Business Entity Formations


The Basics

For most businesses, there are five entities that might be considered for conducting business: a sole proprietorship, a corporation (either "C Corp" or "S Corp"), a limited liability company, a general partnership, and a limited partnership. There are benefits and disadvantages to each type of entity.

The factors that should be considered in determining which entity should be used for conducting business include, among others:

Business Counsel Required

It is imperative that the organizer of the company obtain adequate counsel in the formation and operation of each entity. Counsel should, at a minimum, consist of a business attorney, CPA, insurance agent, and mentor in the type of business to be conducted.

The Sole Proprietorship

The sole proprietorship is the simplest means by which to conduct business and requires the least amount of effort to form and operate. The owner is the operator, the owner reports his or her income and expenses on his or her personal income tax return (Form 1040, Schedule C), and no formal filings are required with the state or federal governments (unless you must report employee taxes). Banking institutions are often more likely to provide loans for sole proprietorships instead of more complex entities or general partnerships, both of which can create banking concerns for the bank. There is no protection from personal liability and a separate entity should be formed if you have personal assets to protect. In Texas, there is no "margin tax" that must be paid on earnings from a sole proprietorship.

The Corporation

The corporation is the most basic form of business entity. It originated in the early 1800s and remains as one of the main forms of business entities. The owners are known as shareholders, the management is with the board of directors, and the day-to-day operations are controlled by the officers. The corporation should be considered if management and ownership requires stricter structure amongst the owners and principals. For example, distributions of excess capital in a corporation must be made in the percentage of ownership.

A subchapter S Corporation is a C Corporation that has filed timely the appropriate documents with the Internal Revenue Service to obtain taxation as a subchapter S Corporation.

The Limited Liability Company

The limited liability company is similar to the corporation, and came into existence in the late 1900s. It should be considered when management is under one or two persons or among several persons, or management and ownership require more flexibility. For example, the members (who are the owners) may manage the company and distributions can be structured in a percentage that is different from the ownership in the company. The company can, but is not required to, appoint officers of the company. Further, foreign ownership is permitted, which differs from subchapter S Corporations. Flexibility is the main benefit for the limited liability company.

The General Partnership

A general partnership consists of two or more persons or other entities coming together for a business purpose. The main foundation for the formation of the general partnership is to share in the income and expenses associated with the general partnership. Each partner and the partnership are liable for the partnership debts and obligations. As such, it is the type of entity that creates the most risk to the owners. In Texas, a general partnership formed of only natural persons is not liable for margin tax.

The Limited Partnership

The limited partnership is an entity that is created with at least one general partner and at least one limited partner. It is often created for entities that are seeking outside, passive investors. It was popular for single person owners prior to 2007, because it was a lawful means by which to avoid the franchise tax in Texas. The Texas legislature has changed the laws by replacing the franchise tax with the margin tax, and making all entities liable for margin tax other than the sole proprietorship and the general partnership with all natural persons as owners. The complexity of the formation and operations for most small businesses is a deterrent to its use today.

Conclusion

There is not one factor that determines which entity is the best for conducting a person's business. The most frequent reason for forming an entity is to protect one's personal assets from creditor actions. This remains true today, but all other factors known to the principals should be considered.