Corporations and Business Entities
There are several types of business entities. Each has its own advantages and disadvantages.
The following is a summary of the types of business entities that are available to you.
Although there is no requirement that you register as a business entity with the state, you may be required to obtain certain licenses and permits depending upon the business you will operate.
Even though a sole proprietorship is not a separate, business entity, you may still elect to operate under a “trade name.” Sometimes this is called a “doing business as” name (a “DBA” name). You can register a DBA name with Maryland’s Department of Assessments and Taxation (“SDAT”). Other states have a similar agency to which you can apply if you are doing business outside of Maryland.
The advantages of a sole proprietorship are:
- It is easy to form with minimal expenses involved;
- Because it is not a separate taxable entity, the effort and expense of filing separate, annual corporate income tax returns is avoided; and
- You retain complete and total control of your business.
The disadvantages of a sole proprietorship are:
- If you have limited funds to start a business, it may be difficult to raise capital;
- There are no additional ownership interests you are able to sell to investors;
- You are personally responsible for any business debts and liabilities of your business;
- Because you are the sole owner of your business, the responsibility of its success or failure falls solely upon you.
A general partnership is simple to set up. It is a business entity that consists of two or more partners with voting rights. Although partnerships can be verbal or oral, it is usually better to have a written partnership to clearly define the relative rights and responsibilities of the partners. A written agreement is particularly important to define what happens to your interest in the partnership if you become disabled, when you retire and when you die. If your partner dies during the partnership, you may unexpectedly find yourself as a partner with your deceased partner’s surviving spouse or children. A written partnership agreement or business succession plan will avoid unwanted, “surprise” partners.
As with a sole proprietorship, you can register a trade name for your partnership with the SDAT.
Partners of a general partnership are personally responsible for the debts and liabilities of the partnership just as you are in a sole proprietorship.
Unlike a sole proprietorship, it may be easier to raise working capital for your business because you have more vested owners.
Similar to a sole proprietorship, you as a partner must report your proportionate share of the profits and losses of the partnership on your personal income tax returns.
Although a partnership terminates upon your death or that of a partner, it can become a different partnership with different or remaining partners. With no business succession plan, your partnership interest will pass to your heirs or beneficiaries of your estate. A Partnership Agreement or “Buy-Sell Agreement” can dictate to whom your partnership interest will pass upon your death. It can also determine the value of your partnership share (or how it will be determined) and how it will be paid upon disability, retirement or death. Often, Buy-Sell Agreements are funded by life insurance policies on the lives of the partners.
Another type of partnership is a limited partnership. A limited partnership must have at least one “general partner” and at least one “limited partner.” The general partners are responsible for the debts and liabilities of the partnership. A limited partner’s liability of the partnership is limited to his or her capital investment, but such a partner has no voting or management rights. You may want to create a limited partnership to provide additional capital to your business. The benefits to potential limited partners include investment opportunity without personal liability should the business fail.
Having the right kind of partnership agreement and a good business succession plan is critical to the success and operation of your partnership, as well as to make sure that upon your retirement, disability and/or death, you and your family receive fair compensation for your partnership interest.
A corporation is a legal entity that is separate from those who own it and is separately responsible for its debts and liabilities. It insulates its owners from personal liability but requires registration with the state, extensive record keeping, more formal documentation, reporting to various governmental entities, and annual costs. A corporation can be treated two different ways for income tax purposes. A “Subchapter C corporation” is considered a separate, taxable entity and is responsible for the payment of income tax on corporate profits. You can make a tax election with the IRS to treat the corporation as a “Subchapter S corporation.” With a Subchapter S corporation, its profits and losses pass through directly to the stockholders. Whether to choose a Subchapter is decision which must be guided by a competent, experienced tax advisor.
A corporation is formed by filing of Articles of Incorporation with the SDAT. Shortly after the Articles are filed, bylaws must be implemented which set forth how the corporation will be structured and operated. The initial board of directors will issue corporate stock to “stockholders.” Each stockholder owns a proportionate ownership interest in the corporation. The stockholders must conduct an annual meeting at which they elect the corporation’s board of directors. The board of directors must meet every year at which it sets the management and long term financial goals of the corporation and elects the corporation’s officers. The officers supervise the day to day operations of the corporation. Minutes of each of these meetings must be maintained.
In order to keep the corporation in good standing, annual franchise fees and personal property tax returns must be filed with the state.
In Maryland you can elect to operate as a “close corporation.” If you intend to own a small, family business, a close corporation may be a good option because a board of directors is not required. Your stockholders will perform the duties of the board of directors. They will meet every year to determine the corporation’s overall and long range policy and financial goals. They will also elect the corporate officers who will manage the day to day operations of the corporation. A close corporation is a less formal corporate entity which still shields you from personal responsibility of its liabilities.
If a Subchapter C corporation earns income, it may issue dividends to its stockholders. Dividends are distributions of corporate profits. If your Subchapter C corporation issues dividends to you, you must report such distributions on your individual tax returns. So, not only does your Subchapter C corporation have to pay income tax on the profits it earns, you as a stockholder will have to report the dividends on your individual tax returns, possibly resulting in double taxation of your corporation’s income.
If you make a “Subchapter S” election with the IRS, this election allows corporate profits and some losses to pass directly to the stockholders. Subchapter S corporations have certain limitations. However, there are some limitations to using a Subchapter S corporation. Two of those drawbacks are that they limited to no more than 100 stockholders and all stockholders must be United States citizens.
Despite their filing requirements and required formalities, the benefits of operating as a corporation are many and significant. They include:
- Because a corporation is a separate, legal entity from you as a stockholder, if it defaults on a loan, is held responsible in a legal proceeding, or faces some other non-criminal liability, it provides you the strongest level of protection from personal responsibility.
- You can sell corporate stock whenever you want. By doing so, you can raise capital for the business as and when needed.
- Since shares of corporate stock represent an ownership interest in property, you can buy and sell your stock as you choose so long as it does not violate any valid stockholder agreement.
- The corporation does not terminate upon your death. Your corporate stock can be distributed to your family or other beneficiaries with good estate planning.
An LLC can have as few as one member. If you decide to use an LLC as your business entity, its profits and losses will pass through to you and any other members. This eliminates the double taxation of income that could result when using a Subchapter C corporation.
Similar to a corporation, the LLC will not terminate upon your death, although you can elect a termination date of the LLC in your Articles of Organization.
A key benefit of using an LLC instead of a sole proprietorship is that even though you can be the sole owner of an LLC, you and any other LLC members will not be personally liable for its debts and liabilities. Although an LLC must be registered with the SDAT and pay annual franchise fees, you will be taxed as a self-employed person, avoiding double taxation of corporate profits.
Another key benefit of an LLC is that you will not be required to have annual meetings of the owners nor maintain annual minutes of such meetings.
An LLC can provide you with a maximum degree of business flexibility and protection from individual liability while at the same time requiring far less formal record keeping than a corporation.
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