Have you ever wondered what type of entity would work best for your business, but you were unsure where to begin? LLC? Corporation? LP? Perhaps we can shed some light on what each different type of entity can offer a business so that you can better decide what’s best for you.
There are, generally speaking, five different types of entities that can be formed in Texas, several of them having different offshoots. They are as follows: sole proprietorships; general partnerships; corporations; limited liability companies; and limited partnerships.
Sole proprietorships are formed when an individual person is doing business under his own name or that of an assumed name. There are no formal organizational requirements and do not require a filing with the Secretary of State’s Office. There is no limit as to the liability of this type of entity and as such, your personal assets are at risk as well as those used in the business. Only the assets of the business can be sold, in contrast to the other type of entities that have ownership interests that can be sold in lieu of the assets, which may result in more tax liability on the sale of the business for the seller. There is no entity taxation at either the state or federal level because there is no entity in existence to be taxed. All income of the business is treated as earned directly by the sole proprietor and is taxed at the ordinary income rates as a result.
General partnerships exist when two or more individuals or entities have shared ownership of the business. There are no formal organizational requirements to form a general partnership and there are no formal management or governance requirements. All partners have unlimited liability for the acts of the partnership and the other partners and all partners have the authority to bind the partnership. Although this type of entity exists for state law purposes, the tax law may view this type of entity as either an association or as a partnership depending on the facts and circumstances. If the facts lend themselves towards an association then the income earned is treated the same as in a sole proprietorship where the income is earned directly by the partner. If the facts lend themselves towards a partnership, then Subchapter K of the internal revenue code (the “code”) will control and the income will be earned by the partnership and will flow through to the partners and depending on the type of business and the amount of income, may qualify for the 20% deduction under section 199A of the code.
Corporations are formed when a certificate of formation is filed with the Texas Secretary of State’s Office and it is accepted. A corporation has the most rigorous management and governance structure of all entities that can be formed in Texas. The formalities such as annual meetings, holding the assets of the corporation at the corporate level, and having arms-length transactions between the corporation and its shareholders and/or directors must be followed to maintain the limited liability protection for the shareholders. The limited liability can only be breached in extreme circumstances and generally protect the shareholder’s personal assets. The stock of a corporation is generally freely transferrable unless it’s clearly noted on the certificate that it is subject to transfer restrictions.
A corporation may be taxed as either a c-corporation or an s-corporation for federal income tax purposes. The tax rate for a c-corporation is much lower now than it has ever been under the Tax Cuts and Jobs Act (TCJA) at 21%. However, it is not clear how long that rate will stay at this historic low so it should be approached with caution. Any income distributed to the shareholders from a c-corporation will be taxed again at the shareholder level – a key feature of a c-corporation known as double tax. There is a single tax to shareholders if the shares of the corporation are sold but there is double taxation if assets are sold as it is deemed income to the entity and then a distribution to shareholders. Generally, this structure is not desirable to small businesses or businesses that hold a lot of appreciating real estate. However, section 1202 of the code makes it worth considering this structure and should be discussed with your attorney and other tax advisors.
An s-corporation carries with it its own unique challenges in that the total number of shareholders is limited, the residency requirements of the owners are ridged, and the ability to own s-corporation stock is limited to certain owners. There can only be one economic class of stock and the income paid out is flowed-through to the owners much like in a partnership. One benefit of the s-corporation though is that the self-employment tax can be avoided by the owner.
Limited liability companies are also formed when a certificate of formation is filed with the Texas Secretary of State’s Office and it is accepted. A limited liability company may be either manager managed or member managed. Depending on the facts and circumstances, one way may be better than the other. Limited liability companies provide their members liability protection for their personal assets much like a corporation. If a limited liability company is owned by one member, either an individual or an entity, then its default tax classification is a disregarded entity. This means that the entity is disregarded for tax purposes and all of the income is deemed to be earned at the member level and is taxed accordingly. However, the member can make an election to have the limited liability company taxed as either a c or an s corporation for tax purposes. If a limited liability company is owned by more than one member, either multiple individuals or entities or a combination thereof, the default tax classification is a partnership. However, as with the single member limited liability company, the members may elect to have it be taxed as either a c or an s corporation.
Limited partnerships are also formed when a certificate of formation is filed with the Texas Secretary of State’s Office and it is accepted. A limited partnership is a partnership in which some partners have limited liability protection – also known as the limited partner(s) – and at least one partner has unlimited liability – also known as the general partner(s). The general partner is usually a limited liability company or a corporation in order to provide limited liability to those forming it. Limited partnerships are taxed as partnerships for federal income tax purposes. There are different variations of the limited partnership, such as limited liability partnerships and limited liability limited partnerships that are recognized by the state. These variations should be discussed with your attorney or other tax advisors.
Deciding on an entity type is not always the easiest task. Working with a professional who is knowledge of the current laws, especially tax laws, can reduce future risk and help secure the best option for your business. The attorneys at Sprouse Shrader Smith are here to assist in all your business formation needs.
Author: Adam Trimble