Every business owner must choose how to form, structure, and run their business. There are a variety of legal formation choices, each with different benefits and drawbacks. A summary of the most common entity choices and the significant aspects of each are:
The most basic structure for a business with one owner is a sole proprietorship. Distinctive features of a sole proprietorship are:
- No formation or Texas State registration requirement;
- Simplicity of operation and management;
- Currently exempt from Texas Franchise Tax liability;
- No income tax reporting requirement;
- Income/loss reported on owner’s personal tax return; and
- Owner required to pay self-employment tax on business earnings.
One of the most significant drawbacks of a sole proprietorship is the lack of liability protection for the owner. Both the owner’s business and personal assets are subject to legal claims against the business or the owner. While a sole proprietorship is simple to form and operate, it should be chosen only if the owner is comfortable with the liability risks that come with it.
General Partnership (GP)
A GP is similar to a sole proprietorship in many aspects. Distinctive features of a GP are:
- All partners are free to participate in the operations and decision making of the entity;
- Formation does not require registration with the State.
- Currently exempt from Texas Franchise Tax liability if all partners are natural persons;
- Limited reporting requirements for federal tax purposes where income/loss are split between partners; and
- Partners’ share of income/loss is reported on their personal tax return.
A significant drawback of a GP is that each partner is jointly and severable liable for all the debts and liabilities of the general partnership.
Limited Liability Partnership (LLP)
An LLP is a partnership entity with a combination of limited partners and at least one general partner. Distinctive features of an LLP are:
- Limited partners are not liable for the obligations of the partnership in excess of the limited partner’s investment, or equity interest, in the LLP;
- A general partner may be held liable for the obligations of the partnership in excess of their equity investment;
- A general partner is required to pay self-employment tax on its share of income; and
- LLPs are required to pay Texas franchise tax on revenue but are exempted on their first $1,230,000 under the current Texas Code
Limited Liability Company (LLC)
An LLC is an alternative entity form that combines the characteristics of partnerships and corporations but limits the owner’s liability to the amount of their investment in the entity. Distinctive features of an LLC are:
- LLCs provide the same liability shield for their members (equity owners) that corporations provide for their shareholders;
- An LLC pays no income tax, but similar to a partnership, the members report their respective share of the LLCs income or loss on their personal return, as they would with a sole proprietorship or partnership;
- LLC members are also required to pay self-employment tax on their LLC income;
- LLCs are required to pay Texas franchise tax on revenue but are exempted on their first $1,230,000 under the current Texas Code; and
- Unlike a sole proprietorship or general partnership, LLC members are not individually liable to outside parties for the company’s debts in excess of their equity investment.
A corporation, while not the usual choice of entity formation for a startup, may be required by investors or appropriate if the company’s management plans to take the company public, selling the company’s equity on a public stock exchange. Formation as a corporation is most appropriate for entities seeking a structure that permits easy conveyance of ownership rights while limiting company control to its management and not to the owners. Distinctive features of a corporation are:
- Corporations must comply with extensive regulations;
- Corporations require significant maintenance and external reporting;
- Corporations can be expensive to maintain;
- Corporations are required to pay Texas franchise tax on revenue but are exempted on their first $1,230,000 under the current Texas code; and
- Corporations are required to file tax returns and pay federal tax on income.
A Subchapter S corporation, or S-Corp. is simply an entity formed as a corporation that has made an election with the Internal Revenue Service (IRS) to be taxed as a partnership. The S-Corp. election allows the entity to be structured as a corporation but treated as a partnership for tax reporting purposes. After certain conditions are satisfied, the entity may choose to drop the subchapter “S” designation and be treated as a corporation for all purposes. The “S” designation is popular with early-stage entities that want to avoid the expense and reporting requirements of a corporation during startup activities but want to be able to avail themselves of the benefits of a corporation at some point in the future.