to act for the benefit of the principal regarding matters within the scope of the relationship.” Id. “[t]he LLCA’s requirement that a manager discharge duties in the best interests of the limited liability company indicates that a manager’s fiduciary duties are owed to the company, not the individual members.” Id.

Additionally, the limited liability company shall file tax returns and pay tax obligations.

The owners of an LLC make its members. Thus the IRS will treat an LLC depending on the number of members in LLC either as a corporation, partnership, or as part of the LLC’s owner’s tax return. So LLC with at least two members is classified as a partnership for federal income tax purposes and LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes.

With regard filing of certifying files or records, the documents must be delivered to the administrator with respective fee mentioned under 450.5101, Sec. 1101 of the Act. The documents which must be delivered includes, certificate of correction, restoration of good standing, articles of organization, amendment to the articles of organization, restated articles of organization, application for reservation of name, certificate of assumed name or a certificate of termination of assumed name, annual statement of resident agent and registered office etc. Similarly, a professional limited liability company in addition to the annual statement, shall file an annual report, with the administrator with a filing fee.

Limited Partnership and Limited Liability Partnership

Under the laws of Michigan, if a partnership is formed by one or more general partners or one or more limited partners then it can be called a limited partnership. In a limited partnership, the general partners would be liable for all the debts and obligations of the firm whereas, the limited partners would be liable only for the debts and obligations of that amount which they have contributed.

Likewise, a business entity formed by two or more persons forms a limited liability partnership. In such partnership the owners shall be personally liable for all debts of the business except for the debts made by another partner. Debts and obligations arising from other grounds are not limited and the partners as a result may incur joint and several liability.[1]

The State of Michigan has enacted the Uniform Limited Partnership Act to authorize the formation of limited partnerships and limited liability partnerships and to define the rights and liabilities of the partners in such entities.

Pros

Under 449.1303 of the Act, unless a limited partner is also a general partner, the limited partner is not liable for the obligations of a limited partnership corporation. But the limited partners shall be liable to those persons who transact business with the limited partnership with the knowledge of limited partner’s participation.

Cons

A limited partnership is not exempt from tax. Since, partners are not employees, they are to file an annual information return to report the profits and losses from its operations, but does not pay income tax. Instead, each partner must include his or her share of the partnership’s income or loss on his or her tax return.[2]

De facto Corporation And Corporation by Estoppel

If a business organization has failed to become a de jure corporation (a corporation by law), then it cannot be treated as a corporation. Under that circumstance, to portray the situation the courts use the terms de facto corporation and corporation by estoppel.

“De facto corporation and corporation by estoppel are separate and distinct doctrines that warrant individual treatment.” Duray Dev, LLC v Perrin, 288 Mich App 143, 152; 792 NW2d 749, 755-56 (2010). “The de facto corporation doctrine provides that a defectively formed corporation—that is, one that fails to meet the technical requirements for forming a de jure corporation—may attain the legal status of a de facto corporation if certain requirements are met.” Id. “The most important aspect of a de facto corporation is that courts perceive and treat it in all respects as if it were a properly formed de jure corporation. For example, it can sue and be sued.” Id. Thus, “the status of the company is crucial to determine whether the parties forming the corporation are individually liable.” Id.

In sum, “the de facto corporation doctrine allows a defectively formed corporation to attain the legal status of a corporation. The corporation by estoppel doctrine prevents a party who dealt with an association as though it were a corporation from denying its existence.” Id. at 756. Stated another way,  “the de facto corporation doctrine establishes the legal existence of the corporation. By contrast, the corporation by estoppel doctrine merely prevents one from arguing against it, and does nothing to establish its actual existence in the eyes of the rest of the world.” Id.

Also, the Michigan Supreme Court established the four elements for a de facto corporation: “[w]hen incorporators have [1] proceeded in good faith, [2] under a valid statute, [3] for an authorized purpose, and [4] have executed and acknowledged articles of association pursuant to that purpose, a corporation de facto instantly comes into being.” Id. at 757. “A de facto corporation is an actual corporation. As to all the world, except the State, it enjoys the status and powers of a de jure corporation.” Id.

However, “the similarities between the Business Corporation Act and the Limited Liability Company Act support the conclusion that the de facto corporation doctrine applies to both. The purposes for forming a limited liability company and a corporation are similar.” Id. at 759.  .” Further, “both the Limited Liability Company Act and the Business Corporation Act contemplate the moment in time when a limited liability company or corporation comes into existence.” Id. “Because the Business Corporation Act and the Limited Liability Company Act relate to the common purpose of forming a business and because both statutes contemplate the moment of existence for each, they should be interpreted in a consistent manner.” Id.

Similarly, the Supreme Court has summarized the principle of corporation by estoppel as follows: “[w]here a body assumes to be a corporation and acts under a particular name, a third party dealing with it under such assumed name is estopped to deny its corporate existence.”

Id. at 759.

