When launching your business, choosing the right business formation and its legal structure is one of the most important decisions you will make. The operating structure of your business determines the liability and taxation arrangements you carry for that business business. Understanding the pros and cons of each type of business entity will help you make the best choice for your business and its future. This article details four common business structures and the legal characteristics of each.

Sole Proprietorships

A sole proprietorship is the simplest form of a business operation. A separate legal entity is not required, regardless of whether the business is operated under the owner’s name or a trade name. Sole proprietorships are the most simple business form and generally inexpensive to establish. If the business name is not the owner’s natural name, then an assumed named certificate (also referred to as a “DBA” for “doing business as”) must be filed with the county or counties where the business will operate. There are no federal income tax or Texas franchise tax filing requirements for sole proprietorships. Rather, the owner simply files his or her personal income tax return and reports the business’s income and expenses on Schedule C of the standard Form 1040. A sole proprietorship does not provide any liability protection to its owner. The owner is personally responsible for the liability of the business. If the business fails, creditors can pursue the owner’s personal assets. Potential creditors include not only those who may have contributed financially but also those who are injured by the owner or any employees.

Partnerships

A partnership requires at least two partners. There are two forms of partnerships; general partnerships have two or more general partners, and limited partnerships have at least one general partner and one limited partner. Every partnership must report its income and expenses by filing a federal partnership tax return (Form 1065). However, taxes are paid at the individual level, not by the partnership directly.

A written agreement (commonly referred to as a partnership agreement) is not required for a general partnership but is highly advised. A general partnership is not required to file a Texas franchise tax return or pay franchise taxes. However, a general partnership affords no liability protection to the partners. Furthermore, liability is joint and several, meaning that each partner is liable to creditors for the full amount of any debts or claims.

Limited partnerships must have partnership agreements and be formally established under Texas law by filing certain documents with the Secretary of State. Every limited partnership must have at least one general partner and at least one limited partner. Most commonly, limited partnerships have one general partner and multiple limited partners. The general partner is liable to creditors for any debt or claims against the partnership while limited partners enjoy limited liability. Limited partners are liable only for the amount of capital they have contributed. All limited partnerships are subject to the Texas franchise tax, which is a tax imposed by the State of Texas for the privilege of having limited liability.

Corporations

S corporations are generally used by family businesses or small businesses. An S corporation’s income and expenses are passed through to the S corporation’s shareholders, without being first taxed at the corporate level. Federal income taxes are reported similarly to those of a partnership and taxes are paid by the individual shareholders.

Choosing between the C and S corporation designations is determined by the types of owners a corporation expects to have and the goals the owners have for the corporation. If the initial owners expect the corporation to be very large or to issue stock to the public, a C corporation is appropriate. Conversely, S corporation stock can only be held by individuals and certain types of trusts and is therefore more suited to smaller, closely held businesses. A corporation can switch between C and S designations but the IRS has strict rules for when and how those switches are made.

Limited Liability Companies (LLCs)

The limited liability company is a relatively new business entity form and has quickly become very common. An LLC is very similar to an S corporation. The LLC form offers a combination of limited liability and the option of partnership-type federal income tax treatment (an LLC may choose to be taxed as a corporation or as a partnership). Furthermore, an LLC does not face the same restrictions as an S corporation regarding the types of permissible shareholders. LLCs must pay Texas franchise taxes because its owners, referred to as “members,” enjoy limited liability.

In conclusion, when starting a business, it is important to understand the owner’s goals for the business. Any new business owner should have at least a minimum level of legal and tax counsel before making any significant decisions and should seek assistance to ensure that any and all filings are made properly and on time. When deciding the best course of action for a new business, it is wise to consider all possible outcomes, good and bad.

Bill Leighton is Board Certified in Tax and Estate Planning and Probate Law by the Texas Board of Legal Specialization (TBLS). TBLS certifies attorneys in 20 specialty areas of law and is the only certification organization authorized by the Supreme Court of Texas. Board Certified attorneys have substantial, relevant experience in a select field of law as well as demonstrated, and tested, special competence in that area of law. They are the only attorneys authorized by the State Bar of Texas to publicly represent themselves as specialists in a select area of law.

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