by Elizabeth BoweryStarting a new business: Deciding the type of business entity to establish
One of the first decisions a new business owner faces is choosing the best type of business entity to establish. Which entity is best for a particular venture depends on several considerations, including how the business is going to be owned (by a single person, by a small number of people, by a primary owner with a number of investors, etc.), the extent to which protecting the owner’s personal assets from the company’s creditors is important, tax implications (such as avoiding double taxation), and the costs associated with starting the business.
There are various types of business entities in the United States. Each state’s law governs how a business is formed in that particular state. Once formed in one state, a business entity can then also operate in other states, as long as it meets the criteria for qualifying to do business in each of those states. The most common forms of business entities are:
- Sole Proprietorships
- Partnerships (including general partnerships and limited partnerships)
- Corporations (including so-called C-corporations and S-corporations)
- Limited Liability Companies
Sole Proprietorships
A sole proprietorship is an unincorporated business that is owned by one individual. There is no legal separation between the owner and the company. As a result, if the business assets are not sufficient to cover the debts and obligations of the business, the owner may be personally responsible for paying debts of the business. As to taxes, the business is not taxed separately from the owner in a sole proprietorship. Instead, the owner is subject to personal and self-employment taxes for federal taxation purposes. In addition, Maryland sole proprietors report their net business profit or loss with their other income and deductions on their personal state tax return and are taxed at individual rates. While no paperwork needs to be filed with the state to form a sole proprietorship, startup costs may include a trade registration (if the business is trading under a name distinct from the owner’s) and, depending on the industry, any required business licenses, permits, or insurance.
Partnerships
A partnership is an unincorporated business in which ownership is shared between two or more people. There are several types of partnerships. In a general partnership, all of the partners manage the business and have unlimited personal liability for the debts and obligations of the business. In a limited partnership, there is only one general partner who manages the business, and one or more limited partners who do not participate in the management of the business. The general partner has unlimited personal liability, but the limited partners have more limited liability, being responsible only to the extent of their investment. In a limited liability partnership, each partner enjoys limited liability for the debts of the partnership and may participate in managing the business.
Partnerships are considered “pass through” entities, where the business itself is not taxed and the business’ profits or losses “pass through” to its owners. Federally, the partnership must file an information return to report its financials. Each partner is subject to personal tax and is taxed at individual rates. General partners are also subject to self-employment tax. In Maryland, partnerships must file an information return to report their financials. The partners report their net business profit or loss with their other income and deductions on their personal tax return and are taxed at individual rates.
The startup expenses are comparable to those of a sole proprietorship in that the partnership may choose to register a tradename and the required business licenses, permits, or insurance are industry specific. However, while the state does not mandate formation documents for the creation of a partnership, prudent business owners will enter into a partnership agreement to clearly establish the partner’s rights and the partnership’s operational structure.
Corporations
C-Corporations
A corporation is a legal entity that is separate from its owners. Corporations are owned by shareholders, which may be individuals or other business entities. As a distinct legal entity, a corporation possesses its own legal identity and can be held legally liable for its business debts and obligations to the extent of the corporation’s assets. Shareholders, by contrast, are generally not personally liable. Moreover, as a separate legal entity, a corporation is subject to federal and state income taxes. The default tax classification for corporations is a so-called C corporation—a corporation that is taxed under Subchapter C of the Internal Revenue Code. C corporations are taxed twice, which is often referred to as “double taxation.” Income earned by a corporation is first taxed at corporate tax rates. Then, if the corporation distributes income to shareholders as dividends, the income is taxed again at individual rates. In practice, the corporation files federal and state corporate tax returns, and the shareholders report the dividends they received as part of their income on their federal and state tax returns.
There are several expenditures associated with starting a corporation. To form a corporation in Maryland, the owners must file Articles of Incorporation with the State Department of Assessments and Taxation, and it carries a filing fee. After the Articles of Incorporation are reviewed and accepted, the corporation’s board of directors is required to hold a meeting where they adopt bylaws (rules that govern the corporation), and there are often legal fees involved in drafting corporate bylaws. Lastly, similar to the other entity types, costs may also include a trade registration, along with any required business licenses, permits or insurance.
