By Affiliate Colleen Pleasant Kline
There are many different kinds of legal entities: sole proprietorships, limited liability companies (“LLCs”), general partnerships, limited partnerships, limited liability partnerships, trusts, and corporations to name a few. I am going to focus on four of the most commonly created entities below. Each type of entity has different liability protections and tax treatment. When forming your business entity you should ask yourself two basic questions 1) how much liability risk to your personal assets are you willing to take; and, 2) how much tax would you like to pay?
Sole Proprietorship. To form a sole proprietorship, you must simply commence business. A sole proprietor is personally liable for all debts, obligations and liabilities of the business. A sole proprietor is disregarded for income tax purposes (meaning all income is reported as self-employment income of the owner).
General Partnerships. General partnerships are when one or more parties decide to commence business together. It is often evidenced by a written partnership agreement, but can also be created without one. The risk is that as a general partner you can be held personally liable for the actions of your partner in connection with your business.
Limited Liability Company (“LLC”). Owners or members or limited liability companies are generally not personally liable for the debts, obligations or liabilities of the LLC. An LLC can be owned by one party or by multiple parties. In addition to filing Articles of Organization, the parties should also enter into an operating agreement. Although an operating agreement is not required under Maryland law, this is highly recommended. An operating agreement outlines the buy-sell provisions, management provisions and other general terms of how you would like to operate the business. Although there are statutory provisions that govern a LLC in the absence of an operating agreement, these default provisions may have unintended consequences if there is later a dispute with the other owners. There is a great deal of flexibility in how you decide to manage and operate the LLC. Unlike a corporation, a LLC does not require formal annual meetings or minutes to maintain its separate legal status. Generally, a LLC has great flexibility in how it can elect to be taxed. Unless the LLC elects to be taxed as a corporation, for tax purposes it is treated as a sole proprietorship if there is one owner, or as a partnership if there are more than two owners. Frequently the LLC owners prefer partnership tax treatment over corporation tax treatment, because a partnership has “flow through taxation,” which means that the profits and income of the LLC are taxed only at the ownership level. A single member LLC or a multimember LLC can elect to be taxed under Subchapter S.
“S-Corporations.” S-Corporations are not a different kind of entity. This is actually a tax status. Just like if you are married, you can elect to file your taxes as married jointly or married separately. A S-election can be made even if the business is not a corporation. The entity merely files a form with the IRS. In order to be eligible to make a S-election, your business cannot have more than 100 owners, all of whom must be U.S. citizens and natural persons (or certain trusts for natural persons). In addition, other than having voting and non-voting ownership interests, all owners must have the equal rights and receive distributions in proportion to their ownership interests. In other words, any entity being taxed under subchapter S cannot have preferred equity.
Corporation. A corporation has formal legal requirements, including filing Articles or Certificate of Incorporation, bylaws, annual minutes and meetings of directors and stockholders. The failure to observe these formalities could result in a loss of the liability shield. Maryland recognizes a “Close Corporation”, which allows a closely held company to elect not to have a board of directors and it also provides some wiggle room on the formalities involved if the charter of the corporation makes this election. There are strict statutory requirements that govern close corporations absent a stockholder’s agreement, which may have unintended consequences if you are not familiar with them. All corporations must have designated a President, Secretary and Treasurer as officers. Generally, unless the corporation makes an election to become taxed under subchapter S, a corporation is subject to two levels of tax, one at the corporation level and another at the owner level.
DISCLAIMER: Opinions and conclusions in this post are solely those of the author unless otherwise indicated. This article is for general information purposes and is not intended to be and should not be taken as legal advice on any particular matter. It is not intended to and does not create any attorney-client relationship. Since legal advice must vary with individual circumstances, do not act or refrain from acting on the basis of this article without consulting professional legal counsel. If you would like additional information on the subject matter of this article, please feel free to contact the author. IRS CIRCULAR 230 NOTICE: Any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding federal tax penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
