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CHOICE
OF LEGAL ENTITY
This Article is
designed to provide a basic summary about the differences between the
following legal entities recognized by the State of Texas:
Corporations
Partnerships
Limited
Liability Companies
Sole
Proprietors
Assumed
Name Certificates or Doing Business As (d/b/a)
Joint
Ventures
There
seems to be two major areas of concern when deciding the formation of a
business: Taxes and Liability. If
a business is not operating in corporate form, professionals are taxed
as individuals. That individual taxation may, however, be filtered
through a form of a partnership, or limited liability company or an S
corporation. This does not
mean the tax results are the same for all these entities. Each has its
own quirks. Likewise, each
entity has different levels of liability associated with its owners.
Due
to the complicated nature of the tax code and the fact that taxation is
not always based on the name of the entity, but many times based on the
actual characteristics and functions of the entity, it is strongly
recommended that you consult competent tax, financial and legal
professionals. This will
help make sure you maximize your corporate structure to its full
benefit. With this in mind here is a general overview of:
Corporation. A corporation (Subchapter C or S) is created when two or more
individuals, partnerships, or other entities join together to form a
separate entity for the purpose of operating a business in the state. A
corporation has its own legal identity, separate from its owners. The
corporation offers protection to the business owners’ personal assets
from debts and liabilities relating to the operation of the corporation.
Taxation of the corporation varies depending on the type of corporation
formed. A corporation must be registered with the Secretary of State.
Subchapter
C Corporation.
A Subchapter C Corporation advantages include exemption of stockholders
from personal liability; continuity of corporate existence in spite of
death, incapacity of owners or managers, or changes of stockholders;
transferability of ownership interest; limited liability of its
stockholders; and standardized statutory methods of organization,
management, and finance affording protection to stockholders and
creditors.
The
chief disadvantages of incorporation are the expenses of incorporation,
the necessity for complying with corporate formalities in the conduct of
business affairs, the necessity for complying with state reporting
requirements, and potential double taxation of corporate earnings.
From the tax standpoint, such disadvantage is more apparent than
real, however, since the tax laws are not inflexible, and the harm that
could result generally may be avoided by making proper choices and
elections.
In
actual practice, the decision to incorporate is often based on tax
considerations. The major tax disadvantage of incorporation, potential
double taxation of corporate earnings, exists only if earnings are
distributed to stockholders as dividends.
Bona fide interest and rental payments made by the corporation to
stockholders in return for the use of money or other property loaned by
stockholders for use in the corporate business are ordinarily deductible
by the corporation in computing its federal and state income taxes.
Even more important, the corporation will be entitled to deduct salaries
paid to stockholders in their capacity as officers and employees of the
corporation, and may also provide such fringe benefits as qualified
profit sharing or pension plans, group term life insurance, stock
bonus plans, and accident and health plans.
Subchapter
S Corporation. In some circumstances, the S corporation may be
a viable choice. Like the
LLC, it offers the limited liability of a corporation with most (but not
all) the tax characteristics of a partnership. Income and deductions
flow through to the individual shareholders and usually retain their tax
character in the process. The Subchapter S Corporation also offers
alternative methods for distributing the business income to the owners.
The
S corporation avoids many problems of the "regular"
corporation. An S corporation cannot be a personal holding company and
cannot hold taxable accumulated earnings.
Double taxation of earnings is not possible and no question can
be raised about the reasonableness of the salaries.
As
with a partnership, the income of an S corporation flows through to the
stockholders without being taxed at the corporate level. Most items of
income and deductions retain their character when passed through, in the
same manner as a partnership.
An
S corporation nevertheless has drawbacks. For example, an S corporation
cannot have more than 35 shareholders and shareholders are taxed on the
earnings of the "S" corporation, even if those earnings are
not yet distributed to the shareholder and are retained.
Nor can it have a corporate shareholder or a subsidiary, or
engage in financial operations (insurance, banking).
The S corporation cannot issue a second class of stock unless the
only distinction between the classes relates to voting rights.
There are fringe benefit problems such as any stockholder holding
2 percent or more of the stock is taxed on the value of the fringe
benefits (a major exception exists for qualified retirement plans; those
costs are deductible.). There are other disadvantages of an S
corporation as well. Though
useful in some situations, professionals have tended to shun S
corporations as an entity of choice.
Professional
Corporations. A Professional
Corporation is organized for the sole and specific purpose of providing
professional services by shareholders who are licensed or otherwise duly
authorized to perform those services. The primary goal of
professional organizations is to achieve for professionals a number of
tax advantages available to corporate executives. Like a PLLC, the term
"professional services," is defined in the act as any type of
personal service that requires as a condition precedent to the rendering
of the services such as a license, permit, certificate or other legal
requirement. The definition applies to services that, by reason of law,
cannot be performed by a corporation due to the professional’s license
requirements.
