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2007 Transactional Academy. Choice of Business Entity Presented by: Jim Browne. Choice of Business Entity. Client: “I’m starting a widget manufacturing business. Do I need to form a legal entity to conduct the business, and if so, what’s the best type of entity to use?”.

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2007 Transactional Academy

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2007 transactional academy l.jpg

2007 Transactional Academy

Choice of Business Entity

Presented by:

Jim Browne


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Choice of Business Entity

Client: “I’m starting a widget manufacturing business. Do I need to form a legal entity to conduct the business, and if so, what’s the best type of entity to use?”


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Choice of Business Entity

  • Summary

    • In most cases, LLC is the preferred business entity

      • No entity level tax or restrictive eligibility requirements

    • A corporation should be used only if

      • The entity’s equity interests are publicly traded

      • The entity is a consolidated subsidiary of an existing corporation, or

      • Corporate form is required by applicable legal requirements


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TX Bus. Org. Code

  • Identifies and governs types of business entities in Texas

  • Consolidation of multiple prior laws

  • Effective for entities formed on or after 1/1/06

    • And LLPs filing or renewing registration on or after 1/1/06

  • Effective for existing entities 1/1/10

    • Procedures provided for early adoption


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TX Bus. Org. Code

  • Types of entities under the TBOC

    • Corporations

      • For profit corporations

      • Nonprofit corporations

    • Limited liability companies

    • Partnerships

      • General partnership

      • Limited partnership

      • Limited liability partnership

    • Real estate investment trusts

  • Associations

    • Cooperative associations

    • Unincorporated nonprofit associations

  • Professional entities

    • Professional associations

    • Professional corporations

    • Professional limited liability companies


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TX Bus. Org. Code


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Choice of Business Entity

  • Most commonly used business entities:

    • Sole proprietorship

    • Corporation

      • C corporation (CC)

      • S corporation (SC)

    • Limited liability company (LLC)

    • Limited partnership (LP)

      • Publicly traded partnership (PTP or MLP)

    • General partnership (GP)

    • Limited liability partnership (LLP)


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Choice of Business Entity

Sole Proprietorship


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Sole Proprietorship

  • Non-tax factors

    • No formal organizational requirements

    • No limited liability

    • No continuity of life – owner’s death terminates business

    • Transferability of interests – only by sale of business assets

    • Access to capital – limited

    • Management/Governance – no formal requirements


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Sole Proprietorship

  • Taxation

    • Number/type of equity owners: >1 owner = partnership

    • No entity level tax (federal or state); earnings taxed directly to owner (Form 1040, Schedule C)

    • All earnings are subject to self-employment tax

      • 15.3% on base amount ($97,500 for 2007)

      • 2.9% on earnings in excess of base amount

  • Evaluation

    • Lack of limited liability generally makes this form of conducting business inadvisable


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Choice of Business Entity

C Corporation


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C Corporation

  • Non-tax factors

    • Organization

      • Certificate of Formation

      • Supplemental Provisions (TBOC 3.007)

    • Limited liability, continuity of life, and free transferability of interests

    • Access to capital – most flexible

    • Management/governance

      • Very formal requirements

      • Failure to observe formalities can result in loss of limited liability


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C Corporation

  • Taxation

    • Number/type of equity owners: no limitation

    • Federal income tax - double taxation

      • Entity level tax (35% max.); no income or loss flow through

      • Distributions of earnings to owners taxed (generally 15% max.)

      • Property contribution or distribution generally taxable

      • Sale of business

        • Sale of stock: single tax to stockholders; carryover tax basis

        • Sale of assets: double tax to stockholders; stepped up tax basis


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C Corporation

  • Taxation (con’t)

    • State taxation – generally same as federal

    • Employment taxes

      • Wage withholding on compensation payments to employees

      • Distributions of residual profits (i.e., dividends) not subject to employment tax


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C Corporation

  • Evaluation

    • Imposition of double taxation makes using a C corporation inadvisable

    • Generally used only when

      • The entity’s equity interests are publicly traded

      • The entity is a consolidated subsidiary of an existing corporation, or

      • Corporate form is required by applicable legal requirements


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Choice of Business Entity

S Corporation


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S Corporation

  • Non-tax factors

    • Organization

      • Same as C corporation

      • File IRS election (subject to eligibility requirements)

