Choose Your Business Entity

Choose Your Business Entity Carefully
It is very important that you take the time to start your organization the way you want, not only now, but in terms of your future plans as well. Each legal form, sole proprietorship, partnership, or corporation, has its advantages and disadvantages and it will determine which income tax return form you have to file. The one you should pick depends on your circumstances, including:

Your financial condition
The line of business you’re entering
The number of employees
The risk involved
Your tax situation

Maryland Recognized Business Entities (link each of the following to its description below with a mechanism to go “Back to List”)
Sole Proprietorship
Partnership (General Partnership, Limited Partnership, Limited Liability Partnership, Limited Liability Limited Partnership)
Corporation (C, S, and B)
Limited Liability Company
Nonprofit

Sole Proprietorship
A sole proprietorship is, as the name suggests, a business with one owner. Of the four types of organization, a sole proprietorship is the most common. A business organized as a sole proprietorship is not separate from its owner, but merely a different name with which the owner represents him/herself to the public. The owner is the business and the business is the owner. They’re inseparable.

Because of this relationship, a sole proprietorship is known as a pass-through entity. This means that all income and expenses pass-through to the owner and are filed as part of the owner’s personal return. If there is a business loss, the owner will enjoy a deduction to offset personal (paycheck) income. However, if the business makes a profit, the owner is responsible for any taxes due.

Since they have few legal requirements, sole proprietorships are easy to form and operate. They can also be more affordable since no legal documents need to be filed in most cases. Basically, all one has to do to form a sole proprietorship is get a business license and begin operations.
Although the sole proprietorship does have the advantage of simplicity, the negatives can steer entrepreneurs away from this form of a business organization. The disadvantages of a sole proprietorship stem from its very nature - the business and the business owner are inseparable. This leads to three potential problems.

First, owners can lose some lucrative tax-free fringe benefits because they cannot participate in company funded employee benefit plans like medical insurance and retirement plans. Second, since the owner and the business are inseparable, whoever sues the business actually sues the owner. The owner’s personal exposure is unlimited. Finally, the business owner is personally liable for the debts of the company and unfortunately, personal assets can be taken to pay company obligations.
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Partnership
A partnership is similar to a sole proprietorship but has two or more owners. Like the sole proprietorship, the partnership is not a separate legal entity from its owners. Unlike the proprietorship however, the partnership can hold property an incur debt in its name.
In general, the partnership shares the same advantages and disadvantages as the sole proprietorship. However, the partnership has an additional drawback. A partner can be held liable for the acts of the other partners, increasing personal liability.

Tax treatment of the partnership is also slightly different. Although it is a pass-through entity and does not pay its own income tax, the partnership does file an informational tax return with the IRS. The pro-rata share of its income and expenses are shown on each partner’s personal return, and any taxes due are paid by the partners.
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Corporation
The corporation was conceived to solve the typical problems of the partnership. Incorporating allows a group of entrepreneurs to act as one, much the way a partnership does, with one important advantage. Since the corporation is a separate legal entity capable of being sued, it can protect its owners by absorbing the liability if something goes wrong. In recent years, the corporation has developed as a tax reduction/planning tool.

A corporation is essentially an “artificial person” created and operated with the permission of the state where it is incorporated. It’s a person like you, but only “on paper.” A corporation is brought to life when a person, the incorporator, files a form with a state known as the articles of incorporation. The owner of a corporation is known as a shareholder.

Since a corporation is a separate legal entity, the corporation actually owns and operates the business on behalf of the shareholder, under the shareholder’s total control. This separation provides a legal distinction between the owner and the business and provides three important benefits:

  1. It allows you, the owner, to hire yourself as an employee (typically as president) and then participate in company funded employee benefit plans like medical insurance and retirement plans.
  2. Since you and you company are now two separate legal entities, lawsuits can be brought against your company instead of you personally.
  3. When debt is incurred in the company name, as a separate legal entity, you are not personally liable and your assets cannot be taken to settle company obligations.

C Corporation
A C corporation is a separately taxable entity. It files a corporate tax return (Form 1120) and pays taxes at the corporate level. Tax on corporate income is paid first at the corporate level and again at the individual level on dividends, resulting in the possibility of double taxation. C corporations have no restrictions on ownership and can have multiple classes of stock. It is required to follow internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder and director meetings, filing annual reports, and paying annual fees.

S Corporation
An S corporation is a pass-through tax entity. It files an informational federal return (Form 1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead “passed-through” the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners. S corporations are restricted to no more than 100 shareholders, and shareholders must be US citizens/residents. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. Also, it can have only one class of stock (disregarding voting rights) and is generally required to follow the same internal and external corporate formalities and obligations as a C Corporation. It is important to remember that being an S corporation is a tax matter only.

B Corporation
A B corporation, or Benefit corporation, is a new class of for-profit corporation in the United States, required by law to create general benefit for society as well as for shareholders. It shifts its focus from maximizing shareholder utility to “stakeholder” utility, which includes owners, employees and the general public. Benefit Corporations must create a material positive impact on society; consider how decisions affect employees, community and the environment; and publicly report their social and environmental performance using established third-party standards.

Until the B Corporation, the role and responsibilities of corporations and corporate boards of directors have been clearly to maximize shareholder (owner) profit. Directors are subject to derivative suits by shareholders for violations of either the duty of care or loyalty which impedes such pursuits. As of October 1, 2010, Maryland became the first state in the nation to approve a new form of business entity known as a Benefit (B) Corporation.
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Limited Liability Company
The Limited Liability Company, or “LLC”, is today’s most popular entity form. It is the most popular because of its flexibility both in its operation and its available tax classifications. Through IRS eyes, a business with multiple members will be either a partnership, a c-corporation, or an s-corporation, with few exceptions. An LLC features the pass-through taxation of a partnership and the limited liability of the corporation to its owners/members. Thus, if the LLC is sued or otherwise becomes in debt, then the members in most situations will not be personally liable to the creditors of the LLC.

While an LLC is normally taxed as a partnership, an LLC may choose to be taxed as an S corporation or as a C corporation. Without making an IRS election, an LLC generally will be ignored for tax purposes if it has only one member or will be taxed as a partnership if it has multiple members. But, when making IRS elections, an LLC member or members can choose that the LLC is taxed as a C corporation or as an S corporation. A tax attorney would be able to guide you toward the optimal tax classification for your LLC.
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Non-Profit Organizations
MDSBTDC does not offer services for non-profit organizations. A non-profit organization is considered a non-stock corporation with the State, with a filing of the Articles of Corporation for a non-stock corporationMaryland Nonprofits provides counseling and training from two locations (Baltimore and Silver Spring). Also, the Charitable Organizations Division of the Office of the Secretary of State will provide resources for your non-profit venture. The property tax exemption application and information can be found through the Department of Assessments and Taxation. The sales and use tax exemption application and information can be found through the Maryland Comptroller.
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