Business Formation and Entity Selection
We are experienced with the formation of corporations, limited liability companies, and other business entities.
Limited Liability Companies
- General Information
- Operating Agreements – Statutory Considerations
- Questions to Consider When Preparing an Operating Agreement
There are four types of business entities used in Illinois which provide varying amounts of liability protection to their owners: corporations, limited liability companies, limited partnerships and limited liability partnerships. Each of these entities is a creation of Illinois state law and therefore each is formed and governed under the respective statutory authority: the Illinois Business Corporation Act, the Illinois Limited Liability Company Act, the Illinois Uniform Limited Partnership Act and the Illinois Uniform Partnership Act (1997). In addition, business can be conducted in Illinois as a sole proprietorship or as a general partnership, which do not provide liability protection to their owners.
Comparison of Entity Options:
Advantages, Disadvantages and Consequences
The following is a review of the differences in the statutory provisions and case law regarding the organization, control, owner liability, use and operations of corporations, limited liability companies, general partnerships and sole proprietorships.
Limited Liability Companies — General Information
A limited liability company (“LLC”) is a business entity in which all of the owners (called “members”) have limited liability for the acts of the LLC and the other members. The LLC also protects its members against “outside liability”, i.e., the risk that the owner’s equity interest in the entity will be subject to attachment by the owner’s personal creditors. A member of an LLC is not considered a co-owner of, and has no transferable interest in, property or assets of the LLC. Only the member’s “distributional interest” is treated as personal property which may be attached by creditors. A creditor who obtains a judgment against a debtor-member is limited solely to a charging order or lien against the discretionary distributions which are made to the member. The judgment creditor appears to have no other statutory remedies against the LLC’s assets to enforce his claim against the member, although it is possible that a court may permit a creditor to pierce an LLC veil. See In re Ashley Albright, 2003 Bankr.Lexis 291 (Bank. D.Colo. April 4, 2003) and Olmstead v. FTC, Case No. SC08-1009 (Fla. June 24, 2010). An LLC is extremely flexible in its structure and operations and has become the entity of choice for many practitioners forming businesses in Illinois.
There are various types of LLCs that can be formed under the relevant state law. An LLC can be either member-managed or manager-managed. Many states, including Illinois, also provide for the formation of single member LLCs.
In addition, family-owned LLCs can be used to accomplish various estate planning goals. Most states recognize LLCs formed in other states and allow such LLCs to conduct business in the “foreign” state, as long as the LLC registers to do business in the state by filing the appropriate documentation with the Secretary of State of the respective state.
The Illinois Limited Liability Company Act (the “LLC Act”) became effective on January 1, 1994. The LLC Act is codified at Chapter 805 Illinois Compiled Statutes (“ILCS”) Act 180.
The owners of an Illinois LLC are referred to as members. The LLC Act allows LLCs to be either member-managed or manager-managed. In a member-managed LLC, the members are in charge of the management of the LLC, while in a manager-managed LLC, the members elect one or more managers, who operate similarly to the officers of a corporation, and are in charge of the management of the LLC. Therefore an LLC can have either decentralized management, where every owner participates in the management, or centralized management, where the power to make management decisions is concentrated in a group of decision makers composed of less than all the owners, who act as agents of the owners in conducting the ordinary business of the LLC.
An LLC is formed in Illinois by filing Articles of Organization with the Illinois Secretary of State. Pursuant to 805 ILCS 180/5-5. The Articles of Organization are required to include: (i) the LLC’s name (in compliance with 805 ILCS 180/1-10) and address of its principal place of business, (ii) the purposes for which the LLC is organized, (iii) the name and address of the LLC’s registered agent, (iv) the name and address of the LLC’s initial manager(s), if applicable, (v), the name and address of the LLC’s initial members(s), if the LLC is to be member-managed, (vi) the latest date, if any, upon which the LLC is to dissolve or other events of dissolution, if any, (vii) the name and address of each organizer , and (viii) any other provisions related to the regulation of the LLC’s internal affairs that the members elect to set out in the Articles.
