Starting 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.