When thinking about what to write about for my first post, I decided it would be fitting to start off with a general discussion of the different types of entities one may choose from when organizing a business in the State of Texas. The Austin Business Advisor will be discussing these different types of entities in greater detail in future posts, but for now we will be sticking with the basics, and providing generalized commentary on the different type of entities available for use in Texas.
- Corporations (for-profit)
- Limited Liability Companies
- Limited Liability Partnerships
- Limited Partnerships
- Professional Organizations
- Unincorporated Entities
Picking the best type of entity for your business is an incredibly important decision that needs to be made carefully, taking into consideration the specific goals, circumstances, and characteristics of your business. Business entities are not “one size fits all” – do not make the mistake of using a certain entity type because you have heard it has worked well before for another business. Failing to take into account the specific needs and characteristics of your business can have disastrous consequences that can easily be avoided with a little bit of planning. This post is a general discussion of the differences among the various entity types available here in Texas, however, it is not intended to serve as specific advice on what type of entity your business should be organized as. The best way to protect yourself by ensuring your business is properly organized is to seek out the services of a qualified attorney.
There are a number of differences between different types of entities, however, the main considerations are typically: (1) taxes, (2) limited liability, (3) ownership, and (4) Complexity / Cost.
Organizing a business as a corporation provides the business owner with limited liability, meaning, that if corporate formalities are observed, the shareholder will not be responsible for the liabilities and obligations of the corporation. While this is very important, other entities such as LLCs, LLPs, and limited partnerships also offer the benefit of limited liability to the business owner. The most important difference a corporation has from other entity types is typically the way it is taxed.
The income of a corporation is taxed a two levels. The corporation pays corporate taxes on taxable income it generates at the corporate level, and afterwards, the shareholder pays taxes on payments the corporation makes to them as dividends. This feature of corporations is often why business owners elect to use an LLC or partnership, or decide to make an election with the IRS to be treated as an S-corporation. It should be noted that dividends are typically taxed at favorable capital gains rates rather than as ordinary income, but the additional layer of tax can often result in a higher effective tax rate. However, despite this additional layer of tax, there are certain situations where corporations are more desirable from a tax perspective. We will discuss many of these situations in greater detail in coming posts to the Austin Business Advisor.
In terms of restrictions on ownership, corporations enjoy maximum flexibility — any number of persons can own shares in a corporation, and the corporation may have multiple classes of stock. Additionally, organizing a corporation is typically somewhat less complicated and expensive than doing so for an LLC or partnership. Corporations are also often favored by businesses seeking investment from certain types of investors, including venture capital firms and other institutional investors.
S-corporations are technically not a different type of entity, rather, an S-corporation is just a corporation that has made an “S election” to be taxed under subchapter S of the Internal Revenue Code. Instead of paying corporate level taxes, the taxable income and tax attributes of an S-corporation are passed directly to its shareholders, meaning that only one level of tax is paid on taxable income earned by the business. The manner in which an S-corporation is taxed is similar, but not identical, to the manner in which LLCs and partnerships are taxed, however, unlike LLCs and partnerships, S-corporations are often advantageous with respect to reducing self-employment taxes.
The tax treatment of S-corporation is often popular with business owners, however, this does not come without certain costs. To make a valid S election, ownership is restricted to no more than 100 shareholders, none of whom may be foreign or organized as entities (with certain exceptions). In addition, an S-corporation may only issue one class of stock, preventing use of shares other than common stock. However, while these limitations are often a barrier for larger businesses, they are frequently less of a concern for small and closely held businesses.
Limited Liability Companies
Limited liability companies (typically referred to as LLCs) have become very popular to entrepreneurs over the last decade. They offer the same limited liability of a corporation, involve only one level of tax, and are also very flexible. With that in mind, an LLC is by no means the “best” type of entity for all businesses, and often they come with greater complexity and cost to organize and operate. Please refer to the Entrepreneur Toolbox above for specific details on the process and cost typically associated with organizing an LLC.
An LLC is, by default, taxed in the same manner as a partnership. Similar to the way S-corporations are taxed, the taxable income and tax attributes of an LLC are passed directly to its owners (which are referred to as its “members”). An LLC have any number of members, however, when an LLC only has one member it is referred to as a single member limited liability company, and is taxed in the same manner as a sole proprietorship (i.e., reported on Schedule C of an individual tax return). Although an LLC enjoys a single level of tax like an S-corporation, an LLC does not enjoy the same self-employment tax benefits as an S-corporation. It should also be noted that an LLC may elect to be taxed as a corporation or under subchapter S, and doing so typically imposes the same limitations applicable to those types of entities.
Limited Liability Partnerships
In many respects, a limited liability partnership (commonly referred to as an LLP) and LLC are very similar. They are typically taxed in the same manner, involve roughly the same complexity and cost to organize, and provide similar limitations on liability to their owners (in part due to recent legislative changes). However, Texas LLPs have some unique requirements which set them apart from other Texas entity types, including an annual fee of $200 assessed to each limited partner. Additionally, until recent legislative changes, LLPs were previously required to maintain liability insurance coverage of at least $100,000. In Texas and elsewhere, state statutes authorizing LLPs predate those relating to LLCs, and while LLPs used to enjoy more popularity, their use is now primarily limited to organizations rendering certain professional services.
The popularity of using Texas limited partnerships has declined since Texas implemented its revised franchise tax in 2008, closing a favorable loophole for limited partnerships. However, there are still some businesses and circumstances which favor limited partnerships, including partnerships organized to make certain types of investments. The Austin Business Advisor will address limited partnerships and these circumstances in more detail in coming posts.
A limited partnership is taxed in the same manner as an LLC which has not elected to be taxed otherwise. However, a limited partnership has a unique characteristic, requiring at least one general partner and at least one limited partner. While the limited partner(s) enjoy limited liability, its general partner(s) does not. Despite this requirement, general partners can obtain limited liability by simply organizing as corporations, which is typically the case in practice. This added complexity to the ownership structure of a limited partnership is the primary difference between a limited partnership and an LLC or LLP, and also one of the reasons limited partnerships have become less popular.
Texas has three types of professional organizations: (i) professional associations, (ii) professional corporations, and (iii) professional limited liability companies. Professional organizations are intended for use by specific professions, including attorneys, doctors, accountants, architects, and veterinarians. These entities roughly mirror partnerships, corporations and LLCs, however, professional organizations typically impose additional requirements relating to professional services, licenses, and significant ownership restrictions. The Austin Business Advisor will discuss the specific requirements relating to Texas professional organizations in coming posts.
When a business has not been organized as one of the business entities described above, it is often referred to as an “unincorporated entity,” typically meaning that it is not registered with the Texas Secretary of State. An unincorporated entity with a single owner is usually referred to as a sole proprietorship, and when there are two or more owners, a general partnership. Unlike the entities described above, unincorporated entities do not provide limited liability to their owners, meaning, the owners of the business are often fully liable for all of the businesses liabilities and obligations. For this simple fact alone, it is almost always inadvisable to operate as a sole proprietorship or general partnership. The risks associated with doing business as an unincorporated entity will be explored in detail in future posts.