How to Choose your Business Entity

If you own a business or are considering starting a business, one of the important decisions facing you will be the selection of a business entity. In Illinois, you can choose from the following: a sole proprietorship, a C corporation, an S corporation, a limited liability company, a series limited liability company, a general partnership, a limited partnership and a registered limited liability partnership. Each entity has specific advantages and disadvantages.

A sole proprietorship is not really a business entity. It is an individual operating a business. All income and expenses are reported on the owner’s personal income tax return. The primary advantage of a sole proprietorship is simplicity. No organizational documents are required. The business does not have a separate income tax return, and there are no annual filings with the Secretary of State. The disadvantages of a sole proprietorship are unlimited liability of the owner for business liabilities and the limitation on ownership. A sole proprietorship, by definition, can have only one owner.

A “C” corporation is taxed under Chapter C of the Internal Revenue Code. It is a separate entity under state law and federal tax law. The primary advantage of a C corporation is limited liability for the business owners. If the business is sufficiently capitalized and the owners observe the corporate formalities, business liabilities should not pass through to the stockholders. A corporation can have an unlimited number of owners and can have different classes of stock, for example, common and preferred stock. The shares of a corporation are also freely transferable, meaning that absent a shareholder agreement a shareholder can sell or give his shares to anyone he pleases and the new owner will receive all of the rights of the original shareholder.

The disadvantages of a “C” corporation are income taxation and paperwork and fees. Articles of incorporation must be filed with the Illinois Secretary of State. The filing fee is $150. The corporation must also file an annual report with the Secretary of State ($75 fee) and a franchise tax return (minimum franchise tax of $25). The corporation must file a separate Illinois income tax return and pay tax on net income at 4.8%. The corporation must have bylaws and annual meetings of the board of directors and the stockholders. Stock certificates should be issued, and corporate resolutions are required for various actions such as opening a bank account.

A C corporation subjects the owners to two levels of taxation. The corporation must pay federal and state income taxes on its net income. If the shareholders want to receive the net income, however, the corporation must declare and pay a dividend. The dividends will be taxable income to the shareholders, resulting in a double tax. It is this system of double taxation that makes it especially difficult to own real property (land and buildings) in a C corporation. Many small business owners view the land and the business as different businesses. Owners frequently want to sell their business but keep the land or vice versa. If a corporation sells its real property, the corporation realizes gain on the sale. The gain can be significant because of the depreciation of the improvements. Then, if the owner wishes to receive the proceeds of the sale, the income must be paid out as salary or dividends, both of which are taxable to the owner as taxable income. As a general rule, you should never own real property in a “C” corporation.

An “S” corporation is identical to a C corporation under state law, however, an S corporation is taxed very differently under Chapter S of the Internal Revenue Code. An S corporation must follow the corporate formalities described above, i.e., articles of organization, bylaws, annual meetings, annual report, etc. In addition, the corporation must file an S corporation election with the IRS. The S election allows the corporation to be taxed more like a partnership; income and deductions flow through to the shareholders. With any S corporation, the owners can take distributions from the corporation without recognizing income. In addition, many businesses operate at a loss in the early years. With an S corporation the losses flow out to the stockholders offsetting other income.

The disadvantages of an S corporation are the restrictions set forth in the tax code. An S corporation cannot have more than 100 shareholders, only certain types of trusts can hold S corporation stock, and non-resident aliens cannot be shareholders. In addition, an S corporation can have only one class of stock.

Limited liability companies (”LLCs”) were created in order to obtain the limited liability of a corporation and the pass through taxation of an S corporation without the tax code restrictions. Owners of an LLC are called members. An LLC is controlled by the members or by designated managers. Member interests can be transferred, but the LLC is not required to admit the transferee as a member, meaning that the transferee cannot vote on any matters. A limited liability company is a very flexible and useful business entity. The primary disadvantage of a limited liability company in Illinois is the fees. The filing fee for a limited liability company is $500, and the annual renewal fee is $250. A limited liability company can elect to be taxed as a corporation (including an S corporation) or as a partnership.

A series limited liability company is a new type of entity that allows you to operate several businesses under one umbrella. For example, if you had several rental properties, you could create a different LLC for each property, such as Rental LLC 1, Rental LLC 2, etc. An advantage to using a series LLC over separate non-series LLCs is that the filing fees are less expensive. The fee for filing Articles of Organization for a series if $750 (as opposed to $500 for each individual LLC), and the annual report fee is $250 for the LLC and $50 for each series (as opposed to $250 for each individual LLC). In addition, it is easier to create a new series at any time in the future. Instead of filing new Articles of Organization for $500, you file a Certificate of Designation for $50.

A general partnership is similar to a sole proprietorship except that there are at least two owners. State law does not require a general partnership to have a written agreement, however, it would be foolish not to have one. A general partnership must file documentation with the county recorder’s office. The general partners are personally liable for all partnership debts. Income and losses pass through to the partners, and the partnership does not pay additional income tax. Partnership interests are not transferable, except as provided in the partnership agreement. If any partner withdraws from the partnership, the partnership is dissolved. The remaining partners may, however, establish a new partnership.

A limited partnership is composed of general partners and limited partners. General partners control the partnership and have unlimited personal liability. (A corporation can serve as the general partner, however, if liability is a concern.) Limited partners can only vote on very limited matters such as dissolution of the partnership. They are essentially silent partners and are not personally liable for partnership debts. Limited partnerships offer many of the benefits of LLCs without the higher filing fees.

A registered limited liability partnership is similar to a general partnership except that general partners can limit their liability. The filing fee for a registered limited liability partnership is $100 per partner up to $5,000.

The choice of business entity can have long lasting consequences for your business. Before choosing an entity, you should consult with your CPA and attorney to ensure that you obtain maximum legal and tax benefits.

by Sara Delano Pavlik

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