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6.11.15 graphic MJS Corporation. Choosing the Right Type of Business Entity M0709953xA6406

by: Mark J. Stegman

When starting a company, one of the first, and maybe the most important, decision that must be made is choosing the right form of business entity.  The right choice of business entity will depend on a variety of factors including cost, ease of formation, management, limiting liability, continuity of existence, transferability of interests and income tax considerations.  The right business formation will help your business thrive while providing peace of mind.  Choices of business entities include the sole proprietorship, partnership, corporation, limited liability company, and others.

The sole proprietorship is the simplest form of business entity, and it consists of a single person carrying on a business for profit.  The ease of creation helps business owners who  are not certain if he or she will continue the business for any significant length of time, avoid spending the time and money on costly filings and legal documents.  The simplicity (but drawback) of conducting business as a sole proprietorship means that the business does not have a separate legal existence from that of its owner, making the proprietor personally liable for all obligations of the business.

The partnership is an association of at least two persons carrying on a business as co-owners.  There is not a formal written agreement or document necessary to create a partnership.  Illinois statutes related to partnerships provide that partners share equally in the profits and losses of the partnership, notwithstanding unequal contributions to the capital of the partnership.  The profit sharing structure under Illinois law may be changed, however, under a written partnership agreement.  Similar to sole proprietorships, partners remain personally liable for the obligations of the partnership, including liabilities incurred on behalf of the partnership by any of its partners.  For income tax purposes, each partner is generally taxed on that partner’s share of the profits earned by the partnership. 

Illinois law provides for events which result in the voluntary of involuntary “disassociation” of a partner from the partnership.  For example, the death or bankruptcy of a partner may have this result.  Some types of dissociations may trigger the complete dissolution of the partnership.  As is the case with profit sharing, this may be altered under the terms of a written partnership agreement.  Partnerships come in many different varieties, each providing their own sets of pros and cons, and include general partnerships, limited partnerships, limited liability partnerships, and limited liability limited partnerships.

The corporation is a distinct legal entity, separate and apart from its owners.  This separate legal status provides many of the advantages, but also additional costs, associated with placing a business within the corporate framework.  Because the corporation is a distinct legal entity from its owners, it can enter into contracts, sue or be sued, and hold title to real property.  The corporation is owned by “shareholders,” who generally serve as passive investors in the business while the management responsibility falls to the officers and the board of directors of the corporation. Unless a shareholder agrees to be personally liable for a corporation’s obligations, a shareholder is not personally liable for those obligations.  A shareholder’s loss (in the absence of a personal guaranty) is generally limited to the investment the shareholder makes in the corporation

In order to maintain the separate legal identity of the corporation, corporate formalities must be complied with, which requires the corporation to make annual filings in every state in which the corporation does business, hold annual meetings of the directors and shareholders, keep corporate funds separate from those of the shareholders, as well as observe other formalities.  Failure to maintain the corporate formalities could result in corporate liability being extended to the corporation’s shareholders. 

For income tax purposes, choices available to corporations include C and S corporations, designated by their respective subchapters under the Internal Revenue Code.  If the shareholders of a corporation elect to be taxed under Subchapter S of the Internal Revenue Code, the income of the corporation is generally taxed to the shareholders and not to the corporation itself.

Limited liability companies are a hybrid form of business entity that combine the income tax advantages of partnerships with the limited liability and flexible ownership structure of the corporate form.  Instead of being owned by partners or shareholders, a limited liability company has members, while managers, not officers, run the day-to-day affairs of the business.  Under the limited liability company structure, the obligations and liabilities of the business do not flow to the members and managers based solely upon their holding those positions, similar to the protection provided by the separate legal identity of a corporation.  Unlike the corporate form, however, the limited liability company does not require the observance of many of the strict corporate formalities, such as annual meetings, to maintain the limited liability aspect.

Each form of business entity offers its own set of advantages and disadvantages.  General considerations in choosing the entity include the number of owners and investors, the potential for liability in undertaking the business, tax considerations, the business owner’s preferred level of control and management, continuity and transferability of ownership, costs, and flexibility. For small businesses, I generally recommend the limited liability company form of conducting business because its business operations can be conducted in a more informal manner than is the case with corporations combined with the income tax advantages of the partnership form; however, determining which type of entity is best for you and your business is a fact specific question that should be determined by consulting an attorney.

Professional Services Disclaimer: Please note that the information presented here is as an educational service, and while it contains information about legal issues, it is not legal advice. No warranty is made regarding the applicability of the information presented to a particular client situation, and the information set forth is not a substitute for original legal research, analysis and drafting for a particular client situation.