How to Choose the Type of Entity for a New Business
The process of choosing a form of entity for a new business can be confusing. An experienced business lawyer can help with the decision making process by listening carefully as you explain your goals, suggest an appropriate type of entity for the business and properly prepare all governing documents to form the entity.
The primary forms of entity in Texas are:
- general partnership
- limited partnership
- limited liability company
In determining which type of entity is appropriate for any given company, we consider issues of taxation, liability protection, desired management structure, ease of operation and costs. I generally defer to the business owner’s CPA for tax advice because the CPA has more information about the client’s finances than I have.
1. Partnership or Joint Venture
A general partnership can be the simplest and least expensive business entity to form because it requires no documentation or filing with any agency. As a practical matter, though, partners usually sign a written partnership agreement so as to define their respective roles and responsibilities. Because there is no filing requirement, the partnership and the individual partners can remain anonymous, allowing a certain measure of privacy.
The primary drawback to a general partnership or joint venture is that each partner is jointly and severally liable for the obligations of the partnership. That means that if a partner incurs obligations, debts or liabilities on behalf of the partnership, all partners are responsible for that obligation.
2. Corporation Formation
A corporation affords limited liability to its owners. Essentially, in the absence of fraud or some similar action, the owners have no liability for any company obligations.
Corporations require a formation document filed with the secretary of state and bylaws which define the overall management of the company. In the absence of “close corporation” formation, corporations have centralized management, with directors and officers being elected each year. Corporations must allocate profits and losses pro rata to the shareholders and such allocation cannot be varied. In addition, except for Subchapter S corporations, the entity is subject to double taxation, once at the corporate level and again when profits are distributed to the shareholders.
3. Limited Partnership
A limited partnership is formed by 2 or more individuals or entities, with one person being the general partner and the others being limited partners. The general partner has unlimited liability for partnership obligation but the limited partners do not. The limited partners are liable for the company obligations only to the extent of their capital contribution to the partnership. Essentially, a limited partner can lose all the money he contributed to the partnership but will not be liable for any loss above his investment.
Management of the limited partnership is vested in the general partner and the limited partnership have no, or very little, right to influence the management of the company. While a written partnership agreement is not required, most limited partners want a written agreement so the general partner will be held to operation of the company in accordance with a partnership agreement.
A drawback of a limited partnership is that it is a little more complicated to form than other types of entities. Formation of the limited partnership includes formation of the second entity to act as general partner. Since the general partner has unlimited liability, we usually create a corporation or LLC to serve as general partner with a 1% ownership interest in the company. That causes additional legal and accounting fees to be incurred.
4. Limited Liability Company
A limited liability company can be seen as a sort of hybrid of a corporation and a partnership. The LLC has centralized management through its members or its managers, similar to a corporation and has pass through taxation similar to a partnership.
Limited liability companies can be very flexible in determining their internal structure. The members who own the company can agree, through an operating agreement, how the company will be managed. The LLC may have managers (similar to directors of a corporation) or it may choose to be managed by the members (similar to a partnership managed by the partners).
Limited liability companies afford their members liability protection similar to those afforded by the corporate structure, or perhaps even more. For instance, if a shareholder of a corporation owes a debt, the creditor may be able to have the stock turned over to him to satisfy the debt, thereby gaining some management control over the company. On the other hand, if a member owes a debt, the creditor can not get the member's interest or management control of the company. He can only get the right to receive distributions that the member would otherwise receive.
Because limited liability companies are very flexible, great care must be taken when preparing the operating agreement. As a minimum, we must consider the intent of the members with respect to management of the business, capitalization, and sharing profits and losses. Members should also consider entering into a member agreement that defines how interests will be transferred voluntarily or upon the death, disability, termination of employment, or divorce of a member.
Talk to a Business Lawyer About Forming a New Company
My opinion as to what you should do when forming a new company? Talk to your CPA and your business lawyer. Set the company up right from the beginning to avoid unnecessary problems and expense later on.
Please remember that this article is only a brief description of the primary types of entities formed in Texas and your specific goals and business needs will determine which entity is right for you.