Part of the “Launch It Legally: An Attorney’s Guide to Starting Your Business” series.
Are you ready to start a business? If so, you may find yourself wondering about the best structure for it. There are many factors to consider, including liability protection, taxes, and the desired ownership and management of the business. Below are the most common business structures and their key features.
Sole Proprietorship
A sole proprietorship only has one owner and in fact is the owner—the owner and business are essentially one and the same. As a result, you do not have to file anything or take action to officially become a sole proprietorship.
Because the entity is not separate from its owner, there is no liability protection between the owner and the business. Given the lack of liability protection, this type of business is generally not recommended.
Partnership
A partnership has two or more owners. As with a sole proprietorship, a partnership is not separate from its owners, the partners. Likewise, there is no liability protection between the partners and the business.
The partners share in the profits and losses of the business, and the profits and losses are recorded on the partners’ individual tax returns. Because of the lack of liability protection, this type of business is generally not recommended.
Corporation
A corporation is a business entity governed by a Board of Directors, who manage the business, as well as officers (President, Vice President, Secretary, and Treasurer), who make day-to-day operational decisions. The Board and Officers’ powers are delineated in the corporation’s Bylaws.
For-profit corporations are owned by shareholders. The shareholders own stock (also called “shares”) of the company, and the rights and obligations of the shareholders are outlined a Shareholder’s Agreement.
Corporations are legally formed by filing Articles of Incorporation with a state’s Secretary of State office. The Articles list the business name, the mailing address, registered agent, Board of Directors, officers, and number of authorized shares. As long as corporate formalities are followed (no commingling of assets, appropriate management structure, etc.), there is a liability shield between the business and its shareholders (i.e., the owners). It is important to prepare Bylaws and the Shareholder’s Agreement at the company’s inception, along with the Articles of Incorporation, to minimize disputes in the future and to maintain the important liability shield.
Most states, Illinois included, impose additional obligations on certain professional and medical corporations at incorporation. The Illinois Professional Service Corporation Act and the Medical Corporation Act outline the particularities for incorporating professional service and medical corporations. Future business owners in these industries who are looking to start a corporation should take the time to review these requirements.
Corporations can be taxed as either C-Corps or S-Corps. Note that C-Corps are subject to double taxation, so you should consult with a tax professional to determine if a corporation structure is appropriate for your business.
Limited Liability Company (LLC)
Limited liability companies, or LLCs, are a more recent and highly popular form of business entity, in part because they require fewer corporate formalities. For example, there is no need for officers or a Board of Directors. They are also easier to manage from a day-to-day standpoint.
The person (or entity) responsible for running the LLC is called the “manager,” and the owners are called “members.” Both members and managers owe fiduciary duties to the business, but a member does not also have to be a manager, and vice versa. Instead of owning stock, as in a corporation, members own “interest” in the LLC, and the rights and obligations (as well as the ownership interest) of each member is outlined in an Operating Agreement. While Operating Agreements are not legally required, we highly recommend you have a custom Operating Agreement drafted, to avoid disputes in the future and to maintain liability protection.
Like corporations, LLCs are legal entities that are formed by filing Articles of Organization with the Secretary of State. The Articles list the business name, mailing address, registered agent, and the name and address of the manager(s). Like corporations, LLCs provide liability protection between its owners and the business.
Similar to how certain professional corporations incur additional obligations, some professional LLCs must be formed as a PLLC (a Professional Limited Liability Company). To learn more about PLLCs in particular, see here.
LLCs differ from corporations when it comes to taxation. For tax purposes, LLCs are by default “pass-through entities.” This means that revenue generated by the LLC passes through the business and is taxed to the members on their individual tax returns. The IRS does not recognize LLCs as separate business entities.
This is the first article of “Launch It Legally: An Attorney’s Guide to Starting Your Business,” a series about forming a new business. Stay tuned for future articles on entity types and key business agreements.