Thinking about starting a new business? Structuring a business entity has several components that should be considered before the checks and stationary are ordered. Most business person’s reasons for choosing a certain type of entity involves around the areas of tax, management, and liability protection and for good reason. First, a short explanation of an “agency” relationship is needed to understand liability and management of any type of business entity.
Agency: An agency relationship is created in any corporate entity. “Agency” is the fiduciary relationship that arises when one person (a “principal”) gives approval to another person (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent gives approval or otherwise consents so to act. Whomever is chosen to be the governing authority for the entity or whomever is given actual or apparent authority to act for the company is an “agent” of the company for purposes of carrying out the company’s business. A simple example of this would be a business owner (the principal) giving a salesperson (the agent) the permission to sell the business’ goods to customers. An act committed by an agent for the purpose of apparently carrying out the ordinary course of business of the company binds the company unless the agent doesn’t have actual authority or the third party in the dealing has knowledge of the agent’s lack of actual authority. So, expanding on the above example, when the salesperson sells a good to a customer, the company is bound by the salesperson’s sale to sell the good to the customer; however, if the salesperson is a fraud and does not work for the company or the third-party knows the salesperson is a fraud, the company is not bound to sell the good. In our example this type of situation would be rare; however, in more complicated business transactions this agency relationship can save business entities and principals alike.
Corporations: In Texas, a Corporation is created by filing a certificate of formation with the Texas Secretary of State, which ensures the Corporation meets minimum state law requirements. Technically, a Corporation is considered a “legal person” within the law. This gives a Corporation the characteristics of limited liability, centralized management, and ease of transferability of ownership interests. A Corporation is operated through a Board of Directors (the “Board”) whom, in turn, appoints officers of the Corporation, such as a President and Secretary. The management is a bit more structured and restricted than other entity types given the fact the Board are the ultimate managers of the Corporation, and are accountable to the owners of the Corporation, whom have the highest authority concerning the appointment of the Board and major undertakings and events of the Corporation. Typically, the owners of a Corporation are its “shareholders,” or people who buy or own shares of the Corporation. A very important aspect of a Corporation is its limited liability to its owners/shareholders. The good news is the owner/shareholder of the Corporation has liability protection from the acts of its agents and the activities of the Corporation.
S Corporations: An S Corporation (“S Corp.”) is a Corporation which elects to have pass-through taxation to their shareholders. Pass-through taxation simply means the Corporation isn’t taxed as a separate entity from its owners; instead income passes through to the owners and is taxed on their personal return. This is advantageous for two reasons: (1) the S Corp. is essentially taxed at shareholder’s individual tax rate (which may be lower than a Corporations tax rate); and (2) the S Corp. is allowed to avoid double taxation on its income which is normally assessed on a Corporation. The only set-back is that not all Corporations may elect to be S Corps as there are certain restrictions on who can become an S Corp. These restrictions are generally for larger Corporations and not smaller start-ups; but, for detailed information on the restrictions and to file an election, individuals need to visit with their accountant. See the information from the Internal Revenue Service, for more information on S Corps.
Limited Liability Company: A Limited Liability Company (LLC) is probably the most popular choice for newly formed businesses. This is because of its limited liability for owners and managers (the same liability standard as a Corporation), its flexible management alternatives and income distributions, and its pass-through taxation process. Again, pass-through taxation simply means that the LLC can be taxed the same as an S Corp and instead of the entity being taxed, the income passes through to the owners and is taxed on their personal return. It is important to note that an LLC can choose to be taxed like a Corporation if the owners desire. One of the flexible aspects of this type of entity is that LLC’s can be governed by either managers or the members themselves—whichever is chosen needs to be specified in the governing company documents. Additionally, the founding members can essentially choose to incorporate either elements of a Corporation or a Partnership, with regard to all aspects of LLC management. Distributions methods, timing, and structure are extremely flexible with an LLC; cash and other assets distributed to each member are made according to the agreed value of the member’s contribution to the company. For example, if a member of the LLC contributed 32% to the formation of the LLC, that member could receive 32% of the income of the LLC once it started making money; or the members could agree to make income distributions in differing proportions.
Sole Proprietorship: Unlike an LLC and a Corporation, a Sole Proprietorship (“SP”) is a single individual doing business either as himself or under an assumed name. A SP does not need formal organization; however, if the business is conducted under an assumed name (a name different than the name of the individual proprietor), then an assumed name certificate (also known as a “DBA”) needs to be filed with the office of the county clerk. If there is no physical business location, than the certificate should be filed in any county the SP conducts business. This form of business offers the highest flexibility regarding management but is the scariest way to operate business because there is no protection for the owner for liability claims. The owner may be responsible for any actions taken by the agents of the business. And, the owner’s personal assets are up for grabs if the business finds itself subject to a money judgment.
Partnership: A Partnership is formed “when two or more persons associate to carry on a business for profit.” There is no requirement for a formal writing of any kind—even to be filed with the state. However, in the event of a disagreement between the partners, a formal, written partnership agreement would govern; without one, the partner’s rights and duties will be governed by Texas statutory law. Therefore, just because a partnership agreement is not required by the state, it is advisable to create one in order to have control of the specific rights and duties of the partners. One good aspect of operating as a Partnership is that it has the same pass-through taxation as the LLC. Again, this simply means the Partnership itself isn’t taxed as a separate entity from its owners; instead income passes through to the owners and is taxed on their personal return. A Partnership has two things in common with a SP: (1) the same assumed name provision applies to Partnership (if applicable) and (2) the same personal liability falls on the founding partners. Clearly, the most important of the two is the liability aspect – in order to combat this the Partnership can choose to register as a Limited Liability Partnership (LLP), which would give the partners the same limited liability of an LLC.
Summary: Choosing the right structure for a new business entity is important. Tax treatment, liability protection, the power to make decisions, and profit distribution methods are impacted by the way a business is organized. Before finalizing your decision on the type of business entity structure to operate under be sure to consider what liability protection the entity structure offers, how taxes should be paid, and the specifics of management of daily company operations. Depending on the specific industry the business will be operating within, there may be further licensing requirements and permit requirements. Further information regarding licenses and permits can be found on the Texas Secretary of States’ website. Note- when discussing various tax issues with your accountant in the context of formation of a new company, remember to discuss self-employment taxes as they have a big effect on entity-type decision.
The Takeaway: There are several things to consider when choosing the correct entity structure for your new Company. Most importantly, pay attention to tax treatment, liability protection, the power to make decisions, and profit distributions. Always consult with your accountant prior to forming a particular type of entity.
– The Business Team
Scott | Josh | Jeremy
The Allen Firm, PC
181 S. Graham Street | Stephenville, Texas 76401
Ph: 254.965.3185 | Fax: 254.965.6539