Determining the best form of legal entity and structure for a new business with a single owner continues to be a challenge for small business owners. The decision should be made only after careful understanding and analysis of the business and its ownership, financial and operational factors, by the business owner, the owner’s accountant, tax adviser and business attorney.
The traditional forms of a sole proprietorship and C corporation continue to look less attractive from general legal, tax, and operational perspectives when compared to the S corporation and Limited Liability Company ("LLC"). While there are a number of resources available that detail and address the opportunities, issues, and problems of these various forms of doing business, this article will very briefly illustrate the major differences, advantages and disadvantages of the sole proprietorship, C corporation, S corporation and LLC.
Sole proprietorship. A sole proprietorship is a business entity that is owned and operated by only one person who has complete liability for all liabilities, complete ownership of all assets (other than leased assets), complete rights to all profits and losses and generally acts as the manager of the business. This form is recommended primarily because of its simplicity - income, expenses, liability for debts and contractual obligations are inseparable with respect to differentiating the owner from the business, with tax gains and losses from the business being simply combined with other personal taxable items.
C Corporation. A C corporation is the most common type of formal business entity structure in the business world and is a legal entity that is separate and distinct from its owners. Most standard corporations are often called "C corporations" which is common business slang to distinguish a corporation whose profits are taxed separate from its owners under subchapter C of the Internal Revenue Code ("Code") , from an S corporation which has special tax treatment described below under subchapter S of the Code. Corporations enjoy most of the rights and responsibilities that a proprietor would possess, that is, a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes.
When stock is purchased, the shareholder becomes an owner in a corporation. Whether a C corporation or an S corporation, the most important aspect of a corporation is the limited liability protection it affords its shareholders. That is, shareholders have the right to participate in the profits, through dividends and/or the appreciation of stock, but are not held personally liable for the company’s debts or other corporate legal liabilities.
S Corporation. In addition to the structural factors identified above for a C corporation, under subchapter S of the Internal Revenue Code, an S corporation is one that elects not to be taxed as a corporation. That is, the S corporation does not directly pay federal income tax on its earnings. Similar to a partnership, it passes its income or losses and other tax items on to its shareholders. There are limits on the number of shareholders as well as the types of shareholders for a corporation to qualify for the S corporation election.
Limited Liability Company. A limited liability company, or LLC, is a relatively new legal form of business, offering limited liability to its owners under most states’ statutory law. It is similar to a corporation from a liability perspective, but is often a more flexible form of ownership, especially suitable for smaller companies with a limited number of owners. Unlike a regular corporation, but similar to an S corporation, an LLC may be treated as a disregarded entity for tax purposes so the income flows directly through to the individual owners.1
Applicable Law. While the sole proprietorship is generally governed by the general rules of law, the S and C corporation both are governed by the state’s Corporation Act, and the LLC is governed by the comparable Limited Liability Company Act.
Establishment. Probably the sole proprietorship’s biggest advantage is the ease and small cost of establishment, in that no filings are necessary and the sole proprietorship formed automatically upon the start of business.
In order to create an Illinois C Corporation or S Corporation, the incorporator needs to file Articles of Incorporation with the Secretary of State at an initial filing cost of $150 plus applicable franchise tax fees. Similarly, the LLC requires Articles of Organization to be filed with the Secretary of State, at an initial filing cost of $500. Once filed with the state, these entities must continue to file annual reports with the Secretary of State, $75 per year and an annual franchise tax for the C corporation and S corporation, and $250 per year for the LLC.
The S corporation must also timely file an IRS Form 2553 in order to formally qualify as an S Corporation, generally 75 days after the corporation has begun conducting business as a corporation, acquired assets or has issued stock to shareholders. Note the corporate entities, the S and C corporations will both require the filing of a separate tax return at the end of the fiscal year, whereas the LLC and sole proprietorship income is reported directly on the owner’s tax return.
Length of Existence. The sole proprietorship cannot exist indefinitely as, by definition, it is based on the longevity of the proprietor/owner and expires when the owner dies. As formal and separate entities, the C corporation, S corporation and LLC may exist in perpetuity.
