Overview of Forms of Business Entities
A. Sole Proprietorship/General Partnership
1. Formation.
The sole proprietorship or general partnership is formed when one or more individuals go into business. No other action is needed. If the business is conducted under an assumed name, then the business owner(s) must file an assumed name certificate and obtain an employer identification number from the IRS.
2. Liability Protection.
Neither the sole proprietorship nor the general partnership offers liability protection to the business owners.
3. Formalities.
The sole proprietorship and general partnership are alter egos of the business owners. Consequently, no observation of formalities is required.
4. Taxation.
The taxation of sole proprietorships and general partnerships is very simple because sole proprietorships are disregarded entities and general partnerships offer flow through taxation of all profits and losses straight to the owners of the business Additionally, neither the sole proprietorship nor the general partnership are subject to franchise tax in the State of Texas.
5. Common Uses.
Businesses that typically benefit from being structured as a sole proprietorship or general partnership include very small businesses where the business owns assets of little value and where the business owners perform the activities of the business or the business owners hire independent contractors to perform the activities of the business. Once the business takes on employees or begins to accumulate assets, the business owner should consider doing business as a statutorily created business entity to limit his exposure to the liabilities of the business and/or to protect the assets of the business from his individual liabilities.
6. Limited Liability Partnership.
A general partnership may elect to become a limited liability partnership by filing a statement providing the following information: 1) the name of the partnership; 2) the federal tax identification number of the partnership; 3) the street address of its principal office in Texas and outside the state, if applicable; 4) the number of partners at the date of application; and 5) a brief statement of the business in which the partnership engages.
A partner's liability in a registered limited liability partnership differs from that in an ordinary partnership. In a registered limited liability partnership, a partner is not individually liable for debts and obligations of the partnership incurred while the partnership is a registered limited liability partnership, nor is the partner liable for tortious acts committed by other partners. However, each partner is exposed to unlimited liability for torts of the partnership. For example, if the partnership owns a building and fails to maintain it and, as a consequence, a person is injured and seeks a judgment against the partnership, each partner is exposed to individual liability.
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B. Corporation
1. Formation.
A Texas corporation can only be created by filing articles of incorporation with the Texas Secretary of State. Texas corporations are governed by the Texas Business Corporation Act.
2. Liability Protection.
A corporation does provide limited liability for its shareholders such that shareholders’ liability is limited to each shareholder’s interest in the corporation. Consequently, the recovery of a judgment creditor of a corporation is limited to the assets of the corporation. In other words, the corporation is responsible for its own debts and torts, not the shareholders. The individual assets of the shareholders may not be used to satisfy the judgment creditor of a corporation, provided the corporate structure is respected by the shareholders and the courts. While the limited liability protection a corporation offers to its shareholders is a fundamental attribute of the corporate form, three important exceptions exist.
a. No Business Asset Protection. First, an often ignored drawback of the corporate form involves business asset protection. Business asset protection is the protection of business assets from the individual liabilities of the business owners. Liability protection does not extend to the assets of the corporation, as the shares owned by a shareholder may be attached by a judgment creditor of a shareholder. If the shareholder owned a controlling interest in the corporation and the judgment creditor satisfied the judgement with the controlling shares of the corporation, the judgment creditor of the individual shareholder could gain control of the business. The creditor could then ultimately run the corporation and sell off all the corporation’s assets to satisfy the judgment.
b. Piercing the Corporate Veil. Second, another exception to the doctrine that the corporate form will protect shareholders from the liabilities of the corporation involves piercing the corporate veil. “‘Piercing the corporate veil,” or “disregarding the corporate entity,” refers to the judicially imposed exception to the principle of limited liability by which courts disregard the separateness of the corporation and hold a shareholder responsible for the corporation’s action as if it were the shareholder’s own.”
Texas courts distinguish between claims arising from tortuous actions and claims arising out of a contract. If the claim involves a tort, the plaintiff need not show that the corporation acted in a fraudulent manner. However, if the claim involves a contract dispute, the plaintiff’s burden of proof is elevated because the plaintiff must show actual fraud. The theory behind this distinction arises from the belief that in a tort case, the relationship with the corporation is involuntary; and in the case of a contract, the relationship with the corporation is voluntary.
The courts in Texas have disregarded the corporate form under the following theories: 1) the corporation form is used as a means to perpetrate fraud; 2) the corporation is organized and operated as a mere tool or business conduit of another corporation; 3) the corporate form is used to evade an existing legal obligation; 4) the corporate form is used to perpetrate monopoly; 5) the corporate form is used to circumvent statute; and 6) the corporate form is used to justify wrongdoing.