S-Corporations
A so-called S-Corporation (S corp) is a corporation that elects to be taxed under Subchapter S of the Internal Revenue Code rather than being taxed as a C-corporation (C corp) under the default rule (as described above); it is a federal tax classification, and the state laws governing corporations do not distinguish between the two. S corps share many similarities with C corps, including the fact that both are separate legal entities, so shareholders are not personally liable for the corporation’s debts, and both typically incur the same range of startup expenses. The main difference between the two lies in the tax advantage offered by an S corp. S corps are “pass through” entities (as described above), thus the S corp is not subject to corporate tax, and income distributed to shareholders is reported as part of their income on their federal and state tax returns. Another difference is that while C corps have no restrictions on ownership, S corps are subject to several limitations, including the requirement that they be owned by individuals (not other business entities) and are limited to 100 shareholders.
Limited Liability Companies
A Limited Liability Company (LLC) offers advantages found in partnerships and corporations. Similar to C corps, LLCs face no restrictions on who can be an owner, and since the LLC is a separate legal entity, its members are protected from personal liability for the LLC’s debts and obligations. Regarding taxation, LLCs can choose to be taxed as a partnership or corporation. An LLC with two or more members is classified as a partnership unless it elects to be taxed as a corporation. If taxed as a partnership, the LLC can avoid the double taxation typically associated with corporations and benefit from “pass through” taxation (as described above). In this case, the LLC is not taxed, and the members report their income on their individual tax returns and are taxed at individual rates. The members are also subject to self-employment tax. The startup expenses are similar to those of a corporation, as, in Maryland, the owners of an LLC must file Articles of Organization with the State Department of Assessments and Taxation to form the company. While Maryland law does not mandate the creation of an operating agreement, it is strongly recommended to have one drafted (if there will be more than one member) to define the members’ rights and the company’s operating procedures. LLCs, like the other business entities, may incur additional costs, including trade registration, as well as any necessary business licenses, permits or insurance.
Consult with a Business Lawyer Before Choosing a Business Entity
Choosing the best type of business entity is an important decision that is often fraught with questions. As business lawyers, we can help you navigate legal complexities so you can focus on growing your business. We assist business owners at every stage of ownership, offering guidance in selecting the best entity, drafting customized governing documents, and providing ongoing business counsel.
by Steve LewickyStructuring the Purchase or Sale of a Business: Asset Sale vs. Stock Sale
There are three ways to structure the purchase or sale of a business: As a sale of a corporation’s stock or of a limited liability company’s member interests (generically referred to as a “stock sale”), as a sale of some or all of the company’s assets, or through a merger. Each of these approaches offer its own advantages and considerations for Buyers and Sellers, including tax implications, liability exposure, and the relative complexity of the transaction. Liability exposure can be a very important consideration, but in this article I will be discussing only the tax implications of selecting between an asset sale and a stock sale.
Tax Advantages to Buyers in an Asset Sale
Beyond gaining protection from assuming the liabilities of the acquired business, a significant benefit for the Buyer in an asset sale is the ability to step up the tax basis of acquired assets to their fair market value. This can yield substantial and ongoing financial benefit to the Buyer. The stepped-up basis mechanism allows Buyers to reset the tax basis of acquired assets to their purchase price, rather than inheriting the Seller’s existing tax basis. As an example, let’s consider a piece of manufacturing equipment:
In a stock purchase, if the original owner purchased the equipment for $200,000, claimed $150,000 in accumulated depreciation, and the equipment at the time of the acquisition has a fair market value of $120,000, the Buyer would inherit a tax basis of $50,000 ($200,000 – $150,000), would have limited future depreciation deductions, and would have a potential taxable gain of $70,000 if the asset is later sold at its $120,000 fair market value. In an asset purchase, however, the Buyer would receive a new tax basis of $120,000 (the current fair market value), would gain access to fresh depreciation deductions calculated from the stepped-up basis, would minimize or eliminate taxable gain on any future sale at fair market value, and would generate higher annual tax deductions, thereby improving cash flow. Stepped-up basis extends across various asset categories, including physical assets (buildings, equipment, and furnishings), intangible assets (patents, trademarks, and customer relationships), and goodwill.