Persons
that may form professional corporations include: accountants, attorneys,
chiropractors, dentists, insurance agents, licensed insurance adjusters,
licensed professional counselors, nurses, occupational therapists,
optometrists, physical therapists, podiatrists, psychologists,
registered public surveyors, respiratory care therapists, and
veterinarians.
Conversely,
the following persons form business corporations rather than
professional corporations: audiologists, engineers, pharmacists, private
security investigators, real estate agents or brokers, security broker
dealers, and speech pathologists. These
professions can incorporate under the Texas Business Corporation Act. As noted under Professional Associations, physicians,
surgeons and other doctors of medicine are specifically excluded from
applicability of the Professional Corporation Act.
Foreign
Corporations. Are entities
formed in other states or countries. Texas State law requires that the
foreign corporation obtain a certificate of authority to do business in
Texas. A certificate of authority will not be issued, however,
unless the application for the certificate of authority states that the
jurisdiction in which the foreign corporation is incorporated would
permit reciprocal admission of the corporation if it were incorporated
in Texas.
Professional
Associations. Professional
associations are regulated in Texas primarily by the Texas Professional
Association Act. This act applies only to persons licensed to
practice medicine by the Texas State Board of Medical Examiners,
including medical doctors, osteopaths, and podiatrists.
The
Texas Professional Corporation Act, specifically excludes physicians,
surgeons and other doctors of medicine from the professional
corporation’s act. All other professionals should consider professional
corporations, regular corporations, limited liability corporations,
professional limited liability corporations and registered limited
liability partnerships.
The
Texas Professional Corporation Act and the Texas Professional
Association Act do not affect existing law concerning the
confidentiality of professional relationships or the professional
liability of a practitioner to his or her client.
Partnerships.
A general partnership exists when two or more individuals or businesses
join to operate a business. Under a general partnership, a separate
business entity exists, but creditors can still look to the partners'
personal assets for satisfaction of debts. General partners share
equally in assets and liabilities. A general partnership requires an
annual partnership income tax return (separate from the partners'
personal returns). A general partnership may be operated under the names
of the owners, or a different name. In either case, an Assumed Name
Certificate must be filed with the county clerk.
The most complex of
the taxing patterns imposed by the Internal Revenue Code is that
applying to partnerships. The goal is to make partnership taxation as
close to individual taxation as possible. The partnership provisions try
to make income, deductions, credits, and other tax items the same in the
hands of a partner as they would be if the partner were a sole
proprietor.
Though
taxation may be complicated as a partnership, the partnership itself is
comparatively simple and it can be the most flexible. The partnership
agreement can contain almost any provision desired; income and
deductions can be allocated in any manner the partners choose. (These
allocations must make economic sense, however, before they will stand up
for tax purposes). Partnerships have no limit on their size or on
the number of their members. Property may be contributed and taken out
without tax consequences.
The
major tax drawback of the partnership form is the inability to deduct
the cost of certain fringe benefits given to partners.
A profit-sharing or pension plan may not be adopted for the
benefit of the partners, but a comparable plan—the Keogh
plan—is available to partners on an individual basis.
Lack of a qualified plan is no longer a major reason for choosing
corporate form. As for the
remaining benefits that are not available as deduction to a partner,
that condition has not deterred professionals from choosing the
partnership form.
Limited
Partnership. A
limited partnership is a partnership formed by two or more persons or
entities, under the laws of Texas, and having one or more general
partners and one or more limited partners. General partners share
equally in debts and assets, while limited partners have limited debt
obligations. A limited partnership must be registered with the Secretary
of State.
A
limited partnership affords greater protection to the limited partners
than is afforded to members of a Registered Limited Liability
Partnership. In a limited partnership, the general partner (which may be
a corporation) has unlimited liability and exposure for the limited
partnership’s debts and obligations. Members in an LLC have no such
exposure.
Generally,
limited partners are not liable for the limited partnership’s debts
and obligations unless the partners have actively engaged in the
management of the business. A registered limited liability partner, on
the other hand, may participate in the management or control of the
partnership business and still enjoy the limited liability afforded by
the RLLP.
The
advantage of a Limited Partnership limits the rights of a judgment
creditor to a charging order against only the income produced from that
partner's interest in the partnership. The creditor may seek the
appointment of a receiver to take the debtor's share of the
partnership's profits. To
the extent that a partnership interest is charged in this matter, the
judgment creditor only has the rights of an assignee of the partnership
interest. Therefore, if the general partner has the right to hold a
distribution of income pursuant to the Limited Partnership Agreement,
the judgment creditor may receive nothing for his or her interest in the
limited partnership that the creditor has obtained.
Registered
Limited Liability Partnership. A
registered limited liability partnership (RLLP) is a general partnership
that has been registered with the Secretary of State.
