Selecting the Right Business Entity
Scott G. Weber
Introduction
With recent tax and lending incentives for small-businesses, you may be considering starting your own business. Whether you are a doctor thinking of opening your own practice, a chef considering opening a restaurant or an investor wanting to start a hedge-fund firm, you will need to select the right business type to suit your particular needs. There are different tax implications, liability considerations and structural issues which accompany each type of entity. This article will provide a brief analysis of the most popular forms of enterprise: sole proprietorship, partnership, LLP, LLC and corporation so as to assist you in determining which form may be best for your specific business needs.
Sole Proprietorship
A sole proprietorship is the default business choice and the most common type of business organization in Illinois. If someone simply opens up a business, without registering as a corporation, then they are deemed a sole proprietorship. If you intend to do business as a sole proprietor under a name other than your legal name, then it is important to, at least, register the business name under the Assumed Business Names Act (805 ILCS 405/1). The advantages of a sole proprietorship are lower costs and less administrative work as compared to the other entity selections. However, there is no separation between the business entity and the owner/manager. Therefore, the tax and liability consequences can be more risky than with an LLC for example. If the business goes bankrupt, then the sole proprietor is personally liable for the debts of the company. Therefore, a person doing business as a sole proprietor should obtain strong liability insurance. This business type would not be beneficial for a company with a high risk of liability (i.e. medical, travel, etc.).
General Partnership
As with the sole proprietorship, a general partnership is easy to get started as all that is required under the Uniform Partnership Act is, "an association of two or more persons carrying on as co-owners a business for profit." (805 ILCS 206/1). While registering is not required, it is best to formulate the terms and governing structure of the partnership in a written Partnership Agreement before the business operates in case a conflict arises. The default rule is that partners share equally in the profits and the losses. General partners are liable for the actions of another partner in business-related matters. Unless the Agreement specifies otherwise, the partnership will dissolve upon the death or disability of a general partner. Therefore, with the share of control and liability for one another’s actions, if you want to include a partner in your business, you must ensure that your partner is someone you can trust; and even if you can have faith in him/her, you should draft an all-encompassing Partnership Agreement to prevent small conflicts from overtaking your business operations. For tax purposes, a partnership is a "pass through" entity, whereby each owner of the partnership will be taxed individually based on his/her share of the partnership profits.
L.L.P.
A limited partnership typically has one general partner who runs the business and one or more limited partners who participate in the profits and losses, but do not run the business. LLPs are great for accounting firms and law firms because they allow individuals to practice without the fear of being held liable for malpractice claims in which the individual has no part. Registering as an LLP protects the limited partners from "the debts, obligations, or liabilities of the partnership resulting from negligence, malpracitce or wrongful acts, or misconduct by another partner, employee or agent of the partnership." 805 ILCS 215. However, if a limited partner exercises control over the actual management of the company, or directs the actions of a fellow employee or partner, then he/she may lose limited liability status. The profits of an LLP pass to the partners who eventually pay on them as a personal income tax.
L.L.C.
The LLC is one of the newest but growing forms of business entities in Illinois. The owners' liability in an LLC is limited to the amount of their initial and subsequent investments in the company. They are subject to limited liability for the debts and actions of the company. The company is organized under an Operating Agreement, which, like a Partnership Agreement, lays the ground rules for the operation of the LLC considering issues like voting rights, dissolution events, business purposes, etc. In addition, LLCs are "pass-through" tax entities whereby the taxes are passed through the business and taxed solely on the member's individual tax returns. The filing fees associated with LLCs are higher than the other business entities. Also, the LLC has only been in existence for less than 40 years whereas the corporation has been around for hundreds of years. Therefore, LLC law is less settled, which may present some uncertainty in making business decisions.
Corporation
The corporation is the most complicated form of business structure. It is a separate legal entity from its shareholders carrying its own set of legal rights and obligations. A corporation is considered to have an unlimited duration. A great advantage of the corporation is the transferability of ownership. Shareholders can easily transfer shares between one another and no member can be held personally liable for the debts or obligations the corporation incurs. However, there is closer state regulation, extensive record-keeping requirements and structural restrictions associated with a corporation.
There are three types of corporations: C, S, or Close. For tax purposes, the C corporations are separate entities which file a corporate return, and the distributions to shareholders are taxed on personal returns, resulting in "double taxation." In order to avoid this consequence, S corporations may be formed, if the pre-requisites are met. If so, the income or losses are passed through to the shareholders and are only taxed once on personal returns. A close corporation is similar to a C corporation, but with written agreements in place of administrative requirements. For example, the shareholders are not required to have a board of directors and can manage the company themselves according to their written agreement. Close corporation shareholders can also restrict how the shares are transferred. A close corporation shares the "double taxation" dilemma as with the C corporation.
Conclusion
The sole proprietorship is the most popular option due to the total control and the ease in getting it running. Yet, the owner maintains full liability for the business failures. The LLP is the best option for professional businesses that may otherwise be liable for the mistakes of employers or the partnership within that business because it insulates individual members from liability. The LLC and Corporation also provide strong liability protection, but may be too costly for a smaller business owner.
While this brief analysis provides a general framework regarding the various types of business entities, the actual registration process requires careful legal attention and should be conducted with the assistance of a legal representative. As with laying the foundation for a new home, the drafting of the company's governing articles and the filing of the registration documents with the IRS and Secretary of State have a lasting effect on the company and must be done with precision. Thus, a lawyer's advice is much needed during the business registration and formation stage. Should you need any assistance in starting your own business, please contact me at 309-674-1133 or sweber@qjhpc.com.