Someone interested in starting a new business will have to go through the process that every new business owner goes through: deciding if they have what it takes to be an entrepreneur, investigating various business ideas, assessing their chances of success, and, finally, taking the plunge.
For purposes of this discussion, we're assuming that you have selected an idea for your new business and have decided to launch it. We'll focus here on the form that your new business should take. Most of the rules are based on Illinois law, although some federal law is involved.
The first step in creating a business entity is to discuss your options with an attorney who specializes in representing small businesses. The following is an explanation of the options that you'll need to discuss with your attorney. One thing to remember is that your choice is not permanent. You can always change the form of your business as your needs change.
Sole proprietorship. The simplest, cheapest, and most basic form is the sole proprietorship. The advantages are the simplicity, the cost, and the fact that there is no double taxation on the income because a sole proprietor is not a separate taxable entity. The disadvantages are that it is limited to situations where there is only one business owner and that the owner is personally responsible for the business's debts.
There are no costs involved in creating a sole proprietorship, unless you want to call the business something other than your name. If you want to call your new business something other than your own name - even if your name is John Doe and you want to call the business John Doe Enterprises - Illinois law requires you to establish the new name by filling out paperwork, paying a fee, and advertising the new name in a local paper. Although the costs are minimal, the requirements discourage anyone who is not serious about operating under the new name. Probably the best way to get the paperwork rolling is to go to a bank and try to open an account using the new name. The bank will supply you with the paperwork.
Partnerships. The next business entity choice is the partnership, of which there are two types: general partnerships and limited partnership. General partnerships are those where the partners share the partnership's obligations, management responsibilities, and debts. Limited partnerships have general partners but they also have partners who invest in the business but are not otherwise involved in its management.
Just as the sole proprietorship is the simplest form for a one-person business, the partnership is the simplest form for businesses owned by two or more people. Partnerships can be created through a partnership agreement or they can be presumed from the facts, such as where two or more people operate a business without having incorporated or taken any other steps to form a business entity.
The advantages of a partnership are simplicity, flexibility, and a favorable tax treatment because the partners are taxed on their individual returns (in other words, the partnership itself doesn't pay any federal taxes). The disadvantages are that each partner can be individually responsible for the full partnership's debts and that each partner is responsible for the actions of other partners.
The more people you have in a business, the more complicated it gets, of course. Partnerships should have a written agreement spelling out the various duties and responsibilities and determining what happens in the event that one or more of the partners wants to leave the partnership.
Under Illinois law, a limited partnership must have at least one general partner and at least one limited partner. A limited partner's liability is limited to the amount that he or she invests in the partnership. The limited partner, however, has no say in how the partnership is managed. Limited partnerships in Illinois must apply for a certificate of limited partnership from the Illinois Secretary of State, which has to be renewed every two years. There are other requirements, such as requiring a certificate of cancellation where partnerships are dissolved, which make limited partnerships more onerous to form in Illinois than general partnerships.
Limited liability companies. Illinois businesses also have the option of forming a limited liability company (LLC). LLCs are corporations that are taxed as partnerships. There are filing requirements and other statutory rules that must be followed. The big advantage of this business form over partnerships is that general partners are not responsible for the acts of other partners. General partners, however, continue to be responsible for the partnership?s debts, as well their own acts. The advantage over S Corporations (see below) is that there are no limits on the number of shareholders.
The disadvantage compared to partnerships is that filing requirements and other restrictions for limited liability companies are more burdensome than for general partnerships. The result is that general partners get the tax benefits of a partnership together with some protections afforded corporations.
Corporations. Another choice for businesses owners is the corporation. Corporations are formed by filing articles of incorporation with the Illinois Secretary of State. The biggest difference between a corporation and the other forms is that a corporation is a separate legal entity that pays taxes, enters into contracts, files for bankruptcy, and does other things that people do.
The advantages of forming a corporation are that those who form the corporation are not personally responsible for the corporations debts, earnings can be retained without having to pay taxes on them, ownership is more easily transferable, owner fringe benefits are easier to provide, and multiple ownership is far easier. The disadvantages are that it is more expensive to form than the other choices, administration is more complicated because of the various statutory requirements, and double taxation exists (taxes are paid on earnings, some of which are distributed to shareholders, who then pay a tax on the distribution).
S Corporations. S Corporations operate much as corporations do, except that the shareholders are taxed similar to the way that partnerships are taxed. In this way, the double taxation described above is avoided. The advantages of an S Corporation are that it can be formed by one person and shareholders get favorable capital gains treatment. The disadvantages are that there are limits on the number of shareholders and that they can offer only one class of stock, which may limit their ability to raise capital.