A partner's liability in a registered limited liability
partnership differs from that of an ordinary partnership. In a
registered limited liability partnership, like a general partner, an
RLLP partner is liable for general partnership debts and obligations,
however, an RLLP partner is not liable for the negligence or malpractice
of other RLLP partners in his or her partnership unless he or she was
involved in or aware of the negligent act.
A partner in a general partnership is liable for all other
partner’s actions in the partnership even if he or she had nothing to
do with the negligent action.
Registered
limited liability partnerships, like general and limited partnerships,
do not pay the Texas franchise tax. LLCs, on the other hand, must pay
the franchise tax.
RLLP’s allow
pre-existing partnerships to enjoy similar benefits to those afforded
LLCs. Due to the tax consequences of disbanding a partnership and then
forming an LLC, many pre-existing partnerships will prefer to chose the
RLLP form instead. An RLLP has many of the same benefits of an LLC but
avoids the tax consequences of changing the organization of a
pre-existing partnership. For example, large firms that desire the
benefits of an LLC but are wary of the tax consequences can form a RLLP.
Family Limited Partnership.
Is a Limited Partnership but centered around the idea of
protecting the family assets while retaining control of the management,
supervision and transferability of the property interests.
The partnership consists of the family members and can be an
alternative to probate.
Limited
Liability Company. A limited
liability company is an unincorporated business entity which shares some
of the aspects of Subchapter S Corporations and limited partnerships,
and yet has more flexibility than more traditional business entities.
The limited liability company is designed to provide its owners with
limited liability and pass‑through tax advantages without the
restrictions imposed on Subchapter S Corporations and limited
partnerships. A limited liability company must be registered with the
Secretary of State.
An
LLC is created in the same manner as a corporation. Articles of
organization are filed that show the full liability of each organizer.
Assets of the individual members are not available for the company’s
obligations beyond what has been contributed. The LLC merges the limited
liability of a corporation with the tax advantages of a partnership or
sole proprietorship.
The
theory behind the LLC is that it will be taxed as a partnership. That
result, however, depends on the manner the company is formed and
operated. In Texas, the LLC can be formed in a manner that will allow it
to act like a corporation as it may have long terms of life, a
transferability of interests, or a centralization of management pattern
that permits it to operate like a corporation.
Texas LLC’s are taxed as a partnership rather than as a
corporation and they must pay a state franchise tax.
Whatever
its drawbacks, it is likely the LLC will eventually be the entity of
choice for most small and medium-sized businesses.
Professional
Limited Liability Company.
Is like and LLC, however it is organized for the sole purpose of
rendering one type of professional services and that has as its members
only professional individuals or professional entities.
The rendering of the professional service requires that the prior
to rendering of the service, the member must obtain a license, permit,
certificate of registration, or other legal authorization.
Professional services include, but not limited to, services
rendered by an architect, attorney, certified public accountant,
dentist, doctor, or veterinarian.
Sole Proprietorship.
A sole proprietorship exists when a single individual
operates a business and owns all assets.
A sole proprietor is personally liable for all debts, and
business ownership is nontransferable.
Under a sole proprietorship, the life of the business is limited
to the life of the individual proprietor.
The sole proprietorship makes no legal distinction between
personal and business debts, and it does not require a separate income
tax return. A sole proprietorship is operated under the name of the
owner, or an Assumed Name Certificate must be filed with the county
clerk.
Assumed
Name Certificates or Doing Business As (d/b/a).
If the business will
operate as a sole proprietorship or a general partnership, an Assumed
Name Certificate or a dba Certificate for each name (or deviation of
that name) the business will use must be on file with the county clerk
in each county where a business premise will be maintained. If no
business premise will be maintained, it should be filed in each county
where business will be conducted.
If
the business will operate as a corporation, limited partnership, or
limited liability company, and the business will be identified by a name
other than the name on file with the Secretary of State, an Assumed Name
Certificate must be filed with the Secretary of State and each county in
which the business will have a registered or principal office.
Neither
the filing of an Assumed Name Certificate nor the reservation or
registration of a company name imparts any real protection to the party
filing the certificate. It is merely a formal process that informs the
general public of the registered agent for a business and where official
contact with the business can be made.
Joint
Venture. A
joint venture is not a specific type of tax entity. Its tax
classification is drawn from its manner of formation and operation.
Though a joint venture can take almost any recognizable tax form, most
joint ventures are either partnerships or corporations.
Joint ventures can, under some circumstances, ignore their
association and retain their individual tax status for the operation.
Partnership
status. Unless incorporated,
most joint ventures are taxed as partnerships. Those ventures that do
not incorporate choose that route to avoid corporate taxation. They
purposely elect to be a partnership so the income and deductions of the
venture will flow
through to the venturers in their original tax form. Capital gain will
not be turned into ordinary income when paid out as a dividend, for
example. Such deductions as depreciation are directly deductible by the
venturers if the partnership form is used.
