When you start a business one of the first decisions you make is the type of entity you should form. This is also one of the most important choices that you make. However, depending on the legal structure you choose, every entity has its own requirements in terms of taxation, the extensive paperwork, personal liability and most importantly, the potential of the business in raising capital/revenue.
Generally, entrepreneurs have a number of choices when it comes to incorporating a business. But considering the fluid nature of entities, there are some advantages as well as disadvantages attached to each entity type that may change as your business grows.
Therefore, it is important to choose the legal structure that is in consistence with your particular business needs. Some of the questions you may want to ask yourself include:
- What will be your product or service or purpose?
- How many owners will you have?
- What is your current financial situation?
- Will you be raising capital? Investing capital? Incurring debts?
- How will debts and revenues be distributed?
- What are you exit strategies?
- What are the roles and responsibilities of each party? What will happen if they do not perform?
- What will happen in the instances of death, divorce, or disability of any of the major stakeholders?
Based on these crucial questions, you will have to select the best fit. We highly recommend working with an attorney, who will work with you to incorporate as much of the above as possible into your formation and formalization. So before you make this crucial decision, let us have a look at the common entity types to choose from.
Jurisdiction
Every state has different rules and entity types. This article only covers Texas entities. If you are not in Texas this information will not apply to you.
Texas Sole proprietorship
A sole proprietorship is the simplest form of business entity. Typically at the start of a business, the owner may not take many different business entities into consideration and adopt sole proprietor as the default option. If you do not file any corporation formation documents and operate the business as the sole owner then you are operating as a sole proprietorship.
For the taxation process, all an owner is required to do is to record their profit and loss on a personal record journal and that is what it’s all about. However, having this particular business entity is also about associating your personal assets with your business. This means that if your business fails, you may require paying off the debts using your personal savings and property. This is very risky and offers you no personal protection from liability. It is highly inadvisable to choose this entity type and instead, we recommend choosing to formally create an entity in order to provide some personal liability protection for you and your family.
Texas Partnerships
A partnership, in its size and functionality, is similar to a sole proprietorship. This type of entity is established when you are working with some else. But similar to a sole proprietorship, this type of entity ties the personal assets of all the partners and business together. When you are working with others as partners and again no formal paperwork creating an entity has been filed it is assumed that in the eyes of the law you are functioning as a partnership. Again just like with a sole proprietorship it is highly inadvisable to choose a partnership by default and instead we recommend choosing to formally create an entity in order to provide some personal liability protection for you and your family.
As long as the partners manage the business affairs personally, you may choose to formally establish a limited partnership or limited liability partnership, as opposed to just a partnership by default. While this may not completely eliminate the personal liability against business debts, it may help in reducing it significantly. This will include filing with the Secretary of state and writing up a formal partnership agreement. Keep in mind that if for any reason any one of the partners walks away or refuses to continue, they may also take away the idea and kill the established business altogether. Writing custom terms into the limited partnership or limited liability partnership agreement can help mitigate these risks.
Texas Corporation
A Corporation is another type of common entity. However, the efforts and paperwork involved in establishing this type of entity may seem complex to some owners of small businesses. One of the major benefits of establishing corporation is that it is considered as a separate entity and you may protect your personal assets in this way.
Whereas the accounting and record keeping of corporation is a bit complex, it does provide a greater degree of protection.
Often times the tax consequences of creating a corporation discourages entrepreneurs from this entity type. To assist you further, let us have a brief look at S Corporation, which allows you the liability protection benefits of a corporation with the option of pass through taxation.
S Corporation – S corporation is a status that helps the smaller companies. This status of corporation helps in avoiding the issues, such as double taxation, of C corporations by allowing pass through taxation. However, the statuses of S corporation have some limitations in terms of number or types of stockholders. Generally non-citizens may not be shareholders of S corporations. Moreover, S corporations are more scrutinized, due to their extensive abuse by the larger corporations.
Texas LLC – Limited Liability Company
LLCs are a popular choice of entity and that is because this entity type provides a lot of choices to their owners. Typically, the owner has a choice to either obtain the tax structure similar to a corporation, which includes the taxation of the corporation’s income, or the structure of a partnership (pass through taxation) or even a proprietorship (in which personal income is based on business income and loss and eventually taxed). However, no matter what taxation structure you opt, the personal assets of owners are still provided with liability protection in the case of an LLC.
Other Considerations in Choosing Business Entity
Apart from choosing an entity on the basis of business need, business lawyers strongly recommend considering some other factors as well. NOTE: not matter what entity type you choose you will always have personal liability for your personal actions. So, you will always be liable for fraud, malpractice, theft, tortious conduct, etc. You will also always bear responsibility for financial obligations that you sign for personally or that you guarantee for your business.
Tax Implications
Depending on the business goals and individual situation, there are some opportunities to minimize the taxation. These options are easily available to corporations than the entities such as sole proprietorship or the partnership. If you are wondering about the issue of double taxation associated with corporations, then you can also avoid this by opting for an S corporation status. There may be other possibilities outside of what we have discussed here as well, such as setting up a trust or investment fund.
Administration Cost and Other Costs of Ongoing Formation
While we do have liability benefits in opting for a corporation, these benefits may not offset the other administrative costs that are attached to the establishment of a corporation. If you do not have the time and money to maintain and follow the corporate governance rules then creation of an entity will not protect you. At the end of the day you must keep records and follow your own governing documents (partnership agreement, company agreement, bylaws, etc.) in order to benefit from the creation of an entity. For this reason it is really important that your governing documents reflect your business and you don’t just use a standard template from online that has no bearing on how your business really operates.
Flexibility
No two business situations are same; especially where multiple owners are dealing with business. Hence, individual needs should be taken as a critical consideration. Similarly, no two individuals will be having the same concerns, goals, or other financial situations. Each entity types has a certain amount of flexibility so it can and should be customized to your needs.
Feel free to reach out to us regarding a consultation on choosing an entity type for your business.