For corporations in the 21% corporate tax bracket, the tax savings from stepped-up basis can be substantial. If a transaction includes $500,000 in stepped-up basis, the Buyer could realize tax savings of $105,000 over time, through increased depreciation deductions. These tax advantages often influence acquisition negotiations, since Buyers may be willing to pay a premium for assets due to the long-term tax benefits of stepped-up basis. This benefit has to be weighed against the Seller’s potential need for a higher purchase price to offset its increased tax burden in an asset sale.
Another benefit for the Buyer in an asset sale are opportunities for enhanced depreciation and amortization deductions, thanks to the step-up in basis. Depreciation applies to tangible assets such as buildings, equipment, and vehicles, while amortization applies to intangible assets (patents, customer relationships) and goodwill. Both mechanisms allow companies to deduct the cost of assets over their prescribed useful lives, reducing taxable income and generating tax savings. As an example, let’s consider a transaction involving manufacturing equipment valued at $500,000, customer relationships valued at $250,000, and a commercial building valued at $1,000,000. In a stock purchase, the Buyer will inherit the Seller’s existing tax basis. If the Seller has already claimed significant depreciation, the Buyer’s future deductions would then be limited. For instance, if the equipment has a depreciated basis of $100,000, the Buyer could only claim future depreciation on that amount, even though the Buyer presumably paid market value for the equipment in the acquisition transaction. In an asset purchase, however, the Buyer can claim depreciation and amortization based on the full fair market value of the assets. In the above example, the manufacturing equipment (valued at $500,000, with a 7-year depreciation schedule), would have annual depreciation of about $71,428, with an annual tax savings of about $15,000 at a 21% corporate tax rate. That would be a tax savings over the depreciation period of $105,000. The customer relationships (valued at $250,000 in this example, with a 15-year amortization schedule), would result in an annual amortization of $16,667, and annual tax savings (at a 21% corporate rate) of $3,500, for a total tax savings over the amortization period of $52,500. The commercial building (valued at $1,000,000 in this example, with a 39-year depreciation schedule), would have annual depreciation of about $25,641, yielding annual tax savings of $5,285 at a 21% corporate rate, resulting in aggregate tax savings over the depreciation period of $210,000.
The tax code may provide further opportunities to accelerate these benefits through its bonus depreciation provisions. Current tax law allows for 100% first-year bonus depreciation on many qualifying assets, enabling immediate write-off of their entire cost. While this provision doesn’t apply to buildings or to most intangibles, it can significantly accelerate tax benefits for eligible assets.
The parties may state, in their purchase-sale agreement, an agreed upon allocation of the purchase price, which can affect the timing of tax benefits. Buyers often benefit from allocating more of the purchase price to assets with shorter recovery periods. Any agreed-to allocation must be reasonable and supportable, however, in order to pass muster with the IRS.
Enhanced depreciation and amortization can create temporary differences between book and tax income, resulting in deferred tax liabilities. These enhanced deductions represent a significant financial advantage of asset purchases, often justifying higher purchase prices or providing additional negotiating leverage. The present value of accelerated tax savings can materially improve the Buyer’s return on investment and provide additional cash flow for debt service or business reinvestment.
Another significant financial advantage to an asset purchase is the ability to amortize goodwill for tax purposes. This is not available in a stock purchase. Goodwill emerges when a Buyer pays more than the fair market value of identifiable assets, reflecting the additional value attributed to intangible factors such as brand reputation, customer relationships, employee expertise, market position, and potential synergies. This premium often represents a significant portion of the purchase price in business acquisitions. Goodwill can be amortized over a 15-year period, generating substantial tax savings for the acquiring company.
If a Buyer acquires a business for $5 million, but the identifiable assets have a fair market value of $3.5 million. The $1.5 million difference represents goodwill. The tax treatment of this goodwill varies dramatically between asset and stock purchases. In a stock purchase transaction, the Buyer receives no tax benefit from the goodwill premium. While the goodwill is recognized for accounting purposes, it cannot be amortized for tax purposes, resulting in no tax deductions over the life of the asset. In an asset purchase transaction, however, the tax treatment can be far more advantageous. In the above example where there is $1.5 million in goodwill, there would be an annual amortization deduction of $100,000 ($1.5 million over 15 years), which would yield annual tax savings of $21,000 at a 21% corporate tax rate, and total tax savings over 15-year period of $315,000. This tax treatment not only converts what otherwise would be a non-deductible purchase premium into tax-deductible amortization over the amortization period, but also allows companies to forecast tax benefits with certainty. The present value of goodwill amortization tax savings often justifies paying a higher purchase price.
