One of the first decisions a new business owner faces is which kind of business entity to form. This decision typically revolves around taxes and liability, but other criteria may be involved. This primer serves as a brief introduction to the most common types of business entities in Texas. It is recommended you consult with a business lawyer regarding which type of business entity to select for your business. After the proper business entity is selected, this lawyer can also assist with the governing documents, contracts, employment documents, and other matters. Johnsen Law advises on all of these matters. To learn more, contact us now.
Sole Proprietorship
This is the simplest kind of business entity. When one person conducts business for profit, a sole proprietorship is automatically formed. No filing with the Texas Secretary of State is required to form a sole proprietorship. The only filing requirement is that if the person is conducting business under another name, an assumed name certificate must be filed identifying the name under which the person is doing business. Unlike other entities, a sole proprietorship provides no protection from personal liability. Income is taxed directly to the individual.
Pros: simplicity; no filing required to form entity; flow through taxation.
Cons: no protection from personal liability.
General Partnership
This entity also has no filing requirement, other than an assumed name certificate in the event the business is conducted under a name other than the surnames of the partners. General partnerships are automatically formed when two or more people associate to conduct business for profit. All of these people are general partners. While no formal partnership agreement is required, the Texas Business Organizations Code will govern the relations of the general partners in the absence of a partnership agreement. As with a sole proprietorship, a general partnership does not provide any protection from personal liability. Income is also taxed directly to the partners.
Pros: simplicity; no filing required to form entity; flow through taxation.
Cons: no protection from personal liability.
Corporation
A corporation is formed by filing a certificate of formation with the Texas Secretary of State. Legally a corporation is a person. As a result, corporations are generally taxed on their income and then dividends to shareholders are taxed again. This is called double taxation, and is seen as one of the drawbacks of corporations. Some corporations can avoid double taxation by electing with the IRS to be taxed as an S corporation. Because a corporation is a legal person, the shareholders are generally protected from personal liability. There are certain theories under which the shareholders can be personally liable, such as when the corporate form has been used to perpetrate a fraud. Finally, the corporation’s citizenship for diversity purposes is its place of incorporation and principal place of business, the effect of which is to allow the corporation to defend itself in federal court in all other states, even if it has owners domiciled in multiple states. This is an often overlooked advantage of a corporation.
Pros: protection from personal liability; diversity citizenship limited to two states.
Cons: double taxation.
Limited Liability Company
A limited liability company is also formed by filing a certificate of formation with the Texas Secretary of State. Limited liability companies have characteristics of both corporations and partnerships, and there is a lot of flexibility in how limited liability companies are structured, including how the company is taxed and managed. The structure of a limited liability company is generally accomplished through the company agreement. Like corporations, limited liability companies generally protect the members from personal liability. However, the law regarding personal liability is less developed with limited liability companies than it is with corporations. The citizenship of a limited liability company is the domicile of each of its members, and therefore it is possible that a limited liability company may not be able to defend itself in federal court even though it does not do business in that state. Income is generally taxed directly to the members of the limited liability company.
Pros: flexibility; protection from personal liability; generally flow through taxation.
Cons: less governing law; possible odd application of diversity jurisdiction if members reside in states where company does not do business.
Limited Partnership
A limited partnership is also formed by filing a certificate of formation with the Texas Secretary of State. Limited partnerships have two or more people, at least one of which is a general partner and one of which is a limited partner. General partners control the operations of the partnership and are personally liable for the debts and obligations of the partnership, while limited partners act as silent investors and are generally protected from personal liability. General partners are oftentimes another business entity, so as to provide an additional layer of liability protection. While no formal partnership agreement is required, the Texas Business Organizations Code will govern the relations of the partners in the absence of a partnership agreement. Income is taxed directly to the partners. As with limited liability companies, there could be an odd application of diversity jurisdiction given citizenship is determined from the domiciles of the partners rather than where the partnership conducts business.
Pros: certain protection from personal liability; commonly used in certain industries.
Cons: possible odd application of diversity jurisdiction if partners reside in states where company does not do business.
Limited Liability Partnership
Limited liability partnerships are formed to limit the liability of the general partners of a general partnership or limited partnership. As with other partnerships, income is taxed directly to the partners. The partnership must pay $200 per partner per year.
Pros: protection from personal liability.
Cons: $200 fee per partner per year.
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