Before starting your new business, there are a number of important decisions you need to make. One of these is choosing a business entity.
A business entity is the structure under which your company operates. Different types of business entities have different characteristics, such as tax treatment, liability protection, operating requirements, and statutory requirements. Some of the common entity types are summarized below (please note that this post is primarily focused on Texas business entities. For information on other states, please contact us).
The simplest type of business is the Sole-Proprietorship. As the name implies, a sole proprietorship is a business which is owned by only one person. A Sole Proprietorship generally operates under the name of the owner, and federal income taxes are paid under the name of the individual owner. The Sole-Proprietorship is the easiest business to form because it requires no state or federal filings. The entity is formed as soon as an individual begins his or her business venture. One disadvantage to the Sole-Proprietorship is it subjects the owner to full liability for the debts of the business.
This is an important factor to keep in mind, as other business entities can be deemed a Sole-Proprietorship under certain circumstances. This will be a topic in a future post.
The next entity type is a General Partnership. This is very similar to the Sole-Proprietorship, except it has more than one owner. There is no state filing required to form a Partnership; simply having 2 or more persons associate to carry on a business for profit forms the partnership. Most partnerships will want to have a written partnership agreement that spells out how the partnership will be operated, but there is no requirement that such an agreement exist. Like a Sole-Proprietorship, partners of a General Partnership have unlimited liability for the debts of the business.
A corporation is an entity in which the business acts as its own distinct “person” apart from its owners. Ownership is represented by shares of stock. That is, each individual, business, or other entity that owns those shares of the company’s stock (the shareholders) are owners of the company.
Management of the company is usually vested in the Directors of the company. The Directors are elected by the shareholders, and Directors need not, but can be, shareholders. One advantage of a corporation is that its shareholders are not liable for the debts of the company; their potential loss is restricted to the value of the shares themselves. Other advantages of a corporation include its ease of ownership transferability and its management structure.
To form a corporation, a filing with the Texas Secretary of State is required. Further, the corporation itself must file its own tax return and pays taxes on its income. Shareholders can receive dividends from the company that represents extra capital the company has generated from its operations.
An S-Corporation is a corporation that has made a specific federal tax filing with the IRS. This filing is strictly a federal tax filing and has no impact on the operation of the business, which is governed by state law. As explained above, further discussion of taxes and an S Corporation election is beyond the scope of this post.
Limited Liability Company
A Limited Liability Company (LLC) is a creature of state law only. Compared to the sole-proprietorship, general partnership, and corporation business entities, it is a relatively new business entity. Each state has its own law or statute that authorizes the formation of an LLC and its operation.
Ownership consists of one or more persons, individuals, or entities and each such owner is called a “Member”. The hallmark of an LLC is that each Member has limited liability. A member can only lose the amount they invested in the company. However, under certain circumstances, the limited liability may be stripped from a member under certain circumstances which will be discussed in a later post.
An LLC can be managed by either its members or by its managers. However, the form of management under either of these management structures can vary widely and is usually spelled out in the LLC’s Operating Agreement.
To form an LLC, a filing, called a Certificate of Formation in Texas, must be filed with the Texas Secretary of State. This filing must include certain minimum statutory information, including the management structure of the LLC. An LLC is usually treated by the IRS as a partnership and members thus enjoy pass-through tax treatment like a partner in a partnership.
Other business entities not described above include the Limited Partnership, the Limited Liability Partnership, the Professional Limited Liability Company, the Professional Corporation, and the Professional Association.
If you are planning on starting a business, please contact one of our attorneys today to learn more about how we can help you form your new business.