    • Limited liability and continuity of life

    • No free transferability of interests (due to IRS eligibility requirements)

    • Access to capital: limited (due to IRS eligibility requirements)

    • Management/governance – same as C corporation


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S Corporation

  • Taxation

    • Eligibility requirements

      • Domestic corporation

      • Not more than 100 shareholders

      • Generally only individuals as shareholders

      • No foreign shareholders

      • Only one class of stock

      • Not a bank on reserve method or an insurance company

      • Other


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S Corporation

  • Taxation (con’t)

    • Federal income tax – partial flow through taxation

      • SC’s income is reported by shareholders; stock basis adjusts

      • Losses limited to stock basis (excluding entity level debt)

      • No special allocations

      • Cash distributions taxed only if > stock basis (excluding entity level debt)

      • Property contribution or distribution generally taxable

      • Sale of business

        • Single level of tax whether stock sale or asset sale

        • Deemed asset sale election available under Sec. 338(h)(10) (requires ≥ 80% stock purchase and 100% gain recognition)


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S Corporation

  • Taxation (con’t)

    • State taxation

      • Texas – same as C corporation

      • Other – varies; most same as federal

    • Employment taxes – same as C corporation

      • Might allow residual profits to escape self-employment tax even if owner is actively involved in the operation of the business


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S Corporation

  • Evaluation

    • Numerous drawbacks

      • Eligibility requirements (easily breached)

      • No stock basis for entity level debt

      • Taxation of property contributions/distributions

    • Result = LLC generally a preferable alternative

    • Minor potential advantage = no self-employment tax on residual earnings (?)


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Choice of Business Entity

Limited Liability Company


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Limited Liability Company

  • Non-tax factors

    • Organization

      • Certificate of formation

      • Supplemental provisions (TBOC 3.010)

    • Limited liability and continuity of life

    • Transferability of interests: can’t be “publicly traded”

    • Access to capital:

      • Limitation on publicly traded status

      • Flow through taxation complex and problematic for tax exempt and foreign investors


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Limited Liability Company

  • Non-tax factors (con’t)

    • Management/governance:

      • less formality than a corporation

      • Can be member managed (similar to a general partnership) or manager managed (similar to a corporation)


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Limited Liability Company

  • Taxation

    • Number/type of equity owners: no limitation (subject to limitation on publicly traded status)

    • A single member LLC’s default classification for federal tax purposes = disregarded entity

      • If owner = individual, LLC = sole proprietorship

      • If owner = entity, LLC = unincorporated division or branch

    • A multiple member LLC’s default classification for federal tax purposes = partnership

    • An LLC can elect to be treated as a corporation for tax purposes; rarely advisable


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Limited Liability Company

  • Taxation (con’t)

    • Federal income tax (default) – full flow through taxation

      • LLC members report entity’s income and adjust tax basis

      • Losses flow though to extent of tax basis (including entity level debt), subject to “at risk” and “passive activity” rules

      • Special allocations permitted if “substantial economic effect”

      • Cash distributions taxed only to the extent > tax basis (including entity level debt)

      • Property contributions/distributions generally tax free

      • Sale of business

        • Single level of tax whether equity sale or asset sale

        • Stepped up basis tax election under Sec. 754 (no 80% requirement)


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Limited Liability Company

  • Taxation (con’t)

    • State taxation

      • Texas – generally same as C corporation

      • Other – varies; most same as federal

    • Employment taxes

      • Single member LLC – same as sole proprietorship; all earnings = self-employment income

      • Multiple member LLC

        • Salary payments are subject to employment taxes

        • Uncertain whether residual profits are subject to self-employment tax


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Limited Liability Company

  • Evaluation

    • LLC is generally the preferred business entity

      • No special eligibility requirements

      • Full flow through taxation

      • Tax exempt and foreign investors often invest through a corporation (“blocker”)

    • Potential drawback = uncertainty regarding self-employment tax on residual profit

    • Consider forming LLC under non-Texas law (e.g., DE or NV)

      • “Location of the payor” rule under Texas franchise tax sources certain receipts from an LLC to the LLC’s legal domicile.