In short, one can essentially claim a corporate form if someone sues after the fact, even if the company was not incorporated at that time. Thus, a de-facto corporation allows a defectively formed corporation to attain the legal status of a corporation. But in contrast, unless the company is incorporated as an LLC, the members remain subject to any liability.

Unincorporated

An unincorporated entity is an entity which has not been granted formal corporate status by incorporation. It may be a separate entity for accounting purpose, but it may or may not be a separate legal entity.

Generally, “a person who signs a contract on behalf of a company that is not yet in existence becomes personally liable on that contract. However, a court can order that the company is instead liable if it finds that corporation by estoppel prevented the opposing party from arguing against the existence of a corporation.” Duray Dev, LLC v Perrin, 288 Mich App 143, 159; 792 NW2d 749, 759 (2010).

Sec. 2051.

(1) Any natural person may sue or be sued in his own name. A person conducting a business under a name subject to certification pursuant to the assumed name statute may be sued in such name in an action arising out of the conduct of such business.

(2) A partnership, partnership association, or any unincorporated voluntary association having a distinguishing name may sue or be sued in its partnership or association name, or in the names of any of its members designated as such or both.

(3) A corporation, either domestic or foreign, may sue or be sued in its corporate name, except as otherwise provided by statute.

(4) Actions to which this state or any governmental unit, including but not limited to a public, municipal, quasi-municipal, or governmental corporation, unincorporated board, public body, or political subdivision is a party may be brought by or against such party in its own name, or in the official capacity of an officer authorized to sue or be sued in its behalf, except that an officer of the state or any such unit shall be sued in his official capacity for the purpose of enforcing the performance by him of an official duty. Whenever any officer sues or is sued in his official capacity, he may be described as a party by his official title and not by name, subject to the discretion of the court, upon its own motion or that of any party, to require his name to be added.

MCL § 600.2051

“An unincorporated association is not a ‘person’ unless expressly declared such by statute. . . . In an unincorporated association, however, title to purchases vests in the members.”

People v Budzan, 295 Mich 547, 550-51; 295 NW 259, 260 (1940). Moreover, “[n]o corporation can exist except by force of express law.” Detroit Schuetzenbund v Detroit Agitations Verein, 44 Mich 313, 315; 6 NW 675, 676 (1880).

Furthermore, “the trustees of any incorporated society which is organized for a lawful purpose may receive gifts or promises on its behalf, and a mutual subscription may be supported even though no payee be named, provided the object is made definite and certain.” Allen v Duffy, 43 Mich 1, 4; 4 NW 427, 428 (1880). Thus, the trustees of an unincorporated society could maintain an action to enforce promises made in its behalf.

Cons

However, “the law does not authorize an unincorporated society to bring suit in its society name.” Detroit Schuetzenbund v Detroit Agitations Verein, 44 Mich 313, 316; 6 NW 675, 677 (1880). Also, “individual members of unincorporated associations are liable for the contracts and undertakings of the association” Cox v. Gov’t Employees Ins. Co., 126 F.2d 254, 256 (6th Cir. 1942).

Furthermore, “no statute has been called to our [the Court’s] attention which authorizes the formation of corporations to oppose the enforcement of other statutes, or to agitate for their appeal, or to influence legislation, or to give immunity to convicted parties by paying their fines for them.” Detroit Schuetzenbund v Detroit Agitations Verein, 44 Mich 313, 315; 6 NW 675, 676 (1880).

The statute provides that:

Sec. 17. At the election of an unincorporated business, profession or other activity, the entity, on behalf of the owners, may compute and pay the tax due with respect to each owner’s share of the net profit of the activity after giving effect to exemptions to which each owner is entitled. This election is available to all unincorporated business entities having 2 or more owners regardless of the residence of the owners. The tax thus paid by the entity shall constitute all tax due with respect to each owner’s distributive share of the net profits of the unincorporated business, profession or other activity.

If the unincorporated business, profession or other activity elects under this section to file a return and pay the tax on behalf of its owners, the election and filing are deemed to meet the requirements of this ordinance for the filing of a return for each owner who has no other income subject to the tax. However, a return is required from any such owner having taxable income other than his distributive share of the net profits of the entity. In such case the entire income subject to the tax shall be included in the return and credit taken thereon for the tax paid in his behalf by the unincorporated activity.

If the unincorporated business, profession or other activity elects to pay the tax on behalf of the owners, then the unincorporated business, profession or other activity assumes the status of a taxpayer and is liable to interest and penalty if payment is not made by the due date, in accordance with the calendar or fiscal year used by the unincorporated business, profession or other activity.

Mich. Comp. Laws Ann. § 141.617

Therefore, if the unincorporated business elects to pay the tax on behalf of the owners with respect to each owner’s share of net profit, then such unincorporated business assumes the status of a taxpayer and becomes liable to pay the interest and penalty if payment is not made by due date.

