Choosing a Business Entity: Part I

December 28, 2022  | By David Lowe

Part I: Formation, Day-to-Day Operations and Liability

You are excited to start your own business. You offer a unique product or service, target a clearly defined market, possess the expertise to deliver superior value to clients and invest long hours to make your venture successful.

What else do you need? One of the keys to a financial win is choosing the right entity structure for your company. The type of legal entity you choose can have significant effects on your personal liability and taxes, your company’s day-to-day operations and the continuity of the business if a key decision-maker ultimately leaves the team.

Some of the main business forms are sole proprietorships, partnerships, limited liability companies (LLCs) and corporations (C corp or S corp). Each one has distinct characteristics, along with specific advantages and disadvantages.

This post is not intended to provide specific legal or tax advice. Many of the examples in this post refer to Texas, although the legal particulars for business entities may vary from state to state. Please consult your attorney or CPA for guidance specific to your situation. With that said, here are some high-level factors to consider when deciding what entity type may be best for your business.

Entity Formation and Day-to-Day Operations

The entity types mentioned above differ in terms of how an entrepreneur sets up the entity, and how the business functions. Let’s look at the basics.

Sole proprietorships

As the name implies, these are business ventures that one person owns and runs. They can operate under the individual’s name or use a doing-business-as moniker. These are very easy to set up – and shut down, if necessary. Also, they do not require the more complicated legal filings that the state mandates for the formation of other entity types.

Partnerships

Professionals such as attorneys, accountants or physicians sometimes choose a partnership structure. This entity type involves multiple owners who contribute capital to the business. Partners also share profits and losses in proportion to their respective interest percentages.

Partnerships can be divided into further subcategories: general partnerships, limited partnerships and limited liability partnerships (LLPs). Not every state allows for LLPs, so this post will focus simply on the main differences between general and limited partnerships.

General partners may participate in day-to-day management. Limited partners have a stake in the business as investors, but they do not exercise management control.

Partnerships often operate according to the terms of a written partnership agreement, although rules vary by state. The Texas Secretary of State office provides a general summary of requirements for partnerships in the Lone Star State.

Limited liability companies (LLCs)

Whereas the individuals are the key elements in a partnership, the entity is the key element in a limited liability company, according to the Texas Secretary of State office. As such, there are more formal requirements for establishing an LLC.

To create an LLC in Texas, it is necessary to file a certificate of formation with the Texas Secretary of State office. In addition, many states require LLCs to file an annual report and pay a tax or fee each year. Failing to fulfill those requirements can result in hefty penalties.

An operating agreement – even if not mandated by state law – is a valuable document that outlines how the LLC will be managed. This document, co-authored by Professor Elizabeth S. Miller of the Baylor University School of Law, discusses model agreements for closely held LLCs. As always, please consult legal counsel for specific advice.

Unlike with S corporations, there is no limit to the number of members in an LLC.

Corporations

In the eyes of the law, a corporation is a “person,” or an entity, separate from the actual people who own and manage the business. Corporations issue stock, so raising capital can be easier for corporations than for other business forms – such as partnerships or sole proprietorships.

However, corporations are more complex and expensive to establish. A nascent corporation must file articles of incorporation – sometimes called a certificate of formation – with the state. As Business News Daily explains, articles of incorporation state the corporation’s purpose and also typically include these details:

• The business name
• The name and address of the registered agent. (This person or company is the state’s point of contact for key legal documents and official communications.)
• The names and addresses of all board of directors members
• The type and amount of stock shares available – including common stock and preferred stock

Here is the Texas certificate of formation for for-profit corporations. Commentary and instructions are on pages 1-4. The form itself starts on page 5.

Corporations are governed by a board of directors, which appoints one or more officers to manage the daily operations of the business. Titles may include president, vice president, secretary, treasurer or other relevant offices. That’s right – that means official board meetings.

Large corporations may have frequent and elaborate meeting procedures. A closely held family company still should be professional, but it likely can choose a more casual meeting atmosphere. My parents own a small C corporation, and they have held annual meetings around their dining room table (or even in the car while driving to an out-of-town restaurant). Their company documents specify a particular month for the annual meeting, but when that timeline proves inconvenient, rescheduling is simple. All it takes is a quick vote of the board of directors. Detailed meeting notes and accurate corporate resolutions are good practices, but nobody needs to memorize the minutiae of Robert’s Rules of Order.