To secure these tax benefits, Buyers must ensure that the allocation to goodwill stated in the purchase-sale agreement is reasonable and supportable, is based on proper valuations, documented in the purchase agreement, and is reported consistently on tax returns. While tax treatment allows for straight-line amortization, accounting rules require periodic impairment testing, which requires separate tracking systems, deferred tax accounting, regular monitoring and reporting, and compliance with tax and accounting requirements.
The goodwill amortization benefit represents one of the most compelling reasons Buyers generally prefer asset purchase structures. The ability to generate substantial tax savings over a 15-year period often influences both deal structure and purchase price negotiations.
Advantages to Sellers in an Asset Sale
Although the asset sale structure generally favors Buyers, Sellers potentially can receive a higher purchase price in an asset sale, to offset tax implications, and an asset sale gives a Seller the ability to retain particular assets or intellectual property. If some but not all of the business assets are sold, then the Seller has the option of continuing to operate with its retained assets (if not prohibited from doing so in the purchase-sale agreement), and the Seller may have some flexibility in handling remaining liabilities of the business.
Tax Advantages to Sellers in a Stock Sale
Stock sales typically provide Sellers in corporate acquisitions with more favorable tax treatment than do asset sales, and Sellers therefore often prefer this transaction structure. Tax advantages come in the form of lower effective tax rates and simplified tax treatment. The fundamental tax benefit of a stock sale lies in its single-level taxation at preferential capital gains rates. When corporate shareholders sell their stock, they pay tax only once, on the difference between the sale price and their basis in the stock. Current federal long-term capital gains rates max out at 20%, but with additional state taxes that vary by state. Let’s take the example of a C-Corporation sale with a sale price of $5 million, and a tax basis of $3 million, resulting in a capital gain of $2 million. With an asset sale, this transaction would result in double taxation. First, the C-Corporation would recognize the $2 million gain that would be taxed at the federal corporate tax rate of 21%, resulting in a corporate tax liability of $420,000, and net proceeds to the corporation after this tax of $4.58 million. Thereafter, if or when the proceeds are distributed to shareholders, the federal capital gains rate of 20% will be applied to this $4.58 million, resulting in shareholder tax liability of $916,000. The combined tax burden at both levels of taxation in this example would be $1.08 million, resulting in an effective tax rate on the gain of about 67%.
The same transaction structured as a stock sale would result in a single level of taxation at the shareholder level. In the above example, the $2 million gain would be taxed at the 20% federal capital gains rate for a total tax liability of $400,000, for an effective tax rate on the gain of 20%. In this example, there would be a tax savings for the Seller of $935,000, comparing the tax sale scenario to the asset sale scenario.
Capital gains rates present a substantial advantage over ordinary income tax rates, of course. While ordinary income tax rates can reach 37% at the federal level, long-term federal capital gains rates are typically 20% for high-income Sellers, with additional state tax rates varying by jurisdiction. To secure capital gains treatment, stock must be held for more than one year to qualify for long-term capital gains rates, the transaction must represent a genuine sale or exchange of a capital asset, the Seller must maintain proper documentation of their basis in the stock, and the sale must be properly structured and executed.
C-Corporations benefit most dramatically from stock sale treatment, as a stock sale eliminates the double taxation inherent in the C-Corporation structure. The avoidance of corporate-level taxation represents a pure tax savings that flows directly to shareholders’ bottom line. The above example considered a C-Corporation, but tax treatment depends on entity type.
S-Corporations also benefit from stock sale treatment, though the advantage is more nuanced. While S-Corporations generally avoid double taxation even in asset sales, stock sale treatment ensures the entire gain receives capital gains treatment, rather than having portions potentially taxed as ordinary income depending on the character of underlying assets.
Limited Liability Companies and partnerships, when selling membership interests or partnership interests, typically receive treatment similar to stock sales, providing comparable tax benefits to their owners — but asset sales for partnerships may result in ordinary income treatment for certain assets, and there may be complexity in allocating gain among partners.
