When you are getting ready to form a business, some important initial considerations include your choice in business structure and classifying your contractors/employees correctly. This article discusses the various types of business structures, along with the pros and cons of each. Further, this article outlines the reasons for correctly characterizing the individuals that work for you and factors to help guide what their classification should be. Lastly, this article includes a checklist of additional considerations to be mindful of during the process of setting up your business.
Choosing the Right Business Structure
There are many considerations to think about prior to starting a business, including choosing the right structure. Depending on the expected needs of your business, you will likely consider either a sole proprietorship, general partnership, limited liability company, or corporation. Each structure offers different benefits and disadvantages to the business owner, thus deciding on the best one for your business is imperative.
A sole proprietorship is an unincorporated business that does not have a distinct legal existence separate from the owner.1 If the business name is different than the owner’s name, then you are required to register an assumed business name.2 Some advantages of this structure include simplicity in organization and the ability to disregard corporate formalities that other structures require such as mandatory annual meetings or election of directors.3 Furthermore, sole proprietorships offer pass-through taxation, which means the business’ profits are taxed at the owner’s tax rate rather than the corporate tax rate. Another benefit to the sole proprietorship is the minimal formation costs. For example, filing your company’s assumed business name with your local county clerk’s office costs only $50. However, there are a few reasons why this structure may not be the right fit for your new business. Because a sole proprietorship is not a separate entity from the owner, the owner will not be shielded from personal liability of business obligations.4 This means that in the case a lawsuit is filed against your business or your business incurs a debt obligation, your personal assets as the owner become at risk.5
A general partnership is formed when at least two or more persons carry on a business for profit, sharing equally in the business’ profits and losses. Unlike sole proprietorships, general partnerships are a distinct legal entity separate from its owners.6 However, similarly to sole proprietors, general partners remain individually and personally liability for the business’ obligations, including debts and liabilities incurred by any other partners in the business.7 General partnerships are also subject to pass-through taxation. Additionally, partners in a general partnership may use their own names for the name of the business or file an application for an assumed business name.8
A corporation is also a separate legal entity from its owners. An important advantage that this structure offers is limited liability for the owners which shields them from personal liability of the debts and obligations of the business. The owners of a corporation are called shareholders and their liability is limited to assets contributed to the corporation.9 The structure of a corporation differs from a sole proprietorship in part because a corporation requires strict observance of corporate formalities to avoid risk of incurring personal liability.10 To organize a corporation, you must submit articles of incorporation to your Secretary of State.11 The filing fee is $150. An important consideration when looking at this structure is the tax treatment of a corporation. Unlike the other business structures mentioned in this article, corporations do not get pass-through tax treatment and are thus subject to double taxation.
Limited Liability Company
A limited liability company is a business entity that is characterized by the limited liability aspect of corporations combined with pass-through tax treatment.12 One or more persons may organize a limited liability company. A limited liability company can be either member-managed or manager-managed.13 An owner of a limited liability company is considered a member.14 A member-managed structure provides owners with responsibility for the day-to-day running of the business. A manager-managed structure allows managers to operate the day-to-day business responsibilities. This option is more appropriate when the owners prefer to be passive investors instead of being hands on in operating the business each day. A limited liability company is formed when you file your business’ articles of organization with your Secretary of State. The filing fee is $150.15
Classifying the Individuals That Work for You
The classification of the individuals that work for your company is important for a few reasons. First, if the individual is an employee, then you are required to obtain workers’ compensation and withhold income taxes. If the individual is an independent contractor, then it is their responsibility to pay their own income taxes. In determining whether an individual is an employee, there are generally two tests used by most states.
For example, in Illinois, the “ABC test” is used in the context of the Worker Payment and Collection Act to determine whether an individual is an independent contractor. Under this test, an individual may be classified as an independent contractor if (A) he has been and will continue to be free from control and direction over the performance of his work, both under his contract of service with his employer and in fact; (B) he performs work which is either outside the usual course of business or is performed outside all the places of business of the employer unless the employer is in the business of contracting third parties for the placement of employees; and (C) he is in an independently established trade, occupation, profession, or business.16
The other test is a common law test and has typically been used to determine status in the context of worker’s compensation claims. Here, the factors considered in analyzing whether an employment relationship exists includes whether the employer (1) may control the manner in which a person performs the work; (2) dictates the person’s schedule; (3) pays the person hourly; (4) withholds income taxes and social security from the person’s compensation; (5) may discharge the person at will; and (6) supplies the person with materials and equipment.17
Another consideration for ensuring the desired classification of the individual that works for you is the risk of vicarious liability. Vicarious liability occurs when one is deemed responsible for the acts of another. The doctrine of Respondeat Superior places vicarious liability on the employers for the actions of their employees that occur within the course and scope of employment. Alternatively, employers are typically on held vicariously liable for their independent contractors when the work is an inherently dangerous activity.
Obtain an Employer Identification Number: When you start to organize your business, if you are considering having employees then you must obtain an employer identification number (EIN). Sole proprietors without employees are not required to register for an EIN, but are still encouraged to do so.
Funding and Investors: Prior to starting your business, it is important to anticipate how your new business is going to be funded. If you have found an investor to help fund your business, there are a few considerations to keep in mind. For example, how involved you are hoping your investor will be or if the investor plans to engage in other investment opportunities that are competitive to your new business.
Non-Disclosure Agreements: Non-disclosure agreements (NDAs) protect your company’s proprietary and confidential information. This can be essential when you are in the early stages of forming a business and are disclosing information about your business to investors, clients, or potential employees.
Operating Agreement: While drafting your own operating agreement is not required, personalizing your operating agreement can ensure the internal functions you expect your company to have are governed accordingly.
Business Bank Accounts: If your new business is a separate legal entity, it is important to keep your personal and business accounts separate.
There is not a one size fits all solution that applies when structuring your business. Each business has their own unique attributes and challenges. To best structure your business for success, set up a free consultation with The Royko Group; our business formation experience can provide critical legal support and guidance for new or growing businesses. For more information, please give us a call at 312-600-8015 or visit our website, https://roykogroup.com.
1 Miriam Leskovar Burkland et al, Ch. 1.3, Business Law: Choice of Entity (IICLE 2020).
2 805 ILCS 405/1.1.
3 Business Law: Choice of Entity at Ch. 1.3.
6 Id. at Ch. 1.4.
8 805 ILCS 405/1.1.
9 Business Law: Choice of Entity at Ch. 1.11.
12 Business Law: Choice of Entity at Ch. 1.22.
14 805 ILCS 180/1-5.
16 Bruger v. Olero, Inc., 434 F. Supp. 3d 647, 652 (N.D. Ill. 2020).
17 Oleksy v. Illinois Workers’ Comp. Comm’n, 2021 IL App (1st) 191939WC-U.
Legal disclaimer: The business information presented in this article does not, and is not, intended to constitute legal advice; All information, and content available in this article are for general informational purposes only. If you require specific legal advice, you should contact a specialist lawyer.