S corporations

The formation process for an S corporation is similar to that for a C corporation, as described above. One major difference between the two types of corporations relates to taxation, a topic for the upcoming Part II of this post.

In addition, several specific restrictions apply to S corporation. For example, to qualify as an S corp, an entity must:

• Be a United States corporation
• Not be an insurance company, Domestic International Sales Corporation (DISC) or other ineligible financial institution
• Have no more than 100 shareholders
• Have only one class of stock (whereas C corporations can offer preferred and common stock)

In addition, shareholders must be United States citizens or resident aliens, estates, or certain types of trusts (subject to specific rules). Partnerships, corporations and non-resident aliens may not own S corporation shares. In contrast, as the Houston Chronicle’s small business blog notes, it is common for corporations to buy shares in other C corporations.

Liability

Along with considering how to create a specific entity type, it is important to guard against liabilities that could arise from business activities.

Entrepreneurs often are optimists. They chase big goals and exude confidence that they will achieve them. Nevertheless, it is essential to protect yourself in a worst-case scenario. What will happen to you and your loved ones if your business does not succeed financially?

Liability matters. Specifically, your business entity type can determine whether the law makes you personally liable for your company’s debts or other torts. Consider the liability effects of the following business types:

Sole proprietorship

While this business form is easy to set up, it can be risky, because the business owner assumes 100% liability. As the Houston Chronicle notes, this means:

• Creditors can sue you personally if the business can’t pay off its debts
• If you can’t pay your personal debts, creditors can target your business assets
• You could be liable for injuries that occur at your business. Say a client trips over a welcome mat in the lobby and sustains an injury. As a sole proprietor, you might have to pay hefty bills.

General partnership

This entity type also poses significant liability concerns. As Cornell University’s Legal Information Institute notes, general partners take on unlimited joint and several personal liability. In other words, a general partner’s personal financial assets can be at risk because of other general partners’ actions.

As the Legal Information Institute explains, joint and several liability means that each party is liable, on his or her own, for the full amount of damages awarded to a person who sues the partnership. For example, if a business with three general partners is sued for $3 million, the plaintiff could make any one of the partners pay the full $3 million. If that particular partner could not collect a proportionate share from the other partners, that one business partner would be stuck paying the entire bill.

Limited partnerships

In contrast to general partners’ high potential liability, limited partners enjoy more protection. As Wolters Kluwer notes, limited partners do not participate in day-to-day management, and their personal assets usually can’t be seized to pay off business liabilities. Limited partners’ liability is capped at the amount of their investment in the limited partnership.

LLCs

Aptly named, limited liability companies offer a key advantage by reducing business owners’ liability. Therefore, LLCs can be a useful tool for protecting personal assets if one’s company encounters financial trouble.

For Lone Star State entrepreneurs, here’s the exact language from Section 101.114 of the state’s Business Organizations Code: “Except as and to the extent the company agreement specifically provides otherwise, a member or manager is not liable for a debt, obligation, or liability of a limited liability company, including a debt, obligation, or liability under a judgment, decree or order of a court.”

What if you have multiple investment ventures? A series LLC can provide liability protection for several distinct assets, such as separate rental properties in different parts of town. With a series LLC, an investor can shield personal finances without the hassle and expense of creating an individual LLC for each property. This site and this Texas Secretary of State FAQ page provide general information about series LLCs. As always, please consult an attorney for specific legal advice.

Corporations

As noted earlier, corporations can be somewhat involved to establish and maintain. The administrative burdens can be worthwhile, though, because of the liability protection that corporations offer. Corporate shareholders generally are not personally liable for the debts of the business – as long as the corporation follows the proper formalities for the entity and shareholders do not commingle personal assets with business assets.

Part II: Coming Soon

We hope this basic introduction has helped you identify some of the key issues to consider when choosing a business entity type. The upcoming Part II of this post will explore taxation considerations and will look at a few hypothetical case studies. Those examples will aim to show how entrepreneurs weigh the factors involved in entity selection.

Here’s to a thriving business!