What Entity Structure Should I Choose for my Texas Business?
The attorneys at Jackson, Landrith, & Kulesz are familiar with transactional law and know that what entity structure is best for you depends on the individual circumstances, your company’s ambitions, and the level of risk you are willing to tolerate. For instance, if the prospect of having your assets, like your car or house, seized by creditors due to outstanding business debts scares you, a partnership might be a bad idea.
Conversely, a partnership could be a great idea if you run a smaller business that is unlikely to incur significant debts with a couple of co-partners you are well-acquainted with. If you hope to sell ownership interests of your company to the public, you will have to choose a corporation. Also, certain professionals seeking to offer their professional services via an organized entity may choose one of several types of entities, such as a PC, an LLP, a PLLC or a PLLP.
We help guide our clients to choose the best entity structure based on their business type, goals, and long-term vision for the company. Our lawyers here at Jackson, Landrith, and Kulesz can help you choose the right entity structure for you today.
Choosing the Right Entity Structure
Ultimately, the decision regarding the business structure you choose in Texas is an informed one you should make in consultation with an attorney and accountant. Knowledgeable lawyers can help you take into various issues:
- Regarding management
- Operational formalities, and
- Potential expense.
The following is a list and breakdown of the most prominent entity types:
- Sole Proprietorships
- Limited Partnerships (LPs)
- Limited Liability Partnerships (LLPs)
- Professional Corporations/Professional Limited Liability Companies
- Limited Liability Companies (LLCs)
If you have any questions about what the right entity structure in Texas is right for you, contact us for a consultation today.
Entity Options in Texas
The simplest organizational form, a sole proprietorship, is an entity that uses the sole proprietor’s legal name. However, the individual can create a fictitious or doing business as (“DBA”) name for marketing and banking purposes. The owner does not need to register their business, which saves the owner some money in registration and annual fees.
A sole proprietor who intends to hire employees must obtain employee identification numbers from the IRS. One unique aspect of sole proprietorships is that all profits and losses pass directly to the owner. Thus, the sole proprietor is obligated to report business income and pay taxes on their individual tax filings.
The biggest drawback of sole proprietorships is that the owner is personally liable for the business’s debts and obligations. Therefore, sole proprietors assume the possible risk of loss of property, income, and other assets they own. Use this entity form when unlimited liability does not put you at risk. For example, this is ideal when running a rather small business that will not incur significant debt or liability.
At common law in Texas, a partnership is formed when three elements are met:
(1) mutuality of interest;
(2) mutuality of control; and
(3) sharing of profits and losses.
Courts have continued to rely on the three elements above to determine whether a partnership has been formed.
The Texas legislature finally did away with the common law test when it created the Revised Uniform Partnership Act. This act defines a partnership as ‘an association between two or more persons to carry on a business for profit.
Unlike other business entities like a limited partnership or LLC, there are no filing requirements or formalities for forming a partnership. Therefore, a partnership can be created completely orally or without the partners even knowing they created one.
Sharing profits or co-ownership of property are strong indicators that a partnership has been formed. Partners can enter into an agreement that controls:
- How the partnership will be governed,
- How profits and losses will be split, and
- Voting rights.
The following are the statutory, or default, rules that will apply to a partnership unless an agreement instructs otherwise.
All partners have equal rights in the partnership’s management. This includes each partner being entitled to one vote. Decisions in the partnership’s ordinary course of business require a majority vote, whereas decisions outside the ordinary course require unanimous consent.
Partners also owe other partners the fiduciary duties of care and loyalty. This duty requires partners to act reasonably and in the partnership’s best interests.
The significant downside to a partnership is that each partner is jointly and severally liable for partnership obligations. If the partnership cannot meet its debts, creditors can recover from the partners personally. Finally, partnerships are not taxed directly. Rather each individual member pays taxes on their share of partnership income, like an LLC.
A partnership is a good entity form for a business with only a few owners, which won’t incur substantial liability that can become the partners’ problem.
A Limited Liability Company (“LLC”) is a non-corporate entity form that provides its owners (called “members”) with limited liability and flow-through tax treatment. Articles of organization must be filed to form an LLC. In most states, the document required to create an LLC is called the articles of organization, but in Texas, this document is called a certificate of formation. The certificate requires:
(1) the LLC’s name;
(2) the name and address of the LLC’s registered agent;
(3) the address of the LLC’s registered office; and
(4) an election as to whether the LLC will be manager-managed.
An operating agreement is typically drafted to govern the LLC’s management and other issues. Members owe each other and the LLC the fiduciary duties of care and loyalty. Management of the LLC is presumptively vested in all of its members, but the operating agreement can detail other management arrangements.
Like partnerships, decisions in the LLC’s ordinary course of business require a majority vote, whereas decisions outside the ordinary course require unanimous consent. An LLC is a hybrid entity that mixes two appealing attributes from other entity forms: the flow-through tax treatment partnerships offer and the limited liability that corporations present. This makes an LLC a very appealing entity form for those seeking to avoid liability and hefty tax bills.
Limited Partnerships (“LP”). Texas law defines a Limited Partnerships (“LP”) as an organization consisting of at least one general partner who manages the partnership’s day-to-day operations and at least one limited partner who is not involved with the management of the business at all.
Limited Partners usually only provide funds to the business. The partners must file a Certificate of Formation with the secretary of state to form an LP. This certificate must include:
(1) the LP’s name;
(2) the name and address of the agent for service of process;
(3) the name and address of each general partner; and
(4) the address where they will keep the records.
