I.    Choices for the Legal Structure of Your Business Entity

Generally speaking, Texas law provides for five basic forms of business organizations:
•    Sole Proprietorships
•    General Partnerships
•    Limited Partnerships
•    Limited Liability Company (“LLC”)
•    Corporation

A.    Sole Proprietorship

The sole proprietorship is the simplest and most convenient form of business organization.  In a sole proprietorship, there is no legal difference between the owner and the business.  The owner does not need to file anything with the state to be a sole proprietor—other than a “DBA” or assumed name certificate, which must be filed with the county in order to operate a business under a name other than the name of the owner.

In a sole proprietorship, there is only one owner.  That owner makes all the decisions and is subject to complete liability for everything that happens in the business.  The business does not pay taxes separately, rather business income is taxed on Schedule C of the owner’s federal income tax return.  There are no state taxes.

A business that is owned as community property by a husband and wife can be considered a sole proprietorship, and need not be treated as a partnership.  However, the husband and wife will need to file an election to be taxed as a “qualified joint venture” in order to avoid being treated as a partnership by the IRS.

Generally, the advantages of a sole proprietorship when there is only one owner are simplicity, flexibility, virtually no cost to set up, and no double federal taxation or state taxation.  The principal disadvantage is unlimited personal liability.

B.    General Partnership

A General Partnership is a business for profit that is jointly owned by two or more persons (and these “persons” may be corporations or other business organizations).  A partnership is formed when the parties intend to jointly own a business for profit.  It is not necessary that the parties use the term “partnership.”  Typically, a partnership involves the sharing of profits and losses and mutual control and management of the business, but these typical elements can be modified by agreement. Furthermore, a partnership may exist even if there is no written partnership agreement.  Nothing needs to be filed with the state to create a partnership, although an assumed name certificate or DBA will usually need to be filed with the county.

A partnership is considered to be an entity separate from its owners, and it may sue or be sued in its own name, make contracts and otherwise do business as a unique entity.  However, all partners are each jointly responsible for all partnership debts and are each liable for all claims against the partnership.  Partners also have duties to each other and to the partnership to act with care and loyalty, utmost good faith, fairness and honesty.

General partnerships are not taxed separately from the individual partners. Partnerships are required to report their income or losses for federal tax purposes on a Form 1065, and each partner receives a Form K-1 apportioning his or her share of the partnership income or loss.  General partnerships do not pay the state tax.

Generally, the advantages of a general partnership when there is more than one owner are simplicity, flexibility, virtually no cost to set up, and no double federal taxation or state taxation.  The principal disadvantage is unlimited personal liability.

1.    Joint Venture

A joint venture is essentially the same thing as a partnership.  After the Texas Revised Uniform Partnership Act became effective for all partnerships in 1999, it is not clear that any separate legal distinctions exist for joint ventures from partnerships.  Traditionally, the distinction was that joint ventures were partnerships for limited purposes; that is, that the parties agreed that the joint venture would be for only one particular project or one particular purpose, after which the joint venture would not exist any more.  The agreement to form a joint venture rather than a partnership also made clear that the participants were not in business together generally and were free to compete with each other and were under no duties of loyalty or care to each other, except within the scope of the joint venture project.  Under the new Texas partnership law, such limitations can also be placed on a partnership by agreement.  Therefore, the advantages and disadvantages of the joint venture are the same as those of the partnership.

2.    Registered Limited Liability Partnership

A Registered Limited Liability Partnership (LLP) is a general partnership, except that the individual partners are not individually liable for the errors and omissions of other partners or employees or representatives of the partnership, unless they are directly involved or had notice of the errors and omissions at the time of the occurrence and failed to take reasonable steps to prevent or cure them.  Furthermore, partners are not individually liable for partnership debts or contractual obligations.  This type of business organization is typically utilized where the business primarily provides services of the sort that malpractice claims against individual partners are a significant risk, and the organization is large enough that there is a fear that a partner might be subject to liability for acts of another partner that were taken without the involvement or knowledge of the first partner.  If there are only two partners, and both are involved on all projects of the business, then the LLP form would not be any more beneficial than that of a general partnership. LLPs must file papers with the Texas Secretary of State and pay fees in order to be formed; otherwise it is just a general partnership.  An LLP is taxed at the federal level exactly like a general partnership; but unlike a general partnership, an LLP must pay the state franchise tax.

C.    Limited Partnership

A Limited Partnership is a business organization that separates ownership and control of the business.  In a limited partnership there are one or more general partners, who operate the business and are subject to the same obligations and liabilities as in any general partnership, and there are one or more limited partners, who are co-owners of the company but are not allowed to be involved in the management or control of the business.  Limited partners are also not subject to any individual liability for debts or claims against the partnership.  Limited partnerships must file organizing papers with the state and pay fees.  Limited partnerships are taxed like general partnerships but are subject to the state franchise tax.

The advantages of the limited partnership are flexibility, no federal taxation, and limited liability for limited partners.  The disadvantages relative to general partnership are higher cost and administrative requirements, the inability of limited partners to participate actively in the management, and the application of the state tax.