An LLC’s name must include the words “limited liability company” or the “L.L.C.” or “LLC” abbreviation. There are certain other requirements and prohibitions regarding an LLC’s name, which are set forth in805 ILCS 180/1-10.
The Illinois Secretary of State charges a filing fee of $500 to file the Articles of Organization for an LLC. The LLC must also pay a fee of at least $250 each year when it files its annual report.
Limited Liability Company– Operating Agreement: Statutory Considerations
An LLC may adopt an operating agreement to govern the operations of the LLC and such agreement may contain provisions which alter the default statutory rules of the Illinois LLC Act (805 ILCS 180/15-5). Almost all of the provisions in the LLC Act may be overridden by the LLC’s Articles of Organization or Operating Agreement. However under 805 ILCS 180/15-5(b) an Operating Agreement may not:
(1) unreasonably restrict a right to information or access to records under 805 ILCS 180/10-15;
(2) vary the right to expel a member in an event specified in subdivision (6) of 805 ILCS 180/35-45;
(3) vary the requirement to wind up the limited liability company’s business in a case specified in subdivisions (3) or (4) of 805 ILCS 180/35-1;
(4) restrict rights of a person, other than a manager, member, and transferee of a member’s distributional interest, under the LLC Act;
(5) restrict the power of a member to dissociate under 805 ILCS 180/35-50, although an operating agreement may determine whether a dissociation is wrongful under 805 ILCS 180/35-50, and it may eliminate or vary the obligation of the limited liability company to purchase the dissociated member’s distributional interest under 805 ILCS 180/35-60;
(6) eliminate or reduce a member’s fiduciary duties, but may;
(A) identify specific types or categories of activities that do not violate these duties, if not manifestly unreasonable;
and (B) specify the number or percentage of members or disinterested managers that may authorize or ratify, after full disclosure of all materials facts, a specific act or transaction that otherwise would violate these duties;
or (7) eliminate or reduce the obligation of good faith and fair dealing under subsection(d) of 805 ILCS 180/15-3, but the operating agreement may determine the standards by which the performance of the obligation is to be measured, if the standards are not manifestly unreasonable.
In preparing an LLC Operating Agreement, it is important to review the default provisions and modify such provisions in the Operating Agreement as appropriate to address the specific objectives, goals and other needs of the LLC and its members.
In a member-managed company, the default provisions of the LLC Act specify that each member has equal rights in the management and conduct of the company’s business. In such an LLC, the members approve the actions and operations of the LLC. Such approval is generally made by a majority vote of the members of the LLC, unless otherwise provided in the Articles of Organization or Operating Agreement. See 805 ICLS 180/15-1(a). The Operating Agreement may modify the standard practice in any number of ways. For example, it may state different voting requirements for specified actions, i.e., a majority for standard business matters, a super-majority (possibly 80%) to incur indebtedness over $25,000, for example, to liquidate or sell the business operated by the company, and unanimous consent to admit new members. Another example of possible modifications in the Operating Agreement would be the establishment of committees, such as an Executive Committee or Strategic Planning Committee. The Operating Agreement could also allocate responsibilities among the member/managers and/or committees.
