DISCUSSION OF TEXAS BUSINESS ENTITIES

 


1. What are business entities?

a. Business entities are various legal entities that courts recognize as having some of the rights and obligations of a natural person, distinct from its owners.
b. Rights, duties, privileges, and obligations that are important to business entities include: i.     Certain owners of certain types of entities can be insulated from responsibility for damages that result from the actions or inactions of the entity, except in limited circumstances ("Limitation of Liability").
ii. The right to be recognized in a court of law as a party in a lawsuit, distinct from the owners of the entity. ("Standing")
iii. The right to own and protect property. ("Property Rights")
iv. The right to make promises and to enforce promises made to it by others. ("Right to Contract") 2.   Fundamentals regarding business entities.
a. Except in special circumstances, the owners of the business entity have the right to have the company operated in a way that maximizes the return to the owners as a group.
b. Business entities create tax issues or consequences.
c. Ownership interests in business entities can be bought and sold.
d. In time, every natural person's ownership interest in a business entity will end.
3.  Why form a business entity instead of conducting business as a sole proprietor or a common law partnership?
a. Liability Considerations
b. Transferability Issues
        i. Investment
        ii. Sale - Succession
c.  Tax Considerations
d. Profitability/Accounting Considerations


DISCUSSION OF BENEFITS/ATTRIBUTES OF FORMING BUSINESS ENTITIES

4.  Limitation of Liability

a. The various kinds of business entities vary widely in the degree to which liabilities of the entity can be enforced against the owners of the entity. In most cases, the owners of the entity want substantial limitations of liability. i. Unlimited and Expanded Liability - Worst Case. If business is conducted under a general partnership, each partner is jointly and severally liable for all of the partnership's liabilities. A partner's personal assets can be taken to satisfy his own liabilities, and the liabilities of the partnership, which include liabilities incurred by bad-acting partners. (Such that conducting a business in the form of a partnership can expose each owner to a higher risk of liability than if that owner had conducted business as a sole proprietorship.)   ii. Limited Liability for All Owners. If a corporation or limited liability company is properly organized and administered, the personal assets of a person who only has an ownership interest in the entity (e.g., stock ownership) can be shielded from the corporation's liabilities, except in limited circumstances (for example, environmental or payroll tax liabilities). (However, in many cases, persons who are owners also take on other roles such as employee, officer, or director, which can be sources of liability. Also, owners can enter into agreements that can obligate the owners to contribute money to the entity in various circumstances.)   iii. Limited Liability for Some Owners. In a Limited Partnership certain of the owners have limited liability (Limited Partners) while at least one of the owner's personal assets must be exposed to the risk that they will be taken to satisfy liabilities of the Limited Partnership (General Partners). Limited Partners have limited rights to control the business of the Limited Partnership, while General Partners has the general right to run the Limited Partnership. There are means to circumvent the unlimited liability of the General Partner, for example by forming a corporation to be the general partner of the limited partnership. 5.   Tax Consequences - The taxation of business entities is a complicated area that must be addressed by a tax professional, since federal and state tax treatment varies widely depending on which form the business has taken. The main distinction is whether income made by the entity is taxable to the owners based on when it was received by the entity or based on when it was distributed to the owners. There are three basic scenarios: a. Sole Proprietorship - For tax purposes, a sole proprietorship is not recognized as being independent from its owner, such that all income of the business is directly attributed to the sole owner.   b. Pass Through or Partnership-Like Tax Treatment - The treatment of income and loss is passed through to the owners in accordance with agreements between the owners.   c. Standard Corporate Tax Treatment - The corporation pays income tax on its earnings while the owners pay taxes on dividends when they receive them, if ever. 6.  Transferability Issues - There are two basic issues regarding transferability of ownership interests: a. Attracting "Investment" or Apportioning ownership between "Investors" - Investors can bring time, knowledge, talent, physical resources and money to a corporation in the hopes of getting a return on their investment. A corporation can provide this return on investment in a variety of ways. Investors of cash will most often want rights to ownership interests in return for their investment. Granting investors an ownership interest in the business can be relatively easy if a business entity is in place, as procedures for the admission of new owners are often set out in the initial papers of the entity.   b. Transferring ownership interests to others or Sale of the Business - The owners of interests in businesses in time will want to sell their interest or somehow transfer the interest to others. The creation of a formal business entity simplifies the problems associated with transfers of ownership interests. For example, in the sale of a business, a corporation could simply sell all of its assets to another person, while an individual would more or less be forced to itemize or segregate the things to be sold from those non-business assets to be retained. Likewise, it is possible for a person who owned less than all of the shares of stock of a corporation to sell their shares without affecting the operation of the business, while the sale of a common-law partnership interest technically results in the termination of the partnership. 7.  Segregation of Risks - Closely related to the desirability of having limitations of the liability of the owners, is desirability of being able to segregate businesses and risks into separate stand alone entities, the profitability of each of which can be determined without reference to each other or the owner's personal assets.

