BUSINESS ENTITY FORMATION

Sole Proprietorships

• • Overview:
    A sole proprietorship is a business managed by one individual without forming a separate legal entity. Even many “mom and pop” operations, sometimes involving multiple contributors, are reported as sole proprietorships. Similar arrangements include co-ownership, joint ownership, or undivided interests in property. Notably, a single-member LLC is treated as a sole proprietorship for federal tax purposes unless a different tax election is made.
  • Practical Issues:
    Typically, such a business operates under an assumed name and uses the owner’s personal Social Security number for banking. No formal state filings are required except for an assumed name certificate, meaning all contracts and liabilities rest solely on the individual. Consequently, personal assets are fully exposed unless protected by business liability insurance.
  • Tax Considerations:
    Income and losses are reported on Schedule C of the owner’s personal return. While not subject to the Texas Margin Tax, any income classified as self-employment earnings is liable for self-employment tax. The IRS also scrutinizes unreported income and improper deductions of personal expenses.

General Partnership

• • • Overview:
      Essentially a collective of sole proprietorships, a general partnership consists of two or more parties collaborating for profit. Typically governed by a partnership agreement—although not legally required—this structure outlines profit sharing, management duties, capital contributions, and procedures for dissolution. In the absence of an agreement, state laws provide a default framework.
    • Practical Issues:
      Each partner is jointly and severally liable for all obligations, meaning one partner can be held accountable for another’s actions. While these arrangements are easy to form—even orally—it is advisable to have a written agreement to clarify each partner’s rights and responsibilities.
    • Tax Considerations:
      Profits and losses pass through to partners based on their agreed ratios, and any income subject to self-employment tax is handled at the individual level. The complexities of partnership taxation allow for creative structuring, yet they also carry risks if not managed with expert advice. Limited exceptions may apply regarding the Texas Margin Tax.

Limited Partnerships

• • Overview:
    Popular for both family wealth transfers and business ventures, limited partnerships consist of one or more general partners managing daily operations and one or more limited partners who contribute capital without engaging in management. To shield personal assets, the general partner is often a separate entity. State laws permit limited partners to take on some roles without jeopardizing their limited liability, provided their actions conform to the partnership agreement.
  • Practical Issues:
    As a state-created entity, a limited partnership must file a Certificate of Formation to secure liability protection. A detailed partnership agreement is essential to delineate control, voting rights, and operational responsibilities, often enabling a small owner or even an entity with minimal equity to retain operational control.
  • Tax Considerations:
    Similar to general partnerships, income flows through to partners based on their share. A key benefit is that limited partners typically avoid self-employment tax on their share of income. Nonetheless, the entity is generally subject to the Texas Margin Tax and offers unique tax planning opportunities under partnership law.

Limited Liability Companies (LLCs)

• • Overview:
    The LLC has become increasingly popular as a hybrid structure combining corporate liability protection with partnership tax treatment. Owners—referred to as members—enjoy limited personal liability while the entity may be taxed as a partnership unless it elects corporate taxation.
  • Practical Issues:
    Forming an LLC requires filing a Certificate of Formation, and its governance is outlined in a Company Agreement—a blend of corporate bylaws and partnership agreements. LLCs offer operational flexibility with fewer formalities than corporations. Additionally, Texas law generally restricts creditors to obtaining only a charging order against a debtor’s interest, preventing full control over the LLC.
  • Tax Considerations:
    A single-member LLC is taxed like a sole proprietorship, with income reported on the owner’s tax return, while multi-member LLCs are generally treated as partnerships. However, member-managers active in operations may be subject to self-employment tax on their distributive share. Like other entities, LLCs are subject to the Texas Margin Tax.

• S Corporations

  • Overview:
    Formed like any other corporation by filing a Certificate of Formation, an S corporation then elects special tax status with the IRS, causing its income and deductions to flow through to shareholders. Eligibility is governed by specific IRS requirements, such as a limit on the number and type of shareholders and restrictions on stock classes.
  • Practical Issues:
    As a state-law corporation, an S corporation provides limited liability and operates under established corporate governance structures. Shareholder agreements can facilitate control, succession, and buy-sell arrangements. The entity remains subject to the Texas Margin Tax and must adhere to strict federal tax regulations.
  • Tax Considerations:
    While S corporations avoid corporate income tax, complications may arise if transitioning from C corporation status, including built-in gains or passive income taxes. Shareholders are not subject to self-employment tax on distributions beyond reasonable compensation, though asset distributions can trigger taxable gains at the corporate level, reducing tax planning flexibility.

C Corporations

• • Overview:
    A C corporation is created by filing a Certificate of Formation without electing S status, resulting in the entity being taxed independently. This means corporate profits face taxation, and any dividend distributions are also taxed, leading to “double taxation.”
  • Practical Issues:
    Operationally, C corporations function similarly to S corporations. Today, they are less common among closely held businesses due to the inherent double taxation; however, they remain preferred by venture capitalists and companies aiming for public offerings.
  • Tax Considerations:
    The double tax—first at the corporate level and again on shareholder dividends—diminishes the appeal of C corporations for many small business owners, especially when asset sales are involved.