Under a manager-managed LLC formed under the Act [see 805 ILCS 180/15-1(b)], one or more managers of the LLC has substantial authority to make decisions for the LLC in the manner of a General Partner in a Limited Partnership. In such an LLC, except as otherwise provided in the Articles of Organization or Operating Agreement, (1) each manager has equal rights in the management and conduct of the company’s business; (2) any matter relating to the business of the company may be exclusively decided by the manager or, if there is more than one manager, by a majority of the managers; and (3) a manager (a) must be designated, appointed, elected, removed, or replaced by a vote, approval, or consent of a majority of the members: and (b) holds office until a successor has been elected and qualified, unless the manager sooner resigns or is removed. The Operating Agreement for a manager-managed LLC may also specify modifications from the standard. For example, the number and identity of the managers could be specified. The question of the whether each manager can act independently or must a majority of managers agree on each action could be addressed, i.e., a vote requirements for specific actions by the managers (majority rules for matters in the ordinary course of business, super-majority to borrow money in excess of $25,000, and unanimous vote to enter into a new business or sell an existing business.) The Operating Agreement could state whether the signature of one manager binds the company or whether multiple signatures are required. The removal of managers by the members could require a vote (majority or super-majority) and contain a provision that removal requires cause or can be done without cause.
The following matters require unanimous approval of the Members, [See 805 ICLS 180/15-1(c)], unless modified in the Articles of Organization or Operating Agreement:
(1) the amendment of the operating agreement under 805 ICLS 180/15-5;
(2) an amendment to the articles of organization under 805 ICLS 180/ 5-25;
(3) the compromise of an obligation to make a contribution under 805 ICLS 180/20-5;
(4) the compromise, as among members, of an obligation of a member to make a contribution or return money or other property paid or distributed in violation of the LLC Act;
(5) the making of interim distributions under subsection (a) of 805 ICLS 180/ 25-1, including the redemption of an interest;
(6) the admission of a new member;
(7) the use of the company’s property to redeem an interest subject to a charging order;
(8) the consent to dissolve the company under subdivision (2) of subsection (a) of 805 ICLS 180/35-1;
(9) a waiver of the right to have the company’s business wound up and the company terminated under805 ICLS 180/35-3;
(10) the consent of members to merge with another entity under 805 ICLS 180/37-20;
and (11) the sale, lease, exchange, or other disposal of all, or substantially all, of the company’s property with or without goodwill.
The LLC Act includes certain other provisions such as distribution of profits and losses, voting power, distributions, which generally treat each member as being equal. These provisions can be modified for an LLC which has varying member percentage interests in the Articles of Organization or in the Operating Agreement.
LLCs with one member may be formed in Illinois. A single-member LLC is organized in Illinois in the same manner as a multiple-member LLC and is governed by same provisions of the LLC Act; however many of the governance provisions have limited applicability to a single ¬member entity. Although an Operating Agreement may not be necessary for a single-member member-managed LLC, many practitioners advise such LLCs to adopt an agreement in the event the LLC obtains additional members in the future or a lender to the LLC requires an Operating Agreement. A single-member LLC is generally treated as a disregarded entity for federal income tax purposes.
Questions to Consider When Preparing an Operating Agreement
The following is a list of issues to consider in preparing an Operating Agreement for a Limited Liability Company.
- What happens upon the death of a member? Does the deceased member’s estate have a right to sell the interest back to the Company? If, yes, at what price? Does the Company have a right to buy the interest back from the estate? If, yes, at what price? Typically a formula price is established, such as book value, a multiple of sales or net income etc.
- Limitation on sales during a member’s lifetime. Typically the Company and the other members have a right of first refusal to acquire the interest of another member prior to a sale to a third party.
- Should the Company have an option to purchase the interest of a member, which is transferred by a member in connection with his divorce or bankruptcy? If so, at what price. Typically, this price is lower than the price for death in (1) above.
- Should the Company have an option to purchase a member’s interest if he or she leaves the Company? If so, at what price. Should the member have the right to sell his interest back to the Company if he or she leaves the Company and the Company does not elect to purchase his interest? If so, at what price?
- What happens to the interest if an active member is disabled and cannot return to work?
- What are the terms of any buyback of the interest by the Company and remaining member? Initial cash payment, installment payments over what period of time and interest rate on outstanding amount?
- Should a member be restricted from competing with the Company after he leaves the Company, voluntarily or if he is asked to leave by the other members?