Texas law prohibits limited partners from participating in the control of the LP in any way. Unlike general partners, limited partners do not owe each other or general partners a duty of care or loyalty. Liability depends on which type of partner someone is. General partners are jointly and severally liable for the LP’s obligations, like a general partnership. Often we create a Corporation or LLC to act as the general partner.
Conversely, limited partners have limited liability; they are only liable up to the value of their investments. However, this limited liability is lost when a limited partner participates in the management of the LP. An LP is a good entity choice for those starting a business that will be funded by investors who are not seeking an active role in management.
A Limited Liability Partnerships (“LLP”) is a general partnership where all partners have limited liability. Licensed professionals, like attorneys or doctors, frequently form LLPs to protect each partner from liability for professional malpractice of other partners. Still, any two or more people can develop an LLP if they wish. Each partner is, however, still liable for his own negligence as well as the negligence of people he supervises.
An LLP is created when a pre-existing partnership registers with the Texas Secretary of State, The application for registration must include:
(1) the LLP’s name;
(2) the address of the partnership’s principal office; and
(3) the number of partners.
LLPs are flow-through entities. This means that Each partner pays taxes on their individual income taxes, like general and limited partnerships. Partners should also remember that annual Texas requires LLPs to file yearly renewals of their registrations.
A corporation (denoted with “Inc. or “Corp””) is also technically referred to as a C-corporation to differentiate between an S-corporation. Articles of Incorporation must be filed to form a corporation. In Texas specifically, a form called the Certificate of Formation For-Profit Corporation must be filed with the Texas Secretary of State.
At a minimum, this form must state:
(1) the corporation’s name;
(2) name and address of the incorporator;
(3) address of the corporation’s registered agent and office; and
(4) certain information concerning stock.
The articles must provide the maximum number of shares the corporation can sell, known as the authorized stock.
Corporations must have an initial organizational meeting between the initial directors listed in the articles of incorporation as well. The directors will adopt the corporation’s initial bylaws, rules that govern its behavior and appoint officers at this meeting. A corporation will be formed once these formalities are completed.
A board of directors, which the shareholders usually annually elects, manages a corporation. Directors owe fiduciary duties of care and loyalty, but the business judgment rule insulates directors from liability for all actions reasonably taken, even if the corporation takes major losses. The board also elects the officers, typically a President, Vice President, Secretary, and Treasurer.
Conversely, shareholders are not involved in daily management; they only vote to elect or remove directors and make fundamental corporate changes, like a merger.
Shareholders are not personally liable for the corporation’s obligations. Rather they have limited liability. This means shareholders are only liable for the amount they invested into the corporation.
Double taxation is the main con associated with the corporate entity. A corporation pays taxes on its profits, and shareholders are taxed individually on their distributions, hence the “double” taxation. Corporations are chosen when the owners plan to sell shares of a company to the public or many investors.
Unlike every other entity form on this list, an S-corporation has nothing to do with Texas state law. Rather it is solely a federal tax election. An S-corporation is formed by filing an election, contained in IRS Form 2553, with the IRS.
An S-corporation fixes that double taxation problem we just discussed. Like an LLC, an S-corporation is a pass-through entity. However, there are many several restrictions that an S-corporation brings with it:
(1) S-corporation shareholders must be US citizens or residents. Other corporations and non-resident aliens are not eligible to be shareholders;
(2) There are a maximum of 100 shareholders allowed; and
(3) only one class of stock can be issued.
An S-corporation election is a plausible route for shareholders of a smaller company aiming to lower their tax bill.
A professional corporation (“PC”) is organized solely to render one specific professional service. A professional service is defined as one that requires a license to practice. Certain professionals, like doctors or lawyers, must use a professional entity form to form a business to offer their professional services. A professional corporation is formed by filing a certificate of formation with the Texas Secretary of State, which includes:
(1) the PC’s name;
(2) the PC’s purpose;
(3) the PC’s directors;
(4) registered agent and office; and
(5) the number of authorized shares.
All shareholders, officers, directors, and employees (other than ancillary personnel) must be licensed to perform the professional service for which the entity was organized.
Ancillary personnel are employees who do not possess a professional license and work under the supervision of licensed employees. One drawback to professional corporations is that it does not protect their directors and shareholders from malpractice liability, unlike other corporate forms.
Likewise, an existing LLC or a new entity can elect to offer professional services via a professional limited liability company (“PLLC”). A certificate of formation, similar to the one used to file a regular LLC, must be filed to form a PLLC.
A PLLC is subject to the same restrictions imposed on shareholders and officers in a PC. Namely, all members and managers of a PLLC must be licensed to offer the professional service that the PLLC provides.
An integral part of an entity’s business operation is adequate insurance coverage. Our attorneys
can advise you on the appropriate coverage.
It is crucial that your entity receive accurate and timely advice before engaging in business, as many facets of a business operation are dependent on solid tax advice. Our attorneys will, in concert with your tax advisor, get you on the right path. Tax avoidance is perfectly legal; tax evasion is not.
Choosing the right entity structure for your business in Texas can have a significant impact on the daily operations and long-term growth of your company. Further, depending on your line of work, your level of liability can be significantly impacted based on your business entity choice.
Contact us today so that we can help ensure you choose the best entity structure for your needs and structure your entity properly.