Types of Texas Entities
There are two main considerations when selecting a business entity type in Texas. First, the potential business owner must decide how he or she wants to govern the operation of the organization. If it is a small organization or a single individual owns 100 percent, a sole proprietorship or single-member LLC may be the best solution. However, larger organizations with multiple owners may want to consider a more traditional corporate form. The good news is that there are ways to convert the business to a different form if the endeavor is wildly successful and an IPO is in your future!
Secondly, the business owners must decide the type of tax treatment they want for the organization. A traditional corporation is subject to “double taxation.” In other words, the profits of the business are taxed at the corporate rate AND any dividends or income to its shareholders are taxed at the qualifying rate for that type of income. Other entity types are considered “pass through” businesses (i.e. LLCs, sole proprietors, and partnerships). This means that the income of the business is passed through to the owners based on their ownership percentage. The double tax is eliminated, but owners must plan for any additional taxes on their individual returns.
The following are the recognized business organizations in the State of Texas:
This entity is as its name implies – a single individual owns the 100 percent of the business. It is one of the most common and the simplest forms of business. There is no formal organization with the Texas Secretary of State and operations are conducted under an assumed name. An assumed name certificate (a DBA) should be filed with the office of the county clerk in the county where a business premise is maintained. If no business premise is maintained, then an assumed name certificate should be filed in all counties where business is conducted under the assumed name.
One major drawback to sole proprietorships is that there is no liability protection. In other words, the personal assets of the sole proprietor are subject to potential loss if the owner acquires debt or is the subject of a lawsuit. Additionally, it is difficult to raise investment capital in a sole proprietorship as most investors want an equity (ownership) position in exchange for the influx of money.
Corporations are independent legal entities, wholly separate from the owners and employees who control them. When Texas law describes a “person” that definition almost always includes corporations. Owners of corporations are called shareholders and they an elected board of directors manages the operations of the company. The board of directors hires the corporate officers (i.e. Chief Executive Officer, Chief Operating Officer, etc.) to handle the day-to-day affairs of the company. In Texas corporations must have at least one director. Additionally, corporations must have a president and secretary. However, Texas law allows a single person to hold all three positions of director, president, and secretary.
As mentioned above, a corporation is a legal person with the characteristics of limited liability, centralization of management, perpetual duration, and ease of transferability of ownership interests. Assuming corporate formalities are maintained and the corporate form is not abused, the corporation provides a powerful shield from liability for its shareholders. Those corporate formalities include: 1) maintaining a registered agent and office in Texas; 2) creation of bylaws; 3) issuance of stock certificates; 4) holding annual shareholders and directors meetings; 5) documenting meetings (including important decisions of the directors); and 6) filing a separate tax return for the corporation. Additionally, owners who maintain operational control of corporations must take care not to use the corporation for personal expenses or otherwise abuse the corporation. If so, the owners could be subject to a process called “piercing the corporate veil.” This would allow creditors to ignore the liability protections of the corporation and go after the owners’ personal assets.
Despite the protective benefits of corporations, they require many formalities to maintain the corporate structure. In addition, corporations are subject to corporate income taxes (i.e. double tax). This means the profits of the company are taxed at the company level. Then, if any of those profits are distributed to shareholders in the form of dividends, the individual shareholders are taxed on the dividends.
A “C” corporation is the traditional corporate form of business. All of the Fortune 100 companies are set up as C Corporations.
An “S” corporation is not a matter of state corporate law but rather a federal tax election. A for-profit corporation elects to be taxed as an “S” corporation by filing an election with the Internal Revenue Service. Conversion to an “S” corporation makes the corporation a “pass-through” organization for federal tax purposes. However, electing to become an “S” corporation imposes limitations on the company. Specifically, the company is limited to one class of stock, cannot have more than 100 shareholders, and there are limitations on who can become shareholders.
Non-profit corporations are similar to their for-profit counterparts with the formalities of the entity (i.e. annual meetings, separate tax filing, etc.). However, non-profit corporations are formed for certain charitable, civic, religious, or other social purposes. Non-profits may file for tax exempt status with the IRS (think 501(c)(3)). This filing is completely separate from the filing with the Secretary of State. As a result, non-profits cannot style themselves as tax-exempt unless the IRS grants them that status.
Limited Liability Company
Limited Liability Companies are the most common type of entities filed with the Texas Secretary of State. LLCs combine the liability protections of corporations with the tax benefits of partnerships. This makes them a very attractive corporate form for most business owners.
Owners of LLCs are called members. In this regard, any “person” may be a member of an LLC. This includes individuals, corporations, partnerships, or other LLCs. When filing the certificate of formation for an LLC, the members elected for the members themselves or for managers to govern the company. Managers are similar to the directors of a corporation.
One benefit of an LLC over a corporation is the lack of formal requirements for governance. LLCs do not require annual meetings or the specific offices (i.e. director, president, and secretary) a corporation requires. Additionally, an LLC provides to its members the same liability shield as a corporation.
By default, an LLC with more than one member is taxed as a partnership – a “pass-through” entity. However, the members of an LLC can affirmatively elect to be taxed as a corporation through a filling with the IRS.
All partnership entities are considered “pass-through” entities with regard to tax issues. This means that the profits or losses of the organization pass through to the percent of ownership to the partners. The entity itself does not pay any income taxes.
A general partnership is an oral or written agreement among two or more principals (partners) to operate a business; that is, to share profits and losses and control of the business. There are no required filings with the Texas Secretary of State. Just as in a sole proprietorship, a general partnership does not afford any liability protections to the partners. In other words, creditors can attach to the personal assets of the partners.
A limited partnership requires at least one general partner and one limited partner. The general partner has control of the operation of the organization, but also retains all liability for the partnership. All limited partnerships must be filed with the Texas Secretary of State. Limited partnerships are useful for forms for real estate developers and others who want to provide a simple process for investors who want a share of the profits and losses, but no liability exposure for the venture.
Limited Liability Partnership
Limited liability partnerships are essentially general partnerships with some liability protections for the partners. An LLP must: 1) contain the abbreviation “L.L.P.” or the words “Registered Limited Liability Company” in its name; 2) file a certificate of formation with the Texas Secretary of State and pay the required filing fee (currently $200 per partner); and 3) maintain at least $100,000 in insurance to cover errors and omissions (i.e. malpractice).
Professional entities are generally reserved for a certain subset of professions spelled out in the Texas Business Organizations Code. The Texas Secretary of State has provided a chart which can help professionals with their choice of entity. You can find that chart here. Professions in Texas require a license and generally include the following:
- Certified Public Accountants (CPAs)
- Public Accountant
Professional associations in Texas are reserved for healthcare professionals. They operate in similar way to corporations with a board of directors or executive committee. However, PAs do not have the same level of formality as a standard corporation.
As the name implies, professional corporations operate just as for-profit corporations in Texas. There is a variety of professions which may elect to form a professional corporation.
Professional Limited Liability Corporation
The same subset of professions who may choose a professional corporation, may also choose a professional limited liability company. The differences between the entities are analogous to their non-professional counterparts.