The Bare Bones Basics of Texas Business Entities
Guest Contributor: BRIAN E. WALTERS, Attorney at Law, Brown McCarroll, L.L.P.
GETTING THE BALL ROLLING
So, you want to start a business in Texas. You know what type of business you want to open, you have your business plan, and you have some capital to get started. It is now time to figure out the ideal entity form for your business. Do you want it to be a corporation, a limited liability company, or perhaps a limited partnership? What’s the difference and why is it important? This paper discusses some of the basic business entities available in Texas and some of the benefits they offer. A basic understanding of business entities is important because if a businessperson does not voluntarily choose one, the State of Texas may very well do it for you. This can result in unexpected consequences for the unwary. First, let us dispense with the legal formalities: this article is for informational purposes only and is not an adequate substitute for the advice of an experienced business or transactional attorney. Anyone considering starting their own business should seek consultation with an attorney with experience in business transactions. This article is not legal advice. This article also does not go into detail on the tax advantages of one entity type over another, as these can vary based upon the purpose of the business entity.
FIRST DECISION – TO FILE OR NOT TO FILE?
The first decision you’re going to have to make is whether you want to form a filing entity or not. The process of forming a business is not exactly common knowledge, so let us begin with a discussion of some fundamental aspects of business entities in Texas. Texas businesses can be broken down into two basic categories:
- Filing Entities
- Nonfiling Entities
Nonfiling Entities are the most basic business forms available in Texas. These businesses are formed without any formal action on the part of the owner or the State of Texas. In other words, if I go out into the business world without making any filings with the State of Texas and start an auto repair shop called “Walters Automotive,” I will be operating my business as a Nonfiling Entity. State of Texas. In other words,
Businesses may also be created as Filing Entities. Filing Entities may only be formed by filing the appropriate forms with the Secretary of State of Texas. This occurs when an owner or organizer files a “certificate of formation” with the Texas Secretary of State.
NONFILING ENTITIES (AKA THE “EASY-TO-FORM” ENTITIES)
The two most common Nonfiling Entities used in business in Texas are: (1) the sole proprietorship; and (2) the general partnership. Each of these is created without any formal action on the part of the owner or owners, as the case may be.
- The Sole Proprietorship
The “sole proprietorship” is the most basic type of business in Texas. It is a one-man or one-woman show, and simply involves that individual carrying on a business for profit. The only requirement under Texas law regarding sole proprietorships is that if the individual plans on doing business under a name other than his or her surname, he or she must file a “Doing Business As” or “DBA” with the County Clerk’s office in the county where the business is to be operated or maintained. The following is an example of a sole proprietorship: assume that I wanted to start selling custom-made wallets with decorative western embossing. I would go to the Travis County Clerk’s office, fill out my DBA for “Wacky Western Wallets,” and then I would be up and running. That’s really all there is to it. Setting up a sole proprietorship is typically done without
the involvement of an attorney. The sole proprietorship has one major disadvantage that everyone reading this should be aware of: it offers the owner absolutely no liability protection whatsoever from the debts and obligations of the business. This means that if the business defaults on a loan, gets sued over a missed order, or if someone is injured on your business’s property, you, as the owner, will be on the hook for the bill. In the event that you can’t pay a bill, a creditor may be able to go after your personal bank account and possessions to satisfy the debt. We will see later in this article that there are a number of entity types in Texas that can shield an owner from these types of liability.
- The General Partnership
A small step above the sole proprietorship is the General Partnership. A general partnership is essentially any association between two or more people that is carried on for profit. Each person in this association is called a “general partner.” The catch that you should be aware of here is that in Texas, partnerships can be created without the intention of the parties. This means that even if you don’t mean to form a partnership with someone, the law may determine that you are partners because of the way you behaved in a business relationship. This is a problem because that determination can end up costing you money. Texas partners split profits and losses by default. This means if you and Jimmy are running businesses and are determined to be partners by Texas law and Jimmy loses a bunch of money in his end of the business, it is possible that he could sue you alleging that you are responsible for half of those losses. This is why it is very important when entering into a business arrangement with another person to draw out the rules of how that arrangement will operate. Preferably this should be done in an attorney’s office.