3. Formalities.
In order for the corporate structure to be respected by the courts and prevent the corporate veil from being pierced, the shareholders should observe corporate formalities. Specifically, the corporation should, inter alia: 1) keep the minute book up to date by including minutes of annual and special meetings; 2) maintain financial records separately from the individual shareholders; 3) issue stock certificates; 4) adhere to the bylaws; 5) maintain the stock ledger; 6) hold directors meetings to approve large expenditures, long-term leases, and compensation plans; 7) insure that the corporation is adequately capitalized and insured; and 8) avoid transactions involving self-dealing.
4. Taxation.
All corporations are subject to franchise tax in Texas. A corporation must pay franchise taxes equal to the greater of .25% of the net capital of the corporation or 4.5% of the net taxable earned surplus. No franchise tax is due if the corporation: 1) had no gross receipts in the State of Texas; 2) had total gross receipts of less than $150,000; or 3) had total taxable capital of less than $40,000 and its earned surplus totaled less than $2,222.
Under federal law, a corporation may be taxed as a corporation under subchapter C of the Internal Revenue Code or as a pass through entity under subchapter S of the Internal Revenue Code.
a. C Corporation. Unless the corporation elects otherwise, it will be taxed under subchapter C of the Internal Revenue Code. Consequently, the net income of the corporation will be subject to income tax at the corporate level. If the net income is distributed to shareholders and not added to the retained earnings of the corporation, the shareholders must pay income tax on the dividend, resulting in what many practitioners refer to as “double taxation.” Some individuals get around this double taxation issue by taking the net income out of the corporate entity as wages. These wages are a deduction to the corporation and income to the shareholder employee.
b. S Corporation. If a corporation makes an election with the IRS on Form 2553 to be taxed as a subchapter S corporation, then the corporation will be taxed as a flow through entity. The Form 2553 must be filed: 1) at any time on or before the 15th day of the third month of the tax year; or 2) at any time during the preceding tax year. Often times, practitioners interpret the 15th day of the third month to mean 75 days. However, if a corporation is formed, say on January 31, the Form 2553 is due by March 15th, which could give the tax professional as few as 42 days to file the election in a leap year.
A corporation must have the following characteristics in order to qualify for subchapter S tax treatment: 1) it is a domestic corporation; 2) it has no more than 75 shareholders; 3) the shareholders are individuals, estates, certain exempt organizations, or qualified subchapter S trusts; 4) no nonresident aliens are shareholders; 5) it has only one class of stock; and 6) it has a tax year ending December 31, unless electing otherwise.
The taxation regime outlined in subchapter S of the Internal Revenue Code allows flow through taxation so that the net profits of the corporation flow straight to the shareholders’ individual income tax return instead of being first taxed at the corporate level. Generally, the S corporation enables shareholders to receive a reasonable salary and then take the remaining profits as net income subject only to income tax, not social security and medicare taxes. However, the benefits associated with taking the profits out of the S corporation without those profits being subject to social security and medicare taxes must be balanced against the franchise tax. So, if a shareholder does not take the net income of a corporation in salary, which is deductible to a corporation, and pay the appropriate social security and medicare taxes (which social security wage base is $87,000 in 2003 while the 2.9% medicare tax wage base is unlimited), then such shareholder could pay 4.5% in franchise tax on the net income earned in a corporation, as compared to only 2.9% in medicare tax on the wages paid out of a corporation.
5. Common Uses.
The C corporation is frequently used by business owners seeking venture capital, planning to go public, anticipating much growth, seeking to increase the value of the business, and/or requiring the maintenance of a large capital base by the corporation (for research and development, as an example). Small businesses often operate as S corporations.
6. Other Types of Corporations
a. Professional Corporation. The professional corporation is formed by filing articles of incorporation with the Texas Secretary of State and setting out inside the articles that the corporation is a professional corporation. The professional corporation is governed by the Texas Professional Corporation Act. The professional corporation may be taxed as either a C corporation or an S corporation. Business owners may form professional corporations if they are professional service providers such as attorneys, architects, CPAs, etc. The professional corporation does not offer limited liability protection for the professional malpractice of the shareholder. However, the business owner enjoys limited liability for claims accruing from sources other than the business owner’s own activity. For example, if a client of the business owner suffers injury from a fall in the business owner’s office, the business owner will be shielded from personal liability, so long as the fall did not result from the business owner’s own negligence.
