STARTUP WEEK - Business Entities
This is the first installment of Startup Week here at AustinTechnologyLawBlog.com. We’ve talked with some small companies here in Austin and there was a request to focus our attention on some of the legal issues facing a local start-up. So we were happy to oblige.
This first blog post focuses on business entity selection and will try and give a quick summary of the more popular Texas entities and give some advantages and disadvantages of each. It is important to notice that this information is meant to be educational and informative for the public, anyone attempting to form a business entity should consult an accountant and an attorney before forming an entity. This does not constitute legal advice in anyway. Personal wealth, investments, future investors, as well as a number of other issues can significantly change the outcome of the entity selection.
Sole Proprietor
A sole proprietorship is one of the most common and simplest forms of a business entity. When an individual begins work without formal registration with the state the individual/company is seen as a sole proprietor. The default entity for an individual, a sole proprietorship is the easiest to form and least expensive business entity out there (grand total of $0, unless you operate under a name other than your own surname then you would need to reserve an assumed name). The money from the business flows directly to the owner, and the owner can distribute the money as he/she sees fit. However, with such freedom comes much responsibility. The biggest trade off here is likely that a sole proprietor must assume all liability of the company. If the company defaults on a contract, an employee wrecks a car, someone slips and falls, etc. and damages are due from the company, not only would the company assets be subject to the judgment, but so would the owner’s personal assets.
Partnership
“[A]n association of two or more persons to carry on a business for profit as owners creates a partnership, regardless of whether: (i) the persons intend to create a partnership, or (ii) the association is called a ‘partnership,’ ‘joint venture,’ or other name.” (TBOC §152.051). This means that if two or more people agree to start a business together and share profits (no matter if the entity is called a partnership or not), and do nothing else, the business is a partnership. The law does not call for any formal requirements to form a partnership. Therefore, the rules of contract law apply making the creation of a partnership often quite simple and inexpensive. If one chooses a partnership, a partnership agreement should be created, but the partners will enjoy a large amount of flexibility in drafting this agreement. This contractual freedom is one of the main benefits of selecting a partnership. As long as the provisions are legal, partners may draft their agreement with very little restrictions. The partnership agreement is vital to the partnership and should govern all actions of the partnership, from distribution of funds to how to wind down the partnership. However, as with a sole proprietorship, the freedom from regulation comes at a cost. Partners are jointly and individually liable for the actions of the partnership. Therefore, if the company is liable for any action (even if it was your partner who was the cause of that liability) the assets of the business, your partner’s personal assets, and even your personal assets are subject to satisfy that liability. Personal liability is something most everyone wants to separate from their business, so it is important to make sure a partnership is not accidentally created. On occasion, two parties can come to agreement to partner together, even though the individuals (or companies) don’t intend for a formal partnership union to occur. Be cautious about ventures with others as an accidental partnership could cause you to be personally liable for the actions of others.
Limited Liability Partnership (“LLP”)
The Texas legislature has authorized the formation of registered limited liability partnerships (LLP). The major difference of an LLP and a partnership, as you can imagine by the title, is that the LLP has a limited liability. The partners are not personally liable for the negligent acts of other partners or partnership employees (except in certain limited situations) AND the partners are not personally liable for the contractual obligations of the LLP. The protection of the partners from these liabilities makes this business entity a substantially better choice than a partnership in most cases. The LLP, as with any business entity, cannot afford a partner a personal liability protection from his own actions. A partner is liable for his own tortious actions and no business entity will shield him from that personal liability. As with the partnership, the LLP should maintain a partnership agreement, which is similarly very flexible. However, an LLP must file with the state. To receive this protection with the LLP, one must register with the Texas Secretary of State and follow the appropriate guidelines (TBOC §152.802), follow the naming requirements (TBOC § 5.063) and carry insurance (TBOC §152.804).
Corporation
A corporation is a separate legal entity which comes into existence by charter from the state. Being a separate entity, a corporation can be thought of as an entirely other person with certain benefits (a perpetual life) and obligations (must pay taxes, can be sued, and can contract). A corporation can be for profit or nonprofit, but this review will only cover for-profit corporations. A for-profit corporation can be a (i) publicly traded general corporation, (ii) general corporation not publicly traded, and (iii) a close corporation. Generally, shareholders, through their bylaws, may establish their own decision making process and freely transfer their ownership rights, subject to the laws of Texas. The structure of the corporation generally provides for shareholders to purchase stock, then elect board members who then appoint directors. Issues such as elections, voting requirements, make up of a quorum, duties and rights of shareholders, board members, and directors are all determined by the bylaws. These bylaws can be somewhat flexible, but are governed by Texas law.