While general partnerships are extremely easy to form (no filing requirements and no formal agreement required), the use of a general partnership for carrying on a business is almost never in the best interest of the partners. First of all, unless you and your partners draw up a partnership agreement outlining the rules you’re going to live by while running the business, the State of Texas will do it for you. In the absence of a specific agreement between the partners, the “Texas Business Organizations Code” (abbreviated “BOC”) dictates the rights and privileges of the partners. Additionally, as with a sole proprietorship, the general partnership offers the partners no protection from the debts and obligations of the partnership. The only difference here is that a creditor has more people to go after to get paid back if the partnership can’t pay its bills.
FILING ENTITIES (AKA, THE “TIME TO CALL A LAWYER” ENTITIES)
Now we can get into the more formal business entities in Texas. Typically, new businesses that elect to start out as filing entities in Texas begin as one of the following:
- Limited Partnership;
- Corporation; or a
- Limited Liability Company
As stated earlier, the following is a very brief discussion of these business entities. When forming one of these entities, it is best to consult with an attorney in order to be sure the entity will function the way you (and anyone else starting the business with you) want it to.
The Limited Partnership
The limited partnership is the first step above the general partnership in terms of liability protection. It offers a number of advantages over a general partnership; however, the formation of a limited partnership is much more complicated than that of a general partnership. Limited partnerships, as filing entities, are formed by filing a certificate of formation with the Texas Secretary of State. Once this document is filed, the limited partnership has been created. Keep in mind, however, that until a partnership agreement is drafted for the limited partnership, the operation and governance of the limited partnership will be dictated by the BOC.
Limited partnerships break up partners into two separate classes: (1) general partners; and (2) limited partners. General partners in a limited partnership typically operate similarly to general partners in a general partnership. They control the operation of the limited partnership. General partners are also responsible for the debts and obligations of the limited partnership and are not afforded liability protection under Texas law. Limited partners enjoy liability protection under Texas law. This means that limited partners are legally protected from the debts and obligations of the limited partnership. This offers a distinct advantage over a general partnership. Additionally, limited partners are not allowed to participate in the operation of the limited partnership and do not function as agents of the limited partnership. Essentially, limited partners are what many people think of as “silent investors.” They put up money to invest in the limited partnership but do not get to have a say in how it is run.
These arrangements are typically found where there is one person who has an idea for a business and that person is looking for investors to provide capital to get the business started. If you choose to operate through a limited partnership, it is best to consult with both a corporate attorney as well as a CPA due to the complex nature of these entities. The partnership agreements governing these entities tend to be quite long and are very entity-specific. Limited partnerships are almost never set up by themselves, and typically involve at least one other business entity as the general partner which provides additional liability protection to the person running the limited partnership.
Corporations are a very common business entity form in Texas. They are probably the most well known entity in Texas and the United States, and almost everyone is familiar with some part of their makeup. Corporations are unique in our discussion, however, as Texas law views them as a separate entity from the owners. In other words, a corporation may be thought of as a make-believe person that you are creating in the eyes of the law. This person has the capacity to sue and be sued, to hold property, and, most importantly, has the obligation to pay taxes separately from the owners.
The owners of a corporation are called shareholders. Each shareholder owns a certain number of shares of the corporation. The number of shares held by one person divided by the total number of shares issued by the corporation determines the percent of the corporation owned by that particular shareholder. For example, if there are two owners of a corporation, each owning 500 shares of the corporation, and the corporation has issued 1,000 shares total, each shareholder is a 50% owner of the corporation. Shareholders do not participate in the day-to-day operation of the corporation; however, their approval may be required in order to take certain fundamental actions including terminating the corporation or selling all or substantially all of its assets.