b. Professional Association. The professional association is formed by filing articles of association with the Texas Secretary of State and it is governed by the Texas Professional Association Act. The professional association may be taxed as either a C corporation or an S corporation. The professional association is not subject to franchise tax in Texas. The types of individuals that can form a professional association are only those persons duly licensed to practice a profession, including: podiatry, dentistry, optometry or therapeutic optometry, or chiropractic medicine. Again, this type of entity does not offer limited liability protection for the professional malpractice of the shareholder. However, like the professional corporation, the business owner enjoys limited liability for claims accruing from sources other than the business owner’s own activity.
c. Nonprofit Corporation. The nonprofit corporation is formed by filing articles of incorporation for a Texas nonprofit corporation with the Texas Secretary of State. If the nonprofit seeks to be exempt from state and federal taxation, the corporation must file a Form 1023 Application for Recognition of Exemption with the IRS and pay a user fee amounting to $150 if gross receipts will average less than $10,000 per year for five years, or $500 if gross receipts are expected to average more than $10,000 per year. If the application is approved, then the nonprofit will receive a determination letter or advanced ruling from the IRS. If the nonprofit seeks tax exempt status with the State of Texas, the nonprofit must file a statement of activities with the Texas Comptroller of Public Accounts and enclose the determination letter or advanced ruling received by the IRS.
Upon formation, all the officers and directors of a nonprofit enjoy limited liability so long as their actions do not constitute a breach of the fiduciary duty of loyalty to the nonprofit corporation.
Generally, as long as the nonprofit corporation receives tax exempt status from the IRS, it is not subject to federal income tax and so long as the nonprofit corporation receives tax exempt status from the Texas Comptroller of Public Accounts it is not subject to sales or franchise tax. Three important exceptions exist to this rule. First, unrelated business income, which is income received that is not in furtherance of the nonprofit’s tax exempt purpose, is subject to income tax. Second, the nonprofit must pay employment taxes. Third, the nonprofit must also pay property tax unless the real property is used in furtherance of its exempt purpose.
Additionally, if a nonprofit’s gross receipts total more than $25,000 and it is not a church or other organization exempt from filing, then the nonprofit is required to file annual returns with the IRS. Such filings are done on Form 990.
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C. Limited Liability Company
1. Formation.
The limited liability company is formed by filing articles of organization with the Texas Secretary of State and it is governed by the Texas Limited Liability Company Act.
2. Liability Protection.
Like the corporation, the limited liability company offers limited liability protection to its members, such that each member’s liability is limited to each member’s interest in the limited liability company. Consequently, if a liability accrues within the limited liability company, then the members’ personal assets will be protected from a judgment creditor of the limited liability company, provided that the company form was respected by the members and the courts.
a. Business Asset Protection. Perhaps the most important difference between the corporation and the limited liability company relates to business asset protection. In the event a judgment creditor of a member of a limited liability company seeks to satisfy such judgment with such member’ interest in a limited liability company, the creditor will obtain only the rights of an assignee. This assignee interest does not give a creditor voting rights nor does it give a creditor the power to force a distribution on such interest. As a result, the limited liability company and its assets are protected from the judgment creditors of its members.
b. Piercing the Company Veil. The same theories that apply to a corporation with regard to piercing the corporate veil likely apply to a limited liability company.
3. Formalities.
Like a corporation, in order for the company form to be respected by the courts, thereby shielding members from company liabilities, the members must adhere to the formalities of operating a limited liability company. The formalities associated with the limited liability company are similar to the formalities associated with a corporation, with one relatively important difference. If the limited liability company is taxed as a disregarded entity or partnership, minutes of annual and special meetings are unnecessary. However, most practitioners encourage business owners to conduct annual and special meetings even if they are not required.
4. Taxation.
With an limited liability company, it is possible to have several different structures for taxation. A breakdown is as follows:
a. Sole Proprietorship. By default, if a single person or entity forms a limited liability company, then the taxation of such limited liability company will be deemed to be disregarded and the limited liability company will be taxed as a sole proprietorship if the member of the limited liability company is an individual, or it will be taxed as a branch or division of the entity owner. This type of taxation results in all of the limited liability company’s income and expenses being reported on the individual or entity’s income tax return. While the limited liability company is a disregarded entity for tax purposes, it is not disregarded under state law, affording the members the benefits associated with limited liability.
b. Partnership. By default, if two or more single persons or entities form a limited liability company, then the taxation of such limited liability company will be deemed to be a partnership and the limited liability company will be required to file a Form 1065 tax return.
c. C Corporation. A limited liability company, after formation, may elect to be taxed as a corporation by filing Form 8832 Entity Classification Election and checking the box choosing to be taxed as an association taxable as a corporation. As a result, net income earned by the limited liability company will be taxed inside the limited liability company at the lower corporate tax rate. Like a corporation, a limited liability company making this election is required to file income tax Form 1120.
d. S Corporation. If the limited liability company files Form 8832, electing to be taxed as an association taxable as a corporation, and Form 2553, electing to be taxed under subchapter S of the IRC, then the limited liability company will be taxed as a subchapter S corporation. Like a subchapter S corporation, the limited liability company making these elections is required to file income tax Form 1120S.
