First of all, a warning. If a party desires to enjoy the protections afforded to those doing business under a separate entity, it is vitally important that the entity formation documents be completed fully and completely. Many online services only produce the filing form, without the accompanying operational documents. Not producing a full set of documents can and will expose a business owner to some uninvited risks.
The importance of forming a business entity separate from yourself individually cannot be overestimated. If an individual desires to pursue a business or investment, they are well advised to take advantages of the important protections and tax benefits afforded through the establishment of a business entity. The type of entity to be formed depends on a number of factors, explored more fully below. But put quite simply, forming a separate entity typically provides a business owner protection from 1) individual liability, and 2) double taxation.
Without a separate entity, an individual running a business as a sole proprietorship could be held liable for any and all debts, judgments and other liabilities arising from the business endeavor. If a customer or tenant, for example, slips and falls, the owner’s personal assets could be at risk if they are found liable for the accident. By forming a separate entity, and actually running the business through that entity, an individual can shelter his/her personal assets from creditors and judgment holders. It is vitally important, however, to perform all activities, including contracting, banking and communicating, in the name of the entity. Any commingling of funds with your personal funds, or taking action in your personal name, could “pierce the veil” of the entity and allow a good plaintiff’s attorney to prove that the entity was just a shell, or a sham. In such cases, a plaintiff or creditor could attack your personal assets.
By forming the right type of entity, a business owner can enjoy the benefits of “pass-through taxation”, meaning that all gains, losses and expenses flow through to their personal tax return, rather than being taxed at the “corporate” level. This pass-through feature prevents earnings from being double-taxed.
What type of entity is right for you? Below you will find a very brief look at some of the advantages and disadvantages of several different forms of ownership.
Advantages: Easy to form, no statutory requirements, easy to manage/operate, no double taxation, no Texas Margin (Franchise) tax. Disadvantages: Owner is personally liable, cannot have more than one owner.
Advantages: Limited Liability for limited partners, full control for principal owner, can have multiple partners, pass-through taxation. Disadvantages: Unlimited liability of each partner, control issues.
Advantages: Limited Liability for limited partners, full control for principal owner, can have multiple partners, pass-through taxation. Disadvantages: More expensive to form, more expensive to file, Margin Tax.
Regular Corporation (C-Corp.):
Advantages: Limited liability for all stockholders, can have multiple owners, clear control, familiar roles (Directors, stockholders, officers). Disadvantages: Double Taxation (earnings taxed at corporate level as well as at dividend level), Margin Tax, annual corporate formalities necessary to avoid “piercing the veil”.
Subchapter S Corporation (S-Corp.):
Advantages: Limited liability for all stockholders, can have multiple owners, clear control, familiar roles, pass-through taxation. Disadvantages: Margin Tax, annual corporate formalities.
Limited Liability Company (LLC):
Advantages: Limited liability for all members, can have multiple members, pass-through taxation, no annual corporate formalities. Disadvantages: Unfamiliar structure (managers/members instead of directors/shareholders), formation expenses, subject to Margin Tax.
Up until a few years ago, in searching for an entity allowing for limited liability and no double taxation, many Texans leaned toward a limited partnership structure to avoid Texas Franchise taxes. However, the law recently changed, subjecting most partnerships, LLC’s and corporations to the same state tax burden (now called the Margin Tax). With the playing field now leveled, state taxation issues (at least in Texas) are no longer a consideration. Although there is a place for all types of entities, many Texans now select an entity based on the following criteria:
- First, they are seeking protection from personal liability. A sole proprietorship and/or general partnership is therefore not always a safe way to conduct business.
- Second, they seek pass-through taxation, to avoid taxation at the corporate level. For this reason, a C-Corp is often disfavored.
- Third, they desire to limit formation and filing fees. A limited partnership is much more expensive to form and file.
- Fourth, they desire to limit the need for annual corporate formalities, for fear that if they fail to update corporate minutes, for example, their liability protection could be at risk. For this reason, many avoid an S-Corp.
- As a result of the above issues, one can see why the LLC form of business entity is quickly becoming the entity of choice for small businesses. With that said, however, Sub-S corporations remain attractive to those who desire a traditional corporate setup, as long as they keep track of annual corporate formalities. It should be noted, however, that despite its expense, a limited partnership is an excellent structure for a business owner who want to attract investment partners (to raise funds), but wants to retain full control of daily operations.