In addition to having advantage in applicable rates of taxation, stock sales also eliminate concerns about depreciation recapture that may occur in asset sales, where equipment and machinery gains may be taxed as ordinary income, real estate depreciation may be recaptured at 25% rates, and other asset classes may trigger different tax rates. Stock sales also eliminate the need to characterize gain on an asset-by-asset basis, thereby reducing complexity in state tax compliance, simplifying tax reporting and compliance, and providing greater certainty in tax outcome. Stock sales also can avoid multiple state tax filing requirements, reduce exposure to state transfer taxes, and simplify compliance across jurisdictions.
Advantages to Buyers in a Stock Sale
While the stock sale structure typically favors Sellers, a stock sale gives the Buyer a simpler transaction structure, with fewer formal requirements, along with automatic transfer of contracts, licenses, and permits. There is no need to retitle individual assets, as there would be in an asset sale. A simpler transaction structure results in reduced transaction costs and complexity. A stock sale also allows seamless continuation of business operations, preserves existing contracts and relationships of the business, maintains existing permits and licenses, and retains the corporate entity and tax attributes.
Section 338(h)(10) Election
In some circumstances, Section 338(h)(10) of the Internal Revenue Code provides a sophisticated mechanism that allows C-Corporations to combine the legal benefits of a stock sale with the tax advantages of an asset sale. This election represents a hybrid approach, where the transaction is legally executed as a stock purchase while being treated as an asset purchase for federal tax purposes. To qualify for this election, the purchasing entity must be a corporation (not an individual or partnership), the Buyer must acquire at least 80% of the target company’s stock in a taxable purchase, the target must be either an S corporation or a subsidiary member of a consolidated group, and both Buyer and Seller must formally agree to make the election.
When a Section 338(h)(10) election is made, the transaction is treated as a hypothetical asset sale followed by a liquidation of the target company. The target company is deemed to have sold all its assets to a new corporation at fair market value, and the Buyer receives a stepped-up tax basis in the acquired assets. For S corporations, shareholders experience a single level of taxation. The transaction avoids double taxation typically associated with C corporation asset sales.
The Buyer obtains stepped-up basis in assets for enhanced depreciation and amortization, benefits from the legal simplicity of a stock acquisition, avoids need to transfer individual assets or obtain third-party consents, and preserves valuable contracts and permits that might be non-transferable. The Seller achieves potentially higher purchase price due to the Buyer’s tax benefits, maintains transaction efficiency of stock sale, avoids the complications of an asset-by-asset transfer, and might receive more favorable overall tax treatment compared to straight asset sale. The election process involves specific timing and procedural requirements, however. The election must be filed by the 15th day of the 9th month following the acquisition month, requires formal agreement between Buyer and Seller, and is irrevocable once made. In addition, the purchase price must be allocated among assets according to IRS rules.
While potentially advantageous, a Section 338(h)(10) election may result in state tax treatment that differs from federal treatment, and there are complex valuation and allocation requirements. The election may result in higher taxes for the Seller when compared to a straight stock sale.
Summary
The choice between an asset sale and a stock sale requires careful consideration of a number of factors, including the tax implications discussed above, as well as liability exposure, transaction complexity, and circumstances that may be applicable to the particular business involved. Asset sales generally favor Buyers due to tax benefits and for reasons of risk management, and stock sales often appeal to Sellers due to tax efficiency and transaction simplicity. The optimal structure depends on the specific circumstances of the transaction and the priorities of the parties.
The availability of Section 338(h)(10) elections adds another layer of sophistication to the structure decision, potentially offering a beneficial hybrid approach that combines the advantages of both asset and stock sales. However, this option requires careful analysis and consideration of all parties’ circumstances and objectives.
None of the information provided in this article constitutes legal advice or tax advice. Every situation is different and should be thoroughly reviewed by and discussed with your legal and tax advisors. Please do not rely on the contents of this article as the basis for making decisions regarding your particular situation. If you are contemplating the purchase or sale of a business in the State of Maryland, Lewicky, O’Connor, Hunt & Meiser stands ready to provide legal support for your contemplated transaction.
by Samantha ChanThe Americans With Disabilities Act Requires Employers to Offer Reasonable Accommodations to Employees with Disabilities
The Americans With Disabilities Act (ADA) and Maryland law require employers to provide reasonable accommodations to qualified employees with disabilities, unless doing so would cause undue hardship to the employer. Navigating requests from employees with disabilities for reasonable accommodations can be complex, but it is a critical responsibility for employers in Maryland. Here’s some of the things that employers need to be aware of to comply with the law and to foster an inclusive workplace.
