Starting Your Own Business Entity: Know the Basic Legal Framework
Whether to generate additional income, be one’s own boss, create flexible hours around child care, or fulfill a dream of one’s own, many folks, especially in Maine, start their own business. As they set up these small businesses, many people fail to take advantage of available options which are open to them and which may limit their personal and tax liability.
This article is intended to discuss some of those legal options available to small business owners and to briefly explain the pros and cons in adopting these various business entities.
I. SOLE PROPRIETORSHIP
Most people who begin a small individual business adopt a sole proprietorship as their business entity. They often do this without planning to do so and simply form a sole proprietorship by default.
A sole proprietorship is exactly what it says it is. Any person who uses their labor or ideas for the purpose of generating profit, and does so under their own personal ownership, has formed a sole proprietorship. There are no formal requirements to form a sole proprietorship, and any income which is generated by the individual’s labor will be attributed to them personally through their own social security number.
While many people operate this type of business under their own name, some people also adopt a name for the business. In legal terms this is known as a “dba”, which stands for “doing business as”. While the business enterprise has a name separate from the individual, all of the tax and personal liability still flows directly to the individual.
Some of the benefits of operating as a sole proprietorship are the ease with which people can do this. There is no additional cost of formation, and no formal requirements to form the sole proprietorship. All income can be claimed directly through a person’s own social security number and taxes can be paid on a personal level. There are no specific licensing requirements with the state; however, in Maine there is a requirement that anyone operating a dba must file with the clerk of the city or town in which such business is to be operated a certificate signed and sworn to by the owner, setting forth their name and place of residence, the name of the business, and a statement that they are the sole proprietor. 31 M.R.S.A. § 2. This is clearly the easiest and least expensive method, at least up front, to use in operating a business.
There are, however, drawbacks to operating as a sole proprietorship. The biggest concern is that any liability which is generated by a person operating as a sole proprietorship runs directly to the person individually. This means that, if in the course of operating your small business something were to happen which would generate a lawsuit against the business, all of the individual’s personal assets would be at risk. For instance, should a carpenter drop a board which they are working with at a project and that board strikes a third party, then that third party can sue the carpenter directly. There is no protection from the liability, other than any insurance which the individual might have to cover such a circumstance. Not only would the person be entitled to look to the assets of the business, they could also look to any personal assets, including real estate or savings, that the individual might have, and which might have been derived from other sources than the business which created the negligence.
In addition, there may be cases where certain tax deductions or beneficial tax treatments may not be available to an individual under a sole proprietorship which might be available to someone who has formed a separate entity. These tax issues are ones that any person who is thinking about starting any small business should take up with their accountant prior to deciding how they would like to operate their business.
II. PARTNERSHIP
Under Maine law, when any two people combine their labor or other resources together for the purposes of generating a profit, and agree to share in the profits which are generated, a partnership is formed. There is no requirement that one or more persons who involve themselves in a situation like this take any formal action to form a partnership. The law will impute to them the partnership form of doing business, unless the parties have chosen some other entity.
Partnerships are similar to sole proprietorships in that the business and tax liabilities flow directly to the individuals in the partnership. This can be a significant concern in regards to operating a small business with other people. A partner who has not been involved in a negligent act, which was committed by one of the other partners, may have all of their assets, both business and personal, at risk under a partnership form of business. Likewise, tax liability will flow directly through to the partners, regardless of whether or not they generated the tax liability. This can leave partners in a situation where they are responsible for taxation when they may or may not have had the ability to see profits in regards to the work which was completed. Because many partnerships are not formally created, there is no written agreement among the partners as to how they will handle various business decisions and/or tax liabilities. This can lead to significant problems when the partners have a dispute regarding the operation of the business.
Partnerships can be formed and partnership agreements can be drafted that define the relationship of the partners in regards to the business. In any case where parties are choosing a partnership form of business entity, a partnership agreement should be drafted and reviewed by all of the partners. In any case where there is a dispute, or there is some question regarding income or taxation, the written and signed partnership agreement will control over a party’s personal understanding of how things were to be handled.
Partnerships can also be set up in a very formalized manner, such as a limited partnership or a limited liability partnership (LLP). Limited partnerships allow some degree of protection from liability for the limited partners. A limited partnership sets up a relationship where some of the partners are deemed to be limited in their activity within the partnership and/or liability for partnership actions. In a limited partnership, one of the partners must be designated as a general partner to manage the day to day affairs of the partnership. A general partner is liable for the actions of the partnership. In any case where people want to establish a limited partnership for purposes of doing business, they should consult legal counsel and draft a very formalized agreement so that all parties understand their relationship to the partnership. Limited partnerships can be a good vehicle for attracting investors who are willing to risk a finite amount of money on a business arrangement but do not wish to be involved in the day to day operations, or risk assets beyond what they are investing in the partnership. Prior to the creation of limited liability companies and limited liability partnerships, limited partnerships were a common and popular business form for attracting investors.
While no formal registration is required for a partnership under Maine law, a limited partnership does require that a Certificate of Limited Partnership be delivered to the Secretary of State for filing. Section 1321 of Title 31 sets out the requirements for a Certificate of Limited Partnership. In addition, as with the sole proprietorships, there is a law requiring local registration (which is widely ignored). That law states that, “[w]henever two or more persons become associated as partners or otherwise for the purpose of engaging in any mercantile enterprise, they shall, before commencing business, deposit in the office of the clerk of the city or town in which the same is to be carried on a certificate signed and sworn to by them, setting forth their names and places of residence, the nature of the business in which they intend to engage and giving the name under which they are to transact business.” 31 M.R.S.A. § 1.