A corporation provides limited personal liability for shareholders ensuring they will only be held accountable for their investments in the stock of the company. However, the limited liability protection afforded shareholders of a corporation can be bypassed if the corporation does not act as a separate entity. The legal terminology for losing this corporate protection is called “piercing the corporate veil.” If a liability occurs (debt, lawsuit, etc), a claimant will try and “pierce the corporate veil” by proving the shareholder(s) did not treat the corporation as separate entity. Texas courts look at several factors to determine whether the shareholders treated the corporation as separate entity, such as: whether a corporation does not maintain corporate documentation/records, pays employment taxes, and whether it holds a separate bank account.
Additionally, a major factor in determining whether or not to choose a corporate structure is often tax rates. A corporation is taxed on the income received and then the shareholders and directors are taxed again when the corporation disperses dividends or salaries. However, one can make an S-Election to try and alleviate this double taxation. By making an S-Election the corporation is not taxed on the income received, and the income flows directly through to the shareholders, board members, and directors. However, the S-Election comes with some catches. There is a limit on the type of investors, the number of shareholders, and the type of stock an S-Corp can have. These restrictions affect some, but not others. For instance, if you intend to deal with foreign investors, venture capital groups, or angel investors most will require a C- Corp (or a corporation without an S-Election). These investors would rather deal with double taxation rather than being subject to these corporate limitations. Alternatively, with a small company attempting to achieve a lifestyle business (not intended to be sold later down the road) these corporate limitations might not apply and thus make an S-Election a good decision. This tax election is very detailed and important and it should be noted that if one chooses an S-Election incorrectly there can be penalties. Again, please contact an attorney or an accountant before going forward with this decision.
To form a corporation, one must apply through the Texas Secretary of State for the appropriate corporate structure and follow the naming requirements (TBOC § 5.054). Make sure your articles of incorporation, bylaws, stock purchase agreements, etc are drafted as well (more to come on these issues later in the week).
Limited Liability Company (“LLC”)
A limited liability company is a hybrid entity that is neither a partnership nor a corporation, but rather a combination of both (at least to some degree). The LLC provides a limited liability for its members, provides quite a bit of flexibility in its structure, and requires significantly lower filing fees than an LLP. The members, or owners of the LLC, carry no personal liability or obligations of the LLC. This limited liability protection is the corporate half on an LLC. As in a corporation, the members are generally limited to a loss equal to the amount invested. However, it is important to note that the LLC cannot afford an individual member protection from a member’s own action. For instance, if a company provides a cleaning service and one of the members is performing the actual cleaning and negligently burns down the house, the LLC and the member performing the service will be subject to this liability. However, the other members will be afforded the protection from a personal attack (a claimant may still sue each member of the LLC, but the other members have no personal liability in this case).
The structure of the LLC can be flexible as well. An operating agreement, the governing document of the LLC, has the flexibility of a partnership agreement, with some exceptions. The flexibility of the operating agreement can cause different forms of governance. However, if no operating agreement is formed or does not address certain aspects, Texas laws provide certain defaults for an LLC. For instance, if there is no provision in the operating agreement, a member can only assign his/her ownership interest in the LLC, but the recipient of the ownership interest is not entitled to the rights and duties of a member. Therefore, an LLC allows for interest transfer like a corporation, but the rights associated with the ownership interest do not transfer, unless otherwise stated. Additionally, absent a provision in the operating agreement, the allocation of profits and losses are subject to the amount contributed (stated in the articles of formation). An LLC may have a single member or multiple members, while the management of the LLC can be by a single member, multiple members, member managers, or nonmember managers. The articles of formation or operating agreement should provide whether the member(s) can run the LLC, whether the members can appoint one or more of themselves as managers and run the operations of an LLC, or members can appoint a nonmember as a manager and the nonmember manager can run the LLC.
To form a LLC, one must apply through the Texas Secretary of State and follow the naming requirements (TBOC § 5.056). Again most every element of the LLC can be altered by an operating agreement; so much care should be given when drafting this agreement.
This summary is a brief overview of the make up of the business entities in Texas. See here for a spread sheet of the differences in these entities.
