Do You Need a Liability Limiting Entity?
Perhaps the primary consideration when determining what type of business entity you want to have is how to limit your liability. If you own a company as, say, a sole proprietor, you are personally liable for the debts of the company. Lose a big lawsuit, or default on a business debt and your other personal assets - your house, bank accounts, etc. - could be lost to satisfy the debt. However, if you have a company organized as one of the various kinds of liability limiting entities, your liability is limited to your investment in the company. Thus, your house and other assets not directly invested in the company are not at risk of being lost.
There are, broadly, three types of liability limiting entity which would be considered appropriate for most small businesses: the Corporation, the LLC, and the Limited Partnership. The choice of which entity is right for you may be as much a question for your CPA as for your attorney, but in all three your liability is substantially limited.
Corporations: There are two general kinds of corporation, C-Corps and S-Corps. The difference has to do with how the entity is treated for federal taxes purposes. C-Corporations are the typical corporation where corporate income and losses are realized and taxed at the corporate level, and profits are then distributed to the shareholders who report those on their own income taxes. S-Corporations “pass through” their taxes to their shareholders, so the shareholders individually realize corporate income and losses on their personal tax returns. Many, if not most, small companies choose the pass-through treatment to avoid the “double taxation” inherent in the C-Corporation structure. However, depending on your total income and personal tax rates, sometimes C-Corporation status is financially better. In any case, S-Corporations are limited in the number of shareholders they can have (no more than 100) and can issue only one class of stock, so the size of the expected company, the types of shares, and the total number of expected investors may help determine whether to choose C-Corp or S-Corp status.
LLCs: The Liability Limiting Company is a more recent invention which is intended to simplify and streamline business governance. Where Corporations have shareholders and directors who must hold meetings and have minutes, the LLC is a much more informal entity. All things being equal, the LLC is often a good choice for small businesses simply because of the lower paperwork requirements for ongoing corporate governance. Texas is one of the few states that allow "nested LLCs" where several related businesses can be held, and franchise tax reporting handled, by one 'parent' LLC. This can have advantages in ease of administration while protecting the assets of one LLC from liability arising from the operation of a different LLC. However, the IRS has not made clear how it intends to treat these entities and so it is wise to tread carefully.
Limited Partnerships: The Limited Partnership is a structure that is useful when there will be more passive investors than active managers of the company. The “limited partners” are limited in two senses - their control over company governance is limited, and their liability for losses is limited to their investment. Limited Partnerships have a General Partner who has effective control over the company and who is personally liable for the debts of the company. Texas has the additional “Limited Liability Limited Partnership” (LLLP) structure available which affords the general partners liability protection. LPs and LLLPs are most often found in real estate businesses, where large numbers of passive investors put money into the development of commercial or retail real estate which is then managed by the general partner. However, the LP is not limited to real estate: one of the more famous non-real estate limited partnership is Cable News Network (CNN), which is organized as a LLLP under Delaware law.
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