Numerous methods are available to form your business, each with its own benefits and disadvantages. A business owner who selects the wrong business structure or fails to properly file the required incorporation forms with the Secretary of State may be held personally liable for any obligations incurred on behalf of business or run into tax issues with the IRS. This article will explore the differences between business entities with respect to formality, liability, management, transferability of ownership, continuity of life, and taxation.
Methods of Business Formation in Texas
There are several ways outlined below in which you can form your business. Many of the differences boil down to the way taxes are accounted for and liability. For these reasons it’s critical to discuss your plans with an experienced Houston business lawyer who can help guide you on the right direction based on your current and future needs.
A sole proprietorship may be formed where the company is owned by only one person who also owns all the assets of the company. A sole proprietorship is not required to register with the Secretary of State, however, you must obtain an assumed name certificate (commonly referred to as a DBA) if the business is operated under a name other than that of the owner. The owner of a sole proprietorship and the business itself are one in the same and do not exist as a separate legal entity. Consequently, the owner is personally liable for the business’s obligations, including any debts and judgments that may be rendered against the company. The owner oversees management and has the ability to freely transfer ownership of the company. A sole proprietorship cannot exist beyond the life of the owner unless ownership is transferred.
A corporation is owned by shareholders, whose ownership interest is represented by shares of stock in the company. You must file a certificate of formation with the Secretary of State to become a corporation. A corporation is a legal entity separate from its owner, thus, the shareholders, officers, and directors are generally not personally liable for the corporation’s debts and obligations. However, shareholders, officers, and directors are liable for their own wrongdoings, and, in certain circumstances, such persons may be held personally liable if a court rules to set aside limited liability. A corporation is typically managed by a board of directors, who then delegates day-to-day management authority to officers—such as the CEO/President, Vice President, CFO, etc. The owners of a corporation may transfer ownership interest through the sale of their shares of stock. The ability to transfer ownership helps to bring in new investors in exchange for ownership interest, and also ensures that the life of a corporation can extend beyond its current owners.
General Partnership (“GP”)
A general partnership consists of at least two owners who agree to run a business as co-owners for profit. A general partnership is operated by a partnership agreement that is not required to be filed with the Secretary of State. Partnership agreements need not be in writing, unless the law requires that the specific type of agreement be in writing, such as a partnership that cannot be completed within one year. You may need to obtain a DBA if the name of the general partnership is something other than the surname of all of the partners. Partnerships are not treated as distinct legal entities, thus, partners are personally liable for the obligations of the partnership. Management is shared among the partners. The transfer of ownership interest requires the consent of the other partners which means that a general partnership typically does not continue beyond the life of the partners. However, a withdrawing partner can agree to allow the remaining partners to continue the business.
Limited Partnership (“LP”)
A limited partnership consists of limited liability partners and at least one general partner. You must file a certificate of formation with the Secretary of State but the operations of a limited partnership are governed by a partnership agreement. A limited partner’s liability for the partnership’s obligations is limited only to the amount of their capital contribution to the business. On the other hand, a general partner assumes full personal liability for the obligations of the partnership. In return, general partners receive the majority of management rights. Unless otherwise specified in the partnership agreement, partnership interest is assignable in whole or in part to another person and will not dissolve the limited partnership. The assignee is only entitled to a financial distribution from the partner making the assignment—there is no right to become a partner nor to inherit the rights of the assigning partner. A limited partnership may be dissolved as specified in the certificate of formation or partnership agreement, through written consent of all the partners, the withdrawal of the sole general partner, or dissolution by court order.
Limited Liability Partnership (“LLP”)
In Texas, only a pre-existing general partnership or a pre-existing limited partnership may register with the Secretary of State as a limited liability partnership. Registering as a limited liability partnership does not create a partnership nor does it create a separate legal entity. Like other partnerships, a limited liability partnership operates based on the terms of the partnership agreement. Unlike in a limited partnership, all the partners enjoy limited liability for the obligations of the business with this formation structure. Partners share in the management of a limited liability partnership, just as in a general partnership.
Limited Liability Company (“LLC”)
The limited liability company is a relatively new form of business entity in Texas that is designed to provide limited liability like in a corporation but also to allow for flexibility and simplicity in the structure of management and ownership like in a partnership setting. You must file a certificate of corporation with the Secretary of State to form a limited liability company. The limited liability company provides the greatest flexibility to business owners because it is governed solely by the terms of a written agreement, which essentially serves as a contract. Thus, the owners may choose the parameters of management, transferability of ownership, and how long the business is to continue, among other important business factors. A limited liability company may be managed by its members or by a group of managers, depending on the setup laid out in the written agreement.