What is the right business entity for you?
The legal structure used to set up your new small business is a very important decision that will have ramifications throughout the life of your business. The chosen structure dictates the rights and obligations amongst the owners of the business and the level of financial risk that each of the owners has in the business. Every business is different and many factors need to be consider before choosing the right entity. There are four basic small business entities to choose from. All of them have their own benefits and drawbacks.
A sole proprietorship is the most basic type of small business entity. The vast majority of all businesses in the United States are operated as sole proprietorships. However, a sole proprietorship is not really a separate business entity apart from the individual. With a sole proprietorship, the business operations are owned by one individual who is personally liable for all of the business’s debts. A sole proprietorship is not required to file its own separate tax return. Instead, the profits and losses of a sole proprietorship business are reported to the IRS on the owner’s 1040 Tax Return.
A partnership is similar to a sole proprietorship in that it is very easy to form. A partnership consists of two or more individuals who conduct business based upon a partnership agreement amongst themselves, which need not be written. Like a sole proprietorship, all of the owners remain personally liable for the business’s debts and the partnership pays taxes on its profits by reporting those profits on the individual partners’ 1040 Tax Returns.
Limited liability Company
A limited liability company is a more formal structure than a sole proprietorship or partnership. In order to form a limited liability company, the owners must register the Company with the Secretary of State and then pay an annual fee to keep the company’s registration current. It is wise to draft a formal operating agreement which governs the operation of the company. However even if there is no written agreement, the Illinois Limited Liability Company Act will govern the operation of the business and the relationship of the owners.
One of the main advantages of a limited liability company is that it provides the owners with protection from the debts and liabilities of the business. With a sole proprietorship or partnership, the owners’ personal assets are potentially subject to the creditors of the business. However, with the limited liability company a business creditor cannot look to collect from the business owners’ personal assets, such as bank accounts and real estate, unless the creditor can prove that the owner somehow acted improperly such as by commingling business funds with their own funds. Instead, the creditors can only look to the assets of the business.
A corporation also needs to be registered with the Secretary of State, and it is highly advisable to have formal written corporate bylaws which govern the operation of the business. However, in the absence of such bylaws, the Illinois Corporation Act will govern the business and the rights and obligations of its shareholders.
Like a limited liability company, a corporation is a separate entity apart from its owners and provides protection to the owners/shareholders from the debts and obligations of the business. There are different types of corporations, and in-depth analysis of each of those types of corporations is beyond the scope of this article. However, most of the differences between the different types of corporations relate to taxation.
Important factors to consider
Limited liability companies and corporations provide the most protection to owners from personal liability for the business’s debts. Both limited liability companies and corporations are their own entities separate and apart from the owners. In contrast, the owners of sole proprietorship’s and partnerships remain personally liable for the debts of their business.
An owner of a limited liability company will pay taxes, just as a sole proprietor or owner of a partnership does. All of the business profits are consider personal income to the owner and they are reflected on the owner’s 1040 Tax Return. These are what are known as “pass-through” entities. Meaning that the income from the business passes through to the owner’s personal tax returns.
In contrast, a corporation files its own tax return each year, paying tax on all profits.
Other concerns must be considered when selecting the appropriate business entity. For example, if you plan to seek outside funding, you will need a more formal type of business entity such as a limited liability company or corporation. Further, if you plan to operate a business which will need certain licensing, such as a liquor license, you must also form a separate entity such as a limited liability company or corporation.
After considering the issues described above and discussing them with your potential partners, it is strongly advised that you consult with a qualified attorney with knowledge in small business legal services. The experienced Chicago small business lawyers at Hays Firm LLC have helped hundreds of business owners through the process of establishing their new business entity. Please feel free to contact us anytime to discuss how we can help you.