Purpose. The sole proprietorship, C corporation and S corporation can generally have any lawful, legitimate business purpose. While there are some prohibitions for certain types of businesses that may be applied to an LLC under state law or certain professional licensing statutes that should be reviewed, these limitations are gradually being removed.
Liability. The basic and presumed advantage of the C corporation, S corporation and LLC is the limited legal liability for all members of shareholders and members of these entities. In general, assuming these entities and their principals have adhered to statutory law, and while certain fiduciary duties apply, the liability for debts and other legal obligations of the entity do not pass through to the ownership interests. This is extremely different from the basic fact that the sole proprietor/owner remains personally liable for all debts and legal liabilities of the business. Note however, that an individual is always personally responsible for his or her own negligence.
It should also be noted that this key advantage of the corporate structures and LLCs is not always a given. Courts have established the legal premise of "piercing the corporate veil" where evidence and factors exist that the organization was an owner’s alter ego rather than a separate entity. Certain circumstances that courts consider in this regard include failure to observe corporate formalities, absence of corporate records, dividend nonpayment and inadequate capitalization.
LLC’s continue to be perceived as having more exposure to this potential risk than standard C and S corporations, solely on the basis that there is limited case law for LLC’s in this regard.2 However, as the case law develops for LLC’s there appears to be less and less a practical concern in this regard, as the basic legal concepts applicable to corporations appear to be carrying over by the courts in a generally consistent way. Further, in Illinois, the law specifically provides that an LLC does not need to follow the same corporate formalities that are required for corporations; though attorneys often recommend the formalities be followed just to document the actions of the company.
Transferability. Generally, the C corporation will provide the most flexibility for an owner to transfer, sell or otherwise dispose of an entire or a part of an ownership interest. Obviously, the sole proprietor is at the other end of the spectrum in not providing any real flexibility in this regard. By statute, the S corporation and LLC have statutorily imposed restrictions on the ability to transfer ownership interests that must be carefully reviewed in order to determine what transfer opportunities may exist.
Taxation. A C corporation is the only clearly tax disadvantaged entity in that there is the problematic result of double taxation when the corporate entity is taxed and dividends are paid to shareholder which are then taxable to the shareholder. While the sole proprietorship structure directly eliminates this result, the S corporation and LLC’s key statutory advantage is that they also allow pass through of the income and losses of the entity to the shareholders and members while also bestowing the benefits of limited liability.
Depending upon the circumstances, an existing advantage of an S corporation compared to an LLC, is that an S corporation shareholder’s distributive share of income or loss is not subject to self-employment tax. An LLC member, who generally is treated as a general partner for self-employment tax purposes, will be subject to self-employment tax for any distributive share of profits.
Conclusion. Each business situation is unique and there is no one guaranteed entity that is the absolute right choice that will work in every case to meet the needs of the business owner. It is only through thoughtful consideration of those needs by the owner and his advisors that the best choice can be made.3
1 The Complete Guide to Limited Liability Companies, Wayne Hagendorf, Knowles Publishing, orig. ed. 1995
2"Does the LLC Make the Illinois Close Corporation with S Election Obsolete?", Gail Petravick and Coleen Troutman, Illinois Bar Journal, October, 2007, p, 532.
3 See also www.bizfilings.com.
Gerald A. Cassioppi is a founding member and Managing Partner of Nyberg & Cassioppi, LLC. He has extensive legal and bus-iness experience and is also a Certified Public Accountant. Mr. Cassioppi is a graduate of the University of Illinois, Champaign-Urbana, where he received both his Bachelor of Science degree in Accounting, With Honors, in 1979 and his Juris Doctor degree from its College of Law in 1982. He has served as a member and Vice President of the Naperville District 203 School Board, a member of the Naperville Transportation Advisory Board and Treasurer of the Rotary Club of Naperville, and is presently Chairman of the of the DuPage County Bar Association Business Law Committee and a member of the Illinois State Bar Association.