Kelly M. Davis & Associates

Types of Business Entities in Texas

The General Partnership

A general partnership is exactly that: An enterprise between two or more partners. It is perhaps the simplest of business entities. In Texas, two statutes are especially important concerning partnerships; The Texas Uniform Partnership Act and the Texas Revised Partnership Act. On this page, the term "partnership" means a general partnership. Different rules apply for limited partnerships.

Forming a partnership is easy. All that one has to have is an association between two or more partners that they will associate for a common enterprise, and share the profits and losses from that enterprise. A partnership does not have to use a special name, and it does not have to file anything with the Secretary of State of Texas to begin its existence. A partnership may exist even when there is no written or oral agreement to form one; the mere association and sharing of profits and losses can create a partnership. A partnership may be perpetual in nature, although typically the partnership agreement limits its term.

Because of the foregoing, one can see how easy it is to get into sticky situations without realizing it. Therefore, a written partnership agreement that sets out the partners' responsibilities and ownership interests and the way the partnership is going to work is probably a vitally necessary document to have.

A partnership is not its own "person" under the law. It is merely a vehicle for its owners to use to accomplish their business purposes. This means that all profits and losses will be passed directly to the owners, either in equal proportions (if there is no agreement providing for different ownership interests) or in proportion to their respective ownership interests (if there is such an agreement). It also means that the partners are personally responsible for the partnership's debts and for claims against the partnership. General partners have joint and several liability for those debts and claims.

The owners of a partnership are its general partners. A partnership must have at least two partners, but beyond that there is no restriction on the number or type of owners it may have. It can be owned by any number of individuals or business entities. There may be different classes of ownership interests in the same partnership. Partners may transfer their interests, but there is fully substitution of the transferee only if the partnership agreement provides for substitution.

All partners must make a contribution to purchase their interest in the partnership, but there are no limitations on what kind of property may be contributed. Partners may, and usually do, participate in the partnership's management. The withdrawal, death, or retirement of a partner triggers an "event of withdrawal," which may or may not lead to a winding up (that is, a closing down) of the partnership.

Generally, partnership interests are not subject to the provisions of the Securities Act of 1933. However, the Act may apply to a partnership interest if the partner lacks the power or ability to participate in the partnership's decisions. You should consult with an attorney experienced in securities law if you have any questions in this area.

Because profits and losses pass through the partnership to its owners, income is taxed at the partners' level. Special allocations of tax items are permitted if the entity is a partnership for tax purposes. Contributions on the formation of the partnership are not taxable unless there is a disguised sale or the partnership is relieved from debts. Partners may deduct their shares of partnership losses subject to their basis limitations, but the partnership debt is included in calculating the basis. The IRS's "at risk" and "passive activity" limitations apply to a partnership. Distributions are not taxable to the extent of a partner's tax basis in the partnership interest, earnings and profits. The liquidation of a partnership is not taxable to a partner to the extent of the partner's tax basis in the partnership interest. Partnerships are not subject to the Texas franchise tax.

Typically, there is no mechanism for a partnership to qualify to conduct business in another state. If you plan to have your partnership do business outside of Texas, you should speak with an attorney in that state who is experienced with its laws and regulations concerning foreign partnerships.

If you decide to form a general partnership, you should stay alert to these important points:

1. Remember that the partnership laws in Texas are quite broad, and it is easy to take on more than you intended. The best way to define everyone's rights, privileges, and duties in your partnership is to have a written partnership agreement. Depending on how extensive your business is going to be, drafting that agreement might be expensive, but the money you spend at the beginning of your venture could save you much more money later on, particularly if disagreements arise between the owners.

2. Remember that a general partnership offers no shield from personal liability; the owners are jointly and severally liable for the debts it incurs, and for any claims that are made against it.

3. Remember that one partner has as much authority and responsibility as any other partner. The word is taken literally; partners share the profits, the losses, and the consequences of their decisions. It is just as important for all the owners to know what is going on in a small partnership as it is in a big corporation.

To look at the other kinds of business entities that are available, click on one the following:

The Sole Proprietorship

Very simply, the sole proprietorship is you, all alone, conducting your business. With all the attention paid to corporations, partnerships, limited liability companies, and the other more complex business vehicles in the commercial world, it is still true that many businesses, especially small ones, are simple sole proprietorships. This should not be all that surprising. Many young businesses are "mom and pop" enterprises, with both the decision-making and the work output resting in the hands of very few, even one, number of people. Many professionals, too, practice their work by themselves, and they avoid the record-keeping and report-filing responsibilities that the government imposes on many kinds of business entities.