Corporations typically have a more complex management structure than the business entities discussed thus far. Corporations are governed by their bylaws, which typically outline
the relationships of the various parties who are shareholders, directors, or officers in the corporation. Under most circumstances, a board of directors governs the major operations of the corporation. Members of the board of directors are elected by the shareholders at the annual meeting. These directors, in turn, appoint executive officers, such as a president, vice-president, treasurer, and secretary to run the day-to-day operations of the corporation. Shareholders of the corporation do not determine how the corporation is run. That job is reserved to the directors and the executive officers.
The question of who runs the corporation, however, may simply be a question of which hat a particular person is wearing. For example, if I started a corporation as the sole shareholder (i.e. I am the only owner of the corporation), I would promptly elect myself as the sole member of the board of directors and then appoint myself as the president of the corporation. In this example, while I would have no authority to take actions or sign documents on behalf of the corporation as Brian Walters, shareholder, I would have authority to take action and sign documents as Brian Walters, President. Some corporations exist without boards of directors. These are known as “close corporations.” Close corporations will not be discussed here in detail because they are uncommon. The basic idea behind close corporations is that the shareholders themselves run all aspects of the corporation.
Corporations, by default, are required to pay income tax on their earnings. This means that if you are the shareholder of a corporation operating under its default classification, it will pay taxes on its earnings before they can be passed to you in a dividend. Additionally, you, individually, will pay income tax on the dividends you receive. This “double taxation” is one of the major drawbacks of the corporate entity form. Corporations may, however, eliminate this double taxation by electing to become an “S” Corporation. This is by no means a thorough discussion on this topic, and the decision to make this election should be discussed in detail with your attorney and/or CPA.
The Limited Liability Company
The limited liability company (“LLC”) is another type of filing entity in Texas. It, as with the other filing entities discussed, is created by filing a certificate of formation with the Texas Secretary of State. LLCs are owned by their members, which are analogous to shareholders of a corporation. LLCs may be manager-managed or member-managed. This gives the opportunity to the owners of the LLC to either manage the LLC themselves or elect managers which operate like a board of directors of a corporation. Additionally, like a corporation, executive officers (president, vice-president, secretary, treasurer, etc.) may be elected by the managers or members of the LLC, depending on whether the LLC is manager-managed or member-managed.
An LLC is a very flexible business entity under Texas law. It can be referred to as a “designer” entity in that each LLC can be created and custom-built to meet the needs of the particular owner or owners. If the owners want to have a governing board similar to a board of directors of a corporation, that can be arranged. If it is a one-man or one-woman show, then all decisions can be made by the same person. If you want different classes of ownership and rights to decide the actions of the LLC, the LLC can be designed to do so. This entity even has the ability to choose how it is taxed by the Internal Revenue Service. Each of these characteristics is determined by the Company Agreement, which is the governing document of the LLC, similar to the Bylaws of a corporation.
In addition to being very flexible, the LLC also lacks many of the rigid requirements of corporations. For instance, there is no requirement for an initial meeting of the owners or managers of an LLC. There is also no requirement for an annual meeting. These are just some of the nuisances that can be avoided by the formation of an LLC. Additionally, with the revisions to the Texas Tax Code in 2007, there is very little incentive any more not to use an LLC.
Other Business Entities in Texas
There are many other business forms in Texas aside from those discussed above. For example, the following is a list of some of the other available business entity forms in Texas:
- Limited Liability Partnerships;
- Professional Associations;
- Professional Corporations;
- Professional Limited Liability Companies;
- Cooperative Associations;
- Nonprofit Corporations; and
- Unincorporated Nonprofit Associations.
Each business entity described in the list above has its own unique characteristics and it is very possible that one of these forms may be a more appropriate business form than a corporation, a limited partnership, or an LLC. The scope of this paper, however, is limited to those entity forms which this practitioner most often sees formed by an individual seeking to start his or her own business.
The most important part of choosing a business entity in Texas is being fully aware of the advantages and disadvantages of each form. While this paper serves as a basic discussion of
these entities, it by no means covers all of the potential benefits and pitfalls of choosing one entity over another. If you choose to form a filing entity, please seek professional guidance in choosing an entity type. The cost of consulting with a attorney at the outset is almost always less than the cost of having to employ that same attorney to fix the problems which may be created by an poor business entity selection.