- With regard to passive investors:
- Will the passive investor receive cash distributions equal to return of his investment plus a preferential return prior to distributions of cash flow to active members?
- If yes, what will be the rate of the annual preferential return? Cumulative, compounded?
- How much capital will each member contribute to the Company?
- How will the members fund a cash flow deficit?
- What happens if the members cannot agree on the management of the Company and there is a deadlock?
A corporation is formed in Illinois pursuant to the provisions of the Illinois Business Corporation Act of 1983(“BCA”) which is codified at Chapter 805 Illinois Compiled Statutes (“ILCS”) Act 5 et seq. Corporations are the oldest and most well known types of business entities formed under the relevant statutory authority. Many practitioners and clients prefer using corporations because they believe the history of corporations provides a more established and predictable legal environment.
A corporation is formed in Illinois by filing Articles of Incorporation (“Articles”) with the Secretary of State. Upon issuance of the Articles, the corporation’s shareholders should hold their first meeting at which meeting they should elect the initial directors, if the initial directors are not named in the Articles, and adopt the corporation’s by-laws. The corporation’s directors elect the corporation’s officers at the directors’ first meeting. The business and affairs of a corporation are managed under the direction of a Board of Directors. The Board of Directors approves transactions and other actions of the corporation and, and those actions are carried out by the corporation’s officers. The directors are elected by the shareholders of the corporation. A corporation has centralized management in that the power to make management decisions is concentrated in a group of decision makers composed of less than all the owners, who act as agents of the owners in conducting the ordinary business of the corporation.
A “C Corporation” is a corporation formed pursuant to the BCA but subject to the Federal income tax provisions of “Subchapter C” of the Internal Revenue Code. Subchapter C provides that a corporation is taxed independently of its shareholders, thus creating a double taxation on the earnings of a C Corporation, both at the corporation level and at the shareholder level when corporate earnings are paid out as dividends or the shareholder sells corporate shares.
An “S Corporation” is a federal income tax law classification and designation and is governed by “Subchapter S” of the Internal Revenue Code §§ 1361 et seq. An “S Corporation” is a conduit or “pass-through” entity for Federal income tax purposes, meaning the entity does not generally pay tax on its earnings, similar to the taxation of a partnership or LLC, and avoids the double taxation scenario of a “C Corporation.”
An “S Corporation” is formed and governed pursuant to the BCA in the same manner as a “C Corporation.” A corporation can elect to be treated as an “S Corporation” for Federal income tax purposes by filing Form 2553 Election by a Small Business Corporation with the Internal Revenue Service. This form, with respect to a taxable year, must generally be filed any time during the preceding year or any time on or before the 15th day of the 3rd month of the applicable year. Once a valid election is filed, the corporation continues to be treated as an S Corporation until the election terminates or is revoked.
Section 1361 of the Code specifies a number of requirements for a corporation to qualify as an S Corporation. These restrictions limit the number and types of shareholders which an S Corporation is allowed to have. In general, an S Corporation may not have more than 100 shareholders (with an exception for certain family members who are treated as one shareholder for purposes of the 100 shareholder test), all of the shareholders must be individuals, certain tax exempt organizations, estates and certain trusts and none of the shareholders can be nonresident aliens. An S Corporation can not have more than one class of stock. If the S Corporation violates these requirements at any time during its existence, its election will terminate and the corporation will be treated as a C Corporation for federal income tax purposes.
Sole Proprietorships and General Partnerships
Businesses may also be operated as sole proprietorships or general partnerships. While these entities generally do not require any formal filings (other than assumed name certificates filed at the county level) and can be relatively easy to establish, they also do not offer any liability protection to its owners. Furthermore, both a sole proprietorship and general partnership have decentralized management. In a general partnership every partner is an agent of the partnership and the act of every partner generally binds the partnership. Unless otherwise provided in the partnership agreement, each general partner has equal rights in the management and conduct of the partnership’s business.