Limit Your Liability

Without a legal entity, you are operating as a proprietorship, the oldest form of business. A proprietorship can only have one owner, although husband and wife are considered one for this purpose.

If you upset someone, fail to allegedly pay a creditor or vendor, they can come after you personally—which is not a good thing. Although, there are circumstances where creditors can pierce the corporate veil, but this usually requires proof the entity is undercapitalized, underinsured, or otherwise not a commercially reasonable separate entity. With or without an entity, consider buying insurance, including general liability, products liability, employee fidelity, workers’ compensation, unemployment insurance, etc.—it’s all very, very difficult if not impossible.

In other words, to conduct business prudently and responsibly, you need a legal entity.

Partnership Formalities

A partnership can be formed with a handshake, but write it down, as oral agreements often foment serious disputes. With a general partnership each partner has personal liability. A limited partnership has one or more general partners, and one or more limited partners. Limited partners might lose their investment, but their other assets are not at risk. You can even get around the general partner’s unlimited liability by having a corporation (or another entity like an limited liability company) serve as the general partner. To get the benefits of limited partnership treatment, you must file a certificate and pay relevant state fees. Furthermore, if limited partners make day-to-day business decisions, they can wind up with general partner liability. So you may want to consider an a limited liability company (see more below for limited liability companies).

LLCs Are Very Flexible

By far, the most flexible business entity is a limited liability company, commonly referred to as an LLC. Adapted originally from European countries, LLCs exist in most states. Everyone is a “member” (not a shareholder), and there is almost infinite flexibility with regards to the formation of an LLC. You can have different classes of members, different voting rights, different capital requirements and management roles, and more. LLCs start with a simple fill-in-the-blanks form filed with the secretary of state and should also have a longer agreement called an “operating agreement,” which spells out all of the details as to how the LLC functions and operates. LLCs receive pass-through tax treatment, and investors generally do not need to worry about acquiring liability if they are too involved (as limited partners in a limited partnership do).

Beware of Double Tax with C-Corporations

The most classic business entity is the corporation—we all have a basic understanding of the corporation with shares, board of directors, officers, etc. Like an LLC or limited partnership, a corporation begins its life with a simple filing with the secretary of state. A corporation’s owners are the shareholders, who elect a board of directors, who in turn select officers. Corporations generally offer limited liability and an orderly structure that most people understand for shareholders. Plus, the units of ownership— shares of stock — can (subject to securities laws) be freely traded.

A corporation is the only alternative for big public companies. Corporations are separate legal entities and are separately taxed. Plus, if the corporation pays dividends, the shareholders are also taxed. Any after tax proceeds are then taxed to the shareholders as income tax. Accordingly, pass-through entities like partnerships and LLCs are more attractive for tax reasons.

S Corporations

Under state law, an S corporation is just like any other corporation. But if you file a one page “S election” with the IRS, the entity is taxed almost like a partnership or LLC. However, an S corporation can face corporate tax under certain limited circumstances. An S corporation can have no more than 100 shareholders, only domestic shareholders (U.S. citizens and resident aliens), generally individual shareholders (meaning other corporations cannot own shares), and a calendar fiscal year. If there are multiple classes of stock, only differences in voting rights are allowed. For most small businesses, these criteria are easy to meet. If the owners are more comfortable with the corporate form than with an LLC, an S corporation can be a good choice. Unfortunately, the accounting rules for S corporations are complicated, and it is hard for existing C corporations to convert.

Many of these rules can be avoided if you start out with an S corporation. To do this, file your S election within 75 days of forming your corporation.

Weighing Advantages and Disadvantages

Whatever type of business you start or run, the key is the business itself, not the structure through which it operates. You can probably make any of these choices work, no matter which you select (or which you inherit). Still, you will want something that complements your operation and that is tax efficient. How do you weigh the pluses and minuses on your facts? Talk to an attorney familiar with entity formation.

At Bajaria Law, we routinely help our clients select formation options that best meet their unique needs; taking into account appropriate liability and tax factors. Generally, our clients are small and medium sized businesses in Texas, specifically in the Houston, Dallas-Fort Worth (DFW), and Austin metroplitan areas.