What Are Reasonable Accommodations?
Reasonable accommodations are adjustments or modifications that enable an employee with a disability to perform the essential functions of his or her job. The required accommodation will be specific to each situation, but some illustrative examples are:
• Providing assistive technology or adaptive equipment;
• Adjusting work schedules to allow for medical appointments;
• Modifying workplace policies or practices; or
• Making physical changes to the workspace, such as installing ramps or ergonomic desks.
When Is an Accommodation “Reasonable”?
Accommodations are considered reasonable if they effectively address the employee’s needs without imposing significant difficulty or expense on the employer. Factors such as the size of the company, the nature of the request, and the cost of implementation are key considerations.
Employer Responsibilities Under the ADA
1. Engage in an Interactive Process: Employers are legally required to engage in a good-faith dialogue with the employee to understand their limitations and determine an appropriate solution.
2. Maintain Confidentiality: All medical information related to the request must remain confidential.
3. Avoid Retaliation: Employers cannot retaliate against employees for requesting accommodations.
Common Mistakes to Avoid
• Delaying the Process: Timely responses to requests are essential. Unreasonable delays can lead to liability.
• Rejecting a Request Without Consideration: Employers must assess all requests thoroughly before deciding if an accommodation is unreasonable.
• Failing to Document the Process: Keeping detailed records of discussions and decisions can protect against claims of noncompliance.
Get Professional Guidance
Navigating accommodation requests can be tricky, especially when determining whether an adjustment constitutes an undue hardship and because there is no one-size-fits-all policy. An attorney can help an employer understand its obligations, minimize legal risks, and ensure compliance with federal and Maryland-specific laws.
If you’re dealing with an accommodation request or need assistance crafting policies to comply with the ADA, contact Lewicky, O’Connor, Hunt & Meiser at (410) 489-1996 or [email protected] today.
by David HisleMaryland Has Lowered the Age of Court Jurisdiction Over Juvenile Cases
In Maryland, anyone under the age of 18 is considered a child / juvenile. Children who are charged with and/or commit crimes are not treated the same as adults. In fact, a criminal offense committed by a child is deemed a delinquent act – a delinquent act is any offense that would be considered a crime had it been committed by an adult. Once a child is proved to have committed a delinquent act, then that child will be considered an adjudicated delinquent and the juvenile court will make a disposition regarding that child, one that typically imposes some guidance, counseling, rehabilitation, and/or treatment.
After a child is arrested or is the subject of a complaint filed by the police, school, or private citizen, Maryland’s Department of Juvenile Services (DJS) will evaluate and assess the complaint – this evaluation and assessment will be performed by an intake officer. The child may be taken into custody by court order, lawful arrest, emergency protection, or as a runaway. Once a child is taken into custody, the child’s parent, custodian or guardian must be notified immediately. DJS may determine that an informal adjustment be used to address the matter rather than any judicial intervention – such as community service, individual / family counseling, substance abuse treatment, restitution, and/or referrals to other agencies for additional services. If DJS determines that judicial intervention is necessary, it will refer the matter to the State’s Attorney for the filing of a petition – should the State file a petition in juvenile court alleging that a child is a delinquent (and the child is not detained), the juvenile court will first conduct the fact finding hearing called an adjudication hearing to determine whether the child committed the offense – and if the juvenile court determines the child did commit the offense, the court will schedule a disposition hearing at which time the court will decide whether the child needs guidance, rehabilitation, and/or treatment.
