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Creating a New Business Entity

The First Steps

    A single owner of a business gains benefits from forming an entity. The several owners of a multi-owner business gain tremendous benefits from forming an entity. There are some detriments, as well. Which type of entity, then, is the best? Only rarely will it be a corporation.

    First, the type of entity to create is a different question from what type of federal income taxation to select. Often, accountants and friends will say, "You need to from an S corporation." But, there is no such thing as an "S corporation." There are entities that can be taxed under sub-chapter S of the Internal Revenue Code, and these are corporations, partnerships and limited liability companies. So, often, the first decision is what type of federal income taxation is "best" for you: sub-chapter S, sub-chapter K, sub-chapter C, or even to have all tax transactions simply be placed on your own Form 1040 or Form 1120. Note that when four persons want to start a business, it is possible that sub-chapter C is "best" for you, sub-chapter S is "best" for another, having the entity be totally disregarded is "best" for one and sub-chapter K is "best" for one. Therefore, the only best type of entity is the one that is best for the owners. Both determining the type of taxation and determining the type of entity requires fact-finding by an attorney. A limited liability company (LLC) with more than one owner, and a limited liability partnership (LLP), may choose whether to be taxed under sub-chapter C, sub-chapter S or sub-chapter K.

    Protection of Personal Assets. Generally, the main reason persons have a separate entity is to contain the liability for the entity’s acts or omissions to the entity’s own assets. Major corporations do this, not just individuals. There are a couple of things to consider, though. (1) A general partnership does not provide this asset protection. A general partnership may be formed without even knowing it, so intentionally creating an entity with asset protection can lead to enhanced protection. (2) A person is always liable in a suit for that person’s own torts-the type of claim that is most likely to have large damages. So, an entity will not fully protect you from being personally liable, if you are the only actor. Whether there are employees who act for the business makes the real difference in your potential personal liability. Note however, that contract liabilities are generally limited by using an entity, even when there are no employees. (3) If you have nothing you need to protect, protection of personal assets has little relevance. Many persons in Texas have almost no assets that a lawsuit judgment creditor could obtain (judgment creditors generally cannot obtain your home, cars, furnishings, or retirement plan, among other things).

    Federal Income Taxation. An entity usually provides a choice for tailoring the selection of the federal taxation scheme that is "best" for the owners. Factors include the higher amount of benefits that are deductible under "C," but those come at the price of double taxation on any distribution above salary. Many attempt to gain lower payments to FICA by using "S" rather then "K," but then "S" may trigger capital gain tax on what would otherwise never be taxed under "K." Often I have found the advice for "S" is with the illegal intention to manipulate the salary amount so low as to be fraudulent.

    Centralized Management. An entity generally provides a means for bringing unified decision making about how to use assets or business operations. A family of cousins and grandchildren with oil and gas interests is a good example of a situation where centralized management for negotiation is useful, or perhaps is even needed.

    Texas (Franchise) Margin Tax. Sole proprietors and general partnerships with only natural persons (both are the common "dba" way of doing business) do not pay a franchise tax. All of the Texas entities that generate more than $1.0 million of revenue in Texas pay a franchise tax of 1% on a calculated "gross margin" of gross revenue minus 30% or minus all wages, salaries and distributions up to a total of $300,000 per owner or employee; or, only for retail and wholesale businesses, a tax of 0.5% on a calculated "gross margin" of gross revenue minus 30% or minus certain cost of goods sold amounts.

     More Cost in a Lawsuit. For one owner, (1) creating an entity may simply create a second defendant for a lawsuit, and (2) an entity must have an attorney represent it in a lawsuit, but an individual can represent himself or herself.

Last Updated: January 15, 2010