8. Agreement in Advance on Fundamental Issues - The formation of a business entity involving more than one owner helps the owners decide and agree in advance how the business will be conducted and how the results of the business will be distributed among the owners. Having this determined in writing before formation helps to avoid misunderstandings.
 

DISCUSSION OF TYPES OF BUSINESS ENTITIES

9. Default Business "Entities"

a. Sole Proprietorship
b. Common-Law Partnership
10.  What entities can conduct business in Texas?
a. Individuals (Sole Proprietorships)
b. General Partnerships (Joint Ventures)
c. Limited Partnerships
d. Corporations
e. Limited Liability Companies
f. Non-Profit Corporations
g. Trusts - Receiverships - Bankruptcy Estates
h. Various Entities Reserved for Licensed Professionals
        i. Registered Limited Liability Partnerships
        ii. Professional Corporations
        iii. Professional Associations
i.  Various Entities Reserved for Certain Businesses
j. Business entities formed outside of Texas.
11.  Sole Proprietorship - The individual has unlimited personal liability for actions of the business. Taxation is at one level, the personal level.

12. General Partnerships - Under general partnership, liability is joint and several for all partners. Partners have unlimited personal liability for acts of partnership. All partners can be involved in the day to day operations of the business. Taxation is at one level.

13. Limited Partnerships - Under limited partnership, you must have at least one general partner for which liability is unlimited. Liability is limited for all limited partners. Only the general partners can be involved in the day to day operations of the business. Taxation is at one level. Franchise tax is not applicable.

14. Corporations - The owners of a corporation are called "shareholders". The shareholders elect "directors" who are charged with managing the business. The directors elect "officers" who are responsible for running the business on a day to day basis. Generally corporations must pay federal income tax and profits are distributed to the shareholders as dividends; however subchapter S qualification can achieve partnership type tax treatment. Shareholders pay taxes on dividend payments, when, if ever, they are received by the shareholder. The shareholders have limited liability for the actions or inactions of the corporation.

15. Limited Liability Companies ("LLC's") - LLC's combine partnership-like tax treatment with limitation of liability for all owners. The owners of an LLC are called "members" The members elect "managers" which are charged with managing the business. Depending on the desires of the members, either the members or the managers can elect "officers".

16. Professional Corporations, Registered Limited Liability Partnerships, Professional Associations - These are special entities reserved for licensed professionals. Historically, professionals who wanted to conduct business together formed partnerships. The problem with this was that each partner was personally liable for malpractice committed by the other partners. These entities were created in an effort to limit this vicarious liability. The result is that a claimant can get all of the assets of the entity, all of the non-exempt assets of the persons who committed malpractice, but not the personal assets of the other owners of the entity.

17. Non-Profit Corporations - Many business activities can be conducted in the form of a non-profit corporation, however, you must have a purpose that will support a non-profit status. Likewise, having a non-profit purpose means that the owners can not have the right to have the entity operated in a way that maximizes pecuniary benefits to them. The advantages of forming non-profit corporations lies mostly in the area of "image" considerations, since the objectives of a non-profit corporation can be achieved through other types of entities.

18. Business Entities Formed Outside of Texas - In order to properly conduct business in Texas (i.e. have an office in Texas) business entities formed outside of Texas must register as a foreign business entity. (The term "foreign" applies to entities formed in other states of the United States, as well as other countries.) Texas citizens who expect the primary place of the business to be in Texas do not usually form a foreign business entity without a reason. One should be aware of the potential need to register as a foreign business entity in out-of-state locations where a Texas business entity conducts business.

19. Trusts - Trusts are substantially different than corporations, and are not necessarily registered with the secretary of state. Typically, a trust is a repository for an asset. The asset is managed by a Trustee whose duty to manage the asset according to the trust agreement is higher than any personal interest he may have. The Trustee is personally liable for the negligence of the trust and is liable to the beneficiaries of the trust for mismanagement. While the beneficiaries of the trust are shielded from the liabilities of the trust, the Trustee is substantially exposed. Trusts are not often formed to be a business entity.

20. Receiverships - Bankruptcy Estates - These are entities that are created by a Court. The business is run by an appointee of the court and not for the benefit of the owners.

21. There are special entity types that are reserved for, and must be used by, certain special businesses. These include banks, insurance company, burial associations, etc.