Effective November 1, 2024, Maryland’s juvenile laws have changed – most significantly, children between the ages of 10 to 12 years of age may be subject to the juvenile court’s jurisdiction and may be adjudicated delinquent for particular offenses. Prior to this change, the juvenile court’s jurisdiction regarding delinquency only covered children who were at least 13 years of age.
by Steve LewickySubcontractors Can Make a Project Owner Pay for Services and Materials Provided by the Subcontractor on a Construction Project, When Payment is not Received from the General Contractor
Construction projects almost always involve framers, carpenters, plumbers, electricians, drywall installers, and other subcontractors contracting with a general contractor to supply services and materials to the building project (unless the property owner directly contracts with tradesmen). If the framers, carpenters, plumbers, electricians, drywall installers, or other subcontractors are not paid for their work in a timely manner, they can sue the general contractor for breach of contract. Separate and in addition to bringing a lawsuit for breach of contract against the general contractor, subcontractors also can seek to establish a mechanic’s lien — to make the owner of the property pay for the provided services or supplies if the general contractor refuses to pay, or is no longer able to pay. This gives contractors and subcontractors on construction projects a powerful tool to obtain payment for materials and services – and it is something that property owners need to aware of.
Through a mechanic’s lien, a person or company that provides labor or materials on a construction project can place a lien against improved real property for the value of unpaid labor or materials – but only if the requirements of the mechanic’s lien statute are strictly adhered to.
Maryland’s mechanic’s lien statute is complicated, and this article provides only a general summary, without addressing all of the requirements and nuances. Generally speaking, any person or company that furnishes work or materials to a construction project in Maryland pursuant to a contract may establish a mechanic’s lien if they are owed money on a project. Contractors, subcontractors and suppliers can all claim such a lien, regardless of whether they have a contract directly with the owner of the property, as long as the labor was performed for or about the subject building, and as long as the materials were for the building project.
A mechanic’s lien is only available for certain types of construction projects in Maryland. Newly constructed buildings are subject to mechanic’s liens, though what exactly constitutes a “building” is sometimes a contested issue, because not every type of structure on land constitutes a building for these purposes. For construction projects that involve repair or renovation of existing buildings, a mechanic’s lien is only available in Maryland if the project involves the repair, re-building or improvement of the building to the extent of 15% of its value. Condominium units and the common elements of condominiums are also subject to mechanic’s liens, but there are special notice requirements apply to condominiums.
An important aspect of Maryland mechanic’s liens is a requirement to give written notice of an intention to seek a lien in some circumstances, and strict time limitations for giving notice and bringing suit.
Anyone seeking a mechanic’s lien who does not have a direct contractual relationship with the property owner – for example, subcontractors, and in many cases material suppliers – must comply with notice provisions set forth in the mechanic’s lien statute. When this type of notice is required, it must be mailed by the lien claimant to the property owner within 120 days after the claimant performed the work or furnished the materials. There are nuances regarding when this 120-day period begins to run, and numerous court cases address this issue.
Separate and apart from giving any required notice of an intention to claim a mechanic’s lien, a petition seeking to establish the mechanic’s lien must be filed in the appropriate Circuit Court no later than 180 days after the work has been finished or the materials furnished. The correct parties must be named as defendants in the suit, and there are detailed requirements for what must be included in the petition that is filed with the court.
After a petition is filed with the court, there is a two-step process whereby the court first reviews the papers that have been filed, and holds an initial show-cause process and proceeding to determine if there is sufficient cause to establish an interim mechanic’s lien. The court typically will set a bond for entry of an interim lien. If an interim lien is established, then in a second stage the court will later hold a trial on the merits of whether the mechanic’s lien should continue thereafter until satisfied. At any time after a petition to establish a mechanics lien is filed, the property owner can file a petition to have the property released from the lien upon the filing of a bond sufficient to protect the lien claimant. Once a lien is established, the lien claimant then has one year to file a petition to enforce the lien.
Mechanic’s liens can be an important method for contractors, subcontractors and suppliers to ensure payment, but they are complicated and are subject to strict time constraints. The Maryland mechanic’s lien statute differs from those of other states in many ways. If you are a contractor, subcontractor or supplier seeking payment for labor or materials provided in Maryland, or if you are a Maryland property owner that has received notice that someone intends to assert a mechanic’s lien, or has already petitioned the court for a mechanic’s lien, I encourage you to promptly consult with an attorney who is knowledgeable about this area of law. Very strict limitations apply to these claims.
Mechanic’s liens are not available for government construction projects, but somewhat similar protections are provided to subcontractors on government construction projects through the bonding requirements in the Miller Act (for federal government construction projects) and the Maryland Little Miller Act (for state government construction projects). Other laws also protect subcontractors, such as the Maryland trust fund statute and the Maryland Prompt Payment Act.
Steve Lewicky
(410) 489-1996