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Choice of Business Entity

Limited Partnership


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Limited Partnership

  • Non-tax factors

    • Organization

      • Certificate of formation

      • Supplemental provisions (TBOC 3.011)

    • Limited liability and continuity of life

      • Requires at least one general partner with unlimited liability

      • Corporate or LLC general partner can be used

    • Transferability of interests: can’t be “publicly traded”

    • Access to capital – generally same as LLC

    • Management/governance – similar to manager managed LLC


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Limited Partnership

  • Taxation

    • Number/type of equity owners: must be >1 owner; can’t be publicly traded (similar to multiple member LLC)

    • Can elect to be taxed as a corporation; rarely advisable

    • Federal income tax (default) – full flow through taxation

      • Same as multiple member LLC

    • State taxation

      • Texas – generally = C corporation, unless a “passive entity”

      • Other – generally same as federal

    • Employment tax – similar to S corporation


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Limited Partnership

  • Evaluation

    • Similar to, but more cumbersome than, an LLC

    • Might be used if an LLC is subject to state income tax as a corporation (as was formerly the case in Texas)

      • Note: an LLC cannot qualify as a “passive entity” in Texas

    • Might be used to mitigate uncertainty regarding self-employment tax


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Choice of Business Entity

Publicly Traded Partnership


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Publicly Traded Partnership

  • Description

    • Limited partnership that is publicly traded

    • Often referred to as a master limited partnership or “MLP”

    • Publicly traded partnership normally taxed as a corporation

    • Taxed as a partnership if 90% of income is from:

      • Interest, dividends, or real property rent or gains

      • Exploration, development, mining, production, processing, refining, transportation, or marketing of any natural resource

      • Commodities, or futures, forwards, and options on commodities


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Publicly Traded Partnership

  • Evaluation

    • Limited to industries that generate qualifying income

      • E.g., natural gas pipelines

    • Favorable tax status but enormous tax complexity

      • Tracking tax adjustments necessary to keep shares fungible requires significant accounting expense

      • Schedule K1 much more complex than Form 1099-DIV

    • Tax-exempt and foreign owners have issues (UBTI/ECI)


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Choice of Business Entity

General Partnership


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General Partnership

  • Non-tax factors

    • No formal organizational requirements

    • No limited liability (joint and several liability)

    • No continuity of life – death or withdrawal of any GP terminates business (can reconstitute)

    • No free transferability of interests

    • Access to capital: limited

    • Management/governance –

      • No formal requirements

      • Any partner can bind the partnership


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General Partnership

  • Taxation

    • Number/type of equity owners: same as limited partnership

    • Can elect to be taxed as a corporation; rarely advisable

    • Federal income tax (default) – full flow through taxation

      • Generally no at-risk or passive activity limitations on losses

    • State taxation

      • Texas – generally = C corporation, except for “passive entities” and “general partnerships of all natural persons”

      • Other – generally same as federal

    • Employment tax – similar to sole proprietorship


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General Partnership

  • Evaluation

    • Rarely advisable for a business entity, primarily due to joint and several liability


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Choice of Business Entity

Limited Liability Partnership


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Limited Liability Partnership

  • Description and effect

    • Either a limited partnership or a general partnership that registers as an LLP. See TBOC 152.802.

    • Partners have limited liability, except for negligence etc. of another partner where

      • The partner was supervising or directing the other partner

      • The partner was directly involved in the specific activity in which the negligence etc. was committed by the other partner

    • Tax effect: generally same as limited partnership


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Limited Liability Partnership

  • Evaluation

    • LLC is generally preferable to an LLP

    • Use LLP when:

      • Business can’t operate as an LLC

      • State tax implications favor LLP


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Choice of Business Entity

  • Summary

    • In most cases, LLC is the preferred business entity

      • No entity level tax or restrictive eligibility requirements

    • A corporation should be used only if

      • The entity’s equity interests are publicly traded

      • The entity is a consolidated subsidiary of an existing corporation, or

      • Corporate form is required by applicable legal requirements


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Professional Entities

  • Professional corporation or association

    • Definition:

      • Professional corporation: provides non-medical licensed professional services (e.g., architecture, law, accounting)

      • Professional association: provides medical services

    • Protects owners from entity debts and acts of other shareholders; entity has joint and several liability with owners (similar to LLP)

    • Taxation: generally same as a corporation with some special rules; can elect S corporation status

  • Professional limited liability company

    • Professional entity formed and taxed as a limited liability company


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Disclaimers

  • This document is not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors.

  • Any tax advice contained in this document and any attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter.


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