There are no special requirements in Texas for forming a sole proprietorship. All one has to do is start one's business. Many sole proprietors use a business name (e.g., John Smith the programmer might want to market his services as "Smith Programming Consultants"). This is entirely legal; however, the businessman should check with the county clerk in his county to see if the name he wants to use in his business has already been registered as the assumed name (sometimes called a "doing business as") of another company. If so he will need to choose a different name. If the name he wants to use is not registered to someone else, he can register it himself to protect his rights in the name as his business grows and develops its own reputation.

A sole proprietorship has no legal status in Texas apart from its owner; the two are one. This means that a sole proprietor will be personally responsible for all debts and obligations of the business as well as all claims made against it. There is no "shield" to protect the sole proprietor from creditors or claimants. On the other hand, since by nature a sole proprietorship has only one owner, although the owner will be personally liable, creditors and claimants should not be able to obtain joint and several liability against other family members, etc., who are not owners of the business.

The sole proprietor may represent himself in court. However, court proceedings can be very complicated. There are sophisticated procedural rules that govern how a case is run, and these procedural rules can cause a case to be won or lost before the judge or jury even considers the facts of the case or the law that should control it. When one adds in the constantly changing nature of the law itself, it is easy to see how overwhelming it could be to handle one's own case.

There are no shares of stock or certificates or other papers to confer ownership of a sole proprietorship. The owner simply owns all of the assets and liabilities of the business. He may buy, sell, swap, trade, or give away those assets and liabilities freely, although certain kinds of property often have to be registered (for example, motor vehicles). Tax considerations and the application of special laws dealing with the liquidation of a business, for example, the Bulk Sales Act, may also affect how one goes about acquiring or selling a sole proprietorship.

Since there is no stock in a sole proprietorship, the provisions of the Securities Act of 1933 do not apply.

Income is taxed at the owner's personal level. Similarly, the deductions that the business would be allowed to take pass through to the owner.

Another state may have special rules for how a foreign business man may do business there. If you plan to do business outside of Texas, you need to know what those qualification provisions are and how to satisfy them.

If you decide to have a sole proprietorship, you should stay alert to these important points:

1. Remember that you have "no" protection from creditors or claimants of your business. You are personally liable for the consequences of your venture. While many people tout a number of devices such as "living trusts" as a means to protect your assets from those creditors and claimants, you need to remember that in Texas an asset-saving device utilized principally to shield assets from creditors may be declared void.

2. Maintain proper records. While what you spend on your business may be deductible for tax purposes, not everything you spend is necessarily a business expense. You cannot depend on the IRS to take your word for it when it comes to any particular deduction. You should maintain separate bank accounts and sets of records for your business and your personal endeavors and document the transfer of money or property between them. When in doubt, keep a record of it!

3. Pay your taxes! The Internal Revenue Service imposes a 100% penalty on unpaid payroll taxes and it can assess this tax against any "responsible person" in the business. Just what a "responsible person" is, is too broad to discuss here, but this is the IRS's term, and you can imagine how broadly they apply it.

The Subchapter S Corporation

The Subchapter S corporation is a corporation that passes profits and losses through to its owners in the manner of a partnership. In Texas, the rules governing it are almost identical to those governing a Subchapter C corporation. A C corporation can become an S corporation by electing that status either at its incorporation or later, and by making that election with the Internal Revenue Service.

A corporation must use "Corporation," "Incorporated," "Company," or an abbreviation of one of those words in its name. It is formed by filing articles of incorporation with the Secretary of State of Texas, and by adopting bylaws for its operation. The Secretary of State charges a filing fee to record the articles of incorporation and issue a corporate charter. The corporation's term is typically perpetual unless the articles of incorporation limit its duration.

A corporation is a separate "person" under the law, and therefore, if it is properly organized and managed, it should protect its owners from any personal liability for corporate debts and obligations and from claims against the corporation. If a plaintiff "pierces the corporate veil," the shareholders are liable only to the extent of their individual ownership interests. There is no joint and several liability of shareholders.

Even though a corporation is a separate entity legally, it cannot represent itself in court. A corporate officer may represent the corporation only if he or she is a licensed attorney. The largest corporations tend to have in-house legal counsel, but most smaller enterprises use independent, outside counsel to update their corporate records, to offer legal advice on business plans and transactions, negotiate for them in business deals, and to represent them in court.