5. Common Uses.
The Limited Liability Company is frequently used by business owners, small or large, who seek limited liability protection along with business asset protection, in a simple or complex type of entity.
6. Professional Limited Liability Company.
The limited liability company will be deemed to be a professional limited liability company if the members file articles of organization which state that the company is a professional limited liability company formed for the purpose of rendering professional services by individuals licensed in any type of professional service which requires as a condition precedent to the rendering of such service the obtaining of a license, permit, or certificate. Examples of such professional service providers include: architects, attorneys, certified public accountants, dentists, public accountants, and veterinarians.
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D. Limited Partnership
1. Formation.
A limited partnership is created by filing a certificate of limited partnership with the Texas Secretary of State.
2. Liability Protection.
A limited partnership does provide limited liability to its limited partners, such that each limited partner’s liability is limited to such partner’s interest in the limited partnership. However, the general partner of a limited partnership is personally liable for the liabilities of the limited partnership. Consequently, if the limited partnership will own assets giving rise to liability exposure, the well advised business owner will not serve as the general partner of the partnership, individually. Rather, such business owner will form another business entity such as a limited liability company or a corporation to serve as the general partner of the limited partnership, shielding the business owner from personal liability. When selecting a business entity to be used as the general partner of a limited partnership, most practitioners favor the use of the limited liability company over the corporation because the limited liability company provides business asset protection, which protects the assets of a business from the individual liabilities of its stakeholders.
a. Business Asset Protection. Like the limited liability company, the assets of the limited partnership are protected from the judgment creditors of the limited partners. If a judgment creditor of a limited partner seeks to satisfy such judgment with the limited partner’s interest in the limited partnership, the judgment creditor is treated as having the same rights as an assignee.
b. Piercing the Partnership Veil. Little authority exists on the issue of whether the partnership veil may be pierced so that limited partners are exposed to personal liability for the wrongdoings of the limited partnership. However, practitioners suggest that piercing the partnership veil is likely not a remedy available to the judgment creditors of a limited partnership.
3. Formalities.
As with any other type of entity, the structure of the limited partnership must be respected by its partners. If it is respected, then the limited partners’ personal assets will be protected from a lawsuit. To insure the protection afforded to the limited partners, the partners must adhere to the formal requirements of the limited partnership. This involves keeping all limited partnership income and expenses separate from the partners’ personal income and expenses.
4. Taxation.
Limited partnerships do not pay Texas franchise tax. Federal partnership taxation is governed by subchapter K of the Internal Revenue Code. The partnership is required to file Form 1065 and issue a K-1 to each partner, setting out each partner’s share of partnership net income or loss. The taxation of a limited partnership is often referred to as “flow through” or “conduit” taxation because net income and losses are not taxed at the partnership level, rather, net income and losses flow through to the partners and are reported by the partners on their individual income tax returns. While subchapter S corporations and partnerships both offer flow through taxation, key differences make taxation under subchapter K preferable in many cases.
Partnership taxation offers unique flexibility with regard to the distribution of income and losses to the partners. Most of this flexibility springs from Section 704 of the Internal Revenue Code, which allows a partner’s distributive share of each income or loss to be determined by the partnership agreement. Therefore a partner’s distributive share need not be the same for each item. For example, an item producing income can be allocated to a partner with losses from outside the venture, and any item producing losses can be allocated to a partner with income from external sources.” However, such allocation will be re-allocated in proportion to the partner’s interest in the partnership if the allocation does not have “substantial economic effect.” Subchapter S does not provide this type of flexibility in the allocation of income and loss.
Another key advantage of taxation under subchapter K involves the addition of partnership liabilities to the basis of the limited partners. Under subchapter K, as the partnership takes on debt, each partner’s basis will be increased by such partner’s proportionate share of the debt. Again, subchapter S does not allow the shareholders of an S corporation to increase their basis in the corporate stock when the corporation takes on liabilities. As a result, highly leveraged businesses prefer the use of the limited partnership over the S corporation.
5. Common Uses.
Families often use limited partnerships for estate planning and asset protection purposes. This topic will be addressed at length later in the outline. Additionally, businesses seeking to avoid franchise tax and businesses that are highly leveraged use the limited partnership. Finally, the limited partnership is attractive to profitable businesses that plan to distribute most of the profits to investors.
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