Category Archives: Business Formation

Entity Formation: LLC or S-Corp

A common question when establishing a business entity for a small business in Illinois is whether it should be formed as a Limited Liability Company (LLC) or an S Corporation (S-Corp).  While S-Corps have a long history, LLCs are relatively new constructs, authorized in 1994 by 805 ILCS 180.  As LLCs have become a more recognized and viable entity over the past two decades, more companies are choosing to organize in this manner and forsake some of the difficulties imposed by the S-Corp form of business.  This post compares some of the major similarities and differences between these two types of entities.

A.       Major Commonalities

  1.  Organization:  Both are formed by filing an organizational document with the Illinois Secretary of State (Articles of Incorporation for the S-Corp and Articles of Organization for the LLC).
  2. Governance:  Both are governed internally by a specific type of organizational document (S-Corps use bylaws; LLCs use an operating agreement).
  3. Liability:  Both provide limited liability for their owners (owners of an S-Corp are called shareholders; owners of an LLC are called members )
  4. Tax Treatment:  Both receive flow-through tax treatment regarding federal taxes (however, differences may arise due to S-Corp being governed by Subchapter S of the Internal Revenue Code whereas LLCs are governed by Subchapter K of the Code).

B.       Major Differences

  1. Number of Owners:  Whereas LLCs may have any number of members, S-Corps may not have more than 100 shareholders.
  2. Types of Owners:  LLCs may have corporations, partnerships and other entities as members whereas S-Corps can (generally) only have individuals as shareholders.  Additionally, S-Corps may not have nonresident aliens as shareholders; LLCs do not have a similar restriction.
  3. Governance:  Unless registered as a close corporation, S-Corps are managed by directors and officers, not the shareholders; LLCs, on the other hand, may be run by managers, directors, officers, the owners, or a combination thereof.  S-Corps must adhere to strict governance procedures, or risk what is known as a “piercing of the corporate veil” in which the owners may lose their limited liability protection.  For example, the failure to hold regular director meetings may be cause to hold the owners personally liable for the company’s obligations.  Outside of filing an annual report with the Secretary of State, LLCs have very few formal governance requirements.
  4. Tax Treatment:  While both entities have the ability for flow-through tax treatment, there are potentially significant differences (for example, an S-Corp may not get flow-through tax treatment if it was previously converted from a C-Corp or if it has excessive net passive income for three consecutive years; conversely, LLCs may be subject to self-employment taxes and may potentially lose its flow-through status if it is classified as a “publicly-traded entity.”

Conversion from an S-Corp to an LLC?

In reviewing the above, one may come to the conclusion that a company previously formed as an S-Corp would be better served by converting to an LLC.  While this can be done in most instances, there are tax and other considerations which must be taken into account.  Furthermore, there are numerous situations where an S-Corp may actually be the better entity.  Early stage technology companies are a prime example of an instance where the corporate form of organization is better than an LLC.  Upcoming posts will address other forms of organization for businesses.

The Small Business

People follow many paths to the point where they start their own business. For some, it is the American dream, a desire they hold all their lives. Others realize that they do not like working for other people-they just want to be their own boss.

Still others see themselves as pushed into going into business for themselves, perhaps because they have lost a corporate job they had always believed was secure. Some business owners start because they want a particular lifestyle, as might a mother who wants to work from home to be near her children. And then there are those who have the vision and drive to create a unique new product or service.

Whatever the reason for starting a business, many experts say that small businesses-which make up 99.7 percent of all employers in the United States-are a prime fuel of the American economy. And each of these business owners confronts a maze of decisions as they establish and move forward with their enterprises.

While there are virtually infinite ways to manage a business and an array of support services available, laws and regulations put boundaries on the choices that a business owner will make. If the business owner has a basic knowledge of the options, he or she can make smarter choices and avoid time-consuming and expensive problems.

One of the earliest decisions a potential business owner makes is how exactly to begin. Selecting a business that fits the owner’s personality, knowledge and resources is a step that usually takes both research and thought. Many people just assume that they will start a business from scratch. But others do not want to do so, and they decide to buy an existing business or a franchise.

In the coming months, we will look at numerous issues facing small business owners, entrepreneurs, and people who want to start their own business.

Introduction to Business Entities (Part 3)

Earlier posts analyzed several forms that businesses can take, including sole proprietorships, partnerships, and corporations.  This post looks at the most recently authorized form of business, the Limited Liability Company, or LLC.  While only available in Illinois for approximately the past 20 years, LLCs are the favored form of business for many small companies, as detailed below.

A limited liability company is an association whose characteristics are a combination of those of a corporation and a partnership. Unlike a partnership, an LLC is a separate legal entity from its owners. The owners are called members and have limited liability in that they are not liable for anything greater than their personal investment in the company. Members are not personally liable for the torts other members commit or any debts or obligations of the LLC.

Limited liability companies may be member-managed or manager-managed. The form of control is set forth in Articles of Organization which must be filed with the Illinois Secretary of State to establish the company.  No further documentation is required to form an LLC, but it is advisable to have an operating agreement, which provides details on the management and operations of the company. In a member-managed LLC, one or more of the owners will run the company. In a manager-managed LLC, the members appoint managers who will run the day-to-day operations of the company.

An additional advantage of an LLC is the flexibility it provides regarding taxation. Members generally elect “pass through” tax treatment (akin to a sole proprietor), thus eliminating any potential “double taxation” problems that corporations encounter.  Members can, however, choose to be taxed as a corporation in situations where that would be beneficial.