To conclude, even though such unincorporated entity avoids the costs associated with incorporating, they remain personally liable and have no corporate “shell” to protect their personal assets (as they would if they incorporated an LLC). Apart from that, when the question of liability arises, the individual members of unincorporated associations would become liable for the contracts and undertakings of the association.

Non-Profit Corporations

A nonprofit corporation is a corporation which is incorporated to carry out any lawful purpose that does not involve pecuniary profit or gain for its directors, officers, shareholders, or members. The State of Michigan has enacted the Non- Profit Corporation Act to classify and consolidate the laws relating to organization of nonprofit corporations.

Pros

The articles of incorporation may contain provision for management of the business and conduct of the affairs of the corporation, or creating, defining, limiting, or regulating the powers of the corporation, its directors, officers, members, or shareholders, or a class of directors, shareholders, or members. Under Sec.450.2209 of the Act, it is stated that the articles of association may also contain provision that eliminates or limits a director’s or volunteer officer’s liability to the corporation, its shareholders, or its members for money damages for any action taken or any failure to take any action as a director or volunteer officer, except liability for receiving financial benefit for which she is not entitled to, or intentional infliction of harm on the corporation, its shareholders, or members or violation of section 551 or an intentional criminal act or a liability imposed under section 497(a). But if the articles of incorporation contain a provision that eliminates the liability of a volunteer director or officer then such provision would eliminate the liability of such volunteer director or officer.

Moreover a corporate under the provision of 450.2261 of the Act, has the powers to have perpetual duration, to sue and be sued, have a corporate seal, adopt and amend byelaws for the purpose of corporation, elect or appoint officers or employees, to receive gifts, lease or hold property without limit in value, to make contract, guarantees, bonds etc., lend money, pay donations, pensions, and finally can cease or dissolve the activities of a corporation. [3]

An additional benefit is that, under Sec. 501(c)(3) of Internal Revenue Code, nonprofit corporations are organizations that the Internal Revenue Service recognizes as tax exempt. Although the nonprofit organizations are exempt from income tax, they are required to file annual returns of their income and expenses with the Internal Revenue Service. If such a nonprofit organization has unrelated business income, then they must file an unrelated business income tax return. In addition to that may file other returns and pay employment taxes. [4]

Cons

Under Sec. 450.2201 and 450.2202, in order to incorporate a nonprofit corporation, it may initially file articles of incorporation for the corporation which must be which must be duly signed by the incorporators. The articles of incorporation must include the name of the corporation and the purpose for which the corporation is formed.

Apart from that, the entities under this Act, under the provisions of 450.2262, obligates itself to the payment of death and sick benefits to its members. But, it shall not make, issue, or deliver any certificate or other written evidence of the obligation in the State of Michigan. However, any payment or distribution of any part of the assets, income, or profit of a corporation shall be made only for the purposes of the corporation. Similarly, a corporation shall not make a direct or indirect transfer of money or other property or incur indebtedness to or for the benefit of its directors or officers without adequate consideration.

Moreover, under the provision 450.2327, the charges and expenses for organization and reorganization of a corporation must be paid by the corporation from the consideration received by it. Additionally under the provision of 450.2301, a corporation’s lawful activities may include charging of fees or prices for its services or products and as a consideration may receive the income and may make a profit as a result of its receipt. But the resulting profit must be used only for the maintenance, expansion, or operation of the lawful activities of the corporation and should not be used for paying salary or wages. Also, such assets held by the corporation for charitable purposes may not be distributed or conveyed for non-charitable purposes.[5]

Thus, due to tax exemption and inclusion of a provision in the articles of incorporation that eliminates or limits a director’s or volunteer officer’s liability to the corporation in case of nonprofit corporation; in the instant case, it would be advisable to incorporate the entity as a nonprofit corporation. This is because a nonprofit corporation’s resulting profit must be used only for the maintenance, expansion, or operation of the lawful activities of the corporation and should not be used for paying salary or wages. So under that circumstance since ‘Lake Street’ receives a very small profit and is concerned about the exposure if filed as an unincorporated association, incorporating the entity as nonprofit corporation would be appropriate.

CONCLUSION

Based on the foregoing, it can be concluded that an entity incorporated as nonprofit corporation would be more apposite as it is exempt from tax liability in contrast to limited liability company and does not hold the risk of remaining personally liable as in case of an unincorporated entity.

[1]   http://www.michigan.gov/lara/0,4601,7-154-35299_61343_35413_35430-114995–,00.html

[2] http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Partnerships

[3] http://www.legislature.mi.gov/(S(dbfkisabhdrrv1ddqe3kyqss))/documents/mcl/pdf/mcl-act-162-of-1982.pdf

[4] http://www.irs.gov/Charities-&-Non-Profits/Exempt-Organizations-Required-Filings-2

[5] http://www.legislature.mi.gov/(S(dbfkisabhdrrv1ddqe3kyqss))/documents/mcl/pdf/mcl-act-162-of-1982.pdf