Legal business structures matter.

When you are first setting up your business, you are making a lot of decisions. One of the most important is what legal structure you should use. We asked small business attorney Debra S. Friedman of Freedman & Friedman, LLC in Olney, Maryland, to provide some quick tips on what kind of a legal entity to form, and we got more than a few quick tips. Read below and learn that this is not a quick decision. You need to be educated on which corporate structure is right for you now, and in the future.

Knowing the difference between a sole proprietorship, a partnership, a limited liability company, and a corporation is important. Your choice of entity can impact your income, your taxes and your personal liability.  Additionally, the different entities have varying levels of operating formalities.

Sole Proprietorship: A sole proprietorship allows you to engage in a business by and for yourself.  If you decided to sell your crafts – and you do not establish a corporation or an LLC, you’re a sole proprietor.  It’s that easy.  There’s no requirement to register your business with the State Department of Assessments and Taxation (SDAT). If you want to operate under a name other than your name, you can register a trade name. Be aware, however, that a sole proprietorship provides you no protection from personal liability. If you are in a high risk line of work, this is probably not a good choice.

Partnership: If you are in business with one or more other parties, and you have not formed a corporation or an LLC, you’re in a partnership. There are two types of partnerships – general and limited.  A general partnership provides the partners no protection from personal liability. This could result in you being held responsible for your partner’s debts or wrong doing. In a limited partnership, the limited partners receive profit distributions, but have no right to participate in the day-to-day operations of the partnership. Additionally, a limited partner’s liability is limited to its investment in the partnership. On the other hand, the general partners’ personal liability is not limited.  Negotiating and drafting a partnership agreement can be time consuming and costly.

Limited Liability Company: A limited liability company is similar to a limited partnership, however, it is generally less expensive to set up and easier to operate. Additionally, all of the members (owners) of a limited liability company enjoy the protection of limited liability (limited to the value of their investment in the LLC).  Properly drafted and executed Articles of Organization are required to register an LLC with SDAT. Once the LLC is registered, the members may elect to execute an Operating Agreement. The Operating Agreement sets forth the framework of the operations of the LLC including its management, capital and distributions. It will also address what happens to a member’s interest in the LLC upon their death.

If the members do not execute an operating agreement the state act will control the operations of the LLC. Please note, however, that the state act does not address all of the operating facets of an LLC.  Therefore, a written operating agreement is strongly recommended. An LLC is a “pass through” entity, meaning it does not pay income taxes. Rather, the LLC’s income is taxed to its members. There are no requirements for annual meetings (members or otherwise).

The LLC may be managed by its members or by a manager. The Operating Agreement will set forth the manager’s authority. Members of an LLC receive draws and must pay self-employment taxes. Opting to be taxed as a subchapter “s” corporation may, depending on certain variables, enable you to reduce your self-employment taxes, but it will also increase your operating expenses. The “s” chapter election also comes with restrictions as to who may be an owner of the LLC and how many owners the LLC may have.

Corporation: A corporation, established with Articles of Incorporation, is a separate entity with its own identity – almost like a person. Operations are described in the Corporate Bylaws.  Because a corporation is a separate legal entity, its income is subject to “double taxation”, meaning the corporation’s income is taxed first to the corporation and then taxed again to its shareholders. A corporation, however, may have other tax benefits that are not available to other entities. A corporation is owned by shareholders and managed by officers and directors.  In most cases, corporations are required to have annual meetings:  one for the directors and one for the shareholders. A corporation is a great vehicle if you plan to go public. A corporation may also opt to be taxed as a subchapter “s” corporation. Such an election will allow the corporation to be taxed as a “pass through” entity, but as with the LLC, such election comes with restrictions as to who may be an owner of the corporation and how many owners the corporation may have. There may be other tax implications as well.

Limited liability is a valuable benefit. But beware. Simply registering your business is not sufficient to maintain your limited liability. If corporate formalities are not properly followed or if an LLC is not really operated like a business, creditors may be able to reach beyond the veil of limited liability. 

This articles presents a very basic overview of the various entity structures.  It is by no means complete nor is it intended to serve as legal advice. Already in business and think you may have chosen the wrong structure?  Or perhaps you started out as a sole proprietor and your business has grown along with the associated risks. It’s not too late. There are options available to convert your current business into the structure that makes the best business sense for you and your company. Feel free to contact us at 301-367-3877 or dfriedman@fsquaredlaw.com  if you have questions.