Business Start-Up / Entity Selection and Formation

Choices. If you plan to start your own business, expand an existing one with a new division or perhaps create a strategic alliance with another business to help you both better serve an untapped market segment, choosing the proper entity is important for tax implications, ease of operation and liability protection, both from your customers and from each other.

Sole Proprietorship. This is the simplest form of business but also leaves your personal assets at risk. A sole proprietorship is not a separate entity but rather is the owner doing business under her name or an assumed business name. If an assumed name will be used, it must be cleared to be assure that it does not create confusion with any local business or federal service or trademark then registered in each county in which the business will operate. Because this is not a separate entity it does not protect its owner from personal liability for business obligations, and cannot be used for estate planning purposes.

Partnerships. Two or more individuals or entities operating a business and sharing profits and losses is a partnership, whether or not a written agreement is made. A general partnership is a separate entity, distinct from is owners but, like the sole proprietorship, it does not protect its owners from business liabilities. A general partnership may qualify as a limited liability partnership (LLP) and would then shield its partners from business obligations and from acts of any partner. As a result, this entity is typically used by lawyers and accountants seeking to work together while insulating each partner from personal liability for the negligence or misconduct of other partners. A limited partnership (LP), on the other hand, is virtually identical to a general partnership except that it has a general partner that typically operates the business (often a corporation or LLC) and the limited partners are passive investors that risk the amount that they invest but do not otherwise have personal liability for business obligations unless they meaningfully participate in managing the business, sharing in the role of the general partner. The limited partnership is used for specific projects that may have substantial value when completed, like feature films or commercial real estate developments.

Corporations. Before the advent of LLCs, corporations were the default entity of choice for offering personal liability protection for their owners. Corporations are creatures of statute so that there is little flexibility in how they are structured. Certain formalities, like annual meetings and maintaining a corporate record book, are required in order for courts to shield shareholders from personal liability for business obligations. In Illinois, it is possible to form a Close Corporation in which the shareholders directly operate the business without a board of directors. Although originally intended for multiple owners and separate officers, it is possible to have a one-person corporation in which that person wears the hats of officer, director and shareholder. Corporations can also be taxed in different ways, referred to as C or S corporations identified by the corresponding subsection of the Internal Revenue Code.

Limited Liability Company. The limited liability company (LLC) has been available since 1994 in Illinois. It combines the structural flexibility of partnership with personal liability protection of a corporation and the tax characteristics of either form, although the “pass-through” income tax treatment of a partnership is the default making LLCs the obvious choice of entity for owning real estate. LLCs have grown in popularity and, based on recent Illinois court rulings, seem to offer the highest degree of personal liability protection for the day-to-day decision makers (managers) and the owners (members). Additionally, while a transfer of corporate stock typically includes voting rights that would be very disruptive in the hands of a creditor or surviving spouse of a deceased shareholder, the transfer of an LLC membership interest does not include voting rights but only the economic characteristics entitling the transferee to distributions, if any are made, but also burdening the transferee with potential liabilities for losses and taxes. A limited liability company may also establish designated series, typically like corporate subsidiaries or affiliates, that can have separate purposes and own property that is separate from and cannot create liability for, the primary LLC or other series under that LLC. This ability to compartmentalize liabilities associated with particular business lines or real estate makes the Series LLC an excellent choice for those that own multiple real estate parcels or buildings but want to consolidate management and tax liabilities for all into a single entity.

Jurisdiction. The Internet is teaming with strong sales pitches for incorporating in other states, especially Delaware and Nevada. However, if your business is formed in another state but actually located here, it must be “qualified” to do business in Illinois which entails the same initial and ongoing administrative costs as if the business was formed in Illinois. The company would be subject to tax in both the state in which it was formed as well as Illinois and possibly other states in which it is “doing business.” In other words, it generally makes sense to form the business in the state where the business is located.