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Forming a Business

When planning for creating or purchasing a business, focus needs to center on the legal structure of the desired entity. Perhaps the key concern is the manner for apportioning financial participation and entity control among parties involved in the proposed organization. Other concerns include taxation, avoiding personal liability, and the time and resources needed to set up and maintain a business structure. Depending on the urgency placed on each concern, any particular form of business structure can be more or less appropriate.

A sole proprietorship has the advantage of simplicity. One person, or one married couple, sets up, runs, and owns the business, operating either under his or her own name or a trade name. The owner controls the business, can do so in an informal structure, bears liability for all debts, can include the business in personal tax returns, and can transfer part or all of the business at will. On the other hand, under a sole proprietorship, the owner faces unlimited personal liability for the business, and injury or death can interrupt the operation of the business or even cause it to disintegrate.

A general partnership is another common and simple business structure. When two or more persons desire to join together as co-owners of a business for profit, this structure allows for easy formation and the opportunity for informal organization. In Maryland, the state's Uniform Partnership Act provides a basic legal structure for the formation and management of this business entity, unless a written partnership agreement expressly establishes different rules, which is often advisable to assure the intent of the parties is clear and enforceable. A partnership often affords an increased ability to raise funds, for more than one person is involved, and persons can even be brought in as limited partners, which allows them to participate in the funding and profits of the business while avoiding personal liability for the risks. A partnership is a means to bring persons of different skills into the business so that it can run more efficiently. And like a sole proprietorship, profits or losses can be reported on the partners' personal tax returns. There are some distinct disadvantages to this form of business structure. All general partners are jointly and individually liable for the actions of the other partners. Any profits must be shared. Since decisions require more than one person's action, disputes often arise. And, like a sole proprietorship, injury and death can interrupt the operation of the partnership or even cause it to disintegrate.

A corporation is a creation of law. It is a legal entity that stands separate and apart from the individuals who own it. A corporation can enter into contracts, sue or be sued, and be taxed. It is complex in its formation and operation. Owners have limited liability for the debts or judgments against the corporation, and normally can only be held accountable to the extent of their investment. Still, incorporation can entail disadvantage. Owners and officers can be held personally liable for their actions, if those actions constitute torts, or violate legally imposed obligations such as withholding and paying employment taxes. Federal and state governments regulate corporations more closely than other business entities and costs can be great for compliance. And the time and costs involved in incorporating and operating under a corporate structure can be substantial. A corporation, however, because it is a legally constructed entity, has a life of its own and injury or death of owners does not interrupt its operation or cause its disintegration.

A Subchapter S Corporation is a function only of the tax status of the entity, albeit choosing this course places certain legal restrictions upon its operation. Electing this provision of the tax code allows the shareholder(s) to treat earnings and profits as distributions of the corporation and report them directly on personal tax returns, thus avoiding prior taxation within the corporation itself, what is often referred to as double taxation. If the shareholder is active in the operation and management of the entity, however, he or she must receive wages that qualify as “reasonable compensation” and be liable for payroll taxes.

A Limited Liability Company (LLC) is a relatively recent legal entity. It is a hybrid business entity that most if not all states allow. Basically it affords the owner or owners the limited liability of a corporation without requiring incorporation, thus providing the simplicity of operation and tax advantages of a sole proprietorship or general partnership. While there are more formalities involved in its creation than in a sole proprietorship or general partnership, it has fewer formal requirements than a corporation. It has advantages over the Subchapter S Corporation, however, because the restrictions placed on Subchapter S Corporations are not placed on LLCs. And owners may take part in the management of the LLC without losing their limited liability status, unlike limited partners in a partnership.

This brief overview of business entities is meant only as an introduction to some, though not all, of the options available. Because each is subject to legal rules and requirements, a lawyer should be consulted prior to final decision making.