The owners of a corporation are its shareholders, who own shares of stock in the corporation. There may be no more than thirty-five shareholders of a Subchapter S corporation. Corporations, non-resident aliens, partnerships, certain kinds of trusts, pension plans or charities may not be shareholders. There may be only one class of ownership interest, but different members of that class may have different voting rights. Shareholders may freely transfer their interests to others, but they may also sign agreements (usually called "buy-sell" or "stock restriction" agreements) to restrict the transferability of their shares.

All shareholders must make a contribution to purchase their stock. This contribution may be cash, promissory notes, real or personal property, services already performed or securities. Shareholders are permitted to participate in the corporation's management. The withdrawal, death or retirement of a shareholder does not trigger the dissolution of the corporation.

The shares of stock in a corporation are securities. The provisions of the Securities Act of 1933 apply, but if the corporation is not publicly traded, Section 4(2) of the Act or Regulation D may exempt them from its provisions. You should consult with an attorney experienced in securities law before planning to offer your corporation publicly.

Income is taxed at the corporate and at the shareholder level. Stock dividends receive fairly unfavorable tax treatment by the Internal Revenue Service which are often avoided in smaller corporations, especially where the owners work daily in the company's operations and can receive bonuses in prosperous years. Special allocations of tax items are made pro rata according to the extent of stock ownership. Contributions on the formation of the corporation are taxable unless the transferors meet the 80% control test of Section 351 of the Internal Revenue Code. Shareholders may deduct subject to basis limitations, and the corporate debt is not included in calculating the basis. The IRS's "at risk" and "passive activity" limitations do apply if the corporation is a closely-held corporation. Distributions generally are not taxable to the extent of the shareholder's basis in his stock. The liquidation of a corporation is taxable at the shareholder level via a flow-through of the corporate items.

Most states have requirements to qualify a foreign corporation to do business in their state. If you plan to have your corporation do business outside of Texas, you need to know what those qualification provisions are and how to satisfy them.

If you decide to form a corporation, you should stay alert to these important points:

1. Make sure the corporation is properly formed. You must file articles of incorporation with the Secretary of State before the State of Texas can issue a charter for your corporation. After that, you must adopt bylaws, elect a board of directors, issue stock to the shareholders and receive payment for that stock. It is also important to make sure that you capitalize your corporation adequately for its initial operations.

2. Maintain proper records. Your corporation should have its own bank accounts. Shareholders and directors should hold annual meetings, as well as special meetings whenever major matters of policy need to have guidance and decision. These meetings should be recorded in corporate minutes and kept in the corporate books.

3. Do not use the corporation as an extension of someone's personal will. In order to qualify for the corporate shield from personal liability, an owner needs to let the corporation live its own existence, separate from his life. The corporation should not pay personal expenses of the owner, or be standing in the owner's shoes for personal matters. If you fail to keep the line between your personal and corporate lives clean and distinct, you may wake up one day facing extensive personal liability for corporate actions.

4. Pay your taxes! The Internal Revenue Service imposes a 100% penalty on unpaid payroll taxes, and it can assess this tax against any "responsible person" in the corporation. Just what a "responsible person" is, is too broad to discuss here, but this is the IRS's term, and you can imagine how broadly they apply it! The State of Texas charges a franchise tax, too. Failure to pay the franchise tax can result in the forfeiture of your corporation's right to do business in Texas, and it will subject owners and others in control to personal liability for certain claims against the corporation.

The Limited Partnership

A limited partnership is sort of a hybrid of a general partnership and a corporation. It provides protection for its limited partners from debts and claims of the business entity, but it allows the partners to pass profits and losses directly through the entity to them. It is similar to, but slightly different from, a general partnership in that there are two different kinds of partners. On this page, the term "partnership" means a limited partnership.

To form a limited partnership, the partners must enter into a written or an oral partnership agreement. They must also file a certificate of limited partnership with the Secretary of State of Texas. There is a filing fee for the certificate of limited partnership. Although an oral partnership agreement will work to form a limited partnership, one should be aware that it is very easy, inadvertently, to turn what one thought was a limited partnership into a general partnership. For that reason alone, it is probably a better idea to have a written partnership agreement defining the general and limited partners and their respective rights and duties. Although a partnership may have a perpetual term, typically the partnership agreement specifies a limited term for its existence.

A limited partnership must use the term, "Limited," "Limited Partnership," "Ltd.," or "L.P." in its name.

