Business Law Series, Vol. 1: Choosing a Business Entity
Learn about the available business structures that best fits your growing business.
When starting any business endeavor, one of the first things every entrepreneur must do is to figure out their business structure. One's business structure will affect the liabilities and benefits the business' activities have on its owners. Additionally, as you will read below, even if you decide not to formally organize under the laws of your state, you will be liable for the actions of the business in numerous ways.
Below are the most common business entities available including their benefits and risks.
The first business entity we will explore is the sole proprietorship. A sole proprietorship is defined as any unincorporated business owned and controlled entirely by one individual. If you open a business and don’t incorporate, you are automatically a sole proprietor. So entrepreneurs who simply begin selling their products or providing their services are in a sole proprietorship.
The benefit of doing business as a sole proprietor is that you don’t have to take any action with the state before doing business, you are free to run the business anyway that you see fit, and you don’t have to comply with any written documents like an operating agreement or bylaws. You can operate anywhere you want, you can end the business at any time you want, and you would pay taxes for profits and losses through your personal tax return. Although filing taxes for a sole proprietorship is easier, for Maryland and federal purposes, the owner is personally responsible for all financial obligations and debts of the business.
Although forming a sole proprietorship is easy, the owner is personally responsible for liabilities and debts of the business. For example, if you take out any loans to run the business, you will be personally liability to pay them back. Should you default on payments, then the creditor can come for your personal assets including your bank account, home, car, etc. In addition to the financial liability, you would also be directly liability for any personal injuries that could arise from the operation of your business. I personally do not suggest entrepreneurs run their business as a sole proprietorship because of the amount of liability they will endure if something goes wrong.
Although you don't need to file formation documents with the state, a sole proprietorship should file for a trade name, if you don't want to operate under your own name, file for all necessary permits and licenses, get a tax identification number, and get liability insurance.
A partnership is started by two or more people engaging in business together. Like a sole proprietorship, partnerships don’t require incorporating. The major benefit is that the liabilities are shared equally between the partners, though not eliminated. Partnerships do not provide limited liability meaning that each partner will be personally liable for all debts and legal actions the company may face. Also, the partners pay taxes on their income equally.
In addition to the exposure to liability, entrepreneurs lose their freedom to conduct business in any way they see fit because there are other people with competing interests. So, it is very important, but not required, that partners have a written agreement in place that will provide guidance on how the partnership will operate.
A partnership should file for a trade name, if you don't want to operate under your own names, file for all necessary permits and licenses, get a tax identification number, and get liability insurance.
Limited Liability Company (LLC)
A limited liability company (LLC) is a business structure that provides its members (i.e. owners) with limited liability for the operations of the business, pass-through taxation, and the flexibility to form the business operations in any way the members see fit.
Unlike in a sole proprietorship or a partnership, the owners would not likely be held personally liable for the business' liabilities and debts. For example, if the LLC is sued, the member’s personal assets, such as their property and bank accounts, will be generally protected from being used to satisfy a judgment against the company.
Second, pursuant to the Maryland LLC Act, the LLC will have the freedom and flexibility to run the business in the way that works best for them. In contrast, corporations are required to hold periodic meetings, keep detailed records of business activities, elect a board of directors, among other corporate formalities. In an LLC, the members would have comprehensive flexibility to decide how the company will operate by drafting an operating agreement that would fully layout how the members will run the business.
Third, members are taxed at the personal level (i.e., pass-through taxation), so just like in a sole proprietorship or a partnership, the income earned by the LLC is income earned by the member(s) and is paid once by each member separately.
Lastly, to form your LLC, you will need to file articles of organization and have a registered agent in every state where you intend to do business. However, in addition to the benefits stated above, LLCs enjoy a level of credibility that the prior entities lack.
A corporation is a business entity that has the legal authority to act as a single person, distinct from its owners (i.e., stockholders). Corporations have the right to issue stock, and they can exist indefinitely.
Just like LLCs, corporation owners enjoy limited personal liability for business operations. In addition to the limited personal liability, owners can easily sell their share of ownership of the company.
The drawbacks of the corporate structure are the more rigid formalities that should be followed. For example, after forming a corporation, there are ongoing record-keeping requirements and rules about how the company must be structured making it inflexible in comparison to the LLC. Another sore spot with the corporate structure is that the owners are usually taxed twice, once at the corporate level and once as a stockholder (double taxation).
Non-profits Non-profits companies are typically a business corporation that does not distribute its income to its members, directors, or officers. Some nonprofits can even benefit from tax-exempt status. Tax exempt organizations are recognized under the IRS as operating exclusively for charitable, religious, scientific, educational, or certain other purposes recognized by the IRS. Tax exemption allows donors to the organization to deduct charitable contributions on their taxes. Benefit Corporation Benefit corporations are a relatively new business structure that function as a hybrid of for-profit companies and non-profits. They are formed for both public benefit and profit generation.
To become a benefit corporation, owners must include in their charter (state filing) a statement that the corporation is a benefit corporation and has the purpose of creating a “general public benefit” or a “specific public benefit.” Owners would also have to submit an annual benefit report to each stockholder
Maryland defines "a ‘general’ public benefit as a ‘material, positive impact on society and the environment, as measured by a third-party standard, through activities that promote a combination of specific public benefits." Specific public benefits include things like:
providing individuals or communities with beneficial products or services;
promoting economic opportunity for individuals or communities beyond the creation of jobs in the normal course of business;
preserving the environment;
improving human health;
promoting the arts, sciences, or advancement of knowledge;
increasing the flow of capital to entities with a public benefit purpose; or
the accomplishment of any other particular benefit for society or the environment.
Every business is a little different so there is no one size fits all solution. You should always contact a business attorney once you decide to form your business so you can get off on the right foot and avoid unnecessary issues that will arise.
You can contact me at Rolanzo@wro-law.com if you have questions about starting a business.
Forming a Limited Liability in Maryland, The People’s Law Library of Maryland, https://www.peoples-law.org/forming-limited-liability-company-llc-state-maryland
Md. Corporations and Associations Code Ann., Limited Liability Company Act, Title 4A
Md. Code, Corporations and Associations, § 4A-402
Md. Code, Corporations and Associations, § 2-111, and 4A-402
Maryland corporations are governed by the Code of Maryland – Corporations and Associations, Titles 1-7.
Nonprofit Law, The People’s Law Library of Maryland, https://www.peoples-law.org/nonprofit-law
Md. Code Ann. Corps. and Assn’s. § 5-6C-01 to 08; How to Form a Benefit Corporation in Maryland, The People’s Law Library of Maryland, https://www.peoples-law.org/how-form-benefit-corporation-maryland