A Comparison Guide
Interested in starting a business but not sure where to begin? One of the first things you should consider is how you want your business to be structured. Different structures are better for different situations, so getting some basic information on the difference between business entity types is an important first step.
There are a number of different types of businesses, but the most common are Partnerships, LLCs, S-Corporations, and C-Corporations. Each of these business entity types have benefits and drawbacks.
What is a partnership?
Partnerships are formed when two people start running a business together. Technically, to be in a partnership, two or more people just need to start acting like partners. Often times, people do not even know they are in a partnership. (See 805 ILCS 206/202 for Illinois partnerships) Despite how easy it is to form a partnership, there are several possible problems.
First, a partnership has what is called joint and several liability. This means that any and all partners can be sued for most actions taken within the partnership, regardless of which partner(s) committed the act. Also, if one partner doesn’t pay a business debt, the other partner(s) could be automatically on the hook for the entire amount.
Second, a partnership’s profit and loss is taxed directly to the partners. The up-side is that partnerships are only taxed once, which is not true for corporations. The down-side is that in some cases this can be pretty complicated. For example, if the partnership makes profit but invests it back into the partnership, the partners are still taxed personally as though it was income.
Third, partnerships are very flexible. Partners can structure their relationship however they like (splitting profits 90/10, voting rights, and so on) by putting it in the partnership agreement. However, without a partnership agreement, partners are bound by the default rules in partnership law.
The take-away? A partnership is not the best structure if you want to ensure personal liability protection. But if you are in a partnership, it is important to have an executed partnership agreement in place.
A Quick Note on Sole Proprietorships
Sole proprietorships are another business option for individuals. A sole proprietorship looks a lot like a partnership, but includes only the individual owner of the business. As with a partnership, there is nothing to shield the individual from liability or taking on the tax responsibility.
What kind of company is a corporation?
Corporations are more difficult to set up than partnerships or sole proprietorships. (For Illinois formation, see 805 ILCS 5/2.) They require that the owner(s) file with the state. However, unlike partnerships, corporations have certain protections for the owners.
The first protection of a corporation is that it provides limited liability. Unlike partnerships, a corporation is considered a separate entity from its owners. When a corporation is sued, the money it may lose can (usually) only be taken from the corporation, not the owners. Therefore, the owners are protected from losing more than what they put into the corporation.
When deciding whether to incorporate, or form a C-Corporation, the owner(s) should consider the tax consequences. C-Corporations have their own tax forms, and the corporation’s profits belong to the corporation. So any profits the corporation makes are taxed at the time the profits are reported to the IRS. To get money out of a corporation, owners receive what is called a dividend. This dividend is taxed as income on the individual’s tax forms. So, if you are making money as the owner of a corporation, that money is actually being taxed twice. However, the individual is only ever taxed when they actually receive the money, unlike in a partnership or sole proprietorship.
The actual structure of a corporation is governed by corporate law (in Illinois, 805 ILCS 5). The corporation must have a board of directors that makes decisions like who will be officers (e.g., CEO) in the company. However, some larger decisions need to be voted on by the owners. Owners of a corporation are called shareholders. Shareholders buy parts of the corporation (stock). Shareholders and board members can be the same people.
Finally, because corporations issue stock, they have the option of selling stock. Public corporations can sell stock in the stock market.
What is the difference between an S-Corporation and a C-Corporation?
The main difference between C-Corporations and S-Corporations is how they are taxed. S-Corporations are corporations that elect to be taxed under “Subchapter S” and are only taxed once, similar to a partnership.
There are specific requirements a business must meet to be able to elect to become an S-Corporation, including:
Be a domestic corporation
Have only allowable shareholders
including individuals, certain trust, and estates and
may not include partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders
Have one class of stock
Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
An LLC or C-Corporation that meets the requirements can elect to be taxed as an S-Corporation.
Limited Liability Companies (LLCs)
What is an LLC? Is an LLC a Corporation?
LLCs are not corporations, but rather a sort of combination of Corporations and Partnerships. Because they have many advantages of both partnerships and corporations, they are increasing in popularity. LLC’s are often considered to be the most flexible entity type.
The best part about LLCs is that, like corporations, they provide limited liability, which protects the owners’ personal assets.
Like corporations, LLCs have to be filed with the state. Owners in an LLC are called Members. The LLC can also designate the person or people that run the LLC day-to-day, called Managers. (For Illinois LLCs, see 805 ILCS 180/10.)
Like partnerships, LLC members can structure their business however they want in an operating agreement, the LLC version of a partnership agreement. (See 805 ILCS 180/5.)
The unique part about an LLC is that it can be taxed as a partnership/sole proprietorship, an S-Corporation or a C-Corporation.
Read more about LLCs here.
Here’s a quick summary of the differences:
|Start-up/ Formation||Just start working together||Articles of Incorporation or Certificate of Incorporation filed with state||Incorporate as C-Corp or LLC with the state, then file election with the I.R.S.||Articles of Organization filed with state|
|Agreement||Partnership Agreement||Corporate By-Laws||Corporate By-Laws/Operating Agreement||Operating Agreement|
|Tax||Taxed Once||Taxed Twice||Taxed Once||Choose how to be taxed|
|Liability||Joint and Several Liability (individuals liable)||Limited liability (typically only corporation is liable)||Limited liability (typically only corporation is liable)||Limited liability (typically only LLC is liable)|
|People who run the company||Partners||Board of Directors elects officers to manage day-to-day||Depends whether a C-Corp or LLC||Members or Managers – Members have flexibility to decide how the business is run|
If you still aren’t sure what kind of business is right for you, or you think you want to change the type of business you are in, a small business lawyer could be just what you need. Contact us at email@example.com for more information on how we can help you.
* Thank you to our law clerk, Rebecca Lyon, for her assistance in drafting this blog post.