Both partnerships and limited partnerships are governed by Maine statutes, under Title 31 M.R.S.A. Chapter 17 for the “Uniform Partnership Act” and under Chapter 19 for the “Uniform Limited Partnership Act”. These statutory sections should be consulted before establishing a partnership or a limited partnership.
III. LIMITED LIABILITY PARTNERSHIP
As mentioned above, there are also limited liability partnerships (in contrast to limited partnerships). Maine law has adopted statutory requirements for limited liability partnerships (LLPs). In order to form a limited liability partnership, a person must file a Certificate of Limited Liability Partnership with the Secretary of State. This Certificate must include the name of the LLP, the residence or mailing address of a contact partner, the street address of the partnership’s chief executive office – if it is different from the street address for the general office for the LLP, and any other matters that the partners determine to be required within the Certificate.
Upon filing of the Certificate of the Limited Liability Partnership, the entity has control over the name which it establishes. Because there is an exclusive right to the use of the name, only names that are not already in use can be adopted. This is also true for limited liability companies and corporations. If one wishes to form a limited liability partnership, they should research whether or not the name they wish to use is available.
Limited liability partnerships offer a certain level of protection from liability to the partners. Individuals cannot protect themselves from their own liability but may be protected from other partner’s liabilities in certain cases. If a person wishes to form a limited liability partnership, they should consult legal counsel and their accountant as there are significant legal requirements in formation of a limited liability partnership.
IV. LIMITED LIABILITY COMPANIES
Since having been established by Maine law, limited liability companies are the overwhelmingly most popular form of business entity currently in use in the State of Maine. A limited liability company offers protection to the individual members from the company liabilities, when operated properly. At the same time, these entities also offer the individuals preferential tax treatment, providing that any income earned by the company passes through directly to the members.
Limited liability companies also have a great advantage in that they are very flexible in defining the relationship between the various members of the company. A limited liability company agreement can allow certain members to have increased voting rights, while other members can have increased distribution rights as to income.
Just last year, the State of Maine adopted a new limited liability company statute that had the effect of making limited liability companies even more flexible. However, the law now requires that all limited liability companies have a limited liability company agreement that acts like a constitution for the business entity. Within the agreement, members are free, in almost all instances, to determine how they want the company to operate and what the relationship of the members will be. If the members do not define certain relationships within their agreement, then there are default sections within the statute that would control the company’s operation. However, members are allowed, with very few exceptions, to determine how to operate the limited liability company and how to structure the relationship between the members.
A limited liability company provides excellent liability protection to the members, is flexible in determining how to operate the entity and to structure the relationship between the members, and carries with it preferential tax treatment in that any profits to the company pass through directly to the members, unless otherwise designated by the members. Due to the flexibility, protection from liability, and tax benefits of this business entity, it is widely used for small businesses in the State of Maine.
Anyone wishing to form a limited liability company, given the statutory requirements involved in setting up and operating the company, should contact legal counsel and an accountant before determining to operate their business under this entity form.
V. CORPORATIONS
Finally, we come to the best known and longest established business entity, the corporation. Corporations have been allowed in law for more than a century and, for the most part, have retained their characteristics over that period of time.
Corporations allow for participatory ownership of a business entity through the issuance of stock certificates. Most people are familiar with corporations through the stock market. The corporate business entity allows businesses to raise significant amounts of money through the sale of shares and to allow individuals to invest in businesses without concern that they will be liable for missteps or liabilities. At the same time, any investment in a corporation is at risk if the corporation fails.
Under Maine law, in order to form a corporation, Articles of Incorporation have to be filed with the Secretary of State’s office. These Articles of Incorporation include the name of the corporation; the clerk of the corporation, who acts as a secretary for the corporation more or less; and the incorporators, who are the people who are forming the corporation. It does not require that shareholder names be listed on the Articles, or that any specific purpose, beyond the general purpose of legal business activities, be stated within the Articles of Incorporation.
Corporations are run by officers who are elected by the directors of the corporation. The directors of the corporation are in turn elected by the shareholders. This hierarchy of management within a corporation is set out in a document known as the bylaws of the corporation. These bylaws establish the various authorities of different officers and directors and set out the procedures by which decisions can be made within the corporation. In order to operate a corporation correctly, yearly meetings have to be convened and votes have to be taken in regards to the management of the corporation. In this way, it is much more formal than a limited liability company, and requires more attention to detail in the day to day operations.
Up and until the establishment of limited liability companies, corporations were the predominant business entity that was used by both large and small businesses. Under federal tax law, a person forming a small business corporation can request treatment as a small business under the Internal Revenue Code. This is called a “Sub Chapter S Election.” This allows for pass-through taxation of any income from the corporation to the shareholders. In this way, any double taxation (that is, a tax on corporate profits followed by a tax to the individual shareholders when they receive the monies) is avoided.
Corporations are still used fairly commonly here in the State of Maine and have some specific benefits in regards to companies where the primary shareholders are also the primary employees. There may be tax benefits available to a corporation that might not be available to a LLC. Anyone wishing to form a limited liability company or a corporation should consult legal counsel and an accountant to determine which entity would best serve their needs.
This article is a brief overview of entities that individuals or groups of individuals can use to establish and operate their businesses. It is not meant to be exhaustive, nor is it meant to be legal advice. Any persons who wish to investigate or form a business entity should contact their own legal counsel and/or accountant. John Conway is an business attorney at Linnell, Choate & Webber in Auburn, Maine. Linnell, Choate & Webber is a full service law firm providing legal services to individuals, companies, and municipalities throughout Maine. It has been in operation since its founding in 1931. You can reach John Conway at 784-4563 (telephone); jconway@lcwlaw.com (email); or 784-1981 (fax).