A partnership is not its own "person" under the law. It is merely a vehicle for its owners to use to accomplish their business purposes. This means that all profits and losses will be passed directly to the owners, either in equal proportions (if there is no agreement providing for different ownership interests) or in proportion to their respective ownership interests (if there is such an agreement). Also, the general partners have joint and several liability for the partnership's debts and for claims made against it. The limited partners usually have individual liability for partnership debts and claims against it only to the extent of their ownership interests. However, if a limited partner takes a role in the management and operation of the partnership, he or she may be deemed to be a general partner with a general partner's joint and several liability.

The owners of a limited partnership are its general and limited partners. A partnership must have at least one general partner, at least one limited partner, and at least two different partners. In other words, the same person or entity cannot be both the general and the limited partner. The general partners are responsible for the day-to-day operation and management of the partnership, while the limited partners have much more restricted roles in its management. There are no restrictions on the number or type of partners the limited partnership may have. It can be owned by any number of individuals or business entities. There may be different classes of ownership interests in the same partnership. Partners may transfer their interests, but there is fully substitution of the transferee only if the partnership agreement provides for substitution, and there may be tax issues that arise from a freely transferable interest.

All partners must make a contribution to purchase their interest in the partnership. The contribution must be cash, property, services rendered or a promissory note or other obligation. General partners may participate in the partnership's management, but the participation of limited partners is restricted.

The withdrawal, death or retirement of a general partner triggers an "event of withdrawal," which may or may not lead to a winding up (that is, a closing down) of the partnership. The partnership's regulations may provide that a general partner's withdrawal, death or retirement does not trigger partnership dissolution, but this may raise a tax issue. The death, withdrawal or retirement of a limited partner does not trigger an "event of withdrawal."

The general partners' interests are not subject to the provisions of the Securities Act of 1933. The limited partners' interests are "securities" under the Act, but may be exempt from the provisions of the Act if the partnership is not publicly traded. If you have any questions about how the Securities Act affects partnership interests, you should consult with an attorney experienced in securities law.

Many states have mechanisms for a foreign limited partnership to qualify to do business there. If you plan to have your limited partnership do business outside the State of Texas, you should speak with an attorney in that state who is experienced with its laws and regulations concerning foreign partnerships.

If you decide to form a limited partnership, you should stay alert to these important points:

1. Do your paperwork. While literally nothing is required to form a general partnership, you must file a certificate of limited partnership, and you must have a (preferably written) partnership agreement. Also, there must be some form of partnership agreement defining everyone's roles, rights and duties. An oral agreement is only as good as the audience's memory. A written agreement is probably a better idea.

2. Keep your roles straight. The difference between a general and a limited partner is an important one, and it is very easy for a limited partner to lose his protection from personal liability by doing things that make him a general partner. The bigger the role a partner plays in managing the partnership, the more likely that partner is to be considered a general partner.

3. Remember that a general partner has no shield from personal liability; he is jointly and severally liable for the debts the partnership incurs, and for any claims that are made against it.

The Limited Liability Company

A limited liability company is a relative newcomer to Texas business law. It offers tax treatment similar to that of a general partnership and limited partnership while providing protection from personal liability for business debts and claims like that of a corporation. The limited liability company does its business through managers, who may be the owning members or who may be acting on their behalf, depending on how the entity is set up. One word of caution: Because the limited liability company is a relatively new and hybrid kind of entity, the Internal Revenue Service may try to classify the entity as a corporation for tax purposes.

To form a limited partnership, the members file articles of organization with the Secretary of State for Texas, and they adopt regulations. These documents are similar to the articles of incorporation and bylaws found in a corporation. There is a filing fee to file the articles of organization.

A limited liability company partnership must use the term, "Limited Liability Company," "Limited Company," "L.L.C.," "LLC," "L.C.," or "LC" in its name. Typically, it has a limited term of existence in its articles of organization.

If properly formed and run, the limited liability company will shield its owners from personal liability for the business' debts and claims against it. This is very important, because if the business enterprise were to be classified as a partnership, the owners could have joint and several liability for the debts and claims.

The owners of a limited liability company are its members. There is no limit on the number of types of members a limited liability company may have, but it must have at least two members to be considered a partnership for tax purposes. It can be owned by any number of individuals or business entities. There may be different classes of ownership interests among the members. Members may transfer their interests with full substitution for the transferee if the articles of organization permit it, but there may be a tax issue if ownership interests are fully transferable.

Members must make a contribution to purchase their interest in the limited liability company. The contribution may be cash, property, services rendered or a promissory note or other obligation to pay cash or transfer property. The members may participate in the company's management, but the participation of limited partners is restricted.

The withdrawal, death or retirement of a general partner dissolves the limited liability company unless the regulations provide otherwise, in which case there may be a tax issue arising from the non-dissolution.

