How to Choose a Business Entity
In selecting a business entity in Texas, your choices are for the most part the following five business entity forms:
- General Partnership
- Limited Partnership
- Limited Liability Partnership (or LLP)
- Limited Liability Company (or LLC).
The entity you choose depends on the objectives of your business. In most situations, you will focus on two key factors:
- whether the entity will be taxed and
- the extent to which the entity will shield its owners from liability.
As to taxation, owners must take into account both federal and state taxes. Corporations pay federal taxes ranging from 15% to 35% of taxable net income, and then the owners of the corporation also pay federal income taxes on the distributions they receive from the entity, resulting in what has come to be called, “double taxation.” On the other hand, an entity such as a partnership may be a non-taxable “flow-through” entity, in which case the entity pays no federal income taxes and only the owners pay federal income taxes on the distributions they receive from the entity. As to state taxes, Texas does not have a personal income tax on business owners, but most business entities in Texas pay a “Margin Tax.” The Margin Tax is imposed on almost all Texas businesses except sole proprietorships and some, but very few, general partnerships.
The second key consideration, “limited liability,” means that no member of the entity is personally liable for the debts or obligations of the entity. Some entities provide fairly complete limitation of liability, others provide some limitation of liability, and still others provide no protection to their owners.
With these two key factors of taxation and limitation of liability in mind, let’s take a look at several of the most common entities available for Texas businesses, focusing on the advantages and disadvantages of each.
A corporation is formed by filing the appropriate documents with the Texas Secretary of State. The primary advantage of operating a business as a corporation is limited liability of shareholders. With this advantage come the following disadvantages: 1) expense of formation and maintenance, 2) statutorily required formalities, and 3) double federal taxation for plain corporations (also called C-corporations), restrictions on corporations that file and “S” election, and Texas Margin Taxes.
An S-corporation is a corporation that, once formed by filing with the Texas Secretary of State, files an “S” election with the internal revenue service to be treated as an “S-corporation.” By filing this election, the corporation pays no tax on its income. Instead, corporate income is treated as having been received by the shareholders, and they alone pay income taxes on it. However, this “flow-through” status comes with a price. To be eligible for S-corporation status, a corporation must meet the following restrictions: 1) it has to be a “domestic” corporation, that is, one organized under the laws of the United States, 2) it can have no more than 100 shareholders, 3) it can have no more than one class of stock, and 4) it can have no shareholders other than individuals who are residents or citizens of the United States.
A partnership is an association of two or more persons to carry on a business for profit. Any person may be a partner in a partnership. A corporation, organization, estate, trust, partnership, or any other legal entity can also be a partner in a partnership. A partnership can be one of the simplest, least expensive business entities to form because partners do not have to write or file any particular document. A partnership can be formed by simply writing up a partnership agreement, or a partnership can be deemed to exist by simply evaluating the “factors” promulgated by Texas statutes that indicate whether two people are partners or not. Partners also have wide latitude in how the partnership will be managed. Most of the time, however, partners will want to have a written partnership agreement, which can be very complex. As to taxation and limitation of liability, a general partnership is a flow-through conduit for both taxation and limitation of liability. All partners of a general partnership are liable for all debts and obligations of the partnership. The good news is that the Texas Margin Tax is not applicable to a general partnership if all of its partners are individuals, but the Texas Margin Tax is imposed on a general partnership if it has a business entity as a partner.
A “limited partnership” is a partnership formed with one or more “general partners” and one or more “limited partners. A general partner of a limited partnership has the same unlimited liability for partnership debts as does a partner in a general partnership. A limited partner is liabile for debts or claims against the partnership only in the amount of that limited partner’s capital contribution to the partnership. A limited partner can lose this limited liability, however, if he or she participates in the management of the partnership business. Therefore, management is centralized in the general partner or partners. The cost of forming a limited partnership is usually greater than that of forming a general partnership because specific documents have to be filed with the Texas Secretary of State. As to taxation, a domestic limited partnership is a flow-through conduit, paying no federal income taxes. However, LP’s do have to pay the Texas Margin Tax.
LIMITED LIABILITY COMPANY
Limited liability companies, also known as “LLC’s,” are the relative newcomers in the choice of entity selection in Texas. Texas was the fourth state to adopt an LLC statute, and now every state has adopted an LLC Act. An LLC is formed by filing the appropriate documents with the Texas Secretary of State. If properly structured, an LLC’s owners have both a corporation-style liability shield and the pass-through federal income tax benefits of a partnership. All members of an LLC have this limited liability, even if they participate in the business; so the owners of an LLC have maximum freedom to determine the internal structure and operation of the LLC. However, LLC’s in Texas must pay the Margin Tax.
LIMITED LIABILITY PARTNERSHIP
A limited liability partnership is a general partnership in which the individual liability of partners for partnership obligations is substantially limited. LLP’s were first designed in Texas to afford certain professionals limited liability. These professions originally included those such as physicians, architects, attorneys, certified public accountants, and veterinarians; but Texas soon enlarged the province of LLP’s to let them apply to all partnerships. But be forewarned. Although LLP’s are the entity of choice for many Texas professionals, not all states permit all types of professionals to have limited liability for professional malpractice. Texas limited liability partnerships have three unique requirements: 1) their name must include “limited liability partnership” or an abbreviation thereof, 2) they must file an application with the Texas Secretary of State along with an extra filing fee of $200.00 per partner, and 3) must carry at least $100,000.00 of liability insurance. As to limitation of liability, LLP’s are also unusual. Unlike partners in a general partnership, who are liable for all partnership obligations, partners in a limited liability partnership are not personally liable for partnership obligations unless the obligations are attributable to the fault of the partner. As for taxation, LLP’s are a flow-through entity that does not pay federal income tax. As to the Texas Margin Tax, LLP’s may be subject to it.
HOW DO I CHOOSE?
If the owners are content to pay federal income taxes at the entity level and then pay federal income taxes on the earnings distributed to them, the choice is easy – regular corporation If the owners do not want to pay federal income taxes at the entity level, the choice is a little more complicated and includes general partnership, LLP, limited partnership, LLC, or corporation with S-corporation election.
If limited liability of the owners is unimportant and all of them are individuals, a general partnership in which all will be liable for all partnership liabilities may be the best choice.
If the owners are willing to accept liability for their own errors but want to avoid liability for errors of the other partners and if they are willing to risk being subject to the Texas Margin Tax, the LLP may be a good selection.
A limited partnership can provide the advantage of flow-through taxation, but may risk having to pay the Texas Margin Tax and may run the risk of limited partners participating too much and becoming liable as general partners.
The LLC may be the answer for some by providing flow-through taxation and limited liability along with flexibility in structure, but must pay the Texas Margin Tax. Also, beware. As a result of their newness, conducting business in other states as an LLC may raise questions regarding the extent to which other states will limit members’ liability.
The S-corporation will give limitation of owner liability and federal income tax flow-through, but it must pay the Texas Margin Tax. Also, there are limitations on its availability under I.R.S. rules.