The flexibility LLCs provide their owners, the tax benefits, and the simplicity in establishing and running them are major benefits to this structure.  There are instances, however, when a corporate form is a better option and will be discussed in future posts.

Introduction to Business Entities (Part 2)

The last post looked at 3 business entities – the sole proprietorship, the general partnership, and the limited partnership.  Here, we take a look at corporations and, in the following post, limited liability companies.

A corporation is a business entity that is separate from its owners (shareholders) and, therefore, offers its owners limited liability.  Corporations must follow specific rules of operation, or there may be a “piercing of the corporate veil,” meaning the owners may become liable for more than their initial investment in the company.  Corporations may be “publicly” or “privately” held and follow two basic structures regarding tax treatment: C Corporations and S Corporations.

            The traditional form of corporation is a C Corporation.  Most are privately or closely held, meaning their stock is not publicly traded in a market. However, the mega-companies people come into contact with every day are usually publicly traded C Corporations.  Shareholders of smaller C Corporations often also act as directors and officers of the company, whereas larger C Corporations generally have a board of directors and officers distinct from their shareholders.

            Formation and operation of a C Corporation is somewhat complex, as particular rules and formalities must be followed.  To initiate the company, a promoter must file appropriate documents with the Illinois Secretary of State, which include the articles of incorporation. Next, directors must be appointed and bylaws must be created. Finally, all necessary permits and licenses required for operating the business must be obtained.

            Once formed, the corporation must adhere to various formalities, including holding regular meetings of the board of directors and shareholders.  Minutes of meetings must be kept and corporate action must be properly documented.  Finally, an issue that may be overplayed at times, but must be taken into account is the “double taxation” problem C Corporations face.  Simply put, double taxation means that corporate income is subject to income tax and the shareholders are also subject to income tax on dividends they are paid from the corporation. 

            S Corporations are set up and run similar to C Corporations, but differ in tax treatment.  S Corporations are flow through entities and are not subject to double taxation as discussed above.  The S Corporation’s income is reported on each shareholders personal income taxes, based on their percentage of shares owned.  In return for this benefit, S Corporations must adhere to limitations not placed on C Corporations, most notable of which involves the number and types of shareholders allowed.  Otherwise, S Corporations must be governed in a manner similar to C Corporations. 

The next post will discuss what is, in many instances, the best form of organization for small businesses, the Limited Liability Company.

Introduction to Business Entities

In this two part post, I’m going to look at the six major business entities authorized in Illinois.  The legal structure a business takes is of utmost importance when starting a business.  While entrepreneurs need to focus on sales and marketing efforts to bring  their venture to life, they also have to consider their company’s legal structure, as the form the entity takes determines many things, including how it will be taxed, where liability within the entity falls, and who may act on behalf of the entity.  When starting a business, it is important for entrepreneurs to understand the differences between each business structure in order to properly determine which type of entity best suits their needs.  This outline will discuss the sole proprietorship, general partnership, and limited partnership.  Part two will discuss the Limited Liability Company and two types of corporations.

Sole Proprietorship

A sole proprietorship is the simplest, quickest and cheapest way to establish a business.  No forms need be filed with the state and no fees need be paid.  A business license or permit may, however, be required.  Additionally, the business must file a d/b/a (“doing business as”) form with the state if the owner wishes to operate under a name different than his/her exact legal name.  A sole proprietorship is an individually owned and operated business where the proprietor is the one and only owner and decision maker for the business. From a legal standpoint, the entity is not separate from the owner and, as a result, profits and losses from the sole proprietorship are reported and taxed on the owner’s personal tax return.

The simplicity of setting up a sole proprietorship must be weighed against the pitfalls it subjects the owner to, primarily unlimited personal liability, meaning the business owner is responsible for all debts and lawsuits filed against the business.  While insurance may reduce some of the risk inherent in a sole proprietorship, it is generally insufficient to cover all the potential liabilities that may arise.

General Partnership

This is the same as a sole proprietorship, but it involves two people rather than one.  By default, the partners share management and operational control of the entity and also share equally in the profits/losses of the company.  A partnership agreement may, however, establish different amounts of control and/or payments among the partners.  While a General Partnership may be established without any formal filing, it is highly recommended that the partners have an agreement in place which details their rights and duties to each other.

Similar to a sole proprietorship, taxation occurs at the personal level. Each partner is taxed on their income tax return, based on his/her ownership percentage and the amount of income they receive.  While not directly taxed, partnerships are required to file tax returns for informational purposes.  Also like a sole proprietorship, partners in a General Partnership are subject to unlimited personal liability. Each partner is responsible in full for the business’s debts, any lawsuits filed against the business, and torts committed by themselves, their co-partners, and their employees.  Again, insurance can reduce some, but not all of the risk involved here.  Additionally, partners are jointly and severally liable for the company’s debts, meaning that a creditor may go after one partner for the full debt of the company.  There is no requirement for a creditor to obtain equal judgments against all partners.

Limited Partnership

A limited partnership is a partnership in which there are one or more “general partners” as well as one or more “limited partners.”  Under this structure, the limited partners have limited liability (they may lose their investment in the venture, but are not liable for debts of the company).  In return for this limited liability, limited partners can have no management authority.  In effect, a limited partner is simply an investor in the business and if a limited partner does assert any management control, he will lose his limited liability status and revert to a general partner. The managers of this type of entity are the general partners, whose rights and duties are the same as those described in the general partnership section above.  Limited partnerships are required to file documentation with the Secretary of State to establish the entity and the company is taxed as a partnership.