By Preston R. Polk
When starting a business, determining which business entity structure is right for your venture can seem daunting. Limited partnership, limited liability company, corporation or a professional entity; each serves a purpose, but which one is right for you?
This article is intended to explain each entity structure and be a tool for selecting your new venture.
Limited Partnership (LP)
An LP has one or more general partners, who have managerial rights and personal liability for the partnership debts and obligations, and one or more limited partners, whose roles are generally passive and whose liability is limited to their capital contributions. An LP must have at least one general partner and one limited partner.
The disadvantage of an LP is that the general partners can be held personally liable for partnership obligations, though it is possible to mitigate this by the use of a corporate or LLC general partner. Likewise, the limited partners could face personal liability if they are also a general partner or if they participate in the control of the business; a limited partner’s limited liability hinges on non-participation in the management and control of the LP. Accordingly, the limited partners have very little say in the management of the LP. Because a general partner is always personally liable for the debts and obligations of the LP, limited partners that are truly passive can enjoy limited liability in most cases.
An LP is often used in estate planning and for asset protection purposes. Additionally, if the business plans to distribute most of the profits to investors, the LP may be a good option.
Corporation
Corporations offer advantages in terms of limited liability, centralized management, and ease of transferability of ownership. Management of a corporation is vested in its board of directors, with shareholders, in most cases, taking a more passive role in the management of the corporation.
The main disadvantage of a corporation is the default tax treatment of corporations resulting in “double taxation”—both the corporation’s income and distributions to shareholders are taxed. However, an election to be taxed as an S-Corporation can relieve the corporation from incurring this “double taxation.”
Corporations are commonly used by business owners seeking venture capital or other corporate financing, plan to go public, anticipate significant growth, seek to increase the value of the business, and/or maintain a large capital base for the corporation’s activities. The S-Corporation election makes the corporate structure attractive for small companies.
Limited Liability Company (LLC)
First adopted in Texas in 1991, LLCs have gained popularity at rapid speed. LLCs have the benefits of being able to be taxed as a disregarded entity (if single member) or a partnership (if multiple members), the contractual flexibility of a partnership, and the liability protection like a corporation. Unlike corporations, in which many of the provisions for the ownership and management of the entity are provided for in state statute, owners of LLCs are free in many respects to make their own rules regarding the management and financial terms for an LLC through the company agreement. Although the Texas Business Organizations Code contains default rules related to the management of LLCs, a company agreement is able to waive or modify those default rules to fit the goals and objectives of the entity.
Management of LLCs depends on whether the LLC elects to be managed by managers or by its members. Managers handle the day-to-day operations of the company and oversee a majority of the control. Some actions, like entering into a sale of substantially all of the company’s assets, may be required to be voted on and approved by the members. In manager-managed LLCs, members are able to have a more passive role in the day-to-day operations of the company, while still having a voice on some of the “bigger” issues. On the other hand, member-managed LLCs are operated solely by the members of the company.
The LLC is frequently used by business owners, small and large, who seek limited liability protection along with business asset protection, in a simple or complex type of entity. Accordingly, there is no question of why LLCs have become so popular. In most cases, the LLC is an appropriate choice for your new venture.
Professional Entity (PE)
If your business will be performing professional services, such as attorneys, architects, CPAs, etc., a PE would be right for you. A PE can be a Professional Corporation (PC), Professional Association (PA), or Professional Limited Liability Company (PLLC). The professional designation in-it-of-itself does not alter the liability protections or default tax treatments for such entities, but does have additional requirements for the owners, members, governing or managerial personnel. For example, such individuals must be licensed to practice the professional service in the state of the entity’s formation. Another key item to note is that the liability protection for claims accruing from sources other than the business owner’s activities does not extend to protection from professional malpractice of the owner.
Sole Proprietorship/General Partnership
Although not listed above, a sole proprietorship or general partnership are entity structures that are available in Texas. However, unlike the other entity structures described above, a sole proprietorship or general partnership may be formed without the filing of a certificate of formation with the Secretary of State of Texas. However, an assumed name filing is required if the business is conducted under an assumed name.
The pitfall of a sole proprietorship and general partnership is that neither offer liability protection to the entity owners; likewise, the entity owner’s personal debts and obligations may be collected from assets of the entity. Thus, it is generally preferable to form an entity with limited liability to protect the business’s owners from personal liability exposure to debts and obligations of the sole proprietorship or general partnership.
This article is provided for educational purposes only and does not constitute legal advice. Cantey Hanger LLP encourages you to consult with an attorney to assist you in identifying the best entity structure for your business venture.
Preston Polk is an attorney in Cantey Hanger’s Business Transactions practice area. He can be reached at ppolk@canteyhanger.com.