The members' ownership interests may be subject to the provisions of the Securities Act of 1933. Whether they are "securities" under the Act probably depends on the level of member participation. If you have any questions about how the Securities Act affects members' interests, you should consult with an attorney experienced in securities law.

Income in a limited liability company is taxed at the partners' level if the company is properly structured. Special allocations of tax items are permitted if the entity is a partnership for tax purposes. Contributions on the formation of the company are not taxable unless there is a disguised sale or the member is relieved from debts. Members may deduct their shares of company losses subject to their basis limitations, but the company's debt is included in calculating the basis. The IRS's "at risk" and "passive activity" limitations apply to a limited liability company. Distributions are not taxable to the extent of a member's tax basis in the company interest. The liquidation of a limited liability company is not taxable to a member to the extent of his tax basis in the company's interest. Limited liability companies are subject to the Texas franchise tax.

Most states have mechanisms for a foreign limited liability company to qualify to do business there. If you plan to have your company do business outside the State of Texas, you should speak with an attorney in that state who is experienced with its laws and regulations concerning foreign limited liability companies.

If you decide to form a limited liability company, you should stay alert to these important points:

1. Do your paperwork. You must file articles of organization and prepare regulations to constitute your limited liability company. If you neglect these steps, you may find that you have created a general partnership, exposing you and your colleagues to joint and several liability.

2. Stick to your game plan, especially concerning tax treatment of your business. Your company's tax treatment, and your own as its owner, are vastly different depending on whether your LLC is considered a corporation or a partnership for tax purposes. You should consult with your accountant or tax consultant, and with your attorney, to determine the type of tax treatment you want to have, and to learn how you need to structure and operate your LLC to obtain that treatment.

3. Pay your taxes! The Internal Revenue Service can seek a one hundred percent penalty for unpaid payroll taxes from a "responsible person" within the company. Just what a "responsible person" is can be complicated, but as you can tell from the generality of the term, it can turn into a dragnet that could well snare you, one of the company's owners. Also, the State of Texas collects a franchise tax on LLC's, and failure to pay this tax can cause your company to lose its right to do business in Texas and can expose its owners to liability for the company's debts and claims against it.

The Subchapter C Corporation

The Subchapter C corporation is the typical corporation most people have heard of. In Texas, it is governed by the provisions of the Texas Business Corporations Act, and it comes in two flavors: The regular corporation, and the close, or "closely-held", corporation. Close corporations are formed by following the provisions of Article 12 of the Texas Business Corporations Act. For most purposes, what follows will be the same for a regular and a close corporation in Texas. Where the close corporation receives different treatment, this page will note that difference.

A corporation must use "Corporation," "Incorporated," "Company" or an abbreviation of one of those words in its name. It is formed by filing articles of incorporation with the Secretary of State of Texas, and by adopting bylaws for its operation. The Secretary of State charges a filing fee to record the articles of incorporation and issue a corporate charter. The corporation's term is typically perpetual unless the articles of incorporation limits its duration.

The owners of a corporation are its shareholders, who own shares of stock in the corporation. There is no restriction on the number or type of owners a corporation may have; it may be owned by a single individual or by several shareholders, and other business entities can own stock in a corporation. There may be different classes of ownership interests in the same corporation. Shareholders may freely transfer their interests to others, but they may also sign agreements (usually called "buy-sell" or "stock restriction" agreements) to restrict the transferability of their shares.

Income is taxed at the corporate and at the shareholder level. Stock dividends receive fairly unfavorable tax treatment by the Internal Revenue Service, and so are often avoided in smaller corporations, especially where the owners work daily in the company's operations and so can receive bonuses in prosperous years. There are no special allocations of tax items in corporations. Contributions on the formation of the corporation are taxable unless the transferors meet the 80% control test of Section 351 of the Internal Revenue Code. Shareholders may not deduct corporate losses. The IRS's "at risk" and "passive activity" limitations do apply if the corporation is a "closely-held" corporation. Distributions are taxable to the extent of earnings and profits. The liquidation of a corporation is taxable to both the corporation and the shareholders.

If you decide to form a corporation, you should stay alert to these important points:

3. Do not use the corporation as an extension of someone's personal will. In order to qualify for the corporate shield from personal liability, an owner needs to let the corporation live its own existence, separate from his life. The corporation should not pay personal expenses of the owner or be standing in the owner's shoes for personal matters. If you fail to keep the line between your personal and corporate lives clean and distinct, you may wake up one day facing extensive personal liability for corporate actions.