D.    Limited Liability Companies

Limited liability companies are a hybrid of a general partnership and corporations.  Limited liability companies are owned by “members” and are run by “managers” who may also be members.  Members are not subject to individual liability for debts or claims against the business.  LLC’s are required to file organizational papers with the Secretary of State and require some care (and probably legal expense) in setting up in order to function as the owners intend.  For example, absent a written agreement to the contrary, the LLC statute presumes that the company will be managed by its members and that each member will have an equal vote regardless of ownership interest.  This provision can come as a shock to an 80% owner who expects to have 80% of the vote (and therefore control).

Limited Liability Companies are taxed like general partnerships, but are subject to the state franchise tax.  Members of an LLC probably owe to each other the same duties that partners owe to each other; however, the members of the LLC have greater flexibility in modifying or specifying exactly their rights and duties in the written agreement.

The advantages of LLCs are limited liability and pass-through taxation.  The disadvantages are greater cost and complexity and application of the state margin tax. 

E.    Corporations

A corporation is a legal entity separate from its owners.  Shareholders may but do not necessarily work in the business or participate in management individually.  A corporation is managed by its board of directors, who are elected by the shareholders.  The duty of the directors is primarily to the corporation, not to individual shareholders.  While shareholders do have some important rights, directors of corporations have greater ability than in any other business form to operate the business without interference by the owners. 

Shareholders are not subject to liability for corporate debts or other claims against the corporation. Directors and officers, likewise, are not individually responsible for corporate debts or contractual obligations or for tort or other claims against the corporation (although a claim may be made against officer directly who individually commits a tort for which the corporation may also be liable).  Corporations must file organizational papers with the state and pay fees, and are subject to the state margin tax.  In terms of administrative cost and complexity, corporations are the most burdensome of all the business forms listed.

Federal income taxation of corporations depends on whether the corporation chooses to be taxed as a “Subchapter C Corporation” or as a “Subchapter S Corporation.”  C-corporations are taxed separately and file their own tax returns, Form 1120.  Owners of C-corporations do not get any benefit of losses suffered by the corporation, and any profits distributed by the corporation to its owners are taxed twice—once as income to the corporation and a second time as income to the shareholders.  S-corporations are taxed like partnerships and LLCs, so that there is no double taxation, and shareholders do receive the tax benefit of any losses.  However, S-corporation status is limited to domestic corporations that are not part of an affiliated group (not a subsidiary), have no more that 75 shareholders, have only one class of stock, and where each shareholder is an individual or the estate of a deceased individual, and no shareholder is a nonresident alien. A qualifying corporation may become a S-corporation by filing Form 2553 with the IRS no later than two months and 15 days after the beginning of the tax year the election is to take effect.

II.    Factors Influencing Your Choice

A.    Federal Taxation

Probably the chief factor in most decisions to structure a business entity is minimization of the tax burden. 

1.    Pass-through taxation

A C-corporation pays taxes on its own income. In all other business organizations and in S-corporations the tax liability is passed-through to the owners.  This means that if a business makes a profit of $1000, then the C-corporation will pay taxes on that $1000 at its own tax rate, while in all other entities, each owner would pay taxes at his individual tax rate on his proportionate share of the $1000.  Why is this important?

a)    Different Tax Rates

The tax rates for corporations and individuals are different.  A corporation making $100,000 to $335,000 pays a marginal tax rate of 39%, while an individual (married filing jointly) would pay only 25% on $100,000-$128,500, only 28% on $128,500-$195,850, and only 33% on $195,850-$349,700.

b)    Double Taxation

If a C-corporation pays out its profits to its owners in the form of dividends (not salary), then those payments are taxed twice: first as corporate income at the corporate rate, and then a second time as dividends at 15%.

c)    Losses and Deductions

If the business loses money, receives tax credits, has a NOL carry-forward from a prior period loss, then those tax benefits are received directly by the owners of pass-through entities (subject to restrictions on those who do not actively participate in the business).  The shareholders in a C-corporation do not share in those tax benefits. These benefits would only be used to offset corporate taxes.

d)    Phantom Income

A significant negative of pass-through taxation is that the owners have to pay taxes on business income even if they do not receive the money.  The taxable income of a business can and usually does exceed the amounts available for distribution to the owners.  For example, money will be spent on non-deductible or partially deductible expenses, such as political contributions or meals and entertainment; money will be spent on capital items that must be depreciated over time; and money may be retained in the business for future working capital.

e)    Self-employment Taxes

Typically, owners of general partnerships, LLCs and S-corporations must pay self-employment taxes on their income.  Distributions to Limited Partners generally are not subject to self-employment taxes.  In C-corporations, the corporation does not pay employment taxes on its own income.  It does pay payroll taxes on the salaries its pays (including salaries to owners), but the payroll taxes paid by the corporation are tax deductible, whereas the self-employment taxes are not.  The tax code also permits somewhat greater deductibility of employee benefits and expenses (which benefit the owners in small corporations) than is allowed in pass-through entities.

f)    Federal Taxation Factor in Perspective

For most small businesses, it is important to keep the tax considerations in perspective.  While the C-corporations pay a much higher marginal tax rate and their dividends are subject to double taxation, most small business in which the owners are also the employees, pay out essentially all their income in the form of salaries and bonuses, so there is no profit left in the corporation to be subject to the higher rates, and none of the money is distributed as dividends.  Salaries and bonuses are deductible to the corporation and thus are not subject to double taxation.  In this situation, the owner of a small C-corporation can actually be in a better situation tax-wise due to the deductibility of payroll taxes and the greater deductibility of employee benefits.  If the company is a small business, in which the owners are the employees, and the business is expected consistently to generate positive income, the benefits of pass-through taxation will be negligible, and C-corporation status might actually be preferable.  If, however, the business is expected to operate at a loss (as often happens in the beginning), and the owners have other income, then pass-through taxation will definitely benefit the owners.

2.    State Taxation

Texas has no income tax, but as of 2007 the state has passed a much enhanced and much more onerous franchise tax (the so-called “margin tax”).  Under the new tax scheme, Texas corporations (both C and S), LLCs, Limited Partnerships, and Limited Liability Partnerships pay 1% (1/2% for retail and wholesale businesses) of the percentage of their tax base earned in Texas.  The tax base is gross receipts less compensation or cost of goods sold, provided that the tax base may not exceed 70% of the gross receipts.  There are significant discounts for smaller businesses, and no tax is due from entities with less than $300,000 in gross receipts.  Sole proprietorships and general partnerships (but not LLPs) are exempt from this tax.

3.    Owner Liability

Every business is subject to liability for its debts, contractual obligations, and tort claims (e.g., personal injury, negligence, malpractice).  A creditor may take all the property of the business to satisfy claims or debts.  The issue is whether a creditor can go after the property that is not in the business that belongs to the owners individually.  The answer is “yes” for general partners and sole proprietors.  The answer is “no” for owners of all other business entities.  (In Limited Partnerships, the limited partners are shielded from personal liability so long as they do not participate in management, but the general partner is fully liable, which is the reason that the general partner is usually set up as a corporation.) In some situations, a creditor may “pierce the corporate veil” to go after the owner’s assets, but only for tort liability and only upon showing that the owner has committed actual fraud.

While limitation of liability is important, it also needs to be kept in perspective for most small businesses.  First, limitation of liability is only valuable of there are other assets to protect.  If a business owner has all his wealth tied up in the business, he gets no real benefit.  Second, in almost every situation, the individual employee can be sued for his own misconduct, as well as the corporation.  If you are the sole shareholder of a small corporation, and you get into an automobile accident while working, then both the corporation and you individually can be sued, in which case the limitation of liability does nothing.  In most small, owner-operated businesses, limitation of tort liability is of little benefit.  The only real protection is good liability insurance.  Finally, while owners of corporations, LLPs, LLCs and limited partners cannot be held personally liable for the company’s debts and contractual obligations, most small business owners discover that they are not able to borrow money or enter into any significant contract without giving a personal guaranty.

4.    Governance and Flexibility

In terms of ease, informality, flexibility, and lack of administrative cost, sole proprietorships and general partnerships are the most beneficial.  It is best with a general partnership to have a written agreement, and partners owe each other duties of care, loyalty, and good faith.  LLPs have the same benefits as general partnerships in this regard, except that they require filing papers with the state, fees, and state taxes.  

Limited partnerships provide most of the benefits of general partnership and allow for passive investors to own a portion of the business without risk of personal liability.  However, limited partners can have only a minimal role in management, or they are treated as general partners and lose their liability protection.  For this reason, this form of business is impractical for many small businesses where all the owners expect to work in the business and participate in management.  Limited Partnerships also involve much greater administrative expense and effort than general partnership.

LLCs are very flexible and convenient.  For small companies with a small number of owners, the administrative hassles involved with the LLC are about the same as with a corporation.  Both require filings with the state and payment of fees for formation and ongoing record keeping and filing of papers.  LLCs tend to be somewhat more flexible and informal than corporations, but greater care is required when setting up an LLC because the law presumes that the internal structures and procedures of an LLC will be set forth in a written agreement.

The governance of a corporation is largely controlled by statute, but law allows corporations considerable flexibility in structuring their internal procedures through shareholder agreements, by-laws and articles of incorporation.  Because ownership in a corporation is represented by shares (with written certificates) and because of the familiarity of the business world with corporations, this business form is probably the best for larger organizations (with many owners).  The share structure of a corporation makes it easier to give or sell small portions of ownership, to raise money, or to pay employees with equity.  The corporation exists independently of its owners, so the company does not go out of existence when one of the owners quits or when the owners decide they don’t want to be in business with each other.  Share interests can be freely bought and sold by shareholders, unless restricted by agreement.  And while shareholder rights are important, the management of a corporation has considerable autonomy in running the business without the direct interference of shareholders.