As a business owner, you may be wondering which organizational structure is right for your business. With several to choose from, along with a vast number of resources online vying for your attention, trying to decide on your own can be overwhelming, and in some cases, downright discouraging.
However, of all the decisions you make when starting your business, choosing your legal structure is one of the most important. Your selection affects how your business will pay taxes as well as the personal liability you face as a business owner. Because of this, the best way to understand business entities and make a selection for your own business is by seeking legal advice from an experienced business attorney.
With that being said, if you are in the early stages of starting a business, here’s what you need to know about the different types of business entities:
Filing vs. Non-Filing Entities
Filing in Texas can be broken down into two basic categories: Filing and non-filing entities. When first setting up your business, it’s important to pick your entity structure since that ultimately determines what you can or cannot do with your business. Here’s how these two categories can be broken down:
The simplest and most informal way to start your business is as a non- filing entity because you can start and run your business without any formal paperwork filed with the state. While seemingly quick and easy, non-filing entities are also at greater risk with fewer legal protections and higher liability amongst business owners.
Non-filing entities can be broken down into two types:
- Sole proprietorship
- General partnership
A sole proprietorship is the simplest structure where generally one person owns and operates the business in its entirety. This is the most common form of business ownership given its ease of setup and inexpensive cost. The tax aspects are also appealing to many because your expenses and income are included on your personal tax return. Moreover, a sole proprietor need only register their name and secure any local licenses prior to opening up shop.
If a business owner wishes to operate under a name other than their own, then they need to file a DBA (Doing Business As) with the local county clerk’s office. This is also referred to as an “assumed name.” With that being said, sole proprietors are 100% personally liable for any and all debts and duties of the business. To illustrate this concept with an example: Without legal protection that separates an individual from their business, creditors would have a legal right to come after your personal bank account and possessions to serve any debt owed.
General partnerships are business arrangements between two or more individuals who agree to share in any assets, profits, and financial and legal liabilities in a business. A drawback with general partnerships is that if one partner fails, it affects the other. This ultimately affects the business, and in some cases may even lead to lawsuits among disagreeing partners. However, this drawback can be mitigated through the help of an experienced business lawyer. Attorneys can help draw up contracts that clarify duties and obligations among partners, helping protect each partner and their interests in the long-run.
Filing business entities
If a business owner chooses to file an entity formation, they can do so through the Texas Secretary of State. This allows business owners to file the appropriate formation document, depending on the entity type chosen, and establish certain legal protections that non-filing entities simply do not have.
There are many different types of filing entities, each with their own advantages and disadvantages. Here is an overview of each.
Limited Partnership (LP)
Two types of partners exist within an LP: general partners and limited partners. A general partner typically has control over business assets and responsibilities, while also carrying liability for business debts and obligations. Limited partners serve only as investors. Meaning they don’t have any control over the business, nor are they subject to the same liabilities as general partners.
Generally, unless a business plans on having many limited partners (passive investors), limited partnerships usually are not recommended for new businesses given the administrative complexities and numerous required filings.
If you have two or more partners who want to be actively involved in the business, a general partnership is easier to form. However, remember that personal liability is a major concern if you decide to structure your business this way.
Tip: If you decide to structure your business as a partnership, you will want to draft a partnership agreement that explains how business decisions are made and how disputes are resolved. This is particularly helpful in the event disagreements arise between partners or someone wants out of the partnership.
Limited Liability Partnership (LLP)
In an LLP, each partner has limited liability. This legal structure works well for businesses involved in professional practices such as doctors, lawyers, accountants, etc. In these instances, partners are responsible for their own malpractice and not of each other. Multiple partners create higher risk in business, so these protections help to reduce liability among partners.
Limited Liability Company (LLC)
An LLC is owned by one or more members and can be either member-managed (where all of the owners have management say-so), or manager-managed (where the owners have a process for appointing or electing a manager to run the business).
The LLC is perhaps the most popular business structure in Texas. Why? An LLC provides the flexibility of a partnership with the protections of a corporation. Like a corporation, LLC owners or managers (depending on how the LLC is structured) can choose their executive officers. Unlike corporations, an LLC is not required to hold an initial meeting of the owners or managers or to conduct annual meetings.
Finally, one of the most attractive features of an LLC is the pass-through tax structure. LLC owners do not have to file a corporate tax return; rather, they simply report their share of profits and losses on their individual tax returns, escaping the “double taxation” experienced by the traditional C-Corp shareholders.
Corporate structuring is the most expensive and complex legal structure when compared to other entity formation types. Corporations are independent entities that are separate of its owners. Because of this, there are consequently more regulations and tax requirements that accompany this structure.
However, the biggest benefit to a business owner that forms their business as a corporation is the liability protection received. No personal assets are at risk as any of the corporation’s debt is separate from its owners. In addition, another key benefit for corporations is their ability to raise money by selling stock.
Texas views corporations (C-Corps) as separate from the owners; meaning, corporations can be seen as a legal entity with legal capabilities. Corporations are capable of suing as well as being sued, can own property, and are liable to pay taxes. C-Corps tend to have several stakeholders that invest and then become owners in the corporation.
When it comes to taxes, corporations are required to pay taxes on any profits earned before its dividends are paid to shareholders. A big catch to this type of partnership is that shareholders also have to pay taxes on those dividends resulting in what’s called “double taxation.”
Investing in an S-Corp helps ease the tax burden that occurs in a C-Corp because an S-Corp does not pay taxes on its income. S-Corp shareholders are required to report their dividends on their personal tax returns. This is what is known as a “pass-through” tax status and essentially removes the double taxation found in a C-Corp.
An S-Corp is a form of a C-Corp that provides limited liability protection and a desirable tax structure. S-Corps can only be obtained if a person is a U.S. Citizen/ resident. Some drawbacks to an S-Corp include limitations in who can own shares as well as limitations in ownership.
Lastly, there is the B-Corp. Formally called the benefit corporation, a B-Corp is designed to boost profit for its shareholders while sharing in a common purpose to support a public cause. Think of some big brands like: Warby Parker, Patagonia, AllBirds, etc. These brands all work for the shared idea of “good business” which includes purpose and a profit. B-Corp structures benefit greatly from its status because it attracts potential employees and consumers that identify with a brand’s socially-conscious efforts.
Nonprofit organizations qualify for tax-exemption by the IRS as these structures further a social or environmental cause for public benefit. Nonprofits are typically identified as a 501 (c) (3) organization, but can include (501 (c) (4) civic leagues, private charities, corporate giving programs, and other social groups and organizations. Nonprofits tend to receive their funding through charitable contributions and grants. To become a 501 (c) (3), a nonprofit business would need to file with the IRS and meet their regulations as well as the dictates of the Texas Comptroller.
Need help setting up a legal structure for your business?
At Clausewitz Reyes, we are experienced business attorneys in San Antonio that have helped numerous businesses set up their legal structure. Contact us if you need help setting up your business entity.