The
Code definition of a partnership includes "a syndicate, group,
pool, joint venture, or other unincorporated organization . . . which is
not . . . a trust or estate or a corporation." No distinction
exists between a partnership and a joint venture that is taxed like a
partnership. Both are subject to the same tax treatment.
Exemption from partnership status is available only if all
members of a joint venture make that election. The election is denied if
the income of the members cannot be determined without the use of
partnership accounting principles.
Associations
taxable as a corporation. While
a joint venture may begin as a partnership, it must avoid the
characteristics of a corporation if it is to maintain partnership
status. Once a partnership has more corporate than partnership
characteristics, it is subject to reclassification as an association
taxable as a corporation.
Six
characteristics decide whether a venture is a partnership or an
association taxable as a corporation. Two of these are common to
both partnerships and corporations. These are associations and the
conduct of a profit-seeking venture. The remaining four therefore decide
the tax nature of a venture. These are continuity of life, centralized
management, limited liability, and free transferability of interests. If
three out of these four are present, the venture is taxed like a
corporation. If only two are present, it is a partnership.
Continuity
of life is present if the death, retirement, or withdrawal of a member
does not cause dissolution. If it does, continuity is not a
characteristic of the venture. Centralized management exists if a small
group has the sole authority to make management decisions. Centralized
management also exists if substantially all the interests are owned by
limited partners. If interests in the venture can be transferred
freely, this is a corporate characteristic. If a transfer dissolves the
venture, the interest is not freely transferable.
Co-ownership
of property. Mere co-ownership
of property, even as a joint venture, does not always lead to taxation
as either a partnership or as a corporation. Co-ownership of property,
by itself, merely requires that each co-owner pick up his share of
income and expense from the property. The co-owners are only investors.
Even when taxpayers who are not co-owners of property unite for a
project, they are not necessarily partners.
For example, if persons organize to dig a ditch to drain their
respective property, no income is involved, only expenses.
They will report the expenses in their own individual tax
returns, not through a partnership return.
When co-owners of a residence jointly lease it, they are not
engaged in business. Once
those owners go beyond merely holding and renting property, however,
they are in business and are treated differently under the tax law. If
they provide services for the residence—cut the grass, haul the
garbage, etc.—their tax status changes.
General
IRS Tax Classification.
Professional
Associations.
As noted above, there are a variety of entities available to a
professional who is engaged in plying his or her occupation. While these
may all be classed as professional associations, for tax purposes, the
term lacks specificity. The Internal Revenue Code does not recognize
such an organization. Instead, the Code deals with:
Sole Proprietorships; Partnerships; Professional Corporations;
Limited Liability Companies; Associations taxable as a corporation;
Subchapter S corporation.
As
this listing show, a professional association does not exist for tax
purposes. A professional association is taxed like the specific tax
entity whose form has been assumed. If it is a partnership, a limited
liability company, or an S corporation, the tax governing pattern is
that imposed on an individual. If it is a corporation or an association
taxable as a corporation, it is taxed under the corporate rules.
However,
if one of these entities assumes too many corporate aspects, it is taxed
as a corporation. This is also true of partnerships and any other
association of professionals. Depending on their formation and their
operations, they may be taxed either as a corporation or a partnership.
Therefore the respect for following corporate formalities is
important not only for tax reasons but for protection against individual
liability.
Professional
Service Corporations. Not only
does the tax law not recognize a professional associations, it does not
even acknowledge that a professional corporation is unique. For tax
purposes, a professional corporation is the same as any other
corporation. The IRS does,
however, recognize the individuality of most professional corporation in
an indirect fashion. The IRS Code has set up a tax classification called
"personal service corporations."
Most professional corporations are also personal service
corporations. They are therefore subject to special rules affecting
these entities.
The
definition of a personal service corporation (PSC) varies, depending on
the particular Code restriction imposed. Basically, a PSC is one engaged
in giving services performed primarily by its employee-owners. Substantially
all the stock of the corporation (at least 95 percent) must be owned by
the employee-owners. For certain rules to apply, that definition is
enlarged. Those rules will apply only if the corporation is engaged in
certain fields. The fields are health, law, engineering, architecture,
actuarial science, accounting, performing arts, and consulting.
The breadth of that listing includes most professionals. Still a third
batch of rules applies only to employees who own 10 percent or more of
the stock of the corporation.
We
hope the above summary will assist you in deciding what type of entity
is right for you. Please be advised that the above is only a partial
summary of each entity. This
area of law is very complicated so please feel free to consult further
with us and/or your tax expert to determine which entity is right for
you. We look forward to
answering your questions.
Article Adapted From Westlaw and the Texas Secretary of State
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