Small Business Legal Issues - Selecting a Business Structure
A U.S. Small Business Administration's article, 10 Steps to Start Your Business, touches on key legal issues that business start-ups face. These key issues are (1) Selecting a Business Structure; (2) Choosing a Business Name; (3) Registering your Business; (4) Obtaining federal and state tax identification numbers; and (5) Applying for Licenses and Permits. This blog post focuses on the first of these key legal issues - selecting a business structure.
Selecting the appropriate business structure is one of the first steps to forming your business. Here are some factors that will influence your decision:
Ownership and Management Structure
Required Governing Documents
So, taxes (ugh, right?). Selecting a business structure that limits tax liabilities is a factor in the decision-making process. As a threshold matter, business entity selection is different than how the entity is treated for taxation purposes. In other words, there is a difference between what a business entity is as opposed to how it is taxed. While the selection of a legal entity will result in a default taxation method, in some instances, an entity can change the default by meeting certain requirements and timely filing paperwork with the IRS to indicate that it chooses to be taxed under a different selection - as a disregarded entity, a partnership, a C-corporation, or an S-corporation. Here is a summary of taxation methods for common business entities,
Corporation - The default federal taxation method for a corporation is a C-corporation. A corporation can elect to be taxed as an S-Corporation if it meets certain requirements and timely files the election with the IRS.
Limited Liability Corporation - The default federal taxation method for a sole-member Limited Liability Corporation is a disregarded entity. Under this tax method, the disregarded entity's owner is considered to own the assets for tax purposes and reports the entity's income and expenses (or losses) on his or her own income tax return. In other words, the entity is "disregarded" and the owner is taxed as a sole proprietor. The default federal taxation method for a multi-member LLC is a partnership. Thus, LLC owners enjoy pass-through taxation instead of being taxed on both (i) a corporation’s profits and (ii) each shareholder’s profit when distributed as a dividend (i.e., "double-taxed"). Either a single-member or multi-member LLC can elect to be taxed as a C-corporation or an S-corporation by meeting certain requirements (e.g., the number, type and residency of stockholders) and timely filing with the IRS.
Limited Partnership - The default federal taxation method for a Limited Partnership is a partnership. A Limited Partnership can elect to taxed as either a C-corporation or an S-corporation by meeting certain requirements and timely filing with the IRS.
Limited Liability Partnership - The default federal taxation method for a Limited Liability Partnership is a partnership. A Limited Liability Partnership can elect to taxed as either a C-corporation or an S-corporation by meeting certain requirements and timely filing with the IRS.
An entity's formality depends on its filing requirements and internal governing documents. The entities with the least formal and less onerous filing requirements are sole proprietorships and general partnerships. Sole proprietors and partners have minimal state filing requirements to meet because these entities do not have required formation filings. If a sole proprietorship or general partnership will operate under a fictitious name, then an assumed name certificate must be filed with the county clerk’s office in the county where the business premises are maintained. As for internal governing documents (documents that help the entity to operate but are not filed with the state) partnerships need a partnership agreement but Texas law does not require it to be in writing. A best practice is to have a written partnership agreement to clearly set out issues like ownership share, disbursements, approval of additional partnership interests, and succession.
To form a Limited Partnership, Limited Liability Corporation or a Corporation, a certificate of formation must be filed with the Texas Secretary of State. In addition, internal governing documents are required. The internal governing documents for a Limited Partnership is a partnership agreement, while the internal governing document for a Limited Liability Corporation is a limited liability company agreement. The internal governing documents for a Corporation are by-laws and stockholders' (a.k.a. "corporate") agreement.
A general or limited partnership can register with the state as a Limited Liability Partnership to limit the liability of general partners. Each partner of a Limited Liability Partnership must annually register with the State. For a limited partnership, the annual registration is in addition to the required certificate of formation filing.
Ownership & Management Structure
An important business consideration is the ownership and management structure of an entity. A sole proprietorship only has one owner while a general partnership has more than one owner. Here is a quick summary of the ownership and management structures of common business entities,
Corporation - Shareholders are the owners of the corporation, and managers of its business affairs are directors. Yet, Texas corporate law allows shareholders to enter into a shareholders’ agreement that eliminates directors and provides for a shareholder management. A corporation is governed by a board of directors. The board of directors must designate officers to manage the day-to-day operations, while certain major decisions must be approved by the stockholders.
Limited Liability Corporation - The owners of an LLC are called members. An LLC can be managed by managers ("manager-managed") or members ("member-managed"). The management structure must be reported on the certificate of formation filed with the state.
Limited Partnership or Limited Liability Partnership - The owners of a Limited Partnership or a Limited Liability Partnership are its partners. A limited partnership or a limited liability partnership requires two or more persons or entities, with at least one serving as a general partner and at least one or more limited partners. Under either entity selection, a limited partner does not take an active role in the business.
Sole proprietors and partnerships do not provide owners with personal liability protection (i.e., limited liability). That is, an owner's personal assets are not protected from business creditors or if a lawsuit is filed against the business, and the assets can be seized to satisfy business obligations, debts, or a judgment. If you are an business owner who does not need liability protection because you will not have employees or independent contractors, will not acquire or sell property, will not enter into any leases, will not enter into any supply or sales contracts, and you operate in a non-litigious industry, then a sole proprietorship or a partnership may meet your business needs.
Here is a summary of the legal protections afforded for other common business structures,
Corporation - A corporation affords protection from personal liability because a stockholder's liability is limited to the amount of capital contributed.
Limited Liability Corporation - LLC members can protect their personal assets from the company’s debts, just as the owners of a corporation do. In an LLC, member liability is limited to capital contribution.
Limited Partnership - In a Limited Partnership, only limited partners enjoy limited liability to the extent of his or her investment in the partnership. In contrast, a general partner does not have personal liability protection.
Limited Liability Partnership - Both general and limited partners are liable only for the amount they invest in the entity.
Forming a sole proprietorship is least costly because it only requires the payment of applicable assumed name certificate filing fees. Each partner in a Limited Partnership must pay an annual registration and filing fee of $200. The certificate of formation filing fee for a Limited Partnership is $750. The certificate of formation filing fee for a Limited Liability Corporation and a Corporation is $300.
These are a few factors to consider when choosing a business entity. Which entity form you choose will also depend on whether you intend to raise capital, administrative requirements to maintain and keep the structure, and your purpose for the entity (e.g., for real estate investment or business acquisition, or to operate in specialized industries). When forming an entity, you should consult with a business lawyer and a certified tax professional at the outset. Choosing not to consult an experienced professional can result in significant missteps in the form of unnecessary taxation, exposure to legal liability, and risking the seizure of personal assets.
Disclaimer: My firm provides business formation and related services for businesses across Texas, including Fort Worth, North Richland Hills, Euless, Bedford, Southlake, Arlington, Irving, Dallas, Plano, Houston, Austin, San Antonio, Corpus Christi, and Beaumont. This web site is designed for general information only. The information presented should not be construed to be formal legal advice nor to form an attorney-client relationship.
About Lisa D. Mares: Lisa D. Mares is an attorney at the Mares Law Firm, PLLC. She is a member of the Northeast Tarrant Chamber of Commerce. She loves sharing stories about the trials and triumphs of raising three daughters with her husband, as well as about her experience as a Camp Fire Fort Worth volunteer. Contact Lisa at firstname.lastname@example.org or learn more about her law firm at www.MaresLawFirm.com.