Business Entity Formations

Organizing a Business

There are several ways to organize a business, and the option selected depends on various factors. The best option for a small, family-owned and operated venture may not be the best choice for a company with several owners and many employees. Each option has benefits and drawbacks. The option selected by a business may change over time as the business’ needs, identity, size, budget, and liabilities change. A person may start out as a sole proprietor but decide years later to incorporate. Before a person or persons decide what option would best meet their needs, an attorney experienced in business matters should be consulted.

The following is a brief summary of the common forms of business organizations. At the end of the chapter, issues that may affect all forms of business are outlined, including registering an assumed name and obtaining tax identification numbers and licenses.

Sole Proprietorship

A sole proprietorship is the simplest form of business organization. One person owns, manages, and controls the business. A sole proprietorship is relatively easy to organize. The benefits of the sole proprietorship include having complete control over the business, ease of the initial set-up, and having business profits taxed at the individual taxpayer rate, which is lower than the rate charged to corporations.

The drawbacks to sole proprietorship include being personally responsible for the debts and liabilities of the business.

Partnership

A partnership is a business owned by two or more parties. There are two types of partnership: general and limited.

General Partnership

A general partnership exists when two or more persons own, manage, and control a business. Persons in a general partnership share the rights, duties, and responsibilities.

State law governs the conduct, liabilities, and dissolution of a partnership, as well as the relationship between and liabilities of the partners.

The benefits of a general partnership include the owners’ control of the business. Unlike the sole proprietor, however, who has exclusive control, partners share control and responsibilities. Partners have the advantage of more than one resource for finances, ideas, and sharing the work load. The formation of a general partnership can be less complicated than other business formats, such as limited partnerships and corporations.

The drawbacks of a general partnership include the partners’ personal responsibility for the debts and liabilities of the partnership.

Limited Partnership

A limited partnership is similar in many respects to a general partnership. In a limited partnership, however, there are two types of partners–general and limited. Texas law requires that a limited partnership have one or more general partners and one or more limited partners. The principal difference between a general and limited partner is that the limited partner can limit his or her personal liability for partnership debts to the amount personally invested in the partnership. The limited partner, in exchange for the reduction in liability, does not control or manage the business. The general partner controls and manages the business and is personally liable for partnership debts.

Because limited partnerships must meet the specific requirements of certain Texas statutes, they can be more complicated to establish.

The benefits of a limited partnership depend on whether one is a general or a limited partner. The general partner enjoys control and management responsibilities.

The drawbacks of a limited partnership also depend on whether one is a general or limited partner. A general partner is personally responsible for the business debts, while the limited partner is only liable for debts up to the amount he or she invested in the partnership.

Unlike a sole proprietorship or general partnership, when a limited partnership dissolves, a certificate of cancellation must be filed with the Texas Secretary of State in order to cancel the certificate of limited partnership.

A limited partnership generally may continue after the death or departure of a partner. The departing partner (or his or her beneficiaries) may be entitled to the fair market value of the partnership interest.

Limited Liability Company

Since 1992, businesses in Texas have had the option of filing as limited liability companies. A limited liability company formed in Texas is a hybrid form of business with characteristics of both a limited partnership and a corporation. An individual member of a limited liability company generally is not liable for the debts or liabilities of the company except to the same extent a corporate shareholder would be personally liable for the corporation’s debts or liabilities.

To form a limited liability company, articles of organization and appropriate fees must be filed with the Texas Secretary of State. Certain records must be kept and made reasonably available to members upon request. There are also restrictions on the name such a company may use. In many respects, the limited liability company operates in the same manner as a general partnership.

Corporation

To create a corporation means to create an artificial “person.” For legal and tax purposes, a corporation is a separate entity from its owners. A corporation may make purchases, enter into contracts, pay taxes, and sue and be sued.

Corporations must be established in compliance with the requirements set forth in Texas law. The shareholders are the owners of the corporation. Management and control of the corporation are the responsibility of the board of directors, whose members may or may not be shareholders. The income, expenses, and losses of the business are filed on the corporation’s tax returns.

There are many requirements for a business to become incorporated. A discussion of the incorporation requirements may be found in the Publicly Held Corporations Law Chapter.

The benefits of a corporation include protecting the shareholders from business debts and responsibilities in most cases. Unlike the business options previously discussed, a corporation’s creditors may not seek to collect debts from the owners of the corporation. However, owners of a new corporation may be required by financial institutions to give personal financial assurances in order to receive funding. There is continuity of a corporate business regardless of individual shareholder status. Even if several shareholders sell their shares in a business or a principal stockholder dies, the corporation’s existence is not affected. Also, a corporation may sell stock or shares in its business to raise capital. Corporations may have several types of stocks or shares available, such as voting shares and nonvoting shares.

The drawbacks of a corporation include double taxation. The corporation files its own tax returns and pays taxes on its profits before paying dividends to the shareholders. When the shareholders receive the dividends, these profits must be included on their individual federal tax returns.

S Corporation

An S corporation derives its name from a section of the Internal Revenue Code. Under Subchapter S of the Code, a corporation that meets certain requirements may be treated as a corporation for liability purposes but treated as a partnership for taxation purposes. Shareholders of an S corporation receive limited liability protection, and their profits from the business are included on their individual federal income tax returns. Although Texas does not have an income tax, corporations, including S corporations, are subject to a franchise tax that operates as a form of income tax. A corporation that is treated as an S corporation for federal tax purposes may receive similar treatment in the calculation of its franchise tax in Texas.

The requirements of an S corporation include:

No more than 35 shareholders

Shareholders must be natural persons (not corporations or partnerships)

Shareholders cannot be nonresident aliens

One class of stock
After a business has incorporated, all shareholders must consent to Subchapter S treatment. The election to be treated as an S corporation must be filed with the Internal Revenue Service in a timely manner.

Franchise

A franchise is a method of selling and distributing goods and services. Franchises are available for many types of ventures. A franchise, unlike the options previously discussed, is not a form of business organization. A franchise is an arrangement between at least two parties, in which one party pays the other a fee for the right to engage in a particular business venture. Franchises are regulated by the Federal Trade Commission and the Texas Secretary of State. Franchises are discussed further in the Franchise & Dealership Law Chapter.

General Business Issues

As previously mentioned, there are a number of issues that impact businesses, whether sole proprietorships or corporations. The following discussion summarizes the most common of these issues.

Name Registration

Texas law requires that any entity regularly doing business in Texas under an assumed name must file an assumed name certificate with the Secretary of State and the county clerk of the county in which the company has its registered office or its principal place of business. A business owner also must submit the proper fees. The certificate must be executed by an officer, general partner, member or other authorized representative of the business and is valid for up to ten years. Requirements for partnerships, corporations and limited liability companies are similar, but there may be additional restrictions. These can be found in the Closely Held Business Law and Publicly Held Corporations Law Chapters.

Tax Identification Numbers

A business in Texas must obtain a federal employer identification number. This identification number is the equivalent of a social security number for individuals. While sole proprietors without employees generally use their social security numbers, other businesses file Form SS-4 with the Internal Revenue Service.

A business with employees also must register with the Texas Employment Commission. The Commission assigns each business an account number.

A business that sells goods or services must obtain a seller’s permit. This permit can be obtained by filing an application with the Comptroller of Public Accounts.

Licenses

A business operating in Texas also may have to obtain federal, state, or local licenses. Businesspersons must determine which licenses and permits are required before beginning their venture.

Resources

For information on forming or registering a corporation or limited partnership, contact the Texas Secretary of State, P.O. Box 13697, Austin, TX 78711, Statutory Documents Division, (512) 463-5551, or Corporation Division, (512) 463-5586.

For tax forms and information on various forms of business, contact the Texas Comptroller of Public Accounts, 111 East 17th Street, Austin, TX 78711, (800) 252-5555. Federal tax forms are available from the Internal Revenue Service, (800) 829-1040.

New businesses with employees should contact the Texas Employment Commission, 101 East 15th Street, Austin, TX 78778, (512) 463-2731, TDD (800) 735-2989.

There is a variety of information generally available on starting a new business. Two useful resources are:

Volunteer Lawyers for the Arts, How to Form a Nonprofit Corporation (available from Nolo Press by sending $39.95 plus $5.00 shipping and handling to VLA, Publications, 1 53rd Street East, New York, NY 10022).

Volunteer Lawyers for the Arts, The Partnership Book: How to Write a Partnership Agreement (available from Nolo Press by sending $24.95 plus $4.00 shipping and handling to VLA, Publications